Corporate Finance, 12e (Ross) Chapter 6 Making Capital Investment Decisions 1) The changes in a firm’s future cash flows that are a direct consequence of accepting a project are called cash flows, A) incremental B) stand-alone C) opportunity D) net present value E) erosion Answer: A Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 2) A cost that has already been paid, or a liability to pay that has already been incurred, is classified as a(n) A) salvage value expense. B) net working capital expense. C) sunk cost D) opportunity cost. E) erosion cost Answer: C Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 1 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.3) The most valuable investment given up if an alternative investment is chosen is referred to as a(n): A) salvage value expense. B) net working capital expense. C) sunk cost D) opportunity cost. E) erosion cost. Answer: D Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Opportunity costs Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 4) A decrease in a firm's current cash flows resulting from the implementation of a new project is referred to as A) salvage value expenses, B) net working capital expenses C) sunk costs. D) opportunity costs F) erosion costs, Answer: E Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation Copyright © 2019 McGraw-Hill Education, All sights reserved, No reproduction or distribution without the prior witten cousent of McGraw-Hill Edueation5) One purpose of identifying all the incremental cash flows related to a proposed project is to A) isolate the total sunk costs so they can be evaluated to determine if the project will add value to the firm, B) eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project C) make each project appear as profitable as possible for the firm, D) include both the proposed and the current operations of a firm in the analysis of the project. E) identify any and all changes in the cash flows of the firm for the past year so they can be included in the analysis. Answer: B Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) Sunk costs include any cost that: A) will change if a project is undertaken B) will be incurred if a project is accepted. C) has previously been incurred and cannot be changed. D) will be paid to a third party and cannot be refunded for any reason whatsoever. E) will occur if'a project is accepted and once incurred, cannot be recouped. Answer: C Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.7) You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are trying to decide whether to fix them or trade the car in for a newer model. In. analyzing the brake situation, the $500 you spent fixing the transmission is a(n) cost. A) opportunity B) fixed C) incremental D) sunk E) relevant Answer: D Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 8) Erosion can be explained as the: ‘A) additional income generated from the sales of a newly added produet. B) loss of current sales due to a new project being implemented C) loss of revenue due to employee theft. D) loss of revenue due to customer theft E) decrease in expected annual revenues as a new product ages Answer: B Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9) Which one of these is an example of erosion that should be included in project analysis? A) The anticipated loss of current sales when a new product is launched. B) The expected decline in sales as the market for a product becomes saturated. C) The reduction in sales that occurs when a competitor introduces a new product. D) The sudden loss of sales due to a major employer in your community implementing massive layofis E) The reduction in sales price that will most likely be required to sell inventory that has aged ‘Answer: A Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topie: Cash flows Bloom's: Understand AACSB: Reflective Thinking 4 Copytight © 2019 McGraw-Hill Edueation, All ights reserved. ‘No reproduction or distribution without the prior written consent of McGraw-Hill Education,Accessibility: Keyboard Navigation 10) Which one of the following should be excluded from the analysis of a project? A) Erosion costs B) Incremental fixed costs C) Incremental variable costs D) Sunk costs E) Opportunity costs Answer: D Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) The cash flows of a project should: A) be computed on a pretax basis. B) include all sunk costs and opportunity costs. C) include all incremental and opportunity costs. D) be applied to the year when the related expense or income is recognized by GAAP. E) include all financing costs related to new debt acquired to finance the project. Answer: C Difficulty: 1 Easy Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 12) All of the following are anticipated effects of a proposed project. Which of these should be considered when computing the cash flow for the final year of the project? A) Operating cash flow and salvage values only B) Salvage values and net working capital recovery only C) Operating cash flow, net working capital recovery, salvage values D) Net working capital recovery and operating cash flow only E) Operating cash flow only Answer: C Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.13) Changes in the net working capital: A) can affect the cash flows of a project every year of the project's life. B) only affect the initial cash flows of a project. C) are included in project analysis only if they represent cash outflows. D) are generally excluded from project analysis due to their irrelevance to the total project. E) can only affect the initial and the final cash flows of a project. Answer: A Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Net working capital Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) The net working capital of a firm will decrease if there is A) a decrease in accounts payable. B) an increase in inventory. C)a decrease in accounts receivable D) an increase in the checking account balance E) a decrease in fixed assets. Answer: C Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topie: Net working capital Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Net working capital: A) can be ignored in project analysis because any expenditure is normally recouped by the end of the project. B) requirements generally, but not always, create a cash inflow at the beginning of a project. C) expenditures commonly occur at the end of a project. D)is frequently affected by the additional sales generated by a new project. E) is the only expenditure where at least a partial recovery can be made at the end of a project. Answer: D Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Net working capital Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.16) A company that opts to forego bonus depreciation and instead uses the MACRS system of depreciation: A) will have equal depreciation costs for each year of an asset's life B) will expense the largest percentage of the cost during an asset's first year of life C) can depreciate the cost of land, if it so desires D) will write off the entire cost of an asset over the asset's class life. E) cannot expense any of the cost of a new asset during the first year of the asset's life. Answer: D Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Depreciation Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) Champion Toys just purchased some MACRS 5-year property at a cost of $230,000. The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years 1 to 6, respectively. Assuming the firm foregoes all bonus depreciation, the book value of the asset as of the end of Year 2 can be calculated as A) $230.000(1 — .20 ~ .32). B) $230,000([1 — (.20)(.32)]. C) $230,000(1 — .20)(1 — .32). D) $230,000/(1 - .20 - .32). E) $230,000(.20)(.32). Answer: A Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Depreciation Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.18) Pete's Garage just purchased some equipment at a cost of $650,000, What is the proper methodology for computing the depreciation expense for Year 3 if the equipment is classified as 5-year property for MACRS? The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years | to 6, respectively. Ignore bonus depreciation A) $680.000(1 ~ .20)(1 — .32)(1 — .192) B) $650,000(1 ~ .20)(1 — .32) C) $650,000(1 — .20)(1 ~ .32)(.192) D) $650,000(1 ~ .192) E) $650,000(.192) Answer: E Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Depreciation Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) The book value of an asset is primarily used to compute the: A) annual depreciation tax shield B) amount of cash received from the sale of the asset. C) amount of tax saved annually due to the depreciation expense D) amount of tax due on the sale of that asset. E) change in depreciation needed to reflect the market value of the asset, Answer: D Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 8 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.20) The salvage value of an asset creates an aftertax cash flow in an amount equal to the sales Price: A) of the asset B) minus the remaining book value C) minus [Tax rate x (Sales price - Book value)]. D) minus [Tax rate x (Book value ~ Sales price)] E) plus the remaining book value. Answer: C Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) The pretax salvage value of an asset is equal to the A) book value if straight-line depreciation is used. B) book value if MACRS depreciation is used. C) market value minus the book value D) book value minus the market value. E) market value. Answer: E Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topie: Cash flows Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) Which depreciation method currently permitted under U.S. tax law provides the fastest means of depreciating an asset? A) MACRS depreciation B) Bonus depreciation only C) Straight-line depreciation D) Sum-of-years digits depreciation E) Partial bonus depreciation combined with MACRS Answer: B Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Depreciation Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9 Copytight © 2019 McGraw-Hill Education, All sights seserved. ‘No reproduction or distribution without the prior written consent of McGraw-Hill Education,23) For a tax-paying firm, the net present value of a project will increase when: A) the initial net working capital requirement increases. B) depreciation is decreased during the early years of a project's life C) the life of the fixed assets used by that project is increased. D) the operating cash flows increase. E) the tax rate increases, Answer: D Difficulty: 1 Easy Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24) A project's operating cash flow will increase when the: A) depreciation expense increases. B) sales projections are lowered C) interest expense is lowered. D) net working capital requirement increases. E) earnings before interest and taxes decreases Answer A Difficulty: 1 Easy Section: 6.3 Altemative Definitions of Operating Cash Flow Topie: Operating cash flow Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) The cash flow tax savings generated as a result of a firm's tax-deductible depreciation, expense is called the: A) aftertax depreciation savings. B) depreciable basis. C) depreciation tax shield. D) operating cash flow. B) aftertax salvage value. Answer: C Difficulty: 1 Easy Section: 6.3 Altemative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.26) Assume a firm has no interest expense or extraordinary items, Given this, the operating cash flow can be computed as A) EBIT ~ Taxes. B) EBIT(1 ~ Tax rate) + Depreciation(Tax rate). C) (Sales — Costs)(1 — Tax rate). D) EBIT ~ Depreciation + Taxes. E) Net income + Depreciation. Answer: E Difficulty: 1 Easy Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) The bottom-up approach to computing the operating cash flow applies only when: A) both the depreciation expense and the interest expense are equal to zero. B) the interest expense is equal to zero. C) the project is a cost-cutting project. D) no fixed assets are required for the project. E) taxes are ignored and the interest expense is equal to zero, Answer: B Difficulty: 1 Easy Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) The top-down approach to computing the operating cash flow A) ignores all noneash items, B) applies only if a project produces sales C) can only be used if the entire cash flows of a firm are included, D) is equal to: Sales - Costs — Taxes + Depreciation. E) includes the interest expense related to a project. Answer A Difficulty: 1 Easy Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.29) For a profitable firm, an increase in which one of the following will increase the operating cash flow? A) Employee salaries B) Office rent ) Building maintenance D) Depreciation E) Equipment rental Answer: D Difficulty: 1 Easy Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) The term "tax shield” refers to a reduction in taxes created by: A) a reduction in sales, B) an increase in interest expense C) noncash expenses. D)a project's incremental expenses. E) opportunity costs Answer: C Difficulty: 1 Easy Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31) A project which is designed to improve the manufacturing efficiency of a firm but will generate no additional sales revenue is referred to as a(n) project. A) sunk cost B) opportunity C) cost-cutting D) revenue-cutting F) revenue-generating Answer: C Difficulty: 1 Easy Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Special projects Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 2 Copyright © 2019 McGraw-Hill Education, All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.32) The annual annuity stream of payments with the same present value as a project's costs is called the project's cost. A) incremental B) sunk C) opportunity D) erosion E) equivalent annual Answer: E Difficulty: 1 Easy Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Special projects Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33) Toni's Tools is comparing machines to determine which one to purchase. The machines sell for differing prices, have differing operating costs, differing machine lives, and will be replaced when wom out, These machines should be compared using: A) net present value only. B) both net present value and the internal rate of return C) their equivalent annual costs D) the depreciation tax shield approach. E) the replacement cost approach Answer: C Difficulty: 1 Easy Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis, Topic: Equivalent annual costs Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) The pro forma income statement for a cost reduction project A) will reflect a reduction in the sales of the firm. B) will generally reflect no incremental sales. C) has to be prepared reflecting the total sales and expenses of the entire firm. D) cannot be prepared due to the lack of any project related sales E) will always reflect a negative project operating cash flow Answer: B Difficulty: 1 Easy Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Special projects Bloom's: Understand AACSB: Reflective Thinking 13 Copytight © 2019 McGraw-Hill Education, ll ights reserved. ‘No reproduction or distribution without the prior written consent of McGraw-Hill Education,Accessibility: Keyboard Navigation 35) The equivalent annual cost method is most useful in determining, ‘A) the annual operating cost of an idle machine that is currently owned by a firm. B) the tax shield benefits of depreciation given the purchase of new assets for a project. C) operating cash flows for cost-cutting projects of equal duration. D) which one of two machines to acquire given equal machine lives but unequal machine costs. E) which one of two machines to purchase when the machines are mutually exclusive, have differing lives, and will be replaced. Answer: E Difficulty: 1 Easy Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis, Topie: Equivalent annual costs Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) Interest rates or rates of return on investments that have been adjusted for the effects of inflation are called rates, A)real B) nominal ©) effective D) stripped E) coupon Answer: A Difficulty: 1 Easy Section: 6.5 Inflation and Capital Budgeting Topic: Nominal and real rates Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation u Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.37) The increase you realize in buying power as a result of owning an investment is referred to as the rate of return, A) inflated B) realized C) nominal D) real E) risk-free Answer: D Difficulty: 1 Easy Section: 6.5 Inflation and Capital Budgeting Topic: Nominal and real rates Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 38) Marshall's purchased a corner lot five years ago at a cost of $498,000 and then spent $63,500 on grading and drainage so the lot could be used for storing outdoor inventory, The lot was recently appraised at $610,000. The company now wants to build a new retail store on the site The building cost is estimated at $1.1 million, What amount should be used as the initial cash outflow for this building project? A) 51,661,500 B) $1,100,000 C) $1,208,635 D) $1,710,000 E) $1,498,000 Answer: D Explanation: CFo = $610,000 + 1,100,000 CFo= $1,710,000 Difficulty: 2 Medium Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation Is Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.39) Samson's purchased a lot four years ago at a cost of $398,000. At that time, the firm spent $289,000 to build a small retail outlet on the site. The most recent appraisal on the property placed a value of $629,000 on the property and building. Samson's now wants to tear down the original structure and build a new strip mall on the site at an estimated cost of $2.3 million. What amount should be used as the initial cash outflow for the new project? A) $2,987,000 B) $2,242,000 C) $2,058,000 D) $2,300,000 E) $2,929,000 Answer: E Explanation: CFo = $629,000 + 2,300,000 CFo = $2,929,000 Difficulty: 2 Medium Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 40) Jamestown Ltd. currently produces boat sails and is considering expanding its operations to include awnings. The expansion would require the use of land the firm purchased three years ago at a cost of $142,000 that is currently valued at $137,500. The expansion could use some equipment that is currently sitting idle if $6,700 of modifications were made to it. The equipment originally cost $139,500 six years ago, has a current book value of $24,700, and a current market value of $39,000. Other capital purchases costing $780,000 will also be required. What is the amount of the initial cash outflow for this expansion project? A) $953,400 B) $962,300 €) $948,900 1D) $927,800 E) $963,200 Answer: E Explanation: CFo = $137,500 + 6,700 + 39,000 + 780,000 CFo = $963,200 Difficulty: 2 Medium Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 16 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.41) The Boat Works currently produces boat sails and is considering expanding its operations to include awnings. The expansion would require the use of land the firm purchased three years ago at a cost of $197,000 that is currently valued at $209,500. The expansion could use some equipment that is currently sitting idle if $7,500 of modifications were made to it. The equipment originally cost $387,500 five years ago, has a current book value of $132,700, and a current market value of $139,000. Other capital purchases costing $520,000 will also be required. What is the value of the opportunity costs that should be included in the initial cash outflow for the expansion project? A) $425,000 B) $485,000 Answer: D Explanation: Opportunity cost = $209,500 + 139,000 Opportunity cost = $348,500 Difficulty: 2 Medium Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Opportunity costs Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 42) Walks Softly currently sells 14,800 pairs of shoes annually at an average price of $59 a pair. Itis considering adding a lower-priced line of shoes that will be priced at $39 a pair. The company estimates it can sell 6,000 pairs of the lower-priced shoes annually but will sell 3,500 less pairs of the higher-priced shoes each year by doing so, What annual sales revenue should be used when evaluating the addition of the lower-priced shoes? A) $27,500 B) $24,000 ©) $31,300 D) $789,100 E) $900,700 Answer: A. Explanation: Sales = 6,000($39) — 3,500($59) Sales = $27,500 Difficulty: 2 Medium Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation a Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.43) Foamsoft currently sells 16,850 pairs of shoes annually at an average price of $79 a pair. Itis considering adding a new line of shoes that would sell for $49 a pair. The company estimates it can sell 5,000 pairs of the lower-priced shoes annually but will sell 1,250 less pairs of the higher- priced shoes each year by doing so. What is the estimated value of the annual erosion cost that should be charged to the lower-priced shoe project? A) $138,750 B) $146,250 C) $98,750 D) $52,000 E) $123,240 Answer: C Explanation: Erosion cos Erosion cost = $98,750 Difficulty: 2 Medium Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 79(1,250) 44) Sue purchased a house for $89,000, spent $56,000 upgrading it, and currently had it appraised at $212,900. The house is being rented to a family for $1,200 a month, the maintenance expenses average $200 a month, and the property taxes are $4,800 a year. If she sells the house she will incur $20,000 in expenses, She is considering converting the house into professional office space. What opportunity cost, if any, should she assign to this property if she has been renting it for the past two years? A) $178,500 B) $120,000 €) $185,000 D) $192,900 Answer: D Explanation: Opportunity cost = $212,900 ~ 20,000 Opportunity cost = $192,900 Difficulty: 2 Medium Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Opportunity costs Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation Is Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.45) Jamie's Motor Home Sales currently sells 110 Class A motor homes, 220 Class C motor homes, and 280 pop-up trailers each year, They are considering adding a mid-range camper with expected annual sales of 300 units. However, if the new camper is added, Class A sales will decline to 85 units and the Class C camper sales will decline to 200 units. The sales of pop-ups ‘will not be affected, Class A motor homes sell for an average of $140,000 each, Class C homes are priced at $59,500, and the pop-ups sell for $5,000 each. The new mid-range camper will sell for $42,900. What is the annual erosion cost of adding the mid-range camper? A) $5,425,000 B) $4,690,000 C) $5,375,000 D) $6,315,000 E) $7,875,000 Answer: B Explanation: Erosion cost = [(110 ~ 85)($140.000)] + [(220 — 200)($59,500)] Erosion cost = $4,690,000 Difficulty: 2 Medium Section: 6.1 Incremental Cash Flows: The Key to Capital Budgeting Topic: Cash flows Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 46) Lee's Furniture just purchased $24,000 of fixed assets that are classified as 5-year MACRS property. The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years 1 to 6, respectively. What is the amount of the depreciation expense for the third year if the firm applies the new bonus method of depreciation? A) S2,304 B) $2,507 C) $4,608 D) so F) $4,800 Answer: D Explanation: Depreciationycar 3 = $0, as all depreciation is taken in Year 1 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Depreciation Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 19 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.47) Lew just purchased $67,600 of equipment that is classified as 5-year MACRS property, The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years 1 to 6, respectively. What will be the book value of this equipment at the end of four years if he ignores bonus depreciation? A) $11,681.28 B) $18,280.20 C) $17,040.00 D) $19,468.80 E) $22,672.00 Answer: A Explanation: Book valueyear4 = $67,600(1 - .20 — .32 - 192 — .1152) Book valueyear 4 = $11,681.28 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topie: Depreciation Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 48) Northern Enterprises just purchased $1,900 of fixed assets that are classified as 3-year MACRS property. The MACRS rates are 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent for Years 1 to 4, respectively, What is the amount of the depreciation expense for Year 2? Ignore bonus depreciation. A) $562.93 B) $633.27 €) $719.67 D) $844.36 F) $1,477.63 Answer: D Explanation: Depreciationvear2 = $1,900(4444) Depreciationyear 2 = $844.36 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Depreciation Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 20 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.49) The Galley purchased some 3-year MACRS property two years ago at a cost of $19,800. The MACRS rates are 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent. The firm no longer uses this property so is selling it today at a price of $13,500. What is the amount of the aftertax profit on the sale? Assume the firm applies bonus depreciation and has a tax rate of 21 percent. A)S9,140.48, B) $10,665.00 C) $8,295.00 D) $7,187.78 E) $10,702.40 Answer: B Explanation: Profit = ($13.00 - $0)(1 - .21) Profit = $10,665 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 50) Three years ago, you purchased some 5-year MACRS equipment at a cost of $135,000. The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years 1 to 6, respectively. You sold the equipment today for $82,500. Which of these statements is correct if your tax rate is 23 percent and you ignore bonus depreciation? A) The tax due on the sale is $10,032.60. B) The book value today is $40,478 C) The book value today is $37,320. D) The taxable amount on the sale is $47,380. E) The tax refund from the sale is $13,219.40. Answer: A Explanation: Book value = $135,000(1 ~ .20 — .32 ~ .192) Book value = $38,880 Taxable amount = $82,500 — 38,880 Taxable amount = $43,620 Tax = 23(S43,620) Tax = $10,032.60 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation au Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.51) Custom Cars purchased $39,000 of fixed assets two years ago that are classified as 5-year MACRS property, The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years | to 6, respectively. The tax rate is 21 percent. If the assets are sold today for $19,000, what will be the aftertax cash flow from the sale? Ignore bonus depreciation A) S16.358.88 B) $17,909.09 ) $18,720.00 D) $18,941.20 E) $19,000.00 Answer: D Explanation: Book valueyear? = $39,000(1 - .20 ~ .32) Book valueyear2 = $18,720 Aftertax cash flow = $19,000 — ($19,000 ~ 18,720)(.21) Aftertax cash flow = $18,941.20 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.52) If Lew’s Steel Forms purchases $618,000 of new equipment, they can lower annual operating costs by $265,000. The equipment will be depreciated straight-line to a zero book value over its 3-year life. Ignore bonus depreciation. At the end of the three years, the equipment will be sold for an estimated $60,000. The equipment will require the company to hold an extra $23,000 of inventory over the 3-year period, What is the NPV if the discount rate is 14 percent and the tax rate is 21 percent? A) ~$2,646.00 B) -$7,014.54 C) -$12,593.78 D) $3,106.54 E) $6,884.40 Answer: B. Explanation: CF CFo = —$641,000 OCF = [$0 — (~$265,000)](1 — .21) + ($618,000/3)(.21) OCF = $252,610 Aftertax salvage value = $60,000 — ($60,000 — 0)(.21) Aftertax salvage value = $47,400 NPV = ~$641,000 + $252,610[(1 — 1/1.14°).14] + (47.400 + 23,000)/L.14° NPV = ~$7,014.54 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Project analysis and evaluation Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation —$618.000 — 23,000 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.53) Winslow Motors purchased $225,000 of MACRS 5-year property, The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years 1 to 6, respectively. The tax rate is 21 percent. If the firm sells the asset after four years for $10,000, what will be the aftertax cash flow from the sale if the firm applies bonus depreciation? A) $6,488.85 B) $8,880.20 C) $7,900.00 D) $7,770.40 F) $11,006.40 Answer: C Explanation: Book valueyear 4 = SO, as the asset will be fully depreciated in Year 1 Aftertax cash flow = $10,000(1 — .21) Aftertax cash flow = $7,900 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 54) A project is expected to create operating cash flows of $26,500 a year for four years. The fixed assets required for the project cost $62,000 and will be worthless at the end of the project An additional $3,000 of net working capital will be required throughout the life of the project. What is the project's net present value if the required rate of return is 12 percent? A) $19,208.11 B) $14,028.18 C) $15,306.09 D) $17,396.31 E) $21,954.17 Answer: D Explanation: NPV $3,000/1.12" NPV = $17,396.31 Difficulty: 2 Medium Section’ 6.2 The Baldwin Company: An Example Topic: Project analysis and evaluation Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation $62,000 ~ 3,000 + $26,500[(1 — 1/1.12').12] + 24 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.55) Assume a project will increase inventory by $61,000, accounts payable by $28,000, and accounts receivable by $36,000, What is the imitial net working capital requirement for this project? A) $53,000 B) $69,000 C) $59,000 1D) $97,000 E) $125,000 Answer: B Explanation: NWC requirement = $61,000 ~ 28,000 + 36,000 NWC requirement = $69,000 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Net working capital Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 56) Brennan's Boats is considering a project which will require additional inventory of $128,000, ‘will decrease accounts payable by $7,000, and will increase accounts receivable by $56,000. What is the initial net working capital requirement for this project? A) $177,000 B) $184,000 C) $191,000 D) $79,000 E) $198,000 Answer: C Explanation: NWC requirement = $128,000 + 7,000 + 56,000 NWC requirement = $191,000 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Net working capital Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.57) Lottie's Boutique needs to maintain 15 percent of its sales in net working capital. The firm is considering a 3-year project which will increase sales from their current level of $110,000 to $125,000 the first year and to $135,000 a year for the following two years. When analyzing the project, what amount should be included for net working capital for the last year if the net working capital returns to its original level at that time? A) $20.250 B) $7,000 €) $13,200 D) $3,750 E) $17.400 Answer: D Explanation: NWC recover: NWC recovery = $3,750 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Net working capital Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation ($135,000 — 110,000)(.18) 58) Wheels and More needs to maintain 8 percent of its sales in net working capital. The firm is considering a 5-year project which will increase sales from their current level of $110,000 to $146,000, $152,000, $158,000, $164,000, and $155,000 for Years 1 to 5 of the project. respectively. What amount should be included in the project analysis cash flows for net working capital for Year 3 of the project? A) -$12,640 B) ~$480 Cc) $0 D) $480 F) $12,640 Answer: B Explanation: NWC requirements = ($158,000 — 152,000)(.08) $480 NWC requirements = Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topie: Net working capital Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 26 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.59) Jeff's Stereos is expanding its product offerings which includes increasing the floor inventory by $150,000, increasing accounts receivable by $35,000, and increasing its debt to suppliers by $75,000. The company will also spend $200,000 for a building contractor to expand the size of the showroom. What is the amount of the project's initial cash flow? A) -$240,000 B) -$310,000 C) -$160,000 D) $298,000 E) -$175,000 Answer: B Explanation: CF CFo = -$310,000 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Apply ‘AACSB: Knowledge Application Accessibility: Keyboard Navigation $150,000 — 35,000 + 75,000 ~ 200,000 Copyright © 2019 MeGraw-til Education, All sights reserved, No reproduction or distribution without the prior witten cousent of McGraw-Hill Edueation60) Reynolds Metals is considering a project with a life of 4 years that will produce annual operating cash flows of $57,000. During the life of the project, inventory will be lowered by 528,000, accounts receivable will increase by $15,000, and accounts payable will increase by $6,000. The project requires the purchase of equipment at an initial cost of $104,000 that will be depreciated straightline to a zero book value over the life of the project. Ignore bonus depreciation. The equipment will be salvaged at the end of the project creating an aftertax cash inflow of $22,000. At the end of the project, net working capital will return to its normal level. What is the net present value of this project given a required return of 16 percent? A) $83,483.48 B) $78,117.05 C) $76,153.17 D) $80,037.86 E) $79,876.02 Answer: C Explanation: CFo = $28,000 — 15,000 + 6,000 ~ 104,000 CFo = -$85,000 CO4 = $57,000 — $28,000 + 15,000 - 6,000 + 22,000 C04 = $60,000 NPV = ~$85,000 + $57,000[(1 ~ 1/1.16°)/.16] + $60,000/1.16° NPV Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Project analysis and evaluation Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 28 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.61) A project will produce an operating cash flow of $7,300 a year for three years. The initial investment for fixed assets will be $11,600, which will be depreciated straight-line to zero over the asset’s 4-year life. Ignore bonus depreciation. The project will require an initial $500 in net working capital plus an additional $500 every year with all net working capital levels restored to their original levels when the project ends. The fixed assets can be sold for an estimated $2,500 at the end of the project, the combined tax rate is 23 percent, and the required rate of return is 12 percent, What is the net present value of the project? A) $7,500.95 B) $9,896.87 ©) $7,072.72 D) $6,353.41 E) $8,398.29 Answer: A. Explanation: Aftertax salvage value = $2,500 ~ [$2.00 - ($11,600/4)1(.23) Aftertax salvage value = $2,592 NPV = ~$11.600 ~ 500 + ($7,300 ~ $00)/1.12 + ($7.300 ~ $00)/1.12° + ($7,300 + Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Project analysis and evaluation, Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 29 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.62) Assume a proposed project under consideration by the James River Co. requires $28,900 in fixed assets, The firm plans to ignore bonus depreciation and instead apply straight-line depreciation to zero over the asset's 6-year life. An aftertax salvage value of $5,400 is expected. The project will produce an annual operating cash flow of $7.300 and will require net working capital of $500 initially plus an additional $500 in Year 3. Net working capital will be restored to its original level when the project ends at the end of Year 6. The tax rate is 21 percent and the required rate of return is 14 percent. What is the net present value of this project? A) $1,565.54 B) $1,196.87 €) $1,072.72 D) $1,337.75 F) $1,398.29 Answer: A Explanation: NPV = ~$28,900 — 500 + $7,300[(1 - viaa’y. 14] - $500/1 is (s1,000 + 5,400)/1.14° NPV = $1,565.54 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Project analysis and evaluation Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 30 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.63) Tech Enterprises is considering a new project that will require $325,000 for fixed assets, $160,000 for inventory, and $35,000 for accounts receivable, Short-term debt is expected to increase by $100,000. The project has a life of 5 years. The fixed assets will be depreciated straight-line to a zero book value over the life of the project. Ignore bonus depreciation. At the end of the project, the fixed assets can be sold for 25 percent of their original cost and the net working capital will return to its original level. The project is expected to generate annual sales of $554,000 with costs of $430,000. The tax rate is 21 percent and the required rate of return is 15 percent. What is the net present value of this project? A) $32,026.45 B) $33,278.35 C) $34,138.25 D) $32,318.29 E) $36,202.48 Answer: B Explanation: CFo = —$325,000 — 160,000 — 38,000 + 100,000 CFo = ~$420,000 OCF = ($554,000 — 430.000)(1 ~ .21) + ($325,000/5)(.21) OCF = $111,610 Aftertax salvage value = $325,000(.25) — {[$325.000(.25) — $0](.21)} Aftertax salvage value = $64,187.50 111,610 + 160,000 + 35.000 — 100.000 + 64,187.50 COs = $270,797.50 $420,000 + $111,610[(1 ~ 1/1.15') 15] + $270,797.50/1 18° Cos Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Project analysis and evaluation Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 31 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.64) The Down Towner is considering a project with a life of 4 years that will require $164,800 for fixed assets and $42,400 for net working capital. The fixed assets will be depreciated using the Year 2018 bonus depreciation method. At the end of the project, the fixed assets can be sold for $37,500 cash and the net working capital will return to its original level. The project is expected to generate annual sales of $195,000 and costs of $117,500. The tax rate is 24 percent and the required rate of return is 13 percent. What is the project's net present value? A) $48,909.09 B) $46,482.43 ©) $42,316.67 D) $56,500.00 E) $59,488.87 Answer: B Explanation: OCF = ($195,000 — 117,500)(1 — .24) OCF = $58,900 Year 1 depreciation tax shield = $164,800(.24) Year | depreciation tax shield = $39,552 Aftertax salvage value = $37,500 — [($37,500 — 0)(.24)] Aftertax salvage value = $28,500 NPV = ~$164,800 ~ 42,400 + $39,552/1.13 + $58,900[(1 ~ 1/1.13°).13] + ($28,500 + 42,400)/1.13" NPV = $46,482.43 Difficulty: 2 Medium Section’ 6.2 The Baldwin Company: An Example Topie: Project analysis and evaluation Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.65) The Mill Wheel is considering a project with a life of 3 years that will require $289,400 for fixed assets, $36,700 for inventory and $27,800 for accounts receivable, Short-term debt is expected to increase by $16,500. The fixed assets will be depreciated straight-line to a zero book value over 5 years. Ignore bonus depreciation. At the end of the project, the fixed assets can be sold for 20 percent of their original cost and the net working capital will return to its original level. The project is expected to generate annual sales of $275,000 and costs of $198,000. The tax rate is 21 percent and the required rate of returm is 16 percent. What is the amount of the cash. flow in the project's final year? A) $208,433.33 B) $197,908.18 C) $191,019.60 D) $160,087.09 E) $181,250.24 Answer: C Explanation: OCF OCF = $72,984.80 Aftertax salvage value = $289,400(.20) ~ [$289,400(.20) - $289,400(2/8)](.21) Aftertax salvage value ~ $70,034.80 COs = $36,700 + 27,800 ~ 16,500 + 72,984.80 + 70,034.80 C3 = $191,019.60 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topie: Cash flows Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation $275,000 — 198,000)(1 ~ .21) + ($289,400/5)(.21) 33 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.66) Leisure Vacations is considering a project with a life of 5 years that will require the purchase of S14 million in new 5-year MACRS equipment. The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years | to 6, respectively. Ignore bonus depreciation. The firm desires a minimum 14 percent rate of retum and the tax rate is 22 percent, The equipment can be sold at the end of the project for an estimated $225,000, What is the amount of the aftertax salvage value? A) $187,600.00 B) $162,418.54 €) $195,322.15 D) $184,238.97 E) $193,240.80 Answer: E Explanation: After tax salvage value = $225,000 ~ [$225,000 — $1,400,000(.0576)](.22) After tax salvage value = $193,240.80 Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Cash flows Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 67) Schroeder Electronics is considering a project which will require the purchase of $5.68 million in new equipment that will be depreciated straight-line to a zero book value over the 5- year life of the project. Ignore bonus depreciation. The firm requires a rate of return of 12 percent and the tax rate is 21 percent. What is the value of the depreciation tax shield in Year 5 of the project? A) $225,608 B) $228,406 ©) $334,800 D) $238,560 E) $0 Answer: D Explanation: Depreciation tax shieldyear 5 = $5,680,000/5(.21) Depreciation tax shieldvear = $238,560 Difficulty: 2 Medium Section: 6.3 Alternative Definitions of Operating Cash Flow Topie: Operating cash flow Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 34 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.68) Emie's Electrical is evaluating a project which will increase annual sales by $50,000 and costs by $30,000. The project has an initial asset cost of $150,000 that will be depreciated straight-line to a zero book value over the 10-year life of the project. Ignore bonus depreciation The applicable tax rate is 25 percent. What is the annual operating cash flow for this project? A) $19,250 B) $15,500 C) $21,350 D) $17,900 B) $18,750 Answer: E Explanation: OCF = ($50,000 ~ 30,000)(1 — .25) + ($150,000/10)(.25) OCF = $18,750 Difficulty: 2 Medium, Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 69) Leisure Vacations is considering a project which will require the purchase of $1.4 million in new 5-Year MACRS equipment. The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years 1 to 6, respectively. Ignore bonus depreciation, The firm desires a minimal 14 percent rate of return and has a combined tax rate of 25 percent. What is the value of the depreciation tax shield in Year 2 of the project? A) $107,500 B) $90,400 C) $89,600 D) $123,416 E) $112,000 Answer: E Explanation: Depreciation tax shieldyear2 = $1,400,000(.32)(.25) Depreciation tax shieldyea 2 = $112,000 Difficulty: 2 Medium Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 35 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.70) Kurt's Cabinets is looking at a project that will require $80,000 in fixed assets and another $20,000 in net working capital. The project is expected to produce annual sales of $110,000 with associated costs of $70,000. The project has a life of 4 years. The company ignores bonus depreciation and instead uses straight-line depreciation to a zero book value over the life of the project. The tax rate is 21 percent. What is the annual operating cash flow for this project? A) $31,600 B) $43,200 ©) $27,000 D) $35,800 E) $40,000 Answer: D Explanation: OCF OCF = $35,800 Difficulty: 2 Medium Section: 6.3 Altemnative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation ($110,000 — 70,000)(1 — .21) + ($80,000/4)(.21) 71) For the current year, Peter's Boats has sales of $760,000 and a profit margin of 5 percent. The annual depreciation expense is $80,000, What is the amount of the annual operating cash flow if the company has no long-term debt? A) $34,000 B) $86,400 €) $118,000 D) $120,400 F) $123,900 Answer: C Explanation: OCF = $760,000(.05) ~ 80,000 OCF = $118,000 Difficulty: 2 Medium Section: 6.3 Altetnative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 36 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.72) Samoa’s Tools has annual sales of $760,000 and a profit margin of 8 percent. The annual depreciation expense is $50,000. What is the amount of the annual operating cash flow if the company has no long-term debt? A) $50,000 B) $60,800 ©) $110,800 D) $810,000 E) $930,000 Answer: C Explanation: OCF = $760,000(.08) + 50,000 OCF = $110,800 Difficulty: 2 Medium Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 73) For this year, Jessica's has sales of $439,000, depreciation of $32,000, and net working capital of $56,000. The firm has a tax rate of 23 percent and a profit margin of 6 percent. The firm has no interest expense. What is the amount of the operating cash flow? A) $49,384 B)S: C) $54,980 D) $58,340 F) $114,340 Answer: D Explanation: OCF = $439,000(.06) + $32,000 OCF = $58,340 Difficulty: 2 Medium Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 9 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.74) For next year, By-Way has projected sales of $435,000, costs of $254,000, depreciation of 535,000, interest expense of $22,000, and taxes of $28,500, What is the amount of the projected operating cash flow? A) $130,500 B) $157,900 €) $152,500 D) $161,500 E) $181,000 Answer: C Explanation: OCF = $435,000 — 254,000 ~ 28,500 OCF = $152,500 Difficulty: 2 Medium Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 75) For this year, Wilbert’s Cakes has costs of $187,400, depreciation of $32,700, interest expense of $14,800, dividends paid of $5,600, taxes of $17,600, and an operating cash flow of $101,900. What is the sales amount? A) $264,200 B) $269,800 ©) $306,900 Answer: C Explanation: OCF = $101,900 = Sales ~ 187.400 ~ 17.600 Sales = $306,900 Difficulty: 2 Medium Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 38 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.76) Ben's Border Café is considering a project that will produce sales of $16,000, increase cash expenses by $10,000, increase taxes by $950, and increase depreciation by $1,500 for each year of the project's 9-year life. What is the amount of the annual operating cash flow using the top- down approach? A)S3,550 B) $5,050 C) $6,100 D) $7,550 E) $4,550 Answer: B Explanation: OCF = $16,000 ~ 10,000 - 950 OCF = $5,050 Difficulty: 2 Medium, Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 77) Camille's Café is considering a project that will not produce any sales but will decrease annual cash expenses by $12,000. If the project is implemented, annual taxes will increase from $23,000 to $25,205, and depreciation will increase from $4,000 to $5,500 per year. What is the amount of the annual operating cash flow using the top-down approach? A) $5,025 B) $9,795 ©) $5,500 D) $12,000 F) S14 Answer: B Explanation: OCF = $0 - (~$12,000) — ($25,205 - 23,000) OCF = $9,795 Difficulty: 2 Medium Section: 6.3 Altetnative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 39 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.78) Romnie's Coffee House is considering a project with a life of one year that will produce sales of $6,000 and increase cash expenses by $2,500, If the project is implemented, taxes will increase by $700. The additional depreciation expense will be $200 and interest expense will increase by $100. An initial cash outlay of $200 is required for net working capital. What is the amount of the operating cash flow using the top-down approach? A)S2.200 B) $1,500 C) $2,800 D) $3,500 E) $4,200 Answer: C Explanation: OCF = $6,000 — 2.500 — 700 OCF = $2,800 Difficulty: 2 Medium Section: 6.3 Altemnative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 79) A project will increase annual sales by $60,000 and annual cash expenses by $51,000. The project will cost $40,000 and will be depreciated using straight-line depreciation to a zero book value over the 4-year life of the project. Ignore bonus depreciation. The company has a marginal tax rate of 23 percent. What is the annual operating cash flow using the tax shield approach? A) 85,850 B) $8,650 €) 89.230 D) $9,770 E) $10,350 Answer: C Explanation: OCF = ($60,000 ~ §1,000)(1 ~ .23) + ($40,000/4)(.23) OCF = $9,230 Difficulty: 2 Medium Section: 6.3 Alternative Definitions of Operating Cash Flow Topie: Operating cash flow Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 40 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.80) A new project with a life of four years will increase sales by $140,000 and cash expenses by 395,000 annually. The project will cost $100,000 and will be depreciated using the Year 2018 bonus depreciation method. The company has a marginal tax rate of 21 percent. What is the value of the depreciation tax shield in Year 2? A)S0 B) $5,250 C) $2,625 D) $3,375 F) $6,500 Answer: A Explanation: Depreciation tax shield = $0, as 100 percent of the depreciation will be taken in Year | Difficulty: 2 Medium, Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 81) Matty's Place is considering the installation of a new computer system that will cut annual operating costs by $12,000. The system will cost $42,000 to purchase and install. This system is expected to have a life of 5 years and will be depreciated to zero using straight-line depreciation Ignore bonus depreciation. What is the amount of the earnings before interest and taxes for each year of this project if the tax rate is 21 percent? A) -$20,400 B) $5,400 C) $3,600 D) $12,000 F) $8.400 Answer: C Explanation: EBIT = $0 ~ (~$12,000) ~ ($42.000/8) EBIT = $3,600 Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis, Topie: Special projects Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 41 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.82) The Wolf's Den is considering replacing the equipment it uses to produce tents. The equipment would cost $1.4 million and lower manufacturing costs by an estimated $215,000 a ‘year. The equipment will be depreciated over 8 years using straight-line depreciation to a book value of zero. Ignore bonus depreciation. The required rate of return is 13 percent and the tax rate is 21 percent, The equipment will be worthless after 8 years. What is the annual operating cash flow from this proposed project? A)S141,900 B) $206,600 ©) $232,400 D) $160,000 E) $40,000 Answer: B Explanation: OCF = [$0 — (—$215,000)](1 — .21) + ($1.400,000/8)(.21) OCF = $206,600 Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Special projects Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 83) The initial cost of one customized machine is $675,000 with an annual operating cost of $14,800, and a life of 4 years. The machine will be worthless and replaced at the end of its life What is the equivalent annual cost of this machine if the required rate of retum is 14.5 percent and we ignore taxes? A) $249,797.41 B) $240,008.02 ©) $248,841.99 D) $247,647.78 E) $251,610.29 Answer: C Explanation: NPV = ~$675,000 — $14,800[(1 ~ 1/1.145'V/.145] NPV = ~$717,684.65 $717,684.65 = EAC[(1 ~ 1/1,148')/.145] BAC = $248,841.99 Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Equivalent annual costs Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 42 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.84) Jackson & Sons uses packing machines to prepare its products for shipping. One machine costs $397,500 and lasts 5 years before it needs replaced, The machine will be worthless after the 5 years. The annual aftertax operating cost per machine is $38,400. What is the equivalent annual cost of one machine if the required rate of return is 16 percent? A) $148,556.67 B) $159,800.23 C) $156,004.12 1D) $143,006.15 F) $154,224.08 Answer: B Explanation: NPV = ~$397,00 ~ $38,400[(1 ~ 1/1.16°)/16] NPV = -$523,232.88 $523,232.88 = EACI(1 ~ 1/1.16 y.16] BAC = $159,800.23 Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Special projects Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 4B Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.85) Bruno's is analyzing two machines to determine which one it should purchase. The company requires a rate of return of 14.6 percent and uses straight-line depreciation to a zero book value over a machine's life. Ignore bonus depreciation and taxes. Machine A has a cost of $318,000, annual operating costs of $8,700, and a life of 3 years. Machine B costs $247,000, has annual operating costs of $9,300, and a life of 2 years. Whichever machine is purchased will be replaced at the end of its useful life. Which machine should Bruno's purchase and why? A) Machine A; because it will save the company about $13,406 a year B) Machine A: because it will save the company about $18,100 a year C) Machine B; because it will save the company about $16,510 a year D) Machine B: because it will save the company about $11,609 a year E) $154,224.08, Answer: A $318,000 ~ $8,700[(1 ~ 1/1.146°).146] NPVa = -$337,996.58 $337,996.58 = EACa[(1 — 1/1.146°)/.146] EACa = $147,053.69 $247,000 ~ $9,300[(1 ~ 1/1.146°)/.146] $262,196.50 $262,196.50 = EACa[(1 — 1/1.146°).146] EACB = $160,459.86 Explanation: NPV. NPVB NPV Machine A lowers the annual cost of the equipment by about $13,406 (= $160,459.86 — 147,053.69). Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Equivalent annual costs Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 44 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.86) Western Tech is considering a new project that will require $118,000 of fixed assets and net working capital of $16,000. The fixed assets will be depreciated on a straight-line basis to a zero salvage value over three years. Ignore bonus depreciation. This project is expected to produce an operating cash flow of $45,000 the first year with that amount decreasing by 5 percent annually for two years before the project is shut down. The fixed assets can be sold for $55,000 at the end of the project and all net working capital will be recovered. What is the net present value of this project at a discount rate of 11.5 percent and a tax rate of 23 percent? A) $3,209.17 B) $15,311.09 C) $12,136.54 D) -$3.770.30 E) -$5,456.32 Answer: C Explanation: NPV = ~$118,000 ~ 16,000 + $45,000/1.115 + [$45,000(1 ~ .08)]/1.115" + {[$45,000(1 ~ .05)"] + [$55,000 ~($55,000 ~ 0){.23)] + $16,000}/1.115° NPV 12,136.54 Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Project analysis and evaluation Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 87) You are working on a bid for a contract, Thus far, you have determined that you will need $156,000 for fixed assets and another $32,000 for net working capital at Time 0. You have also determined that you can recover $68,400 aftertax for the combined fixed assets and net working capital at the end of the 4-year project. What operating cash flow will be required each year for the project to return 16 percent in nominal terms” A) $46,666.67 B) $48,929.74 C) $55,200.16 686,06 Answer: D $186,000 ~ 32,000 + OCF[(1 ~ 1/1.16°)/.16] + Explanation: NPV = $68,400/1.16" $150,223.29 = OCF[(1 ~ 1/1.16°V.16] OCF “$53,686.06 Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis 4s Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.Topic: Special projects Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 88) You plan to bid on a project with a life of 5 years that will require $68,000 of fixed assets. These assets will be depreciated straight-line to zero over the project's life. Ignore bonus depreciation. The relevant discount rate is 12.5 percent, the tax rate is 21 percent, there is no interest expense, net working capital is unaffected, and there is no salvage Value. What is the minimal required amount of annual sales revenue given annual cash costs of $47,900? A) $74,515.75 B) $82,018.27 ©) $57,202.19 D) $68.459.58 E) $52,311.89 Answer: D —$68,000 + OCFL(1 ~ 1/1.125°)/.12: Explanation: NPV = OCF = $19,098.07 $19,098.07 — $68,000/5 EBIT = $5,498.07/(1 ~ .21) EBIT = $6,959.58 1,959.58 + $68,000/5 + $47,900 Sales = $68,459.58 Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Special projects Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 89) Stu is working on a bid for a contract. Thus far, he has determined that he will need $218,000 for fixed assets and another $41,000 for net working capital at Time 0, He has also determined that he can recover $79,900 aftertax for the combined fixed assets and net working capital at the end of the 3-year project. What operating cash flow will be required each year for the project to return 14 percent in nominal terms? A) $116,079.42 B) $97,487.79 ©) $110,220.48, D) $88,330.01 E) $113,360.69 Answer: D Explanation: NPV $218,000 ~ 41,000 + OCF{IL ~ (1/114 )/143 + 46 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.$79,900/1.14 OCF = $88,330.01 Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Special projects Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 90) In working on a bid project, you have determined that $318,000 of fixed assets are required These assets will be depreciated straight-line to zero over the 6-year life of the project. Ignore bonus depreciation, The discount rate is 18 percent, the tax rate is 21 percent, and there is no interest expense. In addition, the annual cash costs will be $198,200. After considering all the project's other cash flows, you have determined that the required operating cash flow is $92,400. What is the required amount of annual sales revenue? A) $299,811.17 B) $302,006.64 C) $284,849.92 D) $301,073.42 E) $279,407.72 Answer: D Explanation: OCF = $92,400 = Net income + $318,000/6 ‘Net income = $39,400 $39.400 = [Sales ~ $198,200 — ($318.000/6)](1 — .21) Sales = $301,073.42 Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis Topic: Special projects Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation ” Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.91) Lew’s Market invested in a project that retumed 14.83 percent during a period when inflation averaged 2.69 percent. What real rate of return did the firm eam on its project? A) 12.41 percent B) 11.03 percent C) 12.99 percent D) 11.82 percent E) 11.29 percent Answer: D Explanation: r= (1,1483/1.0269) - 1 r= .1182, or 11.82% Difficulty: 2 Medium Section: 6.5 Inflation and Capital Budgeting Topic: Nominal and real returns Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 92) MTM Ltd. earns 10.25 percent on its current investments after adjusting for inflation. Inflation is expected to average 2.8 percent annually over the next 5 years. What discount rate should the firm assign to a project assuming the project has a life of 5 years and the same level of risk as the firm's current operations? A) 12.96 percent B) 13.05 percent C) 13.14 percent D) 13.34 percent B) 12.87 percent Answer: D Explanation: R = 1,1025(1.028) - 1 R= 1334, of 13.34% Difficulty: 2 Medium Section: 6.5 Inflation and Capital Budgeting Topic: Nominal and real returns Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 48 Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.93) Lester's has a new project with projected real cash flows of $12,200, $14,600, and $16,300 for Years 1 to 3, respectively, The nominal discount rate is 15.96 percent and the inflation rate is, 4 percent. What is the net present value of the project if the initial cost is $25,000? A)S9,71 1.64 B) $8,946.48 C) $9,508.70 D) $9444.15 E) $9,248.74 Answer: D Explanation: r= (1,1896/1.04) — 1 r= 115, or 11.5% NPV = ~$25,000 + $12,200/1.115 + $14,600/1.115° + $16,300/1.115° NPV = $9,444.15 Difficulty: 2 Medium Section: 6.5 Inflation and Capital Budgeting Topic: Nominal and real retums Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 94) Should financing costs be included as an incremental cash flow in capital budgeting analysis? 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. Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Project analysis and evaluation Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation 49 Copyright © 2019 McGraw-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.95) Explain the underlying assumptions that are being made when a project's total investment in net working capital is recouped when the project ends. Answer: A full recoupment of net working capital assumes that all cash balances are returned to their pre-project levels, all credit granted to customers is fully collected, all inventory is sold at cost, and all accounts payable are paid in full. Difficulty: 2 Medium Section: 6.2 The Baldwin Company: An Example Topic: Project analysis and evaluation Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 96) This chapter introduced three new methods for calculating project operating cash flow (OCF). Under what circumstances is each method appropriate? Answer: Three additional formulations of OCF are the bottom-up, top-down, and tax-shield approaches. The bottom-up method is useful when the analyst has prepared pro forma income statements for a project (since OCF is equal to net income plus depreciation), provided there is no interest expense. The top-down approach defines OCF as sales minus cash costs minus taxes, and is useful when reliable estimates of the relevant dollar costs are available, pethaps in a situation where fixed and variable costs are the focus of the analysis. Finally, the tax-shield approach separately illustrates the project benefits associated with aftertax gross profit (revenue gains and/or cost reductions) and the depreciation tax shield Difficulty: 2 Medium Section: 6.3 Alternative Definitions of Operating Cash Flow Topic: Operating cash flow Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 97) When is it appropriate to use the equivalent annual cost (EAC) methodology, and how do you make a decision using it? Answer: The EAC should be used to evaluate two or more mutually exclusive projets with different lives that will be replicated essentially forever. The manager should choose the project with the lowest, or least-negative, EAC. Difficulty: 2 Medium Section: 6.4 Some Special Cases of Discounted Cash Flow Analysis, Topie: Equivalent annual costs Bloom's: Apply AACSB: Knowledge Application Accessibility: Keyboard Navigation so Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.98) Explain the use of real and nominal discount rates in discounting cash flows. Which is used more often and why? Answer: The most important thing to remember is that real cash flow’ should be discounted at the real interest rate and nominal cash flows should be discounted at the nominal discount rate. Since real cash flows do not include inflation, discounting real cash flows at the nominal rate will artificially reduce the NPV and lead the analyst to reject projects that otherwise should be accepted. Likewise, since nominal cash flows do include inflation, they must be discounted at the nominal discount rate which includes inflation, Discounting nominal cash flows at the real discount rate will result in an artificially high NPV and thus lead to accepting projects that, should otherwise not be accepted. Since most cash flows are nominal, nominal rates are used more often in practice Difficulty: 2 Medium Section: 6.5 Inflation and Capital Budgeting Topic: Nominal and real rates Bloom's: Analyze AACSB: Analytical Thinking SI Copyright © 2019 MeGrayv-Hill Edueation, All rights reserved. 'No reproduction or distribution without the prior written consent of McGraw-Hill Education.