FM12 Ch 12 Test Bank

CHAPTER 12
CASH FLOW ESTIMATION AND RISK ANALYSIS

True/False

Easy:

" "(12.1) Relevant cash flows "Answer: b "EASY "
"[i]."Since the focus of capital budgeting is on cash flows rather than on "
" "net income, changes in noncash balance sheet accounts such as "
" "inventory are not relevant in a capital budgeting analysis. "
" " " " "
"[ii]"If an investment project would make use of land which the firm "
". "currently owns, the project should be charged with the opportunity "
" "cost of the land. "
" " " " "
"[iii"When the cash flows for a project are estimated, interest payments "
"]. "should be included if debt is to be used to help finance the project."
" " " " "
"[iv]"Any cash flow that can be classified as incremental to a particular "
". "project is relevant in a capital budgeting analysis. "
" " " " "
"[v]."Changes in net operating working capital do not need to be considered"
" "in a capital budgeting cash flow analysis because capital budgeting "
" "relates to fixed assets, not working capital. "
" " " " "
"[vi]"Because of improvements in forecasting techniques, estimating the "
". "cash flows associated with a project has become the easiest step in "
" "the capital budgeting process. "
" " " " "
"[vii"Estimating project cash flows is generally the most important but "
"]. "also the most difficult step in the capital budgeting process. "
" "Methodology, such as the use of NPV versus IRR, is important, but "
" "less so than estimating projects' cash flows. "
" " " " "
"[vii"Although it is extremely difficult to make accurate forecasts of the "
"i]. "revenues that a project will generate, the project's initial outlays "
" "and subsequent costs for large projects can be forecasted with great "
" "accuracy. "
" " " " "
"[ix]"In capital budgeting terminology, an "externality" is defined as "
". "something that is outside, or external to, a proposed new project. "
" "Therefore, externalities are not considered in project cash flow "
" "estimates. "
" " " " "
"[x]."In cash flow estimation, the existence of externalities must be taken"
" "into account if those externalities have any effects on the firm's "
" "cash flows. "
" " " " "
"[xi]"Sometimes analysts think that an externality is present in a project,"
". "but they recognize that the particular externality cannot be "
" "quantified with any precision--estimates of its effect would really "
" "just be guesses. In such a situation, the externality should be "
" "ignored, i.e., not considered at all, because if it were considered "
" "it would make the analysis appear more precise than it actually is. "
" " " " "
"[xii"The primary advantage of accelerated depreciation over straight-line "
"]. "depreciation is that the total, undiscounted, depreciation tax "
" "savings over the life of the project are greater when an accelerated "
" "depreciation method is used. "
" " " " "
"[xii"The primary advantage of accelerated depreciation over straight-line "
"i]. "depreciation is that, while the total amount of depreciation and thus"
" "tax savings is unchanged, charges are taken sooner. This means that "
" "the firm gets the benefits of the tax savings sooner, which increases"
" "their present value. "
" " " " "
"[xiv"A firm that bases its capital budgeting decisions on either NPV or "
"]. "IRR will be more likely to accept a given project if it uses MACRS "
" "accelerated depreciation than if it uses the optional straight-line "
" "alternative, other things being equal. "
" " " " "
"[xv]"Using accelerated depreciation has an advantage for a profitable firm"
". "in that it moves some cash flows forward, thus increasing their "
" "present value. On the other hand, using accelerated depreciation "
" "might lower reported profits because of the higher current "
" "depreciation expenses. However, the reported profits problem can be "
" "solved by using different depreciation methods for tax and "
" "stockholder reporting purposes. "
" " " " "
"[xvi"If a firm's projects differ in risk, then different projects should "
"]. "be evaluated using risk-adjusted discount rates. "
" " " " "
"[xvi"Using the same discount rate to evaluate projects with differing "
"i]. "degrees of risk would, over time, cause the firm to accept too many "
" "high-risk projects and to reject too many low-risk proposals. "
" " " " "
"[xvi"The two cardinal rules which financial analysts follow to avoid "
"ii]."capital budgeting errors are: (1) capital budgeting decisions must "
" "be based on accounting income, and (2) all incremental cash flows "
" "should be considered when making accept/reject decisions. "
" " " " "
"[xix"Superior analytical techniques, such as NPV, used in combination with"
"]. "cost of capital adjustments, can overcome the problem of poor cash "
" "flow estimation and lead to generally correct accept/reject "
" "decisions. "
" " " " "
"[xx]"It is extremely difficult to estimate the revenues and costs "
". "associated with large, complex projects that take several years to "
" "develop. This is why subjective judgment is recommended for such "
" "projects instead of a discounted cash flow analysis. "
" " " " "
"[xxi"Opportunity costs include those cash inflows that could be generated "
"]. "from assets the firm already owns, if those assets were not used for "
" "the project being evaluated. "
" " " " "
"[xxi"Suppose Walker Publishing Company is considering bringing out a new "
"i]. "finance text whose projected sales include sales that will be taken "
" "away from another of Walker's books. The lost sales on the existing "
" "book are a sunk cost and as such should not be considered in the "
" "analysis of the new book. "
" " " " "
"[xxi"The change in net operating working capital associated with new "
"ii]."projects is always positive, because new projects mean that more "
" "working capital will be required. This situation is true for both "
" "expansion and replacement projects. "
" " " " "
"[xxi"The use of accelerated versus straight-line depreciation causes net "
"v]. "income reported to stockholders to be lower, and cash flows higher, "
" "during every year of a project's life, other things held constant. "
" " " " "
"[xxv"Sensitivity analysis measures the stand-alone risk of a project by "
"]. "showing how much the project's NPV is affected by a small change in "
" "one of the input variables, such as sales. Other things held "
" "constant, with the independent variable graphed on the horizontal "
" "axis, the steeper the graph of the relationship line, the more risky "
" "the project. "
" " " " "
"[xxv"Which of the following is NOT a cash flow and thus should not be "
"i]. "reflected in the analysis of a capital budgeting project? "
" " " "
" "b. "Shipping and installation costs. "
" "c. "Cannibalization effects. "
" "d. "Opportunity costs. "
" "e. "Sunk costs that have been expensed for tax purposes. "
" " " " "
"[xxv"The relative risk of a proposed project is best accounted for by "
"ii]."which of the following procedures? "
" " " "
" "b. "Adjusting the discount rate downward if the project is judged to"
" " "have above-average risk. "
" "c. "Reducing the NPV by 10% for risky projects. "
" "d. "Picking a risk factor equal to the average discount rate. "
" "e. "Ignoring risk because project risk cannot be measured "
" " "accurately. "
" " " " "
"[xxv"Suppose Tapley Corporation uses a WACC of 8% for below-average risk "
"iii]"projects, 10% for average-risk projects, and 12% for above-average "
". "risk projects. Which of the following independent projects should "
" "Tapley accept, assuming that the company uses the NPV method when "
" "choosing projects? "
" " " "
" "b. "Project B, which has below-average risk and an IRR = 8.5%. "
" "c. "Project C, which has above-average risk and an IRR = 11%. "
" "d. "Without information about the projects' NPVs we cannot determine"
" " "which one or ones should be accepted. "
" "e. "All of the projects should be accepted. "

Easy/Medium:

" "(12.3) Sunk costs "Answer: c "EASY/MEDIUM "
"[xxi"Which of the following statements is CORRECT? "
"x]. " "
" " " "
" "b. "A sunk cost is any cost that was expended in the past but can be"
" " "recovered if the firm decides not to go forward with the "
" " "project. "
" "c. "A sunk cost is a cost that was incurred and expensed in the past"
" " "and cannot be recovered if the firm decides not to go forward "
" " "with the project. "
" "d. "Sunk costs were formerly hard to deal with, but once the NPV "
" " "method came into wide use, it became possible to simply include "
" " "sunk costs in the cash flows and then calculate the PV. "
" "e. "A good example of a sunk cost is a situation where a retailer "
" " "opens a new store, and that leads to a decline in sales of some "
" " "of the firm's existing stores. "
" " " " "
"[xxx"Which of the following statements is CORRECT? "
"]. " "
" " " "
" "b. "Sunk costs must be considered if the IRR method is used but not "
" " "if the firm relies on the NPV method. "
" "c. "A good example of a sunk cost is a situation where a bank opens "
" " "a new office, and that new office leads to a decline in deposits"
" " "of the bank's other offices. "
" "d. "A good example of a sunk cost is money that a banking "
" " "corporation spent last year to investigate the site for a new "
" " "office, then expensed those funds for tax purposes, and now is "
" " "deciding whether to go forward with the project. "
" "e. "If sunk costs are considered and reflected in a project's cash "
" " "flows, then the project's calculated NPV will be higher than it "
" " "otherwise would be. "
" " " " "
"i]. " "
" " " "
" "b. "An example of an externality is a situation where a bank opens a"
" " "new office, and that new office causes deposits in the bank's "
" " "other offices to decline. "
" "c. "The NPV method automatically deals correctly with externalities,"
" " "even if the externalities are not specifically identified, but "
" " "the IRR method does not. This is another reason to favor the "
" " "NPV. "
" "d. "Both the NPV and IRR methods deal correctly with externalities, "
" " "even if the externalities are not specifically identified. "
" " "However, the payback method does not. "
" "e. "The identification of an externality can never lead to an "
" " "increase in the calculated NPV. "
" " " " "
"ii]." "
" " " "
" "b. "If a firm is found guilty of cannibalization in a court of law, "
" " "then it is judged to have taken unfair advantage of its "
" " "customers. Thus, cannibalization is dealt with by society "
" " "through the antitrust laws. "
" "c. "If cannibalization exists, then the cash flows associated with "
" " "the project must be increased to offset these effects. "
" " "Otherwise, the calculated NPV will be biased downward. "
" "d. "If cannibalization is determined to exist, then this means that "
" " "the calculated NPV considering cannibalization will be higher "
" " "than the NPV that does not recognize these effects. "
" "e. "Cannibalization is a type of externality that is not against the"
" " "law, and any harm it causes is done to the firm itself. "
" " " " "
"iii]" "
". " "
" " " "
" "b. "Under current laws and regulations, corporations must use "
" " "straight-line depreciation for all assets whose lives are 5 "
" " "years or longer. "
" "c. "Corporations must use the same depreciation method (e.g., "
" " "straight line or MACRS) for stockholder reporting and tax "
" " "purposes. "
" "d. "Since depreciation is not a cash expense, it has no affect on "
" " "cash flows and thus no affect on capital budgeting decisions. "
" "e. "Under MACRS depreciation rules, higher depreciation charges "
" " "occur in the early years, and this reduces the early cash flows "
" " "and thus lowers a project's projected NPV. "
" " " " "
"iv]." "
" " " "
" "c. "Corporations must use MACRS depreciation for both stockholder "
" " "reporting and tax purposes. "
" "d. "Using MACRS depreciation rather than straight line normally has "
" " "the effect of speeding up cash flows and thus increasing a "
" " "project's forecasted NPV. "
" "e. "Using MACRS depreciation rather than straight line normally has "
" " "the effect of slowing down cash flows and thus reducing a "
" " "project's forecasted NPV. "
" " " " "
"v]. " "
" " " "
" "c. "Under MACRS depreciation, firms write off assets slower than "
" " "they would under straight-line depreciation, and as a result "
" " "projects' forecasted NPVs are normally lower than they would be "
" " "if straight-line depreciation were required for tax purposes. "
" "d. "Under MACRS depreciation, firms can write off assets faster than"
" " "they could under straight-line depreciation, and as a result "
" " "projects' forecasted NPVs are normally lower than they would be "
" "e. "Under MACRS depreciation, firms can write off assets faster than"
" " "they could under straight-line depreciation, and as a result "
" " "projects' forecasted NPVs are normally higher than they would be"

Medium:

" "(12.1) Relevant cash flows "Answer: c "MEDIUM "
"[xxx"A company is considering a new project. The CFO plans to calculate "
"vi]."the project's NPV by estimating the relevant cash flows for each year"
" "of the project's life (the initial investment cost, the annual "
" "operating cash flows, and the terminal cash flow), then discounting "
" "those cash flows at the company's WACC. Which one of the following "
" "factors should the CFO include in the cash flows when estimating the "
" "relevant cash flows? "
" " " "
" "b. "All interest expenses on debt used to help finance the project. "
" "c. "The investment in working capital required to operate the "
" " "project, even if that investment will be recovered at the end of"
" " "the project's life. "
" "d. "Sunk costs that have been incurred relating to the project, but "
" " "only if those costs were incurred prior to the current year. "
" "e. "Effects of the project on other divisions of the firm, but only "
" " "if those effects lower the project's own direct cash flows. "
" " " " "
"[xxx"Which of the following factors should be included in the cash flows "
"vii]"used to estimate a project's NPV? "
". " "
" " " "
" "b. "Interest on funds borrowed to help finance the project. "
" "c. "The end-of-project recovery of any working capital required to "
" " "operate the project. "
" "d. "Cannibalization effects, but only if those effects increase the "
" " "project's projected cash flows. "
" "e. "Expenditures to date on research and development related to the "
" " "project provided those costs have already been expensed for tax "
" " "purposes. "
" "(12.1) Relevant cash flows "Answer: b "MEDIUM "
"[xxx"When evaluating a new project, firms should include in the projected "
"viii"cash flows all of the following EXCEPT: "
"]. " "
" " " "
" "b. "Previous expenditures associated with a market test to determine"
" " "the feasibility of the project provided those costs have been "
" " "expensed for tax purposes. "
" "c. "The value of a building owned by the firm that will be used for "
" " "this project. "
" "d. "A decline in the sales of an existing product provided that "
" " "decline is directly attributable to this project. "
" "e. "The salvage value of assets used for the project at the end of "
" " "the project's life. "
" " " " "
"[xxx"Rowell Company spent $3 million two years ago to build a plant for a "
"ix]."new product. It then decided not to go forward with the project, so "
" "the building is available for sale or for a new product. Rowell owns"
" "the building free and clear--there is no mortgage on it. Which of "
" "the following statements is CORRECT? "
" " " "
" "b. "If the building could be sold, then the after-tax proceeds that "
" " "would be generated by any such sale should be charged as a cost "
" " "to any new project that would use it. "
" "c. "This is an example of an externality, because the very existence"
" " "of the building affects the cash flows for any new project that "
" " "Rowell might consider. "
" "d. "Since the building was built in the past, its cost is a sunk "
" " "cost and thus need not be considered when new projects are being"
" " "evaluated, even if it would be used by those new projects. "
" "e. "If there is a mortgage loan on the building, then the interest "
" " "on that loan would have to be charged to any new project that "
" " "used the building. "
" " " " "
"[xl]"Which of the following SHOULD BE CONSIDERED when a company estimates "
". "the cash flows used to analyze a proposed project? "
" " " "
" "b. "Since the firm's director of capital budgeting spent some of her"
" " "time last year to evaluate the new project, a portion of her "
" " "salary for that year should be charged to the project's initial "
" " "cost. "
" "c. "The company has spent and expensed $1 million on R&D associated "
" " "with the new project. "
" "d. "The company spent and expensed $10 million on a marketing study "
" " "before its current analysis regarding whether to accept or "
" " "reject the project. "
" "e. "The firm would borrow all the money used to finance the new "
" " "project, and the interest on this debt would be $1.5 million per"
" " "year. "
" "(12.1) Relevant cash flows "Answer: c "MEDIUM "
"[xli"Laurier Inc., a household products firm, is considering production of"
"]. "a new detergent. In evaluating whether to go ahead with the project,"
" "which of the following items should NOT be explicitly considered when"
" "cash flows are estimated? "
" " " "
" "b. "The project will utilize some equipment the company currently "
" " "owns but is not now using. A used-equipment dealer has offered "
" " "to buy the equipment. "
" "c. "The company has spent and expensed for tax purposes $3 million "
" " "on research related to the new detergent. These funds cannot be"
" " "recovered, but the research is expected to benefit other "
" " "projects that might be proposed in the future. "
" "d. "The new detergent will cut into sales of the firm's other "
" " "detergents. "
" "e. "If the project is accepted, the company must invest $2 million "
" " "in working capital. However, these funds will be recovered at "
" " "the end of the project's life. "
" " " " "
"[xli"A company is considering a proposed new plant that would increase "
"i]. "productive capacity. Which of the following statements is CORRECT? "
" " " "
" "b. "Since depreciation is a non-cash expense, the firm does not need"
" " "to deal with depreciation when calculating the operating cash "
" " "flows. "
" "c. "When estimating the project's operating cash flows, it is "
" " "important to include any opportunity costs and sunk costs, but "
" " "the firm should ignore cash flow effects of externalities since "
" " "they are accounted for in the discounting process. "
" "d. "Capital budgeting decisions should be based on before-tax cash "
" " "flows. "
" "e. "The WACC used to discount cash flows in a capital budgeting "
" " "analysis should be calculated on a before-tax basis. "
" " " " "
"[xli"Which of the following does NOT have incremental cash flow effects "
"ii]."and thus should NOT be considered in capital budgeting decisions? "
" " " "
" "b. "A new product will generate new sales, but some of those new "
" " "sales will be from customers who switch from one of the firm's "
" " "current products. "
" "c. "A firm must obtain new equipment for the project, and $1 million"
" " "of costs for shipping and installing the new machinery will be "
" " "required. "
" "d. "A firm has spent $2 million on R&D associated with a new "
" " "product. These costs have been expensed for tax purposes, and "
" " "they cannot be recovered if the new project is rejected. "
" "e. "A firm can produce a new product, and the existence of that "
" " "product will stimulate sales of some of the firm's other "
" " "products. "
" " " " "
"[xli"Which of the following is NOT a relevant factor when determining "
"v]. "incremental cash flows for a new product? "
" " " "
" "b. "Revenues from an existing product that would be lost as a result"
" " "of customers switching to the new product. "
" "c. "Shipping and installation costs associated with preparing a "
" " "machine which would be used to produce the new product. "
" "d. "The cost of a marketing study that was completed last year "
" " "related to the new product. This research led to the tentative "
" " "decision to go ahead with the new product, and the cost of the "
" " "research was expensed for tax purposes last year. "
" "e. "The land which would be used for the new project could be sold "
" " "to another firm. "
" " " " "
"[xlv"Which of the following rules is CORRECT for capital budgeting "
"]. "analysis? "
" " " "
" "b. "Only incremental cash flows are relevant when making "
" " "accept/reject decisions. "
" "c. "Sunk costs are not included in the annual cash flows, but they "
" " "must be deducted from the PV of the project's other costs when "
" " "reaching the accept/reject decision. "
" "d. "A proposed project's estimated net income as determined by the "
" " "firm's accountants, using generally accepted accounting "
" " "principles (GAAP), is discounted at the WACC, and if the PV of "
" " "this income stream exceeds the project's cost, the project "
" " "should be accepted. "
" "e. "If a product is competitive with some of the firm's other "
" " "products, this fact should be incorporated into the estimate of "
" " "the relevant cash flows. However, if the new product is "
" " "complementary to some of the firm's other products, this will "
" " "have no effect on the cash flows used in the analysis. "
" "(12.1) Cash flow estimation "Answer: d "MEDIUM "
"[xlv"Which of the following statements is CORRECT? "
"i]. " "
" " " "
" "b. "In a capital budgeting analysis where part of the funds used to "
" " "finance the project are raised as debt, failure to include "
" " "interest expense as a cost when determining the project's cash "
" " "flows will lead to a downward bias in the NPV. "
" "c. "The existence of any type of "externality" will reduce the "
" " "calculated NPV versus the NPV that would exist without the "
" " "externality. "
" "d. "If one of the assets to be used by a potential project is "
" " "already owned by the firm, and if that asset could be leased to "
" " "another firm if the new project were not undertaken, then the "
" " "net rent that could be obtained should be charged as a cost to "
" " "the project under consideration. "
" "e. "If one of the assets to be used by a potential project is "
" " "already owned by the firm but is not being used, then any costs "
" " "associated with that asset is a sunk cost and should be ignored."
" " " " "
"[xlv"Taussig Technologies is considering two potential projects, X and Y. "
"ii]."In assessing the projects' risks, the company estimated the beta of "
" "each project versus both the company's other assets and the stock "
" "market, and it also conducted thorough scenario and simulation "
" "analyses. This research produced the following numbers: "
" " " " " " " "
" "Project beta (vs. market) "1.4 " " "0.8 " "
" "Correlation of the project"Cash flows are not " "Cash flows are "
" "cash flows with cash flows"correlated with the" "highly correlated "
" "from currently existing "cash flows from " "with the cash flows "
" "projects. "existing projects. " "from existing "
" " " " "projects. "
" " "
" " " "
" "b. "Project X has more corporate (or within-firm) risk than Project "
" " "Y. "
" "c. "Project X has more market risk than Project Y. "
" "d. "Project X has the same level of corporate risk as Project Y. "
" "e. "Project X has less market risk than Project Y. "
" " " " "
"[xlv"Currently, Powell Products has a beta of 1.0, and its sales and "
"iii]"profits are positively correlated with the overall economy. The "
". "company estimates that a proposed new project would have a higher "
" "standard deviation and coefficient of variation than one of the "
" "company's average projects. Also, the new project's sales would be "
" "countercyclical in the sense that they would be high when the overall"
" "economy is down and low when the overall economy is strong. On the "
" "basis of this information, which of the following statements is "
" "CORRECT? "
" " " "
" "b. "The proposed new project would increase the firm's corporate "
" " "risk. "
" "c. "The proposed new project would increase the firm's market risk. "
" "d. "The proposed new project would not affect the firm's risk at "
" " "all. "
" "e. "The proposed new project would have less stand-alone risk than "
" " "the firm's typical project. "
" " " " "
"[xli"Which of the following statements is CORRECT? "
"x]. " "
" " " "
" "b. "One advantage of sensitivity analysis relative to scenario "
" " "analysis is that it explicitly takes into account the "
" " "probability of specific effects occurring, whereas scenario "
" " "analysis cannot account for probabilities. "
" "c. "Well-diversified stockholders do not need to consider market "
" " "risk when determining required rates of return. "
" "d. "Market risk is important, but it does not have a direct effect "
" " "on stock prices because it only affects beta. "
" "e. "Simulation analysis is a computerized version of scenario "
" " "analysis where input variables are selected randomly on the "
" " "basis of their probability distributions. "
" " " " "
"[l]."Which of the following statements is CORRECT? "
" " " "
" "b. "In comparing two projects using sensitivity analysis, the one "
" " "with the steeper lines would be considered less risky, because a"
" " "small error in estimating a variable such as unit sales would "
" " "produce only a small error in the project's NPV. "
" "c. "The primary advantage of simulation analysis over scenario "
" " "analysis is that scenario analysis requires a relatively "
" " "powerful computer, coupled with an efficient financial planning "
" " "software package, whereas simulation analysis can be done "
" " "efficiently using a PC with a spreadsheet program or even with "
" " "just a calculator. "
" "d. "Sensitivity analysis is a type of risk analysis that considers "
" " "both the sensitivity of NPV to changes in key variables and the "
" " "likely range of variable values. "
" "e. "As computer technology advances, simulation analysis becomes "
" " "increasingly obsolete and thus less likely to be used than "
" " "sensitivity analysis. "
" " " " "
"[li]"A firm is considering a new project whose risk is greater than the "
". "risk of the firm's average project, based on all methods for "
" "assessing risk. In evaluating this project, it would be reasonable "
" "for management to do which of the following? "
" " " "
" "b. "Increase the estimated NPV of the project to reflect its greater"
" " "risk. "
" "c. "Reject the project, since its acceptance would increase the "
" " "firm's risk. "
" "d. "Ignore the risk differential if the project would amount to only"
" " "a small fraction of the firm's total assets. "
" "e. "Increase the cost of capital used to evaluate the project to "
" " "reflect the project's higher-than-average risk. "
" " " " "
"[lii"Langston Labs has an overall (composite) WACC of 10%, which reflects "
"]. "the cost of capital for its average asset. Its assets vary widely in"
" "risk, and Langston evaluates low-risk projects with a WACC of 8%, "
" "average projects at 10%, and high-risk projects at 12%. The company "
" "is considering the following projects: "
" " " "
" " " " " " " " "
" "b. "A, B, and C. " " " " " "
" "c. "A, B, and D. " " " " " "
" "d. "A, B, C, and D. " " " " " "
" "e. "A, B, C, D, and E. " " " " " "
" " " " "
"[lii"Which of the following procedures is generally used by businesses "
"i]. "when they do capital budgeting analyses? "
" " " "
" "b. "Differential project risk could be accounted for by using "
" " ""risk-adjusted discount rates" or "certainty-equivalent cash "
" " "flows," but the certainty-equivalent procedure is the one most "
" " "firms use. "
" "c. "Other things held constant, if returns on a project are thought "
" " "to be positively correlated with the returns on other firms in "
" " "the economy, then the project's NPV will be found using a lower "
" " "discount rate than would be appropriate if the project's returns"
" " "were negatively correlated. "
" "d. "Monte Carlo simulation uses a computer to generate random sets "
" " "of inputs when determining a project's NPV. Sensitivity and "
" " "scenario analyses, on the other hand, require a lot of "
" " "information on the independent variables, including probability "
" " "distributions and correlations among the independent variables. "
" " "This makes it easier to implement a simulation analysis than a "
" " "scenario or sensitivity analysis. "
" "e. "The assets required by some projects are good collateral to "
" " "support debt financing, hence those projects can be financed "
" " "with a higher debt ratio than other projects. This differential"
" " "debt capacity, if it results in significantly different WACCs, "
" " "should be reflected in a capital budgeting analysis. "
" " " " "
"[liv"Which of the following statements is CORRECT? "
"]. " "
" " " "
" "b. "Only incremental cash flows are relevant in project analysis, "
" " "and the proper incremental cash flows are the reported "
" " "accounting profits, which form the best basis for investor and "
" " "managerial decisions. "
" "c. "It is unrealistic to believe that increases in net operating "
" " "working capital required at the start of an expansion project "
" " "can be recovered at the project's completion. Working capital "
" " "like inventory is almost always used up in operations. Thus, "
" " "cash flows associated with working capital are included only at "
" " "the start of a project's life. "
" "d. "If equipment is expected to be sold for more than its book value"
" " "at the end of a project's life, this will result in a profit. "
" " "In this case, despite taxes on the profit, the end-of-project "
" " "cash flow will be greater than if the asset had been sold at "
" " "book value. "
" "e. "Changes in net operating working capital refer to changes in "
" " "current assets and current liabilities, not to changes in "
" " "long-term assets and liabilities, hence they are not considered "
" " "in a capital budgeting analysis. "

Multiple Choice: Problems

"Note to Professors: We designated many of these questions EASY or MEDIUM."
"This indicates that they are not conceptually hard. However, some of them"
"require a good bit of arithmetic, which will lengthen the time it takes "
"students to work them. We tried to use constant cash flows, straight-line"
"depreciation (except where we wanted to illustrate MACRS depreciation), "
"and short project lives, but illustrating the cash flow estimation process"
"still requires a good bit of arithmetic. This should not be important for"
"take-home tests, but it should be considered when making up timed tests. "

Easy:

" "(Comp: 12.1-12.4) Annual operating CFs, depr'n given"Answer: a "EASY "
"[lv]"You work for Athens Inc., and you must estimate the Year 1 operating "
". "cash flow for a project with the following data. What is the Year 1 "
" "operating cash flow? "
" " " " " " " " "
" " "Sales revenues "$15,000" " "
" " "Depreciation " "$4,000 " " "
" " "Other operating costs "$6,000 " " "
" " "Tax rate " "35.0% " " "
" " " " " " " " "
" "a. "$7,250 " " " " " "
" "b. "$7,431 " " " " " "
" "c. "$7,617 " " " " " "
" "d. "$7,807 " " " " " "
" "e. "$8,003 " " " " " "
" "(Comp: 12.1-12.4) Annual operating CFs, depr'n given"Answer: c "EASY "
"[lvi"Your company, Omega Corporation, is considering a new project which "
"]. "you must analyze. Based on the following data, what is the project's"
" "Year 1 operating cash flow? "
" " " " " " " " "
" " "Sales revenues "$25,000" " "
" " "Depreciation " "$8,000 " " "
" " "Other operating costs "$12,000" " "
" " "Tax rate " "35.0% " " "
" " " " " " " " "
" "a. "$10,585 " " " " " "
" "b. "$10,913 " " " " " "
" "c. "$11,250 " " " " " "
" "d. "$11,588 " " " " " "
" "e. "$11,935 " " " " " "
" " " " " " " " "
" "(Comp: 12.1-12.4) Annual operating CFs: SL depr'n "Answer: d "EASY "
"[lvi"Zeta Software is considering a new project whose data are shown "
"i]. "below. The required equipment has a 3-year tax life, after which it "
" "will be worthless, and it will be depreciated by the straight-line "
" "method over 3 years. Revenues and other operating costs are expected"
" "to be constant over the project's 3-year life. What is the project's"
" "operating cash flow for Year 1? "
" " " " " " " " "
" "Equipment cost (depreciable basis) "$75,000 " "
" "Straight-line depreciation rate "33.33% " "
" "Sales revenues, each year " "$60,000 " "
" "Operating costs excl. depr'n "$25,000 " "
" "Tax rate " " " "35.0% " "
" " " " " " " " "
" "a. "$29,196 " " " " " "
" "b. "$29,945 " " " " " "
" "c. "$30,712 " " " " " "
" "d. "$31,500 " " " " " "
" "e. "$32,287 " " " " " "

Easy/Medium:

" "(Comp: 12.1-12.4) Ann. op. CFs, depr'n and "Answer: e "EASY/MEDIUM"
" "int. given " " "
"[lvi"As a member of Midwest Corporation's financial staff, you must "
"ii]."estimate the Year 1 operating cash flow for a proposed project with "
" "the following data. What is the Year 1 operating cash flow? "
" " " " " " " " "
" " "Sales revenues, each year " "$35,000 " "
" " "Depreciation " "$10,000 " "
" " "Other operating costs " "$17,000 " "
" " "Interest expense " "$4,000 " "
" " "Tax rate " "35.0% " "
" " " " " " " " "
" "a. "$12,380 " " " " " "
" "b. "$13,032 " " " " " "
" "c. "$13,718 " " " " " "
" "d. "$14,440 " " " " " "
" "e. "$15,200 " " " " " "
" "(Comp: 12.1-12.4) Ann. op. CFs, depr'n and "Answer: b "EASY/MEDIUM"
" "int. given " " "
"[lix"You work for the Sing Oil Company, which is considering a new project"
"]. "whose data are shown below. What is the project's operating cash "
" "flow for Year 1? "
" " " " " " " " "
" " "Depreciation " "$8,000 " "
" " "Other operating costs " "$25,000 " "
" " "Interest expense " "$8,000 " "
" " "Tax rate " "35.0% " "
" " " " " " " " "
" "a. "$21,185 " " " " " "
" "b. "$22,300 " " " " " "
" "c. "$23,415 " " " " " "
" "d. "$24,586 " " " " " "
" "e. "$25,815 " " " " " "
" " " " " " " " "
" "(Comp: 12.1-12.4) Ann. Op. CFs: MACRS depr'n "Answer: a "EASY/MEDIUM"
"[lx]"Fool Proof Software is considering a new project whose data are shown"
". "below. The equipment that would be used has a 3-year tax life, and "
" "the MACRS rates for such property are 33%, 45%, 15%, and 7% for Years"
" "1 through 4. Revenues and other operating costs are expected to be "
" "constant over the project's 10-year life. What is the operating cash"
" "flow for Year 1? "
" " " " " " " " "
" "Sales revenues, each year "$60,000 " "
" "Tax rate "35.0% " "
" " " " " " " " "
" "a. "$30,258 " " " " " "
" "b. "$31,770 " " " " " "
" "c. "$33,359 " " " " " "
" "d. "$35,027 " " " " " "
" "e. "$36,778 " " " " " "

Medium:

" "(Comp: 12.1-12.4) Ann. op. CFs: MACRS depr'n, Yr 4"Answer: c "MEDIUM "
" "CF " " "
"[lxi"Your company, Q4 Inc., is considering a new project whose data are "
"]. "shown below. The required equipment has a 3-year tax life, and the "
" "MACRS rates for such property are 33%, 45%, 15%, and 7% for Years 1 "
" "through 4. Revenues and other operating costs are expected to be "
" "constant over the project's 10-year operating life. What is the "
" "project's operating cash flow during Year 4? "
" " " " " " " " "
" "Sales revenues, each year "$50,000 " "
" "Tax rate "35.0% " "
" " " " " " " " "
" "a. "$16,213 " " " " " "
" "b. "$17,067 " " " " " "
" "c. "$17,965 " " " " " "
" "d. "$18,863 " " " " " "
" "e. "$19,806 " " " " " "
" " " " " " " " "
" "(Comp: 12.1-12.4) NPV, SL depr'n, constant CFs "Answer: e "MEDIUM "
"[lxi"California Hideaways is considering a new project whose data are "
"i]. "shown below. The equipment that would be used has a 3-year tax life,"
" "would be depreciated by the straight-line method over its 3-year "
" "life, and would have zero salvage value. No new working capital "
" "would be required. Revenues and other operating costs are expected "
" "to be constant over the project's 3-year life. What is the project's"
" "NPV? (Hint: Cash flows are constant in Years 1-3.) "
" " " " " " " " " "
" " "WACC " "10.0% " "
" " "Net investment cost (depreciable " "$65,000 " "
" " "basis) " " " "
" " "Straight-line depr'n rate " "33.3333%" "
" " "Operating costs excl. depr'n, each " "$25,000 " "
" " "year " " " "
" " "Tax rate " "35.0% " "
" " " " " " " " " "
" "a. "$8,499 " " " " " " "
" "b. "$8,946 " " " " " " "
" "c. "$9,417 " " " " " " "
" "d. "$9,913 " " " " " " "
" "e. "$10,434 " " " " " " "

" "(Comp: 12.1-12.4) Salvage value calculations "Answer: b "MEDIUM "
"[lxi"Bing Services is now in the final year of a project. The equipment "
"ii]."originally cost $20,000, of which 75% has been depreciated. Bing can"
" "sell the used equipment today for $6,000, and its tax rate is 40%. "
" "What is the equipment's net after-tax salvage value for use in a "
" "capital budgeting analysis? Note that if the equipment's final "
" "market value is less than its book value, Bing will receive a tax "
" "credit as a result of the sale. "
" " " " " " " " "
" "a. "$5,320 " " " " " "
" "b. "$5,600 " " " " " "
" "c. "$5,880 " " " " " "
" "d. "$6,174 " " " " " "
" "e. "$6,483 " " " " " "
" " " " " " " " "
" "(Comp: 12.1-12.4) After-tax salvage value "Answer: e "MEDIUM "
"[lxi"Moore & Moore (MM) is considering the purchase of a new machine for "
"v]. "$50,000, installed. MM will use the MACRS accelerated method to "
" "depreciate the machine, which is classified as 5-year property (see "
" "the following MACRS table for depreciation rates). MM expects to "
" "sell the machine at the end of its 4-year operating life for $10,000."
" "If MM's marginal tax rate is 40%, what will the after-tax cash flow "
" "be when it disposes of the machine at the end of Year 4? "
" " " " " " " " "
" " "Ownership Year " " "Depreciation Rate "
" " " "1 " " " "20% "
" " " "2 " " " "32 "
" " " "3 " " " "19 "
" " " "4 " " " "12 "
" " " "5 " " " "11 "
" " " "6 " " " " 6 "
" " " " " " " " "
" "a. "$7,656 " " " " " "
" "b. "$8,059 " " " " " "
" "c. "$8,484 " " " " " "
" "d. "$8,930 " " " " " "
" "e. "$9,400 " " " " " "

Medium/Hard:

" "(Comp: 12.1-12.4) NPV, SL, constant CFs, "Answer: b "MEDIUM/HARD "
" "cannibalization " " "
"[lxv"TexMex Products is considering a new salsa whose data are shown "
"]. "below. The equipment that would be used would be depreciated by the "
" "straight-line method over its 3-year life, would have zero salvage "
" "value, and no new working capital would be required. Revenues and "
" "other operating costs are expected to be constant over the project's "
" "3-year life. However, this project would compete with other TexMex "
" "products and would reduce their pre-tax annual cash flows. What is "
" "the project's NPV? (Hint: Cash flows are constant in Years 1-3.) "
" " " " " " "
" " "Pre-tax cash flow reduction in " "$5,000 " "
" " "other products (cannibalization)" " " "
" " "Investment cost (depr'ble basis)" "$65,000 " "
" " "Straight-line depr'n rate " "33.333% " "
" " "Annual operating costs, ex. " "$25,000 " "
" " "depr'n " " " "
" " "Tax rate " "35.0% " "
" " " " " " " " "
" "b. "$26,599 " " " " " "
" "c. "$27,929 " " " " " "
" "d. "$29,325 " " " " " "
" "e. "$30,792 " " " " " "
" " " " "
"[lxv"Easy Payment Loan Company is thinking of opening a new office, and "
"i]. "the key data are shown below. Easy Payment owns the building, free "
" "and clear, and it would sell it for $100,000 after taxes if it "
" "decides not to open the new office. The equipment that would be used"
" "would be depreciated by the straight-line method over the project's "
" "3-year life, and would have a zero salvage value. No new working "
" "capital would be required, and revenues and other operating costs "
" "would be constant over the project's 3-year life. What is the "
" "project's NPV? (Hint: Cash flows are constant in Years 1-3.) "
" " " " " " "
" " "Net equipment cost (depreciable basis) "$65,000 " "
" " "Straight-line depr'n rate for equipment "33.33% " "
" " "Sales revenues, each year "$150,000 " "
" " "Operating costs excl. depr'n, each year "$25,000 " "
" " "Tax rate " " " "35.0% " "
" " " " "
"[lxv"Dumpe Industries is analyzing an average-risk project, and the "
"ii]."following data have been developed. Unit sales will be constant, but"
" "the sales price will increase with inflation. Fixed costs will also "
" "be constant, but variable costs will rise with inflation. The "
" "project should last for 3 years, and there will be no salvage value. "
" "This is just one project for the firm, so any losses can be used to "
" "offset gains on other firm projects. What is the project's expected "
" "NPV? "
" " " " " "
" " "Units sold " " " "40,000 " "
" " "Average price per unit, Year 1 "$25.00 " "
" " "Fixed op. cost excl. depr'n (constant) "$150,000 " "
" " "Variable op. cost/unit, Year 1 "$20.20 " "
" " "Annual depreciation rate " "33.33% " "
" " "Expected inflation " " "5.00% " "
" " "Tax rate " " " "40.0% " "
" " " " "
"[lxv"Dumpe Industries is analyzing an average-risk project, and the "
"iii]"following data have been developed. Unit sales will be constant, but"
". "the sales price will increase with inflation. Fixed costs will also "
" "be constant, but variable costs will rise with inflation. The "
" "project should last for 3 years, and there will be no salvage value. "
" "This is just one project for the firm, so any losses can be used to "
" "offset gains on other firm projects. The marketing manager does not "
" "think it is necessary to adjust for inflation, but the CFO thinks an "
" "adjustment is required. What is the difference in the expected NPV "
" "if the inflation adjustment is made vs. if it is not made? "
" " " " " "
" " "Units sold " " " "40,000 " "
" " "Average price per unit, Year 1 "$25.00 " "
" " "Fixed op. cost excl. depr'n (constant) "$150,000 " "
" " "Variable op. cost/unit, Year 1 "$20.25 " "
" " "Annual depreciation rate " "33.333% " "
" " "Expected inflation " " "0.00% " "
" " "Tax rate " " " "40.0% " "
" " " " "
"[lxi"Rocky Top Car Wash is considering a new project whose data are shown "
"x]. "below. The equipment that would be used has a 3-year tax life, would"
" "be depreciated by the straight-line method over the project's 3-year "
" "life, and would have zero salvage value. No new working capital "
" "would be required. Revenues and other operating costs are expected "
" "to be constant over the project's 3-year life. This is just one "
" "project for the firm, so any losses can be used to offset gains on "
" "other firm projects. If the number of cars washed declined by 50% "
" "from the expected level, by how much would the project's NPV change? "
" "(Hint: Cash flows are constant in Years 1-3.) "
" " " " " "
" " "Number of cars washed " "2,800 " "
" " "Average price per car " "$25.00 " "
" " "Fixed op. cost excl. depr'n " "$10,000 " "
" " "Variable op. cost/unit (i.e. per car washed)"$5.357 " "
" " "Annual depreciation " " "$20,000 " "
" " "Tax rate " " " "35.0% " "
" " " " "
"[lxx"Merritt Company is considering a new project that has a cost of "
"]. "$1,000,000, and the CFO set up the following simple decision tree to "
" "show its three most likely scenarios. Merritt could arrange with its"
" "work force and suppliers to cease operations at the end of Year 1 "
" "should it choose to do so, but to obtain this abandonment option, "
" "Merritt would have to make a payment to those parties. How much is "
" "the option to abandon worth (in thousands) to Merritt? "
" " " " " " "
" " " "t = 0 "t = 1 "t = 2 "t = 3 "State "
" " " " "
"[lxx"Party Place is considering a new investment whose data are shown "
"i]. "below. The equipment that would be used would be depreciated on a "
" "straight-line basis over the project's 3-year life, would have zero "
" "salvage value, and would require some additional working capital that"
" "would be recovered at the end of the project's life. Revenues and "
" "other operating costs are expected to be constant over the project's "
" "3-year life. What is the project's NPV? (Hint: Cash flows are "
" "constant in Years 1 to 3.) "
" " " " " "
" " "Required new working capital " "$10,000 " "
" " "Straight line depr'n rate " "33.333% " "
" " "Operating costs excl. depr'n, each year "$25,000 " "
" " "Tax rate " " " "35.0% " "
" " " " "
"[lxx"Majestic Theaters is considering investing in some new projection "
"ii]."equipment whose data are shown below. The required equipment has a "
" "3-year tax life and would be fully depreciated by the straight-line "
" "method over the 3 years, but it would have a positive pre-tax salvage"
" "value at the end of Year 3, when the project would be closed down. "
" "Also, some new working capital would be required, but it would be "
" "recovered at the end of the project's life. Revenues and other "
" "operating costs are expected to be constant over the project's 3-year"
" "life. What is the project's NPV? "
" " " " " " " " "
" "Net investment in fixed assets (depreciable "$65,000 " "
" "basis) " " "
" "Required new working capital " "$10,000 " "
" "Straight line depr'n rate " " "33.333% " "
" "Sales revenues, each year " " "$70,000 " "
" "Operating costs excl. depr'n, each year "$25,000 " "
" "Expected pretax salvage value " "$5,000 " "
" "Tax rate " " " " "35.0% " "

" " " " " " " " " " "a. "$23,965 " " " " " " " " "b. "$25,226 " " " " " "
" " "c. "$26,554 " " " " " " " " "d. "$27,882 " " " " " " " " "e. "$29,276
" " " " " " " "

CHAPTER 12
ANSWERS AND SOLUTIONS
-----------------------
[i]. (12.1) Relevant cash flows Answer: b EASY
[ii]. (12.1) Relevant cash flows Answer: a EASY
[iii]. (12.1) Relevant cash flows Answer: b EASY
[iv]. (12.1) Relevant cash flows Answer: a EASY
[v]. (12.1) Net operating working capital Answer: b EASY
[vi]. (12.1) Cash flow estimation Answer: b EASY
[vii]. (12.1) Cash flow estimation Answer: a EASY
[viii]. (12.1) Cash flow estimation Answer: b EASY
[ix]. (12.3) Externalities Answer: b EASY
[x]. (12.3) Externalities Answer: a EASY
[xi]. (12.3) Externalities Answer: b EASY
If the externality is potentially important, it should not be ignored,
because then a large error might be made. It should be discussed at
the very least, and possibly the analysis should be done using several
scenarios regarding the importance of the externality.

[xii]. (12.4) Depreciation cash flows Answer: b EASY
[xiii]. (12.4) Depreciation cash flows Answer: a EASY
[xiv]. (12.4) Depreciation cash flows Answer: a EASY
[xv]. (12.4) Depreciation cash flows Answer: a EASY
[xvi]. (12.8) Risk-adjusted discount rate Answer: a EASY
[xvii]. (12.8) Risk-adjusted discount rate Answer: a EASY
[xviii]. (12.1) Relevant cash flows Answer: b MEDIUM
[xix]. (12.1) Cash flow estimation Answer: b MEDIUM
[xx]. (12.1) Cash flow estimation Answer: b MEDIUM
[xxi]. (12.3) Opportunity costs Answer: a MEDIUM
[xxii]. (12.3) Sunk costs Answer: b MEDIUM
[xxiii]. (12.3) Net operating working capital Answer: b MEDIUM
[xxiv]. (12.4) Depreciation cash flows Answer: b MEDIUM
[xxv]. (12.6) Sensitivity analysis Answer: a MEDIUM
[xxvi]. (12.3) Cash flow issues Answer: e EASY
[xxvii]. (12.8) Risk adjustment Answer: a EASY
[xxviii]. (12.8) Risk and project selection Answer: b EASY
[xxix]. (12.3) Sunk costs Answer: c EASY/MEDIUM
[xxx]. (12.3) Sunk costs Answer: d EASY/MEDIUM
[xxxi]. (12.3) Externalities Answer: b EASY/MEDIUM
[xxxii]. (12.3) Externalities Answer: e EASY/MEDIUM
[xxxiii]. (12.4) Depreciation Answer: a EASY/MEDIUM
[xxxiv]. (12.4) Depreciation Answer: d EASY/MEDIUM
[xxxv]. (12.4) Depreciation Answer: e EASY/MEDIUM
[xxxvi]. (12.1) Relevant cash flows Answer: c MEDIUM
[xxxvii]. (12.1) Relevant cash flows Answer: c MEDIUM
[xxxviii]. (12.1) Relevant cash flows Answer: b MEDIUM
[xxxix]. (12.1) Relevant cash flows Answer: b MEDIUM
[xl]. (12.1) Relevant cash flows Answer: a MEDIUM
[xli]. (12.1) Relevant cash flows Answer: c MEDIUM
[xlii]. (12.1) New project cash flows Answer: a MEDIUM
[xliii]. (12.1) Incremental cash flows Answer: d MEDIUM
[xliv]. (12.1) Incremental cash flows Answer: d MEDIUM
[xlv]. (12.1) Cash flow estimation Answer: b MEDIUM
[xlvi]. (12.1) Cash flow estimation Answer: d MEDIUM
Regarding a and b, note that since interest should not be considered,
exclusion will not lead to any type of bias, positive or negative.

[xlvii]. (12.6) Risk analysis Answer: c MEDIUM
Statement c is true, while the other statements are false. Stand-
alone risk is measured by standard deviation. Therefore, since Y's
standard deviation is higher than X's, Y has higher stand-alone risk
than X. Statement b is false because corporate risk is affected by
the correlation of project cash flows with other company cash flows,
and since Y's cash flows are more highly correlated with the cash
flows of existing projects than X's, Y has more corporate risk than X.
Market risk is measured by beta. Therefore, since X's beta is
greater than Y's, statement c is true.

[xlviii]. (12.6) Risk analysis Answer: a MEDIUM
Statement a is true because the project has a relatively high standard
deviation and thus more stand-alone risk than average. The project's
revenues would be countercyclical to the rest of the firm's and to
other firms' revenues, hence its within-firm and market risks would be
relatively low.

[xlix]. (12.6) Sensitivity, scenario, and simulation analyses Answer:
e MEDIUM
[l]. (12.6) Sensitivity, scenario, and simulation analyses Answer: a
MEDIUM
[li]. (12.8) Effect of a project on a firm's risk Answer: e MEDIUM
[lii]. (12.8) Risk and project selection Answer: c MEDIUM
Statement c is true; the others are false. The following table shows
the required return for each project on the basis of its risk level.

Expected Req'd Return
Project Risk Return for this Risk Decision
A High 15% 12% Accept
B Average 12 10 Accept
C High 11 12 Reject
D Low 9 8 Accept
E Low 6 8 Reject

[liii]. (12.8) Risk adjustment Answer: e MEDIUM
[liv]. (Comp. 12.1-12.4) Cash flows and accounting measures Answer:
d MEDIUM
[lv]. (Comp: 12.1-12.4) Annual operating CFs, depr'n given Answer: a
EASY
Sales revenues $15,000
– Operating costs (x-depr) 6,000
– Depreciation expense 4,000
Operating income (EBIT) $5,000
– Taxes Rate = 35% 1,750
After-tax EBIT $3,250
+ Depreciation 4,000
Operating cash flow $7,250

[lvi]. (Comp: 12.1-12.4) Annual operating CFs, depr'n given Answer:
c EASY
– Depreciation expense 8,000
– Taxes Rate = 35% 1,750

[lvii]. (Comp: 12.1-12.4) Annual operating CFs: SL depr'n Answer: d
EASY
Equipment cost $75,000
Depreciation Rate = 33.333% $25,000

– Basis ( rate = depreciation = 25,000
– Taxes Rate = 35% 3,500
Operating cash flow, Year 1 $31,500

[lviii]. (Comp: 12.1-12.4) Ann. op. CFs, depr'n and int. given Answer:
e EASY/MEDIUM
Sales revenues $35,000 #58 is a bit harder than #56 or #57
because
– Operating costs (x-depr) 17,000 it provides information on
interest, and
– Depreciation expense 10,000 some students might incorrectly
include
Operating income (EBIT) $8,000 it as an input. We like this
wrinkle
– Taxes Rate = 35% 2,800 because it's important that students
After-tax EBIT $5,200 know not to include financing costs in
+ Depreciation 10,000 the cash flows.

[lix]. (Comp: 12.1-12.4) Ann. op. CFs, depr'n and int. given Answer:
b EASY/MEDIUM
Sales revenues $55,000 #59 is a bit harder than #56 or #57
because
– Operating costs (x-depr) 25,000 it provides information on
interest, and
– Depreciation expense 8,000 some students might incorrectly
include
Operating income (EBIT) $22,000 it as an input. We like this
wrinkle
– Taxes Rate = 35% 7,700 because it's important that students
After-tax EBIT $14,300 know not to include financing costs in
+ Depreciation 8,000 the cash flows.

[lx]. (Comp: 12.1-12.4) Ann. Op. CFs: MACRS depr'n Answer: a EASY/MEDIUM
Depreciation rate 33.0%

– Depreciation 21,450
– Taxes Rate = 35% 4,743

[lxi]. (Comp: 12.1-12.4) Ann. op. CFs: MACRS depr'n, Yr 4 CF Answer:
c MEDIUM
Depreciation rate, Year 4 7.0%

– Taxes Rate = 35% -7,035

[lxii]. (Comp: 12.1-12.4) NPV, SL depr'n, constant CFs Answer: e
MEDIUM
WACC 10% Years 0 1 2 3
Investment cost -$65,000
Sales revenues $60,000 $60,000 $60,000
– Operating costs (x-depr) 25,000 25,000 25,000
– Depreciation Rate = 33.333% 21,667 21,667 21,667
Operating income (EBIT) $13,333 $13,333 $13,333
– Taxes Rate = 35% 4,667 4,667 4,667
After-tax EBIT $8,667 $8,667 $8,667
+ Depreciation 21,667 21,667 21,667
Operating cash flow -$65,000 $30,333 $30,333 $30,333

NPV = $10,434

[lxiii]. (Comp: 12.1-12.4) Salvage value calculations Answer: b MEDIUM
% depreciated on equip. 75%
Tax rate 40%

– Accumulated depr'n 15,000
Current book value of equipment $5,000
Market value 6,000
Gain (or loss): Market value – Book value $1,000
Taxes paid on gain or credited on loss -400
Net AT salvage value = market value +/- taxes = $5,600

[lxiv]. (Comp: 12.1-12.4) After-tax salvage value Answer: e MEDIUM
MACRS Dep'ble Annual Book
Year Rate Basis Depr'n Value
1 0.20 $50,000 $10,000 40,000
2 0.32 50,000 $16,000 24,000
3 0.19 50,000 $9,500 14,500
4 0.12 50,000 $6,000 8,500
5 0.11 50,000 $5,500 3,000
6 0.06 50,000 $3,000 0
1.00 $50,000

Gross sales proceeds $10,000
Book value, end of year 4 8,500
Profit $1,500
Tax on profit Rate = 40% 600
Net cash flow = Gross proceeds – Tax $9,400

[lxv]. (Comp: 12.1-12.4) NPV, SL, constant CFs, cannibalization
Answer: b MEDIUM/HARD
t = 0 t = 1 t = 2 t = 3
Investment (Basis) WACC = 10% -$65,000
Sales revenues $75,000 $75,000 $75,000
– Cannibalization cost 5,000 5,000 5,000
– Basis ( rate = depr'n Rate = 33.33% 21,667 21,667
21,667
– Taxes Rate = 35% 8,167 8,167 8,167
After-tax EBIT $15,167 $15,167 $15,167
+ Depreciation 21,667 21,667 21,667

NPV = $26,599

[lxvi].(Comp: 12.1-12.4) NPV, constant CFs, opp. cost Answer: d
MEDIUM/HARD
t = 0 t = 1 t = 2 t = 3
Investment WACC = 10% -$65,000
Opportunity cost -100,000
Revenues $150,000 $150,000 $150,000
– Basis ( rate = depr'n Rate = 33.33% 21,667
21,667 21,667
– Taxes Rate = 35% 36,167 36,167 36,167
After-tax EBIT $67,167 $67,167 $67,167
+ Depreciation 21,667 21,667
21,667

NPV = $55,915

[lxvii]. (12.5) Inflation Answer: c HARD
Base Case Calculations t = 0 t = 1 t = 2 t = 3
Investment cost WACC = 10% -$100,000
Inflation 5.0% 5.0% 5.0%
Price per unit $25.00 $26.25 $27.56
VC per unit $20.20 $21.21 $22.27
Units sold 40,000 40,000 40,000
Sales revenues $1,000,000 $1,050,000 $1,102,500
– Fixed op. cost excl. deprn 150,000 150,000 150,000
– Variable op costs per unit = $20.20 808,000 848,400
890,820
– Depreciation Rate = 33.3% 33,333 33,333
33,333
– Taxes Rate = 40% 3,467 7,307
11,339
After-tax EBIT $5,200 $10,960 $17,008
33,333

Base Case NPV = $9,458

[lxviii]. (12.5) Inflation: adjustment vs. no adjustment Answer: c
HARD
NPV with no adjustment t = 0 t = 1 t = 2 t = 3
Inflation 0.0% 0.0% 0.0%
Price per unit $25.00 $25.00 $25.00
VC per unit $20.25 $20.25 $20.25
Units sold 40,000 40,000 40,000
Sales revenues $1,000,000 $1,000,000 $1,000,000
810,000
33,333
– Taxes Rate = 40% 2,667 2,667
2,667
After-tax EBIT $4,000 $4,000 $4,000
33,333

NPV w/o infl adjustment = -$7,158

NPV with adjustment t = 0 t = 1 t = 2 t = 3
Inflation 5.0% 5.0% 5.0%
Price per unit $25.00 $26.25 $27.56
VC per unit $20.25 $21.26 $22.33
Units sold 40,000 40,000 40,000
Sales revenues $1,000,000 $1,050,000 $1,102,500
893,025
33,333
– Taxes Rate = 40% 2,667 6,467
10,457
After-tax EBIT $4,000 $9,700 $15,685
33,333

NPV w/infl adjustm't = $6,332
Increase w/infl adjustment = $13,490

[lxix]. (12.6) Sensitivity analysis: NPV, constant CFs Answer: e
HARD
Base Case Calculations t = 0 t = 1 t = 2 t = 3
Cars washed 2,800 2,800 2,800
Price per car $25 $25 $25
Variable cost/unit $5.357 $5.357 $5.357
Sales revenues $70,000 $70,000 $70,000
– Variable op costs 15,000 15,000 15,000
– Depreciation 20,000 20,000 20,000
– Taxes Rate = 35% 8,750 8,750 8,750
After-tax EBIT $16,250 $16,250 $16,250
+ Depreciation 20,000 20,000 20,000

Base Case NPV = $30,149

Bad Case Calculations t = 0 t = 1 t = 2 t = 3
Cars washed Declines by 50% 1,400 1,400 1,400
Price per car $25 $25 $25
Variable cost/unit $5.357 $5.357 $5.357
Sales revenues $35,000 $35,000 $35,000
– Variable op costs 7,500 7,500 7,500
– Depreciation 20,000 20,000 20,000
Operating income (EBIT) -$2,500 -$2,500 -$2,500
– Taxes Rate = 35% -875 -875 -875
After-tax EBIT -$1,625 -$1,625 -$1,625
+ Depreciation 20,000 20,000 20,000

Bad Case NPV = -$14,304
Decline in NPV = $44,453

[lxx]. (12.9) Decision trees & real options--nonalgorithmic Answer:
c HARD

[lxxi]. (Comp: 12.1-12.4) NPV, SL, constant CFs, WC Answer: a HARD
t = 0 t = 1 t = 2 t = 3
Investment in fixed assets WACC = 10% -$65,000
Investment in net working capital -$10,000
Sales revenues $70,000 $70,000 $70,000
Depr'n Rate = 33.333% 21,667 21,667 21,667
– Taxes Rate = 35% 8,167 8,167 8,167
After-tax EBIT $15,167 $15,167 $15,167
+ Depreciation 21,667 21,667 21,667
Recovery of working capital
10,000
Total cash flows -$75,000 $36,833 $36,833 $46,833

NPV = $24,112

[lxxii]. (Comp: 12.1-12.4) NPV, constant CFs, WC, SV Answer: c HARD
WACC = 10% t = 0 t = 1 t = 2 t = 3
Investment in fixed assets -$65,000
Investment in net working capital -10,000
Sales revenues $70,000 $70,000 $70,000
Depreciation Rate = 33.333% 21,667 21,667 21,667
– Taxes Rate = 35% 8,167 8,167 8,167
After-tax EBIT $15,167 $15,167 $15,167
+ Depreciation
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Recovery of working capital 10,000
Salvage value, pre-tax 5,000
– Tax on salvage value Rate = 35%
1,750
Total cash flows -$75,000 $36,833 $36,833 $50,083

NPV = $26,554

FM12 Ch 12 Test Bank

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