Chapter 07 Students Sol

Corporate Finance: The Core (Berk/DeMarzo) Chapter 7 - Fundamentals of Capital Budgeting

1) Which of the following statements is false? A) Because value is lost when a resource is used by another project, we should include the opportunity

cost as an incremental cost of the project. B) Sunk costs are incremental with respect to the current decision regarding the project and should be

included in its analysis. C) Overhead expenses are associated with activities that are not directly attributable to a single business

activity but instead affect many different areas of the corporation. D) When computing the incremental earnings of an investment decision, we should include all changes

between the firm’s earnings with the project versus without the project. Answer: B Explanation: A)

B) C) D)

Diff: 2 Topic: 7.1 Forecasting Earnings Skill: Conceptual

2) Which of the following costs would you consider when making a capital budgeting decision? A) Sunk cost B) Opportunity cost C) Interest expense D) Fixed overhead cost

Answer: B Explanation: A)

B) C) D)

Diff: 1 Topic: 7.1 Forecasting Earnings Skill: Conceptual

3) A decrease in the sales of a current project because of the launching of a new project is A) cannibalization. B) a sunk cost. C) an overhead expense. D) irrelevant to the investment decision.

Answer: A Explanation: A)

B) C) D)

Diff: 1 Topic: 7.1 Forecasting Earnings Skill: Definition

4) Money that has been or will be paid regardless of the decision whether or not to proceed with the project is A) cannibalization. B) considered as part of the initial investment in the project. C) an opportunity cost. D) a sunk cost.

Answer: D Explanation: A)

B) C) D)


5) The value of currently unused warehouse space that will be used as part of a new capital budgeting project is A) an opportunity cost. B) irrelevant to the investment decision. C) an overhead expense. D) a sunk cost.

Answer: A Explanation: A)

B) C) D)


6) Suppose that of the 60% of FFLʹs current overnight photo customers, half would start taking their film to a competitor that offers one hour photo processing if FFL fails to offer the one hour service. The level of incremental sales in this case is closest to: A) $60,000 B) $150,000 C) $90,000 D) $120,000


B) C) D) = $150,000 - (cannibalized sales) = 150000 - (.60 × .50) × 100,000 = $120,000

Note that the rate of cannibalization is only 30% (.60 × .50) since the other 30% would have taken their film elsewhere.

Diff: 2 Topic: 7.1 Forecasting Earnings Skill: Analytical

Use the information for the question(s) below. Glucose Scan Incorporated (GSI) currently sells its latest glucose monitor, the Glucoscan 3000, to diabetic patients for $129. GSI plans on lowering their price next year to $99 per unit. The cost of goods sold for each Glucoscan unit is $50, and GSI expects to sell 100,000 units over the next year.

7) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales over the next year by 30% to 130,000 units. The incremental impact of this price drop on the firms EBIT is closest to: A) a decline of 1.5 million B) an increase of 1.5 million C) a decline of 2.4 million D) an increase of 2.4 million

Answer: A Explanation: A) Without price cut = 100,000 units × ($129 - 50) = $7,900,000

With price cut = 130,000 units × ($99 - 50) = $6,370,000 So, incremental = 6,370,000 - 7,900,000 = -1,530,000

B) C) D)


8) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales over the next year by 30% to 130,000 units. Also suppose that for each Glucoscan monitor sold, GSI expects additional sales of $100 per year on glucose testing strips and these strips have a gross profit margin of 75%. Considering the increase in the sale of testing strips, the incremental impact of this price drop on the firms EBIT is closest to: A) A decline of 1.5 million B) Adecline of 0.7 million C) An increase of 0.7 million D) An increase of 1.5 million

Answer: C Explanation: A)

B) C) Without Price Cut

Monitor sales = 100,000 × ($129 - $50) = $7,900,000 Strip sales = 100,000 × ($100 - $25) = $7,500,000 Total EBIT = 7,900,000 + 7,500,000 = 15,400,000 With Price Cut Monitor sales = 130,000 × ($99 - $50) = $6,370.000 Strip sales = 130,000 × ($100 - $25) = $9,750,000 Total EBIT = 6,370,000 + 9,750,000 = 16,120,000 Incremental = 16,120,000 - 15,400,000 = 720,000

D) Diff: 3 Topic: 7.1 Forecasting Earnings Skill: Analytical

Use the information for the question(s) below. The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital of 10%.

9) The incremental EBIT in the first year for the Sisyphean Corporationʹs project is closest to: A) $18,000 B) $8,000 C) $11,700 D) $5,200


B) Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000 / 3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657

C) D)


10) The incremental unlevered net income in the first year for the Sisyphean Corporationʹs project is closest to: A) $8,000 B) $18,000 C) $5,200 D) $11,700


B) C) Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000 / 3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657

D) Diff: 3 Topic: 7.1 Forecasting Earnings Skill: Analytical

11) The depreciation tax shield for the Sisyphean Corporationʹs project in the first year is closest to: A) $8,000 B) $3,500 C) $2,800 D) $5,200


B) Depreciation tax shield = depreciation × τc = (30000/3) × .35 = $3,500 C) D)


12) Which of the following statements is false? A) Depreciation expenses have a positive impact on free cash flow. B) Free Cash Flow = (Revenues - Costs - Depreciation) × (1 - τc) - Capital Expenditures - ΔNWC + τc ×

Depreciation. C) The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay dividends

to shareholders. D) The depreciation tax shield is the tax savings that results from the ability to deduct depreciation.


B) C) D)

Diff: 2 Topic: 7.2 Determining Free Cash Flow and NPV Skill: Conceptual

13) Your firm is considering building a new office complex. Your firm already owns land suitable for the new

complex. The current book value of the land is $100,000, however a commercial real estate again has informed you that an outside buyer is interested in purchasing this land and would be willing to pay $650,000 for it. When calculating the NPV of your new office complex, ignoring taxes, the appropriate incremental cash flow for the use of this land is: A) $650,000 B) $0 C) $100,000 D) $750,000

Answer: A Explanation: A) It is appropriate to use the market value. If taxes are include, the value would be the after-

tax value of the land. B) C) D)

Diff: 2 Topic: 7.2 Determining Free Cash Flow and NPV Skill: Definition

14) The Sisyphean Company is considering a new project that will have an annual depreciation expense of $2.5 million. If Sisypheanʹs marginal corporate tax rate is 40% and their average corporate tax rate is 30%, then what is the value of the depreciation tax shield on their new project? A) $750,000 B) $1,000,000 C) $1,500,000 D) $1,750,000


B) Here we need to use the marginal tax rate. So depreciation tax shield = $2,500,000 × .40 = $1 million

C) D)

Diff: 2 Topic: 7.2 Determining Free Cash Flow and NPV Skill: Analytical

15) Bubba Ho-Tep Company reported net income of $300 million for the most recent fiscal year. The firm had depreciation expenses of $125 million and capital expenditures of $150 million. Although they had no interest expense, the firm did have an increase in net working capital of $20 million. What is Bubba Ho-Tepʹs free cash flow? A) $170 million B) $255 million C) $150 million D) $5 million


B) FCF = NI + Dep - Capital Ex - chg NWC = 300 + 125 - 150 - 20 = 255

C) D)


Use the information for the question(s) below. Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this facility to various agencies and groups providing relief services to the area. THSI estimates that this project will initially cost $5 million to setup and will generate $20 million in revenues during its first and only year in operation (paid in one year). Operating expenses are expected to total $12 million during this year and depreciation expense will be another $3 million. THSI will require no working capital for this investment. THSIʹs marginal tax rate is 35%.

16) Ignoring the original investment of $5 million, what is THSIʹs free cash flow for the first and only year of operation? A) $5.0 million B) $3.75 million C) $8.0 million D) $6.25 million


B) C) D) FCF = (revenues - expenses - depreciation) × (1 - tax rate) + depreciation FCF = (20 - 12 - 3) × (1 - .35) + 3 =6.25


17) Assume that THSIʹs cost of capital for this project is 15%. The NPV of this temporary housing project is closest to: 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 = .434782 or $434,782 B) C) D)


Use the information for the question(s) below. Shepard Industries is evaluating a proposal to expand its current distribution facilities. Management has projected the project will produce the following cash flows for the first two years (in millions). Year 1 2 Revenues 1200 1400 Operating Expense 450 525 Depreciation 240 280 Increase in working capital 60 70 Capital expenditures 300 350 Marginal corporate tax rate 30% 30%

18) The incremental EBIT for Shepard Industries in year one is closest to: A) $360 B) $750 C) $595 D) $510


B) C) D) Revenues 1200 1400

- Expenses 450 525- Depreciation 240 280= EBIT 510 595


19) The incremental EBIT for Shepard Industries in year two is closest to: A) $415 B) $875 C) $595 D) $510


B) C) Revenues 1200 1400

- Expenses 450 525- Depreciation 240 280= EBIT 510 595

D) Diff: 2 Topic: 7.2 Determining Free Cash Flow and NPV Skill: Analytical

WS1) The incremental unlevered net income Shepard Industries in year one is closest to: A) $510 B) $415 C) $600 D) $355


B) C) D) Revenues 1200 1400

- Expenses 450 525- Depreciation 240 280= EBIT 510 595- Taxes (30%) 153 178.5Incremental Net Income 357 416.5


20) The incremental unlevered net income Shepard Industries in year two is closest to: A) $355 B) $415 C) $600 D) $510


B) Revenues 1200 1400- Expenses 450 525- Depreciation 240 280= EBIT 510 595- Taxes (30%) 153 178.5Incremental Net Income 357 416.5

C) D)


WS2) The depreciation tax shield for Shepard Industries project in year one is closest to: A) $84 B) $168 C) $96 D) $72


B) C) D) $240 × .30 = $72


21) The depreciation tax shield for Shepard Industries project in year two is closest to: A) $84 B) $196 C) $72 D) $96

Answer: A Explanation: A) $280 × .30 = $84

B) C) D)


22) The free cash flow from Shepard Industries project in year one is closest to: A) $240 B) $300 C) -$5 D) $390

Answer: A Explanation: A) Free Cash Flow

Revenues 1200 1400- Expenses 450 525- Depreciation 240 280= EBIT 510 595- Taxes (30%) 153 178.5Incremental Net Income 357 416.5+ Depreciation 240 280- Capital expenditures 300 350- Change in NWC 60 70Free Cash Flow 237 276.5

B) C) D)


23) The free cash flow from Shepard Industries project in year two is closest to: A) $345 B) $455 C) $275 D) -$5


B) C) Free Cash Flow

Revenues 1200 1400- Expenses 450 525- Depreciation 240 280= EBIT 510 595- Taxes (30%) 153 178.5Incremental Net Income 357 416.5+ Depreciation 240 280- Capital expenditures 300 350- Change in NWC 60 70Free Cash Flow 237 276.5


Use the information for the question(s) below. Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental cash flow projects: Year 0 1 2 3Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000

WS3) The free cash flow for the first year of Epiphanyʹs project is closest to: A) $43,000 B) $25,000 C) $38,000 D) $45,000


B) C) Year 0 1 2 3

Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000

PV of FCF (FCF / (1 + I)n -90,000 33,929 30,293 37,724 discount rate 0.12 NPV = 11,946 IRR = 19.14%


24) The free cash flow for the last year of Epiphanyʹs project is closest to: A) $53,000 B) $38,000 C) $35,000 D) $43,000

Answer: A Explanation: A) Year 0 1 2 3



B) C) D)


25) The NPV for Epiphanyʹs Project is closest to: A) $4,825 B) $39,000 C) $11,946 D) $20,400


B) C) Year 0 1 2 3




26) Luther Industries has outstanding tax loss carryforwards of $70 million from losses over the past four years. If Luther earns $15 million per year in pre-tax income from now on, Luther first pay taxes in? A) 7 years. B) 2 years. C) 4 years. D) 5 years.


B) C) D) The number of years the tax loss carryforwards will last ban be calculated as the tax loss

carry forward dividend by the annual pre-tax income or:

Years with no tax = $70 million$15 million

= 4.67 years, so Luther wonʹt have to pay taxes for the next

four years, but will have to start paying some taxes 5 years from now. Diff: 1 Topic: 7.2 Determining Free Cash Flow and NPV Skill: Analytical

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