Chapter 11- Cash Flow Estimation and Other Topics in Capital Budgeting

CORPORATE FINANCE

3010

Chapter 11- Cash Flow Estimation and Other Topics in Capital Budgeting

1.Adams Audio is considering whether to make an investment in a new type of technology. Which of the following factors should the company consider when it decides whether to undertake the investment?

a.The company has already spent $3 million researching the technology.

b.The new technology, will affect the cash flows produced by its other operations.

c.If the investment is not made, then the company w1ll be able to sell one of its laboratories for $2 million.

d.All of the factors above should be considered.

e.Factors b and c should be considered.

2.Other things held constant, which of the following would increase the NPV of a project being considered?

a.A shift from MACRS to straight-line depreciation.

b.Making the initial investment in the first year rather than spreading it over the first 3 years.

c.A decrease in the discount rate associated with the project.

d.The sale of the old machine in a replacement decision at capital loss rather than at book value.

e.An increase in required working capital.

3.Which of the following statements is correct?

a.An asset that is sold for less than book value at the end of a project's life will generate a loss for the firm and will cause an actual cash outflow attributable to the project.

b.Only incremental cash flows are relevant in project analysis and the proper incremental cash flows are the reported accounting profits because they form the true basis for investor and managerial decisions.

c.It is unrealistic to expect that increases in net working capital that are required at the start of an expansion project are simply recovered at the project's completion. Thus, these cash flows are included only at the start of a project.

dEquipment sold for more than its book value at the end of a project's life will increase income and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at book value.

e.All of the statements above are false.

4.Regarding the net present value of a replacement decision, which of the following statements is false?

a..The present value of the after-tax cost reduction benefits resulting from the new investment is treated as an inflow.

b.The after-tax market value of the old equipment is treated as an inflow at t = 0.

c.The present value of depreciation expenses on the new equipment, multiplied by the tax rate, is treated as an inflow.

d.Any loss on the sale of the old equipment is multiplied by the tax rate and is treated as an outflow at t = 0.

e.An increase in net working capital is treated as an outflow when the project begins and as an inflow when the project ends.

5.Which of the following statement completions is incorrect? For a profitable firm, when MACRS accelerated depreciation is compared to straight-line depreciation, MACRS accelerated a1lowances produce

a.Higher depreciation charges in the early years of an asset's life.

b.Larger cash flows in the earlier years of an asset's life.

c.Larger total undiscounted profits from the project over the project's life.

d.Smaller accounting profits in the early years, assuming the company uses the same depreciation method for tax and book purposes.

e.None of the above. (All of the above are correct.)

6.Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually. Stanton will use the MACRS method (20%, 32%, 19%, 12%, 11%, 6%) to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for $10,000 before taxes. Stanton’s marginal tax rate is 40 percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If the machine’s cost is $40,000, what is the project’s NPV?

a.$1,014

b.$2,292

c.$7,550

d.$ 817

e.$5,040

[MACRS table required]

7.Given the following information, what is the required cash outflow associated with the acquisition of a new machine; that is, in a project analysis, what is the cash outflow at

t = 0?

a.$ 8,980

b.$ 6,450

c.$ 5,200

d.$ 6,850

e.$12,020

8.Doherty Industries wants .to invest in a new computer system. The company only wants to invest in one system, and has narrowed the choice down to System A and System B.

System A requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $60,000 at the end of each of the next two years. The system can be replaced every two years with the cash inflows and outflows remaining the same.

System B also requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $48,000 at the end of each of the next three years. System B can be replaced every three years, but each time the system is replaced, both the cash inflows and outflows increase by 10 percent.

The company needs a computer system for the six years, after which time the current owners plan on retiring and liquidating the firm. The company's cost of capital is11 percent. What is the NPV (on a six-year extended basis) of the system which creates the most value to the company?

a.$ 17,298.30

b.$ 22,634.77

c.$ 31,211.52

d.$ 38,523.43

e.$103,065.82

9.Dumb & Dumber Development Company has two mutually exclusive investment projects to evaluate. Assume both projects can be repeated indefinitely . The following cash flows are associated with each project:

The project types are equally risky and the firm's cost of capital is 12 percent. What is the EAA of the higher valued project? (Round your final answer to the nearest whole dollar.)

a.$6,857

b.$7,433

c.$11,325

d.$16,470

e.None of the above

10.Meals on Wings Inc. supplies prepared meals for corporate aircraft (as opposed to public commercial airlines), and it needs to purchase new broilers. If the broilers are purchased, they will replace old broilers purchased 10 years ago for $105,000 and which are being depreciated on a straight-line basis to a zero salvage value (15-year depreciable life). The old broilers can be sold for $60,000 . The new broilers will cost $200,000 installed and will be depreciated using MACRS over their 5-year class life (20%, 32%, 19%, 12%, 11%, 6%); they will be sold at their book value at the end of the fifth year. The firm expects to increase its revenues by $18,000 per year if the new broilers are purchased, but cash expenses will also increase by $2,500 per year. If the firm's cost of capital is 10 percent and its tax rate is 35 percent, what is the NPV of the broilers?

a.-$60,644

b.$ 17,972

c.$ 28,451

d.-$44,553

e.$ 5,021