Solved by verified expert :Chapter 21
Review Questions and Exercises
The ______ method of capital budgeting is based on income rather than cash
The discount rate that makes the net present value of a project equal to zero
is called the __ 3. In a capital-budgeting project, the investment required for
accounts receivable and inventories is called _ ____.
(Appendix) __ ___ is the decline in the general purchasing power of the
monetary unit.

1. The planning and control tools used for year-to-year operating decisions are
well suited for capital-budgeting decisions.
2. The present value of $1 million to be received ten years from now is lower
if computed at a discount rate of 10% rather than 14%.
3. Assume a required rate of return of 12% is used to compute the NPV of a
project. If NPV is negative, IRR is less than 12%.
4. The payback method does not consider a project’s cash flows after the payback
5. If the income tax rate for a profitable company is 30%, a depreciation
deduction of $10,000 results in a tax savings of $7,000 (before considering
time value of money).
6. For a profitable company, the gain or loss on the recovery of working
capital in a capital-budgeting project is subject to income tax.
7. It is consistent to use NPV as best for capital-budgeting decisions and then
use AARR to evaluate a manager’s performance over short time horizons.

Multiple Choice
1. (CMA) Amster Corporation has not yet decided on its required rate of return
for use in the evaluation of capital budgeting projects for the current year. This
lack of information prohibits Amster from calculating a project’s

2. (CPA adapted) Brewster Co. is reviewing the following data relating to an
energy- saving investment proposal:

Net initial investment


After-tax cash flow from disposal of the investment at the end
of 5 years


Present value of an annuity of $1 at 12% for 5 years


Present value of $1 at 12% in 5 years


is the amount of after-tax annual savings (including the depreciation effects) needed
for the investment to provide a 12% return?

3. (CMA) Making the common assumption in capital-budgeting analysis that cash inflows
occur in a lump sum at the end of individual years during the life of an investment
project when, in fact, they flow more or less continuously during those years:

4. (CPA adapted) Apex Corp. is considering the purchase of a machine costing $100,000.
The machine’s expected useful life is five years. The estimated annual after-tax
cash flow from operations is: $60,000 in year 1, $30,000 in year 2, $20,000 in
year 3, $20,000 in year 4, and $20,000 in year 5. Assuming these cash flows
will be received evenly during each year, the payback is:

5. (CMA) Fast Freight Inc. is planning to purchase equipment to make its operations
more efficient. The equipment has an estimated life of six years. At the time
of acquiring the equipment, a $9,000 investment in working capital is required.
In a discounted cash-flow analysis, this investment in working capital:

6. Assume in the current year that a profitable company pays $10,000 for
advertising and has depreciation of $10,000. If the income tax rate is 40%, the
after-tax effects on cash flow before considering time value of money are a net
outflow of:

7. (CMA) Garfield Inc. is considering a 10-year capital investment project with
forecasted cash revenues of $40,000 per year and forecasted cash operating
costs of $29,000 per year. The initial cost of the equipment for the project is
$23,000, and Garfield expects to sell the equipment for $9,000 at the end of
the tenth year. The equipment will be depreciated on a straight-line basis over
seven years for tax purposes. The project requires a working capital investment
of $7,000 at its inception and another $5,000 at the end of year 5. The working
capital is fully recoverable at the end of the life of the project. Assuming a
40% tax rate, expected net after-tax cash flow from the project for the tenth
year is:

8. (CMA) Superstrut is considering replacing an old press that cost $80,000 six
years ago with a new one with a purchase cost of $225,000. Shipping and installation
cost an additional $20,000. The old press has a book value of $15,000 and can
be sold currently for $5,000. The increased production of the new press would
increase inventories by $4,000, accounts receivable by $16,000, and accounts
payable by $14,000. Superstrut’s net initial investment for analyzing the
acquisition of the new press, assuming a 40% income tax rate

9. (CMA) Brownel Inc. currently has annual cash revenues of $240,000 and annual
operating costs of $185,000 (all cash items except depreciation of $35,000).
The company is considering the purchase of a new mixing machine costing
$120,000 that would increase cash revenues to $290,000 per year and operating
costs (including depreciation) to $205,000 per year. The new machine would increase
depreciation to $50,000 per year. Using a 40% income tax rate, Brownel’s annual
incremental after-tax cash flow from the new mixing machine is:


Present Situation

Proposed Situation

Cash-flow Difference






Cash operating costs (excludes

$185,000 – 35,000


$205,000 – 50,000






Total operation Cost






10. (Appendix) If the nominal rate of interest is 16% and the inflation rate is
5%, the real rate of interest (rounded to the nearest tenth of a percent) is:
Review Exercises
The following information pertains to a machine recently sold by Powers

Net initial investment


Estimated useful life for tax purposes

8 years

Terminal disposal value for tax purposes


Age at the time of sale

6 years

Cash received from the sale


Income tax rate


Powers uses straight-line depreciation and is a profitable company, calculate
the after-tax cash flow from the sale of the machine.

(CMA adapted) Jasper Company has a payback requirement of three years on new
equipment acquisitions. A new sorter is being evaluated that costs $450,000 and
has an estimated useful life of five years. Straight-line depreciation will be
used with a zero terminal disposal value. Jasper is subject to a 40% income tax

the amount of savings in after-tax annual cash operating costs that must be
generated by the new sorter to meet the company’s payback requirement.

(Appendix) Massey Company’s nominal rate of return for capital-budgeting projects
is 20%, which includes a 10% inflation rate. The present value of $1 at 20% for
one year is 0.833. Assume a 40% income tax rate.

the after-tax present value (expressed in nominal dollars) of:

Before-tax cash operating savings of $100,000 (expressed in year 0 dollars) to
be received at the end of year 1.

b. Year 1 depreciation of $70,000.

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