Financial Decision Models Part 1

Question 1

Accelerated methods of depreciation produce _________________ in earlier years, which reduce the amount of taxes paid.

Answer 1

greater tax expense deductions

Because present value calculations apply higher weights to cash flows occurring in the near
future, having larger tax deductions early on will provide greater benefits from a present value perspective.

Question 2

Asset value is determined based on the present value of its ____________________.

Answer 2

future after-tax cash flows

Question 3

When are costs deemed to be relevant?

Answer 3

Costs are deemed to be relevant if they change as a result of selecting different alternatives..

For Van Purchase and Disposal Example:

The decision to replace the old van will result in the
company paying the purchase price of the new van and receiving the disposal price of
the old van. Neither the purchase price of the new van nor the disposal price of the old
van will be incurred if the van is not replaced. Ignoring income taxes, the book value of
the old van and any potential gain is not relevant.

Question 4

Capital budgeting involves the management’s evaluation of an _________________ since it involves long term commitments for asset acquisition and,
often involves long term financing decisions as well.

Answer 4

UNCERTAIN FUTURE

Management’s decisions on the increased requirement for capital investment and the required return and the cost of capital require evaluation of an uncertain future.

Question 5

The accounting rate of return is based on GAAP basis net income and not cash flows and does not consider ______________________.

Answer 5

the time value of money

Question 6

Capital budgeting decisions do NOT include the _____________________.

Answer 6

financing of short-term working capital needs, which are more operational in nature.

Question 7

t. The________________________ of depreciation is an
accelerated method that applies an annual depreciation rate equal to two times the
straight-line rate.

Answer 7

double declining balance method

The straight-line rate for a piece of equipment with a five-year useful life is 20 percent. Doubling this percentage equals 40 percent. In the first year, the
depreciation is equal to $50,000 x 40% = $20,000. This is greater than the first-year depreciation for all other methodologies. Note that this method does not account for salvage (residual) value in the calculation.

Question 8

Which one of the following is most relevant to a manufacturing equipment replacement
decision?

A. Original cost of the old equipment.
B. Disposal price of the old equipment.
C. Gain or loss on the disposal of the old equipment.
D. A lump-sum write-off amount from the disposal of the old equipment

Answer 8

Choice “B” is correct.

Explanation
Rule: Relevant costs are only those costs that will differ among many alternatives.

Choice “B” is correct. The disposal price of the old equipment is most relevant because it is an expected future inflow that will differ among alternatives. If this old equipment is replaced, there will be a cash inflow from the sale of the old equipment. If the old
equipment is kept, there will be no cash inflow from the sale of the old equipment.

Choice “A” is incorrect. The original cost of the old equipment is a sunk cost and,
therefore, not relevant.

Choice “C” is incorrect. The gain or loss on the disposal of the old equipment is not
relevant. The gain or loss is an accounting computation that combines the book value,
which is always not relevant, and the disposal value, which is relevant. The result is meaningless to future decisions and, therefore, is not relevant.

Choice “D” is incorrect. The book value is not relevant to future decisions because the
undepreciated sunk cost of an asset will only reduce net income in the future as either
depreciation expense or as a loss on disposal

Question 9

Which of the following factors, ignoring income taxes, should not be considered when deciding on an equipment purchase decision?

A. Any estimated salvage value on the old machine.
B. The original cost of the old machine.
C. The estimated useful life of the new machine.
D. The lower maintenance cost on the new machine.

Answer 9

Choice “B” is correct. The original cost of the old machine is a sunk cost that will not
change regardless of the decision that is made. Sunk costs are not relevant and would not be considered by ABC as part of their decision to keep or replace the current machine.

Rule: Relevant costs are only those costs that will differ among many alternatives.

Question 10

In determining cash flows from a proposed investment, the amount of the investment’s
depreciation tax savings (shield) in a given year is equal to:

Answer 10

The depreciation times the tax rate.

The depreciation tax shield represents the reduction in taxes paid as a result of having depreciation as a deductible expense. For example, assuming a
40 percent tax rate, having $10,000 in depreciation expense results in $4,000 ($10,000 × 40%) less in taxes paid as a result of the expense.

Question 11

When employing the MACRS method of depreciation in a capital budgeting decision, the use of MACRS as compared to the straight-line method of depreciation will result in:

Answer 11

MACRS and straight line depreciation will be equal in total (only the timing differs).

Question 12

Assuming Expected Sales, Cash Operating Expense, Depreciation, and Tax Rate are given.
What is the formula for determining after-tax inflow?

Answer 12

Cash flow after tax = (Expected Sales - Cash Op Expense) * (1 - tax rate)

Depreciation tax shield = Deprecation * Tax Rate

Cash flow after tax + Depreciation tax Shield = Total after-tax cash flows.

NOTE: When comparing projects, the one with the larger number has the biggest inflow (obviously).

Question 13

What is the formula for annual Operating Cash Flow (OCF)?

Answer 13

Annual OCF = Pretax Cash Flow x (1-tax rate) + (Deprecation * Tax Rate)

NOTE: Pretax cash flow for a project is equal to:
Sales + Cost Reduction

Question 14

What is the Net Cash outflow formula for capital budgeting?

Answer 14

Net Cash Outflow = Purchase price of New Machine + Shipping/Install/Testing + Required increase in working capital.

Question 15

In evaluating a capital budget project, the use of the net present value model is generally not affected by the:

A. Method of funding the project.
B. Initial cost of the project.
C. Amount of added working capital needed for operations during the term of the
project.
D. Amount of the project’s associated depreciation tax allowance.

Answer 15

Choice “A” is correct. The method of funding the project has no effect on the net present value model. NPV uses a hurdle rate to discount cash flows. If the NPV is positive, the project is acceptable. The method of financing the project, and the cost, are independent of the process of screening the project for acceptability.

Question 16

The common disadvantage of all capital budgeting models (payback period, discounted cash flow, internal rate of return, and net present value) is their reliance on _______________.

Answer 16

ANSWER: future data

Capital financing relates to longer periods of time that are subject to greater levels of uncertainty than other short-term budgeting and financing
decisions.

Question 17

The ______________________ method recognizes the time value of money and discounts cash flows over the life of a project, using the minimum desired
(hurdle) rate.

Answer 17

net present value

Question 18

____________ method does not recognize the time value of money

Answer 18

The payback

Question 19

The _______________ is the accrual accounting increase compared to the initial investment.

Answer 19

accounting rate of return

Question 20

IRR is similar to NPV, but does not assume a _____________________.

Hint: The rate is calculated that produces a NPV of zero.

Answer 20

desired rate of return

Question 21

Net present value, like most capital budgeting techniques, focuses on _______________.

Answer 21

cash flow

Cash flow is a pure measure of financial performance that isolates relevant information for decision making. The amount of cash the firm takes in and pays out for an investment affects the amount of cash the firm has available for operations and other activities.
Net income distorts financial results useful for capital budgeting decisions with non-cash items, such as
depreciation, as well as with sunk costs.

Question 22

Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce
annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year
3. Present values of an annuity of $1 at 14% are:

Year / Future value of $1
1 - 0.88
2 - 1.65
3 - 2.32

Using a 14% cost of capital, what is the present value of these future savings?

Answer 22

ANSWER: $62,900

Years 1 & 2 $30,000 × 1.65 = $49,500
Year 3 $20,000 × (2.32 − 1.65) = $13,400

49500 + 13400 = $62900

OR

PV of year 1 = 30,000 x .88 = 36400

PV of year 2 = 30000 x .77 = 23100
(note: year 2 minus year 1 –>1.65 - .88 = .77)

PV of year 3 = 20000 x .67 = 13400
(note: use year 3-year2 –> 2.32 - 1.65 = .67)

36400 + 23100 + 13400 = $62900

Question 23

To get present value of future savings using an annuity, what information is needed?

Answer 23

Present value of $1 of an ordinary annuity.

Note: Multiply this number times the annual inflow to get the present value for the whole period

Ex/ If PV of an ordinary annuity for 4 years at 10 percent is $3.170
and
Annual inflows are $25000
Then the Present value of the 4 years of cash flows are 25000 * 3.170 = $79250

Question 24

The use of an accelerated method instead of the straight-line method of depreciation in
computing the net present value of a project has the effect of:

A. Raising the hurdle rate necessary to justify the project.
B. Lowering the net present value of the project.
C. Increasing the present value of the depreciation tax shield.
D. Increasing the cash outflows at the initial point of the project

Answer 24

ANSWER: C - Increasing the present value of the depreciation tax shield.

Use of an accelerated method instead of the straight-line method of depreciation in computing the NPV of a project has the effect of increasing the PV of
the deprecation tax shield.

Question 25

What are the 3 components of finding the NPV of a piece of equipment?

Answer 25

Investment (outflow) - PV factor is 1

Annual cash flow (inflow) - multiply times the PV of annuity factor.

Salvage value (inflow) - multiply times the discount factor for the present value of a single sum.

Question 26

The net present value of an investment is equal to:

Answer 26

the discounted after-tax cash flows associated with the investment minus the initial investment.

Question 27

If the net present value of a capital budgeting project is positive, it would indicate that the:

A. Present value of cash outflows exceeds the present value of cash inflows.

B. Internal rate of return is equal to the discount percentage rate used in the net present value computation.

C. Present value index would be less than 100 percent.

D. Rate of return for this project is greater than the discount percentage rate used in the net present value computation.

Answer 27

Choice “D” is correct. If the net present value of a project is positive, it would indicate that the rate of return for the project is greater than the discount percentage rate (hurdle rate) used in the net present value computation.

Choice “A” is incorrect. If the present value of cash outflows exceeds the present value of cash inflows, then the net present value is negative and the rate of return for the project is less than the discount percentage rate (hurdle rate).

Choice “B” is incorrect. If the internal rate of return is equal to the discount percentage rate (hurdle rate) used in the net present value computation, the net present value will be zero.

Choice “C” is incorrect. The present value index will be greater (not less) than 100 percent if the net present value of a project is positive.

Question 28

The net present value of a proposed investment is negative; therefore, the discount rate
used must be:

A. Greater than the project’s internal rate of return.
B. Less than the project’s internal rate of return.
C. Greater than the firm’s cost of equity.
D. Less than the incremental borrowing rate.

Answer 28

Choice “A” is correct. If the NPV of a proposed investment is negative, the discount rate used must be greater than the project’s internal rate of return (IRR). The IRR is the discount rate that results in a NPV of zero. If a discount rate used is greater than the project’s IRR, the present value of future
cash inflows will be lower resulting in a negative net present value. If a discount rate used is less than the project’s IRR, the present value of future cash
inflows will be higher resulting in a positive net present value.

Question 29

When the risks of the individual components of a project’s cash flows are different, an
acceptable procedure to evaluate these cash flows is to:

A. Compute the net present value of each cash flow using the firm’s cost of capital.
B. Compare the internal rate of return from each cash flow to its risk.
C. Utilize the accounting rate of return.
D. Discount each cash flow using a discount rate that reflects the degree of risk

Answer 29

Choice “D” is correct. Discount rates may be adjusted to factor differences in risk into cash flow analysis. For example, a 12 percent discount rate may be used for the first three years of a project and a 15 percent discount rate for subsequent years to reflect
the greater risk associated with the cash flows in the later time periods. Discount rates may also be adapted to compensate for expected inflation.

Question 30

A new venture will require an initial investment in fixed assets of $20,000 and in working capital of $10,000. The fixed assets will have no salvage value at the end of the project’s four-year life, and the working capital will be completely recovered at the end of the project.

The organization’s cost of capital is 16 percent. At a time value of money of 16 percent, the present value of an ordinary annuity of $1/year for four years is 2.8 and the present value of $1 at the end of four years is 0.6. What is the annual net cash inflow required for the project to break even on a time-adjusted basis?

A. $7,143
B. $8,571
C. $10,714
D. $12,857

Answer 30

Choice “B” is correct.

The initial cash outflow is $30,000, which includes the investment in fixed assets ($20,000) and working capital ($10,000). To break even, the project
must return $30,000 in time-adjusted cash inflows. The return of working capital at the end of the project’s life is worth $6,000 ($10,000 × Factor of 0.6) in today’s dollars (time-adjusted). This means another $24,000 in inflows in today’s dollars is needed to break even.

The equation to set up is:
Annual net cash inflows × Factor of 2.8 =$24,000. Rearranging the terms, $24,000 ÷ 2.8 = $8,571.

Question 31

An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method:

A. Computes a desired rate of return for capital projects.
B. Can be used when there is no constant rate of return required for each year of
the project.
C. Uses a discount rate that equates the discounted cash inflows with the outflows.
D. Uses discounted cash flows whereas the internal rate of return model does not.

Answer 31

Choice “B” is correct. The net present value (NPV) model discounts all future cash inflows and outflows to present value. The present values are netted
together and the end output (whether positive or negative) determines the acceptability of the project.

When using the NPV method of capital budgeting, different hurdle rates can be used
for each year of the project to reflect the level of risk associated with each cash flow.
Some cash flows, particularly ones that are further out, have more risk than cash flows
that occur in the near future.
Choice “A” is incorrect. The desired rate of return for capital projects is established by
management and is applicable to both the NPV method and the internal rate of return
(IRR) method.
Choice “C” is incorrect. The IRR is the discount rate that will equate the discounted
cash inflows with the outflows, thus resulting in no gain or loss (breakeven).
Choice “D” is incorrect. Both the NPV method and the IRR method are discounted cash
flow methods

Question 32

Which of the following is a limitation of the profitability index?

A. It uses free cash flows.
B. It ignores the time value of money.
C. It is inconsistent with the goal of shareholder wealth maximization.
D. It requires detailed long-term forecasts of the project’s cash flows.

Answer 32

Choice “D” is correct.
The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability
ratio requires detailed long-term forecasts of project’s cash flows. For longer term projects, cash flow projections might be either unavailable or unreliable.

Choice “A” is incorrect. Free cash flow contemplates cash flows that are available for
distribution to securities holders such as debt or equity holders. Cash flows used for
the profitability index specifically relate to project cash flows.
Choice “B” is incorrect. The time value of money is considered in both the numerator
and the denominator of the profitability index. The profitability index is the ratio of the
present value of net future cash inflows to the present value of the net initial
investment.
Choice “C” is incorrect. The profitability index incorporates discounted cash flows
based on hurdle rates that can be fully integrated with weighted average cost of capital
or marginal cost of capital thresholds. Use of these concepts is fully compatible with
maximization of shareholder value.

Question 33

Which of the following methods should be used if capital rationing needs to be considered
when comparing capital projects?

A. Net present value.
B. Internal rate of return.
C. Return on investment.
D. Profitability index.

Answer 33

Choice “D” is correct.
The profitability index is used for capital rationing. The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. Ranking and selection of investments is made by listing projects in descending order. Limited capital resources are applied in the order of the index until resources are either exhausted or the investment required by the next project exceeds remaining resources.

Choice “A” is incorrect. The net present value method is a technique to screen
investments for compliance with capital investment policy or criteria, not a capital
rationing method.
Choice “B” is incorrect. The internal rate of return method is a technique to screen
investments for compliance with capital investment policy or criteria, not a capital
rationing method.
Choice “C” is incorrect. The return on investment method is a technique to screen
investments for compliance with capital investment policy or criteria, not a capital
rationing method.

Question 34

A company has unlimited capital funds to invest. The decision rule for the company to follow
in order to maximize shareholders’ wealth is to invest in all projects having a (n):

A. Present value greater than zero.
B. Net present value greater than zero.
C. Internal rate of return greater than zero.
D. Accounting rate of return greater than the hurdle rate used in capital budgeting
analyses.

Answer 34

Explanation
Choice “B” is correct.
Rule: If the net present value is positive (greater than zero), a project should be accepted, unless there is a better project. If, however, a company has unlimited funds, all projects with a net present value greater than zero should be accepted in order to maximize shareholder wealth.

Choice “A” is incorrect. Considering only present value greater than zero accounts for
future net cash inflows, but it ignores cash outflows from the initial capital investment.
Choice “C” is incorrect. Considering only internal rate of return greater than zero may
result in the acceptance of a project with an internal rate of return less than the
company’s minimum desired rate of return.
Choice “D” is incorrect. Considering only accounting rate of return greater than hurdle
rate ignores the time value of money

Question 35

What is the fomula for profitability index of a project?

Answer 35

PROFITABILITY INDEX = PRESENT VALUE OF NWT FUTURE CASH INFLOWS / PRESENT VALUE OF NET INITIAL INVESTMENT

The profitability index is used to rank qualifying investments.
Note: The denominator maybe the “present value of the cash outflows” as opposed to
“original cash invested” if the investment is not all made at the time of the initial
investment.

Question 36

The net present value method of capital budgeting assumes that cash flows are reinvested at:

Answer 36

THE DISCOUNT RATE USED IN THE ANALYSIS

Question 37

A disadvantage of the net present value method of capital expenditure evaluation is that it:

Answer 37

DOES NOT PROVIDE THE TRUE RATE OF RETURN ON AN INVESTMENT

Question 38

If a group of projects all have IRR’s greater than a companies reinvestment rate, the project with ____________________ should be chosen.

Answer 38

THE HIGHEST NET PRESENT VALUE (NPV)

Question 39

When cash inflows are received at the end of the year, the analysis uses the present value of an

Answer 39

ordinary annuity of $1 per period for # of periods.