CorporateFinance:TheCore(Berk/DeMarzo)

Chapter7-FundamentalsofCapitalBudgeting

1)Whichofthefollowingstatementsisfalse?
A)Becausevalueislostwhenaresourceisusedbyanotherproject,weshouldincludetheopportunity
costasanincrementalcostoftheproject.
B)Sunkcostsareincrementalwithrespecttothecurrentdecisionregardingtheprojectandshouldbe
includedinitsanalysis.
C)Overheadexpensesareassociatedwithactivitiesthatarenotdirectlyattributabletoasinglebusiness
activitybutinsteadaffectmanydifferentareasofthecorporation.
D)Whencomputingtheincrementalearningsofaninvestmentdecision,weshouldincludeallchanges
betweenthefirmsearningswiththeprojectversuswithouttheproject.
Answer:B
Explanation: A)
B)
C)
D)
Diff:2
Topic:7.1ForecastingEarnings
Skill:Conceptual

2)Whichofthefollowingcostswouldyouconsiderwhenmakingacapitalbudgetingdecision?
A)Sunkcost
B)Opportunitycost
C)Interestexpense
D)Fixedoverheadcost
Answer:B
Explanation: A)
B)
C)
D)
Diff:1
Topic:7.1ForecastingEarnings
Skill:Conceptual

3)Adecreaseinthesalesofacurrentprojectbecauseofthelaunchingofanewprojectis
A)cannibalization.
B)asunkcost.
C)anoverheadexpense.
D)irrelevanttotheinvestmentdecision.
Answer:A
Explanation: A)
B)
C)
D)
Diff:1
Topic:7.1ForecastingEarnings
Skill:Definition

4)Moneythathasbeenorwillbepaidregardlessofthedecisionwhetherornottoproceedwiththeprojectis
A)cannibalization.
B)consideredaspartoftheinitialinvestmentintheproject.
C)anopportunitycost.
D)asunkcost.
Answer:D
Explanation: A)
B)
C)
D)
Diff:1
Topic:7.1ForecastingEarnings
Skill:Definition

5)Thevalueofcurrentlyunusedwarehousespacethatwillbeusedaspartofanewcapitalbudgetingprojectis
A)anopportunitycost.
B)irrelevanttotheinvestmentdecision.
C)anoverheadexpense.
D)asunkcost.
Answer:A
Explanation: A)
B)
C)
D)
Diff:1
Topic:7.1ForecastingEarnings
Skill:Definition

6)Supposethatofthe60%ofFFLscurrentovernightphotocustomers,halfwouldstarttakingtheirfilmtoa
competitorthatoffersonehourphotoprocessingifFFLfailstooffertheonehourservice.Thelevelof
incrementalsalesinthiscaseisclosestto:
A)$60,000
B)$150,000
C)$90,000
D)$120,000
Answer:D
Explanation: A)
B)
C)
D)=$150,000-(cannibalizedsales)=150000-(.60.50)100,000=$120,000
Notethattherateofcannibalizationisonly30%(.60.50)sincetheother30%wouldhave
takentheirfilmelsewhere.
Diff:2
Topic:7.1ForecastingEarnings
Skill:Analytical

Usetheinformationforthequestion(s)below.

GlucoseScanIncorporated(GSI)currentlysellsitslatestglucosemonitor,theGlucoscan3000,todiabeticpatientsfor
$129.GSIplansonloweringtheirpricenextyearto$99perunit.ThecostofgoodssoldforeachGlucoscanunitis$50,
andGSIexpectstosell100,000unitsoverthenextyear.
7)SupposethatifGSIdropsthepriceontheGlucoscan3000immediately,itcanincreasesalesoverthenext
yearby30%to130,000units.TheincrementalimpactofthispricedroponthefirmsEBITisclosestto:
A)adeclineof1.5million
B)anincreaseof1.5million
C)adeclineof2.4million
D)anincreaseof2.4million
Answer:A
Explanation: A)Withoutpricecut=100,000units($129-50)=$7,900,000
Withpricecut=130,000units($99-50)=$6,370,000
So,incremental=6,370,000-7,900,000=-1,530,000
B)
C)
D)
Diff:2
Topic:7.1ForecastingEarnings
Skill:Analytical

8)SupposethatifGSIdropsthepriceontheGlucoscan3000immediately,itcanincreasesalesoverthenext
yearby30%to130,000units.AlsosupposethatforeachGlucoscanmonitorsold,GSIexpectsadditional
salesof$100peryearonglucosetestingstripsandthesestripshaveagrossprofitmarginof75%.
Consideringtheincreaseinthesaleoftestingstrips,theincrementalimpactofthispricedroponthefirms
EBITisclosestto:
A)Adeclineof1.5million
B)Adeclineof0.7million
C)Anincreaseof0.7million
D)Anincreaseof1.5million
Answer:C
Explanation: A)
B)
C)WithoutPriceCut
Monitorsales=100,000($129-$50)=$7,900,000
Stripsales=100,000($100-$25)=$7,500,000
TotalEBIT=7,900,000+7,500,000=15,400,000
WithPriceCut
Monitorsales=130,000($99-$50)=$6,370.000
Stripsales=130,000($100-$25)=$9,750,000
TotalEBIT=6,370,000+9,750,000=16,120,000
Incremental=16,120,000-15,400,000=720,000
D)
Diff:3
Topic:7.1ForecastingEarnings
Skill:Analytical

Usetheinformationforthequestion(s)below.

TheSisypheanCorporationisconsideringinvestinginanewcanemanufacturingmachinethathasanestimatedlifeof
threeyears.Thecostofthemachineis$30,000andthemachinewillbedepreciatedstraightlineoveritsthree-yearlifeto
aresidualvalueof$0.
Thecanemanufacturingmachinewillresultinsalesof2,000canesinyear1.Salesareestimatedtogrowby10%peryear
eachyearthroughyearthree.ThepricepercanethatSisypheanwillchargeitscustomersis$18eachandistoremain
constant.Thecaneshaveacostperunittomanufactureof$9each.
Installationofthemachineandtheresultingincreaseinmanufacturingcapacitywillrequireanincreaseinvariousnet
workingcapitalaccounts.ItisestimatedthattheSisypheanCorporationneedstohold2%ofitsannualsalesincash,4%
ofitsannualsalesinaccountsreceivable,9%ofitsannualsalesininventory,and6%ofitsannualsalesinaccounts
payable.Thefirmisinthe35%taxbracket,andhasacostofcapitalof10%.
9)TheincrementalEBITinthefirstyearfortheSisypheanCorporationsprojectisclosestto:
A)$18,000
B)$8,000
C)$11,700
D)$5,200
Answer:B
Explanation: A)
B)IncrementalEarningsForecast
Year
1
2
3
Units
2,000
2,200
2,420
Sales(units$18)
36,000
39,600
43,560
CostofGoodSold(units$9)
18,000
19,800
21,780
GrossProfit
18,000
19,800
21,780
Depreciation($30,000/3)
10,000
10,000
10,000
EBIT
8,000
9,800
11,780
Incometaxat35%
2,800
3,430
4,123
Unleverednetincome
5,200
6,370
7,657
C)
D)
Diff:3
Topic:7.1ForecastingEarnings
Skill:Analytical

10)TheincrementalunleverednetincomeinthefirstyearfortheSisypheanCorporationsprojectisclosestto:
A)$8,000
B)$18,000
C)$5,200
D)$11,700
Answer:C
Explanation: A)
B)
C)IncrementalEarningsForecast
Year
1
2
3
Units
2,000
2,200
2,420
Sales(units$18)
36,000
39,600
43,560
CostofGoodSold(units$9)
18,000
19,800
21,780
GrossProfit
18,000
19,800
21,780
Depreciation($30,000/3)
10,000
10,000
10,000
EBIT
8,000
9,800
11,780
Incometaxat35%
2,800
3,430
4,123
Unleverednetincome
5,200
6,370
7,657
D)
Diff:3
Topic:7.1ForecastingEarnings
Skill:Analytical

11)ThedepreciationtaxshieldfortheSisypheanCorporationsprojectinthefirstyearisclosestto:
A)$8,000
B)$3,500
C)$2,800
D)$5,200
Answer:B
Explanation: A)
B)Depreciationtaxshield=depreciationc=(30000/3).35=$3,500
C)
D)
Diff:2
Topic:7.1ForecastingEarnings
Skill:Analytical

12)Whichofthefollowingstatementsisfalse?
A)Depreciationexpenseshaveapositiveimpactonfreecashflow.
B)FreeCashFlow=(Revenues-Costs-Depreciation)(1-c)-CapitalExpenditures-NWC+c
Depreciation.
C)Thefirmcannotuseitsearningstobuygoods,payemployees,fundnewinvestments,orpaydividends
toshareholders.
D)Thedepreciationtaxshieldisthetaxsavingsthatresultsfromtheabilitytodeductdepreciation.
Answer:B
Explanation: A)
B)
C)
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Conceptual


13)Yourfirmisconsideringbuildinganewofficecomplex.Yourfirmalreadyownslandsuitableforthenew
complex.Thecurrentbookvalueofthelandis$100,000,howeveracommercialrealestateagainhas
informedyouthatanoutsidebuyerisinterestedinpurchasingthislandandwouldbewillingtopay
$650,000forit.WhencalculatingtheNPVofyournewofficecomplex,ignoringtaxes,theappropriate
incrementalcashflowfortheuseofthislandis:
A)$650,000
B)$0
C)$100,000
D)$750,000
Answer:A
Explanation: A)Itisappropriatetousethemarketvalue.Iftaxesareinclude,thevaluewouldbetheaftertaxvalueoftheland.
B)
C)
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Definition

14)TheSisypheanCompanyisconsideringanewprojectthatwillhaveanannualdepreciationexpenseof$2.5
million.IfSisypheansmarginalcorporatetaxrateis40%andtheiraveragecorporatetaxrateis30%,then
whatisthevalueofthedepreciationtaxshieldontheirnewproject?
A)$750,000
B)$1,000,000
C)$1,500,000
D)$1,750,000
Answer:B
Explanation: A)
B)Hereweneedtousethemarginaltaxrate.
Sodepreciationtaxshield=$2,500,000.40=$1million
C)
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

15)BubbaHo-TepCompanyreportednetincomeof$300millionforthemostrecentfiscalyear.Thefirmhad
depreciationexpensesof$125millionandcapitalexpendituresof$150million.Althoughtheyhadno
interestexpense,thefirmdidhaveanincreaseinnetworkingcapitalof$20million.WhatisBubbaHo-Teps
freecashflow?
A)$170million
B)$255million
C)$150million
D)$5million
Answer:B
Explanation: A)
B)FCF=NI+Dep-CapitalEx-chgNWC
=300+125-150-20=255
C)
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

Usetheinformationforthequestion(s)below.

TemporaryHousingServicesIncorporated(THSI)isconsideringaprojectthatinvolvessettingupatemporaryhousing
facilityinanarearecentlydamagedbyahurricane.THSIwillleasespaceinthisfacilitytovariousagenciesandgroups
providingreliefservicestothearea.THSIestimatesthatthisprojectwillinitiallycost$5milliontosetupandwill
generate$20millioninrevenuesduringitsfirstandonlyyearinoperation(paidinoneyear).Operatingexpensesare
expectedtototal$12millionduringthisyearanddepreciationexpensewillbeanother$3million.THSIwillrequireno
workingcapitalforthisinvestment.THSIsmarginaltaxrateis35%.

16)Ignoringtheoriginalinvestmentof$5million,whatisTHSIsfreecashflowforthefirstandonlyyearof
operation?
A)$5.0million
B)$3.75million
C)$8.0million
D)$6.25million
Answer:D
Explanation: A)
B)
C)
D)FCF=(revenues-expenses-depreciation)(1-taxrate)+depreciation
FCF=(20-12-3)(1-.35)+3=6.25
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

17)AssumethatTHSIscostofcapitalforthisprojectis15%.TheNPVofthistemporaryhousingprojectis
closestto:
A)$435,000
B)-$650,000
C)$1,960,000
D)-$435,000
Answer:A
Explanation: A)FCF=(20-12-3)(1-.35)+3=6.25
So,NPV=-5.0+6.25/1.15=.434782or$434,782
B)
C)
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

Usetheinformationforthequestion(s)below.

ShepardIndustriesisevaluatingaproposaltoexpanditscurrentdistributionfacilities.Managementhasprojectedthe
projectwillproducethefollowingcashflowsforthefirsttwoyears(inmillions).
Year
1
2
Revenues
1200
1400
OperatingExpense
450
525
Depreciation
240
280
Increaseinworkingcapital
60
70
Capitalexpenditures
300
350
Marginalcorporatetaxrate
30%
30%

18)TheincrementalEBITforShepardIndustriesinyearoneisclosestto:
A)$360
B)$750
C)$595
D)$510
Answer:D
Explanation: A)
B)
C)
D)Revenues
1200
1400
-Expenses
450
525
-Depreciation
240
280
=EBIT
510
595
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

19)TheincrementalEBITforShepardIndustriesinyeartwoisclosestto:
A)$415
B)$875
C)$595
D)$510
Answer:C
Explanation: A)
B)
C)Revenues
1200
1400
-Expenses
450
525
-Depreciation
240
280
=EBIT
510
595
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

WS1)TheincrementalunleverednetincomeShepardIndustriesinyearoneisclosestto:
A)$510
B)$415
C)$600
D)$355
Answer:D
Explanation: A)
B)
C)
D)Revenues
1200
1400
-Expenses
450
525
-Depreciation
240
280
=EBIT
510
595
-Taxes(30%)
153
178.5
357
416.5
Incremental Net Income
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

20)TheincrementalunleverednetincomeShepardIndustriesinyeartwoisclosestto:
A)$355
B)$415
C)$600
D)$510
Answer:B
Explanation: A)
B)Revenues
1200
1400
-Expenses
450
525
-Depreciation
240
280
=EBIT
510
595
-Taxes(30%)
153
178.5
357
416.5
Incremental Net Income
C)
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

WS2)ThedepreciationtaxshieldforShepardIndustriesprojectinyearoneisclosestto:
A)$84
B)$168
C)$96
D)$72
Answer:D
Explanation: A)
B)
C)
D)$240.30=$72
Diff:1
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

21)ThedepreciationtaxshieldforShepardIndustriesprojectinyeartwoisclosestto:
A)$84
B)$196
C)$72
D)$96
Answer:A
Explanation: A)$280.30=$84
B)
C)
D)
Diff:1
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

22)ThefreecashflowfromShepardIndustriesprojectinyearoneisclosestto:
A)$240
B)$300
C)-$5
D)$390
Answer:A
Explanation: A)FreeCashFlow
Revenues
1200
1400
-Expenses
450
525
-Depreciation
240
280
=EBIT
510
595
-Taxes(30%)
153
178.5
357
416.5
Incremental Net Income
+Depreciation
240
280
-Capitalexpenditures
300
350
-ChangeinNWC
60
70
237
276.5
Free Cash Flow
B)
C)
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

23)ThefreecashflowfromShepardIndustriesprojectinyeartwoisclosestto:
A)$345
B)$455
C)$275
D)-$5
Answer:C
Explanation: A)
B)
C)FreeCashFlow
Revenues
1200
1400
-Expenses
450
525
-Depreciation
240
280
=EBIT
510
595
-Taxes(30%)
153
178.5
357
416.5
Incremental Net Income
+Depreciation
240
280
-Capitalexpenditures
300
350
-ChangeinNWC
60
70
237
276.5
Free Cash Flow
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

Usetheinformationforthequestion(s)below.

EpiphanyIndustriesisconsideringanewcapitalbudgetingprojectthatwilllastforthreeyears.Epiphanyplansonusing
acostofcapitalof12%toevaluatethisproject.Basedonextensiveresearch,ithaspreparedthefollowingincremental
cashflowprojects:
Year
Sales(Revenues)
-CostofGoodsSold(50%ofSales)
-Depreciation
=EBIT
-Taxes(35%)
=unleverednetincome
+Depreciation
+changestoworkingcapital
-capitalexpenditures

1
100,000
50,000
30,000
20,000
7000
13,000
30,000
-5,000

2
100,000
50,000
30,000
20,000
7000
13,000
30,000
-5,000

3
100,000
50,000
30,000
20,000
7000
13,000
30,000
10,000

-90,000

WS3)ThefreecashflowforthefirstyearofEpiphanysprojectisclosestto:
A)$43,000
B)$25,000
C)$38,000
D)$45,000
Answer:C
Explanation: A)
B)
0
1
C)Year
Sales(Revenues)
-CostofGoodsSold(50%ofSales)
-Depreciation
=EBIT
-Taxes(35%)
=unleverednetincome
+Depreciation
+changestoworkingcapital
-capitalexpenditures
=FreeCashFlow
PVofFCF(FCF/(1+I)n
discountrate
NPV=11,946
IRR=19.14%

D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

-90,000
-90,000
-90,000
0.12

100,000
50,000
30,000
20,000
7000
13,000
30,000
-5,000

2
100,000
50,000
30,000
20,000
7000
13,000
30,000
-5,000

3
100,000
50,000
30,000
20,000
7000
13,000
30,000
10,000

38,000

38,000

53,000

33,929

30,293

37,724

24)ThefreecashflowforthelastyearofEpiphanysprojectisclosestto:
A)$53,000
B)$38,000
C)$35,000
D)$43,000
Answer:A
0
1
Explanation: A)Year
Sales(Revenues)
-CostofGoodsSold(50%ofSales)
-Depreciation
=EBIT
-Taxes(35%)
=unleverednetincome
+Depreciation
+changestoworkingcapital
-capitalexpenditures
=FreeCashFlow
PVofFCF(FCF/(1+I)n
discountrate
NPV=11,946
IRR=19.14%

B)
C)
D)
Diff:2
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

-90,000
-90,000
-90,000
0.12

100,000
50,000
30,000
20,000
7000
13,000
30,000
-5,000

2
100,000
50,000
30,000
20,000
7000
13,000
30,000
-5,000

3
100,000
50,000
30,000
20,000
7000
13,000
30,000
10,000

38,000

38,000

53,000

33,929

30,293

37,724

25)TheNPVforEpiphanysProjectisclosestto:
A)$4,825
B)$39,000
C)$11,946
D)$20,400
Answer:C
Explanation: A)
B)
C)Year
Sales(Revenues)
-CostofGoodsSold(50%ofSales)
-Depreciation
=EBIT
-Taxes(35%)
=unleverednetincome
+Depreciation
+changestoworkingcapital
-capitalexpenditures
=FreeCashFlow
PVofFCF(FCF/(1+I)n
discountrate
NPV=11,946
IRR=19.14%

-90,000
-90,000
-90,000
0.12

1
100,000
50,000
30,000
20,000
7000
13,000
30,000
-5,000

2
100,000
50,000
30,000
20,000
7000
13,000
30,000
-5,000

3
100,000
50,000
30,000
20,000
7000
13,000
30,000
10,000

38,000

38,000

53,000

33,929

30,293

37,724

D)
Diff:3
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical

26)LutherIndustrieshasoutstandingtaxlosscarryforwardsof$70millionfromlossesoverthepastfouryears.
IfLutherearns$15millionperyearinpre-taxincomefromnowon,Lutherfirstpaytaxesin?
A)7years.
B)2years.
C)4years.
D)5years.
Answer:D
Explanation: A)
B)
C)
D)Thenumberofyearsthetaxlosscarryforwardswilllastbanbecalculatedasthetaxloss
carryforwarddividendbytheannualpre-taxincomeor:
$70 million
Yearswithnotax=
=4.67years,soLutherwonthavetopaytaxesforthenext
$15 million
fouryears,butwillhavetostartpayingsometaxes5yearsfromnow.
Diff:1
Topic:7.2DeterminingFreeCashFlowandNPV
Skill:Analytical