CHAPTER 8: CAPITAL BUDGETING DECISIONS—PART II

Multiple Choice

a 4. Companies using MACRS for tax purposes and straight-line depreciation for financial reporting purposes
usually find that the relationship between the tax basis and book value of their assets is
a. the tax basis is lower than book value.
b. the tax basis is higher than book value.
c. the tax basis is the same as book value.
d. none of the above.

c 5. A company that wants to use MACRS for tax purposes must

a. request permission from the IRS.
b. acquire new assets at or near the middle of the year.
c. ignore salvage value in calculating depreciation.
d. do none of the above.

c 6. The government could encourage increases in investment by

a. increasing tax rates.
b. lengthening the MACRS periods.
c. letting a company expense fixed assets in the year acquired instead of through annual depreciation charges.
d. taking actions that would increase interest rates.

a 9. A company is considering replacing a machine with one that will save $50,000 per year in cash operating costs
and have $20,000 more depreciation expense per year than the existing machine. The tax rate is 40%.
Buying the new machine will increase annual net cash flows of the company by
a. $38,000.
b. $30,000.
c. $20,000.
d. $12,000.

c 10. Not-for-profit entities

a. cannot use capital budgeting techniques because profitability is irrelevant to them.
b. cannot use discounted cash flow techniques because the time value of money is irrelevant to them.
c. might have serious problems in quantifying the benefits expected from an investment.
d. should use the IRR method to make investment decisions.

d 12. The proper treatment of an investment in receivables and inventory is to

a. ignore it.
b. add it to the required investment in fixed assets.
c. add it to the required investment in fixed assets and subtract it from the annual cash flows.
d. add it to the investment in fixed assets and add the present value of the recovery to the present value of the
annual cash flows.
a 13. If a company uses a five-year MACRS period to depreciate assets instead of a 10-year life with straight-line
depreciation,
a. the NPV of the investment is higher.
b. the IRR of the investment is lower.
c. there is no difference in either NPV or IRR.
d. total cash flows over the useful life would be lower.

b 16. Classifying an asset in a MACRS life category is based on

a. useful life estimated by the company.
b. asset depreciation range (ADR) guidelines.
c. the cost of the asset.
d. any of the above factors.

103
c 20. With respect to income taxes, the principal advantage of MACRS over straight-line depreciation is that
a. total taxes will be lower under MACRS.
b. taxes will be constant from year to year under MACRS.
c. taxes will be lower in the earlier years under MACRS.
d. taxes will decline in future years under MACRS.

b 24. In capital budgeting, sensitivity analysis is used

a. to determine whether an investment is profitable.
b. to see how a decision would be affected by changes in variables.
c. to test the relationship of the IRR and NPV.
d. to evaluate mutually exclusive investments.

a 26. Because of idle capacity, a company is considering two assets for sale. They are identical in all respects except
that asset A has a higher tax basis than asset B. Only one need be sold now and the market price is the same
for both assets. Which of the following is true?
a. The cash flow is greater from selling asset A.
b. The cash flow is greater from selling asset B.
c. The cash flow is the same no matter which one is sold.
d. It is not possible to determine how the cash flows from sales of the assets will differ.

a 27. If the tax law were changed so that owners of apartment buildings had to depreciate them over 50 years instead
of the current 31.5 years,
a. rents would rise.
b. rents would fall because annual depreciation charges would fall.
c. rents would stay about the same.
d. more people would invest in apartment buildings.

d 35. NPV is appropriate to use to analyze which decision relating to a joint-products company?
a. Whether or not to sell facilities now used for additional processing of one of the joint products.
b. Whether or not to acquire facilities needed for additional processing of one of the joint products.
c. Whether or not to sell facilities now used to operate the joint process.
d. All of the above.

c 43. Hoff is considering the sale of a machine with a book value of $160,000 and 3 years remaining in its useful
life. Straight-line depreciation of $50,000 annually is available. The machine has a current market value of
$100,000. What is the cash flow from selling the machine if the tax rate is 40%?
a. $50,000
b. $100,000
c. $124,000
d. $160,000

a 44. Altoona Company is considering replacing a machine with a book value of $200,000, a remaining useful life of
4 years, and annual straight-line depreciation of $50,000.
The existing machine has a current market value of $175,000. The replacement machine would cost
$320,000, have a 4 year life, and save $100,000 per year in cash operating costs. If the replacement
machine would be depreciated using the straight-line method and the tax rate is 40%, what would be the
increase in annual income taxes if the company replaces the machine?
a. $28,000
b. $40,000
c. $42,000
d. $64,000

b 45. An investment opportunity costing $300,000 is expected to yield net cash flows of $100,000 annually for
five years. The profitability index of the investment at a cutoff rate of 14% would be
a. 3.0.

104
 b. 1.14.
c. 0.33.
d. 14%.

d 46. A project has a NPV of $30,000 when the cutoff rate is 10%. The annual cash flows are $41,010 on an
investment of $100,000. The profitability index for this project is
a. 1.367.
b. 3.333.
c. 2.438.
d. 1.300.

c 47. A project has an IRR in excess of the cost of capital. The profitability index for this project would be
a. less than zero.
b. between zero and one.
c. greater than one.
d. cannot be determined without more information.

b 48. A project has an IRR less than the cost of capital. The profitability index for this project would be
a. less than zero.
b. between zero and one.
c. greater than one.
d. cannot be determined without more information.

105
b 49. Portage Press Company is considering replacing a machine with a book value of $200,000, a remaining useful
life of 5 years, and annual straight-line depreciation of $40,000. The existing machine has a current market
value of $200,000. The replacement machine would cost $300,000, have a 5-year life, and save $100,000
per year in cash operating costs. If the replacement machine would be depreciated using the straight-line
method and the tax rate is 40%, what would be the increase in annual net cash flow if the company
replaces the machine?
a. $60,000
b. $68,000
c. $76,000
d. $84,000

b 50. Winneconne Company is considering replacing a machine with a book value of $400,000, a remaining useful
life of 5 years, and annual straight-line depreciation of $80,000.
The existing machine has a current market value of $400,000. The replacement machine would cost
$550,000, have a 5-year life, and save $75,000 per year in cash operating costs.
If the replacement machine would be depreciated using the straight-line method and the tax rate is 40%,
what would be the net investment required to replace the existing machine?
a. $90,000
b. $150,000
c. $330,000
d. $550,000

True-False

T 1. The higher the IRR on an investment project, the higher its profitability index.

F 2. If the payback period of an investment project is shorter than its life, the project's profitability index is greater
than 1.

F 3. If a company has decided that a certain task must be performed and three machines accomplish that task, the
machine with the lowest initial cash outlay should be selected.

T 4. An investment with an IRR greater than cost of capital has a profitability index greater than 1.

T 5. The only costs and revenues relevant to a replacement decision are those that will change if a replacement is
made.

T 6. Both the incremental and the total-project approaches to analyzing a replacement decision should yield the
same decision.

F 7. Both the IRR and the book rate of return methods of analyzing investments should yield the same decision.

F 8. If the payback period of an investment is shorter than its life, its profitability index is greater than l.

T 9. When compared with straight-line depreciation, using MACRS will result in a larger NPV.

F 10. IRR and book rate of return will usually yield the same value for an investment.

Problems

1. Stockholm Company is considering the sale of a machine with the following characteristics.

Book value $120,000

Remaining useful life 5 years
Annual straight-line depreciation $ 24,000

106
 Current market value $ 70,000

If the company sells the machine its cash operating expenses will increase by $30,000 per year due to an operating
lease. The tax rate is 40%.

a. Find the cash flow from selling the machine.

b. Calculate the increase in annual net cash outflows as a result of selling the machine.

SOLUTION:

a. Cash flow from sale: $90,000 ($70,000 + 40% tax savings on the $50,000 tax loss)

b. Increase in annual cash outflows: $27,600 ($30,000 pretax cost increase - $2,400 decrease in income taxes; the
$30,000 increase in cash costs is partially offset by losing a $24,000 depreciation deduction)

2. Pepin Company is considering replacing a machine that has the following characteristics.

Book value $100,000

Remaining useful life 5 years
Annual straight-line depreciation $ 20,000
Current market value $ 60,000

The replacement machine would cost $150,000, have a five-year life, and save $50,000 per year in cash
operating costs. It would be depreciated using the straight-line method. The tax rate is 40%.

a. Find the net investment required to replace the existing machine.

b. Compute the increase in annual income taxes if the company replaces the machine.

c. Compute the increase in annual net cash flows if the company replaces the machine.

107
SOLUTION:

a. Net investment: $74,000 [$150,000 - $60,000 - 40%($100,000 - 60,000)]

b. Increase in income taxes: $16,000 [40% x ($50,000 pretax flow - $30,000 depreciation + $20,000 lost
depreciation)]

c. Increase in cash flows: $34,000 ($50,000 - $16,000 increase in income taxes)

3. Cable Company is considering the purchase of a machine with the following characteristics.

Cost $100,000
Useful life 10 years
Expected annual cash cost savings $30,000

Cable's income tax rate is 40% and its cost of capital is 12%. Cable expects to use straight-line depreciation for
tax purposes.

a. Compute the expected increase in annual net cash flow for this project.

b. Compute the profitability index for the project.

c. How would the profitability index for this project be affected if Cable were to use MACRS depreciation for tax
purposes and the machine fell into the 7-year MACRS class? (increase decrease not affected) Circle the
appropriate answer.

SOLUTION:

a. Increase in annual net cash flow: $22,000 [$30,000 - (40% x ($30,000 - $10,000)]

b. Profitability index: 1.24 [($22,000 x 5.65)/$100,000]

c. Effect on profitability index: Increase (PI would increase because the tax shield of depreciation would occur
earlier and so be more valuable when considering the time value of money.)

4. Frank Co. has the opportunity to introduce a new product. Frank expects the product to sell for $60 and to have
per-unit variable costs of $35 and annual cash fixed costs of $4,000,000. Expected annual sales volume is
275,000 units. The equipment needed to bring out the new product costs $6,000,000, has a four-year life and no
salvage value, and would be depreciated on a straight-line basis. Frank's cost of capital is 14% and its income
tax rate is 40%.

a. Compute the annual net cash flows for the investment.

b. Compute the NPV of the project.

c. Suppose that some of the 275,000 units expected to be sold would be to customers who currently buy another of
Frank's products, the X-10, which has a $12 per-unit contribution margin. Find the sales of X-10 that can
Frank lose per year and still have the investment in the new product return at least the 14% cost of capital.

d. Suppose that selling the new product has no complementary effects but that Frank's production engineers
anticipate some production problems in making the new product and are not confident of the $35 estimate
of per-unit variable costs for the new product. Find the amount by which Frank's estimate of per-unit
variable cost could be in error and the investment still have a return at least equal to the 14% cost of capital.

108
SOLUTION:

a. Annual net cash flows: $2,325,000 [$2,875,000 pretax - 40% x ($2,875,000 - $1,500,000 depreciation)]

pretax income = 275,000 x ($60 - $35) - $4,000,000 = $2,875,000

b. NPV: $775,050 [($2,325,000 x 2.914) - $6,000,000]

c. Allowable loss of X-10 sales, approximately 36,941 units [($775,050/2.914)/60%]/12

d. Allowable error in per-unit VC, $1.61

{[($775,050/2.914)/60%]/275,000 units}

5. Zenex is considering the purchase of a machine. Data are as follows:

Cost $240,000
Useful life 10 years
Annual straight-line depreciation $ ???
Expected annual savings in cash
operation costs $ 80,000
Additional working capital needed $100,000

Zenex's cutoff rate is 12% and its tax rate is 40%.

a. Compute the annual net cash flows for the investment.

b. Compute the NPV of the project.

c. Compute the profitability index of the project.

SOLUTION:

a. Annual net cash flows: $57,600 [$80,000 pretax - 40% x ($80,000 - $24,000 depreciation)]

b. NPV: $17,640 [($57,600 x 5.650) - $240,000 - $100,000 + ($100,000 x .322)]

c. PI: 1.052 {[($57,600 x 5.650) + ($100,000 x .322)]/($240,000 + $100,000)}

6. Darwin Company is considering the sale of a machine with the following characteristics.

Book value $110,000

Remaining useful life 5 years
Annual straight-line depreciation $ ???
Current market value $120,000

If the company sells the machine its cash operating expenses will increase by $20,000 per year. The tax rate is
40%.

a. Find the cash flow from selling the machine.

109
 b. Calculate the increase in annual net cash outflows as a result of selling the machine.

SOLUTION:

a. Cash flow from sale: $116,000 ($120,000 - 40% tax on the $10,000 tax gain)

b. Increase in annual cash outflows: $20,800 ($20,000 pretax cost increase + $800 increase in income taxes; the
$20,000 increase in cash costs is more than offset by losing a $22,000 depreciation deduction)

7. Rusk Company is considering replacing a machine that has the following characteristics.

Book value $200,000

Remaining useful life 4 years
Annual straight-line depreciation $ ???
Current market value $160,000

The replacement machine would cost $300,000, have a four-year life, and save $37,500 per year in cash
operating costs. It would be depreciated using the straight-line method. The tax rate is 40%.

a. Find the net investment required to replace the existing machine.

b. Compute the increase in annual income taxes if the company replaces the machine.

c. Compute the increase in annual net cash flows if the company replaces the machine.

SOLUTION:

a. Net investment: $124,000 [$300,000 - $160,000 - 40% x ($200,000 - 160,000)]

b. Increase in income taxes: $5,000 [40% x ($37,500 pretax flow - $75,000 depreciation + $50,000 lost
depreciation)]

c. Increase in cash flows: $32,500 ($37,500 - $5,000 increase in income taxes)

8. Zmolek Company is considering the purchase of a machine costing $700,000 with a useful life of 10 years.
Annual cash cost savings are expected to be $200,000. Zmolek's income tax rate is 40% and its cost of capital is
12%. Zmolek expects to use straight-line depreciation for tax purposes.

a. Compute the expected increase in annual net cash flow for this project.

b. Compute the profitability index for the project.

SOLUTION:

a. Increase in annual net cash flow: $148,000 [$200,000 - 40% x ($200,000 - $70,000)]

b. Profitability index: 1.19 [($148,000 x 5.65)/$700,000]

9. Racine Co. has the opportunity to introduce a new product. Racine expects the project to sell for $200 and to
have per-unit variable costs of $130 and annual cash fixed costs of $6,000,000. Expected annual sales volume

110
 is 125,000 units. The equipment needed to bring out the new product costs $7,200,000, has a four-year life and
no salvage value, and would be depreciated on a straight-line basis. Working capital of $500,000 would be
necessary to support the increased sales. Racine's cost of capital is 12% and its income tax rate is 40%.

a. Compute the NPV of this opportunity.

b. Compute the profitability index of this opportunity.

SOLUTION:

a. NPV: negative $184,310

Annual cash flow: $2,370,000 = 60% x [125,000 x ($200 - $130)]

- 60% x $6,000,000 + 40% x $7,200,000/4

NPV: [($2,370,000 x 3.037) - $7,200,000 - 500,000 + ($500,000 x .636)]

b. PI: 0.976 [($2,370,000 x 3.037 + 500,000 x .636)/($7,200,000 + 500,000)]

10. Seiler is considering the purchase of a machine. Data are as follows:

Cost $2,000,000
Useful life 8 years
Annual straight-line depreciation $ ???
Expected annual savings in cash
operation costs $ 750,000
Additional working capital needed $ 500,000

Seiler's cutoff rate is 12% and its tax rate is 40%.

a. Compute the annual net cash flows for the investment.

b. Compute the NPV of the project.

c. Compute the profitability index of the project.

SOLUTION:

a. Annual net cash flows: $550,000 [$750,000 - 40% x ($750,000 - $250,000 depreciation)]

b. NPV: $434,400 [($550,000 x 4.968) - $2,000,000 - $500,000 + ($500,000 x .404)]

c. PI: 1.17 {[($550,000 x 4.968) + ($500,000 x .404)]/($2,000,000 + $500,000)}

111