Capital-Budgeting CPAR PDF

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CPA REVIEW SCHOOL OF THE PHILIPPINES Manila MANAGEMENT ADVISORY SERVICES CAPITAL BUDGETING THEORY 1. Capital budgeting techniques are least likely to be used in evaluating the A. Acquisition of new aircraft a cargo company. B. Design and implementation of a major advertising program. C. Trade for a ...

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CPA REVIEW SCHOOL OF THE PHILIPPINES Manila MANAGEMENT ADVISORY SERVICES CAPITAL BUDGETING

THEORY 1. Capital budgeting techniques are least likely to be used in evaluating the A. Acquisition of new aircraft by a cargo company. B. Design and implementation of a major advertising program. C. Trade for a star quarterback by a football team. D. Adoption of a new method of allocating non-traceable costs to product lines. 2. The “inflation element” refers to the A. Impact that future price increases will have on the original cost of a capital expenditure. B. Fact that the real purchasing power of a monetary unit usually increases over time. C. Future deterioration of the general purchasing power of the monetary unit. D. Future increases in the general purchasing power of the monetary unit. 3. Mahlin Movers, Inc. is planning to purchase equipment to make its operations more efficient. This equipment has an estimated useful life of six years. As part of this acquisition, a P150,000 investment in working capital is required. In a discounted cash flow analysis, this investment in working capital should be A. Amortized over the useful life of the equipment. B. Disregarded because no cash is involved. C. Treated as a recurring annual cash flow that is recovered at the end of six years. D. Treated as an immediate cash outflow that is recovered at the end of six years. 4. To approximate annual cash inflow, depreciation is A. Added back to net income because it is an inflow of cash. B. Subtracted from net income because it is an outflow of cash. C. Subtracted from net income because it is an expense. D. Added back to net income because it is not an outflow of cash. 5. In capital expenditures decisions, the following are relevant in estimating operating costs except A. Future costs. B. Cash costs. C. Differential costs. D. Historical costs. 6. Which of the following best identifies the reason for using probabilities in capital budgeting is A. Different life of projects. C. Uncertainty. B. Cost of capital. D. Time value of money. 7. In capital budgeting decisions, the following items are considered among others: 1. Cash outflow for the investment. 2. Increase in working capital requirements. 3. Profit on sale of old asset 4. Loss on write-off of old asset. For which of the above items would taxes be relevant? A. Items 1 and 3 only. C. All items. B. Items 3 and 4 only. D. Items 1, 3 and 4 only. 8. Your company is purchasing a transport equipment as part of its territorial expansion strategy. The technical services department indicated that this equipment needs overhauling in year 4 or year 5 of its useful life. The overhauling cost will be expected during the year the

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overhauling is done. The finance officer insists that the overhauling be done in year 4, not in year 5. The most likely reason is A. There is lower tax rate in year 5. C. The time value of money is considered. B. There is higher tax rate in year 5 D. Due statements A and C above. 9. An optimal capital budget is determined by the point where the marginal cost of capital is A. Minimized. B. Equal to the average cost of capital. C. Equal to the rate of return on total assets. D. Equal to the marginal rate of return on investment. 10. The following statements refer to the accounting rate of return (ARR) 1. The ARR is based on the accrual basis, not cash basis. 2. The ARR does not consider the time value of money. 3. The profitability of the project is considered. From the above statements, which are considered limitations of the ARR concept? A. Statements 2 and 3 only. C. All the 3 statements. B. Statements 3 and 1 only. D. Statements 1 and 2 only. 11. The payback method assumes that all cash inflows are reinvested to yield a return equal to A. the discount rate. C. the internal rate of return. B. the hurdle rate. D. zero. 12. As a capital budgeting technique, the payback period considers depreciation expenses (DE) and time value of money (TVM) as follows: A. B. C. D. DE relevant irrelevant Irrelevant relevant TVM relevant irrelevant Relevant irrelevant 13. The bailout payback period is A. The payback period used by firms with government insured loans. B. The length of time for payback using cash flows plus the salvage value to recover the original investment C. (a) and (b) D. None of the above. 14. Which of the following methods measures the cash flows and outflows of a project as if they occurred at a single point in time? A. Cash flow based payback period. C. Payback method. B. Capital budgeting. D. Discounted cash flow. 15. When using one of the discounted-cash-flow methods to evaluate the feasibility of a capital budgeting project, which of the following factors generally is not important? A. The method of financing the project under consideration. B. The impact of the project on income taxes to be paid. C. The timing of cash flows relating to the project. D. The amount of cash flows relating to the project. 16. In an investment in plant the return that should keep the market price of the firm stock unchanged is A. Payback C. Net present value B. Discounted rate of return D. Cost of capital 17. The excess present value method is anchored on the theory that the future returns, expressed in terms of present value, must at least be A. Equal to the amount of investment C. More than the amount of investment B. Less than the amount of investment D. Cannot be determined

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18. A company had made the decision to finance next year’s capital projects through debt rather than additional equity. The benchmark cost of capital for these projects should be A. The before-tax cost of new-debt financing. C. The cost of equity financing. B. The after-tax cost of new-debt financing. D. The weighted-average cost of capital. 19. All of the following refer to the discount rate used by a firm in capital budgeting except A. Hurdle rate. C. Opportunity cost. B. Required rate of return. D. Opportunity cost of capital. 20. If a firm identifies (or creates) an investment opportunity with a present value its cost, the value of the firm and the price of its common stock will A. B. C. D. List A Greater than Greater than Equal to Equal to List B Increase Decrease Increase Decrease 21. The common assumption in capital budgeting analysis is that cash inflows occur in lump sums at the end of individual years during the life of an investment project when in fact they flow more or less continuously during those years A. Results in understated estimates of NPV. B. Is done because present value tables for continuous flows cannot be constructed. C. Will result in inconsistent errors being made on estimating NPVs such that project cannot be evaluated reliably. D. Results in higher estimate for the IRR on the investment. 22. An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method A. Computes a desired rate of return for capital projects. B. Can be used when there is no constant rate of return required for each year of the project. C. Uses a discount rate that equates the discounted cash inflows with the outflows. D. Uses discounted cash flows whereas the internal rate of return model does not. 23. When using the net present value method for capital budgeting analysis, the required rate of return is called all of the following except the A. Risk-free rate. B. Cost of capital. C. Discount rate. D. Cutoff rate. 24. A project’s net present value, ignoring income tax considerations, is normally affected by the A. Proceeds from the sale of the asset to be replaced. B. Carrying amount of the asset to be replaced by the project. C. Amount of annual depreciation on the asset to be replaced. D. Amount of annual depreciation on fixed assets used directly on the project. 25. You have determined the profitability of a planned project by finding the present value of all the cash flows from that project. Which of the following would cause the project to look less appealing, that is, have a lower present value? A. The discount rate increases. B. The cash flows are extended over a longer period of time. C. The investment cost decreases without affecting the expected income and life of the project. D. The cash flows are accelerated and the project life is correspondingly shortened. 26. How are the following used in the calculation of the internal rate of return of a proposed project? Ignore income tax considerations. A. B. C. D. Residual sales value of project Exclude Include Exclude Include Depreciation expense Include Include Exclude Exclude

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27. The discount rate that equates the present value of the expected cash flows with the cost of the investment is the A. Net present value C. Accounting rate of return B. Internal rate of return D. Payback period. 28. Which of the following characteristics represent an advantage of the internal rate of return techniques over the accounting rate of return technique in evaluating a project? I Recognition of the project’s salvage value. II Emphasis on cash flows. III Recognition of the time value of money. A. I only. B. I and II. C. II and III. D. I, II, and III. 2 9 .Po l oCo .r e q u i r e sh i g h e rr a t e so fr e t u r nf o rp r o j e c t swi t hal i f es p a ng r e a t e rt h a n5y e a r s .Pr o j e c t se x t e n d i n g b e y o n d5y e a r smu s te a r nah i g h e rs p e c i fi e dr a t eo fr e t u r n .Wh i c ho f t h ef o l l o wi n gc a p i t a l b u d g e t i n gt e c h n i q u e s c a nr e a d i l ya c c o mmo d a t et h i sr e q u i r e me n t ?

Internal Rate of Return Net Present Value

A. Yes No

B. No Yes

30. Which of the following combinations is NOT possible? Profitability Index NPV A. Greater than 1 Positive B. Equals 1 Zero C. Less than 1 Negative D. Less than 1 Positive

C. No No

D. Yes Yes

IRR More than cost of capital Equals cost of capital Less than cost of capital Less than cost of capital

31. Which of the following is always true with regard to the net present value (NPV) approach? A. If a project is found to be acceptable under the NPV approach, it would also be acceptable under the internal rate of return (IRR) approach. B. The NPV and the IRR approaches will always rank projects in the same order. C. If a project is found to be acceptable under the NPV approach, it would also be acceptable under the payback approach. D. The NPV and payback approaches will always rank projects in the same order. 32. When ranking two mutually exclusive investments with different initial amounts, management should give first priority to the project A. That generates cash flows for the longer period of time. B. Whose net after-tax flows equal the initial investment. C. That has the greater accounting rate of return. D. That has the greater profitability index. 33. Which mutually exclusive project would you select, if both are priced at $1,000 and your discount rate is 15%; Project A with three annual cash flows of $1,000, or Project B, with 3 years of zero cash flow followed by 3 years of $1,500 annually? A. Project A. B. Project B. C. The IRRs are equal, hence you are indifferent. D. The NPVs are equal, hence you are indifferent. 3 4 .Pa y b a c kp e r i o d( PP) , p r o fi t a b i l i t yi n d e x( PI ) , a n ds i mp l ea c c o u n t i n gr a t eo f r e t u r n( SARR)a r es o meo f t h ec a p i t a l b u d g e t i n gt e c h n i q u e s .Wh a t i st h ee ff e c t o f a ni n c r e a s ei nt h ec o s t o f c a p i t a l o nt h e s et e c h n i q u e s ?

PP PI SARR

A. Increase Decrease Increase

B. No change Decrease No change

C. No change Increase Decrease

D. Decrease No change No change

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3 5 .Ac o mp a n yi se v a l u a t i n gt h r e ep o s s i b l ei n v e s t me n t s .I n f o r ma t i o nr e l a t i n gt ot h ec o mp a n ya n dt h ei n v e s t me n t s f o l l o w:

Fisher rate for the three projects 7% Cost of capital 8% Based on this information, we know that A. all three projects are acceptable. B. none of the projects are acceptable. C. the capital budgeting evaluation techniques profitability index, net present value, and internal rate of return will provide a consistent ranking of the projects. D. the net present value method will provide a ranking of the projects that is superior to the ranking obtained using the internal rate of return method. 36. Several proposed capital projects which are economically acceptable may have to be ranked due to constraints in financial resources. In ranking these projects, the least pertinent is this statement. A. If the internal rate of return method is used in the capital rationing problem, the higher the rate, the better the project. B. In selecting the required rate of return, one may either calculate the organization’s cost of capital or use a rate generally acceptable in the industry. C. A ranking procedure on the basis of quantitative criteria may be established by specifying a minimum desired rate of return, which rate is used in calculating the net present value of each project. D. If the net present value method is used, the profitability index is calculated to rank the projects. The lower the index, the better the project. 37. Capital budgeting methods are often divided into two classifications: project screening and project ranking. Which one of the following is considered a ranking method rather than a screening method? A. Net present value. C. Profitability index. B. Time-adjusted rate of return. D. Accounting rate of return. 38. A company has analyzed seven new projects, each of which has its own internal rate of return. It should consider each project whose internal rate of return is _____ its marginal cost of capital and accept those projects in _____ order of their internal rate of return. A. Below; decreasing. C. Above; increasing. B. Above; decreasing. D. Below; increasing. 39. Velasquez & Co. is considering an investment proposal for P10 million yielding a net present value of P450,000. The project has a life of 7 years with salvage value of P200,000. The company uses a discount rate of 12%. Which of the following would decrease the net present value? A. Extend the project life and associated cash inflows. B. Increase discount rate to 15%. C. Decrease the initial investment amount to P9.0 million. D. Increase the salvage value. 40. What is the effect of changes in cash inflows, investment cost and cash outflows on profitability (present value) index (PI) A. PI will increase with an increase in cash inflows, a decrease in investment cost, or a decrease in cash outflows. B. PI will increase with an increase in cash inflows, an increase in investment cost, or an increase in cash outflows. C. PI will decrease with an increase in cash inflows, a decrease in investment cost, or a decrease in cash outflows. D. PI will decrease with an increase in cash outflows, an increase in investment cost, or an increase in cash inflows.

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PROBLEMS 1. Acme is considering the sale of a machine with a book value of $80,000 and 3 years remaining in its useful life. Straight-line depreciation of $25,000 annually is available. The machine has a current market value of $100,000. What is the cash flow from selling the machine if the tax rate 40%. A. $25,000 B. $80,000 C. $92,000 D. $100,000 2 Hatchet Company is considering replacing a machine with a book value of $400,000, a remaining useful life of 5 years, and annual straight-line depreciation of $80,000. The existing machine has a current market value of $400,000. The replacement machine would cost $550,000, have a 5-year life, and save $75,000 per year in cash operating costs. If the replacement machine would be depreciated using the straight-line method and the tax rate is 40%, what would be the net investment required to replace the existing machine? A. $90,000. B. $150,000 C. $330,000 D. $550,000 3. Diliman Republic Publishers, Inc. is considering replacing an old press that cost P800,000 six years ago with a new one that would cost P2,250,000. Shipping and installation would cost an additional P200,000. The old press has a book value of P150,000 and could be sold currently for P50,000. The increased production of the new press would increase inventories by P40,000, accounts receivable by P160,000 and accounts payable by P140,000. Diliman Republic’s net initial investment for analyzing the acquisition of the new press assuming a 35% income tax rate would be A. P2,450,000 B. P2,425,000 C. P2,600,000 D. P2,250,000 4. Key Corp. plans to replace a production machine that was acquired several years ago. Acquisition cost is P450,000 with salvage value of P50,000. The machine being considered is worth P800,000 and the supplier is willing to accept the old machine at a trade-in value of P60,000. Should the company decide not to acquire the new machine, it needs to repair the old one at a cost of P200,000. Tax-wise, the trade-in transaction will not have any implication but the cost to repair is tax-deductible. The effective corporate tax rate is 35% of net income subject to tax. For purposes of capital budgeting, the net investment in the new machine is A. P540,000 B. P610,000 C. P660,000 D. P800,000 5. Great Value Company is planning to purchase a new machine costing P50,000 with freight and installation costs amounting to P1,500. The old unit is to be traded-in will be given a trade-in allowance of P7,500. Other assets that are to be retired as a result of the acquisition of the new machine can be salvaged and sold for P3,000. The loss on retirement of these other assets is P1,000 which will reduce income taxes of P400. If the new equipment is not purchased, repair of the old unit will have to be made at an estimated cost of P4,000. This cost can be avoided by purchasing the new equipment. Additional gross working capital of P12,000 will be needed to support operation planned with the new equipment. The net investment assigned to the new machine for decision analysis is A. P50,200 B. P52,600 C. P53,600 D. P57,600 6. Hooker Oak Furniture Company is considering the purchase of wood cutting equipment. Data on the equipment are as follows: Original investment $30,000 Net annual cash inflow $12,000 Expected economic life in years 5 Salvage value at the end of five years $3,000 The company uses the straight-line method of depreciation with no mid-year convention. What is the accounting rate of return on original investment rounded off to the nearest percent, assuming no taxes are paid? A. 40.0% B. 20.0% C. 24.0% D. 22.0% 7. A company is considering putting up P50,000 in a three-year project. The company’s

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expected rate of return is 12%. The present value of P1.00 at 12% for one year is 0.893, for two years is 0.797, and for three years is 0.712. The cash flow, net of income taxes will be P18,000 (present value of P16,074) for the first year and P22,000 (present value of P17,534) for the second year. Assuming that the rate of return is exactly 12%, the cash flow, net of income taxes, for the third year would be A. P7,120 B. P10,000 C. P16,392 D. P23,022 8. Lor Industries is analyzing a capital investment proposal for new machinery to produce a new product over the next ten years. At the end of the ten years, the machinery must be disposed of with a zero net book value but with a scrap salvage value of P20,000. It will require some P30,000 to remove the machinery. The applicable tax rate is 35%. The appropriate “end-of-life” cash flow based on the foregoing information is A. Inflow of P30,000. C. Outflow of P10,000. B. Outflow of P6,500. D. Outflow of P17,000. 9. C Corp. faces a marginal tax rate of 35 percent. One project that is currently under evaluation has a cash flow in the fourth year of its life that has a present value of $10,000 (after-tax). C Corp. assumes that all cash flows occur at the end of the year and the company uses 11 percent as its discount rate. What is the pre-tax amount of the cash flow in year 4? (Round to the nearest dollar.) A. $15,181 B. $23,356 C. $9,8...