TBChap 006

Chapter 06
Making Investment Decisions with the Net Present Value Rule
Multiple Choice Questions
1. Important points to remember while estimating the cash flows of a project are:
I) Only cash flow is relevant.
II) Always estimate cash flows on an incremental basis.
III) Be consistent in the treatment of inflation.
A.
B.
C.
D.
I only
I and II only
II and III only
I, II, and III
2. Preferably, a financial analyst estimates cash flows for a project as:
A.
B.
C.
D.
cash flows before taxes.

cash flows after taxes.
accounting profits before taxes.
accounting profits after taxes.
3. When a firm has the opportunity to add a project that will utilize excess factory
capacity (that is currently not being used), which costs should be used to help
determine if the added project should be undertaken?
A.
B.
C.
D.
allocated overhead costs

sunk costs
incremental costs
average costs
6-1
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4. A reduction in the sales of existing products caused by the introduction of a new

product is an example of:
A.
B.
C.
D.
incidental effects.
opportunity costs.
sunk costs.
allocated overhead costs.
5. When Honda develops a new engine the incidental effects might include the
following:
I) demand for replacement parts;
II) profits from the sale of repair services;
III) offer modified or improved versions of the new engine for other uses
A.
B.
C.
D.
I only
I and II only
I, II, and III
I and III only
6. The cost of a resource that may be relevant to an investment decision even when no
cash changes hand is called a(an):
A.
B.
C.
D.
sunk cost.
opportunity cost.
depreciation cost.
average cost.
7. Net working capital is best represented as:

I) short-term assets;
II) short-term liabilities;
III) long-term assets;
IV) long-term liabilities
A.
B.
C.
D.
I only
(I - II)
(III - I)
(III - IV)
6-2
8. Accountants do not depreciate investment in net working capital because:
A.
it is not a cash flow.
B. it is recovered duringor at the end ofthe project, thus is not a depreciating
asset.
C.
it is a sunk cost.
D. working capital appears on the balance sheet, not the income statement.
9. One should consider net working capital (NWC) in project cash flows because:
A. typically, firms must invest cash in short-term assets to produce finished goods.
B.
NWC represents sunk costs.
C. firms need positive NPV projects for investment.
D. inclusion of NWC typically increases calculated NPV.
10. Investment in inventories includes investment in:
I) raw material; II) work-in-progress; III) finished goods
A.
B.
C.
D.
I only
I and II only
I, II, and III
III only
11. For the case of an electric car project, the following costs should be treated as
incremental costs when deciding whether to go ahead with the project EXCEPT:
A. the consequent reduction in sales of the company's existing gasoline models (i.e.,
incidental effects).
B. interest payments on debt incurred to finance the project.
C. the value of tools that will be transferred to the project from the company's
existing plants instead of being sold.
D. the expenditure on new plants and equipment.
12. The principal short-term assets are:
I) cash; II) accounts receivable; III) inventories; and IV) accounts payable
A.
B.
C.
D.
I only
I and IV only
I, II, and III
IV only
6-3
13. The current market value of a previously purchased machine proposed for use in a
project is an example of a:
A.
B.
C.
D.
sunk cost.
opportunity cost.
fixed cost.
inventoriable cost.
14. Money that a firm has already spent, or committed to spend regardless of whether a
project is taken, is called:
A.
B.
C.
D.
fixed cost.
opportunity cost.
sunk cost.
incremental cost.
15. Costs incurred as a result of past, irrevocable decisions and irrelevant to future
decisions are called:
A.
B.
C.
D.
opportunity costs.
sunk costs.
incremental costs.
marginal costs.
16. For the case of an electric car project, which of the following costs or cash flows
should be categorized as incremental when analyzing whether to invest in the
project?
A. The cost of research and development undertaken for developing the electric car
during the past three years
B.
The annual depreciation charge
C. Tax savings resulting from the depreciation charges
D.
Dividend payments
17. An analyst wishes to determine the value of resources used by a proposed project.
Which values should the analyst use to approximate opportunity costs?
A.
B.
C.
D.
book values
market values
historical values
Accounting values plus an inflation adjustment
6-4
18. If the discount rate is stated in nominal terms thenin order to calculate the NPV in a
consistent mannerthe project requires that:
A.
B.
C.
D.
cash flows be estimated in nominal terms.

cash flows be estimated in real terms.
accounting income be used.
cash flows be estimated ignoring inflation.
19. If the discount rate is stated in real terms thenin order to calculate the NPV in a
A.
B.
C.
D.

cash flows be estimated including future inflation.
20. A firm owns a building with a book value of $150,000 and a market value of
$250,000. If the firm uses the building for a project, then its opportunity cost,
ignoring taxes, is:
A.
B.
C.
D.
$100,000.
$150,000.
$250,000.
$400,000.
21. The real interest rate is 3.0% and the inflation rate is 5.0%. What is the nominal
interest rate?
A.
B.
C.
D.
3.00%
5.00%
8.15%
2.00%
22. If the nominal interest rate is 7.5% and the inflation rate is 4.0%, what is the real
interest rate?
A.
B.
C.
D.
4.0%
9.5%
3.4%
11.5%
6-5
23. Your firm expects to receive a cash flow in two years of $10,816 in nominal terms. If
the real rate of interest is 2% and the inflation rate is 4%, what is the real cash flow
for year 2?
A.
B.
C.
D.
$11,236
$10,816
$10,000
$9,246
24. Given the following data for Project M:
A.
B.
C.
D.
$51.70.
$35.54.
$45.21.
$70.00.
25. Given the following data for Project M:
A.
B.
C.
D.
$25.85.
$17.77.
$22.65.
$35.00.
26. The real rate of interest is 3% and inflation is 4%. What is the nominal rate of
interest?
A.
B.
C.
D.
3%
1.00%
7.12%
-1.00%
6-6
27. The NPV value obtained by discounting nominal cash flows using the nominal
discount rate is the same as the NPV value obtained by discounting:
I) real cash flows using the real discount rate;
II) real cash flows using the nominal discount rate;
III) nominal cash flows using the real discount rate
A.
B.
C.
D.
I only
II only
III only
II and III only
28. The real cash flow occurring in year 2 is $60,000. If the inflation rate is 5% per year
and the real rate of interest is 2% per year, calculate the nominal cash flow for year
2.
A.
B.
C.
D.
$60,000
$62,424
$66,150
$63,654
29. Proper treatment of inflation in NPV calculations involves:

I) discounting nominal cash flows by the nominal discount rate;
II) discounting real cash flows by the real discount rate;
III) discounting nominal cash flows by the real discount rate
A.
B.
C.
D.
I only
II only
III only
I and II only
30. A firm has a general-purpose machine, which has a book value of $300,000 and is
worth $500,000 in the market. If the tax rate is 35%, what is the opportunity cost of
using the machine in a project?
A.
B.
C.
D.
$500,000
$430,000
$300,000
$200,000
6-7
31. Capital equipment costing $250,000 today has 50,000 salvage value at the end of
five years. If the straight-line depreciation method is used, what is the book value of
the equipment at the end of two years?
A.
B.
C.
D.
$200,000
$170,000
$140,000
$150,000
32. A piece of capital equipment costing $400,000 today has no (zero) salvage value at
the end of five years. If straight-line depreciation is used, what is the book value of
the equipment at the end of three years?
A.
B.
C.
D.
$120,000
$80,000
$160,000
$240,000
33. For project Z, year 5 inventories increase by $6,000, accounts receivable by $4,000,
and accounts payable by $3,000. Calculate the increase or decrease in working
capital for year 5.
A.
B.
C.
D.
increases by $5,000
decreases by $1,000
increases by $7,000
decreases by $7,000
34. For project A in year 2, inventories increase by $12,000 and accounts payable
increases by $2,000. Accounts receivable remain the same. Calculate the increase or
decrease in net working capital for year 2.
A.
B.
C.
D.
decreases by $14,000
increases by $14,000
6-8
35. Working capital is a frequent source of errors in estimating project cash flows. These
errors include:
I) forgetting about working capital entirely;
II) forgetting that working capital may change during the life of the project;
III) forgetting that working capital is recovered at the end of the project;
IV) forgetting to depreciate working capital
A.
B.
C.
D.
I and II only
I, II, and III only
II, III, and IV only
I, II, and IV only
36. If depreciation is $600,000 and the marginal tax rate is 35%, then the tax shield due
to depreciation is:
A.
B.
C.
D.
$210,000.
$600,000.
$390,000.
cannot be determined from the information given.
37. If depreciation is $100,000 and the marginal tax rate is 35%, then the tax shield due
to depreciation is:
A.
B.
C.
D.
$35,000
$100,000
$65,000
cannot be determined from the information given
38. Suppose that a project has a depreciable investment of $600,000 and falls under the
following MACRS year 5 class depreciation schedule:
year 1: 20%; year 2: 32%; year 3: 19.2%; year 4: 11.5%; year 5: 11.5%; and year 6:
5.8%.
Calculate depreciation for year 2.
A.
B.
C.
D.
$120,000
$192,000
$96,000
$115,200
6-9
39. Suppose that a project has a depreciable investment of $1,000,000 and falls under
the following MACRS year 5 class depreciation schedule:
year 1: 20%; year 2: 32%; year 3: 19.2%; year 4: 11.5%; year 5: 11.5%; and year 6:
5.8%.
Calculate the depreciation tax shield for year 2 using a tax rate of 30%:
A.
B.
C.
D.
$224,000.
$60,000.
$96,000.
$300,000.
40. A project requires an initial investment of $200,000 and expects to produce a cash
flow before taxes of 120,000 per year for two years (i.e., cash flows will occur at t = 1
and t = 2). The corporate tax rate is 30%. The assets will depreciate using the MACRS
- 3-year schedule: (t = 1, 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The
company's tax situation is such that it can use all applicable tax shields. The
opportunity cost of capital is 12%. Assume that the asset can sell for book value at
the end of the project. Calculate the NPV of the project (approximately):
A.
B.
C.
D.
$22,463.
$19,315.
$16,244.
$5,721.
41. A project requires an initial investment of $200,000 and expects to produce a cash
flow before taxes of 120,000 per year for two years (i.e. cash flows will occur at t = 1
and t = 2). The corporate tax rate is 30%. The assets will depreciate using the MACRS
year 3 schedule: (t = 1: 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The company's
tax situation is such that it can use all applicable tax shields. The opportunity cost of
capital is 11%. Assume that the asset can sell for book value at the end of the
project. Calculate the approximate IRR for the project.
A.
B.
C.
D.
12.00%
11.00%
17.73%
14.06%
6-10
42. Your boss asked you to evaluate a project with an infinite life. Sales and costs project
to $1,000 and $500 per year, respectively. (Assume sales and costs occur at the end
of the year, i.e., profit of $500 at the end of year one.) There is no depreciation and
the tax rate is 30%. The real required rate of return is 10%. The inflation rate is 4%
and is expected to be 4% forever. Sales and costs will increase at the rate of inflation.
If the project costs $3,000, what is the NPV?
A.
B.
C.
D.
$500.00
$1629.62
$365.38
$472.22
43. A project requires an investment of $900 today. It can generate sales of $1,100 per
year forever. Costs are $600 for the first year and will increase by 20% per year.
(Assume all sales and costs occur at year-end, i.e., costs are $600 @ t = 1.) Ignore
taxes and calculate the NPV of the project at a 12% discount rate.
A.
B.
C.
D.
$65.00
$57.51
$100.00
Cannot be calculated as g > r
44. Which of the following countries allows firms to keep two separate sets of books, one
for the stockholders and one for the tax authorities like the Internal Revenue Service?
I) U.S.; II) Japan; III) France
A.
B.
C.
D.
I only
I and II only
I, II, and III only
None of the options
45. Germany allows firms to choose the following depreciation methods:

I) straight-line method; II) declining-balance method
A.
B.
C.
D.
I only
II only
I and II only
Germany allows a very different system
6-11
46. Two machines, A and B, which perform the same functions, have the following costs
and lives.
Which machine would you choose? The two machines are mutually exclusive and the
cost of capital is 15%.
A.
B.
C.
D.
Machine A because the EAC is $1789.89

Machine B because the EAC is $1922.88
Machine A because it has lower PV costs
Machine B because it has longer life
47. Two mutually exclusive projects have the following positive NPVs and project lives.
If the cost of capital were 15%, which project would you accept?
A.
B.
C.
D.
Project A because it has higher EAC

Project B because it has higher EAC
Project A because its NPV can be earned more quickly
Project B because it has higher NPV
48. OM Construction Company must choose between two types of cranes. Crane A costs
$600,000, will last for five years, and will require $60,000 in maintenance each year.
Crane B costs $750,000, will last for seven years, and will require $30,000 in
maintenance each year. Maintenance costs for cranes A and B occur at the end of
each year. The appropriate discount rate is 12% per year. Which machine should OM
Construction purchase?
A.
Crane A as EAC is $226,444
B.
Crane B as EAC is $194,336
C. Crane A because its PV is $816,286, i.e., less than the PV of Project B
D. Cannot be calculated as the revenues for the project are not given
6-12
49. You are considering the purchase of one of two machines required in your production
process. Machine A has a life of two years. Machine A costs $50 initially and then $70
per year in maintenance. Machine B has an initial cost of $90. It requires $40 in
maintenance for each year of its three-year life. Either machine must be replaced at
the end of its life. Which is the better machine for the firm? The discount rate is 15%
and the tax rate is zero.
A.
B.
C.
D.
Machine A as EAC for machine A is $100.76

Machine B as EAC for machine B is $79.42
Machine A as PV of costs for machine A is $163.80
Machine B as PV of costs for machine B is $181.33
50. RainMan Inc. is in the business of producing rain upon request. They must decide
between two investment projects: a new airplane for seeding rain clouds or a new
weather control machine built by Dr. Nutzbaum. The discount rate for the new
airplane is 9%, while the discount rate for the weather machine is 39% (it happens to
have higher market risk). Which investment should the company select and why?
(Assume a 0% inflation rate and that projected costs do not change over time.)
A.
Airplane because it has a higher NPV
B. Weather machine because it has a higher NPV
C. Airplane because it has a higher equivalent annual cash flow
D. Weather machine because it has a higher equivalent annual cash flow
51. Using the technique of equivalent annual cash flows and a discount rate of 7%, what
is the value of the following project?
A.
B.
C.
D.
3.06
3.61
10.25
12.23
6-13
True / False Questions
52. When calculating cash flows, one should consider them on an incremental basis.
True
False
53. When calculating cash flows, one should consider all incidental effects.
True
False
54. Opportunity costs should not be included in project analysis, as they are missed
opportunities.
True
False
55. Working capital is needed for additional investment within a project and should be
included within cash-flow estimates.
True
False
56. Sunk costs are bygones, i.e., they are unaffected by the decision to accept or reject a
project. They should therefore be ignored.
True
False
57. By undertaking an analysis in real terms, the financial manager avoids having to
forecast inflation.
True
False
58. A financial analyst should include interest and dividend payments when calculating a
project's cash flows.
True
False
59. Depreciation expense acts as a tax shield in reducing taxes.

True
False
60. Working capital is one of the most common sources of mistakes in estimating project
cash flows.
True
False
6-14
61. Within the MACRS system of depreciation, most industrial equipment falls into the
ten- and fifteen-year classes.
True
False
62. Most large U.S. corporations keep two separate sets of books, one for stockholders
and one for the Internal Revenue Service.
True
False
63. A financial analyst can use the equivalent annual cash-flow approach to determine
the year in which an existing machine can be profitably replaced with a new
machine.
True
False
64. The rule for comparing machines with different lives is to select the machine with the
greatest equivalent annual cost (EAC).
True
False
65. You should replace a machine when the EAC of continuing to operate it exceeds the
EAC of the new machine.
True
False
66. When evaluating projects with positive NPV but different life spans, the proper
technique to employ is the equivalent annual cash-flow approach.
True
False
67. The equivalent annual cash-flow technique is primarily used whenever the lives of
two different projects are the same.
True
False
Short Answer Questions
6-15
68. Define the term cash flow for a project.
69. What are some of the important points to remember while estimating the cash flows
of a project?
70. Briefly explain how inflation is treated consistently while estimating a project's NPV.
6-16
71. Briefly explain the acronym MACRS.
72. Briefly discuss how tax reporting to governments vs. shareholders is treated in
countries like Japan.
73. What are some of the additional factors that an analyst should consider while
estimating cash flows in foreign countries and currencies?
6-17
74. How do you compare projects with different lives?
75. Briefly explain how the decision to replace an existing machine is made?
76. Briefly explain how the cost of excess capacity is taken into consideration.
6-18
Chapter 06 Making Investment Decisions with the Net Present

Value Rule Answer Key
Multiple Choice Questions
1.
Important points to remember while estimating the cash flows of a project are:
I) Only cash flow is relevant.
II) Always estimate cash flows on an incremental basis.
III) Be consistent in the treatment of inflation.
A.
B.
C.
D.
I only
I and II only
II and III only
I, II, and III
Type: Easy
2.
Preferably, a financial analyst estimates cash flows for a project as:
A.
B.
C.
D.
cash flows before taxes.

cash flows after taxes.
accounting profits before taxes.
accounting profits after taxes.
Type: Medium
3.
When a firm has the opportunity to add a project that will utilize excess factory
capacity (that is currently not being used), which costs should be used to help
determine if the added project should be undertaken?
A.
B.
C.
D.
allocated overhead costs

sunk costs
incremental costs
average costs
Type: Medium
6-19
4.
A reduction in the sales of existing products caused by the introduction of a new

product is an example of:
A.
B.
C.
D.
incidental effects.
opportunity costs.
sunk costs.
allocated overhead costs.
Type: Easy
5.
When Honda develops a new engine the incidental effects might include the
following:
I) demand for replacement parts;
II) profits from the sale of repair services;
III) offer modified or improved versions of the new engine for other uses
A.
B.
C.
D.
I only
I and II only
I, II, and III
I and III only
Type: Medium
6.
The cost of a resource that may be relevant to an investment decision even when
no cash changes hand is called a(an):
A.
B.
C.
D.
sunk cost.
opportunity cost.
depreciation cost.
average cost.
Type: Difficult
6-20
7.
Net working capital is best represented as:

I) short-term assets;
II) short-term liabilities;
III) long-term assets;
IV) long-term liabilities
A.
B.
C.
D.
I only
(I - II)
(III - I)
(III - IV)
Type: Medium
8.
Accountants do not depreciate investment in net working capital because:
A.
it is not a cash flow.
B. it is recovered duringor at the end ofthe project, thus is not a depreciating
asset.
C.
it is a sunk cost.
D. working capital appears on the balance sheet, not the income statement.
Type: Medium
9.
One should consider net working capital (NWC) in project cash flows because:
A. typically, firms must invest cash in short-term assets to produce finished

goods.
B.
NWC represents sunk costs.
C.
firms need positive NPV projects for investment.
D. inclusion of NWC typically increases calculated NPV.
Type: Medium
10.
Investment in inventories includes investment in:

I) raw material; II) work-in-progress; III) finished goods
A.
B.
C.
D.
I only
I and II only
I, II, and III
III only
Type: Easy
6-21
11.
For the case of an electric car project, the following costs should be treated as
incremental costs when deciding whether to go ahead with the project EXCEPT:
A. the consequent reduction in sales of the company's existing gasoline models

(i.e., incidental effects).
B. interest payments on debt incurred to finance the project.
C. the value of tools that will be transferred to the project from the company's
existing plants instead of being sold.
D.
the expenditure on new plants and equipment.
Type: Medium
12.
The principal short-term assets are:

I) cash; II) accounts receivable; III) inventories; and IV) accounts payable
A.
B.
C.
D.
I only
I and IV only
I, II, and III
IV only
Type: Easy
13.
The current market value of a previously purchased machine proposed for use in a
project is an example of a:
A.
B.
C.
D.
sunk cost.
opportunity cost.
fixed cost.
inventoriable cost.
Type: Medium
14.
Money that a firm has already spent, or committed to spend regardless of whether
a project is taken, is called:
A.
B.
C.
D.
fixed cost.
opportunity cost.
sunk cost.
incremental cost.
Type: Medium
6-22
15.
Costs incurred as a result of past, irrevocable decisions and irrelevant to future

decisions are called:
A.
B.
C.
D.
opportunity costs.
sunk costs.
incremental costs.
marginal costs.
Type: Medium
16.
For the case of an electric car project, which of the following costs or cash flows
should be categorized as incremental when analyzing whether to invest in the
project?
A. The cost of research and development undertaken for developing the electric
car during the past three years
B.
The annual depreciation charge
C.
Tax savings resulting from the depreciation charges
D.
Dividend payments
Type: Difficult
17.
An analyst wishes to determine the value of resources used by a proposed project.

Which values should the analyst use to approximate opportunity costs?
A.
B.
C.
D.
book values
market values
historical values
Accounting values plus an inflation adjustment
Type: Medium
18.
If the discount rate is stated in nominal terms thenin order to calculate the NPV
in a consistent mannerthe project requires that:
A.
B.
C.
D.

cash flows be estimated ignoring inflation.
Type: Medium
6-23
19.
If the discount rate is stated in real terms thenin order to calculate the NPV in a
A.
B.
C.
D.

cash flows be estimated including future inflation.
Type: Medium
20.
A firm owns a building with a book value of $150,000 and a market value of
$250,000. If the firm uses the building for a project, then its opportunity cost,
ignoring taxes, is:
A.
B.
C.
D.
$100,000.
$150,000.
$250,000.
$400,000.
Type: Medium
21.
The real interest rate is 3.0% and the inflation rate is 5.0%. What is the nominal
interest rate?
A.
B.
C.
D.
3.00%
5.00%
8.15%
2.00%
1 + nominal rate = (1 + real rate) (1 + inflation rate) = (1.03)(1.05) = (1.0815).

Nominal rate = 0.0815 = 8.15%.
Type: Easy
6-24
22.
If the nominal interest rate is 7.5% and the inflation rate is 4.0%, what is the real
interest rate?
A.
B.
C.
D.
4.0%
9.5%
3.4%
11.5%
1 + real rate = (1 + nominal rate)/(1 + inflation rate) = 1.075/1.04 = 1.0337;

real rate = 3.4%.
Type: Easy
23.
Your firm expects to receive a cash flow in two years of $10,816 in nominal terms.
If the real rate of interest is 2% and the inflation rate is 4%, what is the real cash
flow for year 2?
A.
B.
C.
D.
$11,236
$10,816
$10,000
$9,246
Real cash flow = 10,816/(1.04^2) = 10,000.
Type: Medium
24.
Given the following data for Project M:
A.
B.
C.
D.
$51.70.
$35.54.
$45.21.
$70.00.
NPV = -200 + 150/1.05 + 120/(1.05^2) = 51.70.
Type: Difficult
6-25
25.
Given the following data for Project M:
A.
B.
C.
D.
$25.85.
$17.77.
$22.65.
$35.00.
NPV = -100 + 75/1.1 + 60/(1.1^2) = 17.77.
Type: Difficult
26.
The real rate of interest is 3% and inflation is 4%. What is the nominal rate of
interest?
A.
B.
C.
D.
3%
1.00%
7.12%
-1.00%
1 + nominal rate = 1.03 1.04 = 1.0712; nominal rate = 7.12%.
Type: Easy
27.
The NPV value obtained by discounting nominal cash flows using the nominal
discount rate is the same as the NPV value obtained by discounting:
I) real cash flows using the real discount rate;
II) real cash flows using the nominal discount rate;
III) nominal cash flows using the real discount rate
A.
B.
C.
D.
I only
II only
III only
II and III only
Type: Medium
6-26
28.
The real cash flow occurring in year 2 is $60,000. If the inflation rate is 5% per
year and the real rate of interest is 2% per year, calculate the nominal cash flow
for year 2.
A.
B.
C.
D.
$60,000
$62,424
$66,150
$63,654
Nominal cash flow = (60,000)(1.05)^2 = 66,150.
Type: Medium
29.
Proper treatment of inflation in NPV calculations involves:

I) discounting nominal cash flows by the nominal discount rate;
II) discounting real cash flows by the real discount rate;
III) discounting nominal cash flows by the real discount rate
A.
B.
C.
D.
I only
II only
III only
I and II only
Type: Medium
30.
A firm has a general-purpose machine, which has a book value of $300,000 and is
worth $500,000 in the market. If the tax rate is 35%, what is the opportunity cost
of using the machine in a project?
A.
B.
C.
D.
$500,000
$430,000
$300,000
$200,000
The firm could sell the machine, which would generate a taxable capital gain of
($500,000 - $300,000) = $200,000. The opportunity cost of using the machine
equals the market value of the machine less its tax impact: 500,000 - 200,000
0.35 = 430,000.
Type: Difficult
6-27
31.
Capital equipment costing $250,000 today has 50,000 salvage value at the end of
five years. If the straight-line depreciation method is used, what is the book value
of the equipment at the end of two years?
A.
B.
C.
D.
$200,000
$170,000
$140,000
$150,000
Annual depreciation = (250,000 - 50,000)/5 = 40,000;

Book value at the end of two years = 250,000 - 80,000 = 170,000.
Type: Medium
32.
A piece of capital equipment costing $400,000 today has no (zero) salvage value
at the end of five years. If straight-line depreciation is used, what is the book value
of the equipment at the end of three years?
A.
B.
C.
D.
$120,000
$80,000
$160,000
$240,000
Annual depreciation = $400,000/5 = 80,000;

Depreciation for three years = 240,000;
Book value = 400,000 - 240,000 = 160,000.
Type: Medium
33.
For project Z, year 5 inventories increase by $6,000, accounts receivable by

$4,000, and accounts payable by $3,000. Calculate the increase or decrease in
working capital for year 5.
A.
B.
C.
D.
increases by $5,000
decreases by $1,000
increases by $7,000
decreases by $7,000
Change in working capital = 6000 + 4000 - 3000 = +7,000.
Type: Medium
6-28
34.
For project A in year 2, inventories increase by $12,000 and accounts payable

increases by $2,000. Accounts receivable remain the same. Calculate the increase
or decrease in net working capital for year 2.
A.
B.
C.
D.
Working capital = 12,000 - 2000 = +10,000.
Type: Medium
35.
Working capital is a frequent source of errors in estimating project cash flows.

These errors include:
I) forgetting about working capital entirely;
II) forgetting that working capital may change during the life of the project;
III) forgetting that working capital is recovered at the end of the project;
IV) forgetting to depreciate working capital
A.
B.
C.
D.
I and II only
I, II, and III only
II, III, and IV only
I, II, and IV only
Type: Difficult
36.
If depreciation is $600,000 and the marginal tax rate is 35%, then the tax shield
due to depreciation is:
A.
B.
C.
D.
$210,000.
$600,000.
$390,000.
cannot be determined from the information given.
Tax shield effect = (600,000)(0.35) = 210,000
Type: Easy
6-29
37.
If depreciation is $100,000 and the marginal tax rate is 35%, then the tax shield
due to depreciation is:
A.
B.
C.
D.
$35,000
$100,000
$65,000
cannot be determined from the information given
Tax shield effect = (100,000)(0.35) = 35,000.
Type: Easy
38.
Suppose that a project has a depreciable investment of $600,000 and falls under
year 1: 20%; year 2: 32%; year 3: 19.2%; year 4: 11.5%; year 5: 11.5%; and year
6: 5.8%.
Calculate depreciation for year 2.
A.
B.
C.
D.
$120,000
$192,000
$96,000
$115,200
Depreciation for year 2 = (600,000)(0.32) = 192,000.
Type: Easy
39.
Suppose that a project has a depreciable investment of $1,000,000 and falls under
year 1: 20%; year 2: 32%; year 3: 19.2%; year 4: 11.5%; year 5: 11.5%; and year
6: 5.8%.
Calculate the depreciation tax shield for year 2 using a tax rate of 30%:
A.
B.
C.
D.
$224,000.
$60,000.
$96,000.
$300,000.
Depreciation = (1,000,000)(0.32) = $320,000; The tax shield from depreciation =

$320,000 (0.30) = 96,000.
Type: Easy
6-30
40.
A project requires an initial investment of $200,000 and expects to produce a cash

flow before taxes of 120,000 per year for two years (i.e., cash flows will occur at t
= 1 and t = 2). The corporate tax rate is 30%. The assets will depreciate using the
MACRS - 3-year schedule: (t = 1, 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The
the end of the project. Calculate the NPV of the project (approximately):
A.
B.
C.
D.
$22,463.
$19,315.
$16,244.
$5,721.
Book value at the end of year 2 = (.15 + .07) $200,000 = $44,000

Year 1 cash flow: (120,000 (1 - .30)) + (200,000 .33 .30) = 103,800;
Year 2 cash flow: (120,000 (1 - .30)) + (200,000 .45 .30) + 44,000 =
155,000;
-200,000 + (103,800/1.12) + ((155,000)/(1.12^2)) = $16,244.
Type: Difficult
41.
A project requires an initial investment of $200,000 and expects to produce a cash

flow before taxes of 120,000 per year for two years (i.e. cash flows will occur at t =
1 and t = 2). The corporate tax rate is 30%. The assets will depreciate using the
MACRS year 3 schedule: (t = 1: 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The
the end of the project. Calculate the approximate IRR for the project.
A.
B.
C.
D.
12.00%
11.00%
17.73%
14.06%
Year 1 cash flow: (120,000 (1 - .30)) + (200,000 .33 .30) = 103,800;

Year 2 cash flow: (120,000 (1 - .30)) + (200,000 .45 .30) + 44,000 =
155,000;
0 = -200,000 + (103,800/(1 + IRR)) + (155,000/((1 + IRR)^2)) = 17.73%.
In Excel: Arrange cash flows in order starting with -200,000 in cell A1; +103,800 in
cell A2; +155,000 in cell A3, then "= IRR(A1:A3)".
Type: Difficult
6-31
42.
Your boss asked you to evaluate a project with an infinite life. Sales and costs
project to $1,000 and $500 per year, respectively. (Assume sales and costs occur
at the end of the year, i.e., profit of $500 at the end of year one.) There is no
depreciation and the tax rate is 30%. The real required rate of return is 10%. The
inflation rate is 4% and is expected to be 4% forever. Sales and costs will increase
at the rate of inflation. If the project costs $3,000, what is the NPV?
A.
B.
C.
D.
$500.00
$1629.62
$365.38
$472.22
Easiest to consider real cash flows: NPV = -3000 + [(1000 - 500) (0.7)]/0.10 =
$500.00.
Type: Difficult
43.
A project requires an investment of $900 today. It can generate sales of $1,100 per
year forever. Costs are $600 for the first year and will increase by 20% per year.
(Assume all sales and costs occur at year-end, i.e., costs are $600 @ t = 1.) Ignore
taxes and calculate the NPV of the project at a 12% discount rate.
A.
B.
C.
D.
$65.00
$57.51
$100.00
Cannot be calculated as g > r
NPV = -900 + (1,100 - 600)/1.12 + (1,100 - (600 1.2))/(1.12^2) + (1,100 - 600

(1.2^2))/(1.12)^3 + (1,100 - 600 (1.2^3))/(1.12^4) = $57.51).
(The project is stopped when costs > revenues.)
Type: Difficult
44.
Which of the following countries allows firms to keep two separate sets of books,
one for the stockholders and one for the tax authorities like the Internal Revenue
Service?
I) U.S.; II) Japan; III) France
A.
B.
C.
D.
I only
I and II only
I, II, and III only
None of the options
Type: Easy
6-32
45.
Germany allows firms to choose the following depreciation methods:

I) straight-line method; II) declining-balance method
A.
B.
C.
D.
I only
II only
I and II only
Germany allows a very different system
Type: Easy
46.
Two machines, A and B, which perform the same functions, have the following
costs and lives.
Which machine would you choose? The two machines are mutually exclusive and
the cost of capital is 15%.
A.
B.
C.
D.
Machine A because the EAC is $1789.89

Machine B because the EAC is $1922.88
Machine A because it has lower PV costs
Machine B because it has longer life
EAC(A) = 6,000/3.35215 = 1789.89.

EAC(B) = 8000/4.1604 = 1922.88.
Using a financial calculator:
EAC(A) = PV = 6000; I = 15; FV = 0; & N = 5; Compute: PMT = -1789.89.
EAC(B) = PV = 8000; I = 15; FV = 0; & N = 7; Compute: PMT = -1922.88.
Type: Difficult
6-33
47.
Two mutually exclusive projects have the following positive NPVs and project lives.
If the cost of capital were 15%, which project would you accept?
A.
B.
C.
D.
Project A because it has higher EAC

Project B because it has higher EAC
Project A because its NPV can be earned more quickly
Project B because it has higher NPV
EAC(A) = 5000/2.2832 = 2189.88. (Accept the project with higher EAC.)

EAC(B) = 6500/3.35216 = 1939.05.
Using a financial calculator:
EAC(A) = PV = 5000; I = 15; FV = 0; & N = 3; Compute: PMT = -2189.88.
EAC(B) = PV = 6500; I = 15; FV = 0; & N = 5; Compute: PMT = -1939.05.
Type: Difficult
6-34
48.
OM Construction Company must choose between two types of cranes. Crane A

costs $600,000, will last for five years, and will require $60,000 in maintenance
each year. Crane B costs $750,000, will last for seven years, and will require
$30,000 in maintenance each year. Maintenance costs for cranes A and B occur at
the end of each year. The appropriate discount rate is 12% per year. Which
machine should OM Construction purchase?
A.
Crane A as EAC is $226,444
B.
Crane B as EAC is $194,336
C. Crane A because its PV is $816,286, i.e., less than the PV of Project B
D. Cannot be calculated as the revenues for the project are not given
Crane A: Annuity factor = (1/.12) (1 - (1/(1.12^5))) = 3.6048.

Crane B: Annuity factor = (1/.12) (1 - (1/(1.12^7))) = 4.5638.
Costs:
PV (A) = 600,000 + 60,000 (3.6048) = 816,286;
EAC = 816,286/(3.6048) = $226,444;
PV(B) = 750,000 + 30, 000 (4.5638) = 886,913;
EAC = 886,913/(4.5638) = $194,336.45. (Accept the project with least annual
cost.)
Type: Difficult
6-35
49.
You are considering the purchase of one of two machines required in your
production process. Machine A has a life of two years. Machine A costs $50 initially
and then $70 per year in maintenance. Machine B has an initial cost of $90. It
requires $40 in maintenance for each year of its three-year life. Either machine
must be replaced at the end of its life. Which is the better machine for the firm?
The discount rate is 15% and the tax rate is zero.
A.
B.
C.
D.
Machine A as EAC for machine A is $100.76

Machine B as EAC for machine B is $79.42
Machine A as PV of costs for machine A is $163.80
Machine B as PV of costs for machine B is $181.33
Machine A: Annuity factor = (1/.15) (1 - (1/(1.15^2))) = 1.6257.

Machine B: Annuity factor = (1/.15) (1 - (1/(1.15^3))) = 2.2832.
Costs:
PV(A) = 50 + 70 (1.6257) = 163.80; EAC = 163.80/(1.6257) = 100.76;
PV(B) = 90 + 40 (2.2832) = 181.33; EAC = 181.33/2.2832 = 79.42. (Accept the
project with least annual cost.)
Type: Difficult
6-36
50.
RainMan Inc. is in the business of producing rain upon request. They must decide
between two investment projects: a new airplane for seeding rain clouds or a new
weather control machine built by Dr. Nutzbaum. The discount rate for the new
airplane is 9%, while the discount rate for the weather machine is 39% (it happens
to have higher market risk). Which investment should the company select and
why? (Assume a 0% inflation rate and that projected costs do not change over
time.)
A.
Airplane because it has a higher NPV
B.
Weather machine because it has a higher NPV
C. Airplane because it has a higher equivalent annual cash flow
D. Weather machine because it has a higher equivalent annual cash flow
The NPV of the airplane is 63.72, and the equivalent annual cash flow of the
airplane is 36.22.
The NPV of the weather machine is 61.29, and the equivalent annual cash flow of
the machine is 38.08.
Since they have different life spans, the weather machine has a higher equivalent
annual cash flow and should be accepted.
Type: Difficult
51.
Using the technique of equivalent annual cash flows and a discount rate of 7%,
what is the value of the following project?
A.
B.
C.
D.
3.06
3.61
10.25
12.23
NPV of the project is 12.23, and the equivalent annual cash flow of the project is
3.61.
Type: Medium
6-37
True / False Questions
52.
When calculating cash flows, one should consider them on an incremental basis.
TRUE
Type: Easy
53.
When calculating cash flows, one should consider all incidental effects.
TRUE
Type: Easy
54.
Opportunity costs should not be included in project analysis, as they are missed
opportunities.
FALSE
Type: Medium
55.
Working capital is needed for additional investment within a project and should be
included within cash-flow estimates.
TRUE
Type: Medium
56.
Sunk costs are bygones, i.e., they are unaffected by the decision to accept or
reject a project. They should therefore be ignored.
TRUE
Type: Easy
57.
By undertaking an analysis in real terms, the financial manager avoids having to

forecast inflation.
FALSE
Type: Medium
58.
A financial analyst should include interest and dividend payments when calculating
a project's cash flows.
FALSE
Type: Medium
6-38
59.
Depreciation expense acts as a tax shield in reducing taxes.

TRUE
Type: Medium
60.
Working capital is one of the most common sources of mistakes in estimating

project cash flows.
TRUE
Type: Medium
61.
Within the MACRS system of depreciation, most industrial equipment falls into the
ten- and fifteen-year classes.
FALSE
Type: Difficult
62.
Most large U.S. corporations keep two separate sets of books, one for stockholders
and one for the Internal Revenue Service.
TRUE
Type: Difficult
63.
A financial analyst can use the equivalent annual cash-flow approach to determine
the year in which an existing machine can be profitably replaced with a new
machine.
TRUE
Type: Medium
64.
The rule for comparing machines with different lives is to select the machine with
the greatest equivalent annual cost (EAC).
FALSE
Type: Medium
65.
You should replace a machine when the EAC of continuing to operate it exceeds
the EAC of the new machine.
TRUE
Type: Difficult
6-39
66.
When evaluating projects with positive NPV but different life spans, the proper
technique to employ is the equivalent annual cash-flow approach.
TRUE
Type: Difficult
67.
The equivalent annual cash-flow technique is primarily used whenever the lives of
two different projects are the same.
FALSE
Type: Difficult
Short Answer Questions
68.
Define the term cash flow for a project.
Cash flow for a project is the net income plus depreciation. Always estimate cash
flows on an after-tax basis.
Type: Easy
69.
What are some of the important points to remember while estimating the cash
flows of a project?
Estimate after-tax cash flows on an incremental basis.

Include all incidental effects.
Include working capital requirements.
Include opportunity costs.
Do not include sunk costs.
Take inflation into consideration in a consistent manner.
Type: Medium
6-40
70.
Briefly explain how inflation is treated consistently while estimating a project's

NPV.
There are two ways to treat inflation consistently in the estimation of NPV of a
project. If the discount rate is stated in nominal terms, then consistency requires
that project cash flows also be estimated in nominal terms. This might involve
using different inflation rates for different components of cash flow. If the discount
rate is stated in real terms, then real cash flows are estimated for the project. The
consistency rule is: discount nominal cash flows at a nominal discount rate and
discount real cash flows at a real discount rate.
Type: Medium
71.
Briefly explain the acronym MACRS.
MACRS is short for Modified Accelerated Cost Recovery System. This is the result of
the Tax Reform Act of 1986. It is based on a combination of the double declining
method and straight-line depreciation methods. In this system, assets are
classified into several classes like three-year class, five-year class, etc. Tax
depreciation allowed under each asset class is provided in a table format. It uses a
midyear convention, and hence an asset under the three-year class has
depreciation for four years.
Type: Medium
72.
Briefly discuss how tax reporting to governments vs. shareholders is treated in

countries like Japan.
In Japan and all of the European Community countries, it is not possible to

separate tax accounts reported to the government and those reported to
shareholders. They must be same. In some countries, it is not possible to use
accelerated depreciation.
Type: Medium
6-41
73.
What are some of the additional factors that an analyst should consider while
estimating cash flows in foreign countries and currencies?
Currency of the cash flow should be relevant to the country in which the project
occurs.
Use an appropriate, local inflation rate for the project.
Use the relevant country tax rate and depreciation method for the project.
Use the appropriate discount rate for the project.
Type: Medium
74.
How do you compare projects with different lives?
One can compare projects with different lives (assuming that the projects infinitely
repeat). The projects are analyzed using equivalent annual costs (EAC).
Type: Difficult
75.
Briefly explain how the decision to replace an existing machine is made?
The decision to replace an existing machine is done for economic or technological

reasons, or for both. An equivalent annuity approach is used. As long as the
benefits exceed equivalent annual costs, the decision will be a sound one.
Type: Difficult
76.
Briefly explain how the cost of excess capacity is taken into consideration.
Many managers assume that the marginal cost of excess capacity is zero and
encourage employees to use up the excess capacity. This may not be a very sound
way to utilize excess capacity. If we use the equivalent annual cost (EAC)
approach, the cost of excess capacity can be estimated easily. Indiscriminate use
of excess capacity may result in replacing the existing machine with a new
machine sooner. Earlier replacement is the cost of excess capacity and must be
taken into consideration.
Type: Difficult
6-42
6-43

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Chapter 06

Making Investment Decisions with the Net Present Value Rule

Multiple Choice Questions

2. Preferably, a financial analyst estimates cash flows for a project as:

cash flows before taxes.

allocated overhead costs

4. A reduction in the sales of existing products caused by the introduction of a new

7. Net working capital is best represented as:

8. Accountants do not depreciate investment in net working capital because:

cash flows be estimated in nominal terms.

cash flows be estimated in nominal terms.

24. Given the following data for Project M:

25. Given the following data for Project M:

29. Proper treatment of inflation in NPV calculations involves:

45. Germany allows firms to choose the following depreciation methods:

Machine A because the EAC is $1789.89

Project A because it has higher EAC

Machine A as EAC for machine A is $100.76

True / False Questions

59. Depreciation expense acts as a tax shield in reducing taxes.

Short Answer Questions

68. Define the term cash flow for a project.

71. Briefly explain the acronym MACRS.

74. How do you compare projects with different lives?

Chapter 06 Making Investment Decisions with the Net Present

Multiple Choice Questions

Preferably, a financial analyst estimates cash flows for a project as:

cash flows before taxes.

allocated overhead costs

A reduction in the sales of existing products caused by the introduction of a new

Net working capital is best represented as:

Accountants do not depreciate investment in net working capital because:

A. typically, firms must invest cash in short-term assets to produce finished

Investment in inventories includes investment in:

A. the consequent reduction in sales of the company's existing gasoline models

The principal short-term assets are:

Costs incurred as a result of past, irrevocable decisions and irrelevant to future

An analyst wishes to determine the value of resources used by a proposed project.

cash flows be estimated in nominal terms.

cash flows be estimated in nominal terms.

1 + nominal rate = (1 + real rate) (1 + inflation rate) = (1.03)(1.05) = (1.0815).

1 + real rate = (1 + nominal rate)/(1 + inflation rate) = 1.075/1.04 = 1.0337;

Real cash flow = 10,816/(1.04^2) = 10,000.

Given the following data for Project M:

NPV = -200 + 150/1.05 + 120/(1.05^2) = 51.70.

Given the following data for Project M:

NPV = -100 + 75/1.1 + 60/(1.1^2) = 17.77.

1 + nominal rate = 1.03 1.04 = 1.0712; nominal rate = 7.12%.

Nominal cash flow = (60,000)(1.05)^2 = 66,150.

Proper treatment of inflation in NPV calculations involves:

Annual depreciation = (250,000 - 50,000)/5 = 40,000;

Annual depreciation = $400,000/5 = 80,000;

For project Z, year 5 inventories increase by $6,000, accounts receivable by

Change in working capital = 6000 + 4000 - 3000 = +7,000.

For project A in year 2, inventories increase by $12,000 and accounts payable

Working capital = 12,000 - 2000 = +10,000.

Working capital is a frequent source of errors in estimating project cash flows.

Tax shield effect = (600,000)(0.35) = 210,000

Tax shield effect = (100,000)(0.35) = 35,000.

Depreciation for year 2 = (600,000)(0.32) = 192,000.

Depreciation = (1,000,000)(0.32) = $320,000; The tax shield from depreciation =

A project requires an initial investment of $200,000 and expects to produce a cash

Book value at the end of year 2 = (.15 + .07) $200,000 = $44,000