Financial Management (Chapter 12: Analyzing Project Cash Flows)

12.1   Identifying Incremental Cash Flows

1) Incremental cash flows from a project =

A) Firm cash flows without the project plus or minus changes in net income.

B) Firm cash flows with the project plus firm cash flows without the project.

C) Firm cash flows with the project minus firm cash flows without the project.

D) Firm cash flows without the project plus or minus changes in revenue with the project.

2) Which of the following is NOT one of the categories for a project's relevant after-tax cash flows?

A) Financing flows

B) Initial cash outflow

C) Differential flows over the project's life

D) Terminal cash flow

3) Which of the following is NOT part of a project's initial cash outflow?

A) The asset's purchase price

B) Funds committed to support increased inventory levels due to expected increased sales if the firm adopts the project

C) A marketing survey completed last year to determine the project's feasibility

D) Expenses incurred to install the asset

4) Relevant incremental cash flows include

A) sales captured from the firm's competitors.

B) retained sales that would have been lost to new competing products.

C) incremental sales brought to the firm as a whole.

D) all of the above.

5) Which of the following is NOT considered in the calculation of incremental cash flows?

A) Depreciation tax shield

B) Sunk costs

C) Opportunity costs

D) Both A and B

6) Which of the following cash flows should be included as incremental costs when evaluating capital projects?

A) Investment in working capital that is directly related to a project

B) Expenses that are incurred in order to modify a firm's production facility in order to invest in a project

C) Opportunity costs that are directly related to a project

D) All of the above

7) Depreciation expenses affect tax-related cash flows by

A) increasing taxable income, thus increasing taxes.

B) decreasing taxable income, thus reducing taxes.

C) decreasing taxable income, but not altering cash flows since depreciation is not a cash expense.

D) all of the above.

8) Which of the following would be considered a termination cash flow?

A) The expected salvage value of the asset

B) Any tax payments or refunds associated with the salvage value of the asset

C) Recapture of any investment in working capital that was included as an incremental cash outlay

D) All of the above

9) How is interest expense that is associated with a project treated in the capital budgeting process?

A) It is treated as a cash outflow when estimating the incremental cash flows associated with a project.

B) It is built into the discount rate.

C) It is considered a synergistic incremental cash flow.

D) Interest expense is not relevant to any capital budgeting decisions.

10) Which of the following best describe why cash flows are utilized rather than accounting profits when evaluating capital projects?

A) Deducting interest expense from income and also including it in the discount rate would result in double counting.

B) Cash flows reflect the timing of benefits and costs more accurately than accounting profits.

C) Cash flows are more stable than accounting profits.

D) Both A and B.

11) Which of the following is the best example of an incremental cash inflow/outflow?

A) Cash flows that are achieved by diverting sales from other projects of the firm

B) Cash flows that are associated with the financing of a project

C) Cash flows that occur a little at a time

D) What the total cash flows will be to the company if the project is undertaken as opposed to what they would have been if the project had not been undertaken

12) Which of the following is an example of a sunk cost?

A) Overhead costs that are associated with a project

B) Interest expense associated with a project

C) Market study expenses incurred in order to decide if a firm should accept a project

D) Depreciation expenses associated with a project

13) Which of the following cash flows should be included as incremental costs when evaluating capital projects?

A) A new security system will reduce shoplifting losses by $50,000 per year.

B) New equipment associated with the project will increase depreciation expense by $300,000 per year.

C) Interest on construction loans will increase interest expense by $225,000 per year.

D) The new project will occupy about 5% of the Chief Operating Officer’s time, so 5% of her salary should be included.

14) The calculation of differential cash flows over a project's life should include which of the following?

A) Labor and material savings

B) Additional revenues attributable to the project

C) Investment in net working capital

D) All of the above

15) Which of the following cash flows are NOT considered in the calculation of the initial outlay for a capital investment proposal?

A) Increase in accounts receivable

B) The cost of shipping new equipment

C) The cost of issuing new bonds if the project is financed by a new bond issue

D) The cost of installing new equipment

16) Which of the following expenses should be included when estimating cash flows for investment projects?

A) Interest expense related to financing a project

B) Sunk costs

C) Required principal payments related to financing a project

D) Opportunity costs

17) When evaluating Capital Budgeting decisions, which of the following items should NOT be included in the construction of cash flow projections for purposes of analysis?

A) Net salvage value

B) Changes in net working capital requirements

C) Shipping and installation costs

D) All of the above should be included.

18) Holding all other variables constant, which of the following would INCREASE net working capital for given year on a project?

A) Allowing customers less time to pay for purchases

B) Taking longer to pay suppliers

C) Increasing inventory levels

D) Both A and C

19) If an investment project would make use of land which the firm currently owns, the project should be charged with

A) a sunk cost.

B) an opportunity cost.

C) amortization.

D) interest.

20) The owner of a convenience store is considering adding a take-out sandwich section to her offerings. The new activity will occupy 25% of the space and account for 30% of total revenues. Property insurance on the building is $9,000 per year and will not change because of the new activity. How much of the insurance premium should be allocated to the new product line?

A) $2,700

B) $2,475

C) $2,250

D) $0.00

21) Mr. Smith included the cost of test marketing before production in the calculation of the initial outlay. Apparently, Mr. Smith does not understand the concept of

A) side-effect costs.

B) opportunity costs.

C) sunk costs.

D) variable costs.

22) Sunk costs are a type of incremental cash flow that should be included in all capital-budgeting decisions.

Answer:  FALSE

23) When determining how much overhead cost to include in incremental cash flows for a capital budgeting decision, the allocation of overhead by the accounting department based on percentage of space used by a project should always be used.

Answer:  FALSE

24) The pertinent issue for determining whether overhead costs should be part of a project's relevant after-tax cash flow is whether the project benefits from the overhead items.

Answer:  FALSE

25) The initial outlay involves the immediate cash outflow necessary to purchase the asset and put it in operating order.

Answer:  TRUE

26) When replacing an existing asset, the cash inflow associated with the sale of the old asset and any related tax effects must be considered and accounted for in the analysis.

Answer:  TRUE

27) The initial outlay of an asset does not include installation costs.

Answer:  FALSE

28) In making a capital budgeting decision we only include the incremental cash flows resulting from the investment decision.

Answer:  TRUE

29) To be conservative, capital budgeting analysis assumes that projects cannot add sales to existing lines of business.

Answer:  FALSE

30) A company converts space to use as a manufacturing facility.  Previously it was rented to another company as a warehouse.  This is an example of a sunk cost.

Answer:  FALSE

31) In measuring cash flows we are interested only in the incremental or differential after-tax cash flows that are attributed to the investment proposal being evaluated.

Answer:  TRUE

32) Briefly explain why each of the following should or should not be considered in forecasting incremental cash flows from a project:

a. The cost of building a prototype of a new product to see if it was feasible.

b. Market research suggests that after buying a company's "smart phone" customers will begin to buy more of the same company's notebook computers.

c. A company decides to use existing space for storage. The company could have rented the space to another business for $2,500 a month.

Answer: 
a. The cost of building the prototype is a sunk cost. It will not go away if the decision is not to go ahead with the new product, therefore it is not relevant to the decision.

b. If the company expects additional sales of an existing product as a result of introducing a new product, it should consider those sales as it forecasts incremental cash flows from the project.

c. The foregone rent is an example of opportunity cost. It is easier to forecast than most cash flows and should definitely be considered.

33) Cape Cod Cranberries will finance a new organic juice production facility with a $10,000,000 bond issue. Interest on the bonds will be $637,500 per year for the life of the project. Should the interest payments be subtracted from the project's incremental cash flows?

Answer:  The cost of interest is implicitly built in to the project's cost of capital which will be used to discount the cash flows to their present value. If interest were subtracted from the expected cash flow, it would be counted twice and the project unfairly penalized.

34) Cape Cod Cranberries is evaluating the introduction of a new line of organic cranberry products. Market research suggests that approximates 1/3 of sales of the new products will come at the expense of existing product lines. How should this "cannibalization effect" be incorporated into the analysis.

Answer:  Incremental cash flows are determined by subtracting firm cash flows without the project from firm cash flows with the project. If lower sales of existing products are a direct result of introducing the new products, the company should deduct the lost cash flows from expected cash flows from the new products. (Some students may argue that the sales of non-organic products might eventually have been lost to competition in any case.)

35) Anderson-EOG Inc. is evaluating the construction of a gas pipeline to bring natural gas from Western New York state to New York City. The controller argues that depreciation has to be included among the expenses. The Treasurer argues that depreciation is irrelevant because it does not affect cash flow. Who is correct?

Answer:  Both are partially right and partially wrong. Depreciation is not a cash expense, but it does affect taxable income and therefore taxes. Since taxes affect cash flow, depreciation must be subtracted to arrive at taxable income, then added back in to arrive at operating cash flow.

36) Anderson-EOG Inc. is evaluating the construction of a gas pipeline to bring natural gas from Western New York state to New York City. The controller argues that every project of the company has to absorb a portion of administrative overhead including corporate headquarters and executive salaries. The Treasurer argues that these costs are irrelevant because they are merely being shifted from part of the company to another. Who is correct?

Answer:  Both are partially right and partially wrong. Costs are only relevant to the analysis if they affect the equation Incremental Project Cash Flows = (Firm Cash Flows with the Project) - (Firm Cash Flows without the Project). Executive salaries would be relevant, for example, if a new person is hired to manage the project or if someone is paid more to accept the additional responsibility.

12.2   Forecasting Project Cash Flows

1) Thaler & Co. anticipates an increase of $1,000,000 in Net Operating Income from first year sales of a new product. Taxes will be $350,000 and the company took $150,000 in depreciation expense. Operating cash flow equals

A) $1,000,000

B) $500,000

C) $800,000

D) $650,000

2) Schiller Construction Inc. has estimated the following revenues and expenses related to phase I of a proposed new housing development. Incremental sales= $5,000,000, total cash operating expenses $3,500,000, depreciation $500,000, taxes 35%, interest expense, $200,000. Operating cash flow equals

A) $650,000

B) $1,000,000

C) $1,150,000

D) $975,000

3) Incremental cash flows include all of the following EXCEPT

A) research and development costs.

B) increased labor costs from the project.

C) advertising costs.

D) both B and C.

4) Diamond Inc. has estimated that a new building will cost $2,500,000 to construct. Land was purchased a year ago for $500,000 and could be sold today for $550,000. An environmental impact study required by the state was performed at a cost of $48,000. For capital budgeting purposes, what is the relevant cost of the new building?

A) $2,500,000

B) $3,048,000

C) $3,050,000

D) $3,098,000

5) If SuperMart decides to offer a line of groceries at its discount retail outlet, inventories are expected to increase by $1,200,000, accounts receivable by $300,000 and accounts payable by $500,000. What is the cash outflow for working capital requirements?

A) $2,000,000

B) $1,700,000

C) $1,500,000

D) $1,000,000

6) If depreciation expense is taken over 5 years rather than 3 years, all things equal,

A) net present value will go down.

B) depreciation has no effect on net present value.

C) net present value will go up.

D) the answer depends on the company's marginal tax rate.

7) If the federal income tax rate were increased, the impact of the tax increase on acceptable investment proposals would be to (ignore the impact of the tax change on the cost of capital)

A) decrease the tax shelter from depreciation.

B) decrease net present value but the internal rate of return would stay the same.

C) increase net present value because the tax shelter from interest and depreciation becomes more valuable.

D) decrease both net present value. and internal rate of return.

8) Which of the following would increase the net working capital for a project? An increase in

A) accounts receivable.

B) fixed assets.

C) accounts payable.

D) common stock.

9) Which of the following should be included in the initial outlay?

A) Shipping and installation costs

B) Increased working capital requirements

C) Cost of employee training associated specifically with the asset being evaluated

D) All of the above

10) Depreciation expenses affect capital budgeting analysis by increasing

A) taxes paid.

B) incremental cash flows.

C) the initial outlay.

D) working capital.

11) Which of the following is included in the terminal cash flow?

A) The expected salvage value of the asset

B) Tax impacts from selling assets

C) Recapture of any working capital

D) All of the above

12) A firm purchased an asset with a 5-year life for $90,000, and it cost $10,000 for shipping and installation. According to the current tax laws the cost basis of the asset at time of purchase is

A) $100,000.

B) $95,000.

C) $80,000.

D) $70,000.

13) XYZ, Inc. is considering adding a product line that would utilize floor space in their manufacturing plant which is currently used for storage. XYZ will need to rent new storage space elsewhere. The floor space would be considered a(n)

A) variable cost.

B) opportunity cost.

C) sunk cost.

D) irrelevant cash flow.

14) Which of the following is included in the calculation of the initial outlay for a capital investment?

A) Investment in working capital

B) A feasibility study conducted the previous year.

C) Installation

D) A and C but not B

15) Which of the following would decrease after-tax operating cash flows? A decrease in

A) depreciation expense.

B) interest expense.

C) incremental sales.

D) both A and C.

Use the following information to answer the following question(s).

Delta Inc. is considering the purchase of a new machine which is expected to increase sales by $10,000 in addition to increasing non-depreciation expenses by $3,000 annually. Due to the sales increase, Delta will need to increase working capital by $1,000 at the beginning of the project. Delta will depreciate the machine using the straight-line method over the project's five year life to a salvage value of zero. The machine's purchase price is $20,000. The firm has a marginal tax rate of 34 percent, and its required rate of return is 12 percent.

16) The machine's initial cash outflow is

A) $20,000.

B) $21,000.

C) $27,000.

D) $23,000.

17) The machine's incremental after-tax cash inflow for year 1 is

A) $6,420.

B) $7,980.

C) $8,620.

D) $5,980.

18) The machine's after-tax incremental cash flow in year five is

A) $6,980.

B) $5,980.

C) $7,120.

D) $8,620.

19) The machine's NPV is

A) $1,556.56.

B) $2,556.56.

C) $1,123.99.

D) $2,123.99.

20) The machine's IRR is

A) less than 0.

B) greater than 12 percent.

C) less than 12 percent.

D) equal to 12 percent.

21) ABC already spent $85,000 on a feasibility study for a machine that will produce a new product. The machine will cost $2,575,000. Required modifications will cost $375,000. ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is presumed to have no salvage value. It will only be operated for 3 years, after which it will be sold for $600,000. What is the depreciable cost basis of the machine?

A) $3,025,000

B) $2,950,000

C) $2,575,000

D) $2,350,000

22) ABC already spent $85,000 on a feasibility study for a machine that will produce a new product. The machine will cost $2,575,000. Required modifications will cost $375,000. ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is presumed to have no salvage value. It will only be operated for 3 years, after which it will be sold for $600,000. What is the total investment amount required for the project?

A) $3,025,000

B) $2,950,000

C) $2,575,000

D) $2,350,000

23) ABC will purchase a machine that will cost $2,575,000. Required modifications will cost $375,000. ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is presumed to have no salvage value. ABC plans to depreciate the machine by using the straight-line method. The machine is expected to increase ABC's sales revenues by $1,890,000 per year; operating costs excluding depreciation are estimated at $454,600 per year. Assume that the firm's tax rate is 40%. What is the annual operating cash flow?

A) $922,464

B) $1,126,287

C) $813,563

D) $1,029,811

24) ABC purchased a machine for $2,575,000. Required modifications will cost $375,000. ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is presumed to have no salvage value. It will only be operated for 3 years, after-which it will be sold for $600,000. ABC plans to depreciate the machine by using the straight-line method. Assume that the firm's tax rate is 40%. What is the termination (non-operating) cash flow from the machine in year three?

A) $900,623

B) $1,109,286

C) $1,298,114

D) $879,247

25) Famous Danish Corp. is replacing an old cookie cutter with a new one. The cookie cutter is being sold for $25,000 and it has a net book value of $75,000. Assume that Famous Danish is in the 34% income tax bracket. How much will Famous Danish net from the sale?

A) $61,000

B) $55,000

C) $75,000

D) $42,000

26) Burr Habit Corporation is considering a new product line. The company currently manufactures several lines of snow skiing apparel. The new products, insulated ski shorts, are expected to generate sales less cost of goods sold of $1 million per year for the next five years. They expect that during this five year period, they will lose about $250,000 per year in sales less cost of goods sold on their existing lines of longer ski pants as a result of the introduction of the new product line. The new line will require no additional equipment or space in the plant and can be produced in the same manner as the existing apparel products. The new project will, however, require that the company spend an additional $80,000 per year on insurance in case customers sue for frostbite. Also, a new marketing director would be hired to oversee the line at $45,000 per year in salary and benefits. Because of the different construction of the shorts, an increase in inventory of 3,800 would be required initially. If the marginal tax rate is 30%, compute the incremental after tax cash flows per year for years 1-5.

A) $434,500 per year

B) $625,000 per year

C) $187,500 per year

D) $437,500 per year

27) Regal Enterprises is considering the purchase of a new embroidering machine. It is expected to generate additional sales of $400,000 per year. The machine will cost $295,000, plus $3,000 to install it. The embroiderer will save $12,000 in labor expense each year. Regal is in the 34% income tax bracket. The machine will be depreciated on a straight-line basis over five years (it has no salvage value). The embroiderer will require annual operating expenses of $136,000. What is the annual operating cash flow that the machine will generate?

A) $316,954

B) $124,000

C) $202,424

D) $165,816

28) Woodstock Inc. expects to own a building for five years, then sell it for $1,500,000 net of taxes, sales commissions and other selling costs. Woodstock's cost of capital is 11%. How much will the sale of the building contribute to the NPV of the project?

A) $890,177

B) $1,351,351

C) $1,500,000

D) $2,527,587

29) Which of the following would cause free cash flow to differ from operating cash flow when an investment project is terminated?

A) Sale of assets

B) Recovery of net working capital

C) Income taxes

D) All of the above

30) Which of the following should be considered in the estimation of free cash flows?

A) Cash generated from the sale of a project

B) Recovery of net working capital

C) Operating cash flow

D) All of the above

31) The Director of Capital Budgeting of Capital Assets Corp. is considering the acquisition of a new high speed photocopy machine. The photocopy machine is priced at $85,000 and would require $2,000 in transportation costs and $4,000 for installation. The equipment will have a useful life of 5 years. The proposal will require that Capital Assets Corp. send a technician for training at a cost of $5,000. The firm's marginal tax rate is 40 percent. How much is the initial cash outlay of the photocopy machine?

A) $64,000

B) $77,000

C) $81,000

D) $96,000

32) Jefferson Corporation is considering an expansion project. The necessary equipment could be purchased for $15 million and shipping and installation costs are another $500,000. The project will also require an initial $2 million investment in net working capital. The company's tax rate is 40%. What is the project's initial investment outlay (in millions)?

A) $15.0

B) $15.5

C) $17.0

D) $17.5

33) In the fourth and final year of a project, SVC expects operating cash flow of $440,000. The project required an $80,000 investment in working capital at the beginning. Of that amount, $60,000 will be recovered in year 4. Machinery associated with the project will be sold for exactly its undepreciated value of $15,000. Total free cash flow for the fourth year is

A) $75,000.

B) $1,500,000.

C) $515,000.

D) $535,000.

34) Wright's Warehouse has the following projections for Year 1 of a capital budgeting project.

                Year 1 Incremental Projections:

                Sales                                                              $200,000

                Variable Costs                                            $120,000

                Fixed Costs                                                 $40,000

                Depreciation Expense                             $20,000

                Tax Rate                                                       40%

Calculate the operating cash flow for Year 1.

A) $12,000

B) $32,000

C) $52,000

D) $72,000

35) SpaceTech is considering a new project with the following projections for Year 2.

                Year 2 Projections

                EBIT                                                               $400,000

                Interest Expense                                        $20,000

                Depreciation Expense                              $40,000

                Tax Rate                                                       40%

                Incremental Net Working

                Capital Needs                                            $200,000 

A) $130,000

B) $180,000

C) $230,000

D) $280,000

36) In year 3 of project Gamma. sales were $3,000,0000, cost of goods sold $1,500,000, other cash costs were $400,000, depreciation was $600,000 and interest expense was $250,000. The company's marginal tax rate is 35%. Compute operating cash flow for year 3 of project Gamma.

A) $925,000

B) $675,000

C) $500,000

D) $325,000

37) The Board of Directors of Waste Free Chemicals is considering the acquisition of a new chemical processor. The processor is priced at $600,000 but would require $60,000 in transportation costs and $40,000 for installation. The processor will have a useful life of 10 years. The project will require Waste Free to increase its investment in accounts receivable by $80,000 and will also require an additional investment in inventory of $150,000. The firm's marginal tax rate is 40 percent. How much is the initial cash outlay of the processor?

A) $700,000

B) $850,000

C) $930,000

D) $1,040,000

38) The introduction of a new product at Elia Pharmaceuticals will require a $450,000 increase in inventory, a $730,000 increase in Accounts Receivable, and a $180,000 increase in Accounts Payable.  Introduction of the product will also require a $700,000 expenditure for advertising.  The increase in net working capital required for the introduction of this product is

A) $1,180,000.

B) $1,000,000.

C) $1,360,000.

D) $1,700,000.

39) Which of the following cash flows are NOT considered in the calculation of the initial outlay for a capital investment proposal?

A) Training expense

B) Working capital investments

C) Installation costs of an asset

D) Before-tax selling price of old machine

40) If Morgan Tool & Die Co. acquires a new turret lathe, the lathe will cost $80,000, transportation $6,000, installation $7,500. Installing the new lathe will allow Morgan to reduce its finished goods inventory by $10,000. For capital budgeting purposes, the initial investment required for the new lathe is

A) $83,500.

B) $87,500.

C) $93,500.

D) $103,500.

41) A project under consideration by Bizet Co. will require the purchase of machinery for $50,000 and additional inventory for $15,000. Accounts receivable will increase by $12,000 and accounts payable by $14,000. Liability insurance will increase by $2,500 per year and utilities expense by $1,500 per year. What is the investment in working capital required by this project?

A) $77,000

B) $41,000

C) $13,000

D) $4,000

42) When an old asset is sold for exactly its depreciated value, the only taxable income is the difference between the initial cost of the machine and the selling price.

Answer:  FALSE

43) Because installation costs of a new asset are a current cash expense, they are excluded from the initial outlay.

Answer:  FALSE

44) The capital budgeting decision-making process involves estimating the expected incremental cash flows of a proposal and comparing the present value of these cash flows to the project's cost.

Answer:  TRUE

45) Working capital for a project includes investment in fixed assets.

Answer:  FALSE

46) It is not necessary to consider depreciation in estimating cash flows for a new capital project.

Answer:  FALSE

47) The initial outlay of an asset does not include installation costs.

Answer:  FALSE

48) The depreciation method used in capital budgeting is irrelevant because any depreciation not taken during the life of the project will add to the book value when assets are sold.

Answer:  FALSE

49) Additional cash needed to fill increased working capital requirements should be included in the initial cost of a product when analyzing an investment.

Answer:  TRUE

50) By examining cash flows, we are correctly able to analyze the timing of the benefits.

Answer:  TRUE

51) Accounting profits represents free cash flows that are available for reinvestment.

Answer:  FALSE

52) The hardest step in capital budgeting analysis is estimating the cash flows of a project.

Answer:  TRUE

53) A marketing survey completed last year to determine a project's feasibility would be included as part of the project's initial cash outflow.

Answer:  FALSE

54) It is possible for after-tax operating cash flows to be positive when accounting income is negative.

Answer:  TRUE

55) Sales captured from the firm's competitors can be relevant to the capital-budgeting decision.

Answer:  TRUE

56) Clean-up and restoration costs required by government regulations are negative cash flows associated with a project's termination.

Answer:  TRUE

57) LaVigne Wineries is purchasing a new wine press. The equipment will cost $250,000. Transportation and installation will cost another $35,000. Because of increased production, inventories will increase by $15,000. The press will be depreciated using the straight line method to a book value of $0.00 over its useful life of 7 years. Compute depreciation for each year of the project.

Answer:  For depreciation purposes, the cost of the asset includes transportation, but not, of course, working capital investments. ($250,000 + $35,000)/7 = $40,714.29 depreciation expense per year.

58) Cape Cod Cranberry Products is evaluating the introduction of a new line of juice drinks consisting of cranberry juice blended with sweeter juices such as apple or grape. In the first year the product line is introduced, sales are forecasted at $2,000,000, Cost of Goods Sold at $1,200,000, other cash expenses at $300,000, depreciation expense at $800,000. The company has many other profitable product lines. It's marginal tax rate is 35%. Compute operating cash flow for the first year.

Answer: 

Sales                                                                                         $2,000,000

Cost of Goods Sold                                               (1,200,000)

Gross Profit                                                                                $800,000

Other Cash Exp.                                                                                (300,000)

Depreciation                                                                       (800,000)

Net Operating Income                                     (300,000)

Taxes 35%                                                                                           (105,000)

NOPAT (loss)                                                                     (195,000)

Depreciation                                                                       (800,000)

Operating Cash Flow                                       $605,000

59) Marguerite's Florist is considering the purchase of a new delivery van. It will cost $25,000 plus another $3,000 to have it painted in the company's characteristic floral motif. The van will be depreciated over 5 years using MACRS percentages and a half year convention. Compute depreciation for the second year in the life of the van.

Answer:  For depreciation purposes, the cost of the asset includes repainting, so the base is $25,000 + $3,000) = $28,000. The second year rate 32% so depreciation will be $28,000 × .32 = $8,960.

60) What is the advantage, if any, to using MACRS rather than straight line depreciation?

Answer:  Assuming that a company is profitable and pays taxes, MACRS allows more of the cost of the asset to be written off in the first few years of its life. The faster write-off reduces taxable income in the early years and raises it in the later years. Because of the time value of money, NPV will be higher if taxes can be deferred and cash flow is higher the early years of a project.

12.3   Inflation and Capital Budgeting

1) In 2013, Sunny Electronics expects to sell 100,000 3-D television sets for an average price of $1,000. Expected production costs are $600 per unit. In 2014, volume is expected to increase by 10%, while inflation will increase both the sales price and the cost per unit by 3%. In nominal dollars, expected gross profit for 2014 is

A) $40 million.

B) $45.32 million.

C) $48.20 million.

D) $50 million.

2) In 2013, Sunny Electronics expects to sell 100,000 3-D television sets for an average price of $1,000. Expected production costs are $600 per unit. In 2014, volume is expected to increase by 10%, while inflation will increase both the sales price and the cost per unit by 3%. In real dollars, expected gross profit for 2014 is

A) $40 million.

B) $45.32 million.

C) $48.2 0 million.

D) $50 million.

3) In 2013, Sunny Electronics expects to sell 100,000 3-D television sets for an average price of $1,000. Expected production costs are $600 per unit. In 2014, volume is expected to increase by 10%, Inflation will increase the cost per unit by 3%, but to attract more buyers, Sunny will reduce the price to $950. In nominal dollars, expected gross profit for 2014 is

A) $45.32 million.

B) $40 million.

C) $38 million.

D) $36.52 million.

4) Greenspan Inc. discounts cash flows at a nominal rate of 10%. Inflation over the next few years is expected to average 3%. Which of the following would be a correct adjustment for inflation when computing net present value?

A) Discount cash flows at 10%; increase revenues and expenses by 3% each year.

B) Discount cash flows at 13%; increase revenues and expenses by 3% each year.

C) Discount cash flows at 7%; ignore inflation when forecasting revenues and expenses.

D) Either A or C would be acceptable.

5) Nominal cash flows are expressed in terms of their purchasing power in a base year.

Answer:  FALSE

6) The real discount rate includes expected inflation.

Answer:  FALSE

7) When computing the NPV of a project, if cash flows are discounted at the real cost of capital, then the cash flows should not be adjusted for inflation.

Answer:  TRUE

8) When computing the NPV of a project, it is important to consistently use either nominal dollars and nominal rates or real dollars and real rates.

Answer:  TRUE

9) When computing project cash flows, it is necessary to apply the same rate of inflation to all costs and revenues.

Answer:  FALSE

10) What is meant by "real dollars" and the "real" discount rate? How can they be used to account for inflation when evaluating capital budgeting proposals?

Answer:  Real dollars are used to represent prices or expenses in the absence of inflation. If an item sells for $10 one year and $10.30 the following year solely because of inflation and not because of other factors such as supply and demand, the price would still be stated as $10 "real" dollars. When using real dollars, the interest rate is also disinflated. With 3% inflation, a 10% interest rate is disinflated to 10% - 3% = 7% or more precisely, (1.10/1.03) - 1 = 6.8%.

11) Tversky and Co. have devised a new psychological test for investors' risk tolerance. They expect to sell 10,000 tests in the first year at $150 each. Cash costs associated with producing, administering and scoring the test are $50 per unit. In the second year, volume is expected to be the same, but both the price and the costs will increase 2.5%. Forecast gross profit in the second year.

Answer: 

Revenue                               10,000 units × $150 × 1.025 =  $1,537,500

Cash Costs                          10,000 units × $50 × 1.025 =         512,500

Gross Profit                                                                                                                                         $1,025,000

12.4   Replacement Project Cash Flows

Use the following information to answer the following question(s).

A firm is trying to determine whether to replace an existing asset. The proposed asset has a purchase price of $50,000 and has installation costs of $3,000. The asset will be depreciated over its five year life using the straight-line method. 

The new asset is expected to increase sales by $17,000 and non-depreciation expenses by $2,000 annually over the life of the asset. Due to the increase in sales, the firm expects an increase in working capital during the asset's life of $1,500, and the firm expects to be able to sell the asset for $6,000 at the end of its life. 

The existing asset was originally purchased three years ago for $25,000, has a remaining life of five years, and is being depreciated using the straight-line method. The expected salvage value at the end of the asset's life (i.e., five years from now) is $5,000; however, the current sale price of the existing asset is $20,000, and its current book value is $15,625. 

The firm's marginal tax rate is 34 percent and its required rate of return is 12 percent.

1) If the new machine is purchased, depreciation expense will increase or decrease by

A) increase $8,000.

B) increase $6,900.

C) increase $6,300.

D) decrease $5,000.

2) Increased taxes on the sale of the old machine are

A) $1,487.50.

B) $2,500.50.

C) $3,823.50.

D) $4,312.50.

3) If the new machine is purchased, operating cash flow for years 1 through 5 will increase or decrease by how much?

A) Increase $15,000

B) Decrease $9,900

C) Increase $12,142

D) Increase $5,346

4) What would cause the initial cash outlay of an investment decision to be affected by the sale of an existing asset?

A) If the investment decision is a replacement decision

B) If the asset being purchased is technologically superior

C) If the asset being sold has exceeded its MACR's recovery allowance period

D) All of the above

5) Al's Fabrication Shop is purchasing a new rivet machine to replace an existing one. The new machine costs $8,000 and will require an additional cost of $1,000 for modification and training. It will be depreciated using simplified straight line depreciation over five years. 

The new machine operates much faster than the old machine and with better quality. Consequently, sales are expected to increase by $2,100 per year for the next five years. While it is faster, it is fully automated and will result in increased electricity costs for the firm by $700 per year. It will, however, save about $850 per year in labor costs. 

The old machine is 20 years old and has already been fully depreciated. If the firm's marginal tax rate is 28%, compute the after tax incremental cash flows for the new machine for years 1 through 5.

A) $2,698

B) $450

C) $2,124

D) $1,620

6) National Geographic is replacing an old printing press with a new one. The old press is being sold for $350,000 and it has a net book value of $75,000. Assume that National Geographic is in the 40% income tax bracket. How much will National Geographic pay in income taxes from the sale?

A) $140,000

B) $45,000

C) $110,000

D) $87,010

7) The relevant depreciation expense for a replacement investment is the difference between depreciation on the new asset(s) and the old asset(s).

Answer:  TRUE

8) The salvage value of equipment should not be considered when replacing it with new equipment.

Answer:  FALSE

9) When replacing old assets with new assets, it is safe to assume that working capital requirements will remain the same.

10) The original cost and expected life of old assets are critical considerations in replacement decisions.

Answer:  FALSE

11) Taxes may have a significant effect on the cost of replacing an old asset with a new asset.

Answer:  TRUE

12) Krugman Construction Company is considering the purchase of a new crane at a cost of $600,000. If the new crane is purchased the old crane will sold. It was purchased 5 years ago at a cost of $450,000. To date, the company has taken $200,000 in depreciation on the old crane. Compute the cash flow that would be realized from selling the old crane under each of the following scenarios. Krugman's marginal tax rate is 30%.

a. The crane is sold for $200,000

b. The crane is sold for $250,000

c. The crane is sold for $300,000

Answer: 
a. Sale results in a loss of $50,000 ($200,000 - $250,000 undepreciated cost). The loss results in a tax shelter of $50,000 × .3 =$15,000. The company will realize $200,000 + $15,000 = $215,000 on the sale of the old crane.

b. There is neither a profit nor a loss on disposal of the old crane. Krugman will realize $250,000 on the sale of the old crane.

c. There is a profit of $50,000 on disposal of the old crane which will result in a tax liability of $50,000(.3) = $15,000. Proceeds from sale of the crane will be $300,000 - $15,000 = $285,000.

13) Kahnemann Kookies is evaluating the replacement of an old oven with a new, more energy efficient model. The old oven cost $50,000, is 5 years old and is being depreciated over a life of 10 years to a value of $0.00. The new oven costs $60,000 and will be depreciated over 5 years with no salvage value. Kahnemann uses straight line depreciation, its tax rate is 40%. If the old oven is sold for $10,000, compute the net cost of the new oven.

Answer:  Annual depreciation on the old oven was $50,000/10 or $5,000 per year. Remaining depreciable value is $50,000 - 5($5,000) = $25,000. $10,000 - $25,000 = ($15,000). The loss on disposal of the old asset will result in a tax shelter of $15,000(.4) or $6,000. The net cost of the new machine is:

$60,000 less $10,000 from the sale of the old machine, less $6,0000 tax shelter = $44,000 net cost.

14) Kahnemann Kookies is evaluating the replacement of an old oven with a new, more energy efficient model. The old oven cost $50,000, is 5 years old and is being depreciated over a life of 10 years to a value of $0.00. The new oven costs $60,000 and will be depreciated over 5 years with no salvage value. Kahnemann uses straight line depreciation, its tax rate is 40%. Compute:

a. the change in annual depreciation that would result from purchasing the new machine.

b. the change in taxes each year that would result from purchasing the new machine.

Answer: 

a. Annual depreciation on the old machine is $50,000/10 = $5,000 per year. Depreciation on the new machine, if purchased, would $60,000/5 = $12,000 per year. Depreciation expense would increase by $12,000 - $5,000 = $7,000 per year.

b. The increase in depreciation expense would lower taxes by $7,000(.4) - $2,800 per year.

15) Bull Gator Industries is considering a new assembly line costing $6,000,000. The assembly line will be fully depreciated by the simplified straight line method over its 5 year depreciable life. Operating costs of the new machine are expected to be $1,100,000 per year. The existing assembly line has 5 years remaining before it will be fully depreciated and has a book value of $3,000,000. If sold today the company would receive $2,400,000 for the existing machine. Annual operating costs on the existing machine are $2,100,000 per year. Bull Gator is in the 46 percent marginal tax bracket and has a required rate of return of 12 percent.

a.     Calculate the net present value of replacing the existing machine.

b.     Explain the impact on NPV of the following:

        i.      Required rate of return increases

        ii.    Operating costs of new machine are increased

        iii.   Existing machine sold for less

Answer: 

a. Calculate Initial Outlay

Purchase Price                                       $6,000,000

Sale of old                                               (2,400,000)

Tax savings from sale

($3,000,000 - 2,400,000).46                    (276,000)

Initial Outlay                                         $3,324,000

Free Cash Flows

Change in EBDIT                                  $1,000,000

-Increased Depreciation                         - 600,000

Change in EBIT                                        $400,000

-Taxes (at 46%)                                         - 184,000

+Change in Depreciation                     + 600,000

-Change in Working Capital                 -             0

-Change in Capital Spending               -             0

                                                                       $816,000

Depreciation on old machine

$3,000,000/5 = $600,000

Depreciation on new machine

$6,000,000/5 = $1,200,000

Increase Depreciation

= $600,000 - $1,200,000 = -$600,000

Calculate NPV

NPV = $816,000 × 3.605 - $3,324,000

NPV = -$382,320

b. i. NPV decreases because the present value of the future cash flows decreases

    ii. NPV decreases because cash flows decrease

    iii. NPV decreases because this reduces the cash flow from salvage sale