Which of the following statements is CORRECT?
a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
b. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered regardless of whether the project is accepted or rejected.
c. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
d. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the PV.
A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?
a. In calculating the project's operating cash flows, the firm should notdeduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, “double count” it.
b. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.
c. When estimating the project’s operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.
d. Capital budgeting decisions should be based on before-taxcash flows.
Clemson Software is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow? Show work.
Equipment cost (depreciable basis) $80,000
Straight-line depreciation rate 33.333%
Sales revenues, each year $70,000
Operating costs (excl. deprec.) $40,000
Tax rate 35%
a. $29,916.66 b. $28.666.56 c. $27,575.55 d. $28,833.24
| Q1. | |||||||||
| Answer is b. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered | |||||||||
| regardless of whether the project is accepted or rejected. | |||||||||
| Q2. | |||||||||
| Answer is a. In calculating, the project operating cash flows, the firm should not deduct financing cost such | |||||||||
| as interst expense, because financing cost are accounted for by discounting at the WACC. If interest were | |||||||||
| deducted when estimating cash flows, this would in effect double count it. | |||||||||
| Q3. | |||||||||
| Answer is d. $ 28833.24 | |||||||||
| Explanation: | |||||||||
| Annual revenue | 70000 | ||||||||
| Less: Annual expense | 40000 | ||||||||
| Less: Deprecication | 26667 | ||||||||
| Net icnome before tax | 3333 | ||||||||
| Less: Tax @ 35% | 1167 | ||||||||
| Net incnome after tax | 2166 | ||||||||
| Add: Depreciation | 26667 | ||||||||
| Annual cash inflow of Yr-1 | 28833 | ||||||||
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