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MANAGEMENT ADVISORY SERVICES BASIC CONCEPTS Capital Budgeting Defined The capital budget is a(n) a Plan to insure that there are sufficient funds available for the operating needs of the company b Exercise that sets the long-range goals of the company including the consideration of external influences c Plan that coordinates and communicates a company’s plan for the coming year to all departments and divisions d Plan that assesses the long-term needs of the company for plant and equipment purchases CMA 0695 3-17 In planning and controlling capital expenditures, the most logical sequence is to begin with a Analyzing capital addition proposals b Making capital and expenditure decisions c Analyzing and evaluating all promising alternatives d Identifying capital addition projects and other capital needs CMA 0696 3-11 21 Which of the following involves significant financial investments in projects to develop new products, expand production capacity, or remodel current production facilities? (E) a Capital budgeting c Master budgeting b Working capital d Project-cost budgeting Horngren * The detailed plan for the acquisition and replacement of major portions of property, plant, and equipment is known as the a capital budget c commitments budget b purchases budget d treasury budget Barfield CAPITAL BUDGETING D Capital budgeting is a bottom-up process, while strategic planning is a top-down process Agency Problem in Capital Budgeting 15 The following are agency problems in capital budgeting except: A Reduced effort C Empire building B Need for good information D Perks B&M 16 The following are agency problems in capital budgeting except: A Empire building C Avoiding risks B Entrenching investment D Reducing forecast bias B&M 17 The following are agency problems in capital budgeting except: A Avoiding risks B The free-rider problem C Compensation D All of the above are agency problems B&M 18 The following are agency problems in capital budgeting except: A Monitoring C Avoiding risks B Compensation D Economic value added B&M Uses 107.A capital budget is used by management to determine Barfield a b In what to invest No No How much to invest No Yes _ decisions are concerned with the process of planning, setting goals and priorities, arranging financing, and identifying criteria for making long-term investments a Limited resources c Capital investment b Sell now or process further d Make or buy H&M Capital Budgeting vs Strategic Planning Which of the following statements regarding capital budgeting and strategic planning is true? A Capital budgeting and strategic planning are bottom-up processes B Capital budgeting and strategic planning are top down processes B&M C Capital budgeting is a top-down process, while strategic planning is a bottom-up process CMA EXAMINATION QUESTIONS c Yes No d Yes Yes Capital budgeting is concerned with A Decisions affecting only capital intensive industries B Analysis of short-range decisions C Analysis of long-range decisions D Scheduling office personnel in office buildings Gleim Capital budgeting is used for the decision analysis of A Adding product lines or facilities C Lease-or-buy decisions B Multiple profitable alternatives D All of the answers are correct Gleim Capital budgeting techniques are least likely to be used in evaluating the (E) Page of 105 MANAGEMENT ADVISORY SERVICES a b c d Acquisition of new aircraft by a cargo company Design and implementation of a major advertising program Trade for a star quarterback by a football team CMA 0693 4-19 Adoption of a new method of allocating non-traceable costs to product lines Application A company can replace the machinery currently used to manufacture its product with more efficient machinery The new machinery will reduce labor and also will reduce the percentage of spoiled units It is expected to have a useful life of years The most appropriate technique for determining whether or not the company should replace its machinery with the new, more efficient machinery is: A cost-volume-profit analysis C regression analysis B capital-budgeting analysis D linear programming CIA adapted CAPITAL BUDGETING a identification stage b search stage c information-acquisition stage d selection stage Horngren Search Stage 24 The stage of the capital budgeting process which explores alternative capital investments that will achieve organization objectives is the (E) a identification stage c information-acquisition stage b search stage d selection stage Horngren Selection Stage 26 The stage of the capital budgeting process which chooses projects for implementation is the (E) a selection stage c identification stage b search stage d management-control stage Horngren Not-for-Profit Entities 10 Not-for-profit entities a Cannot use capital budgeting techniques because profitability is irrelevant to them b Cannot use discounted cash flow techniques because the time value of money is irrelevant to them c Might have serious problems in quantifying the benefits expected from an investment d Should use the IRR method to make investment decisions L&H Appropriation Requests Which of the following statements regarding appropriation requests is true? A Usually submitted by head office staff B Represents the first step in the capital budgeting process C Authorization tends to be reserved for senior management D None of the above B&M Life Cycle Costing 22 The accounting system that corresponds to the project dimension in capital budgeting is the (E) a net present value method c accrual accounting rate of return b internal rate of return d life-cycle costing Horngren Which of the following statements regarding appropriation requests is true? A Usually submitted by head office staff B Usually requires a detailed analysis using more than one investment criterion C Usually submitted to a single review at the head office D None of the above B&M Stages Identification Stage 23 The stage of the capital budgeting process which distinguishes which types of capital expenditure projects are necessary to accomplish organization objectives is the (E) a identification stage c information-acquisition stage b search stage d selection stage Horngren Implementation & Control Stage 27 The stage of the capital-budgeting process in which projects get underway and performance is monitored is the (E) a implementation and control stage c identification stage b search stage d management-control stage Horngren Information-Acquisition Stage 25 The stage of the capital budgeting process which considers the expected costs and the expected benefits of alternative capital investments is the (E) CMA EXAMINATION QUESTIONS Acquisition Considerations Effective planning and control is important for the effective administration of a capital expenditure program because: A the long-term commitment increases financial risk Page of 105 MANAGEMENT ADVISORY SERVICES B the magnitude of expenditures is substantial and the economic penalties for unwise decisions are usually severe C decisions made in this area provide the structure for operation of the firm D all of the above Carter & Usry A company manual used for detailing policies and procedures required for administering the capital expenditure program should: A encourage people to work on and submit new ideas B focus attention on useful analytical tasks C facilitate rapid project development and expeditious review D all of the above Carter & Usry 14 The normal methods of analyzing investments a Cannot be used by not-for-profit entities b Do not apply if the project will not produce revenues c Cannot be used if the company plans to finance the project with funds already available internally d Require forecasts of cash flows expected from the project L&H High-Tech Industries is considering the acquisition of a new state-of-the-art manufacturing machine to replace a less efficient machine Hi-Tech has completed a net present value analysis and found it to be favorable Which one of the following factors should not be of concern to Hi-Tech in its acquisition considerations? A The availability of any necessary financing B The probability of near-term technological changes to the manufacturing process C The investment tax credit CMA 1290 4-18 D Maintenance requirements, warranties, and availability of service arrangements A number of evaluations of a single capital expenditure proposal may be necessary because of: A circumstances that change during the time span from the origin of the project idea to its completion B alternative solutions of the problem for which the project is designed C assumptions that vary as to the amount and timing of cash flows D all of the above Carter & Usry 23 Which of the following events is most likely to increase the number of investments that meet a company’s acceptance criteria? (M) CMA EXAMINATION QUESTIONS CAPITAL BUDGETING a b c d Top management raises the target rate of return The interest rate on long-term debt rises The income tax rate rises The IRS allows companies to expense purchases of fixed assets, instead of depreciating them over their lives L&H Qualitative Factors 37 Qualitative issues could increase the acceptability of a project under which of the following conditions? a The IRR is less than the company’s cutoff rate b The project has a negative NPV c The payback period is longer than the company’s cutoff period d All of the above L&H 40 Qualitative factors can influence managers to a Accept an investment project having a negative NPV b Reject an investment project having an IRR greater than the company’s cutoff rate c Raise the “ranking” of an investment project d Take any of the above courses of action L&H 76 Which of the following statements is (are) true about automation? a Automation is inexpensive b Automation should be adopted as soon as new technology is available c Automation should be adopted after a company makes the most efficient use of existing technology d All of the above are true H&M Ethical Consideration Common problems related to ethical considerations in the capital budgeting include all of the following, except: A superiors and associates sometimes apply pressure to circumvent the approval process B pressure may exist to write-off or devalue assets below their true value to justify replacement C the economic benefit of capital projects may be exaggerated to increase the likelihood of approval D the accountant may mistakenly go to the individuals involved in the ethical conflict first, rather than first discussing it with the accounting supervisor E all of the above are ethical problems related to capital budgeting AICPA adapted Page of 105 MANAGEMENT ADVISORY SERVICES CAPITAL BUDGETING Post- Investment Audit 69 Comparison of the actual results for a project to the costs and benefits expected at the time the project was selected is referred to as (E) a the audit trail c a postinvestment audit b management control d a cost-benefit analysis Horngren Expansion Expenditures 10 In which of the following types of capital expenditure decisions does the basis for a decision most markedly shift from cost savings to increased profits and cash flow? A replacement expenditures C improvement expenditures B expansion expenditures D allowance expenditures Carter & Usry 10 Post audit is conducted: A Before starting a project B Before authorizing a project C Shortly after a project has started operating D Long after the project has been completed and the salvage has been realized B&M Improvement Expenditures 11 The capital expenditures in which the benefits are most difficult to quantify are: A replacement expenditures C improvement expenditures B expansion expenditures D allowance expenditures Carter & Usry H&M Not a Capital Expenditure The following capital expenditures may not appear in the capital budget except: A Investment in information technology B Investment in research and development C Investment in training and personal development D Investment in a new office building B&M The following capital expenditures may not appear in the capital budget except: A Marketing B Training and personnel development C Investment in a new machine D Investment in research and development B&M Which of the following capital expenditure may not appear in capital budget? A Investment in a new plant B Investment in a new machine C Investment in information technology D All of the above are included in capital budget B&M Which of the following capital expenditures may not appear in capital budget? A Investment in a new building B Investment in a new machine C Investment in research and development D All of the above are included in capital budget B&M 77 A post audit compares a estimated benefits and costs with budgeted benefits and cost b estimated benefits with estimated costs c actual benefits with actual costs d actual benefits and costs with estimated benefits and costs 27 The post-audit is used to(E) a Improve cash flow forecasts b Stimulate management to improve operations and bring results into line with forecasts c Eliminate potentially profitable but risky projects d Statements a and b are correct e All of the statements above are correct Brigham 11 A post audit will: A Identify the problem that needs to be fixed B Check the accuracy of the cash flow forecasts C Suggest questions that should have been asked before D All of the above B&M Type of Capital Expenditure Replacement Expenditures The following capital expenditures that compare the future costs of the old assets with the future costs of the new assets as a basis for making a decision are: A replacement expenditures C improvement expenditures B expansion expenditures D allowance expenditures Carter & Usry CMA EXAMINATION QUESTIONS Page of 105 MANAGEMENT ADVISORY SERVICES CAPITAL BUDGETING Types of Projects Independent Projects are projects that when accepted or rejected will NOT affect the cash flows of another project a Independent projects c Dependent projects b Mutually exclusive projects d Both b and c H&M a b c d Mutually Exclusive Projects are projects that when accepted preclude the acceptance of competing projects a Independent projects c Dependent projects b Mutually exclusive projects d Both b and c H&M Inflation Element * The “inflation element” refers to the a Impact that future price increases will have on the original cost of a capital expenditure b Fact that the real purchasing power of a monetary unit usually increases over time c Future deterioration of the general purchasing power of the monetary unit d Future increases in the general purchasing power of the monetary unit RPCPA 0597 Relevant and Irrelevant Costs 28 Capital budgeting emphasizes two factors (E) a qualitative and nonfinancial c quantitative and financial b quantitative and nonfinancial d qualitative and financial 56 The focus in capital budgeting should be on (E) a the tax consequences of different investment strategies b the internal rate of return of different strategies c expected future cash flows that differ between alternatives d none of the above Horngren 32 The only future costs that are relevant to deciding whether to accept an investment are those that will CMA EXAMINATION QUESTIONS L&H Which of the following rules are essential to successful cash flow estimates, and ultimately, to successful capital budgeting? (M) a The return on invested capital is the only relevant cash flow b Only incremental cash flows are relevant to the accept/reject decision c Total cash flows are relevant to capital budgeting analysis and the accept/reject decision d Statements a and b are correct e All of the statements above are correct Brigham Salvage Value 60 The relevant terminal disposal price of a machine equals (M) a the difference between the salvage value of the old machine and the ultimate salvage value of the new machine b the total of the salvage values of the old machine and the new machine c the salvage value of the old machine d the salvage value of the new machine Horngren * Karen Company is considering replacing an old machine with a new machine Which of the following items is economically relevant to Karen’s decisions? (M) RPCPA 0598 a b c d Carrying amount of old machine Yes Yes No No Disposal value of new machine Yes No Yes No * You are the treasurer of the Hibang Corp The company is considering a proposed project which has an expected economic life of seven years Net present value is the capital budgeting technique the president wants you to use Salvage value of the project would be (M) a Treated as cash inflow at estimated salvage value b Treated as cash flow at its present value c Irrelevant cash flow item d Treated as cash inflow at the future value RPCPA 1096 Horngren 29 Which of the following are NOT included in the formal financial analysis of a capital budgeting program? (E) a Quality of the output c Cash flow b Safety of employees d Neither (a) nor (b) are included Horngren Be different if the project is accepted rather than rejected Be saved if the project is accepted rather than rejected Be deductible for tax purposes Affect net income in the period that they are incurred Working Capital Page of 105 MANAGEMENT ADVISORY SERVICES 66 In the analysis of a capital budgeting proposal, for which of the following items are there no after-tax consequences? (E) a Cash flow from operations b Gain or loss on the disposal of the asset c Reduction of working capital balances at the end of the useful life of the capital asset d There are no after-tax consequences of any of the above Horngren 11 A major difference between an investment in working capital and one in depreciable assets is that (M) a An investment in working capital is never returned, while most depreciable assets have some residual value b An investment in working capital is returned in full at the end of the project’s life, while an investment in depreciable assets has no residual value c An investment in working capital is not tax-deductible when made, not taxable when returned, while an investment in depreciable assets does allow tax deductions d Because an investment in working capital is usually returned in full at the end of the project’s life, it is ignored in computing the amount of the investment required for the project L&H * Mahlin Movers, Inc is planning to purchase equipment to make its operations more efficient This equipment has an estimated useful life of six years As part of this acquisition, a P150,000 investment in working capital is required In a discounted cash flow analysis, this investment in working capital should be (E) a Amortized over the useful life of the equipment b Disregarded because no cash is involved RPCPA 1095 c Treated as a recurring annual cash flow that is recovered at the end of six years d Treated as an immediate cash outflow that is recovered at the end of six years Fast Freight, Inc is planning to purchase equipment to make its operations more efficient This equipment has an estimated life of years As part of this acquisition, a $75,000 investment in working capital is anticipated In a discounted cash flow analysis, the investment in working capital (E) a Should be amortized over the useful life of the equipment b Should be treated as a recurring cash outflow over the life of the equipment c Should be treated as an immediate cash outflow CMA 0691 4-20 d Should be treated as an immediate cash outflow recovered at the end of years CMA EXAMINATION QUESTIONS CAPITAL BUDGETING 32 In connection with a capital budgeting project, an investment in working capital is normally recovered a At the end of the project’s life c Evenly through the project’s life L&H b In the first year of the project’s life d When the company goes out of business 12 The proper treatment of an investment in receivables and inventory is to a Ignore it b Add it to the required investment in fixed assets c Add it to the required investment in fixed assets and subtract it from the annual cash flows d Add it to the investment in fixed assets and add the present value of the recovery to the present value of the annual cash flows L&H 34 The cash inflow from the return on an investment in working capital is a Adjusted for taxes due b Discounted to present value c Ignored if any depreciable assets also involved in the project have no expected residual value d Not real L & H, RPCPA 1001 29 XYZ Co is adopting just-in-time principles When evaluating an investment project that would reduce inventory, how should XYZ treat the reduction? a Ignore it b Decrease the cost of the investment and decrease cash flows at the end of the project’s life c Decrease the cost of the investment d Decrease the cost of the investment and increase the cash flow at the end of the project’s life L&H Net Working Capital should be considered in project cash flows because: A They are sunk costs B Firms must invest cash in short-term assets to produce finished goods C Firms need positive NPV projects for investment D None of the above B&M Opportunity Costs 10 The value of a previously purchased machine expected to be used by a proposed project is an example of: Page of 105 MANAGEMENT ADVISORY SERVICES A Sunk costs B Opportunity costs CAPITAL BUDGETING C Fixed costs D None of the above B&M Cash Outflows 14 All of the following are common cash outflows from capital expenditure programs, except: A equipment installation D increased working capital requirements B employee training E salvage value at the end of the project C computer programming and fine tuning Carter & Usry 33 For investments that have only costs (no revenues or cost savings), an appropriate decision rule is to accept the project that has the a Longest payback period b Lower present value of cash outflows c Higher present value of future cash outflows d Lowest internal rate of return L&H Cash Inflows 15 As to a capital investment, net cash inflow is equal to the a cost savings resulting from the investment b sum of all future revenues from the investment c net increase in cash receipts over cash payments d net increase in cash payments over cash receipts Barfield Which of the following describes the annual returns that are discounted in determining the NPV of an investment? a Net incomes expected to be earned by the project b Pre-tax cash flows expected from the project c After-tax cash flows expected from the project d After-tax cash flows adjusted for the time value of money L&H 57 Annual after-tax corporate net income can be converted to annual after-tax cash flow by (E) a adding back the depreciation amount b deducting the depreciation amount Barfield c adding back the quantity (t x depreciation deduction), where t is the corporate tax rate d deducting the quantity [(1- t) x depreciation deduction], where t is the corporate tax rate To approximate annual cash inflow, depreciation is a Added back to net income because it is an inflow of cash CMA EXAMINATION QUESTIONS b Subtracted from net income because it is an outflow of cash c Subtracted from net income because it is an expense d Added back to net income because it is not an outflow of cash RPCPA 1001 59 Depreciation is usually not considered an operating cash flow in capital budgeting because (E) a depreciation is usually a constant amount each year over the life of the capital investment b deducting depreciation from operating cash flows would be counting the lump-sum amount twice c depreciation usually does not result in an increase in working capital d depreciation usually has no effect on the disposal price of the machine Horngren 25 Which of these could occur in practice where the capital expenditure relates to the production of an established product or service, the demand for which is expected to vary in response to temporary changes in consumer taste? A perfectly correlated cash flows C independent cash flows B negative cash flows D mixed cash flows Carter & Usry Which of the following is NOT relevant in calculating annual net cash flows for an investment? a Interest payments on funds borrowed to finance the project b Depreciation on fixed assets purchased for the project c The income tax rate d Lost contribution margin if sales of the product invested in will reduce sales of other products L&H 39 Which of the following is NOT relevant in calculating net cash flows for Project N? a Interest payments on funds that would be borrowed to finance Project N b Depreciation on assets purchased for Project N c The contribution margin the company would lose if sales of the product introduced by Project N will reduce sales of other products d The income tax rate applicable to the entity L&H 13 All of the following are common cash inflows related to capital expenditure proposals, except: A additional revenues from increased sales B increased working capital requirements C reduction in inventory carrying costs D salvage value at the end of the project Carter & Usry Page of 105 MANAGEMENT ADVISORY SERVICES CAPITAL BUDGETING Tax Shield on Depreciation Which of the following cash flows should be treated as incremental flows when deciding whether to go ahead with an electric car? A The cost of research and development undertaken for developing the electric car in the past three years B The annual depreciation charge C The reduction in taxes resulting from the depreciation charges D Dividend payments B&M Irrelevant Costs Money that a firm has already spent or committed to spend regardless of whether a project is taken is called: A Sunk costs C Fixed costs B Opportunity costs D None of the above B&M * In capital expenditures decisions, the following are relevant in estimating operating costs except (E) a Future costs c Differential costs b Cash costs d Historical costs RPCPA 1094 b When evaluating corporate projects it is important to include all relevant externalities in the estimated cash flows c Interest expenses should be included in project cash flows d Statements a and b are correct Brigham 10 When evaluating potential projects, which of the following factors should be incorporated as part of a project’s estimated cash flows? (E) a Any sunk costs that were incurred in the past prior to considering the proposed project b Any opportunity costs that are incurred if the project is undertaken c Any externalities (both positive and negative) that are incurred if the project is undertaken d Statements b and c are correct Brigham 11 Which one of the following statements concerning cash flow determination for capital budgeting purposes is not correct? a Tax depreciation must be considered since it affects cash payments for taxes b Book depreciation is relevant since it affects net income d Net working capital changes should be included in cash flow forecasts c Sunk costs are not incremental flows and should not be included CMA 1295 4-11 12 58 An example of a sunk cost in a capital budgeting decision for new equipment is (E) a increase in working capital required by a particular investment choice b the book value of the old equipment c the necessary transportation costs on the new equipment d all of the above are examples of sunk costs Horngren The following cash flows should be treated as incremental flows when deciding whether to go ahead with an electric car except: (M) A The consequent deduction in sales of the company's existing gasoline models B The expenditure on new plants and equipment C The value of tools that can be transferred from the company's existing plants D Interest payment on debt B&M Comprehensive Which of the following statements is most correct? (E) a When evaluating corporate projects it is important to include all sunk costs in the estimated cash flows CMA EXAMINATION QUESTIONS A company is considering a new project The company’s CFO plans to calculate the project’s NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the company’s cost of capital (WACC) Which of the following factors should the CFO include when estimating the relevant cash flows? (E) a Any sunk costs associated with the project b Any interest expenses associated with the project c Any opportunity costs associated with the project d Statements b and c are correct Brigham 13 Which of the following statements is correct? (M) 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 operating 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 Page of 105 MANAGEMENT ADVISORY SERVICES d Equipment 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 Brigham 14 Which of the following statements is most correct? (E) a The rate of depreciation will often affect operating cash flows, even though depreciation is not a cash expense b Corporations should fully account for sunk costs when making investment decisions c Corporations should fully account for opportunity costs when making investment decisions d Statements a and c are correct Brigham CAPITAL BUDGETING 18 Sanford & Son Inc is thinking about expanding their business by opening another shop on property they purchased 10 years ago Which of the following items should be included in the analysis of this endeavor? (M) a The property was cleared of trees and brush years ago at a cost of $5,000 b The new shop is expected to affect the profitability of the existing shop since some current customers will transfer their business to the new shop Sanford and Son estimate that profits at the existing shop will decrease by 10 percent c Sanford & Son can lease the entire property to another company (that wants to grow flowers on the lot) for $5,000 per year d Both statements b and c should be included in the analysis Brigham 19 15 Which of the following is not a cash flow that results from the decision to accept a project? (E) a Changes in net operating working capital d Opportunity costs b Shipping and installation costs e Externalities c Sunk costs Brigham 16 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? (M) 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 will be able to sell one of its laboratories for $2 million d Statements b and c should be considered Brigham 17 Laurier Inc is a household products firm that is considering developing a new detergent In evaluating whether to go ahead with the new detergent project, which of the following items should Laurier explicitly include in its cash flow analysis? (M) a The company will produce the detergent in a vacant facility that they renovated five years ago at a cost of $700,000 b The company will need to use some equipment that it could have leased to another company This equipment lease could have generated $200,000 per year in after-tax income c The new detergent is likely to significantly reduce the sales of the other detergent products the company currently sells d Statements b and c are correct Brigham CMA EXAMINATION QUESTIONS Pickles Corp is a company that sells bottled iced tea The company is thinking about expanding its operations into the bottled lemonade business Which of the following factors should the company incorporate into its capital budgeting decision as it decides whether or not to enter the lemonade business? (M) a If the company enters the lemonade business, its iced tea sales are expected to fall percent as some consumers switch from iced tea to lemonade b Two years ago the company spent $3 million to renovate a building for a proposed project that was never undertaken If the project is adopted, the plan is to have the lemonade produced in this building c If the company doesn’t produce lemonade, it can lease the building to another company and receive after-tax cash flows of $500,000 a year d Statements a and c are correct Brigham 20 Which of the following statements is correct? (M) a 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 in the cash flow statement when determining the project’s cash flows will lead to an upward bias in the NPV b The preceding statement would be true if “upward” were replaced with “downward.” c The existence of “externalities” reduces the NPV to a level below the value that would exist in the absence of externalities d If one of the assets that would be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the project is not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration e The rent referred to in statement d is a sunk cost, and as such it should be ignored Brigham Page of 105 MANAGEMENT ADVISORY SERVICES CAPITAL BUDGETING B bar graph C nonnormal distribution 21 Which of the following constitutes an example of a cost that is not incremental, and therefore, not relevant in an accept/reject decision? (M) a A firm has a parcel of land that can be used for a new plant site, or alternatively, can be used to grow watermelons b A firm can produce a new cleaning product that will generate new sales, but some of the new sales will be from customers who switch from another product the company currently produces c A firm orders and receives a piece of new equipment that is shipped across the country and requires $25,000 in installation and set-up costs d Statements a, b, and c are examples of incremental cash flows, and therefore, relevant cash flows Brigham 22 Which of the following is not considered a relevant concern in deter- mining incremental cash flows for a new product? (M) a The use of factory floor space that is currently unused but available for production of any product b Revenues from the existing product that would be lost as a result of some customers switching to the new product c Shipping and installation costs associated with preparing the machine to be used to produce the new product d The cost of a product analysis completed in the previous tax year and specific to the new product Brigham Uncertainty Which of the following best identifies the reason for using probabilities in capital budgeting decisions? A uncertainty C time value of money B cost of capital D projects with unequal lives AICPA adapted * Which of the following best identifies the reason for using probabilities in capital budgeting is (E) a Different life of projects c Uncertainty RPCPA 0577, 0588, 1093 b Cost of capital d Time value of money CMA EXAMINATION QUESTIONS Carter & Usry 28 The standard deviation of the expected net present value is determined by summing the discounted standard deviations for each period over the life of the project when the cash flows in each of the periods are: A independent D negative B positive E perfectly correlated C mixed Carter & Usry 12 Cinzano Inc wants to use discounted cash flow techniques when analyzing its capital investment projects The company is aware of the uncertainty involved in estimating future cash flows A simple method some companies employ to adjust for the uncertainty inherent in their estimates is to: A ignore salvage values B average the expectations of several different managers C use accelerated depreciation D adjust the minimum desired rate of return E increase the estimates of the cash flows CMA adapted Tax Factor In general 58 Income taxes are levied on a net cash flow b income as measured by accounting rules c net cash flow plus depreciation d income as measured by tax rules Barfield 18 Which of the following statements is true? a All revenue is taxed b All expenses are tax-deductible c Some revenues and expenses have no tax effects d Income taxes are based solely on revenues and expenses * 26 In capital expenditure analysis, which of the following can be constructed to evaluate alternative levels of investment? A normal distribution D pie chart E payoff table L&H In capital budgeting decisions, the following items are considered among others: (M) Cash outflow for the investment Increase in working capital requirements Profit on sale of old asset Page 10 of 105 to the left of the crossover rate NPV X must be smaller than NPVY Therefore, statement c is also true Since statements a, b, and c are all true, the correct choice is statement d 159 This statement reflects exactly the difference between the NPV and IRR methods 160 Both statements a and c are correct; therefore, statement d is the correct choice Due to reinvestment rate assumptions, NPV and IRR can lead to conflicts; however, there will be no conflict between NPV and MIRR if the projects are equal in size (which is one of the assumptions in this question) 161 Statement a is true To see this, sketch out a NPV profile for a normal, independent project, which means that only one NPV profile will appear on the graph If WACC < IRR, then IRR says accept But in that case, NPV > 0, so NPV will also say accept Statement d is false Here is the reasoning: For the NPV profiles to cross, then one project must have a higher NPV at k = than the other project, that is, their vertical axis intercepts will be different A second condition for NPV profiles to cross is that one have a higher IRR than the other The third condition necessary for profiles to cross is that the project with the higher NPV at k = will have the lower IRR One can sketch out two NPV profiles on a graph to see that these three conditions are indeed required The project with the higher NPV at k = must have more cash inflows, because it has the higher NPV when cash flows are not discounted, which is the situation if k = If the project with more total cash inflows also had its cash flows come in earlier, it would dominate the other project its NPV would be higher at all discount rates, and its IRR would also be higher, so the profiles would not cross The only way the profiles can cross is for the project with more total cash inflows to get a relatively high percentage of those inflows in distant years, so that their PVs are low when discounted at high rates Most students either grasp this intuitively or else just guess at the question! 162 Answer (A) is correct If the economic results of alternative capital investments were known with certainty or with minimal risk, the quantitative analyses would reveal the absolute best investment options However, if the economic results are highly uncertain, using a decision-making process that combines rational analysis with intuition is appropriate Moreover, nonquantifiable variables may be involved Answer (B) is incorrect because the decision-making process described combines rational quantitative analysis with intuition In addition, research has shown that intuition can improve decision making Answer (C) is incorrect because knowing with certainty which investment is the most profitable is not possible Answer (D) is incorrect because the term bounded rationality refers to the inability to perceive all aspects of a situation and the tendency to simplify, not to intuitive decision making 163 Statement e is correct; the other statements are false IRR can lead to conflicting decisions with NPV even with normal cash flows if the projects are mutually exclusive Cash outflows are discounted at the cost of capital with the MIRR method, while cash inflows are compounded at the cost of capital Conflicts between NPV and IRR arise when the cost of capital is below the crossover point The discounted payback method does correct the problem of ignoring the time value of money, but it still does not account for cash flows beyond the payback period 164 Statements a and c are correct; therefore, statement d is the correct choice The discounted payback method still ignores cash flows after the payback period 165 Statement a is correct; the other statements are false Multiple IRRs can occur only for projects with nonnormal cash flows Mutually exclusive projects imply that only one project should be chosen The project with the highest NPV should be chosen 166 Statement a is correct; the other statements are false Sketch the profiles From the information given, D has the higher IRR The project’s scale cannot be determined from the information given As C’s NPV declines more rapidly with an increase in rates, this implies that more of the cash flows are coming later on So C would have a slower payback than D 167 Answer (D) is correct MACRS is an accelerated method of depreciation under which depreciation expense will be greater during the early years of an asset's life Thus, the outflows for income taxes will be less in the early years, but greater in the later years, and the NPV (present value of net cash inflows - investment) will be increased The profitability index (present value of net cash inflows ÷ the investment) must increase if the NPV increases Answer (A) is incorrect because the NPV will increase The present value of the net inflows will increase with no change in the investment Answer (B) is incorrect because the IRR will increase Deferring expenses to later years increases the discount rate needed to reduce the NPV to $0 Answer (C) is incorrect because the payback period will be shortened Switching to MACRS defers expenses and increases cash flows early in the project's life 168 12A- Depreciation cash flows Answer: c Diff: M 169 Answer (D) is correct MACRS for assets with lives of 10 years or less is based on the 200% declining-balance method of depreciation Thus, an asset with a 3-year life would have a straight-line rate of 33-1/3%, or a doubledeclining-balance rate of 66-2/3% Answer (A) is incorrect because the straight-line method uses the same percentage each year during an asset's life, but MACRS uses various percentages Answer (B) is incorrect because MACRS is unrelated to the units-ofproduction method Answer (C) is incorrect because MACRS is unrelated to SYD depreciation 170 Answer (A) is correct For tax purposes, straight-line depreciation is an alternative to the MACRS method Both methods will result in the same total depreciation over the life of the asset; however, MACRS will result in greater depreciation in the early years of the asset's life because it is an accelerated method Given that MACRS results in larger depreciation deductions in the early years, taxes will be lower in the early years and higher in the later years Because the incremental benefits will be discounted over a shorter period than the incremental depreciation costs, MACRS is preferable to the straight-line method Answer (B) is incorrect because both methods will produce the same total depreciation over the life of the asset Answer (C) is incorrect because both methods will produce the same total tax payments (assuming rates not change) However, given that the tax payments will be lower in the early years under MACRS, discounting for the time value of money makes the straight-line alternative less advantageous Answer (D) is incorrect because both methods will produce the same total depreciation over the life of the asset 171 Taxes on gain on sale Answer: b Diff: E N When the machine is sold the total accumulated depreciation on it is: (0.2 + 0.32 + 0.19) × $1,000,000 = $710,000 The book value of the equipment is: $1,000,000 - $710,000 = $290,000 The machine is sold for $400,000, so the gain is $400,000 - $290,000 = $110,000 Taxes are calculated as $110,000 × 0.4 = $44,000 172 Risk-adjusted discount rate Answer: c Diff: E ks = 10% + (16% - 10%)1.5 = 10% + 9% = 19% Original IRR = 21% 21% - Risk adjustment 1% = 20% Risk adjusted IRR = 20% > ks = 19% 173 Risk-adjusted discount rate Time lines: Project A: k = 12% CFsA -15,000 4,000 NPVA = ? = 3,978.60 Project B: k = ? Answer: b Diff: M 4,000 4,000 4,000 4,000 Terminal CF = CFsB -14,815 5,100 NPVB = NPVA = 3,978.60 Tabular solution: 5,100 4,000 5,000 Salvage value 9,000 • • • Years 5,100 Salvage value Terminal CF = 5,100 Solve for the NPV of Project A, which is also the NPV of Project B at some k = ? NPVA = -$15,000 + $4,000(PVIFA12%,6) + $5,000(PVIF12%,6) = -$15,000 + $4,000(4.1114) + $5,000(0.5066) = $3,978.60 Solve for kB NPVB = $3,978.60 = -$14,815 + $5,100(PVIFAk,6) $18,793.60 = $5,100(PVIFAk,6) PVIFAk,6 = 3.68502 Look across the row for years in the PVIFA table The factor for 16 percent is 3.6847; therefore, the risk-adjusted rate for Project B is approximately 16 percent 174 Financial calculator solution: A: Inputs: CF0 = -15,000; CF1 = 4,000; Nj = 5; CF2 = 9,000; I = 12 Output: NPV = $3,978.78 B: Inputs: CF0 = -18,793.78; CF1 = 5,100; Nj = Output: IRR = 15.997% ≈ 16% Risk-adjusted discount rate Answer: e Diff: T Time lines: Project A: k = 12% Years CFsA -25,000 13,000 NPVA = ? = 17,663 Project B: k = ? 13,000 13,000 13,000 Terminal value = 5,000 CF4 = 18,000 CFsB -25,000 15,247 NPVA = NPVB = 17,663 Years 15,247 15,247 15,247 Terminal value = CF4 = 15,247 Tabular solution: NPVA = -$25,000 + $13,000(PVIFA12%,3) + $18,000(PVIF12%,4) = -$25,000 + $13,000(2.4018) + $18,000(0.6355) = $17,662.40 NPVB = $17,662.40 = -$25,000 + $15,247(PVIFAk,4) $42,662.40 = $15,247(PVIFAk,4) (PVIFAk,4) = 2.79808 k ≈ 16% Financial calculator solution: A: Inputs: CF0 = -25,000; CF1 = 13,000; Nj = 3; CF2 = 18,000; I = 12 Output: NPVA = 17,663.13 B: Inputs: CF0 = -42,663.13; CF1 = 15,247; Nj = Output: IRR = 16.0% = k 175 New project NPVAnswer: e Diff: M Time line: k = 18% -3,000 NPV = ? 1,728 1,920 Project analysis worksheet: I Initial outlay 1) Cost 2) Decrease in NOWC 3) Total net investment II Operating flows: Year: 4) EBT and depreciation 5) Earnings after taxes (line × 0.6) Years 1,152 ($4,000) 1,000 ($3,000) $2,000 $2,000 $2,000 1,200 1,200 1,200 6) Depreciation (from table) 7) Tax savings from depreciation (5 × 0.4) 8) Net operating flows (line + 7) III Terminal year cash flows: 9) Estimated salvage value 10) Tax on salvage value ((1,000 - 280) × 0.4) 11) Return of NOWC 12) Total termination CFs IV Net cash flows: 13) Total net cash flows ($3,000) 1,320 1,800 600 528 720 240 $1,728 $1,920 $1,440 $1,000 (288) (1,000) ($ 288) $1,728 $1,920 $1,152 Tabular solution: NPV = -$3,000 + $1,728(PVIF18%,1) + $1,920(PVIF18%,2) + $1,152(PVIF18%,3) = -$3,000 + $1,728(0.8475) + $1,920(0.7182) + $1,152(0.6086) = $544.53 Financial calculator solution: Inputs: CF0 = -3000; CF1 = 1728; CF2 = 1920; CF3 = 1152; I = 18 Output: NPV = $544.46 ≈ $544 176 New project NPV Answer: d Diff: M Time line: k = 12% -45,000 NPV = ? 7,800 10,680 Depreciation cash flows: Year MACRS Percent 0.20 0.32 0.19 0.12 0.11 0.06 Project analysis worksheet: I Initial outlay 1) Machine cost ($60,000) 2) Decrease in NOWC 15,000 3) Total net inv ($45,000) II Operating cash flows 7,560 5,880 Depreciable Basis $60,000 60,000 60,000 60,000 60,000 60,000 Years -1,920 Annual Depreciation $12,000 19,200 11,400 7,200 6,600 3,600 $60,000 Year: Reduction in cost $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000 After-tax dec in cost 3,000 3,000 3,000 3,000 3,000 Deprec (from table) 12,000 19,200 11,400 7,200 6,600 Tax savings deprec (line × 0.4) 4,800 7,680 4,560 2,880 2,640 8) Net operating CFs (line + 7) $ 7,800 $10,680 $ 7,560 $ 5,880 $ 5,640 III Terminal year CFs 9) Estimated salvage value $10,000 10) Tax on salvage value (10,000 - 3,600)(0.4) (2,560) 11) Return of NOWC (15,000) 12) Total termination CFs (7,560) IV Net CFs 13) Total Net CFs ($45,000) $ 7,800 $10,680 $ 7,560 $ 5,880 ($ 1,920) 4) 5) 6) 7) Tabular solution: NPV = -$45,000 + $7,800(PVIF12%,1) + $10,680(PVIF12%,2) + $7,560(PVIF12%,3) + $5,880(PVIF12%,4) - $1,920(PVIF12%,5) = -$45,000 + $7,800(0.8929) + $10,680(0.7972) + $7,560(0.7118) + $5,880(0.6355) - $1,920(0.5674) = -$21,492.74 ≈ -$21,493 Financial calculator solution: Inputs: CF0 = -45,000; CF1 = 7,800; CF2 = 10,680; CF3 = 7,560; CF4 = 5,880; CF5 = -1,920; I = 12 Output: NPV = -$21,493.24 ≈ $21,493 177 New project NPVAnswer: b Diff: M Time line: k = 9% -40,000 PV = ? 9,800 11,720 Depreciation cash flows: Year MACRS Percent 0.20 0.32 0.19 0.12 0.11 0.06 9,640 8,520 Depreciable Basis $40,000 40,000 40,000 40,000 40,000 40,000 Years 15,320 Annual Depreciation $ 8,000 12,800 7,600 4,800 4,400 2,400 $40,000 Project analysis worksheet: I Initial outlay 1) Machine cost ($40,000) 2) Decrease in NOWC -3) Total net inv ($40,000) II Operating cash flows Year: 4) Inc in earnings before deprec & tax $ 6,000 $ 6,000 $ 6,000 $ 6,000 $ 6,000 5) After-tax increase in earnings (line × 0.6) 3,600 3,600 3,600 3,600 3,600 6) Before tax reduction in cost 5,000 5,000 5,000 5,000 5,000 7) After tax reduction N in cost (line × 0.4) 3,000 3,000 3,000 3,000 3,000 8) Deprec (from table) 8,000 12,800 7,600 4,800 4,400 9) Deprec tax savings (line × 0.4) 3,200 5,120 3,040 1,920 1,760 10) Net operating CFs _ _ _ _ _ (line + + 9) $ 9,800 $11,720 $ 9,640 $ 8,520 $ 8,360 III Terminal year CFs 11) Estimated salvage value $10,000 12) Tax on salvage value (10,000 - 2,400)(0.4) (3,040) 13) Return of NOWC -14) Total termination CFs 6,960 IV Net CFs 15) Total Net CFs ($40,000) $ 9,800 $11,720 $ 9,640 $ 8,520 $15,320 Tabular solution: NPV = -$40,000 + $9,800(PVIF9%,1) + $11,720(PVIF9%,2) + $9,640(PVIF9%,3) + $8,520(PVIF9%,4) + $15,320(PVIF9%,5) = -$40,000 + $9,800(0.9174) + $11,720(0.8417) + $9,640(0.7722) + $8,520(0.7084) + $15,320(0.6499) = $2,291.29 ≈ $2,292 178 Financial calculator solution: Inputs: CF0 = -40,000; CF1 = 9,800; CF2 = 11,720; CF3 = 9,640; CF4 = 8,520; CF5 = 15,320; I = Output: NPV = $2,291.90 ≈ $2,292 New project NPV Answer: a Diff: M N Equipment purchase NOWC Sales increase Operating costs Operating income Depreciation EBIT Taxes (35%) EBIT(1 - T) +Depreciation Operating cash flow Recovery of NOWC Equipment sale Taxes on sale Net CF -$600,000 -50,000 _ -$650,000 $2,000,000 1,400,000 $ 600,000 200,000 $ 400,000 140,000 $ 260,000 200,000 $ 460,000 $2,000,000 1,400,000 $ 600,000 200,000 $ 400,000 140,000 $ 260,000 200,000 $ 460,000 $ 460,000 $ 460,000 $2,000,000 1,400,000 $ 600,000 200,000 $ 400,000 140,000 $ 260,000 200,000 $ 460,000 50,000 +100,000 -35,000 $ 575,000 NPV = -$650,000 + $460,000/1.12 + $460,000/(1.12)2 + $575,000/(1.12)3 = -$650,000 + $410,714.29 + $366,709.18 + $409,273.64 = $536,697.11 ≈ $536,697 179 New project NPV Year Project cost NOWC* Sales Operating costs (75%) Operating income before deprec Depreciation EBIT Taxes (40%) EBIT(1 - T) Plus: Depreciation Operating CF Recovery of NOWC Net CF Answer: b Diff: M N -5,000,000 -300,000 -$5,300,000 $3,000,000 2,250,000 $ 750,000 1,650,000 -$ 900,000 -360,000 -$ 540,000 1,650,000 $1,110,000 $4,000,000 3,000,000 $1,000,000 2,250,000 -$1,250,000 -500,000 -$ 750,000 2,250,000 $1,500,000 $5,000,000 3,750,000 $1,250,000 750,000 $ 500,000 200,000 $ 300,000 750,000 $1,050,000 $1,110,000 $1,500,000 $1,050,000 $2,000,000 1,500,000 $ 500,000 350,000 $ 150,000 60,000 $ 90,000 350,000 $ 440,000 300,000 $ 740,000 *An increase in inventories is a use of funds for the company, and an increase in accounts payable is a source of funds for the company Thus, the change in net operating working capital will be $200,000 - $500,000 = - $300,000 at time NPV = -$5,300,000 + $1,110,000/1.10 + $1,500,000/(1.10)2 + $1,050,000/(1.10)3 + $740,000/(1.10)4 NPV = -$5,300,000 + $1,009,091 + $1,239,669 + $788,881 + $505,430 NPV = -$1,756,929 180 New project NPV Answer: a Diff: M N ($500,000) (40,000) Project cost NOWC Sales Operating costs Depreciation EBIT Taxes (40%) EBIT(1 - T) Plus: Depreciation Recovery of NOWC Net CF ($540,000) $800,000 480,000 165,000 $155,000 62,000 $ 93,000 165,000 $258,000 $800,000 480,000 225,000 $ 95,000 38,000 $ 57,000 225,000 $282,000 $500,000 300,000 75,000 $125,000 50,000 $ 75,000 75,000 $150,000 $500,000 300,000 35,000 $165,000 66,000 $ 99,000 35,000 40,000 $174,000 NPV = -$540,000 + $258,000/1.10 + $282,000/(1.10)2 + $150,000/(1.10)3 + $174,000/(1.10)4 = -$540,000 + $234,545.45 + $233,057.85 + $112,697.22 + $118,844.34 = $159,144.86 ≈ $159,145 181 New project NPVAnswer: d Diff: T Step 1: Calculate depreciation: Dep = 100,000(0.33) = 33,000 Dep = 100,000(0.45) = 45,000 Dep = 100,000(0.15) = 15,000 Dep = 100,000(0.07) = 7,000 Step 2: Calculate cash flows: CF = -100,000 - 5,000 CF = 50,000 + 33,000 CF = 60,000 + 45,000 CF = 70,000 + 15,000 CF = 60,000 + 7,000 + Step 3: Calculate NPV: Use CF key on calculator Enter cash flows shown above Enter I/YR = 12% Solve for NPV = $168,604 = -105,000 = 83,000 = 105,000 = 85,000 5,000 + 15,000 = 87,000 182 New project NPVAnswer: d Diff: T First, find the after-tax CFs associated with the project This is accomplished by subtracting the depreciation expense from the raw CF, reducing this net CF by taxes and then adding back the depreciation expense For t = 1: ($45,000 - $33,000)(1 - 0.4) + $33,000 = $40,200 Similarly, the after-tax CFs for t = 2, t = 3, and t = are $45,000, $33,000, and $29,800, respectively Now, enter these CFs along with the cost of the equipment to find the presalvage NPV (note that the salvage value is not yet accounted for in these CFs) The appropriate discount rate for these CFs is 11 percent This yields a pre-salvage NPV of $16,498.72 Finally, the salvage value must be discounted The PV of the salvage value is: N = 4; I = 12; PMT = 0; FV = -10,000; and PV = $6,355.18 Adding the PV of the salvage amount to the pre-salvage NPV yields the project NPV of $22,853.90 183 New project NPVAnswer: d Diff: T The cash flows for each of the years are as follows: [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 (10,000)(1 - 0.4) (100,000)(0.20)](1 (100,000)(0.32)](1 (100,000)(0.19)](1 (100,000)(0.12)](1 (100,000)(0.11)](1 (100,000)(0.06)](1 - 0.4) 0.4) 0.4) 0.4) 0.4) 0.4) + + + + + + (100,000)(0.20) (100,000)(0.32) (100,000)(0.19) (100,000)(0.12) (100,000)(0.11) (100,000)(0.06) = = = = = + = -100,000 32,000 36,800 31,600 28,800 28,400 32,400 Enter the cash flows and solve for the NPV = $38,839.56 184 New project NPVAnswer: c Diff: T Get the depreciation using the MACRS table provided in the question Cost (500,000) Inventory ( 50,000) Accounts Payable 10,000 Sales 600,000 600,000 600,000 600,000 Operating Cost 400,000 400,000 400,000 400,000 Depreciation 165,000 225,000 75,000 35,000 EBIT 35,000 ( 25,000) 125,000 165,000 Taxes 14,000 ( 10,000) 50,000 66,000 EBIT(1 - T) 21,000 ( 15,000) 75,000 99,000 After-tax salvage value 30,000 Return of NOWC 40,000 + Depreciation 165,000 225,000 75,000 35,000 Net CF ($540,000) $186,000 $210,000 $150,000 $204,000 Note in year your $40,000 of net operating working capital is recovered plus the after tax salvage value of $30,000 185 Enter the cash flows into the cash flow register and solve for the NPV using the WACC of 10% NPV = $54,676.59 Risk-adjusted NPV Answer: a Diff: M Time lines: Project A: k = 14% CFsA -200,000 NPVA = ? Project B: 71,104 71,104 71,104 71,104 146,411 k = 10% CFsB -200,000 NPVB = ? Years Years 146,411 Calculate required returns on A and B: Project A High risk kRisk adjusted = 12% + 2% = 14% Project B Low risk kRisk adjusted = 12% - 2% = 10% Tabular solution: NPVA = $71,104(PVIFA14%,4) - $200,000 = $71,104(2.9137) - $200,000 = $7,175.72 NPVB = $146,411(PVIF10%,3) + $146,411(PVIF10%,4) - $200,000 = $146,411(0.7513) + $146,411(0.6830) - $200,000 = $9,997.30 Project B has the higher NPV Since they are mutually exclusive, select Project B 186 Financial calculator solution: A Inputs: CF0 = -200,000; CF1 = 71,104; Nj = 4; I = 14 Output: NPVA = $7,176.60 ≈ $7,177 B Inputs: CF0 = -200,000; CF1 = 0; Nj = 2; CF2 = 146,411; Nj = 2; I = 10 Output: NPVB = $10,001.43 ≈ $10,001 Note: The difference in the NPV B between the tabular solution and financial calculator cash flow solution of $4.13 is due to rounding of PVIF factors to four significant decimals Greater precision in the PVIF factors produces identical answers Risk-adjusted NPV Answer: e Diff: M Time line: k = 12% 10 Years -50,000 NPV = ? 6,000 • • • 6,000 Salvage value 6,000 10,000 CF10 = 16,000 kProject = 6% + 4%(1.5) = 12% Tabular solution: NPV = -$50,000 + $6,000(PVIFA12%,10) + $10,000(PVIF12%,10) = -$50,000 + $6,000(5.6502) + $10,000(0.3220) = -$12,878.80 ≈ -$12,879 Financial calculator solution: Inputs: CF0 = -50,000; CF1 = 6,000; Nj = 9; CF10 = 16,000; I = 12% Output: NPV = -$12,878.93 ≈ -$12,879 187 Risk-adjusted NPV Answer: c Diff: M Time lines: Project A: k = 12% CFsA -5,000 PVA = ? 2,000 2,500 Periods 2,250 N Project B: k = 14% CFsB -5,000 PVB = ? Project A: Project B: 3,000 2,600 Periods 2,900 N kAverage risk = 12% kHigh risk = 12% + 2% = 14% Tabular solution: NPVA = $2,000(PVIF12%,1) + $2,500(PVIF12%,2) + $2,250(PVIF12%,3) = $2,000(0.8929) + $2,500(0.7972) + $2,250(0.7118) = $380.35 ≈ $380 NPVB = $3,000(PVIF14%,1) + $2,600(PVIF14%,2) + $2,900(PVIF14%,3) = $3,000(0.8772) + $2,600(0.7695) + $2,900(0.6750) = $1,589.80 ≈ $1,590 - $5,000 $5,000 - $5,000 $5,000 Financial calculator solution: A: Inputs: CF0 = -5,000; CF1 = 2,000; CF2 = 2,500; CF3 = 2,250; I% = 12 Output: NPV = $380.20 ≈ $380 B: Inputs: CF0 = -5,000; CF1 = 3,000; CF2 = 2,600; CF3 = 2,900; I% = 14 Output: NPV = $1,589.61 ≈ $1,590 188 NPV and risk-adjusted discount rate Answer: e Diff: T N The following table shows the cash flows: Initial invest outlay Sales Oper cost Deprec EBIT Less: Taxes EBIT(1 - T) Add back: Deprec NCF -$30.0 -$30.0 $20.0 12.0 10.0 -$ 2.0 -0.8 -$ 1.2 10.0 $ 8.8 $20.0 12.0 10.0 -$ 2.0 -0.8 -$ 1.2 10.0 $ 8.8 $20.0 12.0 10.0 -$ 2.0 -0.8 -$ 1.2 10.0 $ 8.8 $20.0 12.0 0.0 $ 8.0 3.2 $ 4.8 0.0 $ 4.8 $20.0 12.0 0.0 $ 8.0 3.2 $ 4.8 0.0 $ 4.8 Step 1: Determine the NPV of net cash flows: NPV = -$30 + $8.8/1.10 + $8.8/(1.10)2 + $8.8/(1.10)3 + $4.8/(1.10)4 + $4.8/(1.10)5 = -$30 + $8 + $7.2727 + $6.6116 + $3.2785 + $2.9804 = -$1.8568 million Step 2: Determine the NPV of the project’s AT salvage value: $1.2/(1.12)5 = $0.6809 million Step 3: Determine the project’s NPV: Add the PV of the salvage value to the NPV of the cash flows to get the project’s NPV NPV = -$1.8568 + $0.6809 = -$1.1759 million ≈ -$1.18 million Financial calculator solution: Step 1: Determine the NPV of net cash flows: Enter the following inputs in the calculator: CF0 = -30, CF1-3 = 8.8, CF4-5 = 4.8, I = 10, and then solve for NPV = -$1.8568 million Step 2: Determine the NPV of the project’s AT salvage value: Enter the following inputs in the calculator: CF0 = 0, CF1-4 = 0, CF5 = 1.2, I = 12, and then solve for NPV = $0.6809 million Step 3: Determine the project’s NPV: Add the PV of the salvage value to the NPV of the cash flows to get the project’s NPV -$1.8568 + $0.6809 = -$1.1759 million ≈ $-1.18 million 189 Discounting risky outflows Time line: | CFsNew Tech -1,500 NPVNew Tech = ? CFsOld Tech -600 NPVOld Tech = ? Answer: e Diff: M | -315 -600 | -315 -600 | -315 -600 | -315 -600 Recognize that (1) risk outflows must be discounted at lower rates, and (2) since Project New Tech is risky, it must be discounted at a rate of 12% - 3% = 9% Project Old Tech must be discounted at 12% Tabular solution: PVNew Tech = -$1,500 - $315(PVIFA9%,4) = -$1,500 - $315(3.2397) = -$2,520.51 PVOld Tech = -$600 - $600(PVIFA12%,4) = -$600 - $600(3.0373) = -$2,422.38 PVOld Tech is a smaller outflow than NPV New Tech, thus, Project Old Tech is the better project Financial calculator solution: Project New Tech: Inputs: CF0 Output: NPV Project Old Tech: Inputs: CF0 Output: NPV = = = = -1,500; CF1 = -315; Nj = 4; I = -$2,520.51 -600; CF1 = -600; Nj = 4; I = 12 -$2,422.41 190 Risky Projects Answer: d Diff: M Look at the NPV, IRR, and hurdle rate for each project: Project A B C D E Hurdle 9.00% 9.00% 11.00% 13.00% 13.00% NPV $13,822 $11,998 IRR 12.11% 14.04% 10.85% 16.64% 11.63% Projects A and B are mutually exclusive, so we pick project A because it has the largest NPV Projects C, D, and E are independent so we pick the ones whose IRR exceeds the cost of capital, in this case, just D Therefore, the projects undertaken are A and D 191 Scenario analysis Answer: c Diff: M Calculate expected value of NPV: Probability of Outcome, Pi Worst case 0.30 Base case 0.50 Best case 0.20 Unit Sales Sales NPV Volume Price (In 1000s) 6,000 $3,600 -$6,000 10,000 4,200 13,000 13,000 4,400 28,000 Pi(x) 0.3(-6,000) 0.5(13,000) 0.2(28,000) Expected NPV Calculate standard deviation of NPV (in thousands): Pi(x - x )2 (x - x )2 Pi(x - x )2 _ Worst case Base case Best case 0.3(-6 - 10.3) 0.5(13 - 10.3)2 0.2(28 - 10.3)2 265.69 7.29 313.29 (146.01)½ = 12,083 thousand _ 79.707 3.645 62.658 Sum 146.01 Calculate coefficient of variation (CV) of NPV: CVNPV = σNPV/E(NPV) = $12,083/$10,300 = 1.17 192 193 New project investment Answer: a Diff: E Initial investment: Cost ($40,000) Change in NOWC (2,000) ($42,000) = -1,800 = 6,500 = 5,600 = $10,300 Operating cash flow Answer: e Diff: M Depreciation schedule: Depreciable basis = $40,000 MACRS Depreciation Year Rate 0.33 0.45 0.15 0.07 Depreciable Basis $40,000 40,000 40,000 40,000 Annual Depreciation $13,200 18,000 6,000 2,800 $40,000 Operating cash flows: Year 1) Increase in revenues 2) Increase in costs 3) Before-tax change in earnings 4) After-tax change in earnings (line × 0.60) 5) Depreciation 6) Tax savings deprec (line × 0.40) 7) Net operating CFs (line + 6) 194 Non-operating cash flows Answer: a Diff: M Additional Year cash flows: Salvage value Tax on Salvage value Recovery of NOWC $20,000 (5,000) $20,000 (5,000) $20,000 (5,000) 15,000 15,000 15,000 9,000 13,200 9,000 18,000 9,000 6,000 5,280 7,200 2,400 $14,280 $16,200 $11,400 $25,000 (8,880)* 2,000 $18,120 *(Market value - Book value)(Tax rate) ($25,000 - $2,800)(0.40) = $8,880 195 New project NPVAnswer: c Diff: M Time line: k = 14% -42,000 14,280 16,200 Years 11,400 TV = 18,120 29,520 Tabular solution: NPVk = 14% = -$42,000 + $14,280(PVIF14%,1) + $16,200(PVIF14%,2) + $29,520(PVIF14%,3) = -$42,000 + $14,280(0.8772) + $16,200(0.7695) + $29,520(0.6750) = $2,918.32 Financial calculator solution: Inputs: CF0 = -42,000; CF1 = 14,280; CF2 = 16,200; CF3 = 29,520; I = 14 Output: NPV = $2,916.85 ≈ $2,917 Note: Tabular solution differs from calculator solution due to interest factor rounding 196 New project investment Answer: d Diff: E Initial investment: Cost ($50,000) Modification (10,000) Change in NOWC (2,000) Total net investment = ($62,000) 197 Operating cash flow Answer: c Diff: M Depreciation schedule: Depreciable basis = $60,000 MACRS Depreciation Year Rate 0.33 0.45 0.15 0.07 Operating cash flows: Year 1) Before-tax cost reduction 2) After-tax cost reduction (line × 0.6) 3) Depreciation 4) Tax savings from deprec (line × 0.4) 5) Net operating CFs Depreciable Basis $60,000 60,000 60,000 60,000 $20,000 $20,000 $20,000 12,000 19,800 12,000 27,000 12,000 9,000 7,920 $19,920 10,800 $22,800 3,600 $15,600 198 Non-operating cash flows Answer: c Diff: M Additional Year cash flows: Salvage value Tax on salvage value Recovery of NOWC Total terminal year CF $20,000 (6,320)* 2,000 $15,680 *(Market value - Book value)(Tax rate) ($20,000 - $4,200)(0.40) = $6,320 199 Annual Depreciation $19,800 27,000 9,000 4,200 $60,000 New project NPVAnswer: a Diff: M Time line: k = 10% -62,000 19,920 22,800 Years 15,600 TV = 15,680 31,280 Tabular solution: NPVk = 10% = -$62,000 + $19,920(PVIF10%,1) + $22,800(PVIF10%,2) + $31,280(PVIF10%,3) = -$62,000 + $19,920(0.9091) + $22,800(0.8264) + $31,280(0.7513) = -$1,548.14 Financial calculator solution: Inputs: CF0 = -62,000; CF1 = 19,920; CF2 = 22,800; CF3 = 31,280; I = 10 Output: NPV = -$1,546.81 ≈ -$1,547 Note: Tabular solution differs from calculator solution due to interest factor rounding ... supervisor E all of the above are ethical problems related to capital budgeting AICPA adapted Page of 105 MANAGEMENT ADVISORY SERVICES CAPITAL BUDGETING Post- Investment Audit 69 Comparison of the actual... 105 MANAGEMENT ADVISORY SERVICES 99 The capital budgeting technique known as accounting rate of return uses (D) Barfield a b c Salvage value No No Yes Time value of money No Yes Yes CAPITAL BUDGETING. .. cannot be done b can be done only by matching cash inflows and investment outflows on a year -by- year basis Page 17 of 105 MANAGEMENT ADVISORY SERVICES CAPITAL BUDGETING c will product essentially
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Xem thêm: Test bank management advisory services by tan t02 capital budgeting , Test bank management advisory services by tan t02 capital budgeting , . Find the WACCs using both John’s and Becky’s methods. (WACC = ks because there is no debt).