Chapter 9—Cash Flow and Capital Budgeting
MULTIPLE CHOICE
1.
Gamma Electronics is considering the purchase of testing equipment that will cost $500,000. The
equipment has a 5-year lifetime with no salvage value. Assume the new machine will generate after-
tax savings of $100,000 per year for the five years.
If the firm has a 15% cost of capital, what is the equivalent annual cost of the equipment?
a.
$32,924
b.
$42,746
c.
$49,158
d.
$37,863
ANS: C
NPV = -500,000 + 100,000/1.15 + 100,000/1.15
2
+ 100,000/1.15
3
+ 100,000/1.15
4
+ 100,000/1.15
5
= -
164,784
Suppose the equivalent annual cost is x, then
x/1.15 + x/1.15
2
+ x/1.15
3
+ x/1.15
4
+ x/1.15
5
= -164,784
x = -49,158
DIF:
M
REF:
9.4 Special Problems in Capital Budgeting
2.
Thompson Manufacturing must choose between two types of furnaces to install. Model A has a 6 year
life, and an NPV of $5,000. Model B has a 5 year life, and an NPV of $4,200. The relevant discount
rate is 12%. Which model should be chosen? What’s the annual cash flow from that model?
a.
Model B; $1,165
b.
Model B; $840
c.
Model A; $833
d.
Model A; $1,216
ANS: D
Suppose the annual annuity of model A is x, and that of model B is y.
x/1.12 + x/1.12
2
+ x/1.12
3
+ x/1.12
4
+ x/1.12
5
+ x/1.12
6
= 5000
x = $1216
y/1.12 + y/1.12
2
+ y/1.12
3
+ y/1.12
4
+ y/1.12
5
= 4200
y = $1165
DIF:
M
REF:
9.4 Special Problems in Capital Budgeting
3.
A firm is evaluating two machines. Both machines meet the firm’s quality standard. Machine A costs
$40,000 initially and $1,000 per year to maintain. Machine B costs $24,000 initially and $2,000 per
year to maintain. Machine A has a 6 year useful life and machine B has a 3 year useful life. Both ma-
chines have zero salvage value. Assume the firm will continue to replace worn-out machines with sim-
ilar machines, and the discount rate is 7%. Which machine should the firm purchase?
a.
Machine A
b.
Machine B
c.
The firm is indifferent to the two machines
d.
Can’t tell from the given information