CPFM Capital Budgeting Decisions 3 — Questions and Answers
Question 1: An asset costs $80,000 and is depreciated straight-line over 4 years to zero. The annual depreciation tax shield at a 25% tax rate is:
- $20,000
- $5,000 (Correct answer)
- $15,000
- $80,000
Correct answer: $5,000
Depreciation = $20,000/year; tax shield = $20,000 x 0.25 = $5,000.
Question 2: In computing incremental cash flow, an increase in net working capital is treated as:
- A cash inflow at the start
- A cash outflow at the start (Correct answer)
- Ignored entirely
- A non-cash expense
Correct answer: A cash outflow at the start
Increased working capital ties up cash, so it is an outflow at project initiation.
Question 3: The discount rate that makes a project's NPV equal to zero is the:
- Cost of capital
- Internal rate of return (Correct answer)
- Payback rate
- Accounting rate of return
Correct answer: Internal rate of return
By definition, the IRR is the rate at which NPV equals zero.
Question 4: Projects with non-conventional cash flows (sign changes more than once) may have:
- No NPV
- Multiple IRRs (Correct answer)
- Zero payback
- A guaranteed positive NPV
Correct answer: Multiple IRRs
Multiple sign changes in cash flows can produce more than one IRR solution.
Question 5: Terminal (salvage) value received at the end of a project should be:
- Ignored
- Added as an after-tax inflow in the final year (Correct answer)
- Subtracted from the initial outlay
- Depreciated annually
Correct answer: Added as an after-tax inflow in the final year
Salvage proceeds, net of tax effects, are an inflow in the final year of analysis.
Question 6: Which approach is best for comparing projects with unequal lives?
- Payback period
- Equivalent annual annuity (Correct answer)
- Simple IRR comparison
- Accounting rate of return
Correct answer: Equivalent annual annuity
The equivalent annual annuity converts NPVs to a comparable annual basis across different lifespans.
Question 7: Opportunity costs in capital budgeting should be:
- Ignored because no cash changes hands
- Included as a relevant cost of the project (Correct answer)
- Treated as a sunk cost
- Added to NPV
Correct answer: Included as a relevant cost of the project
Forgone benefits from the next-best use of a resource are relevant and must be included.
CPFM Capital Budgeting Decisions 3
An asset costs $80,000 and is depreciated straight-line over 4 years to zero.
The annual depreciation tax shield at a 25% tax rate is: