Answer for Section E: Investment Decisions

1. Correct answer d. Capital investments generally provide benefits into the future and, therefore, the
expenditure is allocated over a period of time (depreciation). Refinancing existing working capital
agreements supports current operations and is not generally treated as capital investment project.

2. Correct answer a. The net present value of the equipment being replaced is least likely to impact the
investment decision. This is a sunk cost and does not affect future decisions.

3. Correct answer a. The financing aspect of the project is considered in setting the appropriate
discount factor. However, the financing cash flows are not included anymore in the determination of
the relevant cash flows. An example of a financing cash flow is proceeds from financing.

4. Correct answer c. The controller should recommend option c as the present value of this option is the
highest as shown below.

Option c: ($20,000 x 6.710) + $5,000 = $139,200

Option a: $135,000
Option b: $40,000 x 3.312 = $132,480
Option d: ($5,000 x 6.247) + ($200,000 x .463) + $5,000 = $128,835

5.

Cash inflow after tax: ($1,200,000 - $300,000) x .6 = $540,000

Tax shield Building: ($2,000,000 ÷ 10) x .4 = 80,000
Tax shield Equipment ($3,000,000 ÷ 5) x .4 = 240,000
$860,000

6. Correct answer c. The first-year operating cash flow for Skyline

Incremental cash inflows $175,000 x .6 = $105,000

Depreciation tax shield ($375,000 x .2) x .4 = 30,000
= $135,000

7.

After-tax cash savings: $28,400 x .6 = $17,040

Depreciation tax shield: $16,000 x .4 = 6,400
Loss of depreciation tax shield: $1,600 x .4 = 640
$22,800

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8.

Equipment $1,600,000
Installation 200,000
Working capital 400,000
Initial investment $2,200,000

9. Correct answer d. Year 0 cash outflows for Skytop total $202,000 as shown below.

Sale of old equipment $ 80,000

New equipment and installation -275,000
Additional A/R and inventory - 30,000
Additional accounts payable + 15,000
Tax shield/loss on old equipment + 8,000 ($100K - $80K) x .4
Cash outflow $202,000

10.
as shown below.

Working capital outflow at Time 0 $40,000

Working capital inflow at Time 5 22,680 ($40,000 x .567)
Net outflow $17,040

11. Correct answer b. A discounted cash flow analysis should not include sunk costs as they will not change
and are not relevant. Changes in working capital and inflation affect future costs and should be
included.

12.

Sale of old equipment $ 3,000

New equipment -95,000
Increase in accounts receivable - 2,000
Increase in accounts payable + 400
Tax shield/Loss on sale + 800 ($50,000 - $45,000 - $3,000) x .4
Cash outflow $92,800

13.

Sale of old equipment $ 25,000

Purchase new equipment -100,000
Tax on gain from sale - 4,000 ($25,000 - $15,000*) x .4
Cash outflow $ 79,000

*Accumulated depreciation ($50,000 ÷ 10) x 7 = $35,000

Book value $50,000 - $35,000 = $15,000

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14. Correct answer c.
Revenue $ 1,500,000
Cash exp. -300,000
Depreciation - 800,000
Pretax Income $ 400,000
Tax at 40% -160,000
Add back depreciation 800,000
1,040,000

Sell land 700,000

Tax on gain /land -80,000
Sell building 800,000
Tax on loss/building 80,000
Sell equipment 120,000
Tax on on gain /equipment -48,000
2,612,000

15. Correct answer d. All of these items should be included in the initial investment as they all impact the
cash flow of the project.

16. Correct answer b. Bison second year incremental cash flow is $34,000 as shown below.

After-tax cash savings $50,000 x .6 = $30,000

Tax shield/new equipment ($180,000+25,000+9,000-14,000) ÷ 5 x .4 = 8,000
- Loss of old tax shield - ($100,000 ÷ 10) x .4 = - 4,000
Incremental Cash flow $34,000
rd
17. year cash flows are $800,000 as shown below.

After tax cash inflows ($8,000,000 - $6,500,000 - $500,000) x .6 $600,000

Depreciation tax shield ($1,500,000 ÷ 3) x .4 200,000
Cash inflow $800,000

18. Correct answer c.

1,000,000 200,000 300,000 = 500,000 taxable
500,000 125,000 (taxes @ .25) = 375,000 + 300,000 = 675,000 (add back depreciation)

19. Correct answer b.

Option b is correct. A decrease in the marginal tax rate will lead to a decrease in the present value of
the tax-deductible amount due to depreciation. Recall that the tax shield amount is calculated as
depreciation x tax rate.

20. Correct answer c.

500,000 (500,000 400,000) x .35 = 465,000

21. Correct answer a. Both the operating costs and the required rate of return should be adjusted for
inflation as inflation will as inflation will affect both in the future.

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22. Correct answer c. Regis would include the operating cash inflows plus the tax shield provided by the
depreciation expense. The depreciation expense does not represent a cash transaction and, therefore, is
not included.

23. Correct answer c. Atlantic would include the present value of the depreciation tax shield totaling
$34,840 as shown below.

Annual tax shield $20,000 x .4 $8,000

Present value @10% $8,000 x 4.355 $34,840

24.

Unit price: $80 x .95 = $76 x .95 = $72.20

Labor cost: $20 x 1.05 = $21 x 1.05 = $22.05
Material cost: $30 x 1.1 = $33 x 1.1 = $36.30
Cash inflow: [125,000 x ($72.20 - $22.05 - $36.30) - $300,000] x .6 $ 858,750
Depreciation tax shield: ($2,000,000 ÷ 4) x .4 200,000
Net cash flow for Year 3 $1,058,750

25. -tax cash flow for Year 5 is $78,950 as shown below.

Cash inflow after tax $75,000 x .6 $45,000

Depreciation tax shield ($275,000 x .145) x .4 15,950
Sale of equipment 30,000
Less tax on $30,000 gain @ 40% 12,000
Net cash flow $78,950

26. Correct answer b. A delay would be the most appropriate in this situation as it is the option to wait
and learn before investing (some refer to this as an investment-timing option). A delay option allows
the staging of investments as a series of outlays (i.e. the construction stages of the new energy plant)
creating the option to abandon the project in midstream if new information is unfavorable. Each
investment stage (for instance, for the energy plant the stages might be demolition, excavation,
construction and fit-out) can be viewed as an option on the value of subsequent stages and valued as
a compound option.

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27. Correct answer c. Earnings per share would increase $.13 per share as shown below.

Sales $20,000,000 $22,000,000 (increase 10%)

Contribution (30%) 6,000,000 6,600,000
Less administrative 300,000 300,000
Less commission (10%) 2,000,000 2,200,000
Operating profit 3,600,000 4,000,000
Interest expense 400,000 400,000
Profit before tax 3,200,000 3,600,000
Tax @35% 1,120,000 1,260,000
Net income $ 2,080,000 $ 2,340,000
Earnings per share $1.04 $1.17 (NI ÷ 2,000,000)

28. Correct answer c. Monte Carlo simulation is a quantitative technique that accounts for risk in decision
making by generating a range of outcomes and associated probabilities.

29. Correct answer d. Start with the next available #; 25 multiples for demand of 4 and 10 multiples for
demand of 5.

30. Correct answer c. The purpose of the simulation is not to generate an optimal solution. Rather it allows the
analyst to model the behavior of a system and generates a range of different outcomes.

31. Correct answer b. The net present value method calculates the expected monetary gain or loss from a
project by discounting all expected future cash inflows and outflows to the present point in time.

32.
shown below.

Present value of current cash flow = 10,000 x ($100 - $70) x .6

= $180,000 x 5.216
= $938,880
Present value of reduced cash flow = 10,000 x ($100 - $63) x .6
= $222,000 x 5.216
= $1,157,952
Increase in net present value = $1,157,952 - $938,880
= $219,072

33.

Present value of cash inflows $9,000 x 3.24 = $29,160

Initial investment $29,160 - $3,000 = $26,160

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34.

Year 0 $(550,000)
Year 1 $(500,000) x .877 (438,500)
Year 2 $450,000 x .769 346,050
Year 3 $350,000 x .675 236,250
Year 4 $350,000 x .592 207,200
Year 5 $380,000* x .519 197,220
Net present value $ (1,780)

*Includes $30,000 from sale of old equipment

$50,000 ($50,000 x .4) = $30,000

35. Correct answer a. An investment decision is acceptable if the net present value is equal to or greater
than zero because the return from the decision is equal to or exceeds the cost of capital.

36. Correct answer c. If Verla outsources the work, the net present value of the cash outflows is $454,920
[($200,000 x .6) x 3.791 = $454,920].

37.

Expected annual sales: (80,000 x .1) + (85,000 x .2) + (90,000 x .3) + (95,000 x .2) +
(100,000 x .1) + (110,000 x .1) = 92,000
Annual after-tax cash flow: (92,000 x $5) x .6 = $276,000
Annual depreciation tax shield: ($1,000,000 ÷ 5) x .4 = $80,000
Net present value: = [($276,000 + $80,000) x 3.605] - $1,000,000
= $1,283,380 - $1,000,000
= $283,380

38. Correct answer c. The revised net present value for the tax shield is $283,000 as shown below.

Year 1: [($1,000,000 x .3333) x .4] x .833 $111,056

Year 2: [($1,000,000 x .4445) x .4] x .694 123,379
Year 3: [($1,000,000 x .1481) x .4] x .579 34,300
Year 4: [($1,000,000 x .0741) x .4] x .482 14,286
Net present value (to nearest thousand) $283,000

39. Correct answer a. The ranking of the scenarios from least effect on the net present value to the greatest
effect is R, S, and T as shown below.

R: [($800,000 x .9) x 3.605] - $2,500,000 $95,000

S: ($800,000 x 3.127) - $2,500,000 $1,600
T: ($800,000 x 3.037) - $2,500,000 $(70,400)

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40.

Discounted cash flow = ($6,000 x .893) + ($6,000 x .797) + ($8,000 x .712) + ($8,000 x .636)
= $20,924
Less investment 20,000
$ 924

41.

After-tax cash flow (x .6) $30,000 $30,000 $240,000 $240,000 $240,000

Tax shield ($500,000 ÷ 5) x .4 40,000 40,000 40,000 40,000 40,000
$70,000 $70,000 $280,000 $280,000 $280,000

Net present value = ($70,000 x 1.528) + [$280,000 x (2.991 1.528)] - $500,000

= $106,960 + $409,640 - $500,000
= $16,600 $16,530

42.
until the annual cash flows are $60,000 or higher ($60,000 x 3.433 = $205,980 - $200,000 = $5,980).
As shown, the probability of the cash flows reaching $60,000 or higher is 40%.

43. Correct answer a. Since the projects are mutually exclusive, Staten should accept Project X (higher net
present value) and reject Project Y.

Net present value Project X = ($47,000 x 3.791) - $150,000

= $28,177
Net present value Project Y = ($280,000 x .621) - $150,000
= $23,880

44. cost of capital is 10% and Project A has a higher net present value at
a discount rate of 10%, Mack should recommend Project A. Since the projects are mutually exclusive,
only one can be accepted.

45. Correct answer a. Delaying the cash outflow for a major overhaul from Year 4 to Year 5 will decrease
its present value and result in an increase in the net present value of the project. All of the other options
would result in a decrease the net present value.

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46. Correct answer d.

Building X
Year Annual rent Discount factor Present value
1 ¥450,000 0.909 409,050
2 450,000 0.826 371,700
3 450,000 0.751 337,950
4 450,000 0.683 307,350
Total PV of annual rent Building X 1,426,050

Building Y
Year Annual rent Discount factor Present value
1 650,000 0.909 590,850
2 650,000 0.826 536,900
Total PV of annual rent Building Y 1,127,750

Building Z
Year Annual rent Discount factor Present value
1 615,000 0.909 559,035
2 615,000 0.826 507,990
3 615,000 0.751 461,865
Total PV of annual rent Building Z 1,528,890

47. Correct answer a.

The sensitivity of NPV to a 10% increase in sales volume is computed as follows

Incremental Units 500
Selling Price 1,000
Variable Cost 500
Margin / unit 500
Additional. Margin 250,000
Margin after tax 187,500
PV Factor 5.6502
Increase in NPV 1,059,413

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48. Correct answer d.
At 30%, after tax cash inflow 70,000 x 70% = 49,000
Depreciation deduction 250,000/6 = 41,667 x 30% = 12,500
Total after tax cash inflow 61,500
61,500 x 4.355* = 267,832.50 discounted cash inflows
(250,000) cash outflow
NPV = 17,832.50 project is acceptable
At 40% tax rate, after tax cash inflow 70,000 x 60% = 42,000
Depreciation deduction 250,000/6 = 41,667 x 40% = 16,667
Total after tax cash inflow 58,667
58,667 x 4.355* = 255,494
(250,000) cash outflow
NPV = 5494 project is acceptable
*PV annuity table, 10% 6 years

49. Correct answer b. The internal rate of return method generally indicates that a project whose internal
rate of return is greater than or equal to the firm's cost of capital should be accepted, whereas a
project whose internal rate of return is less than the firm's cost of capital should be rejected.
Accordingly, as the entity has not limit on its investment capital and it's cost of capital is 6% both
Project A with an internal rate of return of 8% and Project C with an internal rate of return of 6%
should be accepted.

50. Correct answer c. The internal rate of return method evaluates investments by comparing the internal
rate of return to the criterion rate of return from the best alternative investment. For this company the
best alternative investment is a 10% external investment. The company should accept all projects over
the 10% threshold, Project B for $10 million and Project D for $2 million, and invest the cash balance
of $3 million, which equals $15 million less $10 million for Project B and less $2 million for Project
D, in the external investment as no other internal project can earn higher than 10%.

51. Correct answer c. The internal rate of return method is easier to understand (interpret) than the net
present value method. All of the other options are disadvantages of the internal rate of return method.

52. Correct answer d. Since the company has already evaluated the cash flows (net present value) of the
project using a hurdle rate of 14%, the next logical step would be to compare the internal rate of return
to the hurdle and the cost of capital.

53. Correct answer c. Hobart would accept the project under both the internal rate of return of 20% which
exceeds the hurdle rate of 15% and the payback period of 2.7 years ($200,000 ÷ $74,000) which is less
-year benchmark.

54. Correct answer c. BGN Industries should select Option Z as it has the highest net present value
($2,825,000 - $2,000,000) and the internal rate of return is greater than the hurdle rate.

55. Correct answer b. The internal rate of return is the discount rate that equates the present value of future
net cash flows from an investment project with pr

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56. Correct answer c. The approximate internal rates of return are 19.5% and 25.5% as shown.

Project A: 77 + 26 = 103; 77 ÷ 103 = .75%; .75% x 2 = 1.5%; 18% + 1.5% = 19.5%

Project B: 30 + 11 = 41; 30 ÷ 41 - .73%: .73% x 2 = 1.5%; 24% + 1.5% = 25.5%

57. Correct answer c. Options a, b, and d are correct as shown below.

NPV Project A: $100,000 ($40,000 x .909) + ($50,000 x .826) + ($60,000 x .751) = $22,720
NPV Project B: $150,000 ($80,000 x .893) + ($70,000 x .797) + ($40,000 x .712) = $19,950
Payback Project A: $100,000 - $40,000 - $50,000 = $10,000 ÷ $65,000 - .167

Payback Project B: $150,000 - $80,000 - $70,000 = 0

Payback = 2 years

58. Correct answer c. The approximate internal rate of return is 9%. A net present value of zero is
approximately half way between $460 and ($440) and 9% is half way between 8% and 10%.

59. Correct answer c. An internal rate of return equates Ben

below.

($6,000 x .877) + ($6,000 x .769) + ($8,000 x .675) + ($8,000 x .592) = $20,012

60. Correct answer b.

Cash savings Cumulative Initial Investment

Savings Recovered at end of year
Year 0 - - $100,000
Year 1 $35,000 $ 35,000 65,000
Year 2 32,000 67,000 33,000
Year 3 28,000 95,000 5,000
Year 4 26,000 121,000 -
Year 5 24,000 145,000 -
Year 6 20,000 165,000 -
Year 7 15,000 180,000 -
Year 8 10,000 190,000 -

Straight- line interpolation after 3 years reveals that the final $ 5,000 needed to recover
the $ 100,000 ( 5 numbers @ $20,000) investment will be achieved halfway through year 4.
Payback period = 3 years + $5,000.
$26,000.
= 3.192 Rounded to 3.2 years.

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61. Correct answer a.
Accept projects with payback less than 4, reject if greater than 4.
Accept projects with NPV greater than 0 and reject if less than 0.
A is reject/accept, B is accept/accept, C is reject/reject, D is accept/accept, so A.

62. Correct answer a.

a. 10,000 x .9091 = $9,091; 20,000 x .8264 = $16,528; 30,000 x .7513 = $22,539; 35,000 9,091
(one year) 16,528 (two years) = 9,381; 9,381/22,539 = .42

63. Correct answer d. Both the internal rate of return method and the net present value method utilize
discounted flow techniques taking into consideration the time value of money. Payback and average rate
of return do not consider the time value of money.

64. Correct answer d. Statements III and IV are correct. Since the company has no capital rationing, all
projects with positive net present values will enhance the value of Molar. Projects with negative internal
rates of return will cost more than they will return to the company and should be rejected.

65. Correct answer a. Since the net present value of the project is negative using a discount rate of 14%, it can
be concluded that the internal rate of return is something less than 14%.

66. Correct answer c. Since the projects are mutually exclusive, Foggy Products can select only one, and the
one selected should have the highest net present value. If both projects exceed the co
for payback period, they should both be rejected.

67. Correct answer a. The payback period does provide some insight into the risk of a project the longer the
payback period, the riskier the project. The other options are either incorrect or disadvantages of the
payback method.

68.

method.

69.

After-tax cash flow Investment less cash flow

Year 1 $60,000 x .6 = $36,000 $104,000
Year 2 $60,000 x .6 = $36,000 68,000
Year 3 $60,000 x .6 = $36,000 32,000
Year 4 $80,000 x .6 = $48,000 $32,000 ÷ $48,000 = .667
Payback period = 3.7 years

70. - $6,000 - $6,000 - $8,000

= 0).

71. Correct answer d. S - $450,000 - $350,000 -

$250,000 = 0).

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