Principles of Managerial Finance, Brief Ed.

, 8e (Zutter/Smart)
Chapter 11 Capital Budgeting Cash Flows and Risk Refinements

11.1 Project cash flows

1) Accounting figures and cash flows are not necessarily the same due to the presence of certain
non-cash expenditures on a firm's income statement.
Answer: TRUE
Diff: 1
Topic: Relevant Cash Flows
Learning Obj.: LG 1
Learning Outcome: F-08
AACSB: Analytical Thinking

2) Relevant cash flows are the incremental cash outflows and inflows associated with a proposed
capital expenditure.
Answer: TRUE
Diff: 1
Topic: Relevant Cash Flows
Learning Obj.: LG 1
Learning Outcome: F-08
AACSB: Analytical Thinking

3) The relevant cash flows for a proposed capital expenditure are the incremental after-tax cash
outflows and resulting subsequent inflows.
Answer: TRUE
Diff: 1
Topic: Relevant Cash Flows
Learning Obj.: LG 1
Learning Outcome: F-08
AACSB: Reflective Thinking

4) Please explain the difference between a sunk cost and an opportunity cost and give an
example of each type of cost.
Answer: Sunk costs are cash outlays that have already been made (past outlays) and cannot be
recovered. Sunk costs have no effect on the cash flows relevant to the current decision. As a
result, sunk costs should not be included in a project's incremental cash flows.

Opportunity costs are cash flows that could be realized from the best alternative use of an asset
that is already in place. They, therefore, represent cash flows that will not be realized as a result
of employing that asset in the proposed project. Thus, any opportunity costs should be included
as cash outflows when one is determining a project's incremental cash flows.
Diff: 1
Topic: Sunk Costs and Opportunity Costs
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking
5) Incremental cash flows represent the additional cash flows expected as a direct result of the
proposed project.
Answer: TRUE
Diff: 1
Topic: Relevant Cash Flows
Learning Obj.: LG 1
Learning Outcome: F-08
AACSB: Reflective Thinking

6) The three major cash flow components include the initial investment, operating cash flows,
and terminal cash flow.
Answer: TRUE
Diff: 1
Topic: Major Cash Flow Components
Learning Obj.: LG 1
Learning Outcome: F-08
AACSB: Analytical Thinking

7) The three major cash flow components include the initial investment, nonoperating cash
flows, and terminal cash flow.
Answer: FALSE
Diff: 1
Topic: Major Cash Flow Components
Learning Obj.: LG 1
Learning Outcome: F-08
AACSB: Analytical Thinking

8) Initial cash outflows and subsequent operating cash inflows for a project are referred to as
________.
A) necessary cash flows
B) relevant cash flows
C) perpetual cash flows
D) ordinary cash flows
Answer: B
Diff: 1
Topic: Relevant Cash Flows
Learning Obj.: LG 1
Learning Outcome: F-08
AACSB: Analytical Thinking
9) Relevant cash flows for a project are best described as ________.
A) incidental cash flows
B) incremental cash flows
C) sunk cash flows
D) contingent cash flows
Answer: B
Diff: 1
Topic: Relevant Cash Flows
Learning Obj.: LG 1
Learning Outcome: F-08
AACSB: Analytical Thinking

10) Should financing costs such as the returns paid to bondholders and stockholders be
considered in computing after-tax operating cash flows? Why or why not?
Answer: Financing costs are not an incremental cash flow for capital budgeting purposes.
Financing costs are a direct consequence of how the project is financed, not whether the project
is economically viable. Financing costs are embedded in the required rate of return used to
discount project cash flows.
Diff: 1
Topic: Relevant Cash Flows
Learning Obj.: LG 1
Learning Outcome: F-08
AACSB: Analytical Thinking

11) Sunk costs are cash outlays that have already been made and therefore have no effect on the
cash flows relevant to the current decision.
Answer: TRUE
Diff: 1
Topic: Sunk Costs and Opportunity Costs
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking

12) Opportunity costs should be included as cash outflows when determining a project's
incremental cash flows.
Answer: TRUE
Diff: 1
Topic: Sunk Costs and Opportunity Costs
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking
13) A sunk cost is a cash flow that could be realized from the best alternative use of an owned
asset.
Answer: FALSE
Diff: 1
Topic: Sunk Costs and Opportunity Costs
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking

14) An opportunity cost is a cash flow that could be realized from the best alternative use of an
owned asset.
Answer: TRUE
Diff: 1
Topic: Sunk Costs and Opportunity Costs
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking

15) A sunk cost is a cash outlay that has already been made and cannot be recovered.
Answer: TRUE
Diff: 1
Topic: Sunk Costs and Opportunity Costs
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking

16) Companies involved in international capital budgeting projects can minimize the long-term
currency risk by financing the foreign investment at least partly in the local capital markets.
Answer: TRUE
Diff: 1
Topic: International Capital Budgeting and Long-Term Investments
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking

17) Companies involved in international capital budgeting projects can minimize political risks
by structuring the investment as a joint venture and selecting a well-connected local partner.
Answer: TRUE
Diff: 1
Topic: International Capital Budgeting and Long-Term Investments
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking
18) When making replacement decisions, the development of relevant cash flows is complicated
when compared to expansion decisions, due to the need to calculate ________ cash inflows.
A) conventional
B) opportunity
C) incremental
D) sunk
Answer: C
Diff: 1
Topic: Expansion Versus Replacement Decisions
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking

19) In developing the cash flows for an expansion project, the analysis is the same as the analysis
for replacement projects where ________.
A) all cash flows from the old assets are equal
B) prior cash flows are irrelevant
C) all cash flows from the old asset are zero
D) cash inflows equal cash outflows
Answer: C
Diff: 1
Topic: Expansion Versus Replacement Decisions
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking

20) Cash outlays that had been previously made and have no effect on the cash flows relevant to
a current decision are called ________.
A) incremental historical costs
B) incremental past expenses
C) opportunity costs foregone
D) sunk costs
Answer: D
Diff: 1
Topic: Sunk Costs and Opportunity Costs
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking
21) Cash flows that could be realized from the best alternative use of an owned asset are called
________.
A) incremental costs
B) lost resale opportunities
C) opportunity costs
D) sunk costs
Answer: C
Diff: 1
Topic: Sunk Costs and Opportunity Costs
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking

11.2 Finding the initial investment

1) If a new asset is being considered as a replacement for an old asset, the relevant cash flows
would be found by adding the operating cash flows from the old asset to the operating cash flows
from the new asset.
Answer: FALSE
Diff: 1
Topic: Expansion Versus Replacement Decisions
Learning Obj.: LG 2
Learning Outcome: F-08
AACSB: Analytical Thinking

Table 11.1

Fine Press is considering replacing the existing press with a more efficient press. The new press
costs $55,000 and requires $5,000 in installation costs. The old press was purchased 2 years ago
for an installed cost of $35,000 and can be sold for $20,000 net of any removal costs today. Both
presses are depreciated under the MACRS 5-year recovery schedule. The firm pays a 40 percent
marginal tax rate.

2) Calculate the book value of the existing press being replaced. (See Table 11.1)
Answer: Book value of existing press = $35,000 × [1 - (0.20 + 0.32)] = $16,800
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
3) Calculate the tax effect from the sale of the existing asset. (See Table 11.1)
Answer: Tax:
Recaptured depreciation = $20,000 - $16,800 = $3,200
Tax liability = $3,200 × 0.40 = $1,280
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

4) Calculate the initial investment of the new asset. (See Table 11.1)
Answer:

Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

5) To calculate the initial investment, we subtract all cash inflows occurring at time zero from all
cash outflows occurring at time zero.
Answer: TRUE
Diff: 1
Topic: Finding the Initial Investment
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

6) The basic cash flows that must be considered when determining the initial investment
associated with a capital expenditure are the installed cost of the new asset, the after-tax proceeds
(if any) from the sale of an old asset, and the change (if any) in net working capital.
Answer: TRUE
Diff: 1
Topic: Finding the Initial Investment
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking
7) Under MACRS depreciation, the depreciable value of an asset is equal to the asset's purchase
price minus any installation costs.
Answer: FALSE
Diff: 1
Topic: Installed Cost of a New Asset
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

8) The change in net working capital—regardless of whether an increase or decrease—is not

taxable because it merely involves a net buildup or net reduction of current accounts.
Answer: TRUE
Diff: 1
Topic: Change in Net Working Capital
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

9) If an investment in a new asset results in a change in current assets that exceeds the change in
current liabilities, this change in net working capital represents an initial cash outflow.
Answer: TRUE
Diff: 1
Topic: Change in Net Working Capital
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

10) Net working capital is the difference between a firm's total assets and its total liabilities.
Answer: FALSE
Diff: 1
Topic: Change in Net Working Capital
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

11) Which of the following would be used in the computation of an initial investment?
A) the annual after-tax inflow expected from the investment
B) the initial purchase price of the investment
C) the historic cost of the existing investment
D) the profits from the new investment
Answer: B
Diff: 1
Topic: Finding the Initial Investment
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

12) Which of the following basic variables must be considered in determining the initial
investment associated with a capital expenditure?
A) incremental annual savings produced by the new asset
B) cash flows generated by the new investment
C) proceeds from the sale of an existing asset
D) profits on the sale of an existing asset
Answer: C
Diff: 1
Topic: Finding the Initial Investment
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

13) An important cash inflow in the analysis of initial cash flows for a replacement project is
________.
A) taxes
B) the cost of the new asset
C) installation cost
D) the sale value of the old asset
Answer: D
Diff: 1
Topic: Finding the Initial Investment
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

14) When evaluating a capital budgeting project, installation costs of a new machine must be
considered as part of ________.
A) the operating cash inflows
B) the initial investment
C) the incremental operating cash inflows
D) the operating cash outflows
Answer: B
Diff: 1
Topic: Finding the Initial Investment
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking
15) The change in net working capital when evaluating a capital budgeting decision is ________.
A) the change in fixed liabilities minus the change in fixed assets
B) the increase in current assets
C) the increase in current liabilities
D) the change in current assets minus the change in current liabilities
Answer: D
Diff: 1
Topic: Change in Net Working Capital
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

16) In evaluating the initial investment for a capital budgeting project, ________.
A) an increase in net working capital is considered a cash inflow
B) a decrease in net working capital is considered a cash outflow
C) an increase in net working capital is considered a cash outflow
D) net working capital does not have to be considered
Answer: C
Diff: 1
Topic: Change in Net Working Capital
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

17) A corporation is considering expanding operations to meet growing demand. With the capital
expansion, the current accounts are expected to change. Management expects cash to increase by
$20,000, accounts receivable by $40,000, and inventories by $60,000. At the same time accounts
payable will increase by $50,000, accruals by $10,000, and long-term debt by $100,000. The
change in net working capital is ________.
A) an increase of $120,000
B) a decrease of $60,000
C) a decrease of $120,000
D) an increase of $60,000
Answer: D
Diff: 1
Topic: Change in Net Working Capital
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking
18) A corporation is considering expanding operations to meet growing demand. With the capital
expansion the current accounts are expected to change. Management expects cash to increase by
$10,000, accounts receivable by $20,000, and inventories by $30,000. At the same time accounts
payable will increase by $40,000, accruals by $30,000, and long-term debt by $80,000. The
change in net working capital is ________.
A) an increase of $10,000
B) a decrease of $10,000
C) a decrease of $90,000
D) an increase of $80,000
Answer: B
Diff: 1
Topic: Change in Net Working Capital
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking

19) If accounts receivable increase by $1,000,000, inventory decreases by $500,000, and

accounts payable increase by $500,000, net working capital would ________.
A) decrease by $500,000
B) increase by $1,500,000
C) increase by $2,000,000
D) experience no change
Answer: D
Diff: 1
Topic: Change in Net Working Capital
Learning Obj.: LG 3
Learning Outcome: F-08
AACSB: Analytical Thinking
 MACRS RATE
Recovery year 3 years 5 years 7 years 10 years
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 18 14
4 7 12 12 12
5 12 9 9
6 5 9 8
7 9 7
8 4 6
9 6
10 6
11 4

20) A corporation has decided to replace an existing asset with a newer model. Two years ago,
the existing asset originally cost $30,000 and was being depreciated under MACRS using a five-
year recovery period. The existing asset can be sold for $25,000. The new asset will cost $75,000
and will also be depreciated under MACRS using a five-year recovery period. If the assumed tax
rate is 40 percent on ordinary income and capital gains, the initial investment is ________.
A) $42,000
B) $52,440
C) $54,240
D) $50,000
Answer: C
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

21) A corporation has decided to replace an existing asset with a newer model. Two years ago,
the existing asset originally cost $70,000 and was being depreciated under MACRS using a five-
year recovery period. The existing asset can be sold for $30,000. The new asset will cost $80,000
and will also be depreciated under MACRS using a five-year recovery period. If the assumed tax
rate is 40 percent on ordinary income and capital gains, the initial investment is ________.
A) $48,560
B) $44,360
C) $49,240
D) $27,600
Answer: A
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
11.3 Finding the operating cash flows

1) Suppose the tax law changes to allow firms to immediately and fully deduct the cost of
investments they make rather than depreciating them under the MACRS system. If all else
remains the same, this change would tend to increase the NPV of an investment project.
Answer: TRUE
Diff: 1
Topic: Finding the Operating Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Reflective Thinking

2) All other factors held constant, the higher the tax rate that firms must pay, the more valuable
are depreciation deductions.
Answer: TRUE
Diff: 1
Topic: Finding the Operating Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

3) All other factors held constant, the longer the firm must take to depreciate the initial cost of an
investment project, the higher will be the project's NPV.
Answer: FALSE
Diff: 1
Topic: Finding the Operating Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

4) In terms of an investment project's operating cash flows, depreciation deductions are irrelevant
because they do not represent an outlay of cash.
Answer: FALSE
Diff: 1
Topic: Finding the Operating Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking
5) This year a certain investment project generated revenue of $200,000. Other expenses
(excluding depreciation and interest expense) totalled $100,000. Depreciation expense was
$50,000 and interest expense was $10,000. The firm faces a tax rate of 21%. What is the project's
after-tax operating cash flow this year?
A) $89,500
B) $81,600
C) $129,000
D) $79,000
Answer: A
Diff: 1
Topic: Finding the Operating Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

6) John has an extra bedroom in his house that he occasionally rents out using the service Airbnb.
John charges $100 per night, and his room is occupied by a renter approximately 100 nights per
year. He thinks that if he repaints the room the photos he posts on Airbnb to draw customers will
be more attractive, allowing him to charge $110 dollars per night and to rent the room for 120
nights per year. John's tax rate is 28%. What is the annual, after-tax, incremental revenue that
John expects from his painting project?
A) $13,200
B) $9,504
C) $3,200
D) $2,304
Answer: D
Diff: 1
Topic: Finding the Operating Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

11.4 Finding the terminal cash flows

1) The book value of an asset is equal to its installed cost of asset minus the accumulated
depreciation.
Answer: TRUE
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
2) In case of an existing asset which is depreciable and is used in business and is sold for a price
equal to its initial purchase price, the difference between the sales price and its book value is
considered as recaptured depreciation and will be taxed as ordinary income.
Answer: TRUE
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

3) Recaptured depreciation is the portion of the sale price that is below the book value.
Answer: FALSE
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

4) Capital gain is the portion of the sale price that is in excess of the initial purchase price.
Answer: TRUE
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

5) Recaptured depreciation is the portion of the sale price that is in excess of the initial purchase
price.
Answer: FALSE
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

6) If an asset is depreciable and used in business, any loss on the sale of the asset is tax-
deductible only against other capital gains income, not against ordinary income.
Answer: FALSE
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
7) If an asset is sold for more than its initial purchase price, the gain on the sale is composed of
two parts: a capital gain and recaptured depreciation.
Answer: TRUE
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

8) If an asset is sold for book value, the gain on the sale is composed of two parts: a capital gain
and accumulated depreciation.
Answer: FALSE
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

9) If an asset is sold for less than its book value, the loss on the sale may be used to offset
ordinary operating income provided the asset is used in the business.
Answer: TRUE
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

10) The book value of an asset is equal to the ________.

A) fair market value minus the accounting value
B) original purchase price plus annual depreciation expense
C) original purchase price minus accumulated depreciation
D) depreciated value plus recaptured depreciation
Answer: C
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
11) The tax treatment regarding the sale of existing assets that are sold for more than the original
purchase price results in ________.
A) an ordinary tax benefit
B) no tax benefit or liability
C) a recaptured depreciation taxed as ordinary income
D) a capital gain tax liability
Answer: D
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

12) The tax treatment regarding the sale of existing assets that are sold for more than the book
value but less than the original purchase price results in a(n) ________.
A) ordinary tax benefit
B) capital gain tax liability
C) recaptured depreciation taxed as ordinary income
D) capital gain tax liability and recaptured depreciation taxed as ordinary income
Answer: C
Diff: 2
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

13) The tax treatment regarding the sale of existing assets that are sold for their book value
results in ________.
A) an ordinary tax benefit
B) no tax benefit or liability
C) recaptured depreciation taxed as ordinary income
D) a capital gain tax liability and recaptured depreciation taxed as ordinary income
Answer: B
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
14) The portion of an asset's sale price that is above its book value and below its initial purchase
price is called ________.
A) a capital gain
B) recaptured depreciation
C) a capital loss
D) book value
Answer: B
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

15) The portion of an asset's sale price that is below its book value and below its initial purchase
price is called ________.
A) a capital gain
B) recaptured depreciation
C) a capital loss
D) book value
Answer: C
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

16) The tax treatment regarding the sale of existing assets that are sold for less than the book
value results in ________.
A) an ordinary tax benefit
B) a capital loss tax benefit
C) recaptured depreciation taxed as ordinary income
D) a capital gain tax liability and recaptured depreciation taxed as ordinary income
Answer: B
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
MACRS RATE
Recovery year 3 years 5 years 7 years 10 years
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 18 14
4 7 12 12 12
5 12 9 9
6 5 9 8
7 9 7
8 4 6
9 6
10 6
11 4

17) A corporation is selling an existing asset for $21,000. The asset, when purchased, cost
$10,000, was being depreciated under MACRS using a five-year recovery period, and has been
depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and
capital gains, the tax effect of this transaction is ________.
A) $0 tax liability
B) $7,560 tax liability
C) $4,400 tax liability
D) $7,720 tax liability
Answer: D
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

18) A corporation is selling an existing asset for $1,700. The asset, when purchased, cost
$10,000, was being depreciated under MACRS using a five-year recovery period, and has been
depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and
capital gains, the tax effect of this transaction is ________.
A) $0 tax liability
B) $840 tax liability
C) $3,160 tax liability
D) $3,160 tax benefit
Answer: A
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
19) A corporation is selling an existing asset for $1,000. The asset, when purchased, cost
$10,000, was being depreciated under MACRS using a five-year recovery period, and has been
depreciated for four full years. If the assumed tax rate is 40 percent on ordinary income and
capital gains, the tax effect of this transaction is ________.
A) $0 tax liability
B) $1,100 tax liability
C) $3,600 tax liability
D) $280 tax benefit
Answer: D
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

20) A firm is selling an existing asset for $5,000. The asset, when purchased, cost $10,000, was
being depreciated under MACRS using a five-year recovery period and has been depreciated for
four full years. If the assumed tax rate is 40 percent on ordinary income and capital gains, the tax
effect of this transaction is ________.
A) $0 tax liability
B) $1,320 tax liability
C) $1,160 tax liability
D) $2,000 tax benefit
Answer: B
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

21) A loss on the sale of an asset that is depreciable and used in business is ________; a loss on
the sale of a non-depreciable asset is ________.
A) deductible from capital gains income; deductible from ordinary income
B) deductible from ordinary income; deductible only against capital gains
C) a credit against the tax liability; not deductible
D) not deductible; deductible only against capital gains
Answer: B
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
22) Compute the initial purchase price for an asset with book value of $34,800 and total
accumulated depreciation of $85,200.
Answer: Initial purchase price = Book value + Accumulated depreciation = $34,800 + $85,200 =
$120,000
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

MACRS RATE
Recovery year 3 years 5 years 7 years 10 years
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 18 14
4 7 12 12 12
5 12 9 9
6 5 9 8
7 9 7
8 4 6
9 6
10 6
11 4

23) A mixer was purchased two years ago for $120,000 and can be sold for $125,000 today. The
mixer has been depreciated using the MACRS 5-year recovery period and the firm pays 40
percent taxes on both ordinary income and capital gain.
(a) Compute recaptured depreciation and capital gain (loss), if any.
(b) Find the firm's tax liability.
Answer:
(a) Book Value = $120,000 (1 - 0.20 - 0.32) = $57,600
Recaptured depreciation = $125,000 - $57,600= $67,400
Capital gain = $125,000 - $120,000 = $5,000
$72,400
(b) Tax liability = 72,400 × 0.40 = $28,960
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
24) An asset was purchased three years ago for $100,000 and can be sold for $40,000 today. The
asset has been depreciated using the MACRS 5-year recovery period and the firm pays 40
percent taxes on both ordinary income and capital gain.
(a) Compute recaptured depreciation and capital gain (loss), if any.
(b) Find the firm's tax liability.
Answer:
(a) Book Value = $100,000 (1 - 0.20 - 0.32 - 0.19) = $29,000
Recaptured depreciation = $40,000 - $29,000= $11,000
Capital gain = 0
$11,000
(b) Tax liability = 11,000 × 0.40 = $4,400
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

25) A machine was purchased two years ago for $120,000 and can be sold for $50,000 today. The
machine has been depreciated using the MACRS 5-year recovery period and the firm pays 40
percent taxes on both ordinary income and capital gains.
(a) Compute recaptured depreciation and capital gain (loss), if any.
(b) Find the firm's tax liability.
Answer:
(a) Book Value = $120,000 (1 - 0.20 - 0.32) = $57,600
Recaptured depreciation = $0
Capital loss = $57,600 - $50,000 = $7,600
(b) Tax benefit = $7,600 × 0.40 = $3,040
Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking
26) Compute the depreciation values for an asset which costs $55,000 and requires $5,000 in
installation costs using MACRS 5-year recovery period.
Answer: Depreciable value = $55,000 + $5,000 = $60,000

Diff: 1
Topic: After-Tax Proceeds From Sale of Old Asset
Learning Obj.: LG 4
Learning Outcome: F-08
AACSB: Analytical Thinking

27) A corporation is evaluating the relevant cash flows for a capital budgeting decision and must
estimate the terminal cash flow. The proposed machine will be disposed of at the end of its
usable life of five years at an estimated sale price of $15,000. The machine has an original
purchase price of $80,000, installation cost of $20,000, and will be depreciated under the five-
year MACRS. Net working capital is expected to decline by $5,000. The firm has a 40 percent
tax rate on ordinary income and long-term capital gain. The terminal cash flow is ________.
A) $24,000
B) $16,000
C) $14,000
D) $26,000
Answer: B
Diff: 2
Topic: Finding the Terminal Cash Flow
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking
28) A corporation is evaluating the relevant cash flows for a capital budgeting decision and must
estimate the terminal cash flow. The proposed machine will be disposed of at the end of its
usable life of five years at an estimated sale price of $2,000. The machine has an original
purchase price of $80,000, installation cost of $20,000, and will be depreciated under the five-
year MACRS. Net working capital is expected to decline by $5,000. The firm has a 40 percent
tax rate on ordinary income and long-term capital gain. The terminal cash flow is ________.
A) $5,800
B) $7,800
C) $8,200
D) $6,200
Answer: C
Diff: 2
Topic: Finding the Terminal Cash Flow
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking

29) Which of the following must be considered in computing the terminal value of a replacement
project?
A) operating cash flow for the final year
B) after-tax proceeds from the sale of a new asset
C) before-tax proceeds from the sale of an old asset
D) before-tax proceeds from the sale of a new asset
Answer: B
Diff: 1
Topic: Taxes on Sale of Assets
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking
11.5 Risk in capital budgeting (behavioral approaches)

Table 11.3

Cuda Marine Engines, Inc. must develop the relevant cash flows for a replacement capital
investment proposal. The proposed asset costs $50,000 and has installation costs of $3,000. The
asset will be depreciated using a five-year recovery schedule. The existing equipment, which
originally cost $25,000 and will be sold for $10,000, has been depreciated using an MACRS
five-year recovery schedule and three years of depreciation has already been taken. The new
equipment is expected to result in incremental before-tax net profits of $15,000 per year. The
firm has a 40 percent tax rate.

1) The cash flow pattern for the capital investment proposal is ________. (See Table 11.3)
A) a mixed stream and conventional
B) a mixed stream and nonconventional
C) a perpetuity and conventional
D) an annuity and nonconventional
Answer: A
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

2) The book value of the existing asset is ________. (See Table 11.3)
A) $7,250
B) $15,000
C) $21,250
D) $25,000
Answer: A
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking
3) The tax effect on the sale of the existing asset results in ________. (See Table 11.3)
A) $800 tax benefit
B) $1,000 tax liability
C) $1,100 tax liability
D) $6,000 tax liability
Answer: C
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

4) The initial outlay equals ________. (See Table 11.3)

A) $41,100
B) $44,100
C) $38,800
D) $38,960
Answer: B
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

5) The incremental depreciation expense for year 1 is ________. (See Table 11.3)
A) $2,250
B) $7,600
C) $7,000
D) $7,950
Answer: B
Diff: 1
Topic: Interpreting the Term Incremental
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

6) The incremental depreciation expense for year 5 is ________. (See Table 11.3)
A) $2,250
B) $5,110
C) $7,950
D) $6,360
Answer: D
Diff: 1
Topic: Interpreting the Term Incremental
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking
7) The annual incremental after-tax cash flow from operations for year 1 is ________. (See Table
11.3)
A) $13,950
B) $16,600
C) $25,600
D) $30,000
Answer: B
Diff: 1
Topic: Interpreting the Term Incremental
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

Table 11.4

Degnan Dance Company, Inc., a manufacturer of dance and exercise apparel, is considering
replacing an existing piece of equipment with a more sophisticated machine. The following
information is given.

The firm pays 40 percent taxes on ordinary income and capital gains.

8) Calculate the book value of the existing asset being replaced. (See Table 11.4)
Answer: Book value of existing equipment = $100,000 × [1 - (0.20 + 0.32)] = $48,000
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking
9) Calculate the tax effect from the sale of the existing asset. (See Table 11.4)
Answer: Tax:
$105,000 - $100,000 = $5,000 capital gain × 0.4 = $2,000
$52,000 recaptured depreciation × 0.4 = 20,800
Total tax liability $22,800
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

10) Calculate the initial investment required for the new asset. (See Table 11.4)
Answer:

Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

11) Calculate the incremental earnings before depreciation and taxes. (See Table 11.4)
Answer:

Diff: 1
Topic: Interpreting the Term Incremental
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking
12) Calculate the incremental depreciation. (See Table 11.4)
Answer:

Diff: 1
Topic: Interpreting the Term Incremental
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

13) Summarize the incremental after-tax cash flow (relevant cash flows) for years t = 0 through t
= 5. (See Table 11.4)
Answer:

Diff: 2
Topic: Interpreting the Term Incremental
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking
Table 11.5

Nuff Folding Box Company, Inc. is considering purchasing a new gluing machine. The gluing
machine costs $50,000 and requires installation costs of $2,500. This outlay would be partially
offset by the sale of an existing gluer. The existing gluer originally cost $10,000 and is four years
old. It is being depreciated under MACRS using a five-year recovery schedule and can currently
be sold for $15,000. The existing gluer has a remaining useful life of five years. If held until year
5, the existing machine's market value would be zero. Over its five-year life, the new machine
should reduce operating costs (excluding depreciation) by $17,000 per year. Training costs of
employees who will operate the new machine will be a one-time cost of $5,000 which should be
included in the initial outlay. The new machine will be depreciated under MACRS using a five-
year recovery period. The firm has a 12 percent cost of capital and a 40 percent tax on ordinary
income and capital gains.

14) The payback period for the project is ________. (See Table 11.5)
A) 2 years
B) 3 years
C) between 3 and 4 years
D) between 4 and 5 years
Answer: C
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

15) The tax effect of the sale of the existing asset is ________. (See Table 11.5)
A) a tax liability of $2,340
B) a tax benefit of $1,500
C) a tax liability of $3,320
D) a tax liability of $5,320
Answer: D
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking
16) The initial outlay for this project is ________. (See Table 11.5)
A) $42,820
B) $40,320
C) $47,820
D) $35,140
Answer: C
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

17) The present value of the project's annual cash flows is ________. (See Table 11.5)
A) $47,820
B) $42,820
C) $51,635
D) $100,563
Answer: C
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking

18) The net present value of the project is ________. (See Table 11.5)
A) $3,815
B) $2,445
C) $5,614
D) $7,500
Answer: A
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking

19) The internal rate of return for the project is ________. (See Table 11.5)
A) between 7 and 8 percent
B) between 9 and 10 percent
C) greater than 12 percent
D) between 10 and 11 percent
Answer: C
Diff: 1
Topic: Interpreting the Term Cash Flows
Learning Obj.: LG 5
Learning Outcome: F-08
AACSB: Analytical Thinking
20) Different projects have different levels of risk. As a result, the acceptance of a particular
project generally has an impact on a firm's overall risk.
Answer: TRUE
Diff: 1
Topic: Introduction to Risk in Capital Budgeting
Learning Obj.: LG 1
Learning Outcome: F-29
AACSB: Analytical Thinking

21) The acceptance of a particular project usually has no impact on a firm's overall risk.
Answer: FALSE
Diff: 1
Topic: Introduction to Risk in Capital Budgeting
Learning Obj.: LG 1
Learning Outcome: F-29
AACSB: Analytical Thinking

22) All projects should always use the WACC as the required return for capital budgeting
purposes.
Answer: FALSE
Diff: 1
Topic: Introduction to Risk in Capital Budgeting
Learning Obj.: LG 1
Learning Outcome: F-29
AACSB: Analytical Thinking

23) Behavioral approaches for dealing with risk include scenario analysis and simulation.
Answer: TRUE
Diff: 1
Topic: Behavioral Approaches for Dealing with Risk
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

24) Behavioral approaches for dealing with risk include annualized net present values and risk-
adjusted discount rates.
Answer: FALSE
Diff: 1
Topic: Behavioral Approaches for Dealing with Risk
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking
25) In capital budgeting, risk refers to the uncertainty surrounding the cash flows that a project
will generate and the degree of variability of project cash flows.
Answer: TRUE
Diff: 1
Topic: Risk and Cash Inflows
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

26) In capital budgeting, risk is generally thought of as the chance that NPV and IRR will
provide conflicting recommendations to management.
Answer: FALSE
Diff: 1
Topic: Risk and Cash Inflows
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

27) The break even cash inflow is the minimum level of cash inflow necessary for a project to be
acceptable.
Answer: TRUE
Diff: 1
Topic: Risk and Cash Inflows
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Reflective Thinking

28) Projects with a small chance of being acceptable and a broad range of possible cash flows are
riskier than projects having a high chance of being acceptable and a narrow range of possible
cash flows.
Answer: TRUE
Diff: 1
Topic: Risk and Cash Inflows
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

29) In capital budgeting, risk refers to a high degree of variability of the initial investment of a
project.
Answer: FALSE
Diff: 1
Topic: Risk and Cash Inflows
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking
30) In capital budgeting, one of the most common scenario approaches is to estimate the NPVs
associated with pessimistic (worst), most likely (expected), and optimistic (best) estimates of
cash inflow.
Answer: TRUE
Diff: 1
Topic: Scenario Analysis
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

31) Scenario analysis is a behavioral approach that evaluates the impact on a firm's return
through simultaneous changes in a number of variables.
Answer: TRUE
Diff: 1
Topic: Scenario Analysis
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

32) Scenario analysis is a behavioral approach that uses a number of possible outcomes to asses
the variability of returns.
Answer: TRUE
Diff: 1
Topic: Scenario Analysis
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

33) Simulation is a statistics-based approach used in capital budgeting to get a feel for risk by
applying predetermined probability distributions and random numbers to estimate risky
outcomes.
Answer: TRUE
Diff: 1
Topic: Simulation
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

34) The output of simulation provides an excellent basis for decision making since it allows the
decision maker to view a continuum of risk-return trade-offs rather than a single-point estimate.
Answer: TRUE
Diff: 1
Topic: Simulation
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

35) Monte Carlo simulation programs usually build a histogram of the results.
Answer: TRUE
Diff: 1
Topic: Simulation
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

36) Behavioral approaches ________.

A) are used to explicitly recognize project risk
B) are used to get a feel for project risk
C) are not used by rational financial managers
D) are used to quantify the risk
Answer: B
Diff: 1
Topic: Behavioral Approaches for Dealing with Risk
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

37) Breakeven cash inflow refers to ________.

A) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV
greater than or equal to zero
B) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV less
than zero
C) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR less
than zero cost of capital
D) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR equals
zero
Answer: A
Diff: 1
Topic: Risk and Cash Inflows
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

38) In capital budgeting, risk refers to ________.

A) the chance that a project will prove acceptable
B) the conflicting IRR and NPV in a project
C) the degree of variability of initial outlay
D) the uncertainty of cash flows
Answer: D
Diff: 1
Topic: Risk and Cash Inflows
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

39) In capital budgeting, risk refers to ________.

A) the degree of variability of the cash flows
B) the degree of variability of the initial investment
C) the chance that the net present value will be greater than zero
D) the chance that the internal rate of return will exceed the cost of capital
Answer: A
Diff: 1
Topic: Risk and Cash Inflows
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

40) Tangshan Mining Company, with a cost of capital of 10 percent, is considering investing in
project A, with an initial investment of $1,000,000. Project A is expected to provide equal cash
inflows over its 15 year useful life. Based on this information, the breakeven cash inflow for the
project is ________.
A) $1,000,000
B) $131,474
C) $100,000
D) $66,667
Answer: B
Diff: 1
Topic: Risk and Cash Inflows
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking
Table 11.6

A corporation is assessing the risk of two capital budgeting proposals. The financial analysts
have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows
which are given in the following table. The firm's cost of capital is 10 percent.

41) The range of the annual cash inflows for Project A is ________. (See Table 11.6)
A) $30,000
B) $10,000
C) $5,000
D) $0
Answer: B
Diff: 1
Topic: Scenario Analysis
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

42) If the projects have five-year lives, the range of the net present value for Project B is
approximately ________. (See Table 11.6)
A) $80,563
B) $201,000
C) $255,444
D) $303,263
Answer: D
Diff: 2
Topic: Scenario Analysis
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking
43) The expected net present value of Project A if the outcomes are equally probable and the
project has five-year life is ________. (See Table 11.6)
A) -$1,045
B) $17,910
C) $36,865
D) $93,730
Answer: B
Diff: 2
Topic: Scenario Analysis
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

44) A behavioral approach that evaluates the impact on a firm's return through simultaneous
changes in a number variables of a project is called ________.
A) sensitivity analysis
B) scenario analysis
C) simulation analysis
D) Monte Carlo simulation
Answer: B
Diff: 1
Topic: Scenario Analysis
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

45) The advantage of using simulation in the capital budgeting process is the ________.
A) ease of calculation over scenario analysis
B) continuum of risk-return trade-offs for decision making
C) single point estimate that helps the decision maker to choose the most accurate alternative
D) use of several possible outcomes to asses risk
Answer: B
Diff: 1
Topic: Simulation
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking
46) One type of simulation program made popular by the widespread use of personal computers
is called ________.
A) Monaco Simulation
B) Lemans Simulation
C) Cannes Simulation
D) Monte Carlo Simulation
Answer: D
Diff: 2
Topic: Simulation
Learning Obj.: LG 2
Learning Outcome: F-29
AACSB: Analytical Thinking

11.6 Risk-adjusted discount rates

1) The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the
percent of estimated cash inflows that investors would be satisfied to receive for certain rather
than the cash inflows that are possible for each year.
Answer: FALSE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

2) The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given
project to compensate a firm's owners adequately, that is, to maintain or improve the firm's share
price.
Answer: TRUE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

3) The security market line can be used as a graphical presentation of the appropriate discount
rate associated with each level of project risk.
Answer: TRUE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking
4) In CAPM, the total risk is defined as the sum of nondiversifiable and diversifiable risk.
Answer: TRUE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

5) Because of the basic mathematics of compounding and discounting, the risk-adjusted discount
rate (RADR) approach implicitly assumes that risk is an increasing function of time.
Answer: TRUE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

6) The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower
the net present value for a given stream of cash inflows.
Answer: TRUE
Diff: 1
Topic: Applying RADRs
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

7) For assets traded in an efficient market, the diversifiable risk can be eliminated through
diversification.
Answer: TRUE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

8) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a
project's beta and the market risk premium.
Answer: TRUE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking
9) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a
project's beta and the credit risk premium.
Answer: FALSE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

10) In applying risk-adjusted discount rates to project selection, projects falling above the SML
would have a positive NPV and those falling below the SML would have a negative NPV.
Answer: TRUE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

11) In applying risk-adjusted discount rates to project selection, projects falling above the SML
would have a negative NPV and those falling below the SML would have a positive NPV.
Answer: FALSE
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

12) The higher the risk-adjusted net present, the more viable the project.
Answer: TRUE
Diff: 1
Topic: Applying RADRs
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

13) Because a business firm can be viewed as a portfolio of assets, it is important that the firm
maintains a diversified portfolio of assets.
Answer: FALSE
Diff: 1
Topic: Portfolio Effects
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking
14) Even though a business firm can be viewed as a portfolio of assets, firms are not rewarded
for selecting a diversified portfolio of assets because investors can more efficiently diversify the
risk on their own.
Answer: TRUE
Diff: 1
Topic: Portfolio Effects
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

15) RADRs are popular because they are consistent with the general disposition of financial
decision makers toward rates of return.
Answer: TRUE
Diff: 1
Topic: RADRs in Practice
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

16) ________ reflects the return that must be earned on the given project to compensate the
firm's owners adequately.
A) Internal rate of return
B) Cost of capital
C) Risk-adjusted discount rate
D) Average rate of return
Answer: C
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

17) The difference by which the required discount rate exceeds the risk-free rate is called the
________.
A) excess return
B) risk premium
C) inflation premium
D) maturity premium
Answer: B
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking
18) A preferred approach for risk adjustment of capital budgeting cash flows, from a practical
viewpoint, is ________.
A) sensitivity analysis
B) simulation analysis
C) scenario analysis
D) risk-adjusted discount rates
Answer: D
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

19) The theoretical basis from which the concept of risk-adjusted discount rates is derived is
________.
A) the Gordon model
B) the capital asset pricing model
C) simulation theory
D) the basic cost of money
Answer: B
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking
Table 11.7

A firm is considering investment in a capital project which is described below. The firm's cost of
capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The
firm uses the following equation to determine the risk adjusted discount rate, RADR, for each
project: RADR = Rf + Risk Index (Cost of capital - Rf)

20) The net present value without adjusting the discount rate for risk is ________. (See Table
11.7)
A) $336,000
B) $250,000
C) $179,400
D) $87,000
Answer: D
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

21) The discount rate that should be used in the net present value calculation to compensate for
risk is ________. (See Table 11.7)
A) 6 percent
B) 15 percent
C) 18 percent
D) 24 percent
Answer: D
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking
22) The net present value of the project when adjusting for risk is ________. (See Table 11.7)
A) -$9,300
B) $0
C) $87,000
D) $105,000
Answer: A
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

Table 11.8

Tangshan Mining Company is considering investment in one of two mutually exclusive projects
M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the
market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta
for project M is 1.20 and the beta for project N is 1.40.

23) Using the risk-adjusted discount rate method of project evaluation, the NPV for Project M is
________. (See Table 11.8)
A) $156,494
B) $122,970
C) $85,732
D) $500,000
Answer: B
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking
24) Using the risk-adjusted discount rate method of project evaluation, the NPV for Project N is
________. (See Table 11.8)
A) $166,132
B) $122,970
C) $85,732
D) $600,000
Answer: C
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

25) Using the risk-adjusted discount rate method of project evaluation, the better investment for
Tangshan Mining is ________. (See Table 11.8)
A) Project M because it has a higher NPV
B) Project N because it has a higher NPV
C) Project N because it has a higher IRR
D) Project M because it has a higher IRR
Answer: A
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Reflective Thinking

26) Which project would be preferable if both projects were of average risk as the overall firm
and Tangshan Mining has a beta of 1.0? (See Table 11.8)
A) Project M because it has a higher NPV
B) Project N because it has a higher NPV
C) Project N because it has a higher IRR
D) Project M because it has a higher IRR
Answer: B
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Reflective Thinking
27) The shares of firms with diversified operations are________.
A) generally positively affected by diversification, because of the reduction in risk
B) generally negatively affected by diversification, because of the increase in risk
C) generally not affected by diversification, because investors can easily diversify their own
portfolios
D) generally negatively affected by diversification, because of the increase in the required rate of
return
Answer: C
Diff: 1
Topic: Portfolio Effects
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

28) Firms do not usually get rewarded by diversifying investments in different lines of business
because ________.
A) the capital markets are efficient and they quickly respond to change in economic conditions
B) cash flows from such projects tend to respond less to changing economic conditions
C) investors themselves can diversify by holding securities in a variety of firms; they do not need
the firm to do it for them
D) it is not possible for a firm to diversify its risk as the inflation premium is different for
different projects
Answer: C
Diff: 1
Topic: Portfolio Effects
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking
Table 11.9

Johnson Farm Implement is faced with two mutually exclusive projects, P and Q. The following
are the data about the two projects.

29) Evaluate the projects using risk-adjusted discount rates. (See Table 11.9)
Answer: = (15,000/.1) × [1-1/(1.1)3] - 40,000 = -$2,697
= (25,000/.14) × [1-1/(1.14)3] - 50,000 = $8,041
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

30) Which project do you recommend? (See Table 11.9)

Answer: Project P has a negative net present value using RADRs. Project Q has a positive NPV
of $8,041 using RADRs. Project Q is recommended.
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Reflective Thinking
Table 11.10

Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y
which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market
return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X
is 1.20 and the beta for project Y is 1.40.

31) Calculate the risk-adjusted discount rates for Project X and Project Y. (See Table 11.10)
Answer: rx = 5% + 1.20 (15% - 5%) = 17%
ry = 5% + 1.40 (15% - 5%) = 19%
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Analytical Thinking

32) Using the risk-adjusted discount rate method of project evaluation, find the NPV for projects
X and Y. Which project should Nico select using this method? (See Table 11.10)
Answer:

Project X should be chosen as it has a higher NPV

Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Reflective Thinking
33) Calculate the NPV of projects X and Y assuming that the firm did not employ the RADR
method and instead used the firm's overall cost of capital to evaluate projects X and Y. (See Table
11.10)
Answer:

Project Y should be chosen if the cash flows are discounted using cost of capital
Diff: 1
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Reflective Thinking

34) What potential biases exist in project selection if Nico Manufacturing did not adjust for the
difference in risk between Projects X and Y (See Table 11.10).
Answer: The danger of not accounting for differences in project risk is that the firm may
potentially chose unacceptable high-risk projects (with negative NPVs) over potentially
acceptable low-risk projects (with positive NPVs).
Diff: 2
Topic: Determining Risk-Adjusted Discount Rates (RADRs)
Learning Obj.: LG 4
Learning Outcome: F-29
AACSB: Reflective Thinking

11.7 Capital budgeting refinements

1) In case of unequal-lived, mutually exclusive projects, the use of net present value to select the
better project results in an incorrect decision.
Answer: TRUE
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking

2) When unequal-lived projects are independent, the length of the project lives is not critical.
Answer: TRUE
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking

3) When unequal-lived projects are independent, the impact of differing lives must be considered
because the projects do not provide service over comparable time periods.
Answer: FALSE
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking

4) Annualized net present value approach is the most efficient technique for dealing with projects
of unequal lives.
Answer: TRUE
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking

5) In selecting the best group of unequal-lived projects, if the projects are mutually exclusive, the
length of the projects lives is not critical.
Answer: FALSE
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking

6) The annualized net present value approach used to evaluate projects with unequal lives
converts the net present value of unequal-lived, mutually exclusive projects into an equivalent
annual amount.
Answer: TRUE
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking
7) The risk-adjusted discount rate approach to evaluating projects with unequal lives converts the
net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount.
Answer: FALSE
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking

8) The ________ approach is used to convert the net present value of unequal-lived projects into
an equivalent annual amount (in net present value terms).
A) internal rate of return
B) investment opportunities schedule
C) risk-adjusted discount rate
D) annualized net present value
Answer: D
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking
Table 11.11

Yong Importers, an Asian import company, is evaluating two mutually exclusive projects, A and
B. The relevant cash flows for each project are given in the table below. The cost of capital for
use in evaluating each of these equally risky projects is 10 percent.

9) The NPVs of Projects A and B are ________. (See Table 11.11)

A) $95,066 and $56,386, respectively
B) $56,386 and $95,066, respectively
C) -$56,386 and -$95,066, respectively
D) $45,000 and $650,000, respectively
Answer: B
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking

10) The annualized NPV of Project A is ________. (See Table 11.11)

A) $22,674
B) $12,947
C) $38,227
D) $21,828
Answer: A
Diff: 2
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking
11) The annualized NPV of Project B is ________. (See Table 11.11)
A) $11,673
B) $12,947
C) $38,227
D) $21,828
Answer: D
Diff: 2
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking

12) Which project should be chosen on the basis of the normal NPV approach? (See Table 11.11)
A) Project A because its NPV is higher
B) Project B because its NPV is higher
C) Project A because its IRR is higher
D) Project B because its IRR is higher
Answer: B
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Reflective Thinking

13) Which project should be chosen using the Annualized NPV approach? (See Table 11.11)
A) Project A because its annualized NPV is higher
B) Project B because its NPV is higher
C) Project A because its IRR is higher
D) Project B because its annualized NPV is higher
Answer: A
Diff: 1
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Reflective Thinking
14) A firm is evaluating two mutually exclusive projects that have unequal lives. The firm must
evaluate the projects using the annualized net present value approach and recommend which
project they should select. The firm's cost of capital has been determined to be 14 percent, and
the projects have the following initial investments and cash flows:

A) Choose Project R because its ANPV is $6459

B) Choose Project S because its ANPV is $6459
C) Choose Project R because its ANPV is $18,274
D) Choose Project S because its ANPV is $10,637
Answer: B
Diff: 2
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Reflective Thinking
15) A firm is evaluating two mutually exclusive projects that have unequal lives. The firm must
evaluate the projects using the annualized net present value approach and recommend which
project they should select. The firm's cost of capital has been determined to be 18 percent, and
the projects have the following initial investments and cash flows:

Answer:

ANPV of Project W: $22,540/3.127 = $7,208

ANPV of Project Y: $16,900/2.174 = $7,774
Select Project Y, since it has the highest ANPV.
Diff: 2
Topic: Comparing Projects with Unequal Lives
Learning Obj.: LG 5
Learning Outcome: F-29
AACSB: Analytical Thinking

16) Real options are opportunities that are embedded in capital budgeting projects that enable
managers to alter their cash flows and risks in a way that affects project acceptability.
Answer: TRUE
Diff: 1
Topic: Recognizing Real Options
Learning Obj.: LG 6
Learning Outcome: F-19
AACSB: Analytical Thinking

17) The objective of capital rationing is to select the group of projects that provides the highest
overall net present value and does not require more dollars than are budgeted.
Answer: TRUE
Diff: 1
Topic: Capital Rationing
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking
18) A firm with limited funds for investment in capital assets must ration those funds by
allocating them to projects that will maximize share value.
Answer: TRUE
Diff: 1
Topic: Capital Rationing
Learning Obj.: LG 6
Learning Outcome: F-19
AACSB: Analytical Thinking

19) The objective of capital rationing is to select the group of projects that provides the quickest
overall payback and does not require more dollars than are budgeted.
Answer: FALSE
Diff: 1
Topic: Capital Rationing
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking

20) The option to develop follow-on projects, expand markets, expand or retool plants, and so on
that
would not be possible without implementation of the project that is being evaluated is called a
________.
A) growth option
B) timing option
C) flexibility option
D) abandonment option
Answer: A
Diff: 1
Topic: Recognizing Real Options
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking

21) A(n) ________ allows management to avoid or minimize losses on projects that turn bad.
A) abandonment option
B) growth option
C) timing option
D) put option
Answer: A
Diff: 1
Topic: Recognizing Real Options
Learning Obj.: LG 6
Learning Outcome: F-19
AACSB: Analytical Thinking
22) A firm with unlimited funds must evaluate five projects. Projects 1 and 2 are independent and
Projects 3, 4, and 5 are mutually exclusive. The projects are listed with their returns.

A ranking of the projects on the basis of their returns from the best to the worst according to their
acceptability to the firm would be ________.
A) 4, 1, 2 or 5, and 3
B) 4, 1, and 2
C) 3, 2 or 5, 1, and 4
D) 4, 1, 5, and 3
Answer: B
Diff: 1
Topic: Capital Rationing
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Reflective Thinking

23) Which of the following proposed projects should be accepted for the upcoming year since
only $6 million is available for the next year's capital budget. What is the total NPV of the
projects that should be accepted?

A) A, B, & F; total cost = $5.5 million; Total NPV = $1.57

B) F, B, & D; total cost = $6 million; Total NPV = $1.72
C) E, F, & D; total cost = $5.5 million; Total NPV = $1.45
D) A, E, & F; total cost = $5 million; Total NPV = $1.3
Answer: B
Diff: 1
Topic: Capital Rationing
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking
24) The objective of ________ is to select the group of projects that provides the highest overall
net present value and does not require more dollars than are budgeted.
A) capital rationing
B) scenario analysis
C) real options
D) sensitivity analysis
Answer: A
Diff: 1
Topic: Capital Rationing
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking

25) An IRR approach to capital rationing involves graphically plotting project IRRs in
descending order against total dollar investment on an ________ graph.
A) ANPV
B) NPV
C) RADR
D) IOS
Answer: D
Diff: 1
Topic: Capital Rationing
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking

26) If a firm has a limited capital budget to fund its capital projects, it is said to be facing the
problem of ________.
A) constrained capital
B) wealth optimization
C) capital rationing
D) profitability
Answer: C
Diff: 1
Topic: Capital Rationing
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking
27) An approach to capital rationing that involves graphing project returns in descending order
against the total dollar investment to determine the group of acceptable projects is called the
________.
A) net present value approach
B) internal rate of return approach
C) payback approach
D) profitability index approach
Answer: B
Diff: 1
Topic: Capital Rationing
Learning Obj.: LG 6
Learning Outcome: F-08
AACSB: Analytical Thinking