Delta Inc. is considering the purchase of a new machine which is expected to increase sales by $10,000

Use the following information to answer the following question(s).

Delta Inc. is considering the purchase of a new machine which is expected to increase sales by $10,000 in addition to increasing non-depreciation expenses by $3,000 annually. Due to the sales increase, Delta will need to increase working capital by $1,000 at the beginning of the project. Delta will depreciate the machine using the straight-line method over the project's five year life to a salvage value of zero. The machine's purchase price is $20,000. The firm has a marginal tax rate of 34 percent, and its required rate of return is 12 percent.

The machine's initial cash outflow is

A) $20,000.

B) $21,000.

C) $27,000.

D) $23,000.

The machine's incremental after-tax cash inflow for year 1 is

A) $6,420.

B) $7,980.

C) $8,620.

D) $5,980.

The machine's after-tax incremental cash flow in year five is

A) $6,980.

B) $5,980.

C) $7,120.

D) $8,620.

The machine's NPV is

A) $1,556.56.

B) $2,556.56.

C) $1,123.99.

D) $2,123.99.

The machine's IRR is

A) less than 0.

B) greater than 12 percent.

C) less than 12 percent.

D) equal to 12 percent.

XYZ, Inc. is considering adding a product line that would utilize floor space in their manufacturing plant which is currently used for storage. XYZ will need to rent new storage space elsewhere. The floor space would be considered a(n)

A) variable cost.

B) opportunity cost.

C) sunk cost.

D) irrelevant cash flow.

Which of the following is included in the calculation of the initial outlay for a capital investment?

A) Investment in working capital

B) A feasibility study conducted the previous year.

C) Installation

D) A and C but not B

Which of the following would decrease after-tax operating cash flows? A decrease in

A) depreciation expense.

B) interest expense.

C) incremental sales.

D) both A and C.

If the federal income tax rate were increased, the impact of the tax increase on acceptable investment proposals

If the federal income tax rate were increased, the impact of the tax increase on acceptable investment proposals would be to (ignore the impact of the tax change on the cost of capital)

A) decrease the tax shelter from depreciation.

B) decrease net present value but the internal rate of return would stay the same.

C) increase net present value because the tax shelter from interest and depreciation becomes more valuable.

D) decrease both net present value. and internal rate of return.

Which of the following would increase the net working capital for a project? An increase in

A) accounts receivable.

B) fixed assets.

C) accounts payable.

D) common stock.

Which of the following should be included in the initial outlay?

A) Shipping and installation costs

B) Increased working capital requirements

C) Cost of employee training associated specifically with the asset being evaluated

D) All of the above

Depreciation expenses affect capital budgeting analysis by increasing

A) taxes paid.

B) incremental cash flows.

C) the initial outlay.

D) working capital.

Which of the following is included in the terminal cash flow?

A) The expected salvage value of the asset

B) Tax impacts from selling assets

C) Recapture of any working capital

D) All of the above

A firm purchased an asset with a 5-year life for $90,000, and it cost $10,000 for shipping and installation. According to the current tax laws the cost basis of the asset at time of purchase is

A) $100,000.

B) $95,000.

C) $80,000.

D) $70,000.

Thaler & Co. anticipates an increase of $1,000,000 in Net Operating Income from first year sales

Thaler & Co. anticipates an increase of $1,000,000 in Net Operating Income from first year sales of a new product. Taxes will be $350,000 and the company took $150,000 in depreciation expense. Operating cash flow equals

A) $1,000,000

B) $500,000

C) $800,000

D) $650,000

Schiller Construction Inc. has estimated the following revenues and expenses related to phase I of a proposed new housing development. Incremental sales= $5,000,000, total cash operating expenses $3,500,000, depreciation $500,000, taxes 35%, interest expense, $200,000. Operating cash flow equals

A) $650,000

B) $1,000,000

C) $1,150,000

D) $975,000

Incremental cash flows include all of the following EXCEPT

A) research and development costs.

B) increased labor costs from the project.

C) advertising costs.

D) both B and C.

Diamond Inc. has estimated that a new building will cost $2,500,000 to construct. Land was purchased a year ago for $500,000 and could be sold today for $550,000. An environmental impact study required by the state was performed at a cost of $48,000. For capital budgeting purposes, what is the relevant cost of the new building?

A) $2,500,000

B) $3,048,000

C) $3,050,000

D) $3,098,000

If SuperMart decides to offer a line of groceries at its discount retail outlet, inventories are expected to increase by $1,200,000, accounts receivable by $300,000 and accounts payable by $500,000. What is the cash outflow for working capital requirements?

A) $2,000,000

B) $1,700,000

C) $1,500,000

D) $1,000,000

If depreciation expense is taken over 5 years rather than 3 years, all things equal,

A) net present value will go down.

B) depreciation has no effect on net present value.

C) net present value will go up.

D) the answer depends on the company's marginal tax rate.

Cape Cod Cranberries will finance a new organic juice production facility with a $10,000,000 bond issue

Cape Cod Cranberries will finance a new organic juice production facility with a $10,000,000 bond issue. Interest on the bonds will be $637,500 per year for the life of the project. Should the interest payments be subtracted from the project's incremental cash flows?

Answer:  The cost of interest is implicitly built in to the project's cost of capital which will be used to discount the cash flows to their present value. If interest were subtracted from the expected cash flow, it would be counted twice and the project unfairly penalized.

Cape Cod Cranberries is evaluating the introduction of a new line of organic cranberry products. Market research suggests that approximates 1/3 of sales of the new products will come at the expense of existing product lines. How should this "cannibalization effect" be incorporated into the analysis.

Answer:  Incremental cash flows are determined by subtracting firm cash flows without the project from firm cash flows with the project. If lower sales of existing products are a direct result of introducing the new products, the company should deduct the lost cash flows from expected cash flows from the new products. (Some students may argue that the sales of non-organic products might eventually have been lost to competition in any case.)

Anderson-EOG Inc. is evaluating the construction of a gas pipeline to bring natural gas from Western New York state to New York City. The controller argues that depreciation has to be included among the expenses. The Treasurer argues that depreciation is irrelevant because it does not affect cash flow. Who is correct?

Answer:  Both are partially right and partially wrong. Depreciation is not a cash expense, but it does affect taxable income and therefore taxes. Since taxes affect cash flow, depreciation must be subtracted to arrive at taxable income, then added back in to arrive at operating cash flow.

Anderson-EOG Inc. is evaluating the construction of a gas pipeline to bring natural gas from Western New York state to New York City. The controller argues that every project of the company has to absorb a portion of administrative overhead including corporate headquarters and executive salaries. The Treasurer argues that these costs are irrelevant because they are merely being shifted from part of the company to another. Who is correct?

Answer:  Both are partially right and partially wrong. Costs are only relevant to the analysis if they affect the equation Incremental Project Cash Flows = (Firm Cash Flows with the Project) - (Firm Cash Flows without the Project). Executive salaries would be relevant, for example, if a new person is hired to manage the project or if someone is paid more to accept the additional responsibility.

Briefly explain why each of the following should or should not be considered in forecasting incremental cash flows from a project:

a. The cost of building a prototype of a new product to see if it was feasible.

b. Market research suggests that after buying a company's "smart phone" customers will begin to buy more of the same company's notebook computers.

c. A company decides to use existing space for storage. The company could have rented the space to another business for $2,500 a month.

Answer: 
a. The cost of building the prototype is a sunk cost. It will not go away if the decision is not to go ahead with the new product, therefore it is not relevant to the decision.

b. If the company expects additional sales of an existing product as a result of introducing a new product, it should consider those sales as it forecasts incremental cash flows from the project.

c. The foregone rent is an example of opportunity cost. It is easier to forecast than most cash flows and should definitely be considered.

The owner of a convenience store is considering adding a take-out sandwich section to her offerings.

The owner of a convenience store is considering adding a take-out sandwich section to her offerings. The new activity will occupy 25% of the space and account for 30% of total revenues. Property insurance on the building is $9,000 per year and will not change because of the new activity. How much of the insurance premium should be allocated to the new product line?

A) $2,700

B) $2,475

C) $2,250

D) $0.00

Mr. Smith included the cost of test marketing before production in the calculation of the initial outlay. Apparently, Mr. Smith does not understand the concept of

A) side-effect costs.

B) opportunity costs.

C) sunk costs.

D) variable costs.

Sunk costs are a type of incremental cash flow that should be included in all capital-budgeting decisions.

Answer:  FALSE

When determining how much overhead cost to include in incremental cash flows for a capital budgeting decision, the allocation of overhead by the accounting department based on percentage of space used by a project should always be used.

Answer:  FALSE

The pertinent issue for determining whether overhead costs should be part of a project's relevant after-tax cash flow is whether the project benefits from the overhead items.

Answer:  FALSE

The initial outlay involves the immediate cash outflow necessary to purchase the asset and put it in operating order.

Answer:  TRUE

When replacing an existing asset, the cash inflow associated with the sale of the old asset and any related tax effects must be considered and accounted for in the analysis.

Answer:  TRUE

The initial outlay of an asset does not include installation costs.

Answer:  FALSE

In making a capital budgeting decision we only include the incremental cash flows resulting from the investment decision.

Answer:  TRUE

To be conservative, capital budgeting analysis assumes that projects cannot add sales to existing lines of business.

Answer:  FALSE

A company converts space to use as a manufacturing facility.  Previously it was rented to another company as a warehouse.  This is an example of a sunk cost.

Answer:  FALSE

In measuring cash flows we are interested only in the incremental or differential after-tax cash flows that are attributed to the investment proposal being evaluated.

Answer:  TRUE

The calculation of differential cash flows over a project's life should include which of the following?

The calculation of differential cash flows over a project's life should include which of the following?

A) Labor and material savings

B) Additional revenues attributable to the project

C) Investment in net working capital

D) All of the above

Which of the following cash flows are NOT considered in the calculation of the initial outlay for a capital investment proposal?

A) Increase in accounts receivable

B) The cost of shipping new equipment

C) The cost of issuing new bonds if the project is financed by a new bond issue

D) The cost of installing new equipment

Which of the following expenses should be included when estimating cash flows for investment projects?

A) Interest expense related to financing a project

B) Sunk costs

C) Required principal payments related to financing a project

D) Opportunity costs

When evaluating Capital Budgeting decisions, which of the following items should NOT be included in the construction of cash flow projections for purposes of analysis?

A) Net salvage value

B) Changes in net working capital requirements

C) Shipping and installation costs

D) All of the above should be included.

Holding all other variables constant, which of the following would INCREASE net working capital for given year on a project?

A) Allowing customers less time to pay for purchases

B) Taking longer to pay suppliers

C) Increasing inventory levels

D) Both A and C

If an investment project would make use of land which the firm currently owns, the project should be charged with

A) a sunk cost.

B) an opportunity cost.

C) amortization.

D) interest.

Which of the following best describe why cash flows are utilized rather than accounting profits

Which of the following best describe why cash flows are utilized rather than accounting profits when evaluating capital projects?

A) Deducting interest expense from income and also including it in the discount rate would result in double counting.

B) Cash flows reflect the timing of benefits and costs more accurately than accounting profits.

C) Cash flows are more stable than accounting profits.

D) Both A and B.

Which of the following is the best example of an incremental cash inflow/outflow?

A) Cash flows that are achieved by diverting sales from other projects of the firm

B) Cash flows that are associated with the financing of a project

C) Cash flows that occur a little at a time

D) What the total cash flows will be to the company if the project is undertaken as opposed to what they would have been if the project had not been undertaken

Which of the following is an example of a sunk cost?

A) Overhead costs that are associated with a project

B) Interest expense associated with a project

C) Market study expenses incurred in order to decide if a firm should accept a project

D) Depreciation expenses associated with a project

Which of the following cash flows should be included as incremental costs when evaluating capital projects?

A) A new security system will reduce shoplifting losses by $50,000 per year.

B) New equipment associated with the project will increase depreciation expense by $300,000 per year.

C) Interest on construction loans will increase interest expense by $225,000 per year.

D) The new project will occupy about 5% of the Chief Operating Officer’s time, so 5% of her salary should be included.

Which of the following would be considered a termination cash flow?

A) The expected salvage value of the asset

B) Any tax payments or refunds associated with the salvage value of the asset

C) Recapture of any investment in working capital that was included as an incremental cash outlay

D) All of the above

How is interest expense that is associated with a project treated in the capital budgeting process?

A) It is treated as a cash outflow when estimating the incremental cash flows associated with a project.

B) It is built into the discount rate.

C) It is considered a synergistic incremental cash flow.

D) Interest expense is not relevant to any capital budgeting decisions.