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Summary

Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected....

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Chapter 14 Capital Budgeting Decisions

True/False 1. F Medium

The present value of a given sum to be received in five years will be exactly twice as great as the present value of an equal sum to be received in ten years.

2. F Medium

An increase in the discount rate will result in an increase in the present value of a given cash flow.

3. T Easy

The present value of a cash flow decreases as it moves further into the future.

4. F Medium

When the net present value method is used, the internal rate of return is the discount rate used to compute the net present value of a project.

5. F Medium

If net present value is negative, then interpolation is needed in order to make a proposed investment acceptable.

6. T Medium

The net present value method assumes that cash flows from a project are immediately reinvested at a rate of return equal to the discount rate.

7. F Easy

When using internal rate of return to evaluate investment projects, if the internal rate of return is less than the required rate of return, the project should be accepted.

8. T Easy

The internal rate of return for a project is the discount rate that makes the net present value of the project equal to zero.

9. T Medium

In comparing two investment alternatives, the difference between the net present values of the two alternatives obtained using the total cost approach will be the same as the net present value obtained using the incremental cost approach.

10. T Easy

The payback period is the length of time it takes for an investment to recoup its own initial cost out of the cash receipts it generates.

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11. F Medium

Projects with shorter payback periods are always more profitable than projects with longer payback periods.

12. F Easy

The payback method of making capital budgeting decisions gives full consideration to the time value of money.

13. F Easy

If new equipment is replacing old equipment, any salvage received from sale of the old equipment should not be considered in computing the payback period of the new equipment.

14. F Easy

One strength of the simple rate of return method is that it takes into account the time value of money in computing the return on an investment project.

15. T Easy

The preference rule for ranking projects by the profitability index is: the higher the profitability index, the more desirable the project.

Multiple Choice 16. C Medium

An a. b. c. d.

17. B Medium

Suppose an investment has cash inflows of R dollars at the end of each year for two years. The present value of these cash inflows using a 12% discount rate will be: a. greater than under a 10% discount rate. b. less than under a 10% discount rate. c. equal to that under a 10% discount rate. d. sometimes greater than under a 10% discount rate and sometimes less; it depends on R.

18. B Medium CPA adapted

The net present value and internal rate of return methods of capital budgeting are superior to the payback method in that they: a. are easier to implement. b. consider the time value of money. c. require less input. d. reflect the effects of depreciation and income taxes.

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increase in the discount rate: will increase the present value of future cash flows. will have no effect on net present value. will reduce the present value of future cash flows. is one method of compensating for reduced risk.

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19. C Medium CPA adapted

How are the following used in the calculation of the net present value of a proposed project? Ignore income tax considerations.

a. b. c. d.

Depreciation expense Include Include Exclude Exclude

Salvage value Include Exclude Include Exclude

20. D Medium CPA adapted

The net present value method takes into account:

21. C Easy CMA adapted

The net present value method of capital budgeting assumes that cash flows are reinvested at: a. the internal rate of return on the project. b. the rate of return on the company's debt. c. the discount rate used in the analysis. d. a zero rate of return.

22. C Medium

Some investment projects require that a company expand its working capital to service the greater volume of business that will be generated. Under the net present value method, the investment of working capital should be treated as: a. an initial cash outflow for which no discounting is necessary. b. a future cash inflow for which discounting is necessary. c. both an initial cash outflow for which no discounting is necessary and a future cash inflow for which discounting is necessary. d. irrelevant to the net present value analysis.

23. A Medium CMA adapted

(Ignore income taxes in this problem.) How is depreciation handled by the following capital budgeting techniques?

a. b. c. d.

a. b. c. d.

Cash Flow Over Life of Project No No Yes Yes

Internal Rate of Return Excluded Included Excluded Included

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Time Value of Money Yes No No Yes

Simple Rate of Return Included Excluded Excluded Included

Payback Excluded Included Included Excluded

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24. B Easy CPA adapted

Which of the following capital budgeting techniques consider(s) cash flow over the entire life of the project?

25. C Medium CMA adapted

A weakness of the internal rate of return method for screening investment projects is that it: a. does not consider the time value of money. b. implicitly assumes that the company is able to reinvest cash flows from the project at the company's discount rate. c. implicitly assumes that the company is able to reinvest cash flows from the project at the internal rate of return. d. does not take into account all of the cash flows from a project.

26. A Medium

If the net present value of a project is zero based on a discount rate of sixteen percent, then the time-adjusted rate of return: a. is equal to sixteen percent. b. is less than sixteen percent. c. is greater than sixteen percent. d. cannot be determined from the information given.

27. A Easy CMA adapted

The payback method measures: a. how quickly investment dollars may be recovered. b. the cash flow from an investment. c. the economic life of an investment. d. the profitability of an investment.

28. B Medium

An investment project that requires a present investment of $210,000 will have cash inflows of "R" dollars each year for the next five years. The project will terminate in five years. Consider the following statements (ignore income tax considerations):

a. b. c. d.

Internal rate of return Yes Yes No No

Payback Yes No Yes No

I. If "R" is less than $42,000, the payback period exceeds the life of the project. II. If "R" is greater than $42,000, the payback period exceeds the life of the project. III. If "R" equals $42,000, the payback period equals the life of the project. Which statement(s) is (are) true? a. Only I and II. b. Only I and III. c. Only II and III. d. I, II, and III.

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29. A Easy CMA adapted

Which one of the following statements about the payback method of capital budgeting is correct? a. The payback method does not consider the time value of money. b. The payback method considers cash flows after the payback has been reached. c. The payback method uses discounted cash flow techniques. d. The payback method will lead to the same decision as other methods of capital budgeting.

30. B Medium

The evaluation of an investment having uneven cash flows using the payback method: a. cannot be done. b. can be done only by matching cash inflows and investment outflows on a year-by-year basis. c. will product essentially the same results as those obtained through the use of discounted cash flow techniques. d. requires the use of a sophisticated calculator or computer software.

31. B Medium CMA adapted

The capital budgeting method that divides a project's annual incremental net income by the initial investment is the: a. internal rate of return method. b. the simple ( or accounting) rate of return method. c. the payback method. d. the net present value method.

32. B Medium CMA adapted

When determining a net present value in an inflationary environment, adjustments should be made to: a. decrease the discount rate only. b. increase the estimated cash flows and increase the discount rate. c. increase the estimated cash flows only. d. increase the estimated cash flows and decrease the discount rate.

33. B Hard CPA adapted

(Ignore income taxes in this problem.) Kipling Company has invested in a project that has an eight-year life. It is expected that the annual cash inflow from the project will be $20,000. Assuming that the project has a internal rate of return of 12%, how much was the initial investment in the project? a. $160,000 b. $99,360 c. $80,800 d. $64,640

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34. D Medium

(Ignore income taxes in this problem.) White Company's required rate of return on capital budgeting projects is 12%. The company is considering an investment opportunity which would yield a cash flow of $10,000 in five years. What is the most that the company should be willing to invest in this project? a. $36,050. b. $2,774. c. $17,637. d. $5,670.

35. C Easy

(Ignore income taxes in this problem.) In order to receive $12,000 at the end of three years and $10,000 at the end of five years, how much must be invested now if you can earn 14% rate of return? a. $12,978. b. $8,100. c. $13,290. d. $32,054.

36. C Hard

(Ignore income taxes in this problem.) Sue Falls is the president of Sports, Inc. She is considering buying a new machine that would cost $14,125. Sue has determined that the new machine promises a internal rate of return of 12%, but Sue has misplaced the paper which tells the annual cost savings promised by the new machine. She does remember that the machine has a projected life of 10 years. Based on these data, the annual cost savings are: a. it is impossible to determine from the data given. b. $1,412.50. c. $2,500.00. d. $1,695.00.

37. C Hard

(Ignore income taxes in this problem.) The following information is available on a new piece of equipment: Cost of the equipment ...... Annual cash inflows ........ Internal rate of return ... Required rate of return ...

$21,720 $5,000 16% 10%

The life of the equipment is approximately: a. 6 years. b. 4.3 years. c. 8 years. d. it is impossible to determine from the data given.

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38. C Hard CPA adapted

(Ignore income taxes in this problem.) A planned factory expansion project has an estimated initial cost of $800,000. Using a discount rate of 20%, the present value of future cost savings from the expansion is $843,000. To yield exactly a 20% internal rate of return, the actual investment cost cannot exceed the $800,000 estimate by more than: a. $160,000. b. $20,000. c. $43,000. d. $1,075.

39. D Hard CPA adapted

(Ignore income taxes in this problem.) Hilltop Company invested $100,000 in a two-year project. The cash flow was $40,000 for the first year. Assuming that the internal rate of return was exactly 12%, what was the cash flow for the second year of the project? a. $51,247. b. $60,000. c. $64,284. d. $80,652.

40. C Hard

(Ignore income taxes in this problem.) Joe Flubup is the president of Flubup, Inc. He is considering buying a new machine that would cost $25,470. Joe has determined that the new machine promises a internal rate of return of 14%, but Joe has misplaced the paper which tells the annual cost savings promised by the new machine. He does remember that the machine has a projected life of 12 years. Based on these data, the annual cost savings are: a. impossible to determine from the data given. b. $2,122.50. c. $4,500.00. d. $4,650.00.

41. B Hard

(Ignore income taxes in this problem.) The Baker Company purchased a piece of equipment with the following expected results: Useful life ................... 7 years Yearly net cash inflow ........ $50,000 Salvage value ................. -0Internal rate of return ....... 20% Discount rate ................. 16% The initial cost of the equipment was: a. $300,100. b. $180,250 c. $190,600. d. Cannot be determined from the information given.

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42. B Hard

(Ignore income taxes in this problem.) Highpoint, Inc., is considering investing in automated equipment with a ten-year useful life. Managers at Highpoint have estimated the cash flows associated with the tangible costs and benefits of automation, but have been unable to estimate the cash flows associated with the intangible benefits. Using the company's 10% discount rate, the net present value of the cash flows associated with just the tangible costs and benefits is a negative $184,350. How large would the annual net cash inflows from the intangible benefits have to be to make this a financially acceptable investment? a. $18,435. b. $30,000. c. $35,000. d. $37,236.

43. B Hard

(Ignore income taxes in this problem.) Given the following data: Present investment required .. $12,000 Net present value ............ $ 430 Annual cost savings .......... $ ? Discount rate ................ 12% Life of the project .......... 10 years Based on the data given, the annual cost savings would be: a. $1,630.00. b. $2,200.00. c. $2,123.89. d. $2,553.89.

44. A Medium

(Ignore income taxes in this problem.) The following data pertain to an investment in equipment: Investment in the project .......... Net annual cash inflows ............ Working capital required ........... Salvage value of the equipment ..... Life of the project ................

$10,000 2,400 5,000 1,000 8 years

At the completion of the project, the working capital will be released for use elsewhere. Compute the net present value of the project, using a discount rate of 10%: a. $606. b. $8,271. c. ($1,729). d. $1,729.

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45. A Medium

(Ignore income taxes in this problem.) A piece of equipment has a cost of $20,000. The equipment will provide cost savings of $3,500 each year for ten years, after which time it will have a salvage value of $2,500. If the company's discount rate is 12%, the equipment's net present value is: a. $580. b. ($225). c. $17,500. d. $2,275.

46. D Medium

(Ignore income taxes in this problem.) Parks Company is considering an investment proposal in which a working capital investment of $10,000 would be required. The investment would provide cash inflows of $2,000 per year for six years. The working capital would be released for use elsewhere when the project is completed. If the company's discount rate is 10%, the investment's net present value is: a. $1,290. b. ($1,290). c. $2,000. d. $4,350.

47. A Medium

(Ignore income taxes in this problem.) The following data pertain to an investment proposal: Investment in the project (equipment) .. $14,000 Net annual cash inflows promised ....... 2,800 Working capital required ............... 5,000 Salvage value of the equipment ......... 1,000 Life of the project .................... 10 years The working capital would be released for use elsewhere when the project is completed. What is the net present value of the project, using a discount rate of 8%? a. $2,566. b. ($251). c. $251. d. $5,251.

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48. C Medium

(Ignore income taxes in this problem.) Boston Company is contemplating the purchase of a new machine on which the following information has been gathered: Cost of the machine ............... Annual cash inflows expected ...... Salvage value ..................... Life of the machine ...............

$38,900 $10,000 $ 5,000 6 years

The company's discount rate is 16%, and the machine will be depreciated using the straight-line method. Given these data, the machine has a net present value of: a. -$26,100. b. -$23,900. c. $0. d. +$26,100. 49. B Hard

(Ignore income taxes in this problem.) Benz Company is considering the purchase of a machine that costs $100,000 and has a useful life of 18 years. The company's required discount rate is 12%. If the machine's net present value is $5,850, then the annual cash inflows associated with the machine must be (round to the nearest whole dollar): a. $42,413. b. $14,600. c. $13,760. d. it is impossible to determine from the data given.

50. C Hard CPA adapted

(Ignore income taxes in this problem.) Horn Corporation is considering investing in a four-year project. Cash inflows from the project are expected to be as follows: Year 1, $2,000; Year 2, $2,200; Year 3, $2,400; Year 4, $2,600. If using a discount rate of 8%, the project has a positive net present value of $500, what was the amount of the original investment? a. $1,411. b. $2,411. c. $7,054. d. $8,054.

51. B Medium

(Ignore income taxes in this problem.) The Whitton Company uses a discount rate of 16%. The company has an opportunity to buy a machine now for $18,000 that will yield cash inflows of $10,000 per year for each of the next three years. The machine would have no salvage value. The net present value of this machine to the nearest whole dollar is: a. $22,460. b. $4,460. c. $(9,980). d. $12,000.

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52. D Medium

(Ignore income taxes in this problem.) The following data pertain to an investment: Cost of the investment ........ Life of the project ........... Annual cost savings ........... Estimated salvage value ....... Discount rate .................

$18,955 5 years $ 5,000 $ 1,000 10%

The net present value of the proposed investment is: a. $3,355. b. ($3,430). c. $-0-. d. $621. 53. D Medium

(Ignore income taxes in this problem.) The following data pertain to an investment proposal: Cost of the investment .......... Annual cost savings ............. Estimated salvage value ......... Life of the project ............. Discount rate ...................

$20,000 $ 5,000 $ 1,000 8 years 16%

The net present value of the proposed investment is: a. $1,720. b. $6,064. c. $2,154. d. $2,025. 54. C Hard

(Ignore income taxes in this problem.) Stratford Company purchased a machine with an estimated useful life of seven years. The machine will generate cash inflows of $90,000 each year over the next seven years. If the machine has no salvage value at the end of seven years, and assuming the company's discount rate is 10%, what is the purchase price of the machine if the net present value of the investment is $170,000? a. $221,950. b. $170,000. c. $268,120. d. $438,120.

55. C Medium

(Ignore income taxes in this problem.) Sam Weller is thinking of investing $70,000 to start a bookstore. Sam plans to withdraw $15,000 from the business at the end of each year for the next five years. At the end of the fifth year, Sam plans to sell the business for $110,000 cash. At a 12% discount rate, what is the net present value of the investmen...