Part 2 : Capital Budgeting Process Question 1 1 - CMA 1277 5.14 - Capital Budgeting Process Depreciation is incorporated explicitly in the discounted cash flow analysis of an investment proposal because it A. Is a cash inflow. inflow. B. Represents the initial cash outflow spread over the life of the investment. C. Is a cost of operations that cannot be avoided. D. Reduces the cash outlay for income taxes. A. Depreciation is itself itself neither a cash inflow nor a cash outf low. However, because it can shield other incom e from tax, it may result in a decrease in cash outflow, if the firm has other income to shield from tax. B. Depreciation does represent the initial cash outflow spread over the life of the investment. However, this is not the reason depreciation is incorporated in the discounted cash flow analysis of an investment proposal. C. Depreciation is not incorporated in the discounted cash flow analysis of an investment proposal because it is a cost of operations that cannot be avoided. It is, rather, included because it affects cash flow and thus the discounted cash flow analysis for an investment proposal. D. Depreciation is explicitly included in the calculation of the discounted cash flow of an investment proposal because it is a deductible expense expense for the purpose of calculating income tax liability. Thus, the cash outlay for income taxes is reduced by the depreciation and other income is shielded from tax.
Question 2 2 - CMA 1278 5.10 - Capital Budgeting Process The accountant of Ronier, Inc. has prepared an analysis of a proposed capital project using discounted cash flow techniques. One manager has questioned the accuracy of the results because the discount factors employed in the analysis have assumed the cash flows occurred at the end of the year when the cash flows actually occurred uniformly throughout each year. The net present value calculated by the accountant will A. Be unusable for ac tual decision mak ing. B. Be slightly understated but usable. C. Not be in error. D. Be slightly overstated. A. The results will not be unusable unu sable for actual ac tual decision mak ing. B. Assuming Assuming that cash flows occur at the end of the year will result in a slightly understated net present value. However, the analysis will still be usable. C. It cannot be said that the net present value calculated by the account will not be in error, because the actual cash flows will probably occur uniformly throughout the year. D. The net present value will not be overstated by assuming that the cash flows will occur at year end. The cash flows will probably occur uniformly throughout each year, so discounting them as though they occur at the end of each year instead will lead to a slight understatement, not a slight overstatement.
Question 3 3 - CMA 1292 4.10 - Capital Budgeting Process Garfield, Inc. is considering a 10-year capital investment project with forecasted revenues of $40,000 per year and forecasted cash operating expenses of $29,000 per year. The initial cost of the equipment for the project is $23,000, and Garfield expects to sell the equipment for $9,000 at the end of the tenth year. The equipment will be depreciated over 7 (c) HOCK international, page 1
Part 2 : Capital Budgeting Process years. The project requires a working capital investment of $7,000 at its inception and another $5,000 at the end of year 5. Assuming a 40% marginal tax rate, the expected net cash flow from the project in the tenth year is A. $24,000. B. $20,000. C. $11,000. D. $32,000. A. Cash flow in the final f inal year of the project will include: (1) Cash flow from operations of $40,000 revenue less $29,000 expenses, expenses, which equals $11,000. Cash flow net of tax is $11,000 (1 − .40) = $6,600. (2) Released working capital of $7,000 + $5,000 = $12,000. (3) Sale of equipment equipment for $9,000. 100% of the sale price is capital gain, because the equipment equipment was depreciated over 7 years and so its tax basis (its book value for tax purposes) in the tenth year is zero. Therefore, the gain net of tax is $9,000 (1 − .40) = $5,400. Thus, the total expected net cash flow in Year 10 is $6,600 + $12,000 + $5,400 = $24,000. B. An answer of $20,000 results from using an incorrect income tax rate. C. An answer of $11,000 results from omitting working capital recapture, cash flow from the sale of the equipment, and the tax effect. D. An answer of $32,000 results from using gross cash flows, not cash flows net of tax.
Question 4 4 - CMA 1292 4.9 - Capital Budgeting Process Regal Industries is replacing a grinder purchased 5 years ago for $15,000 with a new one costing $25,000 cash. The original grinder is being depreciated on a straight-line basis over 15 years to a zero salvage value; Regal will sell this old equipment to a third party for $6,000 cash. The new equipment will be depreciated on a straight-line basis over 10 years to a zero salvage value. Assuming a 40% marginal tax rate, Regal's net cash investment at the time of purchase if the old grinder is sold and the new one purchased is A. $17,400. B. $15,000. C. $19,000. D. $25,000. A. The net cash flows in Year 0 includes: (1) cash inflow from the sale of the old equipment - $6,000. (2) Tax effect of the sale of the t he old equipment: Book value of old equipment = $10,000 ($15,000 original purchase price minus [$15,000/15 × 5]). Loss on sale = $6,000 sale price minus $10,000 book value = $(4,000). At a 40% tax rate, the tax benefit from the loss is a $1,600 cash inflow from decreased taxes owed. (3) Purchase price of $25,000 for the new equipment is a cash outflow. The net initial cash investment investment is $6,000 + $1,600 − $25,000 = $(17,400). B. $15,000 is the initial investment in the old machine. C. $19,000 is the $25,000 initial investment minus the $6,000 sale price for the old equipment, but it does not include the tax benefit from the loss on the sale of the old equipment. D. $25,000 is the investment in the new machine, but it is not the net cash investment.
Question 5 5 - CMA 1293 4.14 - Capital Budgeting Process A depreciation tax shield shield is
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Part 2 : Capital Budgeting Process A. A reduction in income taxes. B. The cash provided by recording depreciation. C. The expense caused by depreciation. D. An after-tax cash outflow. A. The depreciation tax shield is the amount by which income taxes w ill be lower due to the depreciation expense reported on the income tax return. The depreciation tax shield is so-named because it shields other income of the company from taxation. B. Although depreciation is an expense that does not require a cash outflow at the time it is recorded (because the cash outflow occurred when the asset was originally purchased), cash is not provided by the recording of depreciation. C. The depreciation dep reciation tax shield is not the expense caused by deprec iation. Depreciation expense is itself an expense. This expense, in turn, can reduce income taxes due, assuming the firm has taxable income and can use the expense to reduce its taxes. taxes. D. A depreciation tax shield is neither a cash inflow nor a cash outflow. It does, however, reduce cash outflow for income taxes.
Question 6 6 - CMA 1295 4.11 - Capital Budgeting Process Which one of the following statements concerning cash flow determination for capital budgeting purposes isnot is not correct? correct? A. Net working capital changes change s should be include d in cash flow forec asts. B. Sunk costs are not incremental flows and should not be included. C. Book depreciation is relevant because it affects net income. D. Tax depreciation must be considered because it affects cash payments for taxes. A. It is is correct to say that net working capital change s should be include d in cash flow forec asts. B. It is correct to say that sunk costs are not incremental flows and should not be included. The only cash flows that are relevant in a capital budgeting analysis are those that will occur as a direct result of the project under consideration. Sunk costs by definition are those which have already occurred and cannot be changed. C. It is not correct to say that book depreciation is relevant because it affects net income. Book depreciation is the depreciation expense recorded under generally accepted accounting principles. The depreciation used in capital budgeting analyses analyses is the type of depreciation used for tax purposes, which is different from the type of depreciation used for book purposes. The type of depreciation for tax purposes used in capital budgeting analyses is relevant because it impacts the amount of income tax due, which is relevant because it is a cash flow item. D. It is correct to say that tax depreciation must be considered because it affects cash payments for taxes.
Question 7 7 - CMA 1295 4.15 - Capital Budgeting Process Kore Industries is analyzing a capital investment proposal for new equipment to produce a product over the next 8 years. The analyst is attempting to determine the appropriate "end-of-life" cash flows for the analysis. At the end of 8 years, the equipment must be removed from the plant and will have a net book value of zero, a tax basis of $75,000, a cost to remove of $40,000, and scrap salvage value of $10,000. Kore's effective tax rate is 40%. What is the appropriate "end-of-life" cash flow related to these items that should be used in the analysis? (c) HOCK international, page 3
Part 2 : Capital Budgeting Process
A. $27,000 B. $45,000 C. $(18,000) D. $12,000 A. An answer of $27,000 resul ts from adding the book value of the equ ipment ($75,000) ($75, 000) to the cash received from its sale ($10,000) and subtracting the cost to remove it ($40,000), then multiplying the result by .60 to express it net of tax. However, the $75,000 book value of the equipment is not a cash inflow and the $10,000 cash received from the sale of the old equipment does not represent a taxable gain. B. An answer of $45,000 results from counting the equipment's $75,000 tax basis as a cash inflow and adjusting it by a positive $10,000 for the sale of the equipment and by a negative $40,000 for the cost to remove. However, the $75,000 tax basis is not a cash inflow. Furthermore, the tax consequences of the sale and of the cost to remove need to be included. C. An answer of $(18,000) results from taking the $10,000 cash inflow from the sale of the equipment less the $40,000 cash outflow for cost to remove, and then reducing the resulting $(30,000) by the effect of income tax savings at 40% of the net loss. This assumes that the $10,000 received for the sale is taxable because the equipment's book value is zero. However, the equipment's tax basis is different from its book value. D. Cash inflow from fr om the sale of the equipment will be $10,000. The equipment's tax basis is $75,000. Thus, there will be a capital loss for income tax purposes of $65,000, which will be worth $26,000 in cash for the company ($65,000 × .40) from reduced income taxes. The $40,000 cost to remove will be a net expense after tax of $24,000 ($40,000 × .60). Thus, the net cash flow for the equipment's end of life will be $10,000 + $26,000 − $24,000 = $12,000.
Question 8 8 - CMA 1295 4.17 - Capital Budgeting Process The term that refers to costs incurred in the past that are not relevant to a future decision is A. Full absorption cost. B. Underallocated indirect cost. C. Discretionary cost. D. Sunk cost. A. Full absorption costing is a form of costing that includes both variable and fixed production costs in product costs that follow inventory and are expensed as cost of goods sold only when the inventory is sold. B. An underallocated indirect cost is a cost that has not yet been allocated to production, although it is a cost of production. C. A discretionary cost is a cost that is not a committed cost. It can be increased or decreased at the discretion of the decision maker. Advertising, employee training, preventive maintenance, and research and development are examples of discretionary costs. D. A sunk cost is one that has already been incurred and therefore is not a relevant cost. Sunk costs are not taken into account in the decision making process process because the money has already been spent, and those costs will not be changed by one decision or another.
Question 9 9 - CMA 1295 4.22 - Capital Budgeting Process
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Part 2 : Capital Budgeting Process In equipment-replacement decisions, which one of the following does not affect the decision-making process? A. Original fair marke t value of the old equipm ent. B. Operating costs of the old equipment. C. Cost of the new equipment. D. Current disposal price of the old equipment. A. The original fair market value of the old equipment is not relevant to the decision-making process. B. The operating costs of the old equipment, as well as the operating costs of the new equipment, are relevant to the decision-making process. C. The cost of the new equipment is relevant to the decision-making process. D. The current disposal price of the old equipment is relevant to the decision-making process.
Question 10 10 - CMA 1295 4.3 - Capital Budgeting Process The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40%. What is the net cash outflow at the beginning of the first year that Moore Corporation should use in a capital budgeting analysis? A. $(90,000) B. $(105,000) C. $(96,000) D. $(85,000) A. A cash outflow of $90,000 $90,00 0 is equal to the purchase price of the machine. ma chine. However, this is not the only cost that will be a cash outflow at the beginning of the project. B. The net cash outflow at the beginning of the first year includes the purchase price of $90,000, the transportation cost of $6,000, and the installation cost of $9,000, for a total of $105,000. There is no income tax effect in Year 0, since these costs w ill all be capitalized and depreciated depreciated over the life of the machine. C. A cash outflow of $96,000 includes the purchase price of the machine ($90,000) and the transportation cost ($6,000). However, these are not the only costs that will be cash outflows at the beginning of the project. D. A cash outflow of $85,000 is equal to the purchase price of the machine less the expected salvage value. However, netting out the salvage value at the beginning of the project is incorrect. Furthermore, the purchase price of the machine is not the only cost that will be a cash outflow at the beginning of the project.
Question 11 11 - CMA 1295 4.4 - Capital Budgeting Process The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, the machine is expected to produce (c) HOCK international, page 5
Part 2 : Capital Budgeting Process 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40%. What is the net cash flow for the third year that Moore Corporation should use in a capital budgeting analysis? A. $64,200 B. $68,000 C. $68,400 D. $79,000 A. An answer of $64,200 resul ts from depreciating depr eciating the initial initial costs of the m achine over a ten-year period for tax purposes, rather than for a five-year period. B. An answer of $68,000 results from deducting the salvage value from the cost to determine the depreciable base. However, the problem tells us that federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. C. Operating cash flow will be $100,000 (2,000 units per year × $50 unit contribution margin, calculated as the selling price of $500 per unit less the material and labor costs of $450 per unit. Moore's marginal tax rate is 40%, so the operating cash flow net of tax w ill be $100,000 × (1 − .40) or $60,000. The total capitalized cost of t he machine will be $105,000 ($90,000 purchase price + $6,000 transportation costs + $9,000 installation costs), 100% of which will be depreciated for tax purposes over 5 years. Thus, T hus, depreciation will be $105,000 ÷ 5, or $21,000 per year for years 1 through 5. Therefore, the depreciation tax shield in those years will be $21,000 × .40, or $8,400. The operating cash flow net of tax ($60,000) plus the depreciation tax shield ($8,400) results in net cash flow for the third year of $68,400. D. An answer of $79,000 results from subtracting the annual depreciation amount from the gross operating cash flow. It does not include the effect of income taxes, nor does it recognize that depreciation is a non-cash expense.
Question 12 12 - CMA 1295 4.5 (adapted) - Capital Budgeting Process The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40%. What is the net cash flow for the tenth year of the project that Moore Corporation should use in a capital budgeting analysis? A. $65,000 B. $68,400 C. $100,000 D. $63,000 A. An answer of $65,000 resul ts from adding the operating cash flow net of o f tax to the the salvage value. However, it ignores the tax on the gain on the disposition. B. An answer of $68,400 includes the depreciation tax shield based on a five-year depreciation schedule. This should not be included. The machine is completely depreciated long before the the tenth year, since Federal tax regulations permit machines of this type to be depreciated over 5 years. Furthermore, since the cost of the machine will be 100% depreciated, the amount received as salvage value at the end of the project will be 100% taxable as a gain. This answer does not include the amount received for the disposal net of tax. (c) HOCK international, page 6
Part 2 : Capital Budgeting Process
C. $100,000 is the annual gross operating cash flow. However, that is only one component of the tenth year's net cash flow. D. By the tenth year of the project, 100% of the capitalized capitalized cost will have been depreciated. Cash flow will consist of $100,000 in operating cash flow (200,000 units per year × $50 unit contribution margin, calculated as the selling price of $500 per unit less the material and labor costs of $450 per unit), plus the $5,000 salvage value of the equipment, for total gross cash flow of $105,000. Moore's marginal tax rate is 40%, so the cash flow net of tax will be $105,000 × (1 − .40) = $63,000.
Question 13 13 - CMA 1295 4.8 - Capital Budgeting Process Lawson Inc. is expanding its manufacturing plant, which requires an investment of $4 million in new equipment and plant modifications. Lawson's sales are expected to increase by $3 million per year as a result of the expansion. Cash investment in current assets averages 30% of sales; accounts payable and other current liabilities are 10% of sales. What is the estimated total investment for this expansion? A. $4.6 million. B. $4.9 million. C. $4.3 million. D. $3.4 million. A. The investment in net working capital will be 20% of sales (30% of sales invested in current assets less 10% of sales in current l iabilities). Thus, the increase in working capital required will be $3,000,000 × .20, or $600,000. The investment in new equipment equipment and plant modifications is $4,000,000. The total investment is therefore $4,600,000. B. An answer of $4.9 million results from using 30% of sales as the increase in net working capital, which is incorrect. C. An answer of $4.3 million results from using 10% of sales as the increase in net working capital, which is incorrect. D. An answer of $3.4 million results from subtracting the net working capital increase from the initial investment in new equipment and plant modifications, which is incorrect.
Question 14 14 - CMA 689 1.25 - Capital Budgeting Process All of the fol lowing are examples exampl es of imputed costs co sts except except A. Assets that are considered obsolete that m aintain a net book value. B. Decelerated depreciation. C. The stated interest paid on a bank loan. D. Lending funds to a supplier at a lower-than-market rate in exchange for receiving the supplier's products at a discount. A. Carrying obsolete assets on the balance balanc e sheet violates generally generall y accepted accounting accou nting principles. Obsolete assets should be written off to expense, and thus continuing to carry them on the balance sheet results in an imputed cost (the write-off expense not booked). B. An imputed cost is a cost that has to be inferred because it does not represent an actual payment made or expense booked. An opportunity cost is one type of imputed cost. An opportunity cost is the amount a company could earn if it were use a resource for its next best alternative use. Decelerated depreciation would be the opposite of accelerated depreciation and would result in understated depreciation expense. Therefore, decelerated depreciation would be an example of an imputed cost, because it results in costs that are not stated. (c) HOCK international, page 7
Part 2 : Capital Budgeting Process
C. An imputed cost is a cost that has to be inferred because it does not represent an actual payment made or expense booked. Stated interest paid on a bank loan would not be an example of an imputed cost, because it is a stated cost for w hich actual payment is made. D. An imputed cost is a cost that has to be inferred because it does not represent an actual payment made or expense booked. An opportunity cost is one type of imputed cost. An opportunity cost is the amount a company could earn if it were use a resource for its next best alternative use. Lending money at a below-market interest rate is an imputed cost of purchasing the supplier's products.
Question 15 15 - CMA 691 4.20 - Capital Budgeting Process Fast Freight, Inc. is planning to purchase equipment to make its operations more efficient. This equipment has an estimated life of 6 years. As part of this acquisition, a $75,000 investment in working capital is anticipated. In a discounted cash flow analysis, the investment in working capital A. Should be treated as an im mediate cash outflow ou tflow that is later recovered at the end of 6 years. B. Can be disregarded because no cash is involved. C. Should be amortized over the useful life of the equipment. D. Should be treated as an immediate cash outflow. A. When we speak of an expected increase in w orking capital, we mean we expect accounts receivable and inventory to increase because of the project under consideration. Raw materials inventory may need to be purchased. Accounts Accounts receivable will increase as soon as sales are made. We also expect that accounts payable related to the purchased inventory will i ncrease. However, the increase in accounts payable will not be as large as the increases in accounts receivable and inventory. Thus, working capital w ill increase incrementally by the amount of the increase in current assets (accounts receivable and inventory) less the increase in current liabilities (accounts payable). This incremental increase increase in working w orking capital requires cash, which is needed to purchase the inventory. And the increase in accounts receivable represents goods supplied or services rendered for which the company has incurred expenses, but for which it has not yet received payment. The incremental increase increase in net working capital will be recovered at the end of the project's life, when the final accounts receivable are collected, the final inventory is sold, and the final payables are paid. B. Cash is involved, as increases in accounts rec eivable and inventory require cash. C. The investment in net working capital should not be amortized over the useful life of the equipment. First, it is not an amortizable item. And even if it were, the amortization would be significant in a discounted cash flow analysis only to the extent that amortization would shield other income from taxation. D. Although it is true that the investment in net working capital is an immediate cash outflow, this is not the best answer choice.
Question 16 16 - CMA 693 4.19 - Capital Budgeting Process Of the following decisions, capital budgeting techniques would least likely be used in evaluating the A. Trade for a star qu arterback by a football team . B. Acquisition of new aircraft by a cargo company. C. Design and implementation of a major advertising program. D. Adoption of a new method of allocating nontraceable costs to product lines. A. A star quarterback would woul d be an investment for a football fo otball team , and the investment would not be m ade if it were not (c) HOCK international, page 8
Part 2 : Capital Budgeting Process expected to be a profitable investment. Therefore, capital budgeting techniques would probably be used in evaluating the trade. B. The acquisition of new aircraft by a cargo company would very likely be evaluated using capital budgeting techniques, because it entails a long-term investment. C. A major advertising program would involve significant expenditures that would be expected to return a profit. As such, it would be appropriate to evaluate it using capital budgeting techniques. D. Capital budgeting is used for evaluating long-term capital investment projects. The adoption of a new method of allocating nontraceable costs to product lines would not be evaluated with capital budgeting techniques, because it does not involve any investment or change in cash flows.
Question 17 17 - CMA 694 4.13 - Capital Budgeting Process The tax impact of equipment depreciation affects capital budgeting decisions. Currently, the Modified Accelerated Cost Recovery System (MACRS) is used as the depreciation method for most assets for tax purposes. The MACRS method of depreciation for assets with 3, 5, 7, and 10-year recovery periods is most similar to which one of the following depreciation methods used for financial reporting purposes? A. Units-of-production. B. Sum-of-the-years'-digits. C. 200% declining-balance. D. Straight-line. A. The MACRS method of depreciation deprec iation is not similar to the units-of-production units-of-pro duction method metho d of depreciation. deprec iation. B. The MACRS method of depreciation is not similar to the sum-of-the-years'-digits method of depreciation. C. The MACRS method of depreciation is most similar to the 200% declining balance method of depreciation. D. The MACRS method of depreciation is not similar to straight-line depreciation.
Question 18 18 - CMA 694 4.18 - Capital Budgeting Process All of the fol lowing items are included includ ed in discounted cash flow flo w analysisexcept analysisexcept A. The future asset depreciation depr eciation expense. B. The tax effects of future asset depreciation. C. Future operating cash savings. D. The current asset disposal price. A. This is an example of a question where you have to choose the best answer, even though it may not be fully correct. Future asset depreciation expense is included in discounted cash flow analysis in order to calculate its tax effect. However, the actual amount of the depreciation expense expense itself is not an item that is included in discounted cash flow analysis. B. The tax effects of future asset depreciation are included in discounted cash flow analysis. C. Future operating cash savings are included in discounted cash flow analysis. D. The current asset disposal price (if there is a current asset that will be disposed of) is included in discounted cash flow (c) HOCK international, page 9
Part 2 : Capital Budgeting Process analysis.
Question 19 19 - IMA 08.P3.172 - Capital Budgeting Process Capital investment projects include proposals for all of the following except A. refinancing existing existing working capital agreements agre ements.. B. the expansion of existing product offerings. C. the acquisition of government mandated pollution control equipment. D. additional research and development facilities. A. Capital investment projects include long-term construction, investment, production decisions and other long-term decisions or projects that will continueinto future periods. Refinancing existing working capital agreements is a finance matter, not a capital investment project. B. Capital investment projects include long-term construction, investment, production decisions and other long-term decisions or projects that will continueinto future periods. This is an example of a capital investment project. C. Capital investment projects include long-term construction, investment, production decisions and other long-term decisions or projects that will continue into future periods. This is an example of a capital investment project. D. Capital investment projects include long-term construction, investment, production decisions and other long-term decisions or projects that will continueinto future periods. This is an example of a capital investment project.
Question 20 20 - IMA 08.P3.173 - Capital Budgeting Process Which one of the following items is least likely to directly impact an equipment replacement capital expenditure decision? A. The amount amo unt of additional acc ounts receivable that will be generated gener ated from increased production produc tion and sales. B. The depreciation rate that will be used for tax purposes on the new asset. C. The net present value of the equipment that is being replaced. D. The sales value of the asset that is being replaced. A. Anything that will will influence or affect future fu ture cash flows flo ws of the project will h ave a direct impact on the decision. The increase in accounts receivable will impact working capital, which is one of the cash flows considered in a project. B. Anything that will influence or affect future cash flows of the project will have a direct impact on the decision.The depreciation rate used for tax purposes will affect the depreciation tax shield, which is one of the cash flows connected with the new project. C. Anything Anything that will influence or affect future cash flows of the project will have a direct impact on the decision. The net present value of the equipment to be replaced is not a cash flow ( though it may give an indication of potential future cash flows of the old equipment), so it does not have a direct impact on the decision. D. Anything that will influence or affect future cash flows of the project will have a direct impact on the decision. The sales value of the old asset is a cash flow and it therefore has a direct impact on the decision. (This answer choice is similar to the net present value of the old equipment choice, but this choice is better because it is actually the cash flows from the sale of the old asset.)
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Part 2 : Capital Budgeting Process Question 21 21 - IMA 08.P3.175 - Capital Budgeting Process Calvin Inc. is considering the purchase of a new state-of-art machine to replace its hand-operated machine. Calvin's effective tax rate is 40%, and its cost of capital is 12%.Data regarding the existing and new machines are presented below. Existing New Machine Machine Original cost $50,000 $90,000 Installation costs 0 4,000 Freight and insurance 0 6,000 Expected end salvage value 0 0 Depre epreci ciat atiion meth metho od straigh aightt-lin line straig aight-li -line Expected useful life 10 years 5 years The existing existing machine mach ine has been in service service for seven years and could be sold currently for $25,000. Calvin expects to to realize a before-tax annual reduction in labor costs of $30,000 if the new machine is purchased and placed in service. If the new machine is purchased, the incremental cash flows for the fifth year would amount to A. $26,000 B. $30,000 C. $24,000 D. $18,000 A. The Year 5 incremental cash flows are as follows: Operating cash flow: $30,000 labor labor cost savings × (1 − .40) $18,000 Depreciation tax shield: ($100,000 / 5 × .40) 8,000 Total incremental cash flow $26,000 B. This is the labor savings and does not include the depreciation or the tax impact. C. This answer uses the difference between the depreciation on the new machine in Year 5 and the depreciation on the current machine to calculate the depreciation tax shield for the Year 5 incremental cash flow. However, the current machine has been owned for 7 years already and has a 10 year life. Therefore, it has only 3 years of life and depreciation left, so by Year 5 of the new machine's life, there would be no depreciation taken on the old machine. D. This is the labor savings less the ta x impac impactt and does not take into consideration the depreciation d epreciation tax shield.
Question 22 22 - IMA 08.P3.177 - Capital Budgeting Process The following schedule reflects the incremental costs and revenues for a capital project. The company uses straight-line depreciation. The interest expense reflects an allocation of interest on the amount of this investment, based on the company’s weighted average cost of capital. Revenues Direct costs Variabl e overhead Fixed overhead
$650,000 $270,000 50,000 20,000 (c) HOCK international, page 11
Part 2 : Capital Budgeting Process Depreciation General & adm inistrative Interest expense Total costs Net profit before taxes
70,000 40,000 8,000 458,000 $192,000
The annual cash flow from this investment, before tax considerations, would be A. $262,000 B. $200,000 C. $270,000 D. $192,000 A. This answer results from incorrectly including the interest expense in the analysis. Interest Interest expense should not be included, because the financing of a capital investment is a different process from the capital budgeting cash flow analysis. B. This answer results from incorrectly including depreciation in the analysis. Depreciation should not be included, because this is a cash flow analysis, and depreciation is a non-cash expense. The only effect depreciation would have on a capital budgeting analysis anal ysis is is in the depreciation tax shield, and since this is a before- tax analysis, there is no effect from depreciation. C. The annual cash flow from f rom the investment before tax considerations considerations is: Revenue $650,000 Less costs: Direct costs 270,000 Variable overhead 50,000 Fixed overhead 20,000 General & Administrative 40,000 Net operating cash flow $270,000 The depreciation is not included because this is a cash flow analysis, and depreciation is a non-cash expense. The only effect depreciation would have on a capital budgeting analysis is in the depreciation tax shield, and since this is a before-tax analysis, there is no effect from depreciation. The interest expense is not included because the financing of a capital investment is a different process from the capital budgeting cash flow analysis. D. This is the net profit before taxes, as given in the problem. It is not the annual cash flow from the investment.
Question 23 23 - IMA 08.P3.193 - Capital Budgeting Process Calvin Inc. is considering the purchase of a new state-of-the-art machine to replace its hand-operated machine. Calvin's effective tax rate is 40%, and its cost of capital is 12%. Data regarding the existing and new machines are presented below. Existing New Machine Machine Original cost $50,000 $90,000 Installation cost 0 4,000 Freight and insurance 0 6,000 (c) HOCK international, page 12
Part 2 : Capital Budgeting Process Expected end salvage value 0 0 Depreciation method straight-line straight-line Expected useful life 10 years 5 years The existing machine has been in service for seven years and could be sold currently for $25,000. If the new machine is purchased, Calvin expects to realize a $30,000 before-tax annual reduction in labor costs. If the new machine is purchased, what is the net amount of the initial cash outflow at Time 0 for net present value calculation purposes? A. $79,000 B. $75,000 C. $65,000 D. $100,000 A. The existing machine originally cost $50,000 and it has been in service f or 7 years. Its expected useful life was 10 years when it was purchased and it is being depreciated on the straight line basis. Therefore, $5,000 is being depreciated each year ($50,000 ÷ 10). So the book value of the existing machine at the time of replacement would be $50,000 − (7 × $5,000), which is $15,000. If it is sold for $25,000, there will be a taxable gain of $10,000 on the sale ($25,000 − $15,000). The company's tax rate is 40%, so the tax on the gain will be 40% of $10,000, which is $4,000. The cost of the new machine, machine, the installation and the freight and insurance on its shipment will all be capitalized, so the tax rate will not affect those costs in Year 0. Therefore, the Year 0 net cash outflow will be: Outflows for capitalized equipment: ($90,000) + ($4,000) + ($6,000) = ($100,000) Inflow from sale of existing equipment: $25,000 before tax Outflow for tax on gain on sale of existing equipment: equipment: ($4,000) The net cash outflow is ($100,000) + $25,000 + ($4,000) = ($79,000) B. This is the cost of the new machine plus the installation cost and freight and insurance cost minus the sale price of the existing existing machine. However, H owever, it does not include the tax due on the gain on the sale of the existing existing machine. C. This is the cost of the new machine minus the sale price of the existing machine. However, it does not include the installation cost, the freight and insurance, or the tax due on the gain on the sale of the existing machine. D. This is the cost of the new machine plus the installation cost and the freight and insurance cost. However, it does not include the net after-tax cash to be received from the sale of the existing machine.
(c) HOCK international, page 13
