# The depreciation tax shields

Fin 325, 10/1/2020                                                   QUIZ 2—in class version

30 pts. total

You will get this quiz paper back.  Please insert your note page(s) behind this page when done.  You MUST enter all your responses in writing (below) AND electronically in your iClicker.  (Remember to scroll forward to the next question, after entering each response.)

True/False (2 points for each question, 6 questions, 12 points total)

Indicate whether the sentence or statement is true (write “T” below) or false (“F”).  Choose “A” on your iClicker for True responses and “B” for False responses.

1. Longer duration bonds will, all else equal, have lower volatility than shorter duration bonds.

1. In terms of analyzing capital budget methods, the payback method is inferior to the IRR method.

1. The correlation of the returns on a risk-free asset with the returns on ANY other asset will equal zero.

1. Based on the prices given in column B, the formula in cell C3 (displayed below) correctly calculates the return.

1. Consider team North’s situation in the Beacon simulation in the Beta product market (from a different class than yours).  Here are two elements of the Lost/Bonus order reports for North:

North would have earned lower profits had it reduced its marketing expenditure in Year 6.

1. Consider the NPV profile graph below for two projects, Project F and Project G.

Project F has a higher IRR however Project G has a higher NPV than Project F at low discount rates.

Multiple Choice (3 points for each question, 6 questions, 18 points total)

Identify the letter of the choice that best completes the statement or answers the question.  For numerical problems, choose the response closest to the number you calculate.

1. Capital equipment costing \$550,000 today has salvage value of \$50,000 at the end of 10 years. If straight line depreciation is used, what is the book value of the equipment at the end of year 7?

 a. \$200,000 d. \$125,000 b. \$175,000 e. \$100,000 c. \$150,000

1. Capital equipment costing \$550,000 today has salvage value of \$50,000 at the end of 10 years.  The marginal corporate tax rate is 21%.

What is the present value of all 10 years’ worth of the depreciation tax shields?  Assume straight-line depreciation and a discount rate of 10%.  (Also assume that the firm is very profitable and can use the full amount of each tax shield in each period, i.e. don’t assume any tax-loss carryforwards.)

 a. \$100,000 d. \$25,000 b. \$75,000 e. \$10,000 c. \$50,000

1. The following chart shows risk versus return graphs for 5-different portfolio scenarios.  Each of the 5 graphs displays risk vs. return for a two stock portfolio.  There is one graph for each of five different values of the correlation coefficient.  The five correlations are (in no particular order): 0.0, +0.5, -0.5, +1.0, and -1.0.  Which correlation corresponds to the graph labeled “D”?  (Note that the graph for curve “A” is not displayed perfectly as it should intercept the y-axis.)

 a. 0 d. +1.0 b. 0.5 e. -0.5 c. -1

1. Consider two local banks. Bank A has 100 loans outstanding, each for \$1.0 million, that it expects will be repaid today. Each loan has a 5% probability of default, in which case the bank is not repaid anything. The chance of default is independent across all the loans. Bank B has only one loan of \$100 million outstanding, which it also expects will be repaid today. It also has a 5% probability of not being repaid. Which bank faces less risk? Why?

 a. The expected payoff is higher for Bank A, but is riskier. I prefer Bank B. c. The expected payoffs are the same, but Bank A is less risky. I prefer Bank A. b. The expected payoffs are the same, but Bank A is riskier. I prefer Bank B. d. In both cases the expected loan payoff is the same: \$100 million×0.95=\$95.0 million. Consequently, I don’t care which bank I own.

1. Consider the New Heritage Doll Company case and the two projects under consideration. Which of the following risks is a systematic risk (also known as “non-diversifiable risk”)?
 a. The technical infrastructure required to create the Design Your Own Doll collection may fail. d. High fixed costs, for either project, could lead to very poor sales (and thus negative profits) in the event the economy enters a recession. b. The Match My Doll Collection project may be overpriced and cause NHDC to miss its marketing opportunity. e. All of the risks listed here are systematic risks. c. One of the key managers, for either project, could leave the company for a better job elsewhere, thus damaging the project’s performance.

1. Here are results from the Beacon simulation for the Chi market for Year 7.

Find the Chi unit cost for team West.  Given that the Chi variable cost is \$30,000 per unit, find the overhead cost per unit.  What % of the selling price for team West is the overhead cost per unit?

 a. 11% d. 14% b. 12% e. 15% c. 13%

Finance 325, Fa 20, Quiz 2

TRUE/FALSE

1. ANS:   F

A given change in interest rates will have a greater impact on a longer maturity security.

PTS:    1

1. ANS:   T

IRR is better than payback.

PTS:    1

1. ANS:   T

If the return is truly risk-free, then its return does not change at all and therefore covaries with nothing.

PTS:    1

1. ANS:   T

The percentage change is “(New – Old)/Old”, if you like to remember it that way.

PTS:    1

1. ANS:   F

They spent money on Marketing getting Bonus orders that they couldn’t fill anyway (see the Lost Orders on Beta).  They’d have made higher profits had they spent less in marketing.

PTS:    1

1. ANS:   T

The IRR rule would say to choose Project F as it has a higher IRR.  However, at low discount rates, anyone choosing Project F would be making a mistake as Project G has higher NPV at lower discount rates.

PTS:    1

MULTIPLE CHOICE

1. ANS:   A

Depreciate \$500K over 10 years, or \$50K/year.  7 years depreciation is \$350K, thus book value is 550K – 350K = 200K.

PTS:    1

1. ANS:   B

Depreciate \$500K over 10 years, or \$50K/year.  There is a tax benefit of depreciation of 21% of \$50K, or \$10,500, each year for 10 years.

The present value of the tax shield is a 10-year annuity at 10%

PV = (\$10.5/0.10)(1 – 1/1.10^10) = \$64.5K

[Note that this problem assumes that the asset is depreciated for tax purposes over 10 years.  Current law (2020) allows for immediate expensing, which amounts to straight-line depreciation over 1 year, if you want to think about it that way.  However, the current law is very likely to change over the next few years.

PTS:    1

1. ANS:   B

With a coefficient of -1, the portfolio standard deviation can get as low as 0.  The graphs are:

A..rho equals -1.0

B..rho equals -0.5

C..rho equals  0.0

D..rho equals 0.5

E..rho equals +1.0

PTS:    1

1. ANS:   C                     PTS:    1

1. ANS:   D

A diversified investor cannot diversify the risk of a bad economy.  It’s likely to affect most of the stocks in his/her portfolio.

On the other hand, if a diversified investor owns shares in 500 companies, certainly some of those firms will run into various technical, personnel, and pricing problems.  But all 500 firms won’t simultaneously run into such problems, i.e. these are firm-specific, diversifiable risks.

PTS:    1

1. ANS:   C

You are given a price of \$110K and 319 units sold, thus revenue is \$110K(319) = \$35.09M.  Given that you have the Gross Profit for West, COGS total is therefore \$35,090,000 – \$20,820,004 = \$14,269,996 which works out to \$44,734 per unit.  Overhead is therefore \$44,734-\$30K = \$14,734 per unit of 14.734/110 = 13.4%.

Notice that the contribution margin is high for Chi, \$110K – \$30K of variable cost, or \$80K per unit.  When doing an analysis of whether it’s worth it to obtain more sales, you should focus on the incremental sales margin from each additional sale, or \$80K per unit.

PTS:    1

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