Chapter 7 Fundamentals of Capital Budgeting 7.1 Forecasting Earnings 1) Which of the following statements is false? A) A capital budget lists the projects and investments that c company plans to undertake during the coming year. B) Income Tax = EBIT × (1 - τc). C) When sales of a new product displace sales of an existing product, the situation is often referred to as cannibalization. D) Overhead expenses are often allocated to the different business activities for accounting purposes. Answer: B Diff: 1 Skill: Conceptual 2) Which of the following statements is false? A) Sales will ultimately decline as the product nears obsolescence or faces increased competition. B) Managers sometimes continue to invest in a project that has a negative NPV because they have already invested a large amount in the project and feel that by not continuing it, the prior investment will wasted. C) With straight-line depreciation the asset’s cost is divided equally over its life. D) A projects unlevered net income is equal to its incremental revenues less costs and depreciation, evaluated on an pre-tax basis. Answer: D Diff: 1 Skill: Conceptual 3) Which of the following statements is false? A) We begin the capital budgeting process by determining the incremental earnings of a project. B) The marginal corporate tax rate is the tax rate the firm will pay on an incremental dollar of pre-tax income. C) Investments in plant, property, and equipment are directly listed as expense when calculating earnings. D) The opportunity cost of using a resource is the value it could have provided in its best alternative use. Answer: C Diff: 1 Skill: Conceptual Chapter 7 Fundamentals of Capital Budgeting 145 4) Which of the following statements is false? A) When evaluating a capital budgeting decision, the correct tax rate to use is the firm’s average corporate tax rate. B) To determine the capital budget, firms analyze alternative projects and decide which ones to accept through a process called capital budgeting. C) A new product typically has lower sales initially, as customers gradually become aware of the product. D) Sunk costs have been or will be paid regardless of the decision whether or not to proceed with the project. Answer: A Diff: 2 Skill: Conceptual 5) Which of the following statements is false? A) Because value is lost when a resource is used by another project, we should include the opportunity cost as an incremental cost of the project. B) Sunk costs are incremental with respect to the current decision regarding the project and should be included in its analysis. C) Overhead expenses are associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the corporation. D) When computing the incremental earnings of an investment decision, we should include all changes between the firm’s earnings with the project versus without the project. Answer: B Diff: 2 Skill: Conceptual 6) Which of the following statements is false? A) The firm deducts a fraction of the investments in plant, property, and equipment each year as depreciation. B) If securities are fairly priced, the net present value of a fixed set of cash flows is independent of how those cash flows are financed. C) Sunk cost fallacy is a term used to describe the tendency of people to ignore sunk costs in capital budgeting analysis. D) A good rule to remember is that if our decision does not affect a cash flow then the cash flow should not affect our decision. Answer: C Diff: 2 Skill: Conceptual 146 Berk/DeMarzo · Corporate Finance 7) Which of the following statements is false? A) The ultimate goal in capital budgeting is to determine the effect of the decision to take a particular project on the firmʹs cash flows. B) To the extent that overhead costs are fixed and will be incurred in any case, they are incremental to the project and should be included in the capital budgeting analysis. C) Unlevered Net Income = (Revenue - Costs - Depreciation) × (1 - τc). D) Earnings are not cash flows. Answer: B Diff: 2 Skill: Conceptual 8) Which of the following statements is false? A) Project externalities are direct effects of the project that may increase of decrease the profits of other business activities of the firm. B) Incremental earnings are the amount by which the firmʹs earnings are expected to change as a result of the investment decision. C) The average selling price of a product and its cost of production will generally change over time. D) Any money that has already been spent is a sunk cost and therefore irrelevant in the capital budgeting process. Answer: A Diff: 3 Skill: Conceptual 9) Which of the following statements is false? A) Many projects use a resource that the company already owns. B) When evaluating a capital budgeting decision, we generally include interest expense. C) Only include as incremental expenses in your capital budgeting analysis the additional overhead expenses that arise because of the decision to take on the project. D) As a practical matter, to derive the forecasted cash flows of a project, financial managers often begin by forecasting earnings. Answer: B Diff: 2 Skill: Conceptual Chapter 7 Fundamentals of Capital Budgeting 147 10) Which of the following statements is false? A) The simplest method used to calculate depreciation is the straight-line method. B) A sunk cost is any unrecoverable cost for which the firm is already liable. C) Unlevered Net Income = EBIT × τc. D) The decision to continue or abandon should be based only on the incremental costs and benefits of the project going forward. Answer: C Diff: 1 Skill: Conceptual 11) Which of the following costs would you consider when making a capital budgeting decision? A) Sunk cost B) Opportunity cost C) Interest expense D) Fixed overhead cost Answer: B Diff: 1 Skill: Conceptual 12) A decrease in the sales of a current project because of the launching of a new project is A) cannibalization. B) a sunk cost. C) an overhead expense. D) irrelevant to the investment decision. Answer: A Diff: 1 Skill: Definition 13) Money that has been or will be paid regardless of the decision whether or not to proceed with the project is A) cannibalization. B) considered as part of the initial investment in the project. C) an opportunity cost. D) a sunk cost. Answer: D Diff: 1 Skill: Definition 148 Berk/DeMarzo · Corporate Finance 14) The value of currently unused warehouse space that will be used as part of a new capital budgeting project is A) an opportunity cost. B) irrelevant to the investment decision. C) an overhead expense. D) a sunk cost. Answer: A Diff: 1 Skill: Definition Use the information for the question(s) below. Ford Motor Company is considering launching a new line of hybrid Diesel-Electric SUVs. The heavy advertising expenses associated with the new SUV launch would generate operating losses of $35 million next year. Without the new SUV, Ford expects to earn pre-tax income of $80 million from operations next year. Ford pays a 30% tax rate on its pre-tax income. 15) The amount that Ford Motor Company owe in taxes next year without the launch of the new SUV is closest to: A) $24.0 million B) $56.0 million C) $31.5 million D) $13.5 million Answer: A Explanation: A) = $80 × .30 = $24 million Diff: 1 Skill: Analytical 16) The amount that Ford Motor Company owe in taxes next year with the launch of the new SUV is closest to: A) $13.5 million B) $31.5 million C) $56.0 million D) $24.0 million Answer: A Explanation: A) = (80 - 35) × .30 = 13.5 million Diff: 1 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 149 Use the information for the question(s) below. Food For Less (FFL), a grocery store, is considering offering one hour photo developing in their store. The firm expects that sales from the new one hour machine will be $150,000 per year. FFL currently offers overnight film processing with annual sales of $100,000. While many of the one hour photo sales will be to new customers, FFL estimates that 60% of their current overnight photo customers will switch and use the one hour service. 17) The level of incremental sales associated with introducing the new one hour photo service is closest to: A) $90,000 B) $150,000 C) $60,000 D) $120,000 Answer: A Explanation: A) = $150,000 - (cannibalized sales) = 150000 - .60 × 100,000 = $90,000 Diff: 2 Skill: Analytical 18) Suppose that of the 60% of FFLʹs current overnight photo customers, half would start taking their film to a competitor that offers one hour photo processing if FFL fails to offer the one hour service. The level of incremental sales in this case is closest to: A) $60,000 B) $150,000 C) $90,000 D) $120,000 Answer: D Explanation: D) = $150,000 - (cannibalized sales) = 150000 - (.60 × .50) × 100,000 = $120,000 Note that the rate of cannibalization is only 30% (.60 × .50) since the other 30% would have taken their film elsewhere. Diff: 2 Skill: Analytical 150 Berk/DeMarzo · Corporate Finance Use the information for the question(s) below. Glucose Scan Incorporated (GSI) currently sells its latest glucose monitor, the Glucoscan 3000, to diabetic patients for $129. GSI plans on lowering their price next year to $99 per unit. The cost of goods sold for each Glucoscan unit is $50, and GSI expects to sell 100,000 units over the next year. 19) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales over the next year by 30% to 130,000 units. The incremental impact of this price drop on the firms EBIT is closest to: A) a decline of 1.5 million B) an increase of 1.5 million C) a decline of 2.4 million D) an increase of 2.4 million Answer: A Explanation: A) Without price cut = 100,000 units × ($129 - 50) = $7,900,000 With price cut = 130,000 units × ($99 - 50) = $6,370,000 So, incremental = 6,370,000 - 7,900,000 = -1,530,000 Diff: 2 Skill: Analytical 20) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales over the next year by 30% to 130,000 units. Also suppose that for each Glucoscan monitor sold, GSI expects additional sales of $100 per year on glucose testing strips and these strips have a gross profit margin of 75%. Considering the increase in the sale of testing strips, the incremental impact of this price drop on the firms EBIT is closest to: A) A decline of 1.5 million B) Adecline of 0.7 million C) An increase of 0.7 million D) An increase of 1.5 million Answer: C Explanation: C) Without Price Cut Monitor sales = 100,000 × ($129 - $50) = $7,900,000 Strip sales = 100,000 × ($100 - $25) = $7,500,000 Total EBIT = 7,900,000 + 7,500,000 = 15,400,000 With Price Cut Monitor sales = 130,000 × ($99 - $50) = $6,370.000 Strip sales = 130,000 × ($100 - $25) = $9,750,000 Total EBIT = 6,370,000 + 9,750,000 = 16,120,000 Incremental = 16,120,000 - 15,400,000 = 720,000 Diff: 3 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 151 Use the information for the question(s) below. The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital of 10%. 21) The incremental EBIT in the first year for the Sisyphean Corporationʹs project is closest to: A) $18,000 B) $8,000 C) $11,700 D) $5,200 Answer: B Explanation: B) Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000 / 3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657 Diff: 3 Skill: Analytical 152 Berk/DeMarzo · Corporate Finance 22) The incremental unlevered net income in the first year for the Sisyphean Corporationʹs project is closest to: A) $8,000 B) $18,000 C) $5,200 D) $11,700 Answer: C Explanation: C) Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000 / 3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657 Diff: 3 Skill: Analytical 23) The depreciation tax shield for the Sisyphean Corporationʹs project in the first year is closest to: A) $8,000 B) $3,500 C) $2,800 D) $5,200 Answer: B Explanation: B) Depreciation tax shield = depreciation × τc = (30000/3) × .35 = $3,500 Diff: 2 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 153 24) The amount of incremental income taxes that the Sisyphean Company will pay in the first year on this new project is closest to: A) $6,300 B) $5,200 C) $3,500 D) $2,800 Answer: D Explanation: D) Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000 / 3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657 Diff: 2 Skill: Analytical 25) What is a sunk cost? Should it be included in the incremental cash flows for a project? Why or why not? Answer: A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs will have to be paid regardless of the decision whether or not to proceed with the project. Therefore, sunk costs are not incremental with respect to the current decision regarding the project and should not be included in its analysis. Diff: 2 Skill: Conceptual 26) What is an opportunity cost? Should it be included in the incremental cash flows for a project? Why or why not? Answer: Many projects use resources that the company already owns. An opportunity cost is the cost of using a resource that otherwise could have provided value to the firm. The opportunity cost of using a resource is the value it could have provided in its best alternative use. Because this value is lost when a resource is used by another project, we should always include the opportunity cost as an incremental cost of the project. Diff: 2 Skill: Conceptual 154 Berk/DeMarzo · Corporate Finance Use the information for the question(s) below. The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital of 10%. 27) Construct a simple income statement showing the incremental EBIT and the incremental unlevered net income for all three years of the Sisyphean Companies project. Answer: Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000 / 3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657 Diff: 3 Skill: Analytical 7.2 Determining Free Cash Flow and NPV 1) Which of the following statements is false? A) Depreciation is not a cash expense paid by the firm. B) Net Working Capital = Cash + Inventory + Payables - Receivables. C) Since 1997, companies can ʺcarry backʺ losses for two years and ʺcarry forwardʺ losses for 20 years. D) Earnings do not represent real profits. Answer: B Diff: 2 Skill: Conceptual Chapter 7 Fundamentals of Capital Budgeting 155 2) Which of the following questions is false? A) Net Working Capital = Current Assets - Current Liabilities. B) Because depreciation is not a cash flow, we do not include it in the cash flow forecast. C) Tax loss carry backs allow corporations to take losses during the current year and use them to offset income in future years. D) Earnings are an accounting measure of firm performance. Answer: C Diff: 1 Skill: Conceptual 3) Which of the following statements is false? A) Depreciation is a method used for accounting and tax purposes to allocate the original purchase cost of the asset over its life. B) Sometimes the firm explicitly forecast free cash flow over a shorter horizon than the full horizon of the project or investment. C) Earnings include the cost of capital investments, but do not include non-cash charges, such as depreciation. D) Firms often report a different depreciation expense for accounting and for tax purposes. Answer: C Diff: 1 Skill: Conceptual 4) Which of the following statements is false? A) Most projects will require the firm to invest in net working capital. B) The main components of net working capital are cash, inventory, receivables, and property, plant and equipment. C) ΔNWCt = NWCt - NWCt - 1. D) In the final year of a project, the firm ultimately recovers the investment in net working capital. Answer: B Diff: 1 Skill: Conceptual 5) Which of the following statements is false? A) Depreciation expenses have a positive impact on free cash flow. B) Free Cash Flow = (Revenues - Costs - Depreciation) × (1 - τc) - Capital Expenditures - ΔNWC + τc × Depreciation. C) The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay dividends to shareholders. D) The depreciation tax shield is the tax savings that results from the ability to deduct depreciation. Answer: B Diff: 2 Skill: Conceptual 156 Berk/DeMarzo · Corporate Finance 6) Which of the following statements is false? A) Because only the tax consequences of depreciation are relevant for free cash flow, we should use the depreciation expense that the firm will use for tax purposed in our free cash flow forecasts. B) A firm generally identifies its marginal tax rate by determining the tax bracket that it falls into based on its overall level of pre-tax income. C) Free Cash Flow = (Revenues - Costs) × (1 - τc) - Capital Expenditures - ΔNWC + τc × Depreciation. D) Net working capital is the difference between current liabilities and current assets. Answer: D Diff: 2 Skill: Conceptual 7) Which of the following statements is false? A) The terminal of continuation value of the project represents the market value (as of the last forecast period) of the free cash flow from the project at all future dates. B) The incremental effect of a project on the firm’s available cash is the projectʹs free cash flow. C) (1 - τc) × Depreciation is called the depreciation tax shield. D) To evaluate a capital budgeting decision, we must determine its consequences for the firmʹs available cash. Answer: C Diff: 2 Skill: Conceptual 8) Which of the following cash flows are relevant incremental cash flows for a project that you are currently considering investing in? A) The tax savings brought about by the projects depreciation expense. B) The cost of a marketing survey you conducted to determine demand for the proposed project. C) Interest payments on debt used to finance the project. D) Research and Development expenditures you have made. Answer: A Diff: 2 Skill: Conceptual Chapter 7 Fundamentals of Capital Budgeting 157 9) Your firm is considering building a new office complex. Your firm already owns land suitable for the new complex. The current book value of the land is $100,000, however a commercial real estate again has informed you that an outside buyer is interested in purchasing this land and would be willing to pay $650,000 for it. When calculating the NPV of your new office complex, ignoring taxes, the appropriate incremental cash flow for the use of this land is: A) $650,000 B) $0 C) $100,000 D) $750,000 Answer: A Explanation: A) It is appropriate to use the market value. If taxes are include, the value would be the after-tax value of the land. Diff: 2 Skill: Definition 10) You are considering adding a micro brewery on to one of your firmʹs existing restaurants. This will entail an increase in inventory of $8,000, an increase in accounts payables of $2,500, and an increase in property, plant, and equipment of $40,000. All other accounts will remain unchanged. The change in net working capital resulting from the addition of the micro brewery is: A) $45,500 B) $10,500 C) $6,500 D) $5,500 Answer: D Explanation: D) NWC = CA - CL = $8000 - $2500 = $5500 Diff: 1 Skill: Analytical 11) You are considering adding a micro brewery on to one of your firmʹs existing restaurants. This will entail an investment of $40,000 in new equipment. This equipment will be depreciated straight line over five years. If your firmʹs marginal corporate tax rate is 35%, then what is the value of the micro breweryʹs depreciation tax shield in the first year of operation? A) $2,800 B) $14,000 C) $5,200 D) $26,000 Answer: A Explanation: A) First figure out the straight line depreciation. $40,000 / 5 years = $8000 depreciation per year. Then .35 × $8000 = $2,800 depreciation tax shield per year. Diff: 2 Skill: Analytical 158 Berk/DeMarzo · Corporate Finance 12) The Sisyphean Company is considering a new project that will have an annual depreciation expense of $2.5 million. If Sisypheanʹs marginal corporate tax rate is 40% and their average corporate tax rate is 30%, then what is the value of the depreciation tax shield on their new project? A) $750,000 B) $1,000,000 C) $1,500,000 D) $1,750,000 Answer: B Explanation: B) Here we need to use the marginal tax rate. So depreciation tax shield = $2,500,000 × .40 = $1 million Diff: 2 Skill: Analytical Use the information for the question(s) below. The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital of 10%. 13) The required net working capital in the first year for the Sisyphean Corporationʹs project is closest to: A) $3,600 B) $3,960 C) $2,880 D) $5,400 Answer: A Explanation: A) Networking Capital Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cash (2% of sales) 720 792 871.2 Accounts Receivable (4% of sales) 1440 1584 1742.4 Inventory (9% of sales) 3240 3564 3920.4 Accounts Payable (5% of sales) 1800 1980 2178 NWC (Cash + Inventory+ AR - AP) 3600 3960 4356 Diff: 3 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 159 14) The required net working capital in the second year for the Sisyphean Corporationʹs project is closest to: A) $3,960 B) $4,360 C) $3.190 D) $5,940 Answer: A Explanation: A) Networking Capital Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cash (2% of sales) 720 792 871.2 Accounts Receivable (4% of sales) 1440 1584 1742.4 Inventory (9% of sales) 3240 3564 3920.4 Accounts Payable (5% of sales) 1800 1980 2178 NWC (Cash + Inventory+ AR - AP) 3600 3960 4356 Diff: 3 Skill: Analytical 15) The change in Net working capital from year one to year two is closest to: A) A decrease of $360 B) An increase of $360 C) An increase of $396 D) A decrease of $396 Answer: B Explanation: B) Networking Capital Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cash (2% of sales) 720 792 871.2 Accounts Receivable (4% of sales) 1440 1584 1742.4 Inventory (9% of sales) 3240 3564 3920.4 Accounts Payable (5% of sales) 1800 1980 2178 NWC (Cash + Inventory+ AR - AP) 3600 3960 4356 Change = 3960 - 3600 = 360 Diff: 3 Skill: Analytical 160 Berk/DeMarzo · Corporate Finance 16) Bubba Ho-Tep Company reported net income of $300 million for the most recent fiscal year. The firm had depreciation expenses of $125 million and capital expenditures of $150 million. Although they had no interest expense, the firm did have an increase in net working capital of $20 million. What is Bubba Ho-Tepʹs free cash flow? A) $170 million B) $255 million C) $150 million D) $5 million Answer: B Explanation: B) FCF = NI + Dep - Capital Ex - chg NWC = 300 + 125 - 150 - 20 = 255 Diff: 2 Skill: Analytical Use the information for the question(s) below. Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this facility to various agencies and groups providing relief services to the area. THSI estimates that this project will initially cost $5 million to setup and will generate $20 million in revenues during its first and only year in operation (paid in one year). Operating expenses are expected to total $12 million during this year and depreciation expense will be another $3 million. THSI will require no working capital for this investment. THSIʹs marginal tax rate is 35%. 17) Ignoring the original investment of $5 million, what is THSIʹs free cash flow for the first and only year of operation? A) $5.0 million B) $3.75 million C) $8.0 million D) $6.25 million Answer: D Explanation: D) FCF = (revenues - expenses - depreciation) × (1 - tax rate) + depreciation FCF = (20 - 12 - 3) × (1 - .35) + 3 =6.25 Diff: 2 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 161 18) Assume that THSIʹs cost of capital for this project is 15%. The NPV of this temporary housing project is closest to: A) $435,000 B) -$650,000 C) $1,960,000 D) -$435,000 Answer: A Explanation: A) FCF = (20 - 12 - 3) × (1 - .35) + 3 =6.25 So, NPV = -5.0 + 6.25 / 1.15 = .434782 or $434,782 Diff: 2 Skill: Analytical Use the information for the question(s) below. Shepard Industries is evaluating a proposal to expand its current distribution facilities. Management has projected the project will produce the following cash flows for the first two years (in millions). Year 1 2 Revenues 1200 1400 Operating Expense 450 525 Depreciation 240 280 Increase in working capital 60 70 Capital expenditures 300 350 Marginal corporate tax rate 30% 30% 19) The incremental EBIT for Shepard Industries in year one is closest to: A) $360 B) $750 C) $595 D) $510 Answer: D Explanation: D) Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 Diff: 2 Skill: Analytical 162 Berk/DeMarzo · Corporate Finance 20) The incremental EBIT for Shepard Industries in year two is closest to: A) $415 B) $875 C) $595 D) $510 Answer: C Explanation: C) Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 Diff: 2 Skill: Analytical 21) The incremental unlevered net income Shepard Industries in year one is closest to: A) $510 B) $415 C) $600 D) $355 Answer: D Explanation: D) Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 - Taxes (30%) 153 178.5 Incremental Net Income 357 416.5 Diff: 2 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 163 22) The incremental unlevered net income Shepard Industries in year two is closest to: A) $355 B) $415 C) $600 D) $510 Answer: B Explanation: B) Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 - Taxes (30%) 153 178.5 Incremental Net Income 357 416.5 Diff: 2 Skill: Analytical 23) The depreciation tax shield for Shepard Industries project in year one is closest to: A) $84 B) $168 C) $96 D) $72 Answer: D Explanation: D) $240 × .30 = $72 Diff: 1 Skill: Analytical 24) The depreciation tax shield for Shepard Industries project in year two is closest to: A) $84 B) $196 C) $72 D) $96 Answer: A Explanation: A) $280 × .30 = $84 Diff: 1 Skill: Analytical 164 Berk/DeMarzo · Corporate Finance 25) The free cash flow from Shepard Industries project in year one is closest to: A) $240 B) $300 C) -$5 D) $390 Answer: A Explanation: A) Free Cash Flow Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 - Taxes (30%) 153 178.5 Incremental Net Income 357 416.5 + Depreciation 240 280 - Capital expenditures 300 350 - Change in NWC 60 70 Free Cash Flow 237 276.5 Diff: 2 Skill: Analytical 26) The free cash flow from Shepard Industries project in year two is closest to: A) $345 B) $455 C) $275 D) -$5 Answer: C Explanation: C) Free Cash Flow Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 - Taxes (30%) 153 178.5 Incremental Net Income 357 416.5 + Depreciation 240 280 - Capital expenditures 300 350 - Change in NWC 60 70 Free Cash Flow 237 276.5 Diff: 2 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 165 Use the information for the question(s) below. Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental cash flow projects: Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 27) The free cash flow for the first year of Epiphanyʹs project is closest to: A) $43,000 B) $25,000 C) $38,000 D) $45,000 Answer: C Explanation: C) Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 PV of FCF (FCF / (1 + I)n -90,000 33,929 30,293 37,724 discount rate 0.12 NPV = 11,946 IRR = 19.14% Diff: 2 Skill: Analytical 166 Berk/DeMarzo · Corporate Finance 28) The free cash flow for the last year of Epiphanyʹs project is closest to: A) $53,000 B) $38,000 C) $35,000 D) $43,000 Answer: A Explanation: A) Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 PV of FCF (FCF / (1 + I)n -90,000 33,929 30,293 37,724 discount rate 0.12 NPV = 11,946 IRR = 19.14% Diff: 2 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 167 29) The NPV for Epiphanyʹs Project is closest to: A) $4,825 B) $39,000 C) $11,946 D) $20,400 Answer: C Explanation: C) Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 PV of FCF (FCF / (1 + I)n -90,000 33,929 30,293 37,724 discount rate 0.12 NPV = 11,946 IRR = 19.14% Diff: 3 Skill: Analytical 30) Luther Industries has outstanding tax loss carryforwards of $70 million from losses over the past four years. If Luther earns $15 million per year in pre-tax income from now on, Luther first pay taxes in? A) 7 years. B) 2 years. C) 4 years. D) 5 years. Answer: D Explanation: D) The number of years the tax loss carryforwards will last ban be calculated as the tax loss carry forward dividend by the annual pre-tax income or: Years with no tax = $70 million $15 million = 4.67 years, so Luther wonʹt have to pay taxes for the next four years, but will have to start paying some taxes 5 years from now. Diff: 1 Skill: Analytical 168 Berk/DeMarzo · Corporate Finance 31) You are considering investing $600,000 in a new automated inventory system that will provide and after-tax cost savings of $50,000 next year. These cost savings are expected to grow at the same rate as sales. If sales are expected to grow at 5% per year and your cost of capital is 10%, then what is the NPV of the automated inventory system? A) $400,000 B) $500,000 C) -$100,000 D) $1,000,000 Answer: A Explanation: A) NPV = $50,000 .10 - .05 - $600,000 = $400,000 Diff: 2 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 169 Use the information for the question(s) below. The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital of 10%. 32) Calculate the total Free Cash Flows for each of the three years for the Sisyphean Corporationʹs new project. Answer: Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000 / 3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income Add back Depreciation 5,200 10,000 6,370 10,000 7,657 10,000 Cash Flows from Operations 15,200 16,370 17,657 Networking Capital Forecast Year 1 2 3 Sales (units × $18) 36,000 39,600 43,560 Cash (2% of sales) 720 792 871.2 Accounts Receivable (4% of sales) 1440 1584 1742.4 Inventory (9% of sales) 3240 3564 3920.4 Accounts Payable (5% of sales) 1800 1980 2178 NWC (Cash + Inventory+ AR - AP) 3600 3960 4356 Change (investment) in NWC -3600 -360 -396 4356 Investment in machine -30,000 Total Free Cash Flows -33,600 14,840 15,974 22,013 Diff: 3 Skill: Analytical 170 Berk/DeMarzo · Corporate Finance Use the information for the question(s) below. Kinston Industries is considering investing in a machine that will cost $125,000 and will last for three years. The machine will generate revenues of $120,000 each year and the cost of goods sold will be 50% of sales. At the end of year three the machine will be sold for $15,000. The appropriate cost of capital is 10% and Kinston is in the 35% tax bracket. 33) Assume that Kinstonʹs new machine will be depreciated straight line to a salvage value of $5,000 at the end of year three. What is the after-tax salvage value of this project? Answer: If the machine is depreciated straight line to a book value of $5,000. So $15,000 - $5,000 = $10,000 gain on the sale which is taxable. So the after tax salvage value = $15,000 - $10,000 × .35 (tax rate) = $11,500. Diff: 2 Skill: Analytical 34) Assume that Kinstonʹs new machine will be depreciated straight line to a salvage value of $5,000 at the end of year three. What is the NPV for this project? Answer: Year 0 1 2 3 Sales (revenues) 120,000 120,000 120,000 Cost of Goods Sold 60,000 60,000 60,000 - Depreciation 40,000 40,000 40,000 EBIT 20,000 20,000 20,000 -Taxes(35%) 7,000 7,000 7,000 = unlevered net income 13,000 13,000 13,000 + Depreciation 40,000 40,000 40,000 + capital expenditures -125,000 + Liquidation cash flows 11,500 Free Cash Flow -125,000 53,000 53,000 64,500 PV of FCF (I = 10%) -125,000 48,182 43,802 48,46 NPV = 15,443 Liquidation/Salvage Value Calculation: If the machine is depreciated straight line to a book value of $5,000. So $15,000 - $5,000 = $10,000 gain on the sale which is taxable. So, the after tax salvage value = $15,000 - $10,000 × .35 (tax rate) = $11,500. Diff: 3 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 171 35) Assume that Kinstonʹs new machine will be depreciated using MACRS according to the following schedule: Year 3 Years 1 33.33% 2 44.45% 3 14.81% 4 7.41% What is the NPV of this project? Answer: Year 0 1 2 3 Sales (revenues) 120,000 120,000 120,000 Cost of Goods Sold 60,000 60,000 60,000 - Depreciation 41,663 55,563 18,513 EBIT 18,338 4,438 41,488 -Taxes(35%) 6,418 1,553 14,521 = unlevered net income 11,919 2,884 26,967 + Depreciation 41,663 55,563 18,513 + capital expenditures -125,000 + Liquidation cash flows 12,992 Free Cash Flow -125,000 53,582 58,447 58,471 PV of FCF (I = 10%) -125,000 48,711 48,303 43,930 NPV = 15,944 Liquidation/Salvage Value Calculation: If the machine is depreciated straight line to a book value of 7.41% × 125,000 = $9,263. So $15,000 - $9,263 = $5,737 gain on the sale which is taxable. So the after tax salvage value = $15,000 - $7,737 × .35 (tax rate) = $12,992. Diff: 2 Skill: Analytical 7.3 Analyzing the Project 1) Which of the following statements is false? A) The break-even level of an input is the level for which the investment has an IRR of zero. B) The most difficult part of capital budgeting is deciding how to estimate the cash flows and the cost of capital. C) When evaluating a capital budgeting project, financial managers should make the decision that maximizes NPV. D) Sensitivity analysis reveals which aspects of the project are most critical when we are actually managing the project. Answer: A Diff: 1 Skill: Conceptual 172 Berk/DeMarzo · Corporate Finance 2) Which of the following statements is false? A) Sensitivity analysis allows us to explore the effects of errors in our estimated inputs in our NPV analysis for the project. B) To compute the NPV for a project, you need to estimate the incremental cash flows and choose a discount rate. C) Estimates of the cash flows and cost of capital are often subject to significant uncertainty. D) When we are certain regarding the input to a capital budgeting decision, it is often useful to determine the break-even level of that input. Answer: D Diff: 2 Skill: Conceptual 3) Which of the following statements is false? A) We can use scenario analysis to evaluate alternative pricing strategies for our project. B) Scenario analysis considers the effect on NPV of changing multiple project parameters. C) The difference between the IRR of a project and the cost of capital tells you how much error in the cost of capital it would take to change the investment decision. D) Scenario analysis breaks the NPV calculation into its component assumptions and show how the NPV varies as each one of the underlying assumptions change. Answer: D Diff: 2 Skill: Conceptual 4) The difference between scenario analysis and sensitivity analysis is: A) Scenario analysis is based upon the IRR and sensitivity analysis is based upon NPV. B) Only sensitivity analysis allows us to change our estimated inputs of our NPV analysis. C) Scenario analysis considers the effect on NPV of changing multiple project parameters. D) Only Scenaripo analysis breaks the NPV calculation into its component assumptions. Answer: C Diff: 2 Skill: Definition 5) An exploration of the effect on NPV of changing multiple project parameters is called A) scenario analysis. B) IRR analysis. C) accounting break-even analysis. D) sensitivity analysis. Answer: A Diff: 1 Skill: Definition Chapter 7 Fundamentals of Capital Budgeting 173 6) An analysis that breaks the NPV calculation into its component assumptions and shows how the NPV varies as one of the underlying assumptions is changed is called A) scenario analysis. B) IRR analysis. C) accounting break-even analysis. D) sensitivity analysis. Answer: D Diff: 1 Skill: Definition 7) What is sensitivity analysis? Answer: Sensitivity analysis breaks the NPV calculation into its component assumptions and shows how the NPV varies as each of the underlying assumptions change. Sensitivity analysis allows us to explore the effects of errors in your estimated inputs to our NPV calculations and reveals which aspects of the project are most critical when we are actually managing the project. Diff: 2 Skill: Conceptual 8) How does scenario analysis differ from sensitivity analysis? Answer: Where sensitivity analysis considers the change in NPV for individual parameter changes, scenario analysis considers the effect on NPV of change multiple project parameters simultaneously. Diff: 2 Skill: Conceptual 174 Berk/DeMarzo · Corporate Finance Use the information for the question(s) below. Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental cash flow projects: Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 9) What is the NPV of the Epiphanyʹs project? Answer: Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 PV of FCF (FCF/(1 + I)n) -90,000 33,929 30,293 37,724 discount rate 0.12 NPV = 11,946 Diff: 2 Skill: Analytical Chapter 7 Fundamentals of Capital Budgeting 175 10) Epiphany would like to know how sensitive the projectʹs NPV is to changes in the discount rate. How much can the discount rate vary before the NPV reaches zero? Answer: Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 PV of FCF (FCF/(1 + I)n) -90,000 33,929 30,293 37,724 discount rate 0.12 NPV = 11,946 IRR = 19.14% So the discount rate can vary by 12% - 19.14% = 7.14% Diff: 3 Skill: Analytical 11) Epiphany is worried about the reliability of the sales forecast. How sensitive is the projectʹs NPV to a 10% change in sales. Answer: Base Case Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 PV of FCF (FCF/(1 + I)n) -90,000 33,929 30,293 37,724 discount rate 0.12 NPV = 11,946 IRR = 19 176 Berk/DeMarzo · Corporate Finance 10% Decrease in Sales Year 0 1 2 3 Sales (Revenues) 90,000 90,000 90,000 - Cost of Goods Sold (50% of Sales) 45,000 45,000 45,000 - Depreciation 30,000 30,000 30,000 = EBIT 15,000 15,000 15,000 - Taxes (35%) 5250 5250 5250 = unlevered net income 9,750 9,750 9,750 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 34,750 34,750 49,750 PV of FCF (FCF/(1 + I)n) -90,000 31,027 27,702 35,411 discount rate 0.12 NPV = 4,140 10% Increase in Sales Year 0 1 2 3 Sales (Revenues) 110,000 110,000 110,000 - Cost of Goods Sold (50% of Sales) 55,000 55,000 55,000 - Depreciation 30,000 30,000 30,000 = EBIT 25,000 25,000 25,000 - Taxes (35%) 8750 8750 8750 = unlevered net income 16,250 16,250 16,250 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 41,250 41,250 56,250 PV of FCF (FCF/(1+I)n) -90,000 36,830 32,884 40,038 discount rate 0.12 NPV = 19,752 So a + or - 10% change in sales will cause the NPV to vary between 4,140 and 19,752. Diff: 3 Skill: Analytical
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