Test Prep Test Prep Certifications BUSINESS-ENVIRONMENT-AND-CONCEPTS Questions & Answers

• Question 111:

  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.

  Correct Answer: C

  Rule: The greater the depreciation expense, the greater the depreciation tax shield.

  Deprecation Tax Shield =

  Depreciation Expense ?Marginal Tax Rate

  Choice "c" is correct. 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. Choice

  "a" is incorrect. Depreciation method does not affect the hurdle rate. The hurdle rate is independently

  selected by management. Choice "b" is incorrect. Using an accelerated method instead of the straight-line

  method of depreciation will increase the present value of the deprecation tax shield and therefore increase

  the net present value of the project.

  Choice "d" is incorrect. Depreciation method does not affect cash outflows at the initial point of the project.

• Question 112:

  The Keego Company is planning a $200,000 equipment investment, which has an estimated five-year life with no estimated salvage value. The company has projected the following annual cash flows for the investment.

  

  The net present value for the investment is:

  A. $18,800

  B. $196,200

  C. $(3,800)

  D. $91,743

  Correct Answer: A

  Choice "a" is correct. $18,800 net present value. The net present value of an investment is calculated as the present value of the cash inflows minus the present value of the cash outflows. In this case, there is only one cash outflow (at the purchase date), and that amount ($200,000) is already at present value (or, is multiplied by a present value factor of 1.0).

  

• Question 113:

  Andrew Corporation is evaluating a capital investment that would result in a $30,000 higher contribution margin benefit and increased annual personnel costs of $20,000. The effects of income taxes on the net present value computation on these benefits and costs for the project are to:

  A. Decrease both benefits and costs.

  B. Decrease benefits but increase costs.

  C. Increase benefits but decrease costs.

  D. Increase both benefits and costs.

  Correct Answer: A

  Choice "a" is correct. The effects of income taxes on the net present value computations will decrease both

  benefits and costs for the project. Net present value computations focus of the present value of cash flows.

  Income taxes decrease both the benefit and the cost of cash flows.

  Choices "b", "c", and "d" are incorrect, per the above Explanation.

• Question 114:

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

  A. Is calculated using sensitivity analysis.

  B. Does not provide the true rate of return on investment.

  C. Is difficult to apply because it uses a trial and error approach.

  D. Is difficult to adapt for risk.

  Correct Answer: B

  Choice "b" is correct. The net present value (NPV) method of capital expenditure evaluation does not provide the true rate of return on investment. The NPV indicates whether or not an investment will earn the "hurdle rate" used in the NPV calculation. If the NPV is positive, the return on investment will exceed the hurdle rate. If the NPV is negative, the return on investment will be less than the hurdle rate. If the NPV is zero, the return on investment will be exactly equal to the hurdle rate. Choice "a" is incorrect. Sensitivity analysis is a "what if" technique that asks how a given organization will change if the original estimates used in the capital budgeting model are changed. Choice "c" is incorrect. NPV calculations do not use a trial and error approach. Choice "d" is incorrect. NPV method is not difficult to adapt for risk. To adapt for increased risk, a higher hurdle rate is used. To adapt for less risk, a lower hurdle rate is used.

• Question 115:

  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.

  Correct Answer: A

  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.

  Choices "b", "c", and "d" are incorrect, per the above discussion.

• Question 116:

  Willis, Inc. has a cost of capital of 15 percent and is considering the acquisition of a new machine, which costs $400,000 and has a useful life of five years. Willis projects that earnings and cash flow will increase as follows.

  

  The net present value of this investment is:

  A. Negative, $64,000

  B. Negative, $14,000

  C. Positive, $18,600

  D. Positive, $200,000

  Correct Answer: C

  Choice "c" is correct. Positive NPV, $18,600.

  

• Question 117:

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

  A. The risk-free rate.

  B. The cost of debt.

  C. The rate of return of the project.

  D. The discount rate used in the analysis.

  Correct Answer: D

  Choice "d" is correct. The net present value method of capital budgeting assumes that cash flows are

  reinvested at the discount rate used in the analysis.

  Choices "a", "b", and "c" are incorrect, per the above Explanation.

• Question 118:

  The net present value (NPV) of a project has been calculated to be $215,000. Which one of the following changes in assumptions would decrease the NPV?

  A. Decrease the estimated effective income tax rate.

  B. Extend the project life and associated cash inflows.

  C. Increase the estimated salvage value.

  D. Increase the discount rate.

  Correct Answer: D

  Choice "d" is correct. An increase in the discount rate will decrease the present value of future cash inflows and, therefore, decrease the net present value of the project. Each of the other options would increase the NPV: Choice "a" is incorrect. A decrease in the estimated effective income tax rate will reduce the depreciation tax shield and therefore increase the cash inflow. A larger cash inflow in the future will increase the present value of the cash inflows and therefore increase the net present value of the project. Choice "b" is incorrect. Increasing the project life and associated cash inflows will increase the present value of the cash inflows and therefore increase the net present value. Choice "c" is incorrect. An increase in the estimated salvage value will decrease the present value of the cash outflow and therefore increase the net present value.

• Question 119:

  Barker Inc. has no capital rationing constraint and is analyzing many independent investment alternatives. Barker should accept all investment proposals:

  A. If debt financing is available for them.

  B. That have positive cash flows.

  C. That provide returns greater than the after-tax cost of debt.

  D. That have a positive net present value.

  Correct Answer: D

  Choice "d" is correct. Accept all investment alternatives that have a positive net present value (NPV). A

  positive NPV means the return on the investment exceeds the hurdle rate (the minimum acceptable rate of

  return).

  Choice "a" is incorrect. The cost of debt financing is a factor in determining the hurdle rate.

  Choice "b" is incorrect. The cash flow may be positive but the return on investment may be unacceptable.

  Choice "c" is incorrect. The cost of debt financing is a factor in determining the hurdle rate.

• Question 120:

  McLean Inc. is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of three years. Assume for simplicity that the equipment will be fully depreciated 30, 40, and 30 percent in each of the three years, respectively. The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40 percent estimated income tax rate and a 16 percent hurdle rate to evaluate capital projects.

  Discount rates for a 16 percent rate are as follows.

  

  What is the net present value of this project?

  A. $15,842

  B. $13,278

  C. $9,432

  D. $(35,454)

  Correct Answer: B

  Choice "b" is correct. $13,278 net present value.