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Corporate Finance: The Core, 5e (Berk/DeMarzo) Chapter 8 Fundamentals of Capital Budgeting 8.1 Forecasting Earnings 1) Which of the following statements is FALSE? A) A capital budget lists the projects and investments that a company plans to undertake during the coming year. B) Income Tax = EBIT × (1 - τc). C) When sales of a new product displace sales of an existing product, the situation is often referred to as cannibalization. D) Overhead expenses are often allocated to the different business activities for accounting purposes. Answer: B Explanation: Unlevered net income = EBIT × (1 - τc). Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual

2) Which of the following statements is FALSE? A) Sales will ultimately decline as the product nears obsolescence or faces increased competition. B) Managers sometimes continue to invest in a project that has a negative NPV because they have already invested a large amount in the project and feel that by not continuing it, the prior investment will be wasted. C) With straight-line depreciation the asset's cost is divided equally over its life. D) A project's unlevered net income is equal to its incremental revenues less costs and depreciation, evaluated on a pre-tax basis. Answer: D Explanation: A project's unlevered net income is equal to its incremental revenues less costs and depreciation, evaluated on an after-tax basis. Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual

3) Which of the following statements is FALSE? A) We begin the capital budgeting process by determining the incremental earnings of a project. B) The marginal corporate tax rate is the tax rate the firm will pay on an incremental dollar of pre-tax income. C) Investments in plant, property, and equipment are directly listed as expenses when calculating earnings. D) The opportunity cost of using a resource is the value it could have provided in its best alternative use. Answer: C Explanation: Investments in plant, property, and equipment are not directly listed as expenses when calculating earnings. Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual

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4) Which of the following statements is FALSE? A) When evaluating a capital budgeting decision, the correct tax rate to use is the firm's average corporate tax rate. B) To determine the capital budget, firms analyze alternative projects and decide which ones to accept through a process called capital budgeting. C) A new product typically has lower sales initially, as customers gradually become aware of the product. D) Sunk costs have been or will be paid regardless of the decision whether or not to proceed with the project. Answer: A Explanation: When evaluating a capital budgeting decision, the correct tax rate to use is the firm's marginal corporate tax rate. Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

5) 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: Sunk costs are NOT incremental with respect to the current decision regarding the project and should NOT be included in its analysis. Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

6) Which of the following statements is FALSE? A) The firm deducts a fraction of the investments in plant, property, and equipment each year as depreciation. B) If securities are fairly priced, the net present value of a fixed set of cash flows is independent of how those cash flows are financed. C) Sunk cost fallacy is a term used to describe the tendency of people to ignore sunk costs in capital budgeting analysis. D) A good rule to remember is that if our decision does not affect a cash flow then the cash flow should not affect our decision. Answer: C Explanation: Sunk cost fallacy is a term used to describe the tendency of people to be influenced by sunk costs and to "throw good money after bad" because they have already invested a large amount in the project and feel that by not continuing it, the prior investment will be wasted. Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

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7) Which of the following statements is FALSE? A) The ultimate goal in capital budgeting is to determine the effect on the firm's cash flows of the decision to take a particular project.. B) To the extent that overhead costs are fixed and will be incurred in any case, they are incremental to the project and should be included in the capital budgeting analysis. C) Unlevered Net Income = (Revenue - Costs - Depreciation) × (1 - τc). D) Earnings are not cash flows. Answer: B Explanation: To the extent that overhead costs are fixed and will be incurred in any case, they are NOT incremental to the project and should NOT be included in the capital budgeting analysis. Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

8) Which of the following statements is FALSE? A) Project externalities are direct effects of the project that may increase or decrease the profits of the business activities of other firms. B) Incremental earnings are the amount by which the firm's earnings are expected to change as a result of the investment decision. C) The average selling price of a product and its cost of production will generally change over time. D) Any money that has already been spent is a sunk cost and therefore irrelevant in the capital budgeting process. Answer: A Explanation: Project externalities are cash flows that occur when a project affects other areas of the company's business. Diff: 3 Section: 8.1 Forecasting Earnings Skill: Conceptual

9) Which of the following statements is FALSE? A) Many projects use a resource that the company already owns. B) When evaluating a capital budgeting decision, we generally include interest expense. C) Only include as incremental expenses in your capital budgeting analysis the additional overhead expenses that arise because of the decision to take on the project. D) As a practical matter, to derive the forecasted cash flows of a project, financial managers often begin by forecasting earnings. Answer: B Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

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10) Which of the following statements is FALSE? A) A simple method often used to calculate depreciation is the straight-line method. B) A sunk cost is any unrecoverable cost for which the firm is already liable. C) Unlevered Net Income = EBIT × τc. D) The decision to continue or abandon a project should be based only on the incremental costs and benefits of the project going forward. Answer: C Explanation: Unlevered net income = EBIT × (1 - τc). Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual

11) 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 Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual

12) A decrease in the sales of a current project because of the launching of a new project is called: A) cannibalization. B) a sunk cost. C) an overhead expense. D) an irrelevant aspect of the investment decision. Answer: A Diff: 1 Section: 8.1 Forecasting Earnings Skill: Definition

13) 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 Diff: 1 Section: 8.1 Forecasting Earnings Skill: Definition

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14) 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 Diff: 1 Section: 8.1 Forecasting Earnings Skill: Definition

Use the information for the question(s) below. Ford Motor Company is considering launching a new line of Plug-in Electric SUVs. The heavy advertising expenses associated with the new SUV launch would generate operating losses of $35 million next year. Without the new SUV, Ford expects to earn pre-tax income of $80 million from operations next year. Ford pays a 21% tax rate on its pre-tax income. 15) The amount that Ford Motor Company will owe in taxes next year without the launch of the new SUV is closest to: A) $16.8 million. B) $56.0 million. C) $31.5 million. D) $9.45 million. Answer: A Explanation: = $80 million × .21 = $16.8 million Diff: 1 Section: 8.1 Forecasting Earnings Skill: Analytical

16) The amount that Ford Motor Company will owe in taxes next year with the launch of the new SUV is closest to: A) $9.45 million. B) $31.5 million. C) $56.0 million. D) $24.0 million. Answer: A Explanation: = ($80 million - $35 million) × .21 = $9.45 million Diff: 1 Section: 8.1 Forecasting Earnings Skill: Analytical

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Use the information for the question(s) below. Food For Less (FFL), a grocery store, is considering offering one hour photo developing in their store. The firm expects that sales from the new one-hour machine will be $150,000 per year. FFL currently offers overnight film processing with annual sales of $100,000. While many of the one-hour photo sales will be to new customers, FFL estimates that 60% of their current overnight photo customers will switch and use the one-hour service. 17) The level of incremental sales associated with introducing the new one-hour photo service is closest to: A) $90,000. B) $150,000. C) $60,000. D) $120,000. Answer: A Explanation: = $150,000 - (cannibalized sales) = $150,000 - .60 × $100,000 = $90,000 Diff: 2 Section: 8.1 Forecasting Earnings Skill: Analytical

18) Suppose that of the 60% of FFL's 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. Answer: D Explanation: = $150,000 - (cannibalized sales) = $150,000 - (.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 Section: 8.1 Forecasting Earnings Skill: Analytical

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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. 19) 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 firm's 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: 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 Diff: 2 Section: 8.1 Forecasting Earnings Skill: Analytical

20) 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 firm's EBIT is closest to: A) a decline of $1.5 million. B) a decline of $0.7 million. C) an increase of $0.7 million. D) an increase of $1.5 million. Answer: C Explanation: 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 Diff: 3 Section: 8.1 Forecasting Earnings Skill: Analytical

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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 2000 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 manufacturing cost 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 21% tax bracket, and has a cost of capital of 10%. 21) The incremental EBIT in the first year for the Sisyphean Corporation's project is closest to: A) $18,000. B) $8000. C) $11,700. D) $5200. Answer: B Explanation: Incremental Earnings Forecast ($) 3 Year 1 2 Units 2000 2200 2420 Sales (units × $18) 36,000 39,600 43,560 Cost of Goods 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 8000 9800 11,780 Income Tax at 21% 1680 2058 2474 Unlevered Net Income

6320

7742

9306

Diff: 3 Section: 8.1 Forecasting Earnings Skill: Analytical

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22) The incremental unlevered net income in the first year for the Sisyphean Corporation's project is closest to: A) $8000. B) $18,000. C) $6320. D) $11,700. Answer: C Explanation: Incremental Earnings Forecast ($) 3 Year 1 2 Units 2000 2200 2420 Sales (units × $18) 36,000 39,600 43,560 Cost of Goods 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 8000 9800 11,780 Income Tax at 21% 1680 2058 2474 Unlevered Net Income 6320 7742 9306 Diff: 3 Section: 8.1 Forecasting Earnings Skill: Analytical

23) The depreciation tax shield for the Sisyphean Corporation's project in the first year is closest to: A) $8000. B) $2100. C) $2800. D) $5200. Answer: B Explanation: Depreciation tax shield = depreciation × τc = ($30,000/3) × .21 = $2100 Diff: 2 Section: 8.1 Forecasting Earnings Skill: Analytical

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24) The amount of incremental income taxes that the Sisyphean Company will pay in the first year on this new project is closest to: A) $6300. B) $5200. C) $3500. D) $1680. Answer: D Explanation: Incremental Earnings Forecast ($) 3 Year 1 2 Units 2000 2200 2420 Sales (units × $18) 36,000 39,600 43,560 Cost of Goods 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 8000 9800 11,780 Income Tax at 21% 1680 2058 2474 Unlevered Net Income 6320 7742 9306 Diff: 2 Section: 8.1 Forecasting Earnings Skill: Analytical

25) What is a sunk cost? Should it be included in the incremental cash flows for a project? Why or why not? Answer: A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs will have to be paid regardless of the decision whether or not to proceed with the project. Therefore, sunk costs are not incremental with respect to the current decision regarding the project and should not be included in its analysis. Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

26) What is an opportunity cost? Should it be included in the incremental cash flows for a project? Why or why not? Answer: Many projects use resources that the company already owns. An opportunity cost is the cost of using a resource that otherwise could have provided value to the firm. The opportunity cost of using a resource is the value it could have provided in its best alternative use. Because this value is lost when a resource is used by another project, we should always include the opportunity cost as an incremental cost of the project. Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

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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 2000 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 manufacturing cost of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 21% tax bracket, and has a cost of capital of 10%. 27) Construct a simple income statement showing the incremental EBIT and the incremental unlevered net income for all three years of the Sisyphean Corporation's project. Answer: Incremental Earnings Forecast ($) 3 Year 1 2 Units 2000 2200 2420 Sales (units × $18) 36,000 39,600 43,560 Cost of Goods 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 8000 9800 11,780 Income Tax at 21% Unlevered et income

1680 6320

2058 7742

2474 9306

Diff: 3 Section: 8.1 Forecasting Earnings Skill: Analytical

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8.2 Determining Free Cash Flow and NPV 1) Which of the following statements is FALSE? A) Depreciation is not a cash expense paid by the firm. B) Net Working Capital = Cash + Inventory + Payables - Receivables. C) Prior to 2018, companies could "carry back" losses for two years and "carry forward" losses for 20 years. D) Earnings do not represent real profits. Answer: B Explanation: Net Working Capital = Cash + Inventory + Receivables - Payables. Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Conceptual

2) Which of the following questions is FALSE? A) Net Working Capital = Current Assets - Current Liabilities. B) Because depreciation is not a cash flow, we do not include it in the cash flow forecast. C) Tax loss carrybacks allow corporations to take losses during the current year and use them to offset income in future years. D) Ea...