MEM Engineering Economics 5 — Questions and Answers
Question 1: The modified benefit-cost ratio (BCR) differs from the conventional BCR in that it:
- Uses the IRR instead of the MARR as the discount rate
- Subtracts disbenefits from the numerator rather than adding them to the denominator (Correct answer)
- Excludes initial capital costs from the analysis
- Applies only to government projects costing over $1 million
Correct answer: Subtracts disbenefits from the numerator rather than adding them to the denominator
The modified BCR places disbenefits in the numerator (subtracted from benefits) rather than the denominator (added to costs), which can produce a different ratio value.
Question 2: A real option in capital budgeting gives a firm the right, but not the obligation, to take a future business action. Which of the following is an example of an 'option to abandon'?
- Investing in a pilot plant before committing to full-scale production
- Shutting down a project and selling assets if market conditions deteriorate (Correct answer)
- Delaying a project until regulatory uncertainty is resolved
- Expanding production capacity when demand exceeds forecasts
Correct answer: Shutting down a project and selling assets if market conditions deteriorate
The option to abandon allows management to discontinue a project and recover salvage value if the project performs poorly, limiting downside risk.
Question 3: Which of the following correctly describes the relationship between risk and required return for engineering projects?
- Higher-risk projects require a lower MARR to compensate investors
- Higher-risk projects require a higher MARR to compensate investors (Correct answer)
- Risk has no systematic effect on the appropriate discount rate
- The MARR is set by regulation and is independent of project risk
Correct answer: Higher-risk projects require a higher MARR to compensate investors
Investors require a risk premium for bearing uncertainty; therefore, riskier projects must earn a higher rate of return (higher MARR) to be acceptable.
Question 4: A $200,000 piece of equipment is classified as 5-year MACRS property. Using the MACRS half-year convention, the first-year depreciation rate is 20%. What is the depreciation deduction in year 1?
- $20,000
- $40,000 (Correct answer)
- $33,333
- $26,667
Correct answer: $40,000
Year 1 MACRS deduction = $200,000 × 20% = $40,000, applying the prescribed IRS first-year percentage for 5-year property.
Question 5: Which of the following best describes 'working capital' in the context of an engineering project's cash flow analysis?
- The initial capital expenditure for equipment and facilities
- Funds tied up in inventory, receivables, and other current assets minus current liabilities (Correct answer)
- Annual operating and maintenance costs over the project life
- The depreciation tax shield generated by the project
Correct answer: Funds tied up in inventory, receivables, and other current assets minus current liabilities
Working capital is the net current assets (current assets minus current liabilities) required to support day-to-day operations, treated as a cash outflow at project start and recovered at project end.
Question 6: A project's after-tax cash flow can be approximated as ATCF = BTCF − taxes. If BTCF = $100,000, depreciation = $20,000, and the tax rate is 30%, what is the ATCF?
- $70,000
- $76,000 (Correct answer)
- $80,000
- $84,000
Correct answer: $76,000
Taxable income = BTCF − depreciation = $80,000; taxes = $80,000 × 0.30 = $24,000; ATCF = $100,000 − $24,000 = $76,000.
Question 7: The weighted average cost of capital (WACC) is used in engineering economics as the MARR when:
- A project is financed entirely by equity
- A project uses a mix of debt and equity financing in proportions typical of the firm (Correct answer)
- The firm has no debt and relies solely on retained earnings
- Government grants cover more than 50% of project costs
Correct answer: A project uses a mix of debt and equity financing in proportions typical of the firm
WACC reflects the blended cost of all capital sources weighted by their proportion in the firm's capital structure, making it the appropriate MARR for projects funded with the firm's typical financing mix.
MEM Engineering Economics 5
The modified benefit-cost ratio (BCR) differs from the conventional BCR in that it: