13.1 The Capital Budgeting Process Flashcards by Hyejin Ahn

Calvin, Inc., is considering the purchase of a new state-of-the-art machine to replace its hand-operated machine. Calvin’s effective tax rate is 40%, and its cost of capital is 12%. Data regarding the existing and new machines are presented below.

Original cost
Existing Machine: $50,000
New Machine: $90,000

Installation costs
Existing Machine: 0
New Machine: 4,000

Freight and insurance
Existing Machine: 0
New machine: 6,000

Expected end salvage value
Existing Machine: 0
New Machine: 0

Depreciation method
Existing Machine: straight-line
New Machine: straight-line

Existing Machine: Expected useful life: 10 years
New Machine: 5 years

The existing machine has been in service for 5 years and could be sold currently for $25,000. Calvin expects to realize annual before-tax reductions in labor costs of $30,000 if the new machine is purchased and placed in service.
If the new machine is purchased, the incremental cash flows for the first year would amount to

A. $45,000
B. $30,000
C. $18,000
D. $24,000

D. $24,000

The estimated incremental after-tax operating cash flows for each year of a capital project consist of two components, the after-tax cash inflows from operations and the difference in depreciation tax shields between the old and new equipment. The first of these for Calvin can be calculated as follows:
Net annual labor cost savings: $30,000
Less: Income tax expense ($30,000 × 40%): (12,000)
After-tax cash inflow from operations: $18,000

The depreciation tax shield on the new equipment is derived as follows:
Cost of new equipment ($90,000 + $4,000 + $6,000): $100,000
Divided by: Estimated useful life: ÷ 5
Annual depreciation expense: $ 20,000
Times: Tax rate: × 40%
Annual depreciation tax shield – new equipment: $ 8,000

The depreciation tax shield on the old equipment is derived as follows:
Cost of old equipment: $50,000
Less: Accumulated depreciation [$50,000 × (5 ÷ 10 years)]: (25,000)
Current book value: $25,000
Divided by: Remaining useful life: ÷ 5
Annual depreciation expense: $ 5,000
Times: Tax rate: × 40%
Annual depreciation tax shield – old equipment: $ 2,000

The difference in the two depreciation tax shields is $6,000 ($8,000 – $2,000). Calvin’s total incremental cash flow for the first year of this project is therefore estimated at $24,000 ($18,000 + $6,000).

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The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore’s plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, the machine is expected to produce 2,000 units per year, each with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40%.

What is the net cash outflow at the beginning of the first year that Moore Corporation should use in a capital budgeting analysis?

A. $(85,000)
B. $(90,000)
C. $(96,000)
D. $(105,000)

D. $(105,000)

Initially, the company must invest $105,000 in the machine, consisting of the invoice price of $90,000, the delivery costs of $6,000, and the installation costs of $9,000.

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What is the net cash flow for the third year that Moore Corporation should use in a capital budgeting analysis?

A. $68,400
B. $68,000
C. $64,200
D. $79,000

A. $68,400

The company will receive net cash inflows of $50 per unit ($500 selling price – $450 of variable costs), or a total of $100,000 per year. This amount will be subject to taxation, but, for the first 5 years, there will be a depreciation deduction of $21,000 per year ($105,000 cost divided by 5 years). Therefore, deducting the $21,000 of depreciation expense from the $100,000 of contribution margin will result in taxable income of $79,000. After income taxes of $31,600 ($79,000 × 40%), the net cash flow in the third year is $68,400 ($100,000 – $31,600).

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What is the net cash flow for the tenth year of the project that Moore Corporation should use in a capital budgeting analysis?

A. $100,000
B. $81,000
C. $68,400
D. $63,000

D. $63,000

The company will receive net cash inflows of $50 per unit ($500 selling price – $450 of variable costs), or a total of $100,000 per year. This amount will be subject to taxation, as will the $5,000 gain on sale of the investment, bringing taxable income to $105,000. No depreciation will be deducted in the tenth year because the asset was fully depreciated after 5 years. Because the asset was fully depreciated (book value was zero), the $5,000 salvage value received would be fully taxable. After income taxes of $42,000 ($105,000 × 40%), the net cash flow in the tenth year is $63,000 ($105,000 – $42,000).

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In equipment replacement decisions, which one of the following does not affect the decision-making process?

A. Current disposal price of the old equipment.
B. Operating costs of the old equipment.
C. Original fair value of the old equipment.
D. Operating costs of the new equipment.

C. Original fair value of the old equipment.

All relevant costs should be considered when evaluating an equipment replacement decision. These include the initial investment in the new equipment, any required investment in working capital, the disposal price of the new equipment, the disposal price of the old equipment, the operating costs of the old equipment, and the operating costs of the new equipment. The original cost or fair value of the old equipment is a sunk cost and is irrelevant to future decisions.

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Calamity Cauliflower Corporation is considering undertaking a capital project.

The company would have to commit $24,000 of working capital in addition to an immediate outlay of $160,000 for new equipment. The project is expected to generate $100,000 of annual income for 10 years. At the end of that time, the new equipment, which will be depreciated on a straight-line basis, is expected to have a salvage value of $10,000.

The existing equipment that would be sold to make room for the project has a historical cost of $220,000 and accumulated depreciation of $208,000. It has an estimated remaining useful life of 2 years and the remaining carrying amount is being depreciated on a straight-line basis. A scrap dealer has agreed to buy it for $8,000.

The company’s effective tax rate is 40%.

Calamity Cauliflower’s tax benefit arising from the disposal of the old equipment is

A. $3,200
B. $8,000
C. $4,800
D. $1,600

D. $1,600

A firm enjoys a tax benefit upon recognizing a loss on disposal because the loss reduces taxable income. The old equipment’s tax value is historical cost ($220,000) minus accumulated depreciation ($208,000).

Disposal value $8,000
Less: Tax value (12,000)
Tax-basis loss on disposal $(4,000)

The tax benefit is the tax-basis loss on the disposal times the effective rate.
Tax-basis loss on disposal $4,000
Times: Tax rate x 40%
Tax benefit from disposal $1,600

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Olson Industries needs to add a small plant to accommodate a special contract to supply building materials over a 5-year period. The required initial cash outlays at time = 0 are as follows:

Land $ 500,000
New building 2,000,000
Equipment 3,000,000

Olson uses straight-line depreciation for tax purposes and will depreciate the building over 10 years and the equipment over 5 years. Olson’s effective tax rate is 40%. Revenues from the special contract are estimated at $1.2 million annually, and cash expenses are estimated at $300,000 annually. At the end of the fifth year, the assumed sales values of the land and building are $800,000 and $500,000, respectively. It is further assumed the equipment will be removed at a cost of $50,000 and sold for $300,000.

As Olson utilizes the net present value (NPV) method to analyze investments, the net cash flow for Period 3 would be

A. $860,000
B. $940,000
C. $880,000
D. $60,000

A. $860,000

Projected annual revenues $1,200,000
Less: Annual expenses (300,000)
Net annual cash inflow $ 900,000
Less: Income tax expense ($900,000 × 40%) (360,000)
After-tax cash inflow from operations $ 540,000

Since no old equipment was removed, the total depreciation tax shield is simply derived from the new building and equipment:

Annual depreciation on new building ($2,000,000 ÷ 10) $200,000
Annual depreciation on new equipment ($3,000,000 ÷ 5) 600,000
Annual depreciation expense $800,000
Times: Income tax rate × 40%
Annual depreciation tax shield $320,000

The after-tax cash flows for Year 3 for this project would thus amount to $860,000 ($540,000 + $320,000).

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Depreciation is incorporated explicitly in the discounted cash flow analysis of an investment proposal because it

A. Reduces the cash outlay for income taxes.
B. Is a cost of operations that cannot be avoided.
C. Represents the initial cash outflow spread over the life of the investment.
D. Is a cash inflow.

A. Reduces the cash outlay for income taxes.

Depreciation is a noncash expense that is deductible for federal income tax purposes. Thus, it directly reduces the cash outlay for income taxes and is explicitly incorporated in the capital budgeting model.

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A company is analyzing the purchase of production machinery to meet regulatory requirements. The following facts relate to Year 5, the final year of the project.

$20,000 proceeds will be realized from the sale of the fully depreciated machinery.
The initial $50,000 investment in working capital will be recovered.
The machinery, with an initial total cost of $500,000, was depreciated on a straight-line basis over 5 years.
An accrual of $50,000 will be established on a straight-line basis over the useful life of the asset to cover the costs to restore the site where the machinery is located. However, the actual net decommissioning costs are forecast to be only $40,000.
The machinery generates 10,000 units of product with a sales price of $5 per unit. The cost of production is $2.50 per unit.

What is the after-tax cash flow that the company must consider for Year 5 in its capital budgeting analysis of the project using a 30% effective income tax rate?

A. $97,000
B. $68,500
C. $89,500
D. $83,500

D. $83,500

With respect to one-time items, the company will realize $20,000 from the sale of machinery in Year 5, but this will require $6,000 ($20,000 x 30%) tax payment since the machinery was already fully depreciated. Thus, the net cash flow from the sale would be $14,000. In addition, $50,000 from the recovery of the working capital invested in the project will be made available once the project is completed. The $40,000 of decommissioning costs would be an outflow, but since that amount is tax deductible, it would result in a tax savings of $12,000 ($40,000 x 30%). Therefore, the net outflows from decommissioning would be $28,000. The net cash inflows from project termination would total $36,000 ($14,000 + $50,000 - $28,000). The regular cash flows from Year 5 would amount to $25,000 in profits (10,000 units times the $2.50 contribution margin per unit) minus the $7,500 ($25,000 x 30%) tax on that amount, or $17,500. In addition, there would be a tax shield on the $100,000 of depreciation, which would amount to $30,000 ($100,000 x 30%). Therefore, the net cash inflows in Year 5 would be the $47,500 ($17,500 + $30,000) from normal operations plus the $36,000 related to project termination, or $83,500.

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A firm is evaluating a proposed acquisition of a new machine at a purchase price of $380,000 and installation charges that will amount to $20,000. A $15,000 increase in working capital will be required. The machine will have a useful life of 4 years, after which it can be sold for $50,000. The estimated annual incremental operating revenues and cash operating expenses are $750,000 and $500,000, respectively, for each of the 4 years. The tax rate is 40%, and the cost of capital is 12%. Straight-line depreciation is used for both financial reporting and income tax purposes.
If the project is accepted, the initial investment will be

A. $385,000
B. $365,000
C. $415,000
D. $345,000

C. $415,000

The net initial investment for a capital project consists of three components: the purchase of new equipment, the increase in working capital, and the salvage value of old equipment. The calculation is as follows:

Cost of new equipment ($380,000 + $20,000) $400,000
Increase in working capital 15,000
Salvage value of old equipment 0

Net initial investment: $415,000

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A company installed new equipment with a four-year useful life and no salvage value. The new equipment cost $500,000 and will generate pretax cash savings of $150,000 annually. Old equipment with a book value of $50,000 and a remaining life of two years was sold for $20,000 when the new equipment was purchased. The company uses straight-line depreciation and its effective income tax rate is 40%. The second year’s relevant after-tax cash flow is

A. $90,000
B. $110,000
C. $150,000
D. $140,000

D. $140,000

Cash savings are $150,000 annually. Depreciation expenses would be $125,000 each year ($500,000 ÷ 4 years). Thus, taxable income would be $25,000 ($150,000 - $125,000). The tax on $25,000 at 40% would be $10,000. Therefore, the net cash inflow would be the $150,000 from operations minus the $10,000 of tax expense, or $140,000.

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Capital budgeting is concerned with

A. Scheduling office personnel in office buildings.
B. Decisions affecting only capital intensive industries.
C. Analysis of short-range decisions.
D. Analysis of long-range decisions

D. Analysis of long-range decisions.

Capital budgeting is concerned with long-range decisions, such as whether to add a product line, to build new facilities, or to lease or buy equipment. Any decision regarding cash inflows and outflows over a period of more than 1 year probably needs capital budgeting analysis.

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Kell, Inc., is analyzing an investment for a new product expected to have annual sales of 100,000 units for the next 5 years and then be discontinued. New equipment will be purchased for $1,200,000 and cost $300,000 to install. The equipment will be depreciated on a straight-line basis over 5 years for financial reporting purposes and 3 years for tax purposes. At the end of the fifth year, it will cost $100,000 to remove the equipment, which can be sold for $300,000. Additional working capital of $400,000 will be required immediately and needed for the life of the product. The product will sell for $80, with direct labor and material costs of $65 per unit. Annual indirect costs will increase by $500,000. Kell’s effective tax rate is 40%.

In a capital budgeting analysis, what is the expected cash flow at time = 5 (fifth year of operations) that Kell should use to compute the net present value?

A. $720,000
B. $800,000
C. $1,240,000
D. $1,120,000

D. $1,120,000

The estimated incremental after-tax operating cash flows in the final year of a capital project consist of three components: the after-tax cash inflows from operations, the depreciation tax shield, and the net termination cash flows of the project. The first of these for Kell can be calculated as follows:

Projected annual contribution margin
(100,000 units x $15) $1,500,000
Less: Annual increase in indirect costs (500,000)
= Net annual cash inflow: $1,000,000
Less: Income tax expense
($1,000,000 x 40%) (400,000)
= After-tax cash inflow from operations 600,000

Since the equipment was depreciated over 3 years for tax purposes, no depreciation tax shield remains in the fifth year. The termination cash flows can be calculated as follows:

Proceeds from disposal of new equipment
($300,000 - $100,000) $200,000
Less: Income tax expense ($200,000 x 40%) (80,000)
=After-tax cash inflow from disposal of equipment $120,000
Add: recovery of working capital 400,000
=Total termination cash inflows: 520,000

Total expected cash flows in the fifth year of the project are thus $1,120,000 ($600,000 + $0 + $520,000)

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The capital budgeting process contains several stages. At which stage are financial and nonfinancial factors addressed?

A. Selection.
B. Identification and definition.
C. Information-acquisition.
D. Search.

C. Information-acquisition.

During the information-acquisition stage of the capital budgeting process, quantitative financial factors are given the most scrutiny. These include initial investment and periodic cash inflow. Nonfinancial measures, both quantitative and qualitative, are also identified and addressed. Examples include the need for additional training on new equipment and uncertainty about technological developments and competitors’ actions.

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Which one of the following statements concerning cash flow determination for capital budgeting purposes is not correct?

A. Book depreciation is relevant because it affects net income.
B. Tax depreciation must be considered because it affects cash payments for taxes.
C. Sunk costs are not incremental flows and should not be included.
D. Proceeds from disposal of old equipment should be included in cash flow forecasts.

A. Book depreciation is relevant because it affects net income.

Tax depreciation is relevant to cash flow analysis because it affects the amount of income taxes that must be paid. However, book depreciation is not relevant because it does not affect the amount of cash generated by an investment.

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Which one of the following items is least likely to directly impact an equipment replacement capital expenditure decision?

A. The net present value of the equipment that is being replaced.
B. The depreciation rate that will be used for tax purposes on the new asset.
C. The amount of additional accounts receivable that will be generated from increased production and sales.
D. The sales value of the asset that is being replaced.

A. The net present value of the equipment that is being replaced.

The only relevant valuation of existing equipment is its salvage value at the time of the decision.

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Which one of the following should not be considered when completing a project cash flow analysis?

A. The effect of inflation.
B. Increased depreciation expense.
C. Increased sales related to the project.
D. Lease payments on previously existing equipment.

D. Lease payments on previously existing equipment.

Only relevant costs should be considered in a project cash flow analysis. Lease payments on existing equipment would be a sunk cost and would not be relevant to the decision process.

Which of the following is irrelevant in projecting the cash flows of the final year of a capital project?

A. Cash devoted to use in project.
B. Historical cost of equipment disposed of in the project’s first year.
C. Disposal value of equipment purchased specifically for project.
D. Depreciation tax shield generated by equipment purchased specifically for project.

B. Historical cost of equipment disposed of in the project’s first year.

After disposal of an old piece of equipment, its historical cost no longer affects a firm’s cash flows.

The company’s effective tax rate is 40%.

Calamity Cauliflower’s expected additional depreciation tax shield for the first year of the project is

A. $2,400
B. $4,000
C. $10,000
D. $6,400

B. $4,000

The new equipment ($160,000 historical cost) has an estimated 10-year useful life, so annual depreciation expense is expected to be $16,000. (NOTE: When calculating depreciation expense for the depreciation tax shield, salvage value is not deducted.) The old equipment has a book value of $12,000 ($220,000 historical cost - $208,000 accumulated depreciation) being depreciated on a straight-line basis over the remaining useful life of 2 years results in $6,000 depreciation for the next 2 years. The additional depreciation tax shield for the first year is thus the difference in the two depreciation expense amounts times the tax rate [($16,000 – $6,000) × .40 = $4,000].

In a capital budgeting analysis, what is the cash flow at time = 0 (initial investment) that Kell should use to compute the net present value?

A. $1,900,000
B. $1,700,000
C. $1,300,000
D. $1,500,000

A. $1,900,000

The net initial investment for a capital project consists of three components: the purchase of new equipment (including installation costs), the increase in working capital, and the after-tax proceeds from the disposal of old equipment. For Kell, the first of these is $1,500,000 ($1,200,000 + $300,000), and the second is $400,000. No proceeds will be received on disposal because no existing equipment is being removed. Therefore, the net cash flow at time = 0 is calculated as follows:

Full cost of new equipment $1,500,000
Increase in working capital 400,000
Net initial investment $1,900,000

A company is considering the purchase of a new machine to replace a 5-year old machine and has gathered the following information:

Purchase price of new machine $50,000
Installation cost of new machine 4,000
Market value (selling price) of the old machine 5,000
Book value of the old machine 2,000
Increase in net working capital if new machine is installed
1,000
Effective income tax rate 40%

If the company replaces the old machine with the new machine, what is the cash flow in period 0?
A. $(51,200)
B. $(51,800)
C. $(49,000)
D. $(53,000)

A. $(51,200)

The net initial investment for a capital project consists of three components: the purchase of new equipment, the increase in net working capital, and the after-tax proceeds from the disposal of old equipment. For this company, the first of theses is $54,000 ($50,000 + $4,000), and the second is $1,000. The calculation of the after-tax proceeds from the disposal of the old equipment is as follows:

Salvage value of old equipment $ 5,000
Less: Current tax value (2,000)
Tax-basis gain(loss) on disposal $ 3,000
Times: Tax rate × 40%
Tax detriment(benefit) from disposal $ 1,200

Salvage value of old equipment $ 5,000
Less: Tax detriment from gain on disposal (1,200)
After-tax cash inflow from disposal $ 3,800

The net cash flow for period 0 is therefore:
Full cost of new equipment ($50,000 + $4,000) $(54,000)
Increase in working capital (1,000)
After-tax proceeds from disposal of old equipment 3,800
Net initial investment $(51,200)

The Dickins Corporation is considering the acquisition of a new machine at a cost of $180,000. Transporting the machine to Dickins’ plant will cost $12,000. Installing the machine will cost an additional $18,000. It has a 10-year life and is expected to have a salvage value of $10,000. Furthermore, the machine is expected to produce 4,000 units per year with a selling price of $500 and combined direct materials and direct labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Dickins has a marginal tax rate of 40%.

What is the net cash flow for the tenth year of the project that Dickins should use in a capital budgeting analysis?

A. $126,000
B. $200,000
C. $158,000
D. $136,800

A. $126,000

The company will receive net cash inflows of $50 per unit ($500 selling price – $450 of variable costs), a total of $200,000 per year for 4,000 units. This amount will be subject to taxation, as will the $10,000 gain on sale of the investment, resulting in taxable income of $210,000. No depreciation will be deducted in the tenth year because the asset was fully depreciated after 5 years. At 40%, the tax on $210,000 is $84,000. After subtracting $84,000 of tax expense from the $210,000 of inflows, the net inflows amount to $126,000.

The stage of the capital budgeting process that has the most risk is

A. Identifying alternative possible projects.
B. Forecasting cash flow.
C. Raising funds to initially support the project.
D. Evaluating performance and learning.

B. Forecasting cash flow.

Forecasting cash flows has the most risk in the capital budgeting process. The economic benefit or cost must be estimated period by period. In addition, the economic life, depreciable life, and salvage value of the asset must be estimated. All of these estimates help forecast the cash flows for the project. Because this step requires the most use of estimates, it is said to be the riskiest in the capital budgeting process.

The company owns a building that originally cost $400,000 and has a current book value of $250,000. The building was financed by a loan that has one payment of $20,000 outstanding, which must be paid off upon the sale of the building. The company would like to purchase a new building for $600,000. If the new building is purchased, the existing building would be sold for $380,000. The company’s income tax rate is 40%. If the new building is purchased, the relevant initial cash flows would total

A. $272,000
B. $292,000
C. $372,000
D. $392,000

B. $292,000

Gain on sale of old building
= $380,000 proceeds - 250,000 book value
= $130,000

Tax on gain = $130,000 x 40% = $52,000

After tax cash inflow on sale of old building
= $380,000 proceeds - 52,000 tax on gain = $328,000

Purchase of new building $(600,000)
Loan payment on old building (20,000)
After-tax cash inflow on old building 328,000
Net initial cash outflow = 292,000

Olson Industries needs to add a small plant to accommodate a special contract to supply building materials over a 5-year period. The required initial cash outlays at time = 0 are as follows: Land $ 500,000 New building 2,000,000 Equipment 3,000,000 Olson uses straight-line depreciation for tax purposes and will depreciate the building over 10 years and the equipment over 5 years. Olson’s effective tax rate is 40%. Revenues from the special contract are estimated at $1.2 million annually, and cash expenses are estimated at $300,000 annually. At the end of the fifth year, the assumed sales values of the land and building are $800,000 and $500,000, respectively. It is further assumed the equipment will be removed at a cost of $50,000 and sold for $300,000. As Olson utilizes the net present value (NPV) method to analyze investments, the net cash flow for Period 5 would be A. $2,070,000 B. $1,710,000 C. $2,390,000 D. $2,230,000

C. $2,390,000 The estimated incremental after-tax operating cash flows in the final year of a capital project consist of three components: the after-tax cash inflows from operations, the depreciation tax shield, and the net termination cash flows of the project. The first of these for Olson can be calculated as follows: Projected annual revenues: $1,200,000 Less: Annual expenses: (300,000) = Net annual cash inflow $900,000 Less: Income tax expense ($900,000 x 40%): (360,000) = After-tax cash inflow from operations $540,000 Since no old equipment was removed, the total depreciation tax shield is simply derived from the new building and equipment. Annual depreciation on new building ($2,000,000 ÷ 10): $200,000 Annual depreciation on new equipment ($3,000,000 ÷ 5): 600,000 = Annual depreciation expense $800,000 Times: Income tax rate: x 40% = Annual depreciation tax shield: $320,000 The calculation of the after-tax proceeds from the disposal of the land, building, and equipment involved in the project is as follows: Land 1) Proceeds from disposal: $800,000 Less: current book value (500,000) = Accrual basis gain (loss) on disposal $300,000 Times: Tax rate x 40% = Tax detriment (benefit) from disposal: $120,000 2) Proceeds from disposal: $800,000 Add: Tax benefit: (120,000) = After-tax cash inflow from disposal: $680,000 Building (Loss) 1) Proceeds from disposal: $500,000 Less: current book value (1,000,000) = Accrual basis gain (loss) on disposal $(500,000) Times: Tax rate x 40% = Tax detriment (benefit) from disposal: $(200,000) 2) Proceeds from disposal: $500,000 Add: Tax benefit: 200,000 = After-tax cash inflow from disposal: $700,000 Equipment 1) Proceeds from disposal: $250,000 Less: current book value (0) = Accrual basis gain (loss) on disposal $250,000 Times: Tax rate x 40% = Tax detriment (benefit) from disposal: $100,000 2) Proceeds from disposal: $250,000 Add: Tax benefit: (100,000) = After-tax cash inflow from disposal: $150,000 Total expected cash flows in the fifth year of the project are thus $2,390,000 calculated as follows: After-tax cash inflow from operations: $540,000 Annual depreciation tax shield: 320,000 After-tax cash inflow from disposal of land: 680,000 After-tax cash inflow from disposal of building: 700,000 After-tax cash inflow from disposal of equipment: 150,000 Total expected cash inflows: $2,390,000

A corporation is expanding its plant, which requires an investment of $8 million in new equipment. The corporation’s sales are expected to increase by $6 million per year as a result of the expansion. Cash investment in current assets averages 30% of sales, and accounts payable and other current liabilities are 10% of sales. What is the estimated total cash investment for this expansion? A. $8.6 million. B. $6.8 million. C. $9.2 million. D. $9.8 million.

C. $9.2 million. For capital budgeting purposes, the net investment is the net outlay or cash requirement. This amount includes the cost of the new equipment, minus any cash recovered from the trade or sale of existing assets. The investment required also includes funds to provide for increases in working capital, for example, the additional receivables and inventories resulting from the acquisition of a new manufacturing plant. The investment in working capital is treated as an initial cost of the investment, although it will be recovered at the end of the project (its salvage value equals its initial cost). For the corporation, the additional current assets will be 30% of sales, but current liabilities can be used to fund assets to the extent of 10% of sales. Thus, the initial investment in working capital will equal 20% of the $6 million in sales, or $1,200,000. The total initial cash outlay will consist of the $8 million in new equipment plus $1,200,000 in working capital, a total of $9.2 million.

A firm is replacing a grinder purchased 5 years ago for $15,000 with a new one costing $25,000 cash. The original grinder is being depreciated on a straight-line basis over 15 years to a zero salvage value; the firm will sell this old equipment to a third party for $6,000 cash. The new equipment will be depreciated on a straight-line basis over 10 years to a zero salvage value. Assuming a 40% marginal tax rate, the firm’s net cash investment at the time of purchase if the old grinder is sold and the new one purchased is A. $19,000 B. $17,400 C. $25,000 D. $15,000

B. $17,400 The old machine has a carrying amount of $10,000 [$15,000 cost - 5 ($15,000 cost ÷ 15 years) depreciation]. The loss on the sale is $4,000 ($10,000 – $6,000 cash received), and the tax savings from the loss is $1,600 ($4,000 x 40%). Thus, total inflows are $7,600. The only outflow is the $25,000 purchase price of the new machine. The net cash investment is therefore $17,400 ($25,000 - $7,600).

A company is analyzing a capital investment proposal for new equipment to produce a product over the next 8 years. The analyst is attempting to determine the appropriate “end-of-life” cash flows for the analysis. At the end of 8 years, the equipment must be removed from the plant and will have a net book value of zero, a tax basis of $75,000, a cost to remove of $40,000, and scrap salvage value of $10,000. The effective tax rate is 40%. What is the appropriate “end-of-life” cash flow related to these items that should be used in the analysis? A. $12,000 B. $27,000 C. $45,000 D. $(18,000)

A. $12,000 The tax basis of $75,000 and the $40,000 cost to remove can be written off. However, the $10,000 scrap value is a cash inflow. Thus, the taxable loss is $105,000 ($75,000 loss on disposal + $40,000 expense to remove – $10,000 of inflows). At a 40% tax rate, the $105,000 loss will produce a tax savings (inflow) of $42,000. The final cash flows will consist of an outflow of $40,000 (cost to remove) and inflows of $10,000 (scrap) and $42,000 (tax savings), or a net inflow of $12,000.

What is a challenge that the long-term aspect of capital budgeting presents to a management accountant? A. Freedom of the organization’s financial planning. B. The flexibility of the capital budgeting decision. C. Capital projects affect multiple accounting periods. D. Activity can be tracked for a single accounting period.

C. Capital projects affect multiple accounting periods. Capital budgeting is the process of planning and controlling investments for long-term projects. It is this long-term aspect of capital budgeting that presents the management accountant with specific challenges. Most financial and management accounting topics concern tracking and reporting activity for a single accounting or reporting cycle, such as one month or one year. By their nature, capital projects affect multiple accounting periods and will constrain the organization’s financial planning well into the future. Once made, capital budgeting decisions tend to be relatively inflexible.

The management of an online retailer is interested in purchasing and installing a new server for a total cost of $150,000. The controller has asked an accountant to determine the incremental yearly tax savings should the new server be acquired. The server has an estimated usable life of approximately 4 years and no salvage value. The retailer currently uses straight-line depreciation and is assessed an effective income tax rate of 40%. The accountant should calculate the incremental yearly tax savings to be A. $22,500 B. $37,500 C. $15,000 D. $60,000

C. $15,000 The server will be depreciated $37,500 yearly ($150,000 ÷ 4). Thus, the incremental yearly tax savings is $15,000 ($37,500 × 40%).

A capital investment project has the following expected incremental values next year: Revenue $1,000,000 Operating costs 200,000 Depreciation 300,000 If the income tax rate is 25%, the incremental after-tax operating cash flow is A. $675,000 B. $900,000 C. $375,000 D. $125,000

A. $675,000 The net income generated by the investment project is $375,000 [($1,000,000 – $200,000 – $300,000) × (1 – 25%)]. Additionally, depreciation is a noncash expense and therefore must be added back when calculating the after-tax cash flow. Thus, the incremental after-tax operating cash flow is $675,000 ($375,000 + $300,000).

A treasurer is in the process of determining whether she should invest a portion of her company’s pension plan assets in a publicly traded company. The treasurer has collected the following information on the company: Current-year dividend = $1.50 Yearly dividend increase = 5% Expected investor return = 10% Current share price = $25.00 On the basis of the information provided above, the treasurer is justified in concluding that an investment in the company A. Should be profitable if assumptions hold true. B. Should be unprofitable if assumptions hold true. C. Is risky because of the relatively low dividend yield. D. Is a conservative investment yielding good cash flow.

A. Should be profitable if assumptions hold true. The investment is projected to earn a good return, and the dividend is expected to grow from year to year. If these hold true, then the investment should be profitable.

A company with a 40% tax rate is deciding whether to keep an old machine or replace it with a new machine. Annual depreciation expense is $3,000 for the old machine and would be $5,000 for the new machine. When using net present value to determine if the new machine should be purchased, depreciation would increase the incremental annual cash inflows of the investment by A. $1,200 B. $0 C. $2,000 D. $800

D. $800 Because depreciation is deductible for income tax purposes, it shields some revenue from being taxed. Depreciation of the new machine is $2,000 ($5,000 – $3,000) more than the old machine. Thus, the new machine can provide $800 ($2,000 × 40%) more of a depreciation tax shield than the old machine.

At the conclusion of a capital budgeting project, a piece of equipment is expected to be sold for $500,000. At the time of sale, the book value of the equipment would be $400,000. If the income tax rate is 35%, what is the after-tax cash flow from the sale of the machine? A. $535,000 B. $400,000 C. $465,000 D. $325,000

C. $465,000 Only the $100,000 gain on the sale is applicable for tax purposes. Accordingly, the gain will result in a tax liability (a cash outflow) of $35,000 ($100,000 × 35%). The $500,000 cash inflow is a relevant cash flow. Thus, the after-tax cash flow is $465,000 ($500,000 – $35,000).

For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management A. Wants to use equity funding exclusively. B. Believes too many proposals are being rejected. C. Believes bank loans are riskier than capital investments. D. Wants to factor risk into its consideration of projects.

D. Wants to factor risk into its consideration of projects. Risk analysis measures the likelihood of the variability of future returns from the proposed investment. Risk can be incorporated into capital budgeting decisions in various ways, one of which is to use a hurdle rate (desired rate of return) higher than the firm’s cost of capital, that is, a risk-adjusted discount rate. This method adjusts the interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment must be relatively larger, or the increased discount rate will generate a negative NPV, and the proposed acquisition will be rejected.

A depreciation tax shield is A. The cash provided by recording depreciation. B. The expense caused by depreciation. C. An after-tax cash outflow. D. A reduction in income taxes.

D. A reduction in income taxes. A tax shield is something that protects income from taxation. Thus, a depreciation tax shield is a reduction in income taxes due to the tax deductibility of depreciation.

The maximum benefit forgone by using a scarce resource for a given purpose and not for the next-best alternative is called A. Sunk cost. B. Opportunity cost. C. Incremental cash flow. D. Net initial investment.

B. Opportunity cost. An opportunity cost is the maximum benefit forgone by using a scarce resource for a given purpose and not for the next-best alternative. In capital budgeting, the most basic application of this concept is the desire to place the company’s limited funds in the most promising capital project(s).

A company, which is subject to an effective income tax rate of 30%, is evaluating a proposed capital project. Relevant information for the proposed project is summarized below. Initial investment $500,000 Annual operating cash inflows for the first 3 years: Year 1 185,000 Year 2 175,000 Year 3 152,000 Depreciation will be calculated under the straight-line method using an 8-year estimated service life and a terminal value of $50,000. In determining the estimated total after-tax cash flow in Year 2 of the project, the company should consider the after-tax operating cash A. Inflow plus annual depreciation tax shield. B. Inflow only. C. Inflow plus annual depreciation expense. D. Inflow plus the net impact of the annual depreciation expense and depreciation tax shield.

A. Inflow plus annual depreciation tax shield. The estimated incremental after-tax operating cash flows for each year of a capital project consist of two components, the after-tax cash inflows from operations and the depreciation tax shield on the new equipment. Therefore, the company should consider the after-tax operating cash inflow plus the annual depreciation tax shield.

A. $136,800 The annual operating cash flows for a capital project consists of two components: the after-tax cash inflows from operations and the depreciation tax shield arising from the purchase of new equipment. The first of these for Dickins can be calculated as follows: Net annual operating revenue $4,000 × ($500 – $450) 200,000 Less: Income tax expense ($200,000 × 40%) (80,000) After-tax cash inflow from operations $120,000 The depreciation tax shield is derived as follows: Cost of new equipment ($180,000 + $12,000 + $18,000) $210,000 Divided by: Estimated useful life ÷ 5 Annual depreciation expense $ 42,000 Times: Tax rate × 40% Annual depreciation tax shield $ 16,800 Dickins’s total incremental after-tax operating cash flows for each year of the project’s life is thus $136,800 ($120,000 + $16,800).

Calamity Cauliflower Corporation is considering undertaking a capital project. The company would have to commit $24,000 of working capital in addition to an immediate outlay of $160,000 for new equipment. The project is expected to generate $100,000 of annual income for 10 years. At the end of that time, the new equipment, which will be depreciated on a straight-line basis, is expected to have a salvage value of $10,000. The existing equipment that would be sold to make room for the project has a historical cost of $220,000 and accumulated depreciation of $208,000. It has an estimated remaining useful life of 2 years and the remaining carrying amount is being depreciated on a straight-line basis. A scrap dealer has agreed to buy it for $8,000. The company’s effective tax rate is 40%. If the project is accepted, Calamity Cauliflower’s expected net cash inflow at the end of the first year is A. $60,000 B. $110,000 C. $56,000 D. $64,000

D. $64,000 The annual expected net cash inflow from a capital project consists of the after-tax cash inflow from operations {[$100,000 gross cash inflow – ($100,000 × .40) income tax expense] = $60,000} plus the depreciation tax shield [($16,000 annual depreciation expense on new equipment – $6,000 annual depreciation expense on old equipment) × .40 = $4,000], or $64,000.

Management is evaluating a proposed acquisition of a new machine at a purchase price of $180,000 and with installation costs of $10,000. A $9,000 increase in working capital will be required. The machine will have a useful life of 4 years, after which it can be sold for $30,000. The estimated annual incremental operating revenues and cash operating expenses are $450,000 and $300,000, respectively, for each of the 4 years. The effective income tax rate is 40%, and the cost of capital is 12%. Straight-line depreciation is used for both financial reporting and income tax purposes. If the project is accepted, the estimated incremental after-tax operating cash flows at the end of the first year will be A. $109,000 B. $106,000 C. $150,000 D. $90,000

A. $109,000 The estimated incremental after-tax operating cash flows for each year of a capital project consist of two components: the after-tax cash inflows from operations and the depreciation tax shield arising from the purchase of new equipment (note that salvage value is not subtracted when calculating the depreciation tax shield). The first of these can be calculated as follows: Net annual operating revenue ($450,000 – $300,000): $150,000 Less: Income tax expense ($150,000 × 40%): (60,000) After-tax cash inflow from operations: $ 90,000 The depreciation tax shield is derived as follows: Cost of new equipment ($180,000 + $10,000): $190,000 Divided by: Estimated useful life: ÷ 4 Annual depreciation expense: $ 47,500 Times: Tax rate: × 40% Annual depreciation tax shield: $ 19,000 Total incremental after-tax operating cash flows for each year of the project’s life is thus $109,000 ($90,000 + $19,000).