Capital Budgeting Missed Questions Flashcards
Relevant cash flows for a finance lease and a direct purchase of an asset without borrowing differ with respect to
A. Tax savings on interest expense, the purchase price of the asset, and lease payments.
B. Depreciation tax shield and tax savings on interest expense.
C. Tax savings on interest expense and after-tax salvage value of the asset.
D. Depreciation tax shield and after-tax salvage value of the asset.
A. Tax savings on interest expense, the purchase price of the asset, and lease payments.
Relevant cash flows for a finance lease include (1) the lease payments or loan payments, (2) the depreciation tax shield, (3) tax savings on interest expense, and (4) after-tax cash flows from the salvage (scrap) value received from the sale of the asset. Relevant cash flows for a direct purchase without borrowing include (1) the purchase price of the asset, (2) the depreciation tax shield, and (3) the after-tax salvage value of the asset. The relevant cash flows of the two options therefore differ with respect to the tax savings on interest expense, the purchase price of the asset, and the lease payments.
Which one of the following items is least likely to directly impact an equipment replacement capital expenditure decision?
A. The amount of additional accounts receivable that will be generated from increased production and sales.
B. The net present value of the equipment that is being replaced.
C. The depreciation rate that will be used for tax purposes on the new asset.
D. The sales value of the asset that is being replaced.
B. 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.
A company is considering the acquisition of a new, more efficient press. The cost of the press is $360,000, and the press has an estimated 6-year life with zero salvage value. The company uses straight-line depreciation for both financial reporting and income tax reporting purposes and has a 40% corporate income tax rate. In evaluating equipment acquisitions of this type, the company uses a goal of a 4-year payback period. To meet the desired payback period, the press must produce a minimum annual before-tax operating cash savings of
A. $110,000
B. $114,000
C. $150,000
D. $90,000
A. $110,000
Payback is the number of years required to complete the return of the original investment. Given a periodic constant cash flow, the payback period equals net investment divided by the constant expected periodic after-tax cash flow. The desired payback period is 4 years, so the constant after-tax annual cash flow must be $90,000 ($360,000 ÷ 4). Assuming that the company has sufficient other income to permit realization of the full tax savings, depreciation of the machine will shield $60,000 ($360,000 ÷ 6) of income from taxation each year, an after-tax cash savings of $24,000 ($60,000 × 40%). Thus, the machine must generate an additional $66,000 ($90,000 – $24,000) of after-tax cash savings from operations. This amount is equivalent to $110,000 [$66,000 ÷ (1.0 – .4)] of before-tax operating cash savings.
Net present value as used in investment decision-making is stated in terms of which of the following options?
A. Earnings before interest and taxes.
B. Net income.
C. Earnings before interest, taxes, and depreciation.
D. Cash flow.
D. Cash flow.
Net present value is defined as the difference between (1) the present value of the estimated net cash inflows provided by the investment and (2) the present value of the estimated net cash outflows. If the net present value is positive, the investment should be undertaken.
A company purchased property that it expects to sell for $14,000 next year. The net present value of the investment is $1,000. The company is guaranteed an interest rate of 12% by the bank. What amount did the company pay for the property?
A. $13,000
B. $12,500
C. $11,500
D. $13,500
C. $11,500
The net present value of an investment is the difference between the present value of the inflows expected over the life of the investment and the initial amount of the investment. The present value of the inflow expected from this property is $12,500 ($14,000 ÷ 1.12). Thus, using the formula NPV = PV of cash inflows – Initial investment, the initial investment is $11,500 ($12,500 – $1,000).
Aaron Co. needs a machine for a 5-year project. It can either (1) buy a machine without borrowing for $500,000 or (2) enter into a 5-year operating lease for an annual payment of $105,000. The machine has an estimated useful life of 5 years, after which it can be sold for $15,000. The average tax rate is 30%, and the discount rate for the project is 6%.
Relevant discount factors are below:
Present value of 1 at 6% in 1 year: 0.943
Present value of 1 at 6% in 2 years: 0.890
Present value of 1 at 6% in 3 years: 0.840
Present value of 1 at 6% in 4 years: 0.792
Present value of 1 at 6% in 5 years: 0.747
What is the present value of the relevant net cash outflows of the operating lease?
A. $442,260
B. $309,582
C. $525,000
D. $367,500
B. $309,582
The relevant net cash outflows of the operating lease is the present value of the after-tax lease payments. After-tax lease payments are $73,500 [$105,000 × (1 – 30%)]. The present value of the after-tax lease payments is $309,582 [$73,500 × (0.943 + 0.890 + 0.840 + 0.792 + 0.747)].
The benefits of debt financing over equity financing are likely to be highest in which of the following situations?
A. Low marginal tax rates and few noninterest tax benefits.
B. Low marginal tax rates and many noninterest tax benefits.
C. High marginal tax rates and few noninterest tax benefits.
D. High marginal tax rates and many noninterest tax benefits.
C. High marginal tax rates and few noninterest tax benefits.
Interest paid on debt is tax deductible. Thus, debt financing decreases taxable income, and higher marginal tax rates are avoided. In contrast, dividends paid are not deductible. Consequently, they do not reduce taxable income, and higher marginal tax rates are not avoided. Moreover, when the benefits of equity financing (e.g., lack of fixed payments) are few, debt is more attractive.
If a corporation’s bonds are currently yielding 8% in the marketplace, why is the firm’s cost of debt lower?
A. Additional debt can be issued more cheaply than the original debt.
B. Market interest rates have increased.
C. Interest is deductible for tax purposes.
D. There should be no difference; cost of debt is the same as the bonds’ market yield.
C. Interest is deductible for tax purposes.
Because interest is deductible for tax purposes, the actual cost of debt capital is the net effect of the interest payment and the offsetting tax deduction. The actual cost of debt equals the interest rate times (1 – the marginal tax rate). Thus, if a firm with an 8% market rate is in a 40% tax bracket, the net cost of the debt capital is 4.8% [8% × (1.0 – .40)].
For tax purposes, which of the following is a true statement comparing an operating lease and a finance lease?
A. Under both leases, tax deductions for interest expenses are allowed.
B. Both leases transfer ownership to the lessee.
C. Both leases result in depreciation deductions.
D. Both leases ignore the purchase price of the leased asset.
D. Both leases ignore the purchase price of the leased asset.
For tax purposes, a capital lease (finance lease under U.S. GAAP) is treated as a purchase of the leased asset by borrowing to finance the transaction. But an operating lease is treated as a regular rental contract. Under both an operating lease and a finance lease, the lessor conveys to the lessee the right to control the use of specific plant or equipment (the leased asset) for a stated period in exchange for a stated payment (lease payment). The purchase price of the leased asset is not a factor in the classification of the lease for tax purposes.
An increase in the periodic depreciation tax shield is the result of a(n) <List> in the estimated useful life of a fixed asset and a(n) <List> in the tax rate. (Assume straight-line depreciation of the fixed asset.)</List></List>
List A List B A. Increase Increase B. Decrease Increase C. Increase Decrease D. Decrease Decrease
B. List A List B
Decrease Increase
The periodic tax benefit (shield) relating to a fixed asset equals periodic depreciation expense times the applicable tax rate. An increase in the estimated useful life of the fixed asset results in lower periodic depreciation expense, thereby causing the periodic depreciation tax shield to decrease. But an increase in the applicable tax rate increases the periodic depreciation tax shield.
A company issued common stock and preferred stock. Projected growth rate of the common stock is 5%. The current quarterly dividend on preferred stock is $1.60. The current market price of the preferred stock is $80 and the current market price of the common stock is $95. What is the expected rate of return on the preferred stock?
A. 13%
B. 2%
C. 7%
D. 8%
D. 8%
The expected rate of return on the preferred stock is calculated by dividing the dividend on preferred stock by the market price of preferred stock. Therefore, the expected rate of return is 8% [($1.60 quarterly dividend × 4 quarters) ÷ $80].
Future payments must be discounted in a bond valuation in order to take into account the
A. Time value of money.
B. Fact that the bond was sold at a premium.
C. Difference between the market rate of interest and the coupon rate.
D. Expected interest rate on the coupon payments.
A. Time value of money.
Determining the value of a bond is performed by calculating the present value of a bond’s future principal and interest payments using the market rate of interest as a discount factor. Discounting assumes that the present value of the payments today will be invested at the market interest rate to return the amounts specified by the bond in the future as the bond matures. Therefore, the purpose of discounting future payments is to consider the time value of money.
A company is conducting a risk analysis on a project. One task has a risk probability estimated to be 0.15. The task has a budget of $35,000. If the risk occurs, it will cost $6,000 to correct the problem caused by the risk event. What is the expected monetary value of the risk event?
A. $6,150
B. $4,350
C. $5,250
D. $900
D. $900
The expected monetary value of the risk event is the probability associated with the event multiplied by the cash flows from the event. Thus, the risk event has an expected monetary value of $900 ($6,000 × 15%).
A company purchases an item for $43,000. The salvage value of the item is $3,000. The cost of capital is 8%. Pertinent information related to this purchase is as follows:
Net Cash Flows Present Value
Factor at 8% Year 1 $10,000 0.926 Year 2 15,000 0.857 Year 3 20,000 0.794 Year 4 27,000 0.735
What is the discounted payback period in years?
A. 3.14
B. 2.90
C. 3.25
D. 3.10
C. 3.25
The discounted payback period can be calculated as follows:
Net PV Factor PV of Remaining
Cash Flows Cash Flows Investment Initial investment -- -- -- $43,000 Year 1 $10,000 × 0.926 = $ 9,260 33,740 Year 2 15,000 × 0.857 = 12,855 20,885 Year 3 20,000 × 0.794 = 15,880 5,005 Year 4 27,000 × 0.735 = 19,845 --
Full payback thus occurs sometime in Year 4. If the cash flows of $19,845 are considered to occur smoothly throughout the year, then the following is the percentage of Year 4 that must pass until the amount of $5,005 is attained:
$5,005 / $19,845 = 0.25
The discounted payback period is thus 3.25 years (3 + 0.25).
Fact Pattern: Jorelle Company’s financial staff has been requested to review a proposed investment in new capital equipment. Applicable financial data is presented below. There will be no salvage value at the end of the investment’s life and, due to realistic depreciation practices, it is estimated that the salvage value and net book value are equal at the end of each year. All cash flows are assumed to take place at the end of each year. For investment proposals, Jorelle uses a 12% after-tax target rate of return.
Investment Proposal Year Purchase Cost Annual Net Annual
and Book Value After-Tax Cash Flows Net Income 0 $250,000 $ 0 $ 0 1 168,000 120,000 35,000 2 100,000 108,000 39,000 3 50,000 96,000 43,000 4 18,000 84,000 47,000 5 0 72,000 51,000
Discounted Factors for a 12% Rate of Return Year Present Value of $1.00 Present Value of an Annuity of $1.00
Received at the Received at the
End of Each Period End of Each Period 1 .89 .89 2 .80 1.69 3 .71 2.40 4 .64 3.04 5 .57 3.61 6 .51 4.12
The traditional payback period for the investment proposal is
A. 2.83 years.
B. 2.23 years.
C. Over 5 years.
D. 1.65 years.
B. 2.23 years.
The traditional payback period is the number of periods required for the undiscounted expected cash flows to equal the original investment. When periodic cash flows are not expected to be uniform, a cumulative calculation is necessary. The first year’s cash inflow is $120,000. Adding another $108,000 in Year 2 brings the total payback after 2 years to $228,000. Accordingly, the traditional payback period is about 2.23 years {2 + [($250,000 – $228,000) ÷ $96,000 cash inflow in Year 3]}.
A firm has determined that it can minimize its weighted-average cost of capital (WACC) by using a debt-equity ratio of 2/3. If the firm’s cost of debt is 9% before taxes, the cost of equity is estimated to be 12% before taxes, and the tax rate is 40%, what is the firm’s WACC?
A. 10.80%
B. 6.48%
C. 9.36%
D. 7.92%
C. 9.36%
A firm’s WACC is derived by weighting the (after-tax) cost of each component of the financing structure by its proportion of the financing structure as a whole. The firm’s WACC can be calculated as follows:
Component Weight Component Totals
Cost
Debt 40% × 5.4% = 2.16%
Equity 60% × 12.0% = 7.20%
9.36%
