CH 10

CHAPTER 10—PROJECT CASH FLOWS AND RISK
TRUE/FALSE
1. If an investment project would make use of land which the firm currently owns, the project
should be charged with the opportunity cost of the land.
ANS: T DIF: Easy TOP: Relevant cash flows
2. When calculating the cash flows for a project, you should include interest payments.
ANS: F DIF: Easy TOP: Relevant cash flows
3. With the current techniques available, estimating cash flows has become the easiest step in the
analysis of a capital budgeting project.
ANS: F DIF: Easy TOP: Estimating cash flows
4. Although it is difficult to make accurate forecasts, the initial outlays and subsequent costs of large
projects are forecast with great accuracy, but revenues are more uncertain and large errors are not
uncommon.
ANS: F DIF: Easy TOP: Estimating cash flows
5. Net incremental operating cash flow is calculated by adding back the change in depreciation to
the change in income after taxes.
ANS: T DIF: Easy TOP: Incremental cash flows
6. In cash flow estimation, the presence of externalities has no direct cash flow effects.
ANS: F DIF: Easy TOP: Externalities and cash flows
7. A key difference between replacement and expansion project analyses is that with replacement,
the incremental cash flows are measured as the net difference between projected cash flows from
the current productive assets and cash flows of the proposed new productive assets.
ANS: T DIF: Easy TOP: Replacement project cash flows
8. If an asset being considered for acquisition has beta of zero, its purchase will have no effect on
the firm's market risk.
ANS: F DIF: Easy TOP: Market risk
9. A particular project might have very uncertain cash flows, hence a highly uncertain NPV and
IRR, yet it may not have high market risk.
ANS: T DIF: Easy TOP: Project risk
10. When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if
its IRR is greater than the firm's average required rate of return.
ANS: F DIF: Easy TOP: Accepting risky projects
11. One problem with Monte Carlo simulation analysis is that, while the simulation may provide
some insights into the riskiness of a project, the analysis does not lead to a clear-cut accept versus
reject decision.
ANS: T DIF: Easy TOP: Monte Carlo simulation
214 Chapter 10  Project Cash Flows and Risk
12. Empirical studies of risk strongly support the contention that investors who are well diversified
focus exclusively on market risk when they establish required returns.
ANS: F DIF: Easy TOP: Empirical studies of risk
13. Quantification of risk is the easiest part of incorporating risk into capital budgeting; treatment of
that calculated risk measure is more difficult.
ANS: F DIF: Easy TOP: Quantification of risk
14. If a firm is considering purchasing an asset whose beta is greater than the current beta of the firm,
it should use a discount rate greater than the firm's average required rate of return to evaluate the
possible investment.
ANS: T DIF: Easy TOP: Risk-adjusted discount rate
15. Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that the
more distant cash flows are riskier.
ANS: F DIF: Easy TOP: Risk-adjusted discount rate
16. The situation where a firm accepts projects to the point where the return on the last project
accepted is just equal to or greater than the firm's required rate of return (IRR ≥ k at the margin)
is called capital rationing.
ANS: F DIF: Easy TOP: Capital rationing
17. Capital budgeting decisions must be based on the accounting income the project generates since
stockholders are concerned with the reported net income the firm generates.
ANS: F DIF: Easy TOP: Relevant cash flows
18. A sunk is a cash outlay that has already been incurred and that cannot be recovered regardless of
whether the project is accepted or rejected. These sunk costs are extremely important in capital
budgeting decisions.
ANS: F DIF: Easy TOP: Incremental cash flows
19. Inflation does not need to be built into expected cash flows; the discount rate used in net present
value calculations captures the effect of inflation. If you were to include expected inflation into
cash flows, all net present value calculations would be incorrect.
ANS: F DIF: Easy TOP: Inflation effects
20. Replacement analysis involves the decision of whether to replace an existing asset that is still
productive with a new asset.
ANS: T DIF: Easy TOP: Replacement analysis
21. The stand-alone risk is the risk an asset would have if it were a firm's only asset and it is
measured by the variability of the asset's expected returns.
ANS: T DIF: Easy TOP: Stand-alone risk
22. Corporate risk does not take into consideration the effects of stockholder's diversification; it is
measured by a project's effect on the firm's earnings variability.
ANS: T DIF: Easy TOP: Corporate risk
Chapter 10  Project Cash Flows and Risk 215
23. The beta risk of a project is that part of the project's that cannot be eliminated by diversification.
Investors are not concerned about this type of since it can not be diversified.
ANS: F DIF: Easy TOP: Market risk
24. Sensitivity analysis is a risk analysis technique in which key variables are changed and the
resulting changes in the NPV and IRR are observed.
ANS: T DIF: Easy TOP: Sensitivity analysis
25. The two cardinal rules which financial analysts follow to avoid capital budgeting errors are: (1)
capital budgeting decisions must be based on accounting income, and (2) only incremental cash
flows are relevant to accept/reject decisions.
ANS: F DIF: Medium TOP: Relevant cash flows
26. Suppose a firm is considering production of a new product whose projected sales include sales
that will be taken away from another product the firm also produces. The lost sales on the
existing product are a sunk cost and are not a relevant cost to the new product.
ANS: F DIF: Medium TOP: Sunk costs
27. Superior analytical techniques, such as NPV, used in combination with adjustments to the
average required rate of return, can overcome the problem of poor cash flow estimation in
decision making.
ANS: F DIF: Medium TOP: Cash flow estimation
28. It is extremely difficult to estimate the revenues and costs associated with large complex projects
that take several years to develop. This is why subjective judgment is recommended for such
projects instead of cash flow analysis.
ANS: F DIF: Medium TOP: Cash flow estimation
29. It is possible with a replacement project that the incremental depreciation cash flows will be
negative even if the actual depreciation on the new asset is positive.
ANS: T DIF: Medium TOP: Replacement project depreciation
30. Sensitivity analysis measures the stand-alone risk of a project by showing how much the project's
NPV is affected by a small change in one of the input variables, such as sales. Other things held
constant, with the independent variable graphed on the horizontal axis, the steeper the graph of
the relationship line, the less risky the project.
ANS: F DIF: Medium TOP: Sensitivity analysis
31. As a practical matter, it is much easier to use market risk analysis at the project level than at the
divisional level because it is easier to estimate the beta of a single project such as a machine tool
die maker than the beta of an entire division (or subsidiary) such as Phillip Morris' Kraft foods
unit.
ANS: F DIF: Medium TOP: Market risk
32. If a project is small relative to the total firm, and if its returns are not highly correlated with the
returns on the firm's other assets, then the project may not be very risky in either the within-firm
(corporate) or the market risk sense, even if the returns on the project are highly uncertain and
thus the project has a high degree of stand-alone risk.
ANS: T DIF: Medium TOP: Project risk
33. Assume the following: (1) A firm is considering two projects, one with a 5-year life and the other
with a 10-year life; (2) the cash flows of the two projects are equally risky by all definitions of the
word "risky"; (3) the company uses 40 percent debt and 60 percent equity to finance the projects;
(4) the debt used to finance any given project has a maturity equal to the life of the project; and
(5) the term structure of interest rates has a sharp upward slope. This would suggest, other things
held constant, that a lower discount rate should be used to find the NPV for the 5-year project
than for the 10-year project.
ANS: T DIF: Medium TOP: Risk-adjusted discount rate
34. The cash flows relevant for the analysis of a foreign investment should, from the parent
company's perspective, include the financial cash flows that the subsidiary can legally send back
to the parent company and the cash flows which must remain in the foreign country.
ANS: F DIF: Medium TOP: Relevant investment cash flows
35. The cost of capital may be different for a foreign project than for an equivalent domestic project
because foreign projects may be more or less risky.
ANS: T DIF: Medium TOP: Foreign project's cost of capital
36. When considering the risk of foreign investment, higher risk could arise from exchange rate risk
and political risk while lower risk might result from international diversification.
ANS: T DIF: Medium TOP: Risk and international investment
37. The change in net working capital associated with a capital project may actually result in a
decrease in the firm's current funding requirement, which frees up cash flows for investment.
ANS: T DIF: Medium TOP: Net working capital
38. Expansion project analysis requires determining the amount of incremental cash as a result of the
expansion relative to the cash flows if the expansion project was not accepted. The incremental
cash flows will always be discounted at the same rate as the firm's original cash flows sine we are
simply expanding the firm and not changing the risk of the firm.
ANS: F DIF: Medium TOP: Expansion analysis
MULTIPLE CHOICE
1. When evaluating a new project, the firm should consider all of the following factors except:
a. Changes in working capital attributable to the project.
b. Previous expenditures associated with a market test to determine the feasibility of the
project, if the expenditures have been expensed for tax purposes.
c. The current market value of any equipment to be replaced.
d. The resulting difference in depreciation expense if the project involves replacement.
e. All of the above should be considered.
ANS: B DIF: Easy OBJ: TYPE: Conceptual
TOP: Relevant cash flows
2. Which of the following is not a cash flow that results from the decision to accept a project?
a. Changes in working capital.
b. Shipping and installation costs.
c. Sunk costs.
d. Opportunity costs.
e. Externalities.
ANS: C DIF: Easy OBJ: TYPE: Conceptual
TOP: Determining incremental cash flows
3. Which of the following statements is correct?
a. If a firm's stockholders are well diversified, we know from theory and from studies of
market behavior that corporate risk is not important.
b. Undiversified stockholders, including the owners of small businesses, are more concerned
about corporate risk than market risk.
c. Empirical studies of the determinants of required rates of return (k) have found that only
market risk affects stock prices.
d. Market risk is important but does not have a direct effect on stock price because it only
affects beta.
ANS: B DIF: Easy OBJ: TYPE: Conceptual TOP: Corporate risk
4. Which of the following is not discussed in the text as a method for analyzing risk in capital
budgeting?
a. Sensitivity analysis.
b. Beta, or CAPM, analysis.
c. Monte Carlo simulation.
d. Scenario analysis.
e. All of the above are discussed in the text as methods of analyzing risk in capital
budgeting.
ANS: E DIF: Easy OBJ: TYPE: Conceptual TOP: Risk analysis
5. A firm is considering the purchase of an asset whose risk is greater than the current risk of the
firm, based on any method for assessing risk. In evaluating this asset, the decision maker should
a. Increase the IRR of the asset to reflect the greater risk.
b. Increase the NPV of the asset to reflect the greater risk.
c. Reject the asset, since its acceptance would increase the risk of the firm.
d. Ignore the risk differential if the asset to be accepted would comprise only a small fraction
of the total assets of the firm.
e. Increase the required rate of return used to evaluate the project to reflect the higher risk of
the project.
ANS: E DIF: Easy OBJ: TYPE: Conceptual
TOP: Accepting risky projects
6. Risk in a revenue producing project can best be adjusted for by
a. Ignoring it.
b. Adjusting the discount rate upward for increasing risk.
c. Adjusting the discount rate downward for increasing risk.
d. Picking a risk factor equal to the average discount rate.
e. Reducing the NPV by 10 percent for risky projects.
ANS: B DIF: Easy OBJ: TYPE: Conceptual TOP: Risk adjustment
7. Which of the following statements concerning cash flow evaluation in capital budgeting is
incorrect?
a. When determining a project's terminal cash flows, it is generally assumed that the firm's
operations return to the same level as they were before the project was purchased.
b. If a depreciable asset is sold at a price different than its book value, taxes will affect the
net cash received from the disposal of the asset at the end of its life.
c. The relevant marginal cash flows associated with a project should always include
depreciation, because depreciation is an annual operating expense that requires a cash
payment.
d. If an asset is depreciated using the Modified Accelerated Cost Recovery System
(MACRS), its depreciable basis is the amount that can be depreciated over the asset's
useful life, which generally includes the purchase price plus any shipping and installation
charges or other costs that are incurred in order to prepare the asset for use.
e. The sunk costs associated with an investment proposal are not relevant cash flows for
capital budgeting analysis, so they should not be included in the computation of the
marginal cash flows.
ANS: C DIF: Easy OBJ: TYPE: Conceptual TOP: Cash flows
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.
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.
e. All of the above are false.
ANS: D DIF: Medium OBJ: TYPE: Conceptual
TOP: Cash flows and accounting measures
9. 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 (initial
investment outlay).
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 (initial investment outlay).
e. An increase in net working capital is treated as an outflow when the project begins (initial
investment outlay) and as an inflow when the project ends (terminal cash flow).
10. Which of the following rules are essential to successful cash flow estimates, and ultimately, to
successful capital budgeting?
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. All of the above are correct.
e. Only answers a and b are correct.
ANS: B DIF: Medium OBJ: TYPE: Conceptual
TOP: Relevant cash flows and estimation
11. According to the text, the financial staff's role in the forecasting process centers on
a. Developing the original assumptions used in estimating each project's cash flows.
b. Making sure that no biases are inherent in the forecasts.
c. Deciding which projects are strategically important to the firm.
d. Setting the sales price and quantity estimates for use by other departments.
e. All of the above.
ANS: B DIF: Medium OBJ: TYPE: Conceptual
TOP: Role of financial staff
12. Which of the following is not considered a relevant concern in determining incremental cash
flows for a new product?
a. The use of factory floor space which 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.
e. None of the above (All are relevant concerns in estimating relevant cash flows attributable
to a new product project.)
TOP: Factors affecting cash flows
13. Suppose the firm's required rate of return is stated in nominal terms, but the project's expected
cash flows are expressed in real dollars. In this situation, other things held constant, the calculated
NPV would
a. Be correct.
b. Be biased downward.
c. Be biased upward.
d. Possibly have a bias, but it could be upward or downward.
e. More information is needed; otherwise, we can make no reasonable statement.
ANS: B DIF: Medium OBJ: TYPE: Conceptual TOP: Inflation effects
14. In theory, the decision maker should view market risk as being of primary importance. However,
within-firm, or corporate, risk is relevant to a firm's
a. Well-diversified stockholders, because it may affect debt capacity and operating income.
b. Management, because it affects job stability.
c. Creditors, because it affects the firm's credit worthiness.
d. All of the above are correct.
e. Only answers a and c are correct.
ANS: D DIF: Medium OBJ: TYPE: Conceptual TOP: Corporate risk
15. Which of the following statements is most correct?
a. Sensitivity analysis is incomplete because it fails to consider the range of likely values of
key variables as reflected in their probability distributions.
b. In comparing two projects using sensitivity analysis, the one with the steeper lines would
be considered less risky, because a small error in estimating a variable, such as unit sales,
would produce only a small error in the project's NPV.
c. The primary advantage of simulation is that it provides a very accurate point estimate of a
project's NPV.
d. One important benefit of simulation analysis as compared to scenario analysis, is that once
the analysis is complete, it provides a clear accept/reject decision rule.
e. Answers c and d are both correct.
ANS: A DIF: Medium OBJ: TYPE: Conceptual
TOP: Methods of analysis
16. Monte Carlo simulation
a. Can be useful for estimating a project's stand-alone risk.
b. Is capable of using probability distributions for variables as input data instead of a single
numerical estimate for each variable.
c. Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or
IRR.
d. All of the above.
e. Only answers a and b are correct.
TOP: Monte Carlo simulation
17. Which of the following methods involves calculating an average beta for firms in a similar
business and then applying that beta to determine the beta of its own project?
a. Risk premium method.
b. Pure play method.
c. Accounting beta method.
d. CAPM method.
e. Answers b and c are both correct.
ANS: B DIF: Medium OBJ: TYPE: Conceptual TOP: Project beta
18. If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions
concerning the relationship between risk and return are true, then which of the following should
be true?
a. If the beta of the asset is larger than the firm's beta, then the required return on the asset is
less than the required return on the firm.
b. If the beta of the asset is smaller than the firm's beta, then the required return on the asset
is greater than the required return on the firm.
c. If the beta of the asset is greater than the corporate beta prior to the addition of that asset,
then the corporate beta after the purchase of the asset will be smaller than the original
corporate beta.
d. If the beta of an asset is larger than the corporate beta prior to the addition of that asset,
then the required return on the firm will be greater after the purchase of that asset than
prior to its purchase.
e. None of the above is a true statement.
TOP: Risk and project betas
a. A relatively risky future cash outflow should be evaluated using a relatively low discount
rate.
b. If a firm's managers want to maximize the value of the stock, they should concentrate
exclusively on projects' market, or beta, risk.
c. If a firm evaluates all projects using the same required rate of return to determine NPVs,
then the riskiness of the firm as measured by its beta will probably decline over time.
d. If a firm has a beta which is less than 1.0, say 0.9, this would suggest that its assets' returns
are negatively correlated with the returns of most other firms' assets.
e. The above statements are all false.
TOP: Beta and project risk
20. Using the Security Market Line concept in capital budgeting, which of the following is correct?
a. If the expected rate of return on a given capital project lies above the SML, the project
should be accepted even if its beta is above the beta of the firm's average project.
b. If a project's return lies below the SML, it should be rejected if it has a beta greater than
the firm's existing beta but accepted if its beta is below the firm's beta.
c. If two mutually exclusive projects' expected returns are both above the SML, the project
with the lower risk should be accepted.
d. If a project's expected rate of return is greater than the expected rate of return on an
average project, it should be accepted.
TOP: SML and capital budgeting
21. If a company uses the same discount rate for evaluating all projects, which of the following
results is likely?
a. Accepting poor, high-risk projects.
b. Rejecting good, low-risk projects.
c. Accepting only good, low-risk projects.
d. Accepting no projects.
e. Answers a and b are both correct.
ANS: E DIF: Medium OBJ: TYPE: Conceptual
TOP: Risk-adjusted discount rate
22. If a typical U.S. company uses the same discount rate to evaluate all projects, the firm will most
likely become
a. Riskier over time, and its value will decline.
b. Riskier over time, and its value will rise.
c. Less risky over time, and its value will rise.
d. Less risky over time, and its value will decline.
e. There is no reason to expect its risk position or value to change over time as a result of its
use of a single discount rate.
23. The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems.
Since the company's revenue stream will not be affected by the choice of control systems, the
projects are being evaluated by finding the PV of each set of costs. The firm's required rate of
return is 13 percent, and it adds or subtracts 3 percentage points to adjust for project risk
differences. System A is judged to be a high-risk project (it might end up costing much more to
operate than is expected). The appropriate risk-adjusted discount rate that should be used to
evaluate System A is
a. 10%; this might seem illogical at first, but it correctly adjusts for risk where outflows,
rather than inflows, are being discounted.
b. 13%; the firm's cost of capital should not be adjusted when evaluating outflow only
projects.
c. 16%; since A is more risky, its cash flows should be discounted at a higher rate, because
this correctly penalizes the project for its high risk.
d. Somewhere between 10% and 16%, with the answer depending on the riskiness of the
relevant inflows.
e. Indeterminate, or, more accurately, irrelevant, because for such projects we would simply
select the process that meets the requirements with the lowest required investment.
ANS: A
kA = 13% - 3% = 10%.
If the cash flows are cost only outflows, and the analyst wants to correctly reflect their risk, the
discount rate should be adjusted downward (in this case by subtracting 3 percentage points) to
make the discounted flows comparatively larger.
DIF: Medium OBJ: TYPE: Conceptual TOP: Risk adjustment
a. Sensitivity analysis is used frequently in capital budgeting analysis. Its big advantage is
that because it shows correlations between changes in input variables and NPV, it
accounts for within-firm risk.
b. Other things held constant, the lower the correlation between a project's returns and
returns on the market, the less risky the project.
c. In judging the relative stand-along risks of a set of projects, the projects' standard
deviations of NPV are a better measure than their coefficients of variation.
d. One can run a regression of returns on a project versus returns on the firm's other assets,
get a beta coefficient, and use this beta as a measure of the project's market risk.
e. One can run a regression of returns on a project versus returns on the stock market, get a
beta coefficient, and use this beta as a measure of the project's within-firm risk.
ANS: B
Statement a is false. While sensitivity analysis shows the sensitivity of NPV to changes in key
variables, it doesn't give the range of likely values. A project's stand-alone risk depends on both
factors. Statement c is false; the coefficient of variation is a better measure of relative stand-alone
risk between a set of projects than standard deviation. Statements d and e are false. The
statements have been reversed. A regression of a project's returns versus returns on the firm's
other assets provides a beta which could be used to measure the project's within-firm risk. A
regression of a project's returns versus the returns on the stock market provides a beta which
could be used to measure the project's market risk.
DIF: Medium OBJ: TYPE: Conceptual TOP: Miscellaneous concepts
25. The financial staff's role in the forecasting process includes all of the following except
a. coordinating the efforts of other departments, such as engineering and marketing.
b. ensuring that everyone involved in the forecasts uses a consistent set of economic
assumptions.
c. making sure that no biases are inherent in the forecasts.
d. determine the appropriate discount rate for cash flows.
e. none of the above.
TOP: Role of financial staff
26. Which of the following cash flows are incremental cash flows that need to be considered when
evaluating a capital project?
a. Interest expenses on the financing of the project.
b. Sunk costs of engineering study to determine the feasibility of the project.
c. Opportunity cost of land being used for project that the firm already owns.
d. Both a and b are correct.
e. None of the above.
ANS: C DIF: Medium OBJ: TYPE: Conceptual
TOP: Incremental cash flows
27. Depreciation must be considered when evaluating the incremental operating cash flows
associated with a capital budgeting project because
a. it represents a tax-deductible cash expense.
b. the firm has a cash outflow equal to the depreciation expense each year.
c. although it is a non-cash expense, depreciation has an impact on the taxes paid by the firm,
which is a cash flow.
d. depreciation is a sunk cost.
e. None of the above is correct.
28. Hill Top Lumber Company is considering building a sawmill in the state of Washington because
the company doesn't have such a facility to service its growing customer base that is located on
the west coast. Hill Top's executives believe that future growth in west coast customers will make
the sawmill project a good investment. When evaluating the acceptability of the project, which of
the following would not be considered a relevant cash flow that should be included when
determining its initial investment outlay?
a. Hill Top owns acreage that is large enough and would be an ideal location for the sawmill.
The land, which was purchased five years ago, has a current value of $3 million.
b. It is estimated that the cost of building the sawmill will be $175 million.
c. It will cost $3 million to clear the land on which Hill Top wants to build the sawmill.
d. It is estimated that $20 million of business from existing customers will move to the new
sawmill.
e. All of these cash flows should be included in the computation of the sawmill's initial
investment outlay.
ANS: E DIF: Medium OBJ: TYPE: Conceptual
29. A firm is evaluating a new machine to replace an existing, older machine. The old (existing)
machine is being depreciated at $20,000 per year, whereas the new machine's depreciation will be
$18,000. The firm's marginal tax rate is 30 percent. Everything else equal, if the new machine is
purchased, what effect will the change in depreciation have on the firm's incremental operating
cash flows?
a. There should be no effect on the firm's cash flows, because depreciation is a noncash
expense.
b. Operating cash flows will increase by $2,000.
c. Operating cash flows will increase by $1,400.
d. Operating cash flows will decrease by $600.
e. None of the above is correct.
30. When evaluating the cash flows associated with a capital budgeting project, shipping and
installation costs associated with the purchase of an asset, such as a lathe, are considered part of
the
a. initial investment outlay because these expenses effectively are part of the asset's purchase
price.
b. incremental operating cash flows because shipping and installation costs represent
expenses that have to be written off over the life of the asset.
c. terminal cash flows, because these expenses aren't paid until the end of the asset's life.
d. sunk costs because these expenses do not affect any current or future cash flows associated
with investing in the asset.
e. None of the above is a correct answer.
31. Express Press evaluates many different capital budgeting projects each year. The risks of the
projects often differ significantly, from very little risk to risks that are substantially greater than
the average risk associated with the firm. If Express Press always uses its weighted average cost
of capital, or average required rate of return, to evaluate all of these capital budgeting projects,
then the company might make an incorrect decision, or a mistake, by
a. accepting projects that actually should be rejected.
b. accepting projects with internal rates of return that are too high.
c. rejecting projects that actually should be rejected.
d. rejecting projects with internal rates of return that are lower than the appropriate risk-
adjusted required rate of return.
e. accepting project that actually should be accepted.
32. Cyrus Cypress evaluates all capital budgeting projects with its normal, or average, required rate
of return (k), regardless of the risk associated with the projects. If Cyrus is currently examining
projects that are significantly riskier than the existing assets of the firm, the capital budgeting
decisions that the firm makes could be
a. correct.
b. incorrect because acceptable projects might be rejected when they should be accepted.
c. incorrect because unacceptable projects might be accepted when they should be rejected.
d. Both a and b are correct answers.
e. Both a and c are correct answers.
33. Which of the following items should not be considered when computing the terminal cash flow
for an expansion project?
a. a change in net working capital associated with the purchase of the project
b. the selling price of the asset at the end of its life
c. increases in cash sales that occur because the project is purchased
d. taxes on the sale of the asset at the end of its life
e. none of the above
34. When determining the marginal cash flows associated with an expansion capital budgeting
project, which of the following would be included as an incremental operating cash flow?
a. depreciation
b. shipping and installation
c. increase in working capital
d. salvage value
e. decrease in sales
35. If a firm uses its weighted average cost of capital (WACC) to evaluate all capital budgeting
projects, which of the following could occur?
a. Projects with little or no risk might be rejected when they actually should be accepted.
b. Projects with significant risks might be accepted when the actually should be rejected.
c. Projects with average risk will always be rejected when they actually should be rejected.
d. All of the above could occur.
e. None of the above could occur.
36. An evaluation of four independent capital budgeting projects by the director of capital budgeting
for Ziker Golf Company yielded the following results:
Internal rate of
Project of return, IRR Risk level
L 19.0% Average
E 15.0 High
M 12.0 Low
Q 11.0 Average
The firm's weighted average cost of capital is 12 percent. Ziker Golf generally evaluates projects
that are riskier than average by adjusting its required rate of return by 4 percent, whereas projects
with less-than-average risk are evaluated by adjusting the required rate of return by 2 percent.
Which project(s) should the firm purchase?
a. Project L
b. Projects L and E
c. Projects L and M
d. Projects L, E, and M
ANS: C DIF: Medium OBJ: TYPE: Conceptual TOP: Risk adjustment
37. How do most firms deal with the risks of projects when making capital budgeting decisions?
a. Projects risks are not considered directly because the weighted average cost of capital
(WACC) that is used as the required rate of return for capital budgeting decisions is based
on the riskiness of the firm. As a result, all projects, no matter their risks, can be evaluated
using WACC.
b. Evaluating risk is important only when the projects are similar to the firm's existing assets.
c. Most firms adjust the discount rates used to evaluate new projects that have significantly
different risks than the risk associated with the firm's existing assets.
d. Firms generally increase the required rate of return used to evaluate projects that have
significantly different risks than the risk associated with the firm's existing assets,
regardless of whether the new projects' risks are higher or lower.
ANS: C DIF: Medium OBJ: TYPE: Conceptual TOP: Risk adjustment
38. Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial
manager is evaluating a project with an IRR of 21 percent, before any risk adjustment. The risk-
free rate is 10 percent, and the required rate of return on the market is 16 percent. The project
being evaluated is riskier than Boe's average project, in terms of both beta risk and total risk.
Which of the following statements is correct?
a. The project should be accepted because its IRR (before risk adjustment) is greater than its
required return.
b. The project should be rejected because its IRR (before risk adjustment) is less than its
required return.
c. The accept/reject decision depends on the risk-adjustment policy of the firm. If the firm's
policy were to reduce a riskier-than-average project's IRR by 1 percentage point, then the
project should be accepted.
d. Riskier-than-average projects should have their IRRs increased to reflect their added
riskiness. Clearly, this would make the project acceptable regardless of the amount of the
adjustment.
e. Projects should be evaluated on the basis of their total risk alone. Thus, there is
insufficient information in the problem to make an accept/reject decision.
ANS: C
ks = 10% + (16% - 10%)1.5 = 10% + 9% = 19%.
Original IRR = 21%. 21% - Risk adjustment 1% = 20%.
Risk adjusted IRR = 20% > ks = 19%.
DIF: Easy OBJ: TYPE: Problem TOP: Risk adjustment
39. Carolina Insurance Company, an all-equity life insurance firm, is considering the purchase of a
fire insurance company. If the purchase is made, Carolina will be 50 percent larger than before.
Currently, Carolina's stock has a beta of 1.2 and the return required is 15.2 percent. The fire
insurance company is expected to generate a return of 20 percent with a beta of 2.5. If the risk-
free rate is 8 percent and the market risk premium is 6 percent, should Carolina make the
investment?
a. No; the expected return is less than the required return.
b. No; the IRR is less than the appropriate required rate of return.
c. Yes; the IRR is greater than the appropriate required rate of return.
d. Yes; the expected return is greater than the required return.
e. Yes; the project's risk/return combination lies above the SML.
ANS: A
Calculate the required return, ks, and compare to the expected return, .
= 20%.
ks = 0.08 + (0.06)2.5 = 0.23 = 23%.
ks > ; 23% > 20%; reject the investment.
DIF: Easy OBJ: TYPE: Problem TOP: Required rate of return
40. Given the following information, calculate the NPV of a proposed project: Cost = $4,000;
estimated life = 3 years; initial decrease in accounts receivable = $1000, which must be restored
at the end of the project's life; estimated salvage value = $1,000; net income before taxes and
depreciation = $2,000 per year; method of depreciation = MACRS; tax rate = 40 percent; required
rate of return = 18 percent.
a. $1,137
b. -$151
c. $137
d. $804
e. $544
ANS: E
[MACRS table required]
Project analysis worksheet:

I Initial investment outlay
1) Cost ($4,000)
2) Decrease in NWC 1,000
3) Total net investment ($3,000)
II Incremental operating flows: Year: 0 1 2 3

4) EBT and depreciation 2,000 $2,000 $2,000
5) Earnings after taxes (line 4 × 0.6) 1,200 1,200 1,200
6) Depreciation (from table) 1,320 1,800 600
7) Tax savings from depreciation
(5 × 0.4) 528 720 240
8) Net operating flows

(line 5 + 7) $1,728 $1,920 $1,440
III Terminal cash flow:

9) Estimated salvage value $1,000
10) Tax on salvage value
((1,000 - 280) × 0.4) (288)
11) Return of NWC (1,000)
12) Net CF ($ 288)
IV Net cash flows:

13) Total net cash flows ($3,000) $1,728 $1,920 $1,152
Financial calculator solution:
Inputs: = -3000; = 1728; = 1920; = 1152; I = 18.
Output: NPV = $544.46 $544.
DIF: Medium OBJ: TYPE: Problem TOP: New project NPV
41. Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs
by $5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine,
and it expects to sell the machine at the end of its 5-year operating life for $10,000. The firm
expects to be able to reduce net working capital by $15,000 when the machine is installed, but
required working capital will return to the original level when the machine is sold after 5 years.
Mars' marginal tax rate is 40 percent, and it uses a 12 percent required rate of return to evaluate
projects of this nature. If the machine costs $60,000, what is the NPV of the project?
a. -$15,394
b. -$14,093
c. -$58,512
d. -$21,493
e. -$46,901
ANS: D
Cash flow time line
Depreciation cash flows:

MACRS Depreciable Annual
Year Percent Basis Depreciation
1 0.20 $60,000 $12,000
2 0.32 60,000 19,200
3 0.19 60,000 11,400
4 0.12 60,000 7,200
5 0.11 60,000 6,600
6 0.06 60,000 3,600
$60,000

1) Machine cost ($60,000)
2) Decrease in NWC 15,000
II Incremental operating cash flows:

Year: 0 1 2 3 4 5
4) Reduction in cost $5,000 $5,000 $5,000 $5,000 $5,000
5) After-tax dec. in cost 3,000 3,000 3,000 3,000 3,000
6) Depreciation (from table) 12,000 19,200 11,400 7,200 6,600
7) Tax savings depreciation
(line 6 × 0 . 4) 4,800 7,680 4,560 2,880 2,640
8) Net operating CFs
(line 5 + 7) $7,800 $10,680 $7,560 $5,880 $5,640
III Terminal CF
(10,000 - 3,600) × (0.4) (2,560)
11) Return of NWC (15,000)
12) Net CF ($7,560)
IV Net CFs
13) Total Net CFs ($45,000) $7,800 $10,680 $7,560 $5,880 ($1,920)

Inputs: = -45,000; = 7,800; = 10,680; = 7,560; = 5,880; = -1,920; I =
12.
Output: NPV = -$21,493.24 $21,493.
42. 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 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 required rate of return 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
ANS: B

1 0.20 $40,000 $ 8,000

2 0.32 40,000 12,800
3 0.19 40,000 7,600
4 0.12 40,000 4,800
5 0.11 40,000 4,400
6 0.06 40,000 2,400
$40,000
2) Decrease in NWC --
II Incremental operating cash flows:

Year: 0 1 2 3 4 5
4) Inc. in earnings before deprec.
& tax $6,000 $6,000 $6,000 $6,000 $6,000
5) After-tax increase in earnings
(line 4 × 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 in cost
(line 6 × 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 8 × 0 . 4) 3,200 5,120 3,040 1,920 1,760
(line 5 + 7 + 9) $9,800 $11,720 $9,640 $8,520 $8,360
III Terminal CF
(10,000 - 2,400) (0.4) (3,040)
13) Return of NWC --
14) Net CF ($6,960)
IV Net CFs
15) Total Net CFs ($40,000) $9,800 $11,720 $9,640 $8,520 ($15,320)

Inputs: = -40,000; = 9,800; = 11,720; = 9,640; = 8,520; = 15,320; I
= 9.
Output: NPV = $2,291.90 $2,292.
43. Whitney Crane Inc. has the following independent investment opportunities for the coming year:
Annual Cash
Project Cost Inflows Life (years) IRR
A $10,000 $11,800 1
B 5,000 3,075 2 15
C 12,000 5,696 3
D 3,000 1,009 4 13
The IRRs for Project A and C, respectively, are:
a. 16% and 14%
b. 18% and 10%
c. 18% and 20%
d. 18% and 13%

e. 16% and 13%
ANS: C
Project A
Inputs: N = 1; PV = -10,000; FV = 11,800.
Output: I = 18% = IRRA.
Project B
Inputs: N = 3; PV = -12,000; PMT = 5,696.
Output: I = 19.99% 20% = IRRB.
DIF: Medium OBJ: TYPE: Problem TOP: IRRs
44. Sun State Mining Inc., an all-equity firm, is considering the formation of a new division which
will increase the assets of the firm by 50 percent. Sun State currently has a required rate of return
of 18 percent, U.S. Treasury bonds yield 7 percent, and the market risk premium is 5 percent. If
Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta
coefficient the new division could have?
a. 2.2
b. 1.0
c. 1.8
d. 1.6
e. 2.0
ANS: B
Old assets = 1.0. New assets = 0.5. Total assets = 1.5.
Old required rate:
18% = 7% + (5%)β
beta = 2.2.
New required rate:
16% = 7% + (5%)β
beta = 1.8.
New β must not be greater than 1.8, therefore
0.3333(β) = 0.3333
β = 1.0.
Therefore, beta of the new division cannot exceed 1.0.
DIF: Medium OBJ: TYPE: Problem TOP: Beta risk
45. An all-equity firm is analyzing a potential project which will require an initial, after-tax cash
outlay of $50,000 and after-tax cash inflows of $6,000 per year for 10 years. In addition, this
project will have an after-tax salvage value of $10,000 at the end of Year 10. If the risk-free rate
is 6 percent, the return on an average stock is 10 percent, and the beta of this project is 1.50, then
what is the project's NPV?
a. $13,210
b. $4,905
c. $7,121
d. -$6,158
e. -$12,879
ANS: E
kProject = 6% + 4%(1.5) = 12%.

Inputs: = -50,000; = 6,000; Nj = 9; = 16,000; I = 12%.
Output: NPV = -12,878.93 ≈ $12,879.
DIF: Medium OBJ: TYPE: Problem TOP: Risk-adjusted NPV
46. Real Time Systems Inc. is considering the development of one of two mutually exclusive new
computer models. Each will require a net investment of $5,000. The cash flow figures for each
project are shown below:
Period Project A Project B
1 $2,000 $3,000
2 2,500 2,600
3 2,250 2,900
Model B, which will use a new type of laser disk drive, is considered a high-risk project, while
Model A is of average risk. Real Time adds 2 percentage points to arrive at a risk-adjusted
discount rate when evaluating a high-risk project. The rate used for average risk projects is 12
percent. Which of the following statements regarding the NPVs for Models A and B is most
correct?
a. NPVA = $380; NPVB = $1,815.
b. NPVA = $197; NPVB = $1,590.
c. NPVA = $380; NPVB = $1,590.
d. NPVA = $5,380; NPVB = $6,590.
e. None of the above statements is correct.
ANS: C
Cash flow time lines:
Project A: kAverage risk = 12%.

Project B: kHigh risk = 12% + 2% = 14%.
A:
Inputs: = -5,000; = 2,000; = 2,500; = 2,250; I% = 12.
Output: NPV = $380.20 $380.
B:
Inputs: = -5,000; = 3,000; = 2,600; = 2,900; I% = 14.
Output: NPV = $1,589.61 $1,590.
DIF: Medium OBJ: TYPE: Problem TOP: Risk-adjusted NPV
47. The Unlimited, a national retailing chain, is considering an investment in one of two mutually
exclusive projects. The discount rate used for Project A is 12 percent. Further, Project A costs
$15,000, and it would be depreciated using MACRS. It is expected to have an after-tax salvage
value of $5,000 at the end of 6 years and to produce after-tax cash flows (including depreciation)
of $4,000 for each of the 6 years. Project B costs $14,815 and would also be depreciated using
MACRS. B is expected to have a zero salvage value at the end of its 6-year life and to produce
after-tax cash flows (including depreciation) of $5,100 each year for 6 years. The Unlimited's
marginal tax rate is 40 percent. What risk-adjusted discount rate will equate the NPV of Project B
to that of Project A?
a. 15%
b. 16%
c. 18%
d. 20%
e. 12%
ANS: B
Look across the row for 6 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.
A:
Inputs: = -15,000; = 4,000; Nj = 5; = 9,000; I = 12.
Output: NPV = $3,978.78.
B:
Inputs: = -18,793.78; = 5,100; Nj = 6.
Output: IRR = 15.997% ≈ 16%.
DIF: Medium OBJ: TYPE: Problem TOP: Risk-adjusted discount rate
48. Alabama Pulp Company (APC) can control its environmental pollution using either "Project Old
Tech" or "Project New Tech." Both will do the job, but the actual costs involved with Project
New Tech, which uses unproved, new state-of-the-art technology, could be much higher than the
expected cost levels. The cash outflows associated with Project Old Tech, which uses standard
proven technology, are less risky--they are about as uncertain as the cash flows associated with an
average project. APC's required rate of return for average risk projects normally is set at 12
percent, and the company adds 3 percent for high risk projects but subtracts 3 percent for low risk
projects. The two projects in question meet the criteria for high and average risk, but the financial
manager is concerned about applying the normal rule to such cost-only projects. You must decide
which project to recommend, and you should recommend the one with the lower PV of costs.
What is the PV of costs of the better project?
Cash Outflows
Years 0 1 2 3 4
Project New Tech 1,500 315 315 315 315
Project Old Tech 600 600 600 600 600
a. 2,521
b. 2,399
c. 2,457
d. 2,543
e. 2,422
ANS: E
Cash flow time line:
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%.
PVOld Tech is a smaller outflow than NPVNew Tech, thus, Project Old Tech is the better project.
Project New Tech
Inputs: = -1,500; = -315; Nj = 4; I = 9.
Output: NPV = -$2,520.51.
Project Old Tech
Inputs: = -600; = -600; Nj = 4; I = 12.
Output: NPV = -$2,422.41.
DIF: Medium OBJ: TYPE: Problem TOP: Discounting risky outflows
49. Arizona Rock, an all-equity firm, currently has a beta of 1.25, and kRF = 7 percent and kM = 14
percent. Suppose the firm sells 10 percent of its assets (beta = 1.25) and purchases the same
proportion of new assets with a beta of 1.1. What will be the firm's new overall required rate of
return, and what rate of return must the new assets produce in order to leave the stock price
unchanged?
a. 15.645%; 15.645%
b. 15.75%; 14.7%
c. 15.645%; 14.7%
d. 15.75%; 15.645%
e. 14.75%; 15.75%
ANS: C
β Old, firm = 1.25.
kOld, firm = 0.07 + (14 - 7)1.25 = 15.75%.
β New, firm = 0.9(1.25) + 0.1(1.1) = 1.235.
kNew, firm = 0.07 + 1.235(0.07) = 15.645%.
kNew, assets = 0.07 + 1.1(0.07) = 14.7%.
DIF: Medium OBJ: TYPE: Problem TOP: Required rate of return
50. Klott Company encounters significant uncertainty with its sales volume and price in its primary
product. The firm uses scenario analysis in order to determine an expected NPV, which it then
uses in its budget. The base case, best case, and worst case scenarios and probabilities are
provided in the table below. What is Klott's expected NPV, standard deviation of NPV, and
coefficient of variation of NPV?
Probability of Unit Sales Sales NPV
Outcome Volume Price (In Thousands)
Worst case 0.30 6,000 $3,600 -$6,000
Base case 0.50 10,000 4,200 +13,000
Best case 0.20 13,000 4,400 +28,000
a. Expected NPV = $35,000; σ NPV = 17,500; CVNPV = 2.0.
b. Expected NPV = $35,000; σ NPV = 11,667; CVNPV = 0.33.
c. Expected NPV = $10,300; σ NPV = 12,083; CVNPV = 1.17.
d. Expected NPV = $13,900; σ NPV = 8,476; CVNPV = 0.61.
e. Expected NPV = $10,300; σ NPV = 13,900; CVNPV = 1.35.
ANS: C
Calculate expected value of NPV:
Probability of
Unit Sales Sales NPV
Outcome, Volume Price (In 1000s)
Worst case 0.30 6,000 $3,600 -$6,000 0.3(-6,000) = -1,800
Base case 0.50 10,000 4,200 13,000 0.5(13,000) = 6,500
Best case 0.20 13,000 4,400 28,000 0.2(28,000) = 5,600
Expected NPV = $10,300
Calculate standard deviation of NPV:
Worst case 0.3(-6 - 10.3)2 265.69 79.707

Base case 0.5(13 - 10.3)2 7.29 3.645
Best case 0.2(28 - 10.3)2 313.29 62.658
Sum 146.01
(146.01)1/2 = 12,083 thousand.
Calculate coefficient of variation (CV) of NPV:
CVNPV = σ NPV/E(NPV) = 12,083/10,300 = 1.17.
DIF: Medium OBJ: TYPE: Problem TOP: Scenario analysis
51. Rucker Truck Line (RTL) is evaluating whether the fleet of trucks it owns should be replaced. If
the trucks are replaced, current operating revenues and expenses will not change, except for
depreciation expenses. Annual depreciation will increase from $150,000 to $175,000. Based on
this information, how will the change in depreciation expense affect the incremental operating
cash flows RTL examines when making its capital budgeting decision about replacing the trucks?
RTL's marginal tax rate is 40 percent.
a. After-tax operating cash flows will increase by $15,000.
b. After-tax operating cash flows will increase by $10,000.
c. After-tax operating cash flows will decrease by $25,000.
d. After-tax operating cash flows will decrease by $10,000.
e. Because depreciation is a non-cash expense, operating cash flows should not change.
ANS: B DIF: Medium OBJ: TYPE: Problem
52. Topsider Inc. is considering the purchase of a new leather-cutting machine to replace an existing
machine that has a book value of $3,000 and can be sold for $1,500. The old machine is being
depreciated on a straight-line basis, and its estimated salvage value 3 years from now is zero. The
new machine will reduce costs (before taxes) by $7,000 per year. The new machine has a 3-year
life, it costs $14,000, and it can be sold for an expected $2,000 at the end of the third year. The
new machine would be depreciated over its 3-year life using the MACRS method. Assuming a 40
percent tax rate and a required rate of return of 16 percent, find the new machine's NPV.
a. -$2,822
b. $1,658
c. $4,560
d. $15,374
e. $9,821
ANS: B
MACRS New Asset Old Asset Change in

Year Percent Depreciation Depreciation Depreciation
1 0.33 $4,620 $1,000 $3,620
2 0.45 6,300 1,000 5,300
3 0.15 2,100 1,000 1,100
4 0.07 980 -- 980
2) Sale of old machine 1,500*
3) Tax savings old machine 600
4) Total net inv. ($11,900)
*(3,000 - 1,500) = Loss; Loss × Tax rate = Savings; 1,500 × 0.40 = 600.
II Incremental operating cash flows

Year: 0 1 2 3
5) Reduction in cost $7,000 $7,000 $7,000
6) After-tax decrease in cost 4,200 4,200 4,200
(line 5 × 0.60)
7) Deprec. new machine 4,620 6,300 2,100
8) Deprec. old machine 1,000 1,000 1,000
9) Change in depreciation 3,620 5,300 1,100
(line 7 - 8)
10) Tax savings from deprec. 1,448 2,120 440
(line 9 × 0.40)
11) Net operating cash flows $5,648 $6,320 $4,640
(line 6 + 10)
III Terminal CF
(2,000 - 980)(0.4) (408)
15) Net CF 1,592
IV Net CFs
16) Total Net CFs ($11,900) $5,648 $6,320 $6,232
Inputs: = -11,900; = 5,648; = 6,320; = 6,232; I = 16.
Output: NPV = $1,658.33 $1,658.
Note: Tabular solution differs from calculator solution due to interest factor rounding.
DIF: Tough OBJ: TYPE: Problem TOP: Replacement decision
53. 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; they will be sold at their book value at the end of the 5th 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 required rate of return is 10
percent and its tax rate is 34 percent, what is the NPV of the broilers?
a. -$61,019
b. $17,972
c. $28,451
d. -$44,553
e. $5,021
ANS: A
Depreciation cash flows*:

MACRS New Asset Old Asset Change in
1 0.20 $40,000 $7,000 $33,000
2 0.32 64,000 7,000 57,000
3 0.19 38,000 7,000 31,000
4 0.12 24,000 7,000 17,000
5 0.11 22,000 7,000 15,000
6 0.06 12,000 -- 12,000
*Depreciation old equipment: 105,000/15 = 7,000 per year × 10 years = 70,000 in accumulated
depreciation.
Book value = $105,000

- 70,000
$ 35,000
Replacement analysis worksheet:
1) New equipment cost ($200,000)
2) Market value old equip. 60,000
3) Taxes on sale of old equip. (8,500)*
4) Increase in NWC --
*(Market value - Book value)(Tax rate)

(60,000 - 35,000) (0.34)

Year: 0 1 2 3 4 5
6) Increase in revenues $18,000 $18,000 $18,000 $18,000 $18,000
7) Increase in expenses (2,500) (2,500) (2,500) (2,500) (2,500)
8) AT change in earnings 10,230 10,230 10,230 10,230 10,230
((line 6 + 7) × 0.66)
9) Deprec. on new machine 40,000 64,000 38,000 24,000 22,000
10) Deprec. on old machine 7,000 7,000 7,000 7,000 7,000
11) Change in deprec. 33,000 57,000 31,000 17,000 15,000
(line 9 - 10)
12) Tax savings from deprec. 11,220 19,380 10,540 5,780 5,100
(line 11 × 0.34)
13) Net operating CFs $21,450 $29,610 $20,770 $16,010 $15,330
(line 8 + 12)
III Terminal CF
15) Tax on salvage value --
17) Net CF 12,000
IV Net CFs
18) Total Net CFs ($148,500) $21,450 $29,610 $20,770 $16,010 $27,330

Inputs: = -148,500; = 21,450; = 29,610; = 20,770; = 16,010; =
27,330; I = 10.
Output: NPV = -$61,019.29 -$61,019.
54. Mom's Cookies Inc. is considering the purchase of a new cookie oven. The original cost of the
old oven was $30,000; it is now 5 years old, and it has a current market value of $13,333.33. The
old oven is being depreciated over a 10-year life towards a zero estimated salvage value on a
straight line basis, resulting in a current book value of $15,000 and an annual depreciation
expense of $3,000. The old oven can be used for 6 more years but has no market value after its
depreciable life is over. Management is contemplating the purchase of a new oven whose cost is
$25,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the
new oven are $4,000 a year over its full MACRS depreciable life. Depreciation is computed using
MACRS over a 5-year life, and the required rate of return is 10 percent. Assume a 40 percent tax
rate. What is the net present value of the new oven?
a. -$2,418
b. -$1,731
c. $1,568
d. $163
e. $1,731
ANS: C

MACRS New Asset Old Asset Change In
1 0.20 $ 5,000 $ 3,000 $ 2,000
2 0.32 8,000 3,000 5,000
3 0.19 4,750 3,000 1,750
4 0.12 3,000 3,000 0
5 0.11 2,750 3,000 (250)
6 0.06 1,500 ______ 1,500
$25,000 $15,000 $10,000
Replacement analysis worksheet:
1) New equipment cost ($25,000.00)
2) Market value old equip. 13,333.33
3) Tax savings sale of old equip. 666.67*
5) Total net investment ($11,000.00)

($13,333.33 - $15,000) (0.4) = 666.67

Year: 0 1 2 3 4 5 6
6) Before-tax savings new equip. $4,000 $4,000 $4,000 $4,000 $4,000 $4,000
7) After-tax savings new equip. 2,400 2,400 2,400 2,400 2,400 2,400
(line 6 × 0.6)
8) Dep. new machine 5,000 8,000 4,750 3,000 2,750 1,500
9) Dep. old machine 3,000 3,000 3,000 3,000 3,000 0
10) Change in deprec. 2,000 5,000 1,750 0 (250) 1,500
(line 8 - 9)
11) Tax savings from deprec. 800 2,000 700 0 (100) 600
(line 10 × 0.4)
12) Net operating CFs $3,200 $4,400 $3,100 $2,400 $2,300 $3,000
(line 7 + 11)
III Terminal CF
13) Estimated salvage value 0
14) Net CF 0
IV Net CFs
15) Total Net CFs ($11,000) $3,200 $4,400 $3,100 $2,400 $2,300 $3,000

Inputs: = -11,000; = 3,200; = 4,400; = 3,100; = 2,400; = 2,300;
= 3,000; I = 10.
Output: NPV = $2,635.30 $2,635.
55. Tech Engineering Company is considering the purchase of a new machine to replace an existing
one. The old machine was purchased 5 years ago at a cost of $20,000, and it is being depreciated
on a straight line basis to a zero salvage value over a 10-year life. The current market value of the
old machine is $14,000. The new machine, which falls into the MACRS 5-year class, has an
estimated life of 5 years, it costs $30,000, and Tech plans to sell the machine at the end of the 5th
year for $1,000. The new machine is expected to generate before-tax cash savings of $3,000 per
year. The company's tax rate is 40 percent. What is the IRR of the proposed project?
a. 4.1%
b. 2.2%
c. 0.0%
d. -1.5%
e. -3.3%
ANS: C

MACRS New Old Change In
1 0.20 $ 6,000 $ 2,000 $ 4,000
2 0.32 9,600 2,000 7,600
3 0.19 5,700 2,000 3,700
4 0.12 3,600 2,000 1,600

5 0.11 3,300 2,000 1,300
6 0.06 1,800 ______ 1,800
$30,000 $10,000 $20,000
1) New asset cost ($30,000)
2) Sale of old asset 14,000
3) Tax on sale of old asset (1,600)*
*(Sale value - Book value)(Tax rate)

(14,000 - 10,000) (0.40)

Year: 0 1 2 3 4 5
6) Before-tax savings new asset $3,000 $3,000 $3,000 $3,000 $3,000
7) After-tax savings new asset
(line 6 × 0.6) 1,800 1,800 1,800 1,800 1,800
8) Deprec. new asset 6,000 9,600 5,700 3,600 3,300
9) Deprec. old asset 2,000 2,000 2,000 2,000 2,000
10) Change in deprec.
(line 8 - 9) 4,000 7,600 3,700 1,600 1,300
11) Tax savings from deprec.
(line 10 × 0.4) 1,600 3,040 1,480 640 520
13) Net operating CFs $3,400 $4,840 $3,280 $2,440 $2,320
(line 7 + 11)
III Terminal CF
(1,000 - 1,800)(0.4) 320
17) Net CF 1,320
IV Net CFs
18) Total Net CFs ($17,600) $3,400 $4,840 $3,280 $2,440 $3,640

Inputs: = -17,600; = 3,400; = 4,840; = 3,280; = 2,440; = 3,640.
Output: IRR = 0.0%.
DIF: Tough OBJ: TYPE: Problem TOP: IRR of replacement project
56. California Mining is evaluating the introduction of a new ore production process. Two
alternatives are available. Production Process A has an initial cost of $25,000, a 4-year life, and a
$5,000 net salvage value, and the use of Process A will increase net cash flow by $13,000 per
year for each of the 4 years that the equipment is in use. Production Process B also requires an
initial investment of $25,000, will also last 4 years, and its expected net salvage value is zero, but
Process B will increase net cash flow by $15,247 per year. Management believes that a risk-
adjusted discount rate of 12 percent should be used for Process A. If California Mining is to be
indifferent between the two processes, what risk-adjusted discount rate must be used to evaluate
B?
a. 8%
b. 10%
c. 12%
d. 14%
e. 16%
ANS: E

A:
Inputs: = -25,000; = 13,000; Nj = 3; = 18,000; I = 12.
Output: NPVA = 17,663.13.
B:
Inputs: = -42,663.13; = 15,247; Nj = 4.
Output: IRR = 16.0% = k.
DIF: Tough OBJ: TYPE: Problem TOP: Risk-adjusted discount rate
Exhibit 10-1
You have been asked by the president of your company to evaluate the proposed acquisition of a
new special-purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to
modify it for special use by your firm. The truck falls into the MACRS three-year class, and it
will be sold after three years for $20,000. Use of the truck will require an increase in net working
capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is
expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm's
marginal tax rate is 40 percent.
57. Refer to Exhibit 10-1. What is the initial investment outlay for the truck? (That is, what is the
Year 0 net cash flow?)
a. -$50,000
b. -$52,600
c. -$55,800
d. -$62,000
e. -$65,000
ANS: D
Initial investment outlay:
Cost ($50,000)
Modification (10,000)
Change in NWC (2,000)
Total net investment = ($62,000)
DIF: Easy OBJ: TYPE: Problem TOP: New project investment
58. Refer to Exhibit 10-1. What is the incremental operating cash flow in Year 1?
a. $17,820
b. $18,254
c. $19,920
d. $20,121
e. $21,737
ANS: C
Depreciation schedule:
Depreciable basis = $60,000.
1 0.33 $60,000 $19,800
2 0.45 60,000 27,000
3 0.15 60,000 9,000
4 0.07 60,000 4,200
$60,000
Incremental operating cash flows:
Year 1 2 3
1) Before-tax cost reduction $20,000 $20,000 $20,000
2) After-tax cost reduction
(line 1 × 0.6) 12,000 12,000 12,000
3) Depreciation 19,800 27,000 9,000
4) Tax savings from deprec.

(line 3 × 0.4) 7,920 10,800 3,600
5) Net operating CFs $19,920 $22,800 $15,600
DIF: Medium OBJ: TYPE: Problem TOP: Operating cash flows
59. Refer to Exhibit 10-1. What is the terminal (nonoperating) cash flow at the end of Year 3?
a. $10,000
b. $12,000
c. $15,680
d. $16,000
e. $18,000
ANS: C
Terminal cash flow:
3
Salvage value $20,000
Tax on salvage value (6,320)*
Recovery of NWC 2,000
Total terminal CF $15,680
($20,000 - $4,200) (0.40)
DIF: Medium OBJ: TYPE: Problem TOP: Non-operating cash flows
60. Refer to Exhibit 10-1. The truck's required rate of return is 10 percent. What is its NPV?
a. -$1,547
b. -$562
c. $0
d. $562
e. $1,034
ANS: A

Inputs: = -62,000; = 19,920; = 22,800; = 31,280; I = 10.
Output: NPV = -$1,546.81 -$1,547.
Financial Calculator Section
The following question(s) may require the use of a financial calculator.

61. Your company must ensure the safety of its work force. Two plans are being considered for the
next 10 years: (1) Install a high electrified fence around the property at a cost of $100,000.
Maintenance and electricity would then cost $5,000 per year over the 10-year life of the fence. (2)
Hire security guards at a cost of $25,000 paid at the end of each year. Because the company plans
to build new headquarters with a "state of the art" security system in 10 years, the plan will only
be in effect until that time. Your company's required rate of return is 15 percent for average
projects, and that rate is normally adjusted up or down by 2 percentage points for high- and low-
risk projects. Plan 1 is considered to be of low risk because its costs can be predicted quite
accurately. Plan B, on the other hand, is a high-risk project because of the difficulty of predicting
wage rates. What is the proper PV of costs for the better project?
a. -$104,266.20
b. -$116,465.09
c. -$123,293.02
d. -$127,131.22
e. -$135,656.09
ANS: C
With a financial calculator input the following:

= -100,000
= -5,000
I = 17%
Solve for NPV1 = -$123.293.02.
With a financial calculator input the following:

=0
= -25,000
I = 13%
Solve for NPV2 = -$135,656.09.
Note that because we are dealing with cash outflows, the higher-risk project's discount rate must
be lowered, while the lower-risk project's discount rate must be increased. Thus, Plan 1 has the
lower costs and should be accepted.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Present value of costs
62. Mid-State Electric Company must clean up the water released from its generating plant. The
company's required rate of return is 10 percent for average projects, and that rate is normally
adjusted up or down by 2 percentage points for high- and low-risk projects. Clean-up Plan A,
which is of average risk, has an initial cost of -$1,000 at time 0, and its operating cost will be -
$100 per year for its 10-year life. Plan B, which is a high-risk project, has an initial cost of -$300,
and its annual operating cost over Years 1 to 10 will be -$200. What is the proper PV of costs for
the better project?
a. -$1,430.04
b. -$1,525.88
c. -$1,614.46
d. -$1,642.02
e. -$1,728.19
ANS: C
The first thing to note is that risky cash outflows should be discounted at a lower discount rate, so
in this case we would discount the riskier Project B's cash flows at 10% - 2% = 8%. Project A's
cash flows would be discounted at 10%.
Now we would find the PV of the costs as follows:
Project A
= -1,000
= -100
I = 10.0%
Solve for NPV = -$1,614.46.
Project B
= -300
= -200
I = 8.0%
Solve for NPV = -$1,642.02.
Project A has the lower PV of costs. If Project B had been evaluated with a 12% cost of capital,
its PV of costs would have been -$1,430.04, but that would have been wrong.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: Discounting risky outflows
63. Your company is considering a machine that will cost $1,000 at Time 0 and which can be sold
after 3 years for $100. To operate the machine, $200 must be invested at Time 0 in inventories;
these funds will be recovered when the machine is retired at the end of Year 3. The machine will
produce sales revenues of $900/year for 3 years; variable operating costs (excluding depreciation)
will be 50 percent of sales. Operating cash inflows will begin 1 year from today (at Time 1). The
machine will have depreciation expenses of $500, $300, and $200 in Years 1, 2, and 3,
respectively. The company has a 40 percent tax rate, enough taxable income from other assets to
enable it to get a tax refund from this project if the project's income is negative, and a 10 percent
required rate of return. Inflation is zero. What is the project's NPV?
a. $6.24
b. $7.89
c. $8.87
d. $9.15
e. $10.41
ANS: B
0 1 2 3
Sales $900 $900 $900

Costs (450) (450) (450)
Deprn (500) (300) (200)
EBT ($ 50) $150 $250
Taxes (40%) 20 (60) (100)
Net income ($ 30) $ 90 $150
Add deprn 500 300 200
$470 $390 $350
Cost (1,000)
Inventory (200)
Salvage value 100
Tax on SV (40)
Ret. of inv. ____ ____ ____ 200
(1,200) $470 $390 $610
DIF: Medium OBJ: TYPE: Financial Calculator TOP: New project NPV
64. Your company is considering a machine which will cost $50,000 at Time 0 and which can be sold
after 3 years for $10,000. $12,000 must be invested at Time 0 in inventories and receivables;
these funds will be recovered when the operation is closed at the end of Year 3. The facility will
produce sales revenues of $50,000/year for 3 years; variable operating costs (excluding
depreciation) will be 40 percent of sales. No fixed costs will be incurred. Operating cash inflows
will begin 1 year from today (at t = 1). By an act of Congress, the machine will have depreciation
expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and 3 respectively. The company has a 40
percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this
project if the project's income is negative, and a 15 percent required rate of return. Inflation is
zero. What is the project's NPV?
a. $7,673.71
b. $12,851.75
c. $17,436.84
d. $24,989.67
e. $32,784.25
ANS: A
Purchase (50,000)
Sales 50,000 50,000 50,000
-VC (20,000) (20,000) (20,000)
-Deprec. (40,000) (5,000) (5,000)
EBT (10,000) 25,000 25,000
-Taxes 4,000 (10,000) (10,000)
Net income (6,000) 15,000 15,000
+Depreciation 40,000 5,000 5,000

34,000 20,000 20,000
NWC (12,000) 12,000
RV(AT) 6,000
NCF (62,000) 34,000 20,000 38,000
NPV15% = $7,673.71.
DIF: Medium OBJ: TYPE: Financial Calculator TOP: New project NPV
65. After a long drought, the manager of Long Branch Farm is considering the installation of an
irrigation system which will cost $100,000. It is estimated that the irrigation system will increase
revenues by $20,500 annually, although operating expenses other than depreciation will also
increase by $5,000. The system will be depreciated using MACRS over its depreciable life (5
years) to a zero salvage value. If the tax rate on ordinary income is 40 percent, what is the
project's IRR?
a. 12.6%
b. -1.3%
c. 13.0%
d. 10.2%
e. -4.8%
ANS: B

1 0.20 $100,000 $ 20,000
2 0.32 100,000 32,000
3 0.19 100,000 19,000
4 0.12 100,000 12,000
5 0.11 100,000 11,000
6 0.06 100,000 6,000
$100,000
2) Decrease in NWC --
3) Total net inv. ($100,000)

Year: 0 1 2 3 4 5 6
4) Inc. in before tax & depr. $15,500 $15,500 $15,500 $15,500 $15,500 $15,500
earnings
5) After-tax inc. in revenues 9,300 9,300 9,300 9,300 9,300 9,300
6) Depr. (from table) 20,000 32,000 19,000 12,000 11,000 6,000

7) Tax savings deprec.
(line 6 × 0.4) 8,000 12,800 7,600 4,800 4,400 2,400
(line 5 + 7) $17,300 $22,100 $16,900 $14,100 $13,700 $11,700
II Terminal CF
I
9) Estimated salvage value 0
10) Tax on salvage value 0
11) Return of NWC 0
12) Net CF 0
IV Net CFs
13) Total Net CFs ($100,000) $17,300 $22,100 $16,900 $14,100 $13,700 $11,700

Inputs: = -100,000; = 17,300; = 22,100; = 16,900; = 14,100; =
13,700; = 11,700; I = 12.
Output: IRR = -1.32%
DIF: Tough OBJ: TYPE: Financial Calculator TOP: New project IRR

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CHAPTER 10—PROJECT CASH FLOWS AND RISK

Project analysis worksheet:

II Incremental operating flows: Year: 0 1 2 3

8) Net operating flows

III Terminal cash flow:

IV Net cash flows:

Depreciation cash flows:

I Initial investment outlay

II Incremental operating cash flows:

Financial calculator solution:

Depreciation cash flows:

1 0.20 $40,000 $ 8,000

II Incremental operating cash flows:

Financial calculator solution:

d. 18% and 13%

kProject = 6% + 4%(1.5) = 12%.

Cash flow time lines:

Project A: kAverage risk = 12%.

Cash flow time line:

Worst case 0.3(-6 - 10.3)2 265.69 79.707

MACRS New Asset Old Asset Change in

II Incremental operating cash flows

Depreciation cash flows*:

Book value = $105,000

*(Market value - Book value)(Tax rate)

II Incremental operating cash flows

Financial calculator solution:

Depreciation cash flows:

*(Market value - Book value)(Tax rate)

II Incremental operating cash flows

Financial calculator solution:

Depreciation cash flows:

4 0.12 3,600 2,000 1,600

*(Sale value - Book value)(Tax rate)

II Incremental operating cash flows

Financial calculator solution:

Financial calculator solution:

4) Tax savings from deprec.

Financial calculator solution:

Financial Calculator Section

The following question(s) may require the use of a financial calculator.

With a financial calculator input the following:

With a financial calculator input the following:

Sales $900 $900 $900

+Depreciation 40,000 5,000 5,000

Depreciation cash flows:

II Incremental operating cash flows

6) Depr. (from table) 20,000 32,000 19,000 12,000 11,000 6,000

Financial calculator solution:

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