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Exam 9: Fundamentals of Capital Budgeting

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Question 31

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Which of the following best defines incremental earnings?

A) cash flows arising from a particular investment decision
B) the amount by which a firm's earnings are expected to change as a result of an investment decision
C) the earnings arising from all projects that a company plans to undertake in a fixed time span
D) the net present value (NPV) of earnings that a firm is expected to receive as the result of an investment decision

E) A) and B)
F) C) and D)

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Question 32

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The term "cannibalization" refers to ________.

A) decrease in the sales of current project caused by the launching of new project
B) decrease in the sunk cost caused by launching of new project
C) decrease in overhead expenses incurred due to launch of new project
D) cost of using a resource for the best value it could provide in its best alternative

E) A) and B)
F) C) and D)

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Question 33

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Panjandrum Industries, a manufacturer of industrial piping, is evaluating whether it should expand into the sale of plastic fittings for home garden sprinkler systems. It has made the above estimates of free cash flows resulting from such a decision. There are concerns of the sensitivity of this project to changes in the cost of capital. For what cost of capital does this project break-even?

Which of the following statements regarding real options is NOT correct?

A maker of kitchenware is planning on selling a new chef-quality kitchen knife. The manufacturer expects to sell 1.6 million knives at a price of $120 each. These knives cost $80 each to produce. Selling, general, and administrative expenses are $500,000. The machinery required to produce the knives cost $1.4 million, depreciated by straight-line depreciation over five years. The maker determines that the EBIT break-even point for units sold and sale price is less than these estimates and that the EBIT break-even point for costs per unit, SG&A, and depreciation are greater than these estimates, so decides to go ahead with manufacturing the knife. Was this the correct decision?

A textile company invests $10 million in an open-end spinning machine. This was depreciated using the seven-year MACRS schedule shown above. If the company sold it immediately after the end of year 3 for $7 million, what would be the after-tax cash flow from the sale of this asset, given a tax rate of 40%?

What is the most important function of sensitivity analysis?

A maker of computer games expects to sell 475,000 games at a price of $48 per game. These units cost $10 to produce. Selling, general, and administrative expenses are $1.0 million and depreciation is $280,000. What is the EBIT break-even point for the number of games sold in this case?

Which of the following is an example of cannibalization?

After research into where to place a new restaurant, Burger Billies, a small fast-food chain, plans to open a new store near a small college. The anticipated customer base is students attending the college. They learn that a major fast food chain will be opening a franchise within the college, which leads the owners of Burger Billies to revise their estimate of sales to one below the break-even point. Which of the following is most likely the best real option for Burger Billies to take with regard to the proposed restaurant site?

Visby Rides, a livery car company, is considering buying some new luxury cars. After extensive research, they come up with the above estimates of free cash flow from this project. Visby learns that a competitor is thinking of offering similar services, thus reducing Visby's sales. By how much could sales fall before the net present value (NPV) was zero, given that the cost of capital is 8%, and that cost of goods sold is 45% of revenues?

If available, should MACRS be preferred to straight-line depreciation?

Which of the following statements is FALSE?

What do you understand by break-even analysis?

Luther Industries has outstanding tax loss carryforwards of $72 million from losses over the past four years. If Luther earns $15 million per year in pre-tax income from now on, in how many years will Luther first pay taxes?

Which of the following adjustments should NOT be made when computing free cash flow from incremental earnings?

The ultimate goal of the capital budgeting process is to ________.

The Sisyphean Company is considering a new project that will have an annual depreciation expense of $3.6 million. If Sisyphean's marginal corporate tax rate is 35% and its average corporate tax rate is 30%, then what is the value of the depreciation tax shield on the company's new project?

CathFoods will release a new range of candies which contain antioxidants. New equipment to manufacture the candy will cost $2 million, which will be depreciated by straight-line depreciation over four years. In addition, there will be $5 million spent on promoting the new candy line. It is expected that the range of candies will bring in revenues of $4 million per year for four years with production and support costs of $1.5 million per year. If CathFoods' marginal tax rate is 35%, what are the incremental free cash flows in the second year of this project?

A firm is considering investing in a new machine that will cost $400,000 and will be depreciated straight-line over five years. If the firm's marginal tax rate is 39%, what is the annual depreciation tax shield of purchasing the machine?