1 CORRECTCapital budgeting analysis focuses on profits as opposed to cash flows.

A)True

B)False

Feedback: When making capital budgeting decisions, financial manager should prepare cash-flow estimates for use in net present value analysis.

2 CORRECTMACRS places assets into one of six classes, each of which has an assumed life. Most industrial equipment falls into the 5- and 7-year classes.

A)True

B)False

3 INCORRECT Projects that are calculated as having negative NPVs should be:

A)depreciated over a longer time period.

B)charged less in overhead costs.

C)discounted using lower rates.

D)rejected or abandoned.

Feedback: Projects that are calculated as having negative NPVs should be rejected or abandoned.

4 INCORRECT The value of a proposed capital budgeting project depends upon the:

A)total cash flows produced.

B)incremental cash flows produced.

C)

accounting profits produced.

D)increase in total sales produced.

Feedback: The value of a proposed capital budgeting project depends upon the incremental cash flows produced.

5 INCORRECT When is it appropriate to include sunk costs in the evaluation of a project?

A)Include sunk costs when they are relatively large.

B)Include sunk costs if it improves the project's NPV.

C)Include sunk costs if they are considered to be overhead costs.

D)It is never appropriate to include sunk costs.

Feedback: It is never appropriate to include sunk costs in the evaluation of a project.

6 INCORRECT Assume your firm has an unused machine that originally cost $75,000, has a book

value of $20,000, and is currently worth $25,000. Ignoring taxes, the correct opportunity cost for this machine in capital budgeting decisions is:

A)$75,000

B)$25,000

C)$20,000

D)$5,000

Feedback: The opportunity cost for the machine in capital budgeting decisions is its current market value.

7 CORRECTIf a project is expected to increase inventory by $15,000, increase accounts payable by $10,000, and decrease accounts receivable by $1,000, what effect does working capital have during the life of the project?

A)Increases investment by $4,000.

B)Increases investment by $5,000.

C)Increases investment by $6,000.

D)Working capital has no effect during the life of the project.

Feedback: Working capital is defined to be the difference between current assets and current liabilities. Therefore, working capital increases by (15,000 – 1,000 – 10,000), or 4,000.

8 CORRECTWhich of the following methods will provide a correct analysis for capital budgeting purposes?

A)Discounting real cash flows with real rates.

B)Discounting real cash flows with nominal rates.

C)Discounting nominal cash flows with real rates.

D)All of the above methods will provide similar results.

Feedback: Discounting real cash flows with real rates will provide a correct analysis for capital budgeting purposes.

9 CORRECTYour forecast shows $500,000 annually in sales for each of the next three years. If your second and third year predictions have failed to incorporate 2.5% expected annual inflation, how far off in total dollars is your three-year forecast?

A)$37,813

B)$50,000

C)$52,550

D)$76,250

Feedback:

10 INCORRECT In what manner does depreciation expense affect investment projects?

A)It reduces cash flows by the amount of the depreciation expense.

B)It increases interest expense by the amount of the depreciation expense.

C)It reduces taxable income by the amount of the depreciation expense.

D)It reduces taxes by the amount of the depreciation expense.

Feedback: Depreciation expense reduces taxable income by the amount of itself.

11 INCORRECT For a profitable firm in the 35% marginal tax bracket with $100,000 of annual

depreciation expense, the depreciation tax shield would be:

A)$10,500

B)$30,000

C)$35,000

D)$65,000

Feedback: Depreciation expense reduces taxable income by the amount of itself. In this question, the depreciation tax shield, or the reduced tax due to the reduced taxable income, is 100,000 x 35%, or 35,000.

12 INCORRECT What is the amount of the operating cash flow for a firm with $500,000 profit

before tax, $100,000 depreciation expense, and a 35% marginal tax rate?

A)

$260,000

B)$325,000

C)$360,000

D)$425,000

Feedback:

13 INCORRECT The Modified Accelerated Cost Recovery System allows an increase:

A)in total depreciation over the asset's life.

B)in annual depreciation during earlier years.

C)in real but not nominal depreciation expense.

D)in the number of years in each recovery class.

Feedback: The Modified Accelerated Cost Recovery System allows an increase in annual depreciation during earlier years.

14 INCORRECT When a depreciable asset is ultimately sold, the sales price is:

A)fully taxable.

B)non-taxable.

C)not taxable only if accelerated depreciation was used.

D)taxable if sales price exceeds book value.

Feedback: When a depreciable asset is ultimately sold, the sales price is taxable if sales price exceeds book value.

15 INCORRECT Which of the following is not accurate in depicting cash flows from operations?

A)(revenues - expenses)(1 - tax rate) + (depreciation)

B)Applying "Dollars in Minus Dollars Out" rule!

C)(net income + depreciation)

D)(revenues - cash expenses - taxes paid)

Feedback:Take only the items from the income statement that represent actual cash flows. This means that you start with cash revenues and subtract cash expenses and taxes paid. You do not, however, subtract a charge for depreciation because this does not involve cash going out the door. Thus, Operating cash flow = revenues - cash expenses - taxes

16 INCORRECT Which of the following is not correct when we calculate the cash flows of a

proposed new project?a. Discount cash flows, not profits.b. Estimate the project's incremental cash flows—that is, the difference between the cash flows with the project and those without the project.c. Include all indirect effects of the project, such as its impact on the sales of the firm's other products.d. Count sunk costs.

A)a.

B)b.

C)c.

D)d.

Feedback: When we calculate the cash flows of a proposed new project, we should ignore sunk costs completely.

17 INCORRECT Which of the following are incorrect when we calculate the cash flows of a

proposed new project?

a. Include opportunity costs, such as the value of land that you could otherwise sell.b. Beware of allocated overhead charges for heat, light, and so on. These may not reflect the marginal effects of the project on these costs.c. Remember the investment in working capital. As sales increase, the firm may need to make additional investments in working capital, and as the project finally comes to an end, it will recover these investments.d. Treat inflation consistently. If cash flows are forecast in nominal terms (including the effects of future inflation), use a nominal discount rate. Discount real cash flows at a real rate.e. Do not include debt interest or the cost of repaying a loan. When calculating NPV, assume that the project is financed entirely by the shareholders and that they receive all the cash flows. This separates the investment decision from the financing decision.

A)a.

B)b.

C)c and d.

D)e.

18 INCORRECT Which of the following is not correct regarding cash flows of a project?

a. Project cash flow does not equal profit. You must allow for changes in working capital as well as noncash expenses such as depreciation. b. If you use a nominal cost of capital, consistency requires that you forecast nominal cash flows—that is, cash flows that recognize the effect of inflation.

A)a.

B)b.

C)a and b.

D)neither a nor b is incorrect.

Feedback: Both statements are correct.

19 INCORRECT Which of the following is incorrect regarding a company's tax bill and

depreciation?a. Depreciation is not a cash flow. However, because depreciation reduces taxable income, it reduces taxes. 

b. The tax reduction caused by depreciation is called the depreciation tax shield. c. Modified accelerated cost recovery system (MACRS) depreciation schedules allow more of the depreciation allowance to be taken in early years than is possible under straight-line depreciation. This increases the present value of the tax shield.

A)a.

B)b.

C)c.

D)d.

20 INCORRECT How do changes in working capital affect project cash flows?

A)Increases in net working capital such as accounts receivable or inventory are investments and therefore use cash.

B)Increases in net working capital reduce the net cash flow provided by the project in that period.

C)When working capital is run down, cash is freed up, so cash flow increases.

D)All of the above are correct.

Feedback: Increases in net working capital such as accounts receivable or inventory are investments and therefore use cash—that is, they reduce the net cash flow provided by the project in that period. When working capital is run down, cash is freed up, so cash flow increases.