Chapter 16 Capital Expenditure Decisions: Answer Key

Chapter 16 - Capital Expenditure Decisions
Chapter 16 Capital Expenditure Decisions

Answer Key
True / False Questions
1. The internal rate of return equates the present value of a project's cash inflows with the
present value of the cash outflows.
TRUE
AACSB: Reflective Thinking

AICPA BB: Critical Thinking
AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 16-01
Feedback True: Correct! It is true that the internal rate of return equates the present value of a project's cash inflows with the present value
of the cash outflows.
Feedback False: It is true that the internal rate of return equates the present value of a project's cash inflows with the present value of the
cash outflows.
2. Two widely used methods of discounted-cash-flow analysis are the net-present-value

method and the return on assets method.
FALSE

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback True: The two widely used discounted-cash-flow analysis methods are the net-present-value method and the internal-rate- of-
return method.
Feedback False: Correct! The two widely used discounted-cash-flow analysis methods are the net-present-value method and the internal-
rate- of-return method.
3. A company's hurdle rate is generally influenced by whether management uses the net-
present-value method or the internal-rate-of-return method.
FALSE

AICPA FN: Risk Analysis
Blooms: Remember
Difficulty: 1 Easy
16-1
Feedback True: A company's hurdle rate is generally not influenced by whether management uses the net-present-value method or the
internal-rate-of-return method.
Feedback False: Correct! A company's hurdle rate is generally not influenced by whether management uses the net-present-value method or
the internal-rate-of-return method.
4. An advantage of the NPV method is that the analyst can adjust for risk considerations.
TRUE

Blooms: Remember
Difficulty: 1 Easy
Feedback True: Correct! One advantage of NPV is that an analyst can adjust for risk, which is not available to the IRR method.
Feedback False: One advantage of NPV is that an analyst can adjust for risk, which is not available to the IRR method.
5. The last step in any investment analysis is to determine the cash flows that are relevant to
the analysis.
FALSE

Blooms: Remember
Difficulty: 1 Easy
Feedback True: Determining the cash flows that are relevant is the first step in any investment analysis.
Feedback False: Correct! This is the first step in any investment analysis.
6. The incremental-cost approach looks at the difference in the NPVs of the cost of each
relevant item under two alternatives in an analysis.
TRUE

Blooms: Understand
Difficulty: 2 Medium
Feedback True: Correct! The incremental cost approach looks at the costs that differ between two alternatives using NPVs.
Feedback False: The incremental cost approach looks at the costs that differ between two alternatives using NPVs.
7. All expenses represent cash outflows.

FALSE

Blooms: Understand
Feedback True: Noncash expenses like depreciation do not represent cash outflows.
Feedback False: Correct! Noncash expenses like depreciation do not represent cash outflows.
16-2
8. When income taxes are considered in capital budgeting, the cash flows related to a
company's advertising expense would be correctly figured by taking the cash paid for
advertising and subtracting the result of multiplying [or advertising expense  (1 ‒ tax rate)].
TRUE

Blooms: Understand
Feedback True: Correct! Income taxes considered in capital budgeting are calculated by taking the cash paid for advertising and subtracting
the result of 1 minus the tax rate.
Feedback False: Income taxes considered in capital budgeting are calculated by taking the cash paid for advertising and subtracting the
result of 1 minus the tax rate.
9. Under MACRS, an asset’s estimated salvage value is not subtracted in computing the
asset’s depreciation basis.
TRUE

Blooms: Understand
Feedback True: Correct! Under MACRS, an asset’s estimated salvage value is not subtracted in computing the asset’s depreciation basis.
Feedback False: Under MACRS, an asset’s estimated salvage value is not subtracted in computing the asset’s depreciation basis.
10. MACRS depreciation is based on straight-line depreciation and is typically used for
published financial statements.
FALSE

Blooms: Understand
Feedback True: MACRS depreciation is an accelerated depreciation method used for tax purposes.
Feedback False: Correct! MACRS depreciation is an accelerated depreciation method used for tax purposes.
16-3
11. When preparing an NPV analysis on the disposal of an asset, like equipment, capital gains
and losses are taxed at the same rate as ordinary income in the analysis.
FALSE

Blooms: Understand
Feedback True: Since capital gains and losses are taxed at different rates than ordinary income, it is wise to check with a tax expert
regarding the proper rate to apply in the analysis, since they change from time to time.
Feedback False: Correct! Since capital gains and losses are taxed at different rates than ordinary income, it is wise to check with a tax
expert regarding the proper rate to apply in the analysis, since they change from time to time.
12. Some investment proposals require additional outlays for working capital.
TRUE

Blooms: Understand
Feedback True: Correct! It is true that some investment proposals require additional outlays for working capital.
Feedback False: It is true that some investment proposals require additional outlays for working capital.
16-4
13. Valid methods exist for ranking independent investment projects with positive net present
values.
FALSE

Blooms: Understand
Feedback True: No valid method exists for ranking independent investment projects with positive net present values when investment capital
or managerial time is limited.
Feedback False: Correct! No valid method exists for ranking independent investment projects with positive net present values when
investment capital or managerial time is limited.
14. If a proposal's profitability index is greater than one then the net present value is positive.
TRUE

Blooms: Remember
Difficulty: 1 Easy
Feedback True: Correct! If a profitability index of a proposal is greater than one, the net present value is positive.
Feedback False: If a profitability index of a proposal is greater than one, the net present value is positive.
15. The payback period can only be used if net cash inflows are uniform throughout a
project's life.
FALSE

Blooms: Remember
Difficulty: 1 Easy
Feedback True: Payback method can be used even if net cash inflows are not uniform over a project’s life.
Feedback False: Correct! Payback method can be used even if net cash inflows are not uniform over a project’s life.
16. There is no adjustment in the payback method for the time value of money.
TRUE
Blooms: Remember
Difficulty: 1 Easy
Feedback True: Correct! There is no adjustment in the payback method for the time value of money.
Feedback False: There is no adjustment in the payback method for the time value of money.
17. Activity-based-costing systems are costly, time-consuming to implement, and do not
16-5
improve the ability of an analyst to estimate the cash flows associated with a proposed
project.
FALSE
Blooms: Remember
Difficulty: 1 Easy
Feedback True: Although ABC systems are costly and time-consuming to implement, they do improve the ability of the analyst to estimate the
cash flows associated with a proposed project.
Feedback False: Correct! Although ABC systems are costly and time-consuming to implement, they do improve the ability of the analyst to
estimate the cash flows associated with a proposed project.
18. When benefits are difficult to quantify in an NPV approach to a CIM investment decision,
it is best to exclude them.
FALSE
Blooms: Remember
Difficulty: 1 Easy
Feedback True: Even crude estimates are better than ignoring the benefits in NPV analysis of CIM investments.
Feedback False: Correct! Even crude estimates are better than ignoring the benefits in NPV analysis of CIM investments.
19. Inflation is defined as a decline in the general purchasing power of a monetary unit, such
as a dollar, across time.
TRUE
Blooms: Remember
Difficulty: 1 Easy
Feedback True: Correct! This is the definition of inflation.
Feedback False: This is the definition of inflation.
20. Nominal dollars is another name for real dollars.

FALSE
Blooms: Remember
Difficulty: 1 Easy
Feedback True: Nominal dollars differ from real dollars and these terms describe different concepts.
Feedback False: Correct! Nominal dollars differ from real dollars and these terms describe different concepts.
16-6
Multiple Choice Questions
21. Capital-budgeting decisions primarily involve:

A. emergency situations.
B. long-term decisions.
C. short-term planning situations.
D. cash inflows and outflows in the current year.
E. planning for the acquisition of capital.

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback A: This is an incorrect choice regarding capital- budgeting decisions.
Feedback B: Correct! Capital-budgeting decisions primarily involve long-term decisions.
Feedback C: This is an incorrect choice regarding capital- budgeting decisions.
Feedback D: This is an incorrect choice regarding capital- budgeting decisions.
Feedback E: This is an incorrect choice regarding capital- budgeting decisions.
22. Which of the following would not involve a capital-budgeting analysis?

A. The acquisition of new equipment.
B. The addition of a new product line.
C. The adoption of a new cost driver for overhead application.
D. The construction of a new distribution facility.
E. The decision of a pro football team to trade for and sign a star quarterback to a long-term
contract.

AICPA FN: Research
Blooms: Understand
Feedback A: This would involve a capital budgeting analysis.
Feedback B: This would involve a capital budgeting analysis.
Feedback C: Correct! The adoption of a new cost diver for overhead application would not involve a capital budgeting analysis.
Feedback D: This would involve a capital budgeting analysis.
Feedback E: This would involve a capital budgeting analysis.
16-7
23. The decision process that has managers select from among several acceptable investment
proposals to make the best use of limited funds is known as:
A. capital rationing.
B. capital budgeting.
C. acceptance or rejection analysis (ARA).
D. cost analysis.
E. project planning.

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback A: Correct! This is the definition of capital rationing.
Feedback B: This is not the correct term.
Feedback C: This is not the correct term.
Feedback D: This is not the correct term.
Feedback E: This is not the correct term.
24. Capital budgeting tends to focus primarily on:

A. revenues.
B. costs.
C. cost centers.
D. programs and projects.
E. allocation tools.

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback A: This is an incorrect primary focus.
Feedback B: This is an incorrect primary focus.
Feedback C: This is an incorrect primary focus.
Feedback D: Correct! Capital budgeting tends to focus on programs and projects.
Feedback E: This is an incorrect primary focus.
16-8
25. Discounted-cash-flow analysis focuses primarily on:

A. the stability of cash flows.
B. the timing of cash flows.
C. the probability of cash flows.
D. the sensitivity of cash flows.
E. whether cash flows are increasing or decreasing.

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback A: This is an incorrect primary focus.
Feedback B: Correct! Discounted cash flow analysis focuses primarily on the timing of cash flows.
Feedback C: This is an incorrect primary focus.
Feedback D: This is an incorrect primary focus.
Feedback E: This is an incorrect primary focus.
26. In a net-present-value analysis, the discount rate is often called the:

A. payback rate.
B. hurdle rate.
C. minimal value.
D. net unit rate.
E. objective rate of return.

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback A: This is not the alternative name for the discount rate.
Feedback B: Correct! The discount rate is often called the hurdle rate in NPV analysis.
Feedback C: This is not the alternative name for the discount rate.
Feedback D: This is not the alternative name for the discount rate.
Feedback E: This is not the alternative name for the discount rate.
16-9
27. The hurdle rate that is used in a net-present-value analysis is the same as the firm's:
A. discount rate.
B. internal rate of return.
C. minimum desired rate of return.
D. objective rate of return.
E. discount rate and minimum desired rate of return.

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback A: Although this answer is correct, there is a better answer choice.
Feedback B: This answer is incorrect.
Feedback C: Although this answer is correct, there is a better answer choice.
Feedback D: This answer is incorrect.
Feedback E: Correct! The hurdle rate used in NPV analysis is the same as the firm’s discount rate and minimum desired rate of return.
28. Which of the following is taken into account by the net-present-value method?
A Project’s Immediate Cash Flows During Time Value of

Cash Flows a Project’s Life Money
A. Yes No No
B. Yes Yes No
C. Yes Yes Yes
D. No Yes Yes
E. No Yes No

AICPA FN: Research
Blooms: Understand
Feedback A: This answer combination is incorrect.
Feedback B: This answer combination is incorrect.
Feedback C: Correct! All of these factors are taken into account by the NPV method.
Feedback D: This answer combination is incorrect.
Feedback E: This answer combination is incorrect.
16-10
29. Consider the following factors related to an investment:
I. The net income from the investment.
II. The cash flows from the investment.
III. The timing of the cash flows from the investment.
Which of the preceding factors would be important considerations in a net-present-value

analysis?
A. I only.
B. II only.
C. I and II.
D. II and III.
E. I, II, and III.

AICPA FN: Research
Blooms: Understand
Feedback A: This factor is not important.
Feedback B: While this factor is important, there is a better answer choice.
Feedback C: One of these factors is not important.
Feedback D: Correct! Both the cash flows from the investment and the timing of the cash flows are important for NPV analysis.
Feedback E: One of these factors is not important.
30. The true economic yield produced by an asset is summarized by the asset's:
A. non-discounted cash flows.
B. net present value.
C. future value.
D. annuity discount factor.
E. internal rate of return.

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback A: This is incorrect.
Feedback B: This is incorrect.
Feedback C: This is incorrect.
Feedback D: This is incorrect.
Feedback E: Correct! The true economic yield produced by an asset is summarized by the asset’s internal rate of return.
16-11
31. The internal rate of return on an asset can be calculated:
A. if the return is greater than the hurdle rate.
B. if the asset's cash flows are identical to the future value of a series of cash flows.
C. if the future value of a series of cash flows can be arrived at by the annuity accumulation
factor.
D. by finding a discount rate that yields a zero net present value.
E. by finding a discount rate that yields a positive net present value.

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback D: Correct! The IRR on an asset can be calculated by finding a discount rate that yields a zero net present value.
Feedback E: This is incorrect.
32. The internal rate of return:

A. ignores the time value of money.
B. equates a project's cash inflows with its cash outflows.
C. equates a project's cash outflows with its expenses.
D. equates the present value of a project's cash inflows with the present value of the cash
outflows.
E. equates the present value of a project's cash flows with the future value of the project's cash
flows.

AICPA FN: Research
Blooms: Remember
Difficulty: 1 Easy
Feedback D: Correct! The IRR equates the present value of a project’s cash inflows with the present value of the cash outflows.
16-12
33. Grenada Company is contemplating the acquisition of a machine that costs $50,000 and
promises to reduce annual cash operating costs by $11,000 over each of the next six years.
PV of $1 (i=12%; n = 6): 0.507

PV of a series of $1 cash flows (i=12%, n=6): 4.111
Which of the following is a proper way to evaluate this investment if the company desires a
12% return on all investments?
A. $50,000 versus - $11,000  6.
B. $50,000 versus - $66,000  0.507.
C. $50,000 versus - $66,000  4.111.
D. $50,000 versus - $11,000  4.111.
E. $50,000  0.893 versus - $11,000  4.111.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback D: Correct! $50,000 versus the PV of an annuity for interest rate 12% at 6 periods times the $11,000 reduction in operating costs.
34. Barton Company can acquire a $900,000 machine now that will benefit the firm over the
next 6 years.
FV of 1 (i=8%, n=6): 1.587
FV of a series of $1 cash flows (i=8%, n=6): 7.336
PV of $1 (i=8%; n = 6): 0.630
Annual savings in cash operating costs are expected to total $190,000. If the hurdle rate is 8%,
the investment's net present value is:
A. $(181,800).
B. $(21,630).
C. $44,970.
D. $184,920.
E. None of the answers is correct.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! ($190,000 x 4.623) - $900,000 = $(21,630)
Feedback E: This answer choice is wrong because there is a correct answer listed.
16-13
35. Carlin Company, which uses net present value to analyze investments, requires a 10%
minimum rate of return. A staff assistant recently calculated a $500,000 machine's net present
value to be $86,400, excluding the impact of straight-line depreciation.
FV of 1 (i=10%, n=5): 1.611

PV of $1 (i=10%; n = 5): 0.621
If Carlin ignores income taxes and the machine is expected to have a five-year service life, the
correct net present value of the machine would be:
A. $(13,600).
B. $86,400.
C. $186,400.
D. $292,700.
E. $465,500.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback A: This amount is incorrect.
Feedback B: Correct! There is nothing to calculate here. The answer is given.
Feedback C: This amount is incorrect.
Feedback D: This amount is incorrect.
Feedback E: This amount is incorrect.
16-14
36. A new asset is expected to provide service over the next four years. It will cost $500,000,
generates annual cash inflows of $150,000, and requires cash operating expenses of $30,000
each year. In addition, a $10,000 overhaul will be needed in year 3.
Period FV of 1 FV of a series of $1 PV of $1 PV of a series of $1

(i=10%) cash flows (i=10%) (i=10%) cash flows (i=10%)
1 1.100 1.000 0.909 0.909
2 1.210 2.100 0.826 1.736
3 1.331 3.310 0.751 2.487
4 1.464 4.641 0.683 3.170
If the company requires a 10% rate of return, the net present value of this machine would be:
A. $(127,110), and the machine meets the company's rate-of-return requirement.
B. $(127,110), and the machine does not meet the company's rate-of-return requirement.
C. $(129,600), and the machine does not meet the company's rate-of-return requirement.
D. $(151,700), and the machine meets the company's rate-of-return requirement.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! ($150,000 - $30,000) x 3.170 = $380,400; $380,400 - $500,000 = $(119,600) + ($10,000 x 0.751) = $(127,110); as a
negative amount, it does not meet the company’s rate of return requirement.
16-15
37. Swiss Imports can acquire a $700,000 machine now that will benefit the firm over the
next 5 years. A newly hired staff assistant correctly computed the net present value to be
$134,020 by using a 10% hurdle rate.
FV of 1 (i=10%, n=5): 1.611

PV of $1 (i=10%; n = 5): 0.621
On the basis of this information, the machine was expected to produce annual cash operating
savings of approximately:
A. $166,804.
B. $220,000.
C. $268,605.
D. $834,020.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! x - $700,000 = $134,020; x = $834,020; $834,020 ÷ 3.791 = $220,000
16-16
38. A new machine that costs $172,100 is expected to save annual cash operating costs of
$40,000 over each of the next nine years. Using the tables that follow, the machine's internal
rate of return is:
A. approximately 14%.
B. approximately 16%.
C. approximately 18%.
D. approximately 20%.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: This amount is incorrect.
Feedback C: Correct! $172,100 ÷ $40,000 = 4.3025: at nine years on the PV of annuity chart, this is closest to 18% which has a factor of
4.303.
16-17
16-18
39. Excaliber is considering the acquisition of a $217,750 machine that is expected to

produce annual savings in cash operating costs of $50,000 over the next six years. If Excaliber
uses the internal rate of return (IRR) to evaluate new investments and the company has a
hurdle rate of 12%, which of the following statements is correct, using the tables that follow?
A. The machine's IRR is less than 4%, and the machine should not be acquired.
B. The machine's IRR is approximately 10%, and the machine should not be acquired.
C. The machine's IRR is approximately 10%, and the machine should be acquired.
D. The machine's IRR is approximately 12%, and the machine should be acquired.
E. All of the statements are false.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! $217,750 ÷ $50,000 = 4.355; this factor is equal to the PV of an annuity factor for 6 years of 10%, which is lower
than the company’s hurdle rate. It should not be acquired.
Feedback E: This answer choice is wrong, because there is a correct answer listed.
16-19
16-20
40. A machine costs $25,000; it is expected to generate annual cash revenues of $8,000 and
annual cash expenses of $2,000 for five years. The required rate of return is 12%.
FV of 1 (i=12%, n=5): 1.762

PV of $1 (i=12%; n = 5): 0.567
The net present value of the machine is:

A. $(3,840).
B. $(3,370).
C. $0.
D. $21,630.
E. $28,840.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! [($8,000 – 2,000) x 3.605] - $25,000 = $(3,370)
16-21
41. A machine costs $25,000; it is expected to generate annual cash revenues of $8,000 and
annual cash expenses of $2,000 for five years. The required rate of return is 12%. Using the
tables that follow, which of the following statements about the machine's internal rate of
return is true?
A. The internal rate of return is greater than 12%.
B. The internal rate of return is between 10% and 12%.
C. The internal rate of return is less than 10%.
D. The internal rate of return must be greater than 15%.
E. There is insufficient information to make any judgment about the internal rate of return.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback C: Correct! At 12%, NPV is [($8,000 – 2,000) x 3.605] - $25,000 = $(3,370); $25,000 ÷ $6,000 = 4.167 factor, which is less than
10% and in fact, somewhere between 6 and 8% for five periods on the PV of an annuity table.
16-22
16-23
42. The mayor of Trenton is considering the purchase of a new computer system for the city's
tax department. The system costs $75,000 and has an expected life of five years. The mayor
estimates the following savings will result if the system is purchased:
Year or Savings PV of $1 at PV of an
Period 10% ordinary
annuity at
10%
1 $20,000 0.909 .909
2 25,000 0.826 1.736
3 30,000 0.751 2.487
4 15,000 0.683 3.170
5 12,000 0.621 3.791
If Trenton uses a 10% discount rate for capital-budgeting decisions, the net present value of
the computer system would be:
A. $489.
B. $4,057.
C. $11,658.
D. $63,342.
E. $79,057.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! [($20,000 x 0.909) + ($25,000 x 0.826) + ($30,000 x 0.751) + ($15,000 x 0.683) + ($12,000 x 0.621)] - $75,000 =
$4,057.
16-24
Year Savings
1 $20,000
2 25,000
3 30,000
4 15,000
5 12,000
What can be said about the computer system's internal rate of return if the net present value at
12% is positive? Trenton uses a 10% discount rate for capital-budgeting decisions.
A. The internal rate of return is greater than 12%.
B. The internal rate of return is between 10% and 12%.
C. The internal rate of return is less than 10%.
D. The internal rate of return must be less than 5%.
E. There is insufficient information to make any judgment about the internal rate of return.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback A: Correct! Since the NPV is positive at 12%, the IRR exceeds the 12% rate, since NPV would equal zero at exactly 12%.
Feedback B: This statement is incorrect.
Feedback C: This statement is incorrect.
Feedback D: This statement is incorrect.
Feedback E: This answer choice is wrong, because there is sufficient information to obtain one of the amounts listed.
16-25
Year Savings PV of $1 at PV of an
10% ordinary
annuity at
10%
1 $20,000 0.909 .909
2 25,000 0.826 1.736
3 30,000 0.751 2.487
4 15,000 0.683 3.170
5 12,000 0.621 3.791
Trenton uses a 10% discount rate for capital-budgeting decisions.

A salesperson from a different computer company claims that his machine, which costs
$85,000 and has an estimated service life of four years, will generate annual savings for the
city of $32,000. If the discount rate is 10%, the net present value of this system would be:
A. $16,440.
B. $23,175.
C. $63,512.
D. $101,440.

Blooms: Apply
Difficulty: 3 Hard
Feedback A: Correct! $32,000 x 3.170 = $101,440; $101,440 - $85,000 = $16,440.
16-26
45. A company that is using the internal rate of return (IRR) to evaluate projects should accept
a project if the IRR:
A. is greater than the project's net present value.
B. equates the present value of the project's cash inflows with the present value of the
project's cash outflows.
C. is greater than zero.
D. is greater than the hurdle rate.
E. is less than the firm's cost of investment capital.
Blooms: Remember
Difficulty: 1 Easy
Feedback A: This statement is incorrect.
Feedback D: Correct! The project should be accepted if the IRR is greater than the hurdle rate.
Feedback E: This statement is incorrect.
46. Which of the following choices correctly states the rules for project acceptance under the
net-present-value method and the internal-rate-of-return method?
Net Present Value Internal Rate of Return

A. Positive total Greater than hurdle rate
B. Positive total Less than hurdle rate
C. Negative total Greater than hurdle rate
D. Negative total Less than hurdle rate
E. Greater than hurdle rate Positive number

Blooms: Remember
Difficulty: 1 Easy
Feedback A: Correct! A positive NPV and an IRR greater than the hurdle rate are required rules for project acceptance.
16-27
47. The rule for project acceptance under the net-present-value method is that:
A. NPV should be greater than zero.
B. NPV should be less than zero.
C. NPV should equal zero.
D. NPV should be less than the hurdle rate.
E. NPV should equal the hurdle rate.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: Correct! NPV should be greater than zero for project acceptance.
48. The rule for project acceptance under the internal rate of return method is that:
A. IRR should be greater than zero.
B. IRR should be less than zero.
C. IRR should be greater than the hurdle rate.
D. IRR should be less than the hurdle rate.
E. IRR should equal the hurdle rate.

Blooms: Remember
Difficulty: 1 Easy
Feedback C: Correct! IRR should be greater than the hurdle rate.
16-28
49. The net-present-value method assumes that project funds are reinvested at the:
A. hurdle rate.
B. rate of return earned on the project.
C. cost of debt capital.
D. cost of equity capital.
E. internal rate of return.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: Correct! NPV assumes funds are reinvested at the hurdle rate.
50. The internal-rate-of-return method assumes that project funds are reinvested at the:
A. hurdle rate.
B. rate of return earned on the project.
C. cost of debt capital.
D. cost of equity capital.
E. rate of earnings growth (REG).

Blooms: Remember
Difficulty: 1 Easy
Feedback B: Correct! The IRR assumes funds are reinvested at the rate of return earned on the project.
16-29
51. Which of the following choices correctly states how funds are assumed to be reinvested
under the net-present-value method and the internal-rate-of-return method?
A. At the hurdle rate At the hurdle rate
B. At the hurdle rate At the return earned on the project
C. At the cost of debt capital At the cost of debt capital
D. At the cost of debt capital At the cost of equity capital
E. At the cost of equity capital At the cost of equity capital

Blooms: Remember
Difficulty: 1 Easy
Feedback A: This combination is incorrect.
Feedback B: Correct! NPV assumes funds are reinvested at the hurdle rate. The IRR assumes funds are reinvested at the rate of return
earned on the project.
Feedback C: This combination is incorrect.
Feedback D: This combination is incorrect.
Feedback E: This combination is incorrect.
16-30
52. A company's hurdle rate is generally influenced by:
A. the cost of capital.
B. the firm's depreciable assets.
C. whether management uses the net-present-value method or the internal-rate-of-return
method.
D. project risk.
E. both the cost of capital and project risk.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: While this influences hurdle rate, there is a better answer.
Feedback D: While this influences hurdle rate, there is a better answer.
Feedback E: Correct! The hurdle rate is influenced by cost of capital and project risk.
53. If income taxes are ignored, which of the following choices correctly notes how a project's
depreciation is treated under the net-present-value method and the internal-rate-of-return
method?
A. Considered Considered
B. Considered Ignored
C. Ignored Considered
D. Ignored Ignored
E. The correct answer depends on the depreciation method (straight line or accelerated) that is used.
Blooms: Understand
Feedback C: This answer combination is incorrect.
Feedback D: Correct! Depreciation is ignored in both.
16-31
54. Consider the following statements about the total-cost and the incremental-cost
approaches of investment evaluation:
I. Both approaches will yield the same conclusions.
II. Choosing between these approaches is a matter of personal preference.
III. The incremental approach focuses on cost differences between alternatives.
Which of the above statements is (are) true?

A. I only.
B. II only.
C. III only.
D. II and III.
E. I, II, and III.

Blooms: Understand
Feedback A: While this is true, there is a better answer choice listed.
Feedback B: While this is true, there is a better answer choice listed.
Feedback C: While this is true, there is a better answer choice listed.
Feedback D: While this is true, there is a better answer choice listed.
Feedback E: Correct! All of these statements are true.
55. The systematic follow-up on a capital project to see how the project actually turns out is
commonly known as:
A. capital budgeting assessment (CBA).
B. a postaudit.
C. control of capital expenditures (CCE).
D. overall cost performance.
E. the cost evaluation phase.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: This term is incorrect.
Feedback B: Correct! This is the definition of a postaudit.
Feedback C: This term is incorrect.
Feedback D: This term is incorrect.
Feedback E: This term is incorrect.
16-32
56. Consider the following statements about capital budgeting postaudits:

I. Postaudits can be used to detect desirable projects that were rejected.
II. Postaudits can be used to detect undesirable projects that were accepted.
III. Postaudits may reveal shortcomings in cash-flow projections, providing insights that allow
a company to improve future predictions.
Which of the above statements is (are) correct?

A. I only.
B. II only.
C. III only.
D. II and III.
E. I, II, and III.

Blooms: Remember
Difficulty: 1 Easy
Feedback B: While this statement is true, there is a better answer choice listed.
Feedback C: While this statement is true, there is a better answer choice listed.
Feedback D: Correct! Both statements II and III are correct.
Feedback E: One of these statements is incorrect.
57. Generally speaking, which of the following would not directly affect a company's income
tax payments?
A. Advertising expense.
B. Gain on sale of machinery.
C. Sales revenue.
D. Land owned by the firm.
E. Loss on sale of building.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: This could affect the income tax payments directly.
Feedback B: This could affect the income tax payments directly.
Feedback C: This could affect the income tax payments directly.
Feedback D: Correct! Land owned by the firm would not directly affect the company’s income tax payments.
Feedback E: This could affect the income tax payments directly.
16-33
58. A company's cash flows for income taxes are normally affected by:
A. revenues.
B. operating expenses.
C. gains on the sale of assets.
D. losses on the sale of assets.
E. All of the answers are correct.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: While this would affect the cash flows, there is a better answer choice listed.
Feedback B: While this would affect the cash flows, there is a better answer choice listed.
Feedback C: While this would affect the cash flows, there is a better answer choice listed.
Feedback D: While this would affect the cash flows, there is a better answer choice listed.
Feedback E: Correct! All of these affect a company’s cash flows for income taxes.
59. Consider the following statements about taxes and after-tax cash flows:
I. Capital budgeting analyses should incorporate after-tax cash flows rather than before-tax
cash flows.
II. Added company revenues will result in lower taxes for a firm.
III. Operating expenses may actually provide a tax benefit for an organization.

A. I only.
B. II only.
C. III only.
D. I and II.
E. I and III.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: While this statement is true, there is a better answer choice listed.
Feedback D: One of these statements is incorrect.
Feedback E: Correct! Both statements I and III are correct.
16-34
company's advertising expense would be correctly figured by taking the cash paid for
advertising and:
A. adding the result of multiplying (advertising expense  tax rate).
B. adding the tax rate.
C. adding the result of multiplying [advertising expense  (1 ‒ tax rate)].
D. subtracting the result of multiplying (advertising expense  tax rate).
E. subtracting the result of multiplying [advertising expense  (1 ‒ tax rate)].

Blooms: Understand
Feedback E: Correct! The cash flows related to a company's advertising expense would be correctly figured by taking the cash paid for
advertising and subtracting the result of multiplying [advertising expense  (1-- tax rate)].
61. Of the five expenses that follow, which one is most likely treated differently than the
others when income taxes are considered in a discounted-cash-flow analysis?
A. Salaries expense.
B. Advertising expense.
C. Depreciation expense.
D. Utilities expense.
E. Office expense.

Blooms: Understand
Feedback C: Correct! Depreciation expense is treated differently in a discounted-cash-flow analysis.
16-35
62. Assume that a capital project is being analyzed by a discounted-cash-flow approach, and
an employee first assumes no income taxes and then later assumes a 30% income tax rate.
How would depreciation expense be incorporated in the analysis?
No Income Taxes 30% Income Tax Rate
A. Considered Considered
B. Considered Ignored
C. Ignored Considered
D. Ignored Ignored
E. The correct answer depends on the depreciation method that is used.

Blooms: Understand
Feedback C: Correct! No income taxes are ignored and the 30% income tax rate is considered.
Feedback D: This answer combination is incorrect.
Feedback E: The answer does not depend upon the method used.
63. When a company is analyzing a capital project by a discounted-cash-flow approach and

income taxes are being considered, depreciation:
A. should be ignored.
B. should be considered because it results in a tax savings.
C. should be considered because it is a fixed cost.
D. should be considered because it is a cash inflow.
E. should be considered because, like other expenses, it is a cash outlay related to operations.

Blooms: Remember
Difficulty: 1 Easy
Feedback B: Correct! Depreciation should be considered, because it results in a tax savings.
16-36
company's depreciation expense would be correctly figured by taking the cash paid for
depreciation and:
A. adding the result of multiplying (depreciation expense  tax rate).
B. adding the result of multiplying [depreciation expense  (1 ‒ tax rate)].
C. subtracting the result of multiplying (depreciation expense  tax rate).
D. subtracting the result of multiplying [depreciation expense  (1 ‒ tax rate)].
E. None of the answers, because there is no cash paid for depreciation.

Blooms: Understand
Feedback E: Correct! There is no cash paid for depreciation expense.
65. Jenkins plans to generate $650,000 of sales revenue if a capital project is implemented.
Assuming a 30% tax rate, the sales revenue should be reflected in the analysis by a:
A. $195,000 inflow.
B. $195,000 outflow.
C. $455,000 inflow.
D. $455,000 outflow.
E. $650,000 inflow.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback C: Correct! $650,000 x (1 – 30%) = $455,000 inflow.
16-37
66. Higgins Company plans to incur $350,000 of salaries expense if a capital project is
implemented. Assuming a 30% tax rate, the salaries should be reflected in the analysis by a:
A. $105,000 inflow.
B. $105,000 outflow.
C. $245,000 inflow.
D. $245,000 outflow.
E. $350,000 outflow.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback D: Correct! $350,000 x (1 – 30%) = $245,000 outflow.
67. Bowers Company plans to incur $190,000 of salaries expense and produce $320,000 of
additional sales revenue if a capital project is implemented. Assuming a 30% tax rate, these
two items collectively should appear in a capital budgeting analysis as:
A. a $39,000 inflow.
B. a $39,000 outflow.
C. a $91,000 inflow.
D. a $91,000 outflow.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback C: Correct! ($320,000 - $190,000) x (1 – 30%) = $91,000 inflow.
16-38
68. Hampton Company plans to incur $230,000 of additional cash operating expenses and
produce $410,000 of additional sales revenue if a capital project is implemented. Assuming a
30% tax rate, these two items collectively should appear in a capital budgeting analysis as:
A. a $57,000 inflow.
B. a $57,000 outflow.
C. a $126,000 outflow.
D. a $126,000 inflow.
E. a $161,000 outflow.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback D: Correct! ($410,000 - $230,000) x (1 – 30%) = $126,000 inflow.
69. Pizza Company has $70,000 of depreciation expense and is subject to a 30% income tax
rate. On an after-tax basis, depreciation results in a:
A. $21,000 inflow.
B. $21,000 outflow.
C. $49,000 inflow.
D. $49,000 outflow.
E. neither an inflow nor an outflow because depreciation is a noncash expense.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback A: Correct! $70,000 x 30% = $21,000 inflow.
16-39
70. Coulter Company is studying a capital project that will produce $600,000 of added sales
revenue, $400,000 of additional cash operating expenses, and $50,000 of depreciation.
Assuming a 30% income tax rate, the company's after-tax cash inflow (outflow) is:
A. $105,000.
B. $125,000.
C. $155,000.
D. $175,000.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback C: Correct! [($600,000 - $400,000) x (1 – 30%)] + ($50,000 x 30%) = $155,000.
71. Which of the following is the proper calculation of a company's depreciation tax shield?
A. Depreciation  tax rate.
B. Depreciation  (1 - tax rate).
C. Depreciation  tax rate.
D. Depreciation  (1 - tax rate).
E. Depreciation deduction + income taxes.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: This calculation is incorrect.
Feedback B: This calculation is incorrect.
Feedback C: Correct! This is the calculation used for the depreciation tax shield.
Feedback D: This calculation is incorrect.
Feedback E: This calculation is incorrect.
16-40
72. A depreciation tax shield is a(n):
A. after-tax cash outflow.
B. increase in income tax.
C. factor that has no effect on cash flows.
D. reduction in income tax.
E. sporadic fluctuation in income tax.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: This is not a true statement regarding the depreciation tax shield.
Feedback B: This is not a true statement regarding the depreciation tax shield.
Feedback C: This is not a true statement regarding the depreciation tax shield.
Feedback D: Correct! This is a true statement regarding the depreciation tax shield.
Feedback E: This is not a true statement regarding the depreciation tax shield.
73. Consider the following statements about depreciation tax shields:

I. A depreciation tax shield provides distinct benefits to a business.
II. A depreciation tax shield should be ignored when doing a net-present-value analysis.
III. A depreciation tax shield can occur in more than one year.

A. I only.
B. II only.
C. III only.
D. I and II.
E. I and III.

Blooms: Understand
Feedback A: While this statement is correct, there is a better answer choice listed.
Feedback C: While this statement is correct, there is a better answer choice listed.
16-41
74. A company that uses accelerated depreciation:
A. would write off a larger portion of an asset's cost sooner than under the straight-line
method.
B. would find that depreciation speeds up, with a small portion taken in early years and larger
amounts taken in later years.
C. would find that more tax benefits occur earlier than under the straight-line method.
D. would find itself out of compliance with generally accepted accounting principles (GAAP).
E. would both write off a larger portion of an asset's cost sooner than under the straight-line
method and find that more tax benefits occur earlier than under the straight-line method.

Blooms: Understand
Feedback A: While this statement is true, there is a better answer choice listed.
Feedback E: Both of these statements about accelerated depreciation are true.
75. Poston Company is considering the use of accelerated depreciation rather than straight-
line depreciation for a new asset acquisition. Which of the following choices correctly shows
when the majority of depreciation would be taken (early or late in the asset's life), when most
of the tax savings occur (early or late in the asset's life), and which depreciation method
would have the higher present value?
When Majority of When Majority of Depreciation Method with
Depreciation is Taken Tax Savings Occur Higher Present Value
A. Early in life Early in life Accelerated
B. Early in life Early in life Straight-line
C. Early in life Late in life Straight-line
D. Late in life Late in life Straight-line
E. Late in life Early in life Accelerated

Blooms: Understand
Feedback A: Correct! This is the correct combination of answer choices.
Feedback B: This combination of answer choices is incorrect.
Feedback C: This combination of answer choices is incorrect.
Feedback D: This combination of answer choices is incorrect.
Feedback E: This combination of answer choices is incorrect.
16-42
76. Julio Company purchased a $200,000 machine that has a four-year life and no salvage
value. The company uses straight-line depreciation on all asset acquisitions and is subject to a
30% tax rate. The proper cash flow to show in a discounted-cash-flow analysis as occurring at
time 0 would be:
A. $(200,000).
B. $(140,000).
C. $(35,000).
D. $15,000.
E. $50,000.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback A: Correct! At time zero, the proper cash flow would be $(200,000).
77. If a company desires to be in compliance with current income tax law and write off the
cost of its assets rapidly, the firm would use:
A. straight-line depreciation.
B. sum-of-the-years'-digits depreciation.
C. accelerated depreciation.
D. the Modified Accelerated Cost Recovery System (MACRS).
E. annuity depreciation.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: This method is incorrect.
Feedback B: This method is incorrect.
Feedback C: This method is incorrect.
Feedback D: Correct! MACRS would be used for tax purposes to write off assets rapidly.
Feedback E: This method is incorrect.
16-43
78. The Modified Accelerated Cost Recovery System (MACRS) assumes that, on average,
assets will be placed in service:
A. at the beginning of the tax year.
B. three months into the tax year.
C. halfway through the tax year.
D. at the end of the tax year.
E. in the next tax year.

Blooms: Remember
Difficulty: 1 Easy
Feedback C: Correct! With MACRS, assets are assumed to be placed in service halfway through the tax year.
79. A company used the net-present-value method to analyze an investment and found the
investment to be very attractive. If the firm used straight-line depreciation and changes to the
Modified Accelerated Cost Recovery System (MACRS), the investment's net present value
will:
A. increase.
B. remain the same.
C. decrease.
D. change, but the direction cannot be determined based on the data presented.
E. fluctuate in an erratic manner.

Blooms: Understand
Feedback A: Correct! The investment’s net present value will increase.
16-44
80. A company used the net-present-value method to analyze an investment and found the
investment to be very attractive. If the firm used Modified Accelerated Cost Recovery System
(MACRS) and changes to the straight-line depreciation, the investment's net present value
will:
A. increase.
B. remain the same.
C. decrease.
D. change, but the direction cannot be determined based on the data presented.
E. fluctuate in an erratic manner.

Blooms: Understand
Feedback C: Correct! The investment’s net present value will decrease.
81. Young Company received $18,000 cash from the sale of a machine that had a $13,000
book value. If the company is subject to a 30% income tax rate, the net cash flow to use in a
discounted-cash-flow analysis would be:
A. $3,500.
B. $6,500.
C. $12,600.
D. $16,500.
E. $19,500.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback D: Correct! $18,000 – [($18,000 - $13,000) x 30%] = $16,500.
16-45
82. Dapper Company received $7,000 cash from the sale of a machine that had an $11,000
book value. If the company is subject to a 30% income tax rate, the net cash flow to use in a
discounted-cash-flow analysis would be:
A. $2,100.
B. $4,900.
C. $5,800.
D. $7,000.
E. $8,200.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback E: Correct! $7,000 – [($7,000 - $11,000) x 30%] = $8,200.
83. A machine was sold in December 20x3 for $9,000. It was purchased in January 20x1 for
$15,000, and depreciation of $12,000 was recorded from the date of purchase through the date
of disposal. Assuming a 40% income tax rate, the after-tax cash inflow at the time of sale is:
A. $3,600.
B. $6,600.
C. $8,400.
D. $9,000.
E. $11,400.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! $9,000 x (1 - 40%) + ($15,000 - $12,000) x 40% = $5,400 + $1,200 = $6,600.
16-46
84. Donata Company purchased equipment for $30,000 in December 20x1. The equipment is
expected to generate $10,000 per year of additional revenue and incur $2,000 per year of
additional cash expenses, beginning in 20x2. Under MACRS, depreciation in 20x2 will be
$3,000. If the firm's income tax rate is 40%, the after-tax cash flow in 20x2 would be:
A. $3,200.
B. $3,600.
C. $4,800.
D. $6,000.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback D: Correct! [($10,000 - $2,000) x (1 – 40%)] + ($3,000 x 40%) = $6,000.
Use the following information to answer Questions 85 & 86.
Carmen Company has an asset that cost $5,000 and currently has accumulated depreciation of
$2,000. Suppose the firm sold the asset for $2,500 and is subject to a 30% income tax rate.
85. The loss on disposal would be:

A. $350.
B. $500.
C. $650.
D. $2,500.
E. None, because the transaction produced a gain.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! Book value = $5,000 - $2,000 = $3,000; $3,000 - $2,500 = $500 loss.
Feedback E: This answer choice is wrong because there is a correct loss amount listed.
16-47
86. The net after-tax cash flow of the disposal is:

A. $2,100.
B. $2,350.
C. $2,500.
D. $2,650.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback D: Correct! $2,500 + ($500 x 30%) = $2,650.
87. Workman Company is considering a five-year project that requires a typical investment in
working capital, in this case, $100,000. Consider the following statements about this situation:
I. Workman should include a $100,000 outflow that occurs at time 0 in a discounted-cash-
flow analysis.
II. Workman should include separate $100,000 outflows in each year of the project's five-year
life.
III. Workman should include a $100,000 recovery of its working-capital investment in year 5
of a discounted-cash-flow analysis.

A. I only.
B. II only.
C. III only.
D. I and II.
E. I and III.

Blooms: Understand
Feedback A: This statement is true, but there is a better answer choice listed.
Feedback C: This statement is true, but there is a better answer choice listed.
16-48
88. A machine is expected to produce annual savings in cash operating costs of $400,000 for
the next six years.
FV of 1 (i=10%, n=6): 1.772

PV of $1 (i=10%; n = 6): 0.564
If the company has a 10% after-tax hurdle rate and is subject to a 30% income tax rate, the
correct discounted net cash flow would be:
A. $522,600.
B. $947,520.
C. $1,219,400.
D. $1,742,000.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback C: Correct! $400,000 x (1 – 30%) = $280,000; $280,000 x 4.355 = $1,219,400.
16-49
89. A machine is expected to produce increases in cash operating costs of $200,000 for the
next six years.
FV of 1 (i=14%, n=6): 2.195
PV of $1 (i=14%; n = 6): 0.456
correct discounted net cash flow would be:
A. $(233,340).
B. $(544,460).
C. $(777,800).
D. $(1,011,140).
E. None of the other answers is correct.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! $200,000 x 70% = $(140,000); $(140,000) x 3.889 = $(544,460)
16-50
90. A new machine is expected to produce a MACRS deduction in three years of $50,000.
Year FV of $1 at FV of an PV of $1 at PV of an
12% ordinary 12% ordinary
annuity at annuity at
12% 12%
1 1.120 1.000 0.893 0.893
2 1.254 2.120 0.797 1.690
3 1.405 3.374 0.712 2.402
4 1.574 4.779 0.636 3.037
5 1.762 6.353 0.567 3.605
6 1.974 8.115 0.507 4.111
correct discounted net cash flow to include in an acquisition analysis would be:
A. $0.
B. $10,680.
C. $24,920.
D. $46,280.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! $50,000 x 30% = $15,000; $15,000 x 0.712 = $10,680.
16-51
91. In 10 years, Hopkins Company plans to receive $9,000 cash from the sale of a machine
that has a $5,000 book value.
annuity at 8% annuity at 8%
1 1.080 1.000 0.926 0.926
2 1.166 2.080 0.857 1.783
3 1.260 3.246 0.794 2.577
4 1.361 4.506 0.735 3.312
5 1.469 5.867 0.681 3.993
6 1.587 7.336 0.630 4.623
If the firm is subject to a 30% income tax rate and has an 8% after-tax hurdle rate, the correct
discounted net cash flow would be:
A. $2,916.90.
B. $3,611.40.
C. $4,167.00.
D. $4,722.60.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! $5,000 + [($9,000 - $5,000) x (1 – 30%)] = $7,800; $7,800 x 0.463 = $3,611.40
16-52
92. In eight years, Shu Company plans to receive $11,000 cash from the sale of a machine that
has a $16,000 book value.
12% 12%
1 1.120 1.000 0.893 0.893
2 1.254 2.120 0.797 1.690
3 1.405 3.374 0.712 2.402
4 1.574 4.779 0.636 3.037
5 1.762 6.353 0.567 3.605
6 1.974 8.115 0.507 4.111
If the firm is subject to a 30% income tax rate and has a 12% after-tax hurdle rate, the correct
discounted net cash flow would be:
A. $606.
B. $1,414.
C. $3,838.
D. $5,050.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback D: Correct! $11,000 + [($16,000 - $11,000) x 30%] = $12,500; $12,500 x 0.404 = $5,050.
16-53
93. Consider the following statements about the investment in working capital in a capital
budgeting analysis:
I. Working capital often increases as the result of higher balances in accounts receivable or
inventory necessary to support a project.
II. Working capital increases are sources of cash and should be included in a discounted-cash-
flow analysis.
III. The time 0 cash investment in working capital is included in a discounted-cash-flow
analysis as a cash outflow.

A. I only.
B. II only.
C. III only.
D. I and II.
E. I and III.

Blooms: Understand
Feedback A: This statement is true, but there is a better answer choice listed.
Feedback C: This statement is true, but there is a better answer choice listed.
94. Which of the following tools is sometimes used to rank investment proposals?
A. Profitability index.
B. Annuity index.
C. Project assessment guide (PAG).
D. Investment opportunity index.
E. Capital ranking index.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: Correct! Profitability index is used to sometimes rank investment proposals.
Feedback B: This is not used for ranking.
Feedback C: This is not used for ranking.
Feedback D: This is not used for ranking.
Feedback E: This is not used for ranking.
16-54
95. If a proposal's profitability index is greater than one:
A. the net present value is negative.
B. the net present value is positive.
C. the net present value is zero.
D. none of these, because the net present value cannot be gauged by the profitability index.
E. the proposal should be rejected.

Blooms: Remember
Difficulty: 1 Easy
Feedback B: Correct! The net present value is positive if the profitability index is greater than one.
96. St. Michaels School ranks investments by using the profitability index (PI). The following
data relate to Project X and Project Y:
Project X Project Y
Initial Investment $400,000 $1,300,000
Present value of inflows 600,000 1,800,000
Which project would be more attractive as judged by its ranking, and why?
A. Project X because the PI is 1.50.
B. Project Y because the PI is 1.38.
C. Project X because the PI is 0.67.
D. Project Y because the PI is 0.72.
E. Both projects would be equally attractive in terms of ranking, as indicated by a positive PI.

Blooms: Apply
Difficulty: 3 Hard
Feedback A: Correct! This calculation and statement is correct. $600,000 ÷ $400,000 = 1.50.
16-55
97. Upton evaluates future projects by using the profitability index. The company is currently
reviewing five similar projects and must choose one of the following:
Project Initial Present Value of

Investment Cash Inflows
1 $100,000 $97,000
2 50,000 80,000
3 75,000 110,000
4 60,000 100,000
5 150,000 200,000
Which project should Upton select if the decision is based entirely on the profitability index?
A. Project 1.
B. Project 2.
C. Project 3.
D. Project 4.
E. Project 5.

Blooms: Apply
Difficulty: 3 Hard
Feedback A: This is incorrect. The PI is only 0.97.
Feedback B: This is incorrect. The PI is only 1.60.
Feedback C: This is incorrect. The PI is only 1.47.
Feedback D: Correct! This is the highest PI of 1.67.
Feedback E: This is incorrect. The PI is only 1.33.
16-56
98. The payback period is best defined as:

A. initial investment  annual after-tax cash inflow.
B. annual after-tax cash inflow  initial investment.
C. initial investment  useful life of investment.
D. (present value of the cash flows, exclusive of the initial investment)  initial investment.
E. initial investment  (present value of the cash flows, exclusive of the initial investment).

Blooms: Remember
Difficulty: 1 Easy
Feedback A: Correct! This is the definition for Payback period.
Feedback B: This definition is incorrect.
Feedback C: This definition is incorrect.
Feedback D: This definition is incorrect.
Feedback E: This definition is incorrect.
99. Consider the following statements about the payback period:

I. As shown in your text, the payback period considers the time value of money.
II. The payback period can only be used if net cash inflows are uniform throughout a project's
life.
III. The payback period ignores cash inflows that occur after the payback period is reached.

A. I only.
B. II only.
C. III only.
D. I and II.
E. I, II, and III.

Blooms: Remember
Difficulty: 1 Easy
Feedback C: Correct! Statement III is correct.
Feedback D: These statements are incorrect.
Feedback E: Only one of these statement is correct.
16-57
100. A piece of equipment costs $30,000, and is expected to generate $8,500 of annual cash
revenues and $1,500 of annual cash expenses. The disposal value at the end of the estimated
10-year life is $3,000. Ignoring income taxes, the payback period is:
A. 3.53 years.
B. 3.86 years.
C. 4.29 years.
D. 6.98 years.
E. Some other period of time not noted.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback C: Correct! $30,000 ÷ ($8,500 - $1,500) = 4.29 years.
Feedback E: This answer is wrong, because there is a correct payback period amount listed.
101. Sinclair is considering the acquisition of new machinery that will produce uniform
benefits over the next eight years. The following information is available:
Annual savings in cash operating costs: $350,000
Annual depreciation expense: $250,000
If the company is subject to a 30% tax rate, what denominator should be used to compute the
machinery's payback period?
A. $70,000.
B. $170,000.
C. $245,000.
D. $320,000.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback D: Correct! $350,000 – [30% x ($350,000 - $250,000)] = $320,000.
16-58
102. Krate Inc. is considering a $600,000 investment in new equipment that is anticipated to
produce the following net cash inflows:
Year Net Cash Inflows

1 $120,000
2 250,000
3 110,000
4 80,000
5 160,000
If cash flows occur evenly throughout a year, the equipment's payback period is:
A. 4 years, 2 months.
B. 4 years, 3 months.
C. 4 years, 4 months.
D. 5 years.
E. Some other period of time not noted.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback B: Correct! $600,000 – ($120,000 + $250,000 + $110,000 + $80,000) = $40,000 remaining after 4 years; $40,000 ÷ $160,000 =
25% x 1 year = 3 month; So, 4 years and 3 months.
Feedback E: This answer is wrong, because there is a correct answer listed.
16-59
103. Ocean Wave Packaging is considering a $600,000 investment in new equipment that is
anticipated to produce the following data over a five-year life:
Year Cash Inflows Cash Outflows Depreciation

1 $350,000 $130,000 $120,000
2 450,000 190,000 120,000
3 450,000 170,000 120,000
4 340,000 150,000 120,000
5 300,000 130,000 120,000
Ignoring income taxes and assuming that cash flows occur evenly throughout a year, the
equipment's approximate payback period is:
A. 1 year, 7 months.
B. 2 years, 1 month.
C. 2 years, 5 months.
D. Over 5 years.
E. Some other period of time not noted above.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback C: Correct! $600,000 – ($220,000 + $260,000) = $120,000 after 2 years; $120,000 ÷ $280,000 = 0.43 x 12 months = 5 months;
So, 2 years and 5 months.
Feedback E: This answer is wrong, because there is a correct answer listed.
16-60
104. Which of the following project evaluation methods focuses on accounting income rather
than cash flows?
A. Net present value.
B. Accounting rate of return.
C. Internal rate of return.
D. Payback period.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: This term is incorrect.
Feedback B: Correct! Accounting rate of return focuses on accounting income rather than cash flows.
Feedback C: This term is incorrect.
Feedback D: This term is incorrect.
105. The accounting rate of return focuses on the:

A. total accounting income over a project's life.
B. average accounting income over a project's life.
C. average cash flows over a project's life.
D. cash inflows from a project.
E. tax savings from a project.

Blooms: Remember
Difficulty: 1 Easy
Feedback B: Correct! Accounting rate of return focuses on the average accounting income over a project’s life.
16-61
106. Which of the following choices correctly depicts whether discounted cash flows are used
by the method noted when evaluating long-term investments?
Net Present Value Internal Rate of Return Accounting Rate of Return
A. No No Yes
B. Yes No Yes
C. Yes No No
D. Yes Yes No
E. Yes Yes Yes

Blooms: Understand
Feedback C: This answer combination is incorrect.
Feedback D: Correct! Discounted cash flows are used by net present value and internal rate of return, but not accounting rate of return.
Feedback E: This answer combination is incorrect.
107. Consider the following statements about the accounting rate of return:
I. The accounting rate of return focuses on a project's income rather than its cash flows.
II. Companies can figure the accounting rate of return on either the initial investment figure or
an average investment figure.
III. The accounting rate of return considers the time value of money.

A. I only.
B. II only.
C. III only.
D. I and II.
E. II and III.

Blooms: Remember
Feedback A: While this statement is correct, there is a better answer choice listed.
Feedback B: While this statement is correct, there is a better answer choice listed.
Feedback D: Correct! Statements I and II are correct.
16-62
108. Barrel Corporation, which is subject to a 30% income tax rate, is considering a $420,000
asset that will result in the following over its six-year life:
Average revenue: $920,000
Average operating expenses (excluding depreciation): $770,000
Average depreciation: $70,000
The after-tax accounting rate of return on the initial investment is:
A. 13.33%.
B. 19.05%.
C. 25.00%.
D. 35.71%.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback A: Correct! ($920,000 - $770,000) x (1 - 30%) = $105,000; $70,000 x 30% = $21,000; $105,000 + $21,000 = $126,000;
$126,000 - $70,000 = $56,000; $56,000 ÷ $420,000 = 13.33%.
109. San Marco has a $4,000,000 asset investment and is subject to a 30% income tax rate.
Cash inflows are expected to average $600,000 before tax over the next few years; in contrast,
average income before tax is anticipated to be $500,000. The company's after-tax accounting
rate of return is:
A. 8.75%.
B. 10.50%.
C. 12.50%.
D. 15.00%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Feedback A: Correct! $500,000 – ($500,000 x 30%) = $350,000; $350,000 ÷ $4,000,000 = 8.75%.
16-63
110. When making investment decisions that involve advanced manufacturing systems, the
use of net present value:
A. presents no special problems for the analyst.
B. often gives rise to net-present-value figures that are negative despite a manager's belief that
the investment is beneficial for the firm.
C. should be coupled with Pareto diagrams.
D. often omits a number of factors that are difficult to quantify (e.g., greater manufacturing
flexibility, improved product quality, and so forth).
E. often gives rise to net-present-value figures that are negative despite a manager's belief that
the investment is beneficial for the firm and often omits a number of factors that are difficult
to quantify (e.g., greater manufacturing flexibility, improved product quality, and so forth).

Blooms: Understand
Feedback B: While this statement is true, there is a better answer choice listed.
Feedback D: While this statement is true, there is a better answer choice listed.
Feedback E: Correct! Both these statements are true.
111. Twilight Corporation will evaluate a potential investment in an advanced manufacturing

system by use of the net-present-value (NPV) method. Which of the following system
benefits is least likely to be omitted from the NPV analysis?
A. Savings in operating costs.
B. Greater flexibility in the production process.
C. Improved product quality.
D. Shorter manufacturing cycle time.
E. Ability to fill customer orders more quickly.

Blooms: Understand
Feedback A: Correct! Savings in operating costs are least likely to be omitted from the NPV analysis.
Feedback B: This choice is incorrect.
Feedback C: This choice is incorrect.
Feedback D: This choice is incorrect.
Feedback E: This choice is incorrect.
16-64
112. A cash flow measured in nominal dollars is:
A. the actual cash flow that we experience.
B. the adjustment for a change in the dollar's purchasing power.
C. the discounted cash flow.
D. the realistic cash flow after taxes.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: Correct! Cash flow measured in nominal dollars is the actual cash flow that we experience.
Feedback B: This choice is incorrect.
113. A cash flow measured in real dollars:

A. is the actual cash flow that we experience.
B. is the actual cash flow adjusted for a change in the dollar's purchasing power.
C. reflects the time value of money.
D. equals the cash flow measured in nominal dollars.
E. coincides with the amount of contemplated new investment.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: This choice is incorrect.
Feedback B: Correct! A cash flow measured in real dollars is the actual cash flow adjusted for a change in the dollar’s purchasing power.
Feedback E: This choice is incorrect.
16-65
114. Consider the following statements about the accounting for inflation in a capital
budgeting analysis:
I. An analyst can use nominal dollars in conjunction with a nominal interest rate.
II. An analyst can use real dollars in conjunction with a real interest rate.
III. An analyst can use nominal dollars in conjunction with a real interest rate.

A. I only.
B. II only.
C. III only.
D. I and II.
E. II and III.

Blooms: Remember
Difficulty: 1 Easy
Feedback A: While this statement is correct, there is a better answer choice.
Feedback B: While this statement is correct, there is a better answer choice.
Feedback D: Correct! Statements I and II are correct.
16-66
Essay Questions
115. Randi Corp. is considering the replacement of some machinery that has zero book value
and a current market value of $2,800. One possible alternative is to invest in new machinery
that costs $30,000. The new equipment has a four-year service life and an estimated salvage
value of $3,500, will produce annual cash operating savings of $9,400, and will require a
$2,200 overhaul in year 3. The company uses straight-line depreciation.
annuity at 8% annuity at 8%
1 1.080 1.000 0.926 0.926
2 1.166 2.080 0.857 1.783
3 1.260 3.246 0.794 2.577
4 1.361 4.506 0.735 3.312
5 1.469 5.867 0.681 3.993
6 1.587 7.336 0.630 4.623
Required:
Prepare a net-present-value analysis of Randi’s replacement decision, assuming an 8% hurdle
rate and no income taxes. Should the machinery be acquired? Note: Round calculations to the
nearest dollar.
Solution:
Purchase of net machine $(30,000) x 1.0 $(30,000)

Sale of old machine $2,800 x 1.0 2,800
Cash operating savings $9,400 x 3.312 31,133
Overhaul $(2,200) x 0.794 (1,747)
Salvage value $3,500 x 0.735 2,573
Total $4,759
The machinery should be acquired because the investment has a positive net present value.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-67
116. On January 2, 20x1, Jennifer Grey purchased 800 shares of Sounder Telecommunications
common stock at $35 per share. The company paid a $1.50 dividend per share on December
28 of that year, and raised the amount by $0.50 per share for a distribution on December 28,
20x2. Jennifer sold her entire investment on December 30, 20x2, generating a $5,000 gain on
the sale of stock.
Year FV of $1 at FV of an ordinary PV of $1 at PV of an ordinary

10% annuity at 10% 10% annuity at 10%
1 1.100 1.000 0.909 0.909
2 1.210 2.100 0.826 1.736
3 1.331 3.310 0.751 2.487
4 1.464 4.641 0.683 3.170
5 1.611 6.105 0.621 3.791
6 1.772 7.716 0.564 4.355
Required:
A. Prepare a dated listing of the cash inflows and outflows related to Jennifer’s stock
investment. Ignore income taxes.
B. Assume that Jennifer has a 10% hurdle rate for all investments. Rounding to the nearest
dollar, compute the net present value of her investment in Sounder and determine whether she
achieved her 10% goal.
Solution:
A.
January 2, 20x1 Purchase (800 shares x $35) $(28,000)

December 28, 20x1 Dividend (800 shares x $1.50) 1,200
December 28, 20x2 Dividend (800 shares x $2.00) 1,600
December 30, 20x2 Sale ($28,000 + $5,000) 33,000
B. Jennifer achieved her goal, as indicated by the positive net present value.
Purchase of shares $(28,000) x 1.0 $(28,000)
Dividend, 20x1 $1,200 x 0.909 1,091
Dividend, 20x2 $1,600 x 0.826 1,322
Sale of shares $33,000 x 0.826 27,258
Total $1,671
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-68
117. Racer Industries is currently purchasing Part No. 76 from an outside supplier for $80 per
unit. Because of supplier reliability problems, the company is considering producing the part
internally in an idle manufacturing plant. Annual volume over the next six years is expected to
total 300,000 units at variable manufacturing costs of $75 per unit.
Racer must acquire $80,000 of new equipment if it reopens the plant. The equipment has a
six-year service life, a $14,000 salvage value, and will be depreciated by the straight-line
method. Repairs and maintenance are expected to average $5,200 per year in years 4-6, and
the equipment will be sold at the end of its life.

1 1.120 1.000 0.893 0.893
2 1.254 2.120 0.797 1.690
3 1.405 3.374 0.712 2.402
4 1.574 4.779 0.636 3.037
5 1.762 6.353 0.567 3.605
6 1.974 8.115 0.507 4.111
Required:
Rounding to the nearest dollar, use the net-present-value method (total-cost approach) and a
12% hurdle rate to determine whether Mark should make or buy Part No. 76. Ignore income
taxes.
Solution:
Racer is better off to make Part No. 76.

Buy:
Purchase (300,000 units x $80) $(24,000,000) x 4.111 $ 98,664,000
Make:
Variable manufacturing costs
(300,000 units x $75) $(22,500,000) x 4.111 $(92,497,500)
New Equipment $(80,000) x 1.0 (80,000)
Repairs and maintenance $(5,200) x (4.111 - 2.402) (8,887)
Equipment sale $14,000 x 0.507 7,098
Total $(92,579,289)
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-69
118. Clear Skies Airline Company is planning a project that is expected to last for six years
and generate annual net cash inflows of $75,000. The project will require the purchase of a
$280,000 machine, which is expected to have a salvage value of $10,000 at the end of the six-
year period. The machine will require a $50,000 overhaul at the end of the fourth year. The
company presently has a 12% minimum desired rate of return.
Based on this information, an accountant prepared the following analysis:
Annual net cash inflow $75,000

Annual depreciation $45,000
Annual average cost of overhaul 8,333 (53,333)
Average annual income $21,667
Return on investment $21,667 ÷ $280,000 = 7.74%
The accountant recommends that the project be rejected because it does not meet the
company's minimum desired rate of return. Ignore income taxes.
Required:
A. What criticism(s) would you make of the accountant's evaluation?
B. Use the net-present-value method and determine whether the project should be accepted.
C. Based on your answer in requirement "B," is the internal rate of return greater or less than
12%? Explain.
12% 12%
1 1.120 1.000 0.893 0.893
2 1.254 2.120 0.797 1.690
3 1.405 3.374 0.712 2.402
4 1.574 4.779 0.636 3.037
5 1.762 6.353 0.567 3.605
6 1.974 8.115 0.507 4.111
16-70
Solution:
A. The accountant is focusing on income rather than cash flows. The cash flows should be
discounted to reflect the time value of money, and depreciation should be omitted because of
the absence of taxes.
B.
Purchase price ($280,000) x 1.0 $(280,000)

Annual net cash inflows $75,000 x 4.111 308,325
Overhaul $(50,000) x 0.636 (31,800)
Salvage value $10,000 x 0.507 5,070
Total $1,595
The project should be accepted because the net present value is positive.
C. The net present value is positive using a discount rate of 12%. Thus, the internal rate of
return is greater than 12%.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-71
119. Fulton Township is studying a 700-acre site for a new landfill. The new site will save
$70,000 in annual operating costs for 10 years, as Fulton currently uses the landfill of a
neighboring municipality. Other data are:
Purchase price per acre: $550
Site preparation costs: $110,000
Hurdle rate: 6%
Ignore income taxes.

1 1.060 1.000 0.943 0.943
2 1.124 2.060 0.890 1.833
3 1.191 3.184 0.840 2.673
4 1.263 4.375 0.792 3.465
5 1.338 5.637 0.747 4.212
6 1.419 6.975 0.705 4.917
7 1.504 8.394 0.665 5.582
8 1.594 9.898 0.627 6.210
9 1.690 11.491 0.592 6.802
10 1.791 13.181 0.558 7.360
16-72
Required:
A. Use the net-present-value method and determine whether the landfill should be acquired.
B. Determine the landfill's approximate internal rate of return, using the tables above.
Solution:
A.
Purchase price (700 x $550) $(385,000) x 1.0 $(385,000)

Site preparation $(110,000) x 1.0 (110,000)
Savings in operating costs $70,000 x 7.360 515,200
Total $20,200
Yes, the landfill should be acquired because it has a positive net present value.
B. Let X = present value factor
$70,000X = ($385,000 + $110,000)
X = 7.071
A review of annuity factors for 10 years finds an internal rate of return that falls between 6%
(7.360) and 8% (6.710).
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-73
120. Canton Corporation is considering the acquisition of a new machine that costs $149,040.
The machine is expected to have a four-year service life and will produce annual savings in
cash operating costs of $45,000. Canton evaluates investments by using the internal rate of
return and ignores income taxes.
Required:
A. Briefly define the internal rate of return.
B. What relationship holds true at the internal rate of return with respect to discounted cash
inflows and discounted cash outflows? With respect to net present value?
C. Compute the machine's internal rate of return, using the tables that follow.
16-74
Solution:
A. The internal rate of return is the true economic yield on a project, taking the time value of
money into consideration.
B. At the internal rate of return, the present value of the cash inflows equals the present value
of the cash outflows. Thus, the net present value is zero.
C. $149,040  $45,000 = 3.312, which corresponds with the factor of an 8% return on a four-
year project.

Blooms: Apply
Difficulty: 3 Hard
121. Both net present value (NPV) and the internal rate of return (IRR) have a reinvestment
assumption.
Required:
A. State the assumption for each method.

B. One of the advantages of the NPV method is that users can adjust for risk considerations.
Explain how this is done.
Solution:
A. In the NPV method, cash flows are assumed to be reinvested at the hurdle rate. With the
IRR, cash flows are assumed to be reinvested at the same rate as the project's return.
B. In the NPV method, a higher hurdle rate can be used, either for the entire analysis or for
the estimated cash inflows (savings) that occur late in the project's life.

Blooms: Understand
16-75
122. Consider the five items that follow, which are related to independent investment
opportunities.
Purchase price of a new machine: $850,000
Annual straight-line depreciation: $75,000
Advertising expenses related to a new marketing campaign in year 2: $35,000
Sale of an asset in year 6: Loss on sale, $60,000; proceeds received by seller, $23,000
Required:
Complete the following table, inserting the (pre-discounted) cash flow amounts that would be
used in a net-present-value analysis. Column A should be completed based on the assumption
of no income taxes; in contrast, Column B should be completed assuming the relevant
company is subject to a 30% income tax rate. Be sure to note cash outflows in parentheses.
Column A: Column B:
No Income Taxes 30% Tax Rate
Purchase price of new machine
Annual straight-line depreciation
Annual savings in cash operating costs
Advertising expenses
Sale of Asset
Solution:
Column A: Column B:
No Income Taxes 30% Tax Rate
Purchase price of new machine $(850,000) $(850,000)
Annual straight-line depreciation
Column B: $75,000 x 0.3 ---- 22,500
Annual savings in cash operating costs:
Column B: $120,000 x 0.7 120,000 84,000
Advertising expenses
Column B: $(35,000) x 0.7 (35,000) (24,500)
Sale of Asset
Column B: $60,000 loss x 0.3 = $18,000 tax savings;
$18,000 + $23,000 23,000 41,000
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-76
123. Spear Company is considering a $5.4 million asset investment that has a four-year
service life and a $400,000 salvage value. The investment is expected to produce annual
savings in cash operating costs of $860,000 and will require a $250,000 overhaul in year 3,
which is fully-deductible for tax purposes.
Spear uses the net-present-value method to analyze investments. Asset investments are
depreciated by the straight-line method, ignoring salvage values in related computations.
Required:
A. Ignoring income taxes, determine the (pre-discounted) cash-flow amounts that would be
used in a net-present-value analysis for (1) the asset acquisition, (2) annual savings in cash
operating costs, (3) annual straight-line depreciation, (4) the overhaul in year 3, and (5)
disposal of the asset in year 4. Note cash outflows in parentheses.
B. Repeat requirement "A," assuming the company is subject to a 30% income tax rate.
Assume the company depreciates the asset using the optional straight-line method.
Additionally, it depreciates it over the asset's service life (not its MACRS life).
Solution:
A. Asset acquisition: $(5,400,000)

Annual straight-line depreciation: $0
Year 3 overhaul: $(250,000)
Year 4 asset disposal: $400,000
B. Asset acquisition: $(5,400,000)
Annual savings in cash operating costs: $860,000  0.7 = $602,000
Depreciation should be:
Year 1: $675,000 x .3 = $202,500
Year 2: $1,350,000 x .3 =$405,000
Year 3: $1,350,000 x .3 =$405,000
Year 4: $1,350,000 x .3 =$405,000
Year 5: $675,000 x .3 = $202,500
Year 3 overhaul: $(250,000)  0.7 = $(175,000)
Year 4 asset disposal: $5,400,000 ‒ $5,400,000 accumulated depreciation = $0 book value; $0
book value - $400,000 salvage value = $400,000 gain; $400,000 gain  0.3 = $(120,000)
added tax; $400,000 salvage value ‒ $(120,000) added tax = $280,000
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-77
124. Postaudits are an important part of capital budgeting.
Required:
A. What is a postaudit of a capital investment project?
B. What are the benefits of a postaudit?
C. A manager prepared an unsuccessful proposal for a capital project, as her firm decided not
to fund and pursue the project. The manager observed, "The company's postaudit process will
show that this project should have been funded." Comment on the manager's understanding of
the postaudit process.
Solution:
A. A postaudit is a review of the actual cash flows generated by a project and a comparison of
the actual net present value with the original, anticipated net present value (or IRR).
B. The postaudit provides an opportunity to identify problems in the implementation of a
project, changes in the project's environment, errors in the estimation of cash flows, or
weaknesses in the process by which the project was developed. Hopefully, an organization
will learn from the postaudit and, if appropriate, change its ways so that past errors are not
repeated.
C. The manager's understanding of the postaudit process is flawed. The postaudit is applied to
projects that are funded/implemented. It is not a mechanism to show what might have
happened if a rejected project had been accepted.

Blooms: Understand
16-78
125. Depreciation is often described as a "tax shield."
Required:
A. Explain how depreciation provides such a shield.
B. MACRS is an accelerated depreciation system. Explain how an accelerated system can
provide a more beneficial tax shield than, say, a straight-line depreciation system.
Solution:
A. Depreciation does not require a cash outlay. (The cash outlay occurred when the asset was
acquired.) However, depreciation reduces taxable income and consequently, reduces the cash
outflow for income taxes. Thus, depreciation provides a reduction in cash outflows for income
taxes, or in other words, shields some of a firm's income.
B. Under an accelerated depreciation system, the asset's cost is written off more rapidly than
under the straight-line system. This leaves funds for re-investment sooner, thus allowing a
company to generate greater returns because the money is invested for a longer period of
time.

Blooms: Understand
16-79
126. Tatum Corporation recently purchased a $1,200,000 asset that has a three-year service
life and no salvage value. The company is subject to a 30% income tax rate and employs a
12% after-tax hurdle rate in capital investment decisions.
Management is studying whether to depreciate the asset by using the straight-line method or
the Modified Accelerated Cost Recovery System (MACRS). Assume that the following
MACRS factors are in effect: year 1, 33%; year 2, 45%; year 3, 15%; and year 4, 7%
12% 12%
1 1.120 1.000 0.893 0.893
2 1.254 2.120 0.797 1.690
3 1.405 3.374 0.712 2.402
4 1.574 4.779 0.636 3.037
5 1.762 6.353 0.567 3.605
6 1.974 8.115 0.507 4.111
Required:
A. Calculate the total depreciation expense that Tatum will record under each method.
B. Calculate the total tax savings that will occur with each method.
C. On the basis of your calculations in part "B," which of the two methods will management
likely prefer? Explain your answer.
D. Compute the present value of the tax savings for each method, rounding to the nearest
dollar.
Solution:
A. Both methods will result in the total asset cost of $1,200,000 being written off as
depreciation expense.
B. Straight-line:
Year 1: $200,000 x .3 = 60,000 x .893 = $53,580

Year 2: $400,000 x .3 = 120,000 x .797 = $95,640
Year 3: $400,000 x .3 = 120,000 x .712 = $85,440
Year 4: $200,000 x .3 = 60,000 x .636 = $38,160
TOTAL $272,820
Regardless of the depreciation method chosen (accelerated or the optional straight-line

method) the half-year convention must still be followed. (see text, pg. 705)
16-80
MACRS:
Year 1: $1,200,000 x 0.33 x 0.30 = $118,800

Year 2: $1,200,000 x 0.45 x 0.30 = 162,000
Year 3: $1,200,000 x 0.15 x 0.30 = 54,000
Year 4: $1,200,000 x 0.07 x 0.30 = 25,200
TOTAL $360,000
C. Although the total dollar amounts are the same, the timing differs, with MACRS producing
greater savings in the earlier part of the asset's life. These dollar savings can be reinvested by
the business to generate additional returns, as verified by the present value calculations in
requirement "D."
D.
Straight-Line $272,820
MACRS
Year 1: $118,800 x 0.893 $106,088
Year 2: $162,000 x 0.797 129,114
Year 3: $54,000 x 0.712 38,448
Year 4: $25,200 x 0.636 16,027
TOTAL $289,677
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-81
127. Marker Sail Company plans to purchase $4.5 million of equipment in the not-too-distant
future. The equipment will be depreciated by the optional straight-line method over the
MACRS life of 5 years. Marker is subject to a 30% income tax rate.
The company's accountant is about to perform a net-present-value analysis, assuming a 10%
after-tax hurdle rate.

1 1.100 1.000 0.909 0.909
2 1.210 2.100 0.826 1.736
3 1.331 3.310 0.751 2.487
4 1.464 4.641 0.683 3.170
5 1.611 6.105 0.621 3.791
6 1.772 7.716 0.564 4.355
Required:
A. Determine the discounted cash flows that would be reflected in the analysis in year 0 and
year 1.
B. Determine the discounted cash flow that would be reflected in the analysis in year 6,
assuming that Marker sells the equipment for $450,000,
Solution:
A. Year 0 acquisition cost: $(4,500,000)  1.0 = $(4,500,000)

For taxes, you must ignore salvage value and use the half-year convention.
Year 1 depreciation tax shield: ($4,500,000 / 5) x 0.5 = $450,000 x 0.3 = $135,000 x .909 =
$122,715.
B.
Cost $4,500,000
Less: Accumulated depreciation 4,500,000
Book value $ ---
Selling price 450,000
Gain on sale $ 450,000
Tax on gain ($450,000 x 30%) 135,000
Total cash flow $315,000
Discounted cash flow: ($315,000 x 0.564) $177,660

AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-82
128. You are reviewing some material that deals with investment analysis, preparing for your
first day on the job at Enrique Enterprises. Consider the cash flows that follow.
1. The immediate payment required to purchase a $600,000 milling machine.
2. Straight-line depreciation of $20,000 in year 2 of a long-term investment.
3. Annual savings in cash operating costs of $50,000 over the next eight years.
4. Sale of a machine for $35,000 at the end of its six-year service life. The machine has a
book value of $25,000.
5. A $6,000 equipment overhaul in year 5 that is fully deductible for income tax purposes.

1 1.100 1.000 0.909 0.909
2 1.210 2.100 0.826 1.736
3 1.331 3.310 0.751 2.487
4 1.464 4.641 0.683 3.170
5 1.611 6.105 0.621 3.791
6 1.772 7.716 0.564 4.355
Required:
Calculate the discounted cash flow that is appropriate for each of the preceding items. Assume
a 10% after-tax hurdle rate and a 30% income tax rate, and round to the nearest dollar.
Solution:
1. $(600,000)  1.0 = $(600,000)

2. $20,000  0.30 = $6,000; $6,000  0.826 = $4,956
3. $50,000  0.70 = $35,000; $35,000  5.335 = $186,725
4. $35,000 ‒ $25,000 = $10,000 gain; $10,000  0.30 = $3,000 tax; $35,000 ‒ $3,000 =
$32,000; $32,000  0.564 = $18,048
5. $(6,000)  0.70 = $(4,200); $(4,200)  0.621 = ($2,608)
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-83
129. The Excon Machine Tool Company is considering the addition of a computerized lathe
to its equipment inventory. The initial cost of the equipment is $600,000, and the lathe is
expected to have a useful life of five years and no salvage value. The cost savings and
increased capacity attributable to the machine are estimated to generate increases in the firm's
annual cash inflows (before considering depreciation) of $180,000. The machine will be
depreciated using MACRS for tax purposes. The 5-year MACRS depreciation percentages as
computed by the IRS are: Year 1 = 20.00%; Year 2 = 32.00%; Year 3 = 19.20%; Year 4 =
11.52%; Year 5 = 11.52%; Year 6 = 5.76%.
Warren is currently in the 40% income tax bracket. A 10% after-tax rate of return is desired.

1 1.100 1.000 0.909 0.909
2 1.210 2.100 0.826 1.736
3 1.331 3.310 0.751 2.487
4 1.464 4.641 0.683 3.170
5 1.611 6.105 0.621 3.791
6 1.772 7.716 0.564 4.355
Required:
A. What is the net present value of the investment? Round to the nearest dollar.
B. Should the machine be acquired by the firm?
C. Assume that the equipment will be sold at the end of its useful life for $100,000. If the
depreciation amounts are not revised, calculate the dollar impact of this change on the total
net present value.
16-84
Solution:
A. Purchase price $(600,000) x 1.0 $(600,000)

Increases in cost savings
and capacity $180,000 x 0.60 x 3.791 409,428
MACRS:
Year 1 $600,000 x 0.20 x 0.40 x 0.909 43,632
2 $600,000 x 0.32 x 0.40 x 0.826 63,437
3 $600,000 x 0.192 x 0.40 x 0.751 34,606
4 $600,000 x 0.115 x 0.40 x 0.683 18,851
5 $600,000 x 0.115 x 0.40 x 0.621 17,140
6 $600,000 x 0.058 x 0.40 x 0.564 7,851
Total $(5,055)
B. No, the machine should not be acquired because it has a negative net present value.
C.
Cost $ 600,000
Less: Accumulated depreciation 600,000
Book value $ ---
Selling price 100,000
Gain on sale $ 100,000
Proceeds from sale $100,000

Less: Tax on gain ($100,000 x 40%) 40,000
Total cash flow $60,000
Discounted cash flow: $60,000 x 0.621 $37,260
The net present value will increase by $37,260. In this case, the machine should be acquired
because it has a positive net present value.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-85
130. Warner Corporation is considering the acquisition of a new machine that costs $350,000.
The machine is expected to have a four-year service life and will produce annual savings in
cash operating costs of $100,000. Warner uses the optional straight-line method of
depreciation and depreciates the asset over its four-year service life. The company is subject
to a 30% income tax rate, has an after-tax hurdle rate of 12%, and rounds calculations to the
nearest dollar.

1 1.120 1.000 0.893 0.893
2 1.254 2.120 0.797 1.690
3 1.405 3.374 0.712 2.402
4 1.574 4.779 0.636 3.037
5 1.762 6.353 0.567 3.605
6 1.974 8.115 0.507 4.111
Required:
A. Determine the annual after-tax cash flows that result from acquisition of the machine.
B. Calculate the machine's net present value. Is the machine an attractive investment? Why?
Solution:
A. Annual cash operating costs: $(100,000)  0.7 = $(70,000)
Depreciation tax savings:
Year 1: $43,750 x .3 = 13,125
Year 2: $87,500 x .3 = 26,250
Year 3: $87,500 x .3 = 26,250
Year 4: $87,500 x .3 = 26,250
Year 5: $43,750 x .3 = 13,125
B.
Initial investment $(350,000) x 1.0 $(350,000)
Cash operating savings $70,000 x 3.037 212,590
Depreciation tax shield
Year 1 13,125 x 0.893 11,721
2 26,250 x 0.797 20,921
3 26,250 x 0.712 18,690
4 26,250 x 0.636 16,695
5 13,125 x 0.567 7,442
Net present value $(61,941)
The machine is not considered an attractive investment because it has a negative net present value.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-86
131. Kansas Corporation is reviewing an investment proposal that has an initial cost of
$52,500. An estimate of the investment's end-of-year book value, the yearly after-tax net cash
inflows, and the yearly net income are presented in the schedule below. Yearly after-tax net
cash inflows include savings from the depreciation tax shield. The investment's salvage value
at the end of each year is equal to book value, and there will be no salvage value at the end of
the investment's life.
Year Initial Cost Yearly After- Yearly

and Book Tax Net cash Net
Value Inflows Income
1 $35,000 $20,000 $2,500
2 21,000 17,500 3,500
3 10,500 15,000 4,500
4 3,500 12,500 5,500
5 --- 10,000 6,500
$75,000 $22,500
Kansas uses a 14% after-tax target rate of return for new investment proposals.
14% 14%
1 1.140 1.000 0.877 0.877
2 1.300 2.140 0.769 1.647
3 1.482 3.440 0.675 2.322
4 1.689 4.921 0.592 2.914
5 1.925 6.610 0.519 3.433
6 2.195 8.536 0.456 3.889
Required:
A. Calculate the project's payback period.
B. Calculate the accounting rate of return on the initial investment.
C. Calculate the proposal's net present value. Round to the nearest dollar.
16-87
Solution:
A. The project's payback is 3 years. By the conclusion of this time period, Kansas will have
recovered the investment's cost of $52,500 ($20,000 + $17,500 + $15,000 = $52,500).
B. The accounting rate of return is 8.6%:

Average income ($22,500  5 years = $4,500)  initial investment ($52,500)
C.
Year 0: $(52,500) x 1.0 $(52,500)

Year 1: $20,000 x 0.877 17,540
Year 2: $17,500 x 0.769 13,458
Year 3: $15,000 x 0.675 10,125
Year 4: $12,500 x 0.592 7,400
Year 5: $10,000 x 0.519 5,190
$1,213
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-88
132. Tanner Corporation is considering the acquisition of a new machine that is expected to
produce annual savings in cash operating costs of $30,000 before income taxes. The machine
costs $100,000, has a useful life of five years, and no salvage value. Tanner uses straight-line
depreciation on all assets, is subject to a 30% income tax rate, and has an after-tax hurdle rate
of 8%.
1 1.080 1.000 0.926 0.926
2 1.166 2.080 0.857 1.783
3 1.260 3.246 0.794 2.577
4 1.361 4.506 0.735 3.312
5 1.469 5.867 0.681 3.993
6 1.587 7.336 0.630 4.623
Required:
A. Compute the machine's accounting rate of return on the initial investment.
B. Compute the machine's net present value.
Solution:
A. Average income: ($30,000 ‒ $20,000)  0.70 = $7,000

Accounting rate of return: $7,000  $100,000 = 7%
B.
Initial investment $(100,000) x 1.0 $(100,000)

Savings in operating costs $21,000 x 3.993 83,853
Depreciation tax savings See schedule below 23,070
Net present value $6,923
Depreciation tax savings:

Year 1: 10,000 x .3 = 3,000 x .926 = 2,778
Year 2: 20,000 x .3 = 6,000 x .857 = 5,142
Year 3: 20,000 x .3 = 6,000 x .794 = 4,764
Year 4: 20,000 x .3 = 6,000 x .735 = 4,410
Year 5: 20,000 x .3 = 6,000 x .681 = 4,086
Year 6: 10,000 x .3 = 3,000 x .630 = 1,890
TOTAL $23,070
NPV = $6,923
The present value of the cash inflows from cost and tax savings = $106,923.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-89
133. A profitability index can be used to rank investment proposals.
Required:
A. Define the profitability index.
B. Two projects are under consideration. Project I has a net present value of $20,000 whereas
project II has a net present value of $200,000. Which project is better? Explain. What
weakness in a net-present-value analysis does the profitability index address?
Solution:
A. The profitability index equals the present value of a project's cash inflows divided by the
initial investment.
B. Both projects provide a return greater than the hurdle rate and both are acceptable. It is not
possible to say which one is better. The profitability index provides a ratio that is not
influenced by the size of the project—a limitation of net-present-value (NPV) analysis. Thus,
a project that has a greater NPV and a greater profitability index generally will be more
attractive than another project against which it is being compared.

Blooms: Understand
16-90
134. Marcus & Tyler sells frozen custard and sandwiches. It is considering a new site that will
require a $2 million investment for land acquisition and construction costs. The following
operating results are expected:
Sales Revenue $980,000

Less operating expenses:
Food & Supplies $320,000
Wages & Salaries 180,000
Insurance & Taxes 40,000
Utilities 10,000
Depreciation 70,000 620,000
Operating income $360,000
Disregard income taxes.
Required:
A. If management requires a payback period of four years or less, should the new site be
opened? Why?
B. Compute the accounting rate of return on the initial investment.
C. What significant limitation of payback and the accounting rate of return is overcome by the
net-present-value method?
Solution:
A. Annual net cash inflows: $980,000 ‒ ($620,000 ‒ $70,000) = $430,000

Payback: $2,000,000  $430,000 = 4.65 years
No, because the payback fails to meet management's guideline.
B. $360,000  $2,000,000 = 18%
C. Payback and the accounting rate of return ignore the time value of money, which is the
foundation of the net-present-value method.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16-91
135. The payback method is a popular way to analyze investment proposals.
Required:
A. Explain how the payback period is determined. Generally speaking, from a payback
perspective, which projects are viewed to be the most attractive?
B. Can the payback method take income taxes into consideration? Explain.
C. What are the deficiencies of the payback method?
Solution:
A. The payback period is the time required to recover the initial investment. Projects with the
shortest payback are generally viewed as being the most attractive.
B. Yes, the payback period is based on net cash inflows to the firm, and can be computed
either before taxes or after taxes.
C. There are two major deficiencies. The payback method ignores (1) cash flows that occur
after the payback point has been reached and (2) the time value of money.

Blooms: Understand
16-92
136. An increased number of companies are investing in advanced manufacturing systems.
Required:
A. Many proposed advanced manufacturing systems have a negative net present value when
discounted-cash-flow analysis is used. Explain several causes of this situation.
B. Two major benefits of advanced systems are greater flexibility in the manufacturing
process and improvements in product quality. Explain how these benefits can create problems
when performing discounted-cash-flow analysis.
Solution:
A. Negative net present values may arise from several factors: the investments are very costly;
the hurdle rate may be very high to compensate for project risk; the time horizon may be too
short; and a number of benefits associated with the project may have been excluded from the
analysis because of related quantification problems.
B. Greater flexibility in the manufacturing process and improvements in product quality are
very difficult to quantify. As a result, these items may be excluded from a discounted-cash-
flow analysis, decreasing an investment's attractiveness.

Blooms: Understand
16-93

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Chapter 16 - Capital Expenditure Decisions

Chapter 16 Capital Expenditure Decisions

True / False Questions

AACSB: Reflective Thinking

2. Two widely used methods of discounted-cash-flow analysis are the net-present-value

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

7. All expenses represent cash outflows.

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

17. Activity-based-costing systems are costly, time-consuming to implement, and do not

20. Nominal dollars is another name for real dollars.

Multiple Choice Questions

21. Capital-budgeting decisions primarily involve:

AACSB: Reflective Thinking

22. Which of the following would not involve a capital-budgeting analysis?

AACSB: Reflective Thinking

AACSB: Reflective Thinking

24. Capital budgeting tends to focus primarily on:

AACSB: Reflective Thinking

25. Discounted-cash-flow analysis focuses primarily on:

AACSB: Reflective Thinking

26. In a net-present-value analysis, the discount rate is often called the:

AACSB: Reflective Thinking

AACSB: Reflective Thinking

A Project’s Immediate Cash Flows During Time Value of

AACSB: Reflective Thinking

Which of the preceding factors would be important considerations in a net-present-value

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

32. The internal rate of return:

AACSB: Reflective Thinking

PV of $1 (i=12%; n = 6): 0.507

FV of 1 (i=10%, n=5): 1.611

Period FV of 1 FV of a series of $1 PV of $1 PV of a series of $1

FV of 1 (i=10%, n=5): 1.611

39. Excaliber is considering the acquisition of a $217,750 machine that is expected to

FV of 1 (i=12%, n=5): 1.762

The net present value of the machine is:

Trenton uses a 10% discount rate for capital-budgeting decisions.

AACSB: Reflective Thinking

Net Present Value Internal Rate of Return

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking