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Laramie Labs uses a risk-adjustment when evaluating projects of different risk.Its overall (composite) WACC is 10%, which reflects the cost of capital for its average asset.Its assets vary widely in risk, and Laramie evaluates low-risk projects with a risk-adjusted project cost of capital of 8%, average-risk projects at 10%, and high-risk projects at 12%.The company is considering the following projects:  Project  Risk  Expected Return  A  High 15% B  Average 12% C  High 11% D  Low 9% E  Low 6%\begin{array}{ccr}\text { Project }& \text { Risk }& \text { Expected Return }\\\text { A } & \text { High } & 15 \% \\\text { B } & \text { Average } & 12 \% \\\text { C } & \text { High } & 11 \% \\\text { D } & \text { Low } & 9 \% \\\text { E } & \text { Low } & 6 \%\end{array} Which set of projects would maximize shareholder wealth?


A) A and B.
B) A, B, and C.
C) A, B, and D.
D) A, B, C, and D.
E) A, B, C, D, and E.

F) A) and B)
G) A) and C)

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Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated.

A) True
B) False

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Any cash flows that can be classified as incremental to a particular project⎯i.e., results directly from the decision to undertake the project⎯should be reflected in the capital budgeting analysis.

A) True
B) False

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Whitestone Products is considering a new project whose data are shown below.The required equipment has a 3-year tax life, and the accelerated rates for such property are 33.33%, 44.45%, 14.81%, and 7.41% for Years 1 through 4.Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life.What is the project's Year 4 cash flow?  Equipment cost (depreciable basis)  $70,000 Sales revenues, each year $42,500 Operating costs (excl. deprec.)  $25,000 Tax rate 25.0%\begin{array}{lr}\text { Equipment cost (depreciable basis) } & \$ 70,000 \\\text { Sales revenues, each year } & \$ 42,500 \\\text { Operating costs (excl. deprec.) } & \$ 25,000 \\\text { Tax rate } & 25.0 \%\end{array}


A) $13,016
B) $13,701
C) $14,422
D) $15,143
E) $15,900

F) A) and D)
G) All of the above

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Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?


A) A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products.
B) A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
C) A firm has spent $2 million on R&D associated with a new product.These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
D) A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products.
E) A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

F) D) and E)
G) B) and D)

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Sensitivity analysis measures a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected by a small change in one of the input variables, say sales.Other things held constant, with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the more risky the project, other things held constant.

A) True
B) False

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Which of the following statements is CORRECT?


A) Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer.
B) If firms use accelerated depreciation, they will write off assets slower than they would under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
C) If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
D) If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.
E) Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting.

F) C) and E)
G) B) and E)

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Sheridan Films is considering some new equipment whose data are shown below.The equipment has a 3-year tax life and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down.Also, some new working capital would be required, but it would be recovered at the end of the project's life.Revenues and other operating costs are expected to be constant over the project's 3-year life.What is the project's NPV?  Project cost of capital ( r )  10.0% Net investment in fixed assets (depreciable basis)  $70,000 Required new working capital $10,000 Straight-line deprec. rate 33.333% Sal es revenues, each year $75,000 Operating costs (excl. deprec) , each year $30,000 Expected pretax salvage value $5,000 Tax rate 25.0%\begin{array}{lr}\text { Project cost of capital ( } \mathrm{r} \text { ) } & 10.0 \% \\\text { Net investment in fixed assets (depreciable basis) } & \$ 70,000 \\\text { Required new working capital } & \$ 10,000 \\\text { Straight-line deprec. rate } & 33.333 \%\\\text { Sal es revenues, each year } & \$ 75,000 \\\text { Operating costs (excl. deprec) , each year } & \$ 30,000 \\\text { Expected pretax salvage value } & \$ 5,000 \\\text { Tax rate } & 25.0 \%\end{array}


A) $25,964
B) $27,330
C) $28,768
D) $30,207
E) $31,717

F) B) and D)
G) A) and D)

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Sylvester Media is analyzing an average-risk project, and the following data have been developed.Unit sales will be constant, but the sales price should increase with inflation.Fixed costs will also be constant, but variable costs should rise with inflation.The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value.This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects.The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an adjustment is required.What is the difference in the expected NPV if the inflation adjustment is made vs.if it is not made?  Project cost of capital ( r )  10.0% Net investment cost (depreciable basis)  $200,000 Units sold 50,000 Average price per unit, Year 1$25.00 Fixed op cost excl. deprec. (constant)  $150,000 Variable op. cost ′ unit, Year 1$20.20 Annual depreciation rate 33.333% Expected inflation 4.00% Tax rate 25.0%\begin{array}{lr}\text { Project cost of capital ( } \mathrm{r} \text { ) } & 10.0 \% \\\text { Net investment cost (depreciable basis) } & \$ 200,000 \\\text { Units sold } & 50,000 \\\text { Average price per unit, Year } 1 & \$ 25.00\\\text { Fixed op cost excl. deprec. (constant) } & \$ 150,000 \\\text { Variable op. cost }{ }^{\prime} \text { unit, Year } 1 & \$ 20.20 \\\text { Annual depreciation rate } & 33.333 \% \\\text { Expected inflation } & 4.00 \% \\\text { Tax rate } & 25.0 \%\end{array}


A) $15,330
B) $16,136
C) $16,986
D) $17,835
E) $18,727

F) A) and B)
G) B) and D)

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We can identify the cash costs and cash inflows to a company that will result from a project.These could be called "direct inflows and outflows," and the net difference is the direct net cash flow.If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis.

A) True
B) False

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Which of the following statements is CORRECT?


A) Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions.
B) It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion.Working capital like inventory is almost always used up in operations.Thus, cash flows associated with working capital should be included only at the start of a project's life.
C) If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in a profit.In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant.
D) Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities.Therefore, changes in net working capital should not be considered in a capital budgeting analysis.
E) If an asset is sold for less than its book value at the end of a project's life, it will generate a loss for the firm, hence its terminal cash flow will be negative.

F) A) and B)
G) D) and E)

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Spot-Free Car Wash is considering a new project whose data are shown below.The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project's 3-year life, and would have a zero salvage value after Year 3.No new working capital would be required.Revenues and other operating costs will be constant over the project's life, and this is just one of the firm's many projects, so any losses on it can be used to offset profits in other units.If the number of cars washed declined by 40% from the expected level, by how much would the project's NPV decline? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.)  Project cost of capital (r)  10.0% Net investment cost (depreciable basis)  $60,000 Number of cars washed 2,800 Average price per car $25.00 Fixed op. cost (excl. deprec)  $10,000 Variable op. costiunit (i.e., VC per car washed)  $5.375 Annual depreciation $20,000 Tax rate 25.0%\begin{array}{lr}\text { Project cost of capital (r) } & 10.0 \% \\\text { Net investment cost (depreciable basis) } & \$ 60,000 \\\text { Number of cars washed } & 2,800 \\\text { Average price per car } & \$ 25.00\\\text { Fixed op. cost (excl. deprec) } & \$ 10,000 \\\text { Variable op. costiunit (i.e., VC per car washed) } & \$ 5.375 \\\text { Annual depreciation } & \$ 20,000 \\\text { Tax rate } & 25.0 \%\end{array}


A) $33,391
B) $35,149
C) $36,999
D) $38,946
E) $40,996

F) B) and C)
G) A) and E)

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Which of the following statements is CORRECT?


A) A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
B) A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
C) Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project.
D) A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm's existing stores.
E) A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

F) D) and E)
G) A) and E)

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Which of the following procedures best accounts for the relative risk of a proposed project?


A) Adjusting the discount rate downward if the project is judged to have above-average risk.
B) Reducing the NPV by 10% for risky projects.
C) Picking a risk factor equal to the average discount rate.
D) Ignoring risk because project risk cannot be measured accurately.
E) Adjusting the discount rate upward if the project is judged to have above-average risk.

F) A) and C)
G) B) and E)

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VR Corporation has the opportunity to invest in a new project, the details of which are shown below.What is the Year 1 cash flow for the project?  Sales revenues, each year $42,500 Depreciation $10,000 Other operating costs $17,000 Interest expense $4,000 Tax rate 25.0%\begin{array} { l r } \text { Sales revenues, each year } & \$ 42,500 \\\text { Depreciation } & \$ 10,000 \\\text { Other operating costs } & \$ 17,000 \\\text { Interest expense } & \$ 4,000 \\\text { Tax rate } & 25.0 \%\end{array}


A) $17,614
B) $18,541
C) $19,517
D) $20,544
E) $21,625

F) D) and E)
G) A) and E)

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Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects' initial outlays and subsequent costs can be forecasted with great accuracy.This is especially true for large product development projects.

A) True
B) False

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Puckett Inc.risk-adjusts its WACC to account for project risk.It uses a risk-adjusted project cost of capital of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects.Which of the following independent projects should Puckett accept, assuming that the company uses the NPV method when choosing projects?


A) Project B, which has below-average risk and an IRR = 8.5%.
B) Project C, which has above-average risk and an IRR = 11%.
C) Without information about the projects' NPVs we cannot determine which project(s) should be accepted.
D) All of these projects should be accepted.
E) Project A, which has average risk and an IRR = 9%.

F) A) and C)
G) A) and E)

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Taylor Inc., the company you work for, is considering a new project whose data are shown below.What is the project's Year 1 cash flow?  Sales revenues, each year $62,500 Depreciation $8,000 Other operating costs $25,000 Interest expense $8,000 Tax rate 25.0%\begin{array} { l r } \text { Sales revenues, each year } & \$ 62,500 \\\text { Depreciation } & \$ 8,000 \\\text { Other operating costs } & \$ 25,000 \\\text { Interest expense } & \$ 8,000 \\\text { Tax rate } & 25.0 \%\end{array}


A) $28,619
B) $30,125
C) $31,631
D) $33,213
E) $34,873

F) All of the above
G) A) and E)

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If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.

A) True
B) False

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Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not included in a capital budgeting analysis.

A) True
B) False

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