Chapter 8: Capital Budgeting Cash Flows

Chapter 8 Capital Budgeting Cash Flows 87
Chapter 8
Capital Budgeting Cash Flows
 Learning Goals
1. Understand the motives for key capital expenditure and the steps in the capital budgeting process.
2. Define basic capital budgeting terminology.
3. Discuss relevant cash flows, expansion versus replacement decisions, sunk costs and opportunity
costs, and international budgeting.
4. Calculate the initial investment associated with a proposed capital expenditure.
5. Find the relevant operating cash inflows associated with a proposed capital expenditure.
6. Determine the terminal cash flow associated with a proposed capital expenditure.
 True/False
1. Capital budgeting techniques are used to evaluate the firm’s fixed asset investments which provide
the basis for the firm’s earning power and value.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 1
Topic: Concept of Capital Budgeting
2. The purchase of additional physical facilities, such as additional property or a new factory, is an
example of a capital expenditure.
Answer: TRUE
Learning Goal: 1
Topic: Capital Budgeting Terminology
3. Capital budgeting is the process of evaluating and selecting shortterm investments consistent with
the firm’s goal of owner wealth maximization.
Answer: FALSE
88 Gitman • Principles of Finance, Eleventh Edition
Learning Goal: 1
4. A $60,000 outlay for a new machine with a usable life of 15 years is an operating expenditure that
would appear as a fixed asset on the firm’s balance sheet.
Answer: FALSE
Learning Goal: 1
5. Capital expenditure is an outlay of funds invested only on fixed assets and is expected to produce
benefits over a period of time greater than one year.
Answer: FALSE
Learning Goal: 1
6. An outlay for advertising and management consulting is considered to be a current expenditure.
Answer: FALSE
Learning Goal: 1
7. Capital expenditure proposals are reviewed to assess their appropriateness in light of the firm’s
overall objectives and plans, and to evaluate their economic validity.
Answer: TRUE
Learning Goal: 1
8. A firm with limited funds must ration its funds by allocating them to projects that will maximize
share value.
Answer: TRUE
Learning Goal: 2
Topic: Capital Rationing
9. Independent projects are projects that compete with one another, so that the acceptance of one
eliminates the others from further consideration.
Answer: FALSE
Learning Goal: 2
Topic: Independent Projects
10. A nonconventional cash flow pattern associated with capital investment projects consists of an
initial outflow followed by a series of inflows.
Answer: FALSE
Learning Goal: 2
Topic: Conventional versus Nonconventional Cash Flows
11. If a firm has unlimited funds to invest, all the independent projects that meet its minimum
investment criteria can be implemented.
Answer: TRUE
Learning Goal: 2
12. The following three projects are examples of mutually exclusive projects.
(1) installing air conditioning in the plant
(2) acquiring a small supplier
(3) purchasing a new computer system
Answer: FALSE
Learning Goal: 2
Topic: Mutually Exclusive Projects
13. When the firm is confronted with a number of projects, some of which are mutually exclusive and
some of which are independent, it must first determine the best of each group of mutually exclusive
alternatives. The best of the acceptable independent projects can then be selected.
Answer: TRUE
Learning Goal: 2
14. If a firm has unlimited funds to invest, all the mutually exclusive projects that meet its minimum
investment criteria can be implemented.
Answer: FALSE
Learning Goal: 2
15. Mutually exclusive projects are projects whose cash flows are unrelated to one another; the
acceptance of one does not eliminate the others from further consideration.
Answer: FALSE
Learning Goal: 2
16. To increase its production capacity, a firm is considering: 1) to expand its plant, 2) to acquire
another company, or 3) to contract with another company for production. These three projects are
examples of independent projects.
Answer: FALSE
Learning Goal: 2
17. Accounting figures and cash flows are not necessarily the same due to the presence of certain
noncash expenditures on the firm’s income statement.
Answer: TRUE
Learning Goal: 3
Topic: Relevant Cash Flows
18. The relevant cash flows for a proposed capital expenditure are the incremental aftertax cash
outflows and resulting subsequent inflows.
Answer: TRUE
Learning Goal: 3
19. Foreign direct investment is the transfer of capital, managerial, and technical assets to a foreign
country.
Answer: TRUE
Learning Goal: 3
Topic: International Capital Budgeting
20. If a new asset is being considered as a replacement for an old asset, the relevant cash flows would be
found by adding the expected cash flows attributed to old asset and the expected cash flows for new
asset.
Answer: FALSE
Learning Goal: 3
Topic: Replacement Project Analysis
21. International capital budgeting differs from the domestic version because (1) cash inflows and
outflows occur in a foreign currency, and (2) foreign investments potentially face significant
political risk.
Answer: TRUE
Learning Goal: 3
22. In case of international capital budgeting, the U.S. company can minimize its political risk by
subtracting the investment as a joint venture and by selecting a competent and wellconnected local
partner.
Answer: TRUE
Learning Goal: 3
23. Sunk costs are cash outlays that have already been made and therefore 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.
Answer: TRUE
Learning Goal: 3
Topic: Sunk Costs
24. Opportunity costs should be included as cash outflows when determining a project’s incremental
cash flows.
Answer: TRUE
Learning Goal: 3
Topic: Opportunity Costs
25. In case of international capital budgeting, longterm currency risk can be minimized by at least
partly financing the foreign investment with a dollardenominated capital contribution from the
parent company rather than in the local capital markets.
Answer: FALSE
Learning Goal: 3
26. To calculate the initial investment, we subtract all cash inflows occurring at time zero from all cash
outflows occurring at time zero.
Answer: TRUE
Learning Goal: 4
Topic: Initial Investment
27. The depreciable value of an asset is equal to its purchase price minus installation costs, if any.
Answer: FALSE
Learning Goal: 4
Topic: Depreciable Value of an Asset
28. The book value of an asset is equal to its depreciable value minus the accumulated depreciation.
Answer: TRUE
Learning Goal: 4
Topic: Book Value of an Asset (Equation 8.1)
29. 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
Learning Goal: 4
Topic: Depreciation and Taxes (Equation 8.1)
30. Recaptured depreciation is the portion of the sale price that is below book value and has not been
depreciated.
Answer: FALSE
Learning Goal: 4
31. 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 aftertax proceeds (if any) from
the sale of an old asset, and the change (if any) in net working capital.
Answer: TRUE
Learning Goal: 4
32. Capital gain is the portion of the sale price that is in excess of the initial purchase price.
Answer: TRUE
Learning Goal: 4
Topic: Depreciation and Taxes
33. Recaptured depreciation is the portion of the sale price that is in excess of the initial purchase price.
Answer: FALSE
Learning Goal: 4
34. If an asset is depreciable and used in business, any loss on sale of the asset is deductible only against
capital gains.
Answer: FALSE
Learning Goal: 4
35. The change in net working capital—regardless of whether an increase or decrease—is not taxable
because it merely involves a net buildup or reduction of current accounts.
Answer: TRUE
Learning Goal: 4
Topic: Net Working Capital Investment
36. All benefits expected from a proposed project must be measured on a cash flow basis which may be
found by adding any noncash charges deducted as expense on the firm’s income statement back to
net profits after taxes.
Answer: TRUE
Learning Goal: 5
Topic: Operating Cash Flows
37. In evaluating a proposed project, since our concern is only with how much more or less operating
cash will flow into the firm as a result of the proposed project, incremental operating cash inflows
are the relevant cash flows.
Answer: TRUE
Learning Goal: 5
38. The basic motives for capital expenditures are to expand, replace, or renew fixed assets or to obtain
some other, less tangible benefit over a long period.
Answer: TRUE
Learning Goal: 1
Topic: Motives for Capital Budgeting
39. The primary motive for capital expenditures is to refurbish fixed assets.
Answer: FALSE
Learning Goal: 1
40. Research and development is considered to be a motive for making capital expenditures.
Answer: TRUE
Learning Goal: 1
41. The capital budgeting process consists of five distinct but interrelated steps: proposal generation,
review and analysis, decision making, implementation, and followup.
Answer: TRUE
Learning Goal: 1
Topic: Steps in Capital Budgeting Process
42. The capital budgeting process consists of four distinct but interrelated steps: proposal generation,
review and analysis, decision making, and termination.
Answer: FALSE
Learning Goal: 1
43. Independent projects are those whose cash flows are unrelated to one another; the acceptance of one
does not eliminate the others from further consideration.
Answer: TRUE
Learning Goal: 2
Topic: Independent versus Mutually Exclusive Projects
44. Mutually exclusive projects are those whose cash flows are unrelated to one another; the acceptance
of one does not eliminate the others from further consideration.
Answer: FALSE
Learning Goal: 2
45. Mutually exclusive projects are those whose cash flows compete with one another; the acceptance of
one does not eliminate the others from further consideration.
Answer: FALSE
Learning Goal: 2
46. Mutually exclusive projects are those whose cash flows compete with one another; the acceptance of
one eliminates the others from further consideration.
Answer: TRUE
Learning Goal: 2
47. If a firm is subject to capital rationing, it is able to accept all independent projects that provide an
acceptable return.
Answer: FALSE
Learning Goal: 2
48. If a firm has unlimited funds, it is able to accept all independent projects that provide an acceptable
return.
Answer: TRUE
Learning Goal: 2
49. If a firm is subject to capital rationing, it has only a fixed number of dollars available for capital
expenditures, and numerous projects compete for these dollars.
Answer: TRUE
Learning Goal: 2
50. The ranking approach involves the ranking of capital expenditure projects on the basis of some
predetermined measure such as the rate of return.
Answer: TRUE
Learning Goal: 2
Topic: AcceptReject versus Ranking Approach
51. The acceptreject approach involves the ranking of capital expenditure projects on the basis of some
predetermined measure such as the rate of return.
Answer: FALSE
Learning Goal: 2
Topic: AcceptReject versus Ranking Approach
52. A conventional cash flow pattern is one in which an initial outflow is followed only by a series of
inflows.
Answer: TRUE
Learning Goal: 2
53. A nonconventional cash flow pattern is one in which an initial outflow is followed only by a series
of inflows.
Answer: FALSE
Learning Goal: 2
54. A nonconventional cash flow pattern is one in which an initial outflow is followed by a series of
both inflows and outflows.
Answer: TRUE
Learning Goal: 2
55. Relevant cash flows are the incremental cash outflows and resulting subsequent cash inflows
associated with a proposed capital expenditure.
Answer: TRUE
Learning Goal: 2
56. The three major cash flow components include the initial investment, operating cash inflows, and
terminal cash flows.
Answer: TRUE
Learning Goal: 2
Topic: Major Cash Flow Components
57. The three major cash flow components include the initial investment, nonoperating cash inflows,
and terminal cash flows.
Answer: FALSE
Learning Goal: 2
Topic: Major Cash Flow Components
58. A sunk cost is a cash flow that could be realized from the best alternative use of an owned asset.
Answer: FALSE
Learning Goal: 3
Topic: Sunk Cost
59. An opportunity cost is a cash flow that could be realized from the best alternative use of an owned
asset.
Answer: TRUE
Learning Goal: 3
Topic: Opportunity Cost
60. A sunk cost is a cash outlay that has already been made and therefore has no effect on the cash flows
relevant to a current decision.
Answer: TRUE
Learning Goal: 3
Topic: Sunk Cost
61. 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
Learning Goal: 4
62. If an asset is sold for book value, the gain on the sale is composed of two parts: a capital gain and
recaptured depreciation.
Answer: FALSE
Learning Goal: 4
63. If an asset is sold for less than its book value, the loss on the sale may be used to offset ordinary
operating income.
Answer: TRUE
Learning Goal: 4
64. 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 a cash outflow.
Answer: TRUE
Learning Goal: 4
65. If an investment in a new asset results in a change in current liabilities that exceeds the change in
current assets, this change in net working capital represents a cash outflow.
Answer: FALSE
Learning Goal: 4
66. In computing aftertax operating cash flows, both operating costs and financing costs must be
deducted from any cash inflows received.
Answer: FALSE
Learning Goal: 5
67. In computing aftertax operating cash flows, only operating costs but not financing costs must be
deducted from any cash inflows received.
Answer: TRUE
Learning Goal: 5
 Multiple Choice Questions

1. _________ is the process of evaluating and selecting longterm investments consistent with the
firm’s goal of owner wealth maximization.
(a) Recapitalizing assets
(b) Capital budgeting
(c) Ratio analysis
(d) Restructuring debt
Answer: B
Learning Goal: 1
2. Fixed assets that provide the basis for the firm’s profit and value are often called
(a) tangible assets.
(b) noncurrent assets.
(c) earning assets.
(d) book assets.
Answer: C
Learning Goal: 1
3. The most common motive for adding fixed assets to the firm is
(a) expansion.
(b) replacement.
(c) renewal.
(d) transformation.
Answer: A
Learning Goal: 1
Topic: Motives for Capital Budgeting Expenditures
4. The final step in the capital budgeting process is
(a) implementation.
(b) followup monitoring.
(c) reevaluation.
(d) education.
Answer: B
Learning Goal: 1
5. The first step in the capital budgeting process is
(a) review and analysis.
(b) implementation.
(c) decisionmaking.
(d) proposal generation.
Answer: D
Learning Goal: 1
6. A $60,000 outlay for a new machine with a usable life of 15 years is called
(a) capital expenditure.
(b) operating expenditure.
(c) replacement expenditure.
(d) none of the above.
Answer: A
Learning Goal: 1
7. A capital expenditure is all of the following except
(a) an outlay made for the earning assets of the firm.
(b) expected to produce benefits over a period of time greater than one year.
(c) an outlay for current asset expansion.
(d) commonly used to expand the level of operations.
Answer: C
Learning Goal: 1
8. Which pattern of cash flow stream is the most difficult to use when evaluating projects?
(a) Mixed stream.
(b) Conventional flow.
(c) Nonconventional flow.
(d) Annuity.
Answer: C
Learning Goal: 2
Table 8.1
Operating Cash Inflows
$1,000 $1,000 $1,000 $1,000 $1,000
$2,500
Initial Outlay
9. The cash flow pattern depicted is associated with a capital investment and may be characterized as
(See Table 8.1.)
(a) an annuity and conventional cash flow.
(b) a mixed stream and nonconventional cash flow.
(c) an annuity and nonconventional cash flow.
(d) a mixed stream and conventional cash flow.
Answer: A
Learning Goal: 2
Table 8.2
Operating Cash Inflows
$25,000 $10,000 $50,000 $10,000 $10,000 $60,000
–$100,000
Initial Outlay
10. The cash flow pattern depicted is associated with a capital investment and may be characterized as
(See Table 8.2.)
(a) an annuity and conventional cash flow.
(b) a mixed stream and nonconventional cash flow.
(c) an annuity and nonconventional cash flow.
(d) a mixed stream and conventional cash flow.
Answer: D
Learning Goal: 2
11. _________ projects do not compete with each other; the acceptance of one _________ the others
from consideration.
(a) Capital; eliminates
(b) Independent; does not eliminate
(c) Mutually exclusive; eliminates
(d) Replacement; does not eliminate
Answer: B
Learning Goal: 2
12. _________ projects have the same function; the acceptance of one _________ the others from
consideration.
(a) Capital; eliminates
(b) Independent; does not eliminate
(c) Mutually exclusive; eliminates
(d) Replacement; does not eliminate
Answer: C
Learning Goal: 2
13. A firm with limited dollars available for capital expenditures is subject to
(a) capital dependency.
(b) mutually exclusive projects.
(c) working capital constraints.
(d) capital rationing.
Answer: D
Learning Goal: 2
14. A conventional cash flow pattern associated with capital investment projects consists of an initial
(a) outflow followed by a broken cash series.
(b) inflow followed by a broken series.
(c) outflow followed by a series of inflows.
(d) inflow followed by a series of outflows.
Answer: C
Learning Goal: 2
15. A nonconventional cash flow pattern associated with capital investment projects consists of an
initial
(a) outflow followed by a series of cash inflows and outflows.
(b) inflow followed by a series of cash inflows and outflows.
(c) outflow followed by a series of inflows.
(d) inflow followed by a series of outflows.
Answer: A
Learning Goal: 2
16. _________ is a series of equal annual cash flows.
(a) A mixed stream
(b) A conventional
(c) A nonconventional
(d) An annuity
Answer: D
Learning Goal: 2
Topic: Annuity Cash Flows
17. The cash flows of any project having a conventional pattern include all of the basic components
except
(a) initial investment.
(b) operating cash outflows.
(c) operating cash inflows.
(d) terminal cash flow.
Answer: B
Learning Goal: 2
18. Projects that compete with one another, so that the acceptance of one eliminates the others from
further consideration are called
(a) independent projects.
(b) mutually exclusive projects.
(c) replacement projects.
(d) None of the above.
Answer: B
Learning Goal: 2
19. 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.
Project Status Return(%)

1 Independent 14
2 Independent 12
3 Mutually 10
exclusive
4 Mutually 15
exclusive
5 Mutually 12
exclusive
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
Learning Goal: 2
20. Initial cash flows and subsequent operating cash flows for a project are sometimes referred to as
(a) necessary cash flows.
(b) relevant cash flows.
(c) consistent cash flows.
(d) ordinary cash flows.
Answer: B
Learning Goal: 3
21. 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) nonconventional
(c) incremental
(d) initial
Answer: C
Learning Goal: 3
22. Relevant cash flows for a project are best described as
(a) incidental cash flows.
(b) incremental cash flows.
(c) sunk cash flows.
(d) accounting cash flows.
Answer: B
Learning Goal: 3
23. 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
Learning Goal: 3
Topic: Expansion versus Replacement Project Analysis
24. When evaluating a capital budgeting project the change in net working capital 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
Learning Goal: 4
25. The change in net working capital when evaluating a capital budgeting decision is
(a) current assets minus current liabilities.
(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
Learning Goal: 4
26. The book value of an asset is equal to the
(a) fair market value minus the accounting value.
(b) original purchase price minus annual depreciation expense.
(c) original purchase price minus accumulated depreciation.
(d) depreciated value plus recaptured depreciation.
Answer: C
Learning Goal: 4
Topic: Book Value of an Asset (Equation 8.1)
27. 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
Learning Goal: 4
28. The tax treatment regarding the sale of existing assets that are sold for more than the book value and
more than the original purchase price 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: D
Learning Goal: 4
29. 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
Learning Goal: 4
30. The basic variables that must be considered in determining the initial investment associated with a
capital expenditure are all of the following EXCEPT
(a) incremental annual savings produced by the new asset.
(b) cost of the new asset.
(c) proceeds from the sale of the existing asset.
(d) taxes on the sale of an existing asset.
Answer: A
Learning Goal: 4
31. 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
(b) a capital gain tax liability.
Answer: C
Learning Goal: 4
32. The tax treatment regarding the sale of existing assets that are sold for their book value results in
(b) no tax benefit or liability.
Answer: B
Learning Goal: 4
33. The tax treatment regarding the sale of existing assets that are not depreciable or used in business
and are sold for less than the book value results in
(b) a capital gain tax benefit.
Answer: B
Learning Goal: 4
34. 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 longterm debt by $100,000. The change
in net working capital is
(a) an increase of $120,000.
(b) a decrease of $40,000.
(c) a decrease of $120,000.
(d) an increase of $60,000.
Answer: D
Learning Goal: 4
35. 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 longterm 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
Learning Goal: 4
36. The tax treatment regarding the sale of existing assets that are depreciable and used in business and
are sold for less than the book value results in
(a) a tax benefit from an ordinary loss.
(b) a capital gain tax liability.
Answer: A
Learning Goal: 4
37. A corporation is selling an existing asset for $21,000. The asset, when purchased, cost $10,000, was
being depreciated under MACRS using a fiveyear 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
Learning Goal: 4
(b) $840 tax liability.
(d) $3,160 tax benefit.
Answer: A
Learning Goal: 4
(d) $280 tax benefit.
Answer: D
Learning Goal: 4
40. A firm is selling an existing asset for $5,000. The asset, when purchased, cost $10,000, was being
depreciated under MACRS using a fiveyear 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
(d) $2,000 tax benefit.
Answer: B
Learning Goal: 4
41. A loss on the sale of an asset that is depreciable and used in business is _________; a loss on the
sale of a nondepreciable 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
Learning Goal: 4
42. 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 fiveyear
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 fiveyear 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
Learning Goal: 4
Topic: Initial Investment (Equation 8.1)
43. 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 fiveyear
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 fiveyear 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
Learning Goal: 4
Topic: Initial Investment (Equation 8.1)
44. Benefits expected from proposed capital expenditures must be on an aftertax basis because
(a) taxes are cash outflows.
(b) no benefits may be used by the firm until tax claims are satisfied.
(c) there may also be tax benefits to be evaluated.
(d) it is common, accepted practice to do so.
Answer: B
Learning Goal: 5
45. One basic technique used to evaluate aftertax operating cash flows is to
(a) add noncash charges to net income.
(b) subtract depreciation from operating revenues.
(c) add cash expenses to net income.
(d) subtract cash expenses from noncash charges.
Answer: A
Learning Goal: 5
Computer Disk Duplicators, Inc. has been considering several capital investment proposals for the year
beginning in 2004. For each investment proposal, the relevant cash flows and other relevant financial data
are summarized in the table below. In the case of a replacement decision, the total installed cost of the
equipment will be partially offset by the sale of existing equipment. The firm is subject to a 40 percent tax
rate on ordinary income and on longterm capital gains. The firm’s cost of capital is 15 percent.
Table 8.3
Proposal
Type of Capital 1 2 3
Budgeting Decision Expansion Replacement Replacement
Mutually Mutually
Exclusive Exclusive
Type of Project Independent with 3 with 2
Cost of new asset $1,500,000 $200,000 $300,000
Installation costs $0 $0 $15,000
MACRS (new asset) 10 years 5 years 5 years
Original cost of old asset N/A* $80,000 $100,000
Purchase date (old asset) N/A 1/1/97 1/1/2000
Sale proceeds (old asset) N/A $50,000 $120,000
MACRS (old asset) N/A 5 years 5 years
Annual net profits before
depreciation & taxes (old) N/A $30,000 $25,000
Annual net profits before
depreciation & taxes (new) $250,000 $100,000 $175,000
*Not applicable
46. For Proposal 1, the cash flow pattern for the expansion project is (See Table 8.3.)
(a) a mixed stream and conventional.
(b) a mixed stream and nonconventional.
(c) an annuity and conventional.
(d) an annuity and nonconventional.
Answer: A
Learning Goal: 5
Topic: Expansion Project Analysis
47. For Proposal 1, the initial outlay equals _________. (See Table 8.3.)
(a) $1,380,000
(b) $1,440,000
(c) $1,500,000
(d) $1,620,000
Answer: C
Learning Goal: 5
Topic: Initial Outlay
48. For Proposal 1, the depreciation expense for year 1 is _________. (See Table 8.3.)
(a) $110,400
(b) $115,200
(c) $150,000
(d) $300,000
Answer: C
Learning Goal: 5
Topic: Incremental Depreciation
49. For Proposal 1, the annual incremental aftertax cash flow from operations for year 1 is _________.
(See Table 8.3.)
(a) $60,000
(b) $255,000
(c) $300,000
(d) $210,000
Answer: D
Learning Goal: 5
Topic: Incremental Operating Cash Flows
50. For Proposal 2, the cash flow pattern for the replacement project is (See Table 8.3.)
Answer: A
Learning Goal: 5
51. For Proposal 2, the book value of the existing asset is _________. (See Table 8.3.)
(a) $13,600
(b) $34,400
(c) $66,400
(d) $80,000
Answer: A
Learning Goal: 5
52. For Proposal 2, the tax effect on the sale of the existing asset results in (See Table 8.3.)
(a) $12,000 tax liability.
Answer: B
Learning Goal: 5
53. For Proposal 2, the initial outlay equals (See Table 8.3.)
(a) $120,720 cash outflow.
(b) $164,560 cash outflow.
(c) $150,000 cash outflow.
(d) $167,520 cash outflow.
Answer: B
Learning Goal: 5
54. For Proposal 2, the incremental depreciation expense for year 2 is _________. (See Table 8.3.)
(a) $16,800
(b) $26,400
(c) $38,400
(d) $60,000
Answer: D
Learning Goal: 5
(See Table 8.3.)
(a) $18,000
(b) $24,000
(c) $66,000
(d) $84,000
Answer: C
Learning Goal: 5
56. For Proposal 3, the cash flow pattern for the replacement project is (See Table 8.3.)
Answer: A
Learning Goal: 5
57. For Proposal 3, the book value of the existing asset is _________. (See Table 8.3.)
(a) $21,000
(b) $43,000
(c) $52,000
(d) $80,000
Answer: D
Learning Goal: 5
58. For Proposal 3, the tax effect on the sale of the existing asset results in (See Table 8.3.)
(a) $8,000 tax liability.
Answer: B
Learning Goal: 5
59. For Proposal 3, the initial outlay equals _________. (See Table 8.3.)
(a) $170,400
(b) $211,000
(c) $196,000
(d) $300,000
Answer: B
Learning Goal: 5
(a) $21,000
(b) $42,000
(c) $47,850
(d) $50,850
Answer: C
Learning Goal: 5
(a) $15,750
(b) $10,750
(c) $23,000
(d) $36,150
Answer: A
Learning Goal: 5
(See Table 8.3.)
(a) $45,000
(b) $75,150
(c) $90,150
(d) $109,140
Answer: D
Learning Goal: 5
Table 8.4
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 fiveyear recovery schedule. The existing equipment, which
originally cost $25,000 and will be sold for $10,000, has been depreciated using an MACRS
fiveyear recovery schedule and three years of depreciation has already been taken. The new
equipment is expected to result in incremental beforetax net profits of $15,000 per year. The firm
has a 40 percent tax rate.
63. The cash flow pattern for the capital investment proposal is (See Table 8.4.)
Answer: A
Learning Goal: 5
64. The book value of the existing asset is _________. (See Table 8.4.)
(a) $7,250
(b) $15,000
(c) $21,250
(d) $25,000
Answer: A
Learning Goal: 5
65. The tax effect on the sale of the existing asset results in (See Table 8.4.)
(a) $800 tax benefit.
Answer: C
Learning Goal: 5
66. The initial outlay equals _________. (See Table 8.4.)
(a) $41,100
(b) $44,100
(c) $38,800
(d) $38,960
Answer: B
Learning Goal: 5
67. The incremental depreciation expense for year 1 is _________. (See Table 8.4.)
(a) $2,250
(b) $7,600
(c) $7,000
(d) $7,950
Answer: B
Learning Goal: 5
68. The incremental depreciation expense for year 5 is _________. (See Table 8.4.)
(a) $2,250
(b) $5,110
(c) $7,950
(d) $6,360
Answer: D
Learning Goal: 5
69. The annual incremental aftertax cash flow from operations for year 1 is _________. (See
Table 8.4.)
(a) $13,950
(b) $16,600
(c) $25,600
(d) $30,000
Answer: B
Learning Goal: 5
70. 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 fiveyear MACRS. Net
working capital is expected to decline by $5,000. The firm has a 40 percent tax rate on ordinary
income and longterm capital gain. The terminal cash flow is
(a) $24,000.
(b) $16,000.
(c) $14,000.
(d) $26,000.
Answer: B
Learning Goal: 6
Topic: Terminal Cash Flows (Equation 8.1)
71. 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 fiveyear MACRS. Net
working capital is expected to decline by $5,000. The firm has a 40 percent tax rate on ordinary
income and longterm capital gain. The terminal cash flow is
(a) $5,800.
(b) $7,800.
(c) $8,200.
(d) $6,200.
Answer: C
Learning Goal: 6
Topic: Terminal Cash Flows (Equation 8.1)
72. All of the following are motives for capital budgeting expenditures except
(a) expansion.
(b) replacement.
(c) renewal.
(d) invention.
Answer: D
Learning Goal: 1
Topic: Motives for Capital Budgeting Expenditures
73. All of the following are steps in the capital budgeting process except
(a) implementation.
(b) followup.
(c) transformation.
(d) decisionmaking.
Answer: C
Learning Goal: 1
74. The evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum
acceptance criteria is called
(a) the ranking approach.
(b) an independent investment.
(c) the acceptreject approach.
(d) a mutually exclusive investment.
Answer: C
Learning Goal: 2
Topic: AcceptReject versus Ranking Approaches
75. The ordering of capital expenditure projects on the basis of some predetermined measure such as the
rate of return is called
(a) the ranking approach.
(b) an independent investment.
(c) the acceptreject approach.
(d) a mutually exclusive investment.
Answer: A
Learning Goal: 2
Topic: AcceptReject versus Ranking Approaches
76. 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
Learning Goal: 3
Topic: Sunk Costs
77. 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
Learning Goal: 3
Topic: Sunk Costs
78. In international capital budgeting decisions, political risks can be minimized using all of the
following strategies except
(a) structuring the investment as a joint venture and selecting wellconnected local partner.
(b) structuring the financing of such investments as equity rather than as debt.
(c) structuring the financing of such investments as debt rather than as equity.
(d) None of the above.
Answer: B
Learning Goal: 3
79. 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
Learning Goal: 4
80. 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
Learning Goal: 4
81. 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
Learning Goal: 4
82. All of the following would be used in the computation of an investment’s initial investment except
(a) the annual after tax inflow expected from the investment.
(b) the initial purchase price of the investment.
(c) the resale value of an old asset being replaced.
(d) the tax on the sale of an old asset being replaced.
Answer: A
Learning Goal: 4
 Essay Questions
1. 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
Learning Goal: 4
Topic: Depreciation (Equation 8.1)
2. 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 5year 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.
Answers:
(a) Book Value  120,000 (1 – 0.20 – 0.32)  $57,600
Recaptured depreciation  120,000 – 57,600  $62,400
Capital gain  125,000 – 120,000  5,000
$67,400
(b) Tax liability  67,400  0.40  $26,960
Learning Goal: 4
Topic: MACRS Depreciation and Taxes (Equation 8.1)
3. 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 5year recovery period and the firm pays 40 percent taxes
on both ordinary income and capital gain.
Answers:
(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
Learning Goal: 4
4. 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 5year recovery period and the firm pays
40 percent taxes on both ordinary income and capital gains.
Answers:
(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
Learning Goal: 4
5. Compute the depreciation values for an asset which costs $55,000 and requires $5,000 in installation
costs using MACRS 5year recovery period.
Answer: Depreciable Value  55,000  5,000  $60,000
Year Depreciable Value Percentages Depreciation Values

1 $60,000 20% $12,000
2 60,000 32 19,200
3 60,000 19 11,400
4 60,000 12 7,200
5 60,000 12 7,200
6 60,000 5 3,000
$60,000
Learning Goal: 4
Topic: MACRS Depreciation (Equation 8.1)
Table 8.5
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 5year recovery schedule. The firm is in 40 percent
marginal tax rate.
6. Calculate the book value of the existing press being replaced. (See Table 8.5.)
Answer: Book value of existing press  $35,000  [1 – (0.20  0.32)]  16,800
Learning Goal: 4
Topic: Initial Investment, MACRS Depreciation and Taxes (Equation 8.1)
7. Calculate the tax effect from the sale of the existing asset. (See Table 8.5.)
Answer: Tax:
$20,000 – 16,800  $3,200 recaptured depreciation
$3,200  0.40  $1,280 tax
Learning Goal: 4
8. Calculate the initial investment of the new asset. (See Table 8.5.)
Answer:
Cost of new press $55,000
Installation Cost 5,000
Proceeds from the sale of existing press –20,000
Tax effect on sale of existing press 1,280
Initial investment $41,280
Learning Goal: 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.
Table 8.6
Facts
Existing Machine Proposed Machine
Cost  $100,00 Cost  $150,000
Purchased 2 years ago Installation  $20,000
Depreciation using MACRS over Depreciation—the MACRS a 5year
5year recovery schedule recover schedule will be used.
Current market value  $105,000
Five year usable life remaining Five year usable life expected
Earnings before Depreciation and Taxes
Existing Machine Proposed Machine
Year 1 $160,000 Year 1 $170,000
2 150,000 2 170,000
3 140,000 3 170,000
4 140,000 4 170,000
5 140,000 5 170,000
The firm pays 40 percent taxes on ordinary income and capital gains.
9. Calculate the book value of the existing asset being replaced. (See Table 8.6.)
Answer: Book value of existing equipment  $100,000  [1 – (0.20  0.32)]  48,000
Learning Goal: 5
Topic: MACRS Depreciation (Equation 8.1)
10. Calculate the tax effect from the sale of the existing asset. (See Table 8.6.)
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
Learning Goal: 5
11. Calculate the initial investment required for the new asset. (See Table 8.6.)
Answer:
Cost of new equipment $150,000
Installation cost 20,000
Proceeds from the sale of existing equipment (105,000)
Tax effect on sale of existing equipment 22,800
Initial investment $ 87,800
Learning Goal: 5
12. Calculate the incremental earnings before depreciation and taxes. (See Table 8.6.)
Answer:
Year
1 $10,000
2 20,000
3 30,000
4 30,000
5 30,000
Learning Goal: 5
Topic: Incremental EBDT
13. Calculate the incremental depreciation. (See Table 8.6.)
Answer:
Year
1 $15,000
2 42,400
3 20,300
4 15,400
5 20,400
6 8,500
Learning Goal: 5
14. Summarize the incremental aftertax cash flow (relevant cash flows) for years t  0 through t  5.
(See Table 8.6.)
Answer:
Calculation of Operating Cash Flows
Profits before Net Profits
Depreciation Net Profits After Cash
Year and Taxes Depreciation before Taxes Taxes Taxes Flow
Existing Machine
1 $160,000 $19,000 $141,000 $56,400 $84,600 $103,600
2 150,000 12,000 138,000 55,200 82,800 94,800
3 140,000 12,000 128,000 51,200 76,800 88,800
4 140,000 5,000 135,000 54,000 81,000 86,000
5 140,000 0 140,000 56,000 84,000 84,000
6 0 0 0 0 0 0
Proposed Machine
1 $170,000 $34,000 $136,000 $54,400 $81,600 $115,600
2 170,000 54,400 115,600 46,240 69,360 123,760
3 170,000 32,300 137,700 55,080 82,620 114,920
4 170,000 20,400 149,600 59,840 89,760 110,160
5 170,000 20,400 149,600 59,840 89,760 110,160
6 0 8,500 –8,500 3,400 –5,100 3,400
Calculation of Incremental Cash Flows
Year Proposed Existing Incremental
1 $115,600 $103,600 $12,000
2 123,760 94,800 28,960
3 114,920 88,800 26,120
4 110,160 86,000 24,160
5 110,160 84,000 26,160
6 3,400 0 3,400
Learning Goal: 5
Topic: Incremental Cash Flows
15. 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.
Learning Goal: 3
16. Please explain the difference between a sunk cost and an opportunity cost and give an example of
each type of cost
Answer: There is no one correct answer to this question. A correct answer depends upon the
student’s response.
Learning Goal: 3
Topic: Sunk Costs versus Opportunity Costs

Chapter 8: Capital Budgeting Cash Flows

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 Multiple Choice Questions

Project Status Return(%)

Year Depreciable Value Percentages Depreciation Values

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