School of Banking and Finance

FINS5514 Capital Budgeting and Financing Decisions

Multiple Choice Questions

1. You need a metal cutting machine for your operations. Your current machine is worn out so you are
trying to decide which one of two machines to buy as a replacement. Whichever machine you
purchase will likewise be replaced after its useful life. Machine A costs $389,000 and costs $20,000 a
year to operate over a 4- year life. Machine B costs $220,000 and costs $26,000 to operate over a 2-
year life. Given this information, which one of the following statements is correct if the applicable
discount rate is 12 percent?
a. Machine A reduces the annual cost by about $185,806 compared to machine B.
b. Machine B reduces the annual cost by $15,617 compared to machine A.
c. The equivalent annual cost of machine A is -$148,072.
d. The equivalent annual cost of machine B is -$263,941.

2. You just purchased some new equipment costing $967,400. The equipment is classified as 5- year
property for MACRS. What is the book value of the equipment at the end of year 2?

MACRS 5-year property

Year Rate

1 20.00%

2 32.00%

3 19.20%

4 11.52%

5 11.52%

6 5.76%

a. $372,640
b. $464,352
c. $526,266
d. $773,920
3. A cost cutting project:
a. if accepted, generally has positive operating cash flows.
b. always has an initial cash outflow equal to zero.
c. should be accepted if the net present value is negative.
d. lowers the net income of a firm.

4. Martha is managing a project that has a degree of operating leverage equal to 2.1. How will the
operating cash flows change if the quantity sold decreases by 4 percent?
a. decrease by 8.4 percent
b. decrease by 1.9 percent
c. increase by 1.9 percent
d. increase by 8.4 percent

5. You are considering the purchase of some equipment that you plan to depreciate using straight-line
depreciation to a zero book value over 7 years. The cost will be $313,000. What is the value of the
annual depreciation tax shield if the tax rate is 35 percent?
a. $15,650
b. $16,050
c. $29,064
d. $44,714

6. Baker and Sons is trying to ascertain what the selling price of a new product should be if the project
is to break-even on an accounting basis at a quantity of 1,500 units. The projections include fixed costs
of $3,295, variable costs per unit of $16.92, and a depreciation expense of $1,100. What is the price
they should charge?
a. $19.12
b. $19.31
c. $19.62
d. $19.85

Short Answer Questions

7. You are analyzing a proposed 3-year project. You expect to sell 12,000 units per year at an average
selling price of $14.99 per unit. The initial cash outlay for fixed assets will be $78,000. These assets
will be depreciated straight-line to a zero book value over the life of the project. Fixed costs are
expected to be $61,234 and variable costs should be $5.89 per unit. What is the expected operating
cash flow if the tax rate is 34 percent?
Use this information to answer questions 8 through 11.

The Sable Co. is considering the introduction of a new product. Company management has prepared the
following estimates related to the project as well as the related range of values, where applicable.
Sales quantity 4,000 ± 10 percent;
Fixed costs $12,000 ± 2 percent
Sales price $12.00 ± 4 percent;
Depreciation $2,500
Variable cost per unit $7.00 ± 3 percent;
Tax rate 34 percent

8. What are the total sales under the best case scenario?

9. What is the projected base case net income? (Round to the nearest whole dollar)

10. What is the projected best case earnings before interest and taxes? (To the nearest whole dollar)

11. What is the projected worst case operating cash flow? (Round to the nearest whole dollar)

12. A firm is considering a new three-year expansion project. That needs an initial fixed asset investment
of $2.7 million. The fixed asset will depreciate straight-line to zero over its three year life. The project
is estimated to generate $2,080,000 in annual sales with costs of $775,000. If the tax rate is 35%, what
is the OCF for this project?

13. Evaluating two different machines. Techron I costs $240,000, has a three-year life and pre-tax
operating costs of $63,000 per year. Techron II costs $420,000, has a five-year life and pre-tax
operating costs of $36,000 per year. Both machines have straight line depreciation to zero over the
project’s life and a salvage value of $40,000. Tax rate is 35% and the discount rate is 10%. Calculate
the EAC for both machines. Which is preferable? Why?

14. At an output level of 73,000 units, the DOL is 2.90. If output rises to 78,000 units, what will the
percentage change in operating cash flow be? Will the new level be higher or lower? Explain.

15. Considering a new product. Project costs $1,400,000, has a four year life, and no salvage value;
depreciation is straight-line to zero. Sales are 180 units per year; price per unit is $16,000; variable
costs are $9,800 per unit; fixed costs are $430,000 per year. Required return is 12% and the tax rate
is 35%.
a. Projections for unit sales, variable cost and fixed costs are accurate to +- 10%. What are the upper
and lower bounds of the projections? Base-case NPV? Best and worst case scenarios?
b. Evaluate the sensitivity of the base-case NPV to changes in fixed costs
c. What is the cash break-even level of output for this project (ignoring taxes)?
d. What is the accounting break-even level of output for this project? What is the DOL at the
accounting break-even point? Interpret.