Chapter 8: Capital Budgeting Cash Flows

Chapter8CapitalBudgetingCashFlows87
Chapter8
CapitalBudgetingCashFlows
.1 Learning Goals
1. Understandthemotivesforkeycapitalexpenditureandthestepsinthecapitalbudgetingprocess.
2. Definebasiccapitalbudgetingterminology.
3. Discussrelevantcashflows,expansionversusreplacementdecisions,sunkcostsandopportunity
costs,andinternationalbudgeting.
4. Calculatetheinitialinvestmentassociatedwithaproposedcapitalexpenditure.
5. Findtherelevantoperatingcashinflowsassociatedwithaproposedcapitalexpenditure.
6. Determinetheterminalcashflowassociatedwithaproposedcapitalexpenditure.
.2 True/False
1. Capitalbudgetingtechniquesareusedtoevaluatethefirmsfixedassetinvestmentswhichprovide
thebasisforthefirmsearningpowerandvalue.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:ConceptofCapitalBudgeting
2. Thepurchaseofadditionalphysicalfacilities,suchasadditionalpropertyoranewfactory,isan
exampleofacapitalexpenditure.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:CapitalBudgetingTerminology
3. Capitalbudgetingistheprocessofevaluatingandselectingshortterminvestmentsconsistentwith
thefirmsgoalofownerwealthmaximization.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
88GitmanPrinciplesofFinance,EleventhEdition
4. A$60,000outlayforanewmachinewithausablelifeof15yearsisanoperatingexpenditurethat
wouldappearasafixedassetonthefirmsbalancesheet.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
5. Capitalexpenditureisanoutlayoffundsinvestedonlyonfixedassetsandisexpectedtoproduce
benefitsoveraperiodoftimegreaterthanoneyear.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
6. Anoutlayforadvertisingandmanagementconsultingisconsideredtobeacurrentexpenditure.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
7. Capitalexpenditureproposalsarereviewedtoassesstheirappropriatenessinlightofthefirms
overallobjectivesandplans,andtoevaluatetheireconomicvalidity.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
8. Afirmwithlimitedfundsmustrationitsfundsbyallocatingthemtoprojectsthatwillmaximize
sharevalue.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:CapitalRationing
9. Independentprojectsareprojectsthatcompetewithoneanother,sothattheacceptanceofone
eliminatestheothersfromfurtherconsideration.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:IndependentProjects
10. Anonconventionalcashflowpatternassociatedwithcapitalinvestmentprojectsconsistsofan
initialoutflowfollowedbyaseriesofinflows.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:ConventionalversusNonconventionalCashFlows
11. Ifafirmhasunlimitedfundstoinvest,alltheindependentprojectsthatmeetitsminimum
investmentcriteriacanbeimplemented.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
12. Thefollowingthreeprojectsareexamplesofmutuallyexclusiveprojects.
(1) installingairconditioningintheplant
(2) acquiringasmallsupplier
(3) purchasinganewcomputersystem
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:MutuallyExclusiveProjects
13. Whenthefirmisconfrontedwithanumberofprojects,someofwhicharemutuallyexclusiveand
someofwhichareindependent,itmustfirstdeterminethebestofeachgroupofmutuallyexclusive
alternatives.Thebestoftheacceptableindependentprojectscanthenbeselected.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
14. Ifafirmhasunlimitedfundstoinvest,allthemutuallyexclusiveprojectsthatmeetitsminimum
investmentcriteriacanbeimplemented.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
15. Mutuallyexclusiveprojectsareprojectswhosecashflowsareunrelatedtooneanother;the
acceptanceofonedoesnoteliminatetheothersfromfurtherconsideration.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
16. Toincreaseitsproductioncapacity,afirmisconsidering:1)toexpanditsplant,2)toacquire
anothercompany,or3)tocontractwithanothercompanyforproduction.Thesethreeprojectsare
examplesofindependentprojects.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:2
17. Accountingfiguresandcashflowsarenotnecessarilythesameduetothepresenceofcertain
noncashexpendituresonthefirmsincomestatement.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:RelevantCashFlows
18. Therelevantcashflowsforaproposedcapitalexpenditurearetheincrementalaftertaxcash
outflowsandresultingsubsequentinflows.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
19. Foreigndirectinvestmentisthetransferofcapital,managerial,andtechnicalassetstoaforeign
country.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:InternationalCapitalBudgeting
20. Ifanewassetisbeingconsideredasareplacementforanoldasset,therelevantcashflowswouldbe
foundbyaddingtheexpectedcashflowsattributedtooldassetandtheexpectedcashflowsfornew
asset.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
Topic:ReplacementProjectAnalysis
21. Internationalcapitalbudgetingdiffersfromthedomesticversionbecause(1)cashinflowsand
outflowsoccurinaforeigncurrency,and(2)foreigninvestmentspotentiallyfacesignificant
politicalrisk.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
22. Incaseofinternationalcapitalbudgeting,theU.S.companycanminimizeitspoliticalriskby
subtractingtheinvestmentasajointventureandbyselectingacompetentandwellconnectedlocal
partner.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
23. Sunkcostsarecashoutlaysthathavealreadybeenmadeandthereforehavenoeffectonthecash
flowsrelevanttothecurrentdecision.Asaresult,sunkcostsshouldnotbeincludedinaprojects
incrementalcashflows.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:SunkCosts
24. Opportunitycostsshouldbeincludedascashoutflowswhendeterminingaprojectsincremental
cashflows.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:OpportunityCosts
25. Incaseofinternationalcapitalbudgeting,longtermcurrencyriskcanbeminimizedbyatleast
partlyfinancingtheforeigninvestmentwithadollardenominatedcapitalcontributionfromthe
parentcompanyratherthaninthelocalcapitalmarkets.
Answer: FALSE
LevelofDifficulty:4
LearningGoal:3
26. Tocalculatetheinitialinvestment,wesubtractallcashinflowsoccurringattimezerofromallcash
outflowsoccurringattimezero.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:4
Topic:InitialInvestment
27. Thedepreciablevalueofanassetisequaltoitspurchasepriceminusinstallationcosts,ifany.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:4
Topic:DepreciableValueofanAsset
28. Thebookvalueofanassetisequaltoitsdepreciablevalueminustheaccumulateddepreciation.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:4
Topic:BookValueofanAsset(Equation8.1)
29. Incaseofanexistingassetwhichisdepreciableandisusedinbusinessandissoldforapriceequal
toitsinitialpurchaseprice,thedifferencebetweenthesalespriceanditsbookvalueisconsideredas
recaptureddepreciationandwillbetaxedasordinaryincome.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:DepreciationandTaxes(Equation8.1)
30. Recaptureddepreciationistheportionofthesalepricethatisbelowbookvalueandhasnotbeen
depreciated.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
31. Thebasiccashflowsthatmustbeconsideredwhendeterminingtheinitialinvestmentassociated
withacapitalexpenditurearetheinstalledcostofthenewasset,theaftertaxproceeds(ifany)from
thesaleofanoldasset,andthechange(ifany)innetworkingcapital.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
32. Capitalgainistheportionofthesalepricethatisinexcessoftheinitialpurchaseprice.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:DepreciationandTaxes
33. Recaptureddepreciationistheportionofthesalepricethatisinexcessoftheinitialpurchaseprice.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
34. Ifanassetisdepreciableandusedinbusiness,anylossonsaleoftheassetisdeductibleonlyagainst
capitalgains.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:4
35. Thechangeinnetworkingcapitalregardlessofwhetheranincreaseordecreaseisnottaxable
becauseitmerelyinvolvesanetbuilduporreductionofcurrentaccounts.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:NetWorkingCapitalInvestment
36. Allbenefitsexpectedfromaproposedprojectmustbemeasuredonacashflowbasiswhichmaybe
foundbyaddinganynoncashchargesdeductedasexpenseonthefirmsincomestatementbackto
netprofitsaftertaxes.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:5
Topic:OperatingCashFlows
37. Inevaluatingaproposedproject,sinceourconcernisonlywithhowmuchmoreorlessoperating
cashwillflowintothefirmasaresultoftheproposedproject,incrementaloperatingcashinflows
aretherelevantcashflows.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:5
38. Thebasicmotivesforcapitalexpendituresaretoexpand,replace,orrenewfixedassetsortoobtain
someother,lesstangiblebenefitoveralongperiod.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:MotivesforCapitalBudgeting
39. Theprimarymotiveforcapitalexpendituresistorefurbishfixedassets.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:1
40. Researchanddevelopmentisconsideredtobeamotiveformakingcapitalexpenditures.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
41. Thecapitalbudgetingprocessconsistsoffivedistinctbutinterrelatedsteps:proposalgeneration,
reviewandanalysis,decisionmaking,implementation,andfollowup.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:StepsinCapitalBudgetingProcess
42. Thecapitalbudgetingprocessconsistsoffourdistinctbutinterrelatedsteps:proposalgeneration,
reviewandanalysis,decisionmaking,andtermination.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:1
43. Independentprojectsarethosewhosecashflowsareunrelatedtooneanother;theacceptanceofone
doesnoteliminatetheothersfromfurtherconsideration.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:IndependentversusMutuallyExclusiveProjects
44. Mutuallyexclusiveprojectsarethosewhosecashflowsareunrelatedtooneanother;theacceptance
ofonedoesnoteliminatetheothersfromfurtherconsideration.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:2
45. Mutuallyexclusiveprojectsarethosewhosecashflowscompetewithoneanother;theacceptanceof
onedoesnoteliminatetheothersfromfurtherconsideration.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:2
46. Mutuallyexclusiveprojectsarethosewhosecashflowscompetewithoneanother;theacceptanceof
oneeliminatestheothersfromfurtherconsideration.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
47. Ifafirmissubjecttocapitalrationing,itisabletoacceptallindependentprojectsthatprovidean
acceptablereturn.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
48. Ifafirmhasunlimitedfunds,itisabletoacceptallindependentprojectsthatprovideanacceptable
return.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
49. Ifafirmissubjecttocapitalrationing,ithasonlyafixednumberofdollarsavailableforcapital
expenditures,andnumerousprojectscompeteforthesedollars.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
50. Therankingapproachinvolvestherankingofcapitalexpenditureprojectsonthebasisofsome
predeterminedmeasuresuchastherateofreturn.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:AcceptRejectversusRankingApproach
51. Theacceptrejectapproachinvolvestherankingofcapitalexpenditureprojectsonthebasisofsome
predeterminedmeasuresuchastherateofreturn.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:AcceptRejectversusRankingApproach
52. Aconventionalcashflowpatternisoneinwhichaninitialoutflowisfollowedonlybyaseriesof
inflows.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
53. Anonconventionalcashflowpatternisoneinwhichaninitialoutflowisfollowedonlybyaseries
ofinflows.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
54. Anonconventionalcashflowpatternisoneinwhichaninitialoutflowisfollowedbyaseriesof
bothinflowsandoutflows.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
55. Relevantcashflowsaretheincrementalcashoutflowsandresultingsubsequentcashinflows
associatedwithaproposedcapitalexpenditure.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
56. Thethreemajorcashflowcomponentsincludetheinitialinvestment,operatingcashinflows,and
terminalcashflows.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:MajorCashFlowComponents
57. Thethreemajorcashflowcomponentsincludetheinitialinvestment,nonoperatingcashinflows,
andterminalcashflows.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:MajorCashFlowComponents
58. Asunkcostisacashflowthatcouldberealizedfromthebestalternativeuseofanownedasset.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
Topic:SunkCost
59. Anopportunitycostisacashflowthatcouldberealizedfromthebestalternativeuseofanowned
asset.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:OpportunityCost
60. Asunkcostisacashoutlaythathasalreadybeenmadeandthereforehasnoeffectonthecashflows
relevanttoacurrentdecision.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:SunkCost
61. Ifanassetissoldformorethanitsinitialpurchaseprice,thegainonthesaleiscomposedoftwo
parts:acapitalgainandrecaptureddepreciation.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
62. Ifanassetissoldforbookvalue,thegainonthesaleiscomposedoftwoparts:acapitalgainand
recaptureddepreciation.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
63. Ifanassetissoldforlessthanitsbookvalue,thelossonthesalemaybeusedtooffsetordinary
operatingincome.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
64. Ifaninvestmentinanewassetresultsinachangeincurrentassetsthatexceedsthechangein
currentliabilities,thischangeinnetworkingcapitalrepresentsacashoutflow.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
65. Ifaninvestmentinanewassetresultsinachangeincurrentliabilitiesthatexceedsthechangein
currentassets,thischangeinnetworkingcapitalrepresentsacashoutflow.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:4
66. Incomputingaftertaxoperatingcashflows,bothoperatingcostsandfinancingcostsmustbe
deductedfromanycashinflowsreceived.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:5
67. Incomputingaftertaxoperatingcashflows,onlyoperatingcostsbutnotfinancingcostsmustbe
deductedfromanycashinflowsreceived.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
.3 Multiple Choice Questions

1. _________istheprocessofevaluatingandselectinglongterminvestmentsconsistentwiththe
firmsgoalofownerwealthmaximization.
(a) Recapitalizingassets
(b) Capitalbudgeting
(c) Ratioanalysis
(d) Restructuringdebt
Answer: B
LevelofDifficulty:1
LearningGoal:1
2. Fixedassetsthatprovidethebasisforthefirmsprofitandvalueareoftencalled
(a) tangibleassets.
(b) noncurrentassets.
(c) earningassets.
(d) bookassets.
Answer: C
LevelofDifficulty:1
LearningGoal:1
3. Themostcommonmotiveforaddingfixedassetstothefirmis
(a) expansion.
(b) replacement.
(c) renewal.
(d) transformation.
Answer: A
LevelofDifficulty:1
LearningGoal:1
Topic:MotivesforCapitalBudgetingExpenditures
4. Thefinalstepinthecapitalbudgetingprocessis
(a) implementation.
(b) followupmonitoring.
(c) reevaluation.
(d) education.
Answer: B
LevelofDifficulty:1
LearningGoal:1
5. Thefirststepinthecapitalbudgetingprocessis
(a) reviewandanalysis.
(b) implementation.
(c) decisionmaking.
(d) proposalgeneration.
Answer: D
LevelofDifficulty:1
LearningGoal:1
6. A$60,000outlayforanewmachinewithausablelifeof15yearsiscalled
(a) capitalexpenditure.
(b) operatingexpenditure.
(c) replacementexpenditure.
(d) noneoftheabove.
Answer: A
LevelofDifficulty:2
LearningGoal:1
7. Acapitalexpenditureisallofthefollowingexcept
(a) anoutlaymadefortheearningassetsofthefirm.
(b) expectedtoproducebenefitsoveraperiodoftimegreaterthanoneyear.
(c) anoutlayforcurrentassetexpansion.
(d) commonlyusedtoexpandthelevelofoperations.
Answer: C
LevelofDifficulty:2
LearningGoal:1
8. Whichpatternofcashflowstreamisthemostdifficulttousewhenevaluatingprojects?
(a) Mixedstream.
(b) Conventionalflow.
(c) Nonconventionalflow.
(d) Annuity.
Answer: C
LevelofDifficulty:1
LearningGoal:2
Table8.1
OperatingCashInflows
$1,000 $1,000 $1,000 $1,000 $1,000
$2,500
InitialOutlay
9. Thecashflowpatterndepictedisassociatedwithacapitalinvestmentandmaybecharacterizedas
(SeeTable8.1.)
(a) anannuityandconventionalcashflow.
(b) amixedstreamandnonconventionalcashflow.
(c) anannuityandnonconventionalcashflow.
(d) amixedstreamandconventionalcashflow.
Answer: A
LevelofDifficulty:1
LearningGoal:2
Table8.2
OperatingCashInflows
$25,000 $10,000 $50,000 $10,000 $10,000 $60,000
$100,000
InitialOutlay
10. Thecashflowpatterndepictedisassociatedwithacapitalinvestmentandmaybecharacterizedas
(SeeTable8.2.)
(a) anannuityandconventionalcashflow.
(b) amixedstreamandnonconventionalcashflow.
(c) anannuityandnonconventionalcashflow.
(d) amixedstreamandconventionalcashflow.
Answer: D
LevelofDifficulty:1
LearningGoal:2
11. _________projectsdonotcompetewitheachother;theacceptanceofone_________theothers
fromconsideration.
(a) Capital;eliminates
(b) Independent;doesnoteliminate
(c) Mutuallyexclusive;eliminates
(d) Replacement;doesnoteliminate
Answer: B
LevelofDifficulty:1
LearningGoal:2
12. _________projectshavethesamefunction;theacceptanceofone_________theothersfrom
consideration.
(a) Capital;eliminates
(b) Independent;doesnoteliminate
(c) Mutuallyexclusive;eliminates
(d) Replacement;doesnoteliminate
Answer: C
LevelofDifficulty:1
LearningGoal:2
13. Afirmwithlimiteddollarsavailableforcapitalexpendituresissubjectto
(a) capitaldependency.
(b) mutuallyexclusiveprojects.
(c) workingcapitalconstraints.
(d) capitalrationing.
Answer: D
LevelofDifficulty:1
LearningGoal:2
14. Aconventionalcashflowpatternassociatedwithcapitalinvestmentprojectsconsistsofaninitial
(a) outflowfollowedbyabrokencashseries.
(b) inflowfollowedbyabrokenseries.
(c) outflowfollowedbyaseriesofinflows.
(d) inflowfollowedbyaseriesofoutflows.
Answer: C
LevelofDifficulty:1
LearningGoal:2
15. Anonconventionalcashflowpatternassociatedwithcapitalinvestmentprojectsconsistsofan
initial
(a) outflowfollowedbyaseriesofcashinflowsandoutflows.
(b) inflowfollowedbyaseriesofcashinflowsandoutflows.
(c) outflowfollowedbyaseriesofinflows.
(d) inflowfollowedbyaseriesofoutflows.
Answer: A
LevelofDifficulty:1
LearningGoal:2
16. _________isaseriesofequalannualcashflows.
(a) Amixedstream
(b) Aconventional
(c) Anonconventional
(d) Anannuity
Answer: D
LevelofDifficulty:1
LearningGoal:2
Topic:AnnuityCashFlows
17. Thecashflowsofanyprojecthavingaconventionalpatternincludeallofthebasiccomponents
except
(a) initialinvestment.
(b) operatingcashoutflows.
(c) operatingcashinflows.
(d) terminalcashflow.
Answer: B
LevelofDifficulty:1
LearningGoal:2
18. Projectsthatcompetewithoneanother,sothattheacceptanceofoneeliminatestheothersfrom
furtherconsiderationarecalled
(a) independentprojects.
(b) mutuallyexclusiveprojects.
(c) replacementprojects.
(d) Noneoftheabove.
Answer: B
LevelofDifficulty:2
LearningGoal:2
19. Afirmwithunlimitedfundsmustevaluatefiveprojects.Projects1and2areindependentand
Projects3,4,and5aremutuallyexclusive.Theprojectsarelistedwiththeirreturns.
Project Status Return(%)

1 Independent 14
2 Independent 12
3 Mutuallyexclusive 10
Arankingoftheprojectsonthebasisoftheirreturnsfromthebesttotheworstaccordingtotheir
acceptabilitytothefirmwouldbe
(a) 4,1,2or5,and3.
(b) 4,1,and2.
(c) 3,2or5,1,and4.
(d) 4,1,5,and3.
Answer: B
LevelofDifficulty:3
LearningGoal:2
20. Initialcashflowsandsubsequentoperatingcashflowsforaprojectaresometimesreferredtoas
(a) necessarycashflows.
(b) relevantcashflows.
(c) consistentcashflows.
(d) ordinarycashflows.
Answer: B
LevelofDifficulty:1
LearningGoal:3
21. Whenmakingreplacementdecisions,thedevelopmentofrelevantcashflowsiscomplicatedwhen
comparedtoexpansiondecisions,duetotheneedtocalculate_________cashinflows.
(a) conventional
(b) nonconventional
(c) incremental
(d) initial
Answer: C
LevelofDifficulty:2
LearningGoal:3
22. Relevantcashflowsforaprojectarebestdescribedas
(a) incidentalcashflows.
(b) incrementalcashflows.
(c) sunkcashflows.
(d) accountingcashflows.
Answer: B
LevelofDifficulty:2
LearningGoal:3
23. Indevelopingthecashflowsforanexpansionproject,theanalysisisthesameastheanalysisfor
replacementprojectswhere
(a) allcashflowsfromtheoldassetsareequal.
(b) priorcashflowsareirrelevant.
(c) allcashflowsfromtheoldassetarezero.
(d) cashinflowsequalcashoutflows.
Answer: C
LevelofDifficulty:2
LearningGoal:3
Topic:ExpansionversusReplacementProjectAnalysis
24. Whenevaluatingacapitalbudgetingprojectthechangeinnetworkingcapitalmustbeconsideredas
partof
(a) theoperatingcashinflows.
(b) theinitialinvestment.
(c) theincrementaloperatingcashinflows.
(d) theoperatingcashoutflows.
Answer: B
LevelofDifficulty:1
LearningGoal:4
25. Thechangeinnetworkingcapitalwhenevaluatingacapitalbudgetingdecisionis
(a) currentassetsminuscurrentliabilities.
(b) theincreaseincurrentassets.
(c) theincreaseincurrentliabilities.
(d) thechangeincurrentassetsminusthechangeincurrentliabilities.
Answer: D
LevelofDifficulty:1
LearningGoal:4
26. Thebookvalueofanassetisequaltothe
(a) fairmarketvalueminustheaccountingvalue.
(b) originalpurchasepriceminusannualdepreciationexpense.
(c) originalpurchasepriceminusaccumulateddepreciation.
(d) depreciatedvalueplusrecaptureddepreciation.
Answer: C
LevelofDifficulty:1
LearningGoal:4
Topic:BookValueofanAsset(Equation8.1)
27. Animportantcashinflowintheanalysisofinitialcashflowsforareplacementprojectis
(a) taxes.
(b) thecostofthenewasset.
(c) installationcost.
(d) thesalevalueoftheoldasset.
Answer: D
LevelofDifficulty:1
LearningGoal:4
28. Thetaxtreatmentregardingthesaleofexistingassetsthataresoldformorethanthebookvalueand
morethantheoriginalpurchasepriceresultsin
(a) anordinarytaxbenefit.
(b) notaxbenefitorliability.
(c) recaptureddepreciationtaxedasordinaryincome.
(d) acapitalgaintaxliabilityandrecaptureddepreciationtaxedasordinaryincome.
Answer: D
LevelofDifficulty:2
LearningGoal:4
29. Inevaluatingtheinitialinvestmentforacapitalbudgetingproject,
(a) anincreaseinnetworkingcapitalisconsideredacashinflow.
(b) adecreaseinnetworkingcapitalisconsideredacashoutflow.
(c) anincreaseinnetworkingcapitalisconsideredacashoutflow.
(d) networkingcapitaldoesnothavetobeconsidered.
Answer: C
LevelofDifficulty:2
LearningGoal:4
30. Thebasicvariablesthatmustbeconsideredindeterminingtheinitialinvestmentassociatedwitha
capitalexpenditureareallofthefollowingEXCEPT
(a) incrementalannualsavingsproducedbythenewasset.
(b) costofthenewasset.
(c) proceedsfromthesaleoftheexistingasset.
(d) taxesonthesaleofanexistingasset.
Answer: A
LevelofDifficulty:2
LearningGoal:4
31. Thetaxtreatmentregardingthesaleofexistingassetsthataresoldformorethanthebookvaluebut
lessthantheoriginalpurchasepriceresultsin
(b) acapitalgaintaxliability.
Answer: C
LevelofDifficulty:2
LearningGoal:4
32. Thetaxtreatmentregardingthesaleofexistingassetsthataresoldfortheirbookvalueresultsin
(b) notaxbenefitorliability.
Answer: B
LevelofDifficulty:2
LearningGoal:4
33. Thetaxtreatmentregardingthesaleofexistingassetsthatarenotdepreciableorusedinbusiness
andaresoldforlessthanthebookvalueresultsin
(b) acapitalgaintaxbenefit.
Answer: B
LevelofDifficulty:2
LearningGoal:4
34. Acorporationisconsideringexpandingoperationstomeetgrowingdemand.Withthecapital
expansion,thecurrentaccountsareexpectedtochange.Managementexpectscashtoincreaseby
$20,000,accountsreceivableby$40,000,andinventoriesby$60,000.Atthesametimeaccounts
payablewillincreaseby$50,000,accrualsby$10,000,andlongtermdebtby$100,000.Thechange
innetworkingcapitalis
(a) anincreaseof$120,000.
(b) adecreaseof$40,000.
(c) adecreaseof$120,000.
(d) anincreaseof$60,000.
Answer: D
LevelofDifficulty:3
LearningGoal:4
35. Acorporationisconsideringexpandingoperationstomeetgrowingdemand.Withthecapital
expansionthecurrentaccountsareexpectedtochange.Managementexpectscashtoincreaseby
$10,000,accountsreceivableby$20,000,andinventoriesby$30,000.Atthesametimeaccounts
payablewillincreaseby$40,000,accrualsby$30,000,andlongtermdebtby$80,000.Thechange
innetworkingcapitalis
(a) anincreaseof$10,000.
(b) adecreaseof$10,000.
(c) adecreaseof$90,000.
(d) anincreaseof$80,000.
Answer: B
LevelofDifficulty:3
LearningGoal:4
36. Thetaxtreatmentregardingthesaleofexistingassetsthataredepreciableandusedinbusinessand
aresoldforlessthanthebookvalueresultsin
(a) ataxbenefitfromanordinaryloss.
(b) acapitalgaintaxliability.
Answer: A
LevelofDifficulty:3
LearningGoal:4
37. Acorporationissellinganexistingassetfor$21,000.Theasset,whenpurchased,cost$10,000,was
beingdepreciatedunderMACRSusingafiveyearrecoveryperiod,andhasbeendepreciatedfor
fourfullyears.Iftheassumedtaxrateis40percentonordinaryincomeandcapitalgains,thetax
effectofthistransactionis
(a) $0taxliability.
(b) $7,560taxliability.
(c) $4,400taxliability.
(d) $7,720taxliability.
Answer: D
LevelofDifficulty:3
LearningGoal:4
(a) $0taxliability.
(b) $840taxliability.
(d) $3,160taxbenefit.
Answer: A
LevelofDifficulty:3
LearningGoal:4
(a) $0taxliability.
(d) $280taxbenefit.
Answer: D
LevelofDifficulty:3
LearningGoal:4
40. Afirmissellinganexistingassetfor$5,000.Theasset,whenpurchased,cost$10,000,wasbeing
depreciatedunderMACRSusingafiveyearrecoveryperiodandhasbeendepreciatedforfourfull
years.Iftheassumedtaxrateis40percentonordinaryincomeandcapitalgains,thetaxeffectof
thistransactionis
(a) $0taxliability.
(d) $2,000taxbenefit.
Answer: B
LevelofDifficulty:3
LearningGoal:4
41. Alossonthesaleofanassetthatisdepreciableandusedinbusinessis_________;alossonthe
saleofanondepreciableassetis_________.
(a) deductiblefromcapitalgainsincome;deductiblefromordinaryincome
(b) deductiblefromordinaryincome;deductibleonlyagainstcapitalgains
(c) acreditagainstthetaxliability;notdeductible
(d) notdeductible;deductibleonlyagainstcapitalgains
Answer: B
LevelofDifficulty:3
LearningGoal:4
42. Acorporationhasdecidedtoreplaceanexistingassetwithanewermodel.Twoyearsago,the
existingassetoriginallycost$30,000andwasbeingdepreciatedunderMACRSusingafiveyear
recoveryperiod.Theexistingassetcanbesoldfor$25,000.Thenewassetwillcost$75,000and
willalsobedepreciatedunderMACRSusingafiveyearrecoveryperiod.Iftheassumedtaxrateis
40percentonordinaryincomeandcapitalgains,theinitialinvestmentis_________.
(a) $42,000
(b) $52,440
(c) $54,240
(d) $50,000
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:InitialInvestment(Equation8.1)
43. Acorporationhasdecidedtoreplaceanexistingassetwithanewermodel.Twoyearsago,the
existingassetoriginallycost$70,000andwasbeingdepreciatedunderMACRSusingafiveyear
recoveryperiod.Theexistingassetcanbesoldfor$30,000.Thenewassetwillcost$80,000and
willalsobedepreciatedunderMACRSusingafiveyearrecoveryperiod.Iftheassumedtaxrateis
40percentonordinaryincomeandcapitalgains,theinitialinvestmentis_________.
(a) $48,560
(b) $44,360
(c) $49,240
(d) $27,600
Answer: A
LevelofDifficulty:4
LearningGoal:4
Topic:InitialInvestment(Equation8.1)
44. Benefitsexpectedfromproposedcapitalexpendituresmustbeonanaftertaxbasisbecause
(a) taxesarecashoutflows.
(b) nobenefitsmaybeusedbythefirmuntiltaxclaimsaresatisfied.
(c) theremayalsobetaxbenefitstobeevaluated.
(d) itiscommon,acceptedpracticetodoso.
Answer: B
LevelofDifficulty:2
LearningGoal:5
45. Onebasictechniqueusedtoevaluateaftertaxoperatingcashflowsisto
(a) addnoncashchargestonetincome.
(b) subtractdepreciationfromoperatingrevenues.
(c) addcashexpensestonetincome.
(d) subtractcashexpensesfromnoncashcharges.
Answer: A
LevelofDifficulty:2
LearningGoal:5
ComputerDiskDuplicators,Inc.hasbeenconsideringseveralcapitalinvestmentproposalsfortheyear
beginningin2004.Foreachinvestmentproposal,therelevantcashflowsandotherrelevantfinancialdata
aresummarizedinthetablebelow.Inthecaseofareplacementdecision,thetotalinstalledcostofthe
equipmentwillbepartiallyoffsetbythesaleofexistingequipment.Thefirmissubjecttoa40percenttax
rateonordinaryincomeandonlongtermcapitalgains.Thefirmscostofcapitalis15percent.
Table8.3
Proposal
TypeofCapital 1 2 3
BudgetingDecision Expansion Replacement Replacement
Mutually Mutually
Exclusive Exclusive
TypeofProject Independent with3 with2
Costofnewasset $1,500,000 $200,000 $300,000
Installationcosts $0 $0 $15,000
MACRS(newasset) 10years 5years 5years
Originalcostofoldasset N/A* $80,000 $100,000
Purchasedate(oldasset) N/A 1/1/97 1/1/2000
Saleproceeds(oldasset) N/A $50,000 $120,000
MACRS(oldasset) N/A 5years 5years
Annualnetprofitsbefore
depreciation&taxes(old) N/A $30,000 $25,000
Annualnetprofitsbefore
depreciation&taxes(new) $250,000 $100,000 $175,000
*Notapplicable
46. ForProposal1,thecashflowpatternfortheexpansionprojectis(SeeTable8.3.)
(a) amixedstreamandconventional.
(b) amixedstreamandnonconventional.
(c) anannuityandconventional.
(d) anannuityandnonconventional.
Answer: A
LevelofDifficulty:3
LearningGoal:5
Topic:ExpansionProjectAnalysis
47. ForProposal1,theinitialoutlayequals_________.(SeeTable8.3.)
(a) $1,380,000
(b) $1,440,000
(c) $1,500,000
(d) $1,620,000
Answer: C
LevelofDifficulty:3
LearningGoal:5
Topic:InitialOutlay
48. ForProposal1,thedepreciationexpenseforyear1is_________.(SeeTable8.3.)
(a) $110,400
(b) $115,200
(c) $150,000
(d) $300,000
Answer: C
LevelofDifficulty:3
LearningGoal:5
Topic:IncrementalDepreciation
49. ForProposal1,theannualincrementalaftertaxcashflowfromoperationsforyear1is_________.
(SeeTable8.3.)
(a) $60,000
(b) $255,000
(c) $300,000
(d) $210,000
Answer: D
LevelofDifficulty:3
LearningGoal:5
Topic:IncrementalOperatingCashFlows
50. ForProposal2,thecashflowpatternforthereplacementprojectis(SeeTable8.3.)
Answer: A
LevelofDifficulty:3
LearningGoal:5
51. ForProposal2,thebookvalueoftheexistingassetis_________.(SeeTable8.3.)
(a) $13,600
(b) $34,400
(c) $66,400
(d) $80,000
Answer: A
LevelofDifficulty:3
LearningGoal:5
52. ForProposal2,thetaxeffectonthesaleoftheexistingassetresultsin(SeeTable8.3.)
(a) $12,000taxliability.
Answer: B
LevelofDifficulty:3
LearningGoal:5
53. ForProposal2,theinitialoutlayequals(SeeTable8.3.)
(a) $120,720cashoutflow.
(b) $164,560cashoutflow.
(c) $150,000cashoutflow.
(d) $167,520cashoutflow.
Answer: B
LevelofDifficulty:3
LearningGoal:5
Topic:InitialOutlay
54. ForProposal2,theincrementaldepreciationexpenseforyear2is_________.(SeeTable8.3.)
(a) $16,800
(b) $26,400
(c) $38,400
(d) $60,000
Answer: D
LevelofDifficulty:3
LearningGoal:5
(SeeTable8.3.)
(a) $18,000
(b) $24,000
(c) $66,000
(d) $84,000
Answer: C
LevelofDifficulty:3
LearningGoal:5
56. ForProposal3,thecashflowpatternforthereplacementprojectis(SeeTable8.3.)
Answer: A
LevelofDifficulty:3
LearningGoal:5
57. ForProposal3,thebookvalueoftheexistingassetis_________.(SeeTable8.3.)
(a) $21,000
(b) $43,000
(c) $52,000
(d) $80,000
Answer: D
LevelofDifficulty:3
LearningGoal:5
58. ForProposal3,thetaxeffectonthesaleoftheexistingassetresultsin(SeeTable8.3.)
(a) $8,000taxliability.
Answer: B
LevelofDifficulty:3
LearningGoal:5
59. ForProposal3,theinitialoutlayequals_________.(SeeTable8.3.)
(a) $170,400
(b) $211,000
(c) $196,000
(d) $300,000
Answer: B
LevelofDifficulty:3
LearningGoal:5
Topic:InitialOutlay
(a) $21,000
(b) $42,000
(c) $47,850
(d) $50,850
Answer: C
LevelofDifficulty:3
LearningGoal:5
(a) $15,750
(b) $10,750
(c) $23,000
(d) $36,150
Answer: A
LevelofDifficulty:3
LearningGoal:5
(SeeTable8.3.)
(a) $45,000
(b) $75,150
(c) $90,150
(d) $109,140
Answer: D
LevelofDifficulty:3
LearningGoal:5
Table8.4
CudaMarineEngines,Inc.mustdeveloptherelevantcashflowsforareplacementcapital
investmentproposal.Theproposedassetcosts$50,000andhasinstallationcostsof$3,000.The
assetwillbedepreciatedusingafiveyearrecoveryschedule.Theexistingequipment,which
originallycost$25,000andwillbesoldfor$10,000,hasbeendepreciatedusinganMACRS
fiveyearrecoveryscheduleandthreeyearsofdepreciationhasalreadybeentaken.Thenew
equipmentisexpectedtoresultinincrementalbeforetaxnetprofitsof$15,000peryear.Thefirm
hasa40percenttaxrate.
63. Thecashflowpatternforthecapitalinvestmentproposalis(SeeTable8.4.)
Answer: A
LevelofDifficulty:3
LearningGoal:5
64. Thebookvalueoftheexistingassetis_________.(SeeTable8.4.)
(a) $7,250
(b) $15,000
(c) $21,250
(d) $25,000
Answer: A
LevelofDifficulty:3
LearningGoal:5
65. Thetaxeffectonthesaleoftheexistingassetresultsin(SeeTable8.4.)
(a) $800taxbenefit.
Answer: C
LevelofDifficulty:3
LearningGoal:5
66. Theinitialoutlayequals_________.(SeeTable8.4.)
(a) $41,100
(b) $44,100
(c) $38,800
(d) $38,960
Answer: B
LevelofDifficulty:3
LearningGoal:5
67. Theincrementaldepreciationexpenseforyear1is_________.(SeeTable8.4.)
(a) $2,250
(b) $7,600
(c) $7,000
(d) $7,950
Answer: B
LevelofDifficulty:3
LearningGoal:5
68. Theincrementaldepreciationexpenseforyear5is_________.(SeeTable8.4.)
(a) $2,250
(b) $5,110
(c) $7,950
(d) $6,360
Answer: D
LevelofDifficulty:3
LearningGoal:5
69. Theannualincrementalaftertaxcashflowfromoperationsforyear1is_________.(See
Table8.4.)
(a) $13,950
(b) $16,600
(c) $25,600
(d) $30,000
Answer: B
LevelofDifficulty:3
LearningGoal:5
70. Acorporationisevaluatingtherelevantcashflowsforacapitalbudgetingdecisionandmust
estimatetheterminalcashflow.Theproposedmachinewillbedisposedofattheendofitsusable
lifeoffiveyearsatanestimatedsalepriceof$15,000.Themachinehasanoriginalpurchaseprice
of$80,000,installationcostof$20,000,andwillbedepreciatedunderthefiveyearMACRS.Net
workingcapitalisexpectedtodeclineby$5,000.Thefirmhasa40percenttaxrateonordinary
incomeandlongtermcapitalgain.Theterminalcashflowis
(a) $24,000.
(b) $16,000.
(c) $14,000.
(d) $26,000.
Answer: B
LevelofDifficulty:4
LearningGoal:6
Topic:TerminalCashFlows(Equation8.1)
71. Acorporationisevaluatingtherelevantcashflowsforacapitalbudgetingdecisionandmust
estimatetheterminalcashflow.Theproposedmachinewillbedisposedofattheendofitsusable
lifeoffiveyearsatanestimatedsalepriceof$2,000.Themachinehasanoriginalpurchasepriceof
$80,000,installationcostof$20,000,andwillbedepreciatedunderthefiveyearMACRS.Net
workingcapitalisexpectedtodeclineby$5,000.Thefirmhasa40percenttaxrateonordinary
incomeandlongtermcapitalgain.Theterminalcashflowis
(a) $5,800.
(b) $7,800.
(c) $8,200.
(d) $6,200.
Answer: C
LevelofDifficulty:4
LearningGoal:6
Topic:TerminalCashFlows(Equation8.1)
72. Allofthefollowingaremotivesforcapitalbudgetingexpendituresexcept
(a) expansion.
(b) replacement.
(c) renewal.
(d) invention.
Answer: D
LevelofDifficulty:2
LearningGoal:1
Topic:MotivesforCapitalBudgetingExpenditures
73. Allofthefollowingarestepsinthecapitalbudgetingprocessexcept
(a) implementation.
(b) followup.
(c) transformation.
(d) decisionmaking.
Answer: C
LevelofDifficulty:2
LearningGoal:1
74. Theevaluationofcapitalexpenditureproposalstodeterminewhethertheymeetthefirmsminimum
acceptancecriteriaiscalled
(a) therankingapproach.
(b) anindependentinvestment.
(c) theacceptrejectapproach.
(d) amutuallyexclusiveinvestment.
Answer: C
LevelofDifficulty:2
LearningGoal:2
Topic:AcceptRejectversusRankingApproaches
75. Theorderingofcapitalexpenditureprojectsonthebasisofsomepredeterminedmeasuresuchasthe
rateofreturniscalled
(a) therankingapproach.
(b) anindependentinvestment.
(c) theacceptrejectapproach.
(d) amutuallyexclusiveinvestment.
Answer: A
LevelofDifficulty:2
LearningGoal:2
Topic:AcceptRejectversusRankingApproaches
76. Cashoutlaysthathadbeenpreviouslymadeandhavenoeffectonthecashflowsrelevanttoa
currentdecisionarecalled
(a) incrementalhistoricalcosts.
(b) incrementalpastexpenses.
(c) opportunitycostsforegone.
(d) sunkcosts.
Answer: D
LevelofDifficulty:2
LearningGoal:3
Topic:SunkCosts
77. Cashflowsthatcouldberealizedfromthebestalternativeuseofanownedassetarecalled
(a) incrementalcosts.
(b) lostresaleopportunities.
(c) opportunitycosts.
(d) sunkcosts.
Answer: C
LevelofDifficulty:2
LearningGoal:3
Topic:SunkCosts
78. Ininternationalcapitalbudgetingdecisions,politicalriskscanbeminimizedusingallofthe
followingstrategiesexcept
(a) structuringtheinvestmentasajointventureandselectingwellconnectedlocalpartner.
(b) structuringthefinancingofsuchinvestmentsasequityratherthanasdebt.
(c) structuringthefinancingofsuchinvestmentsasdebtratherthanasequity.
(d) Noneoftheabove.
Answer: B
LevelofDifficulty:3
LearningGoal:3
79. Theportionofanassetssalepricethatisaboveitsbookvalueandbelowitsinitialpurchasepriceis
called
(a) acapitalgain.
(b) recaptureddepreciation.
(c) acapitalloss.
(d) bookvalue.
Answer: B
LevelofDifficulty:3
LearningGoal:4
80. Theportionofanassetssalepricethatisbelowitsbookvalueandbelowitsinitialpurchasepriceis
called
(a) acapitalgain.
(b) recaptureddepreciation.
(c) acapitalloss.
(d) bookvalue.
Answer: C
LevelofDifficulty:3
LearningGoal:4
81. Ifaccountsreceivableincreaseby$1,000,000,inventorydecreasesby$500,000,andaccounts
payableincreaseby$500,000,networkingcapitalwould
(a) decreaseby$500,000.
(b) increaseby$1,500,000.
(c) increaseby$2,000,000.
(d) experiencenochange.
Answer: D
LevelofDifficulty:3
LearningGoal:4
82. Allofthefollowingwouldbeusedinthecomputationofaninvestmentsinitialinvestmentexcept
(a) theannualaftertaxinflowexpectedfromtheinvestment.
(b) theinitialpurchasepriceoftheinvestment.
(c) theresalevalueofanoldassetbeingreplaced.
(d) thetaxonthesaleofanoldassetbeingreplaced.
Answer: A
LevelofDifficulty:2
LearningGoal:4
.4 Essay Questions
1. Computetheinitialpurchasepriceforanassetwithbookvalueof$34,800andtotalaccumulated
depreciationof$85,200.
Answer: Initialpurchasepricebookvalueaccumulateddepreciation34,80085,200
$120,000
LevelofDifficulty:2
LearningGoal:4
Topic:Depreciation(Equation8.1)
2. Amixerwaspurchasedtwoyearsagofor$120,000andcanbesoldfor$125,000today.Themixer
hasbeendepreciatedusingtheMACRS5yearrecoveryperiodandthefirmpays40percenttaxes
onbothordinaryincomeandcapitalgain.
(a) Computerecaptureddepreciationandcapitalgain(loss),ifany.
(b) Findthefirmstaxliability.
Answers:
(a) BookValue120,000(10.200.32)$57,600
Recaptureddepreciation 120,00057,600 $62,400
Capitalgain 125,000120,000 5,000
$67,400
(b) Taxliability67,4000.40$26,960
LevelofDifficulty:3
LearningGoal:4
Topic:MACRSDepreciationandTaxes(Equation8.1)
3. Anassetwaspurchasedthreeyearsagofor$100,000andcanbesoldfor$40,000today.Theasset
hasbeendepreciatedusingtheMACRS5yearrecoveryperiodandthefirmpays40percenttaxes
onbothordinaryincomeandcapitalgain.
Answers:
(a) BookValue100,000(10.200.320.19)$29,000
Recaptureddepreciation40,00029,000 $11,000
Capitalgain 0
$11,000
(b) Taxliability11,0000.40$4,400
LevelofDifficulty:3
LearningGoal:4
4. Amachinewaspurchasedtwoyearsagofor$120,000andcanbesoldfor$50,000today.The
machinehasbeendepreciatedusingtheMACRS5yearrecoveryperiodandthefirmpays
40percenttaxesonbothordinaryincomeandcapitalgains.
Answers:
(a) BookValue120,000(10.200.32)$57,600
Recaptureddepreciation $0
Capitalloss57,60050,000 7,600
(b) Taxbenefit7,6000.40$3,040
LevelofDifficulty:3
LearningGoal:4
5. Computethedepreciationvaluesforanassetwhichcosts$55,000andrequires$5,000ininstallation
costsusingMACRS5yearrecoveryperiod.
Answer: DepreciableValue55,0005,000$60,000
Year DepreciableValue Percentages DepreciationValues

1 $60,000 20% $12,000
2 60,000 32 19,200
3 60,000 19 11,400
4 60,000 12 7,200
5 60,000 12 7,200
6 60,000 5 3,000
$60,000
LevelofDifficulty:3
LearningGoal:4
Topic:MACRSDepreciation(Equation8.1)
Table8.5
FinePressisconsideringreplacingtheexistingpresswithamoreefficientpress.Thenewpress
costs$55,000andrequires$5,000ininstallationcosts.Theoldpresswaspurchased2yearsago
foraninstalledcostof$35,000andcanbesoldfor$20,000netofanyremovalcoststoday.Both
pressesaredepreciatedundertheMACRS5yearrecoveryschedule.Thefirmisin40percent
marginaltaxrate.
6. Calculatethebookvalueoftheexistingpressbeingreplaced.(SeeTable8.5.)
Answer: Bookvalueofexistingpress$35,000[1(0.200.32)]16,800
LevelofDifficulty:3
LearningGoal:4
Topic:InitialInvestment,MACRSDepreciationandTaxes(Equation8.1)
7. Calculatethetaxeffectfromthesaleoftheexistingasset.(SeeTable8.5.)
Answer: Tax:
$20,00016,800$3,200recaptureddepreciation
$3,2000.40$1,280tax
LevelofDifficulty:3
LearningGoal:4
8. Calculatetheinitialinvestmentofthenewasset.(SeeTable8.5.)
Answer:
Costofnewpress $55,000
InstallationCost 5,000
Proceedsfromthesaleofexistingpress 20,000
Taxeffectonsaleofexistingpress 1,280
Initialinvestment $41,280
LevelofDifficulty:3
LearningGoal:4
DegnanDanceCompany,Inc.,amanufacturerofdanceandexerciseapparel,isconsideringreplacingan
existingpieceofequipmentwithamoresophisticatedmachine.Thefollowinginformationisgiven.
Table8.6
Facts
ExistingMachine ProposedMachine
Cost$100,00 Cost$150,000
Purchased2yearsago Installation$20,000
DepreciationusingMACRSover DepreciationtheMACRSa5year
5yearrecoveryschedule recoverschedulewillbeused.
Currentmarketvalue$105,000
Fiveyearusableliferemaining Fiveyearusablelifeexpected
EarningsbeforeDepreciationandTaxes
ExistingMachine ProposedMachine
Year 1 $160,000 Year 1 $170,000
2 150,000 2 170,000
3 140,000 3 170,000
4 140,000 4 170,000
5 140,000 5 170,000
Thefirmpays40percenttaxesonordinaryincomeandcapitalgains.
9. Calculatethebookvalueoftheexistingassetbeingreplaced.(SeeTable8.6.)
Answer: Bookvalueofexistingequipment$100,000[1(0.200.32)]48,000
LevelofDifficulty:3
LearningGoal:5
Topic:MACRSDepreciation(Equation8.1)
10. Calculatethetaxeffectfromthesaleoftheexistingasset.(SeeTable8.6.)
Answer: Tax:
$105,000$100,000$5,000capitalgain 0.4 $2,000
$52,000recaptureddepreciation 0.4 20,800
Totaltaxliability $22,800
LevelofDifficulty:3
LearningGoal:5
11. Calculatetheinitialinvestmentrequiredforthenewasset.(SeeTable8.6.)
Answer:
Costofnewequipment $150,000
Installationcost 20,000
Proceedsfromthesaleofexistingequipment (105,000)
Taxeffectonsaleofexistingequipment 22,800
Initialinvestment $87,800
LevelofDifficulty:3
LearningGoal:5
12. Calculatetheincrementalearningsbeforedepreciationandtaxes.(SeeTable8.6.)
Answer:
Year
1 $10,000
2 20,000
3 30,000
4 30,000
5 30,000
LevelofDifficulty:3
LearningGoal:5
Topic:IncrementalEBDT
13. Calculatetheincrementaldepreciation.(SeeTable8.6.)
Answer:
Year
1 $15,000
2 42,400
3 20,300
4 15,400
5 20,400
6 8,500
LevelofDifficulty:3
LearningGoal:5
14. Summarizetheincrementalaftertaxcashflow(relevantcashflows)foryearst0throught5.
(SeeTable8.6.)
Answer:
CalculationofOperatingCashFlows
Profitsbefore NetProfits
Depreciation NetProfits After Cash
Year andTaxes Depreciation beforeTaxes Taxes Taxes Flow
ExistingMachine
1 $160,000 $19,000 $141,000 $56,400 $84,600 $103,600
2 150,000 12,000 138,000 55,200 82,800 94,800
3 140,000 12,000 128,000 51,200 76,800 88,800
4 140,000 5,000 135,000 54,000 81,000 86,000
5 140,000 0 140,000 56,000 84,000 84,000
6 0 0 0 0 0 0
ProposedMachine
1 $170,000 $34,000 $136,000 $54,400 $81,600 $115,600
2 170,000 54,400 115,600 46,240 69,360 123,760
3 170,000 32,300 137,700 55,080 82,620 114,920
4 170,000 20,400 149,600 59,840 89,760 110,160
5 170,000 20,400 149,600 59,840 89,760 110,160
6 0 8,500 8,500 3,400 5,100 3,400
CalculationofIncrementalCashFlows
Year Proposed Existing Incremental
1 $115,600 $103,600 $12,000
2 123,760 94,800 28,960
3 114,920 88,800 26,120
4 110,160 86,000 24,160
5 110,160 84,000 26,160
6 3,400 0 3,400
LevelofDifficulty:3
LearningGoal:5
Topic:IncrementalCashFlows
15. Shouldfinancingcostssuchasthereturnspaidtobondholdersandstockholdersbeconsideredin
computingaftertaxoperatingcashflows?Whyorwhynot?
Answer: Financingcostsarenotanincrementalcashflowforcapitalbudgetingpurposes.
Financingcostsareadirectconsequenceofhowtheprojectisfinanced,notwhetherthe
projectiseconomicallyviable.Financingcostsareembeddedintherequiredrateofreturn
usedtodiscountprojectcashflows.
LevelofDifficulty:2
LearningGoal:3
16. Pleaseexplainthedifferencebetweenasunkcostandanopportunitycostandgiveanexampleof
eachtypeofcost
Answer: Thereisnoonecorrectanswertothisquestion.Acorrectanswerdependsuponthe
studentsresponse.
LevelofDifficulty:2
LearningGoal:3
Topic:SunkCostsversusOpportunityCosts

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.3 Multiple Choice Questions

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Year DepreciableValue Percentages DepreciationValues

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