CHAPTER7:CAPITALBUDGETINGDECISIONSPARTI

MultipleChoice

d1.Calculatingthepaybackperiodforacapitalprojectrequiresknowingwhichofthefollowing?
a.Usefullifeoftheproject.
b.Thecompany'sminimumrequiredrateofreturn.
c.Theproject'sNPV.
d.Theproject'sannualcashflow.

c2.Thepaybackcriterionforcapitalinvestmentdecisions
a.isconceptuallysuperiortotheIRRcriterion.
b.takesintoconsiderationthetimevalueofmoney.
c.givesprioritytorapidrecoveryofcash.
d.emphasizesthemostprofitableprojects.

a3.WhichofthefollowingisNOTrelevantincalculatingannualnetcashflowsforaninvestment?
a.Interestpaymentsonfundsborrowedtofinancetheproject.
b.Depreciationonfixedassetspurchasedfortheproject.
c.Theincometaxrate.
d.Lostcontributionmarginifsalesoftheproductinvestedinwillreducesalesofotherproducts.

a4.Ifthepresentvalueofthefuturecashflowsforaninvestmentequalstherequiredinvestment,theIRRis
a.equaltothecutoffrate.
b.equaltothecostofborrowedcapital.
c.equaltozero.
d.lowerthanthecompany'scutoffrateofreturn.

b5.TherelationshipbetweenpaybackperiodandIRRisthat
a.apaybackperiodoflessthanonehalfthelifeofaprojectwillyieldanIRRlowerthanthetarget
rate.
b.thepaybackperiodisthepresentvaluefactorfortheIRR.
c.aprojectwhosepaybackperioddoesnotmeetthecompany'scutoffrateforpaybackwillnotmeetthe
company'scriterionforIRR.
d.noneoftheabove.

c6.WhichofthefollowingeventsismostlikelytoreducetheexpectedNPVofaninvestment?
a.Themajorcompetitorfortheproducttobemanufacturedwiththemachinerybeingconsideredfor
purchasehasbeenrated"unsatisfactory"byaconsumergroup.
b.Theinterestrateonlongtermdebtdeclines.
c.TheincometaxrateisraisedbytheCongress.
d.Congressapprovestheuseoffasterdepreciationthanwaspreviouslyavailable.

a7.IfaninvestmenthasapositiveNPV,
a.itsIRRisgreaterthanthecompany'scostofcapital.
b.costofcapitalexceedsthecutoffrateofreturn.
c.itsIRRislessthanthecompany'scutoffrateofreturn.
d.thecutoffrateofreturnexceedscostofcapital.

c8.WhichofthefollowingdescribestheannualreturnsthatarediscountedindeterminingtheNPVofan
investment?
a.Netincomesexpectedtobeearnedbytheproject.
b.Pretaxcashflowsexpectedfromtheproject.
c.Aftertaxcashflowsexpectedfromtheproject.
d.Aftertaxcashflowsadjustedforthetimevalueofmoney.

b9.WhichofthefollowingcapitalbudgetingmethodsdoesNOTconsiderthetimevalueofmoney?
a.IRR.
b.Bookrateofreturn.
c.Timeadjustedrateofreturn.
d.NPV.

b10.Allotherthingsbeingequal,ascostofcapitalincreases
a.morecapitalprojectswillprobablybeacceptable.
b.fewercapitalprojectswillprobablybeacceptable.
c.thenumberofcapitalprojectsthatareacceptablewillchange,butthedirectionofthechangeisnot
determinablejustbyknowingthedirectionofthechangeincostofcapital.
d.thecompanywillprobablywanttoborrowmoneyratherthanissuestock.

d11.WhichofthefollowingisabasicdifferencebetweentheIRRandthebookrateofreturn(BRR)criteria
forevaluatinginvestments?
a.IRRemphasizesexpensesandBRRemphasizesexpenditures.
b.IRRemphasizesrevenuesandBRRemphasizesreceipts.
c.IRRisusedforinternalinvestmentsandBRRisusedforexternalinvestments.
d.IRRconcentratesonreceiptsandexpendituresandBRRconcentratesonrevenuesandexpenses.

a12.Ifaprojecthasapaybackperiodshorterthanitslife,
a.itsNPVmaybenegative.
b.itsIRRisgreaterthancostofcapital.
c.itwillhaveapositiveNPV.
d.itsincrementalcashflowsmaynotcoveritscost.

c13.Costofcapitalis
a.theamountthecompanymustpayforitsplantassets.
b.thedividendsacompanymustpayonitsequitysecurities.
c.thecostthecompanymustincurtoobtainitscapitalresources.
d.thecostthecompanyischargedbyinvestmentbankerswhohandletheissuanceofequityorlongterm
38
 debtsecurities.

d14.Thenormalmethodsofanalyzinginvestments
a.cannotbeusedbynotforprofitentities.
b.donotapplyiftheprojectwillnotproducerevenues.
c.cannotbeusedifthecompanyplanstofinancetheprojectwithfundsalreadyavailableinternally.
d.requireforecastsofcashflowsexpectedfromtheproject.

a15.WhichofthefollowingisNOTadefectofthepaybackmethod?
a.Itignorescashflowsbecauseitusesnetincome.
b.Itignoresprofitability.
c.Itignoresthepresentvaluesofcashflows.
d.Itignoresthepatternofcashflowsbeyondthepaybackperiod.

b16.Acompanywithcostofcapitalof15%planstofinanceaninvestmentwithdebtthatbears10%interest.
Therateitshouldusetodiscountthecashflowsis
a.10%.
b.15%.
c.25%.
d.someotherrate.

c17.WhichofthefollowingeventswillincreasetheNPVofaninvestmentinvolvinganewproduct?
a.Anincreaseintheincometaxrate.
b.Anincreaseintheexpectedperunitvariablecostoftheproduct.
c.Anincreaseintheexpectedannualunitvolumeoftheproduct.
d.Adecreaseintheexpectedsalvagevalueofequipment.

b18.AninvestmenthasapositiveNPVdiscountingthecashflowsata14%costofcapital.Whichstatementis
true?
a.TheIRRislowerthan14%.
b.TheIRRishigherthan14%.
c.Thepaybackperiodislessthan14years.
d.Thebookrateofreturnis14%.

a19.Thetechniquemostconcernedwithliquidityis
a.payback.
b.NPV.
c.IRR.
d.bookrateofreturn.

d20.ThetechniquethatdoesNOTusecashflowsis
a.payback.
b.NPV.
c.IRR.
d.bookrateofreturn.

a21.Iftherewerenoincometaxes,
a.depreciationwouldbeignoredincapitalbudgeting.
b.theNPVmethodwouldnotwork.
c.incomewouldbediscountedinsteadofcashflow.
d.allpotentialinvestmentswouldbedesirable.

a22.Twonewproducts,XandY,arealikeineverywayexceptthatthesalesofXwillstartlowandrise
throughoutitslife,whilethoseofYwillbethesameeachyear.Totalvolumesovertheirfiveyear
liveswillbethesame,aswillsellingprices,unitvariablecosts,cashfixedcosts,andinvestment.
TheNPVofproductX
a.willbelessthanthatofproductY.
b.willbethesameasthatofproductY.
c.willbegreaterthanthatofproductY.
d.noneoftheabove.

d23.Whichofthefollowingeventsismostlikelytoincreasethenumberofinvestmentsthatmeetacompany's
acceptancecriteria?
a.Topmanagementraisesthetargetrateofreturn.
b.Theinterestrateonlongtermdebtrises.
c.Theincometaxraterises.
d.TheIRSallowscompaniestoexpensepurchasesoffixedassets,insteadofdepreciatingthemovertheir
lives.

d24.InvestmentAhasapaybackperiodof5.4years,investmentBoneof6.7years.Fromthisinformationwe
canconclude
a.thatinvestmentAhasahigherNPVthanB.
b.thatinvestmentAhasahigherIRRthanB.
c.thatinvestmentA'sbookrateofreturnishigherthanB's.
d.noneoftheabove.

d25.InvestmentAhasabookrateofreturnof26%,investmentBoneof18%.Fromthisinformationwecan
conclude
a.thatinvestmentAhasahigherNPVthanB.
b.thatinvestmentAhasahigherIRRthanB.
c.thatinvestmentAhasashorterpaybackperiodthanB.
d.noneoftheabove.

c26.Adollarnowisworthmorethanadollartobereceivedinthefuturebecauseof
a.inflation.
b.uncertainty.
c.theopportunitycostofwaiting.
d.noneoftheabove.
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a27.Incontrasttothepaybackandbookrateofreturnmethods,theNPVandIRRmethods
a.considerthetimevalueofmoney.
b.ignoredepreciation.
c.useaftertaxcashflows.
d.alloftheabove.

a28.Whichofthefollowingisadiscountedcashflowmethod?
a.NPV.
b.Payback.
c.Bookrateofreturn.
d.Alloftheabove.

a29.Whichstatementdescribestherelevanceofdepreciationincalculatingcashflows?
a.Depreciationisrelevantonlywhenincometaxesexist.
b.Depreciationisalwaysrelevant.
c.Depreciationisneverrelevant.
d.Depreciationisrelevantonlywithdiscountedcashflowmethods.

b30.Asthediscountrateincreases
a.presentvaluefactorsincrease.
b.presentvaluefactorsdecrease.
c.presentvaluefactorsremainconstant.
d.itisimpossibletotellwhathappenstothefactors.

a31.Asthelengthofanannuityincreases
a.presentvaluefactorsincrease.
b.presentvaluefactorsdecrease.
c.presentvaluefactorsremainconstant.
d.itisimpossibletotellwhathappenstopresentvaluefactors.

a32.Theonlyfuturecoststhatarerelevanttodecidingwhethertoacceptaninvestmentarethosethatwill
a.bedifferentiftheprojectisacceptedratherthanrejected.
b.besavediftheprojectisacceptedratherthanrejected.
c.bedeductiblefortaxpurposes.
d.affectnetincomeintheperiodthattheyareincurred.

a33.Whichofthefollowingistrueofaninvestment?
a.Thelowerthecostofcapital,thehighertheNPV.
b.Thelowerthecostofcapital,thehighertheIRR.
c.Thelongertheproject'slife,theshorteritspaybackperiod.
d.Thehighertheproject'sNPV,theshorteritslife.

c34.WhichofthefollowingmethodsFAILStodistinguishbetweenreturnofinvestmentandreturnoninvestment?
a.NPV.
b.IRR.
c.Payback.
d.Bookrateofreturn.

c35.IfacompanyisNOTsubjecttoincometax,whichofthefollowingistrueofaproposedinvestment?
a.Theproject'sIRRequalstheentity'scostofcapital.
b.Theproject'sNPViszero.
c.Depreciationonassetsrequiredfortheprojectisirrelevanttotheevaluation.
d.Theexpectedannualincreaseinfuturecashflowsequalstheinvestmentrequiredtoundertakethe
project.

d36.WhichofthefollowingincreasesNPVandIRR?
a.Anupwardrevisioninexpectedannualnetcashflows.
b.Anupwardrevisionofexpectedlife.
c.Anupwardrevisionoftheresidualvalueofthelonglivedassetsbeingacquiredfortheproject.
d.Alloftheabove.

d37.Qualitativeissuescouldincreasetheacceptabilityofaprojectunderwhichofthefollowingconditions?
a.TheIRRislessthanthecompany'scutoffrate.
b.TheprojecthasanegativeNPV.
c.Thepaybackperiodislongerthanthecompany'scutoffperiod.
d.Alloftheabove.

a38.IfCo.XwantstouseIRRtoevaluatelongtermdecisionsandtoestablishacutoffrateofreturn,Xmust
besurethecutoffrateis
a.atleastequaltoitscostofcapital.
b.atleastequaltotherateusedbysimilarcompanies.
c.greaterthantheIRRonprojectsacceptedinthepast.
d.greaterthanthecurrentbookrateofreturn.

a39.WhichofthefollowingisNOTrelevantincalculatingnetcashflowsforProjectN?
a.InterestpaymentsonfundsthatwouldbeborrowedtofinanceProjectN.
b.DepreciationonassetspurchasedforProjectN.
c.ThecontributionmarginthecompanywouldloseifsalesoftheproductintroducedbyProjectNwill
reducesalesofotherproducts.
d.Theincometaxrateapplicabletotheentity.

b40.IftheIRRonaninvestmentiszero,
a.itsNPVispositive.
b.itsannualcashflowsequalitsrequiredinvestment.
c.itisgenerallyawiseinvestment.
d.itscashflowsdecreaseoveritslife.

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d41.Ifdepreciationonanewassetexceedsitssavingsincashoperatingcosts,whichofthefollowingis
true?
a.Theprojectisusuallyunacceptable.
b.Theannualaftertaxcashflowonthenewassetwillbegreaterthanthesavingsincashoperating
costs.
c.TheprojecthasanegativeNPV.
d.Alloftheabove.

d42.Costofcapitalis
a.theinterestrateanentitymustpaytoborrowmoney.
b.thereturnanentity'sstockholdersexpectontheirinvestment.
c.therateofreturntheentitycanearnfrominvestingavailablecash.
d.aconceptofmanagerialfinanceincorporatingalloftheaboveideas.

b43. Aninvestmentopportunitycosting$75,000isexpectedtoyieldnetcashflowsof$23,000annuallyfor
fiveyears.TheNPVoftheinvestmentatacutoffrateof14%wouldbe
a.$(3,959).
b.$3,959.
c.$75,000.
d.$78,959.

b44.Aninvestmentopportunitycosting$55,000isexpectedtoyieldnetcashflowsof$22,000annuallyforfive
years.Thepaybackperiodoftheinvestmentis
a.0.4years.
b.2.5years.
c.$33,000.
d.someothernumber.

c45.Aninvestmentopportunitycosting$180,000isexpectedtoyieldnetcashflowsof$53,000annuallyfor
fiveyears.TheIRRoftheinvestmentisbetween
a.10and12%.
b.12and14%.
c.14and16%.
d.16and18%.

b46. Aninvestmentopportunitycosting$150,000isexpectedtoyieldnetcashflowsof$45,000annuallyfor
fiveyears.Thecostofcapitalis10%.Thebookrateofreturnwouldbe
a.10%.
b.20%.
c.30%.
d.33.3%.

a47. Aninvestmentopportunitycosting$150,000isexpectedtoyieldnetcashflowsof$36,000annuallyfor
sixyears.TheNPVoftheinvestmentatacutoffrateof12%wouldbe
a.$(2,004).
b.$2,004.
c.$150,000.
d.$147,996.

c48.Aninvestmentopportunitycosting$100,000isexpectedtoyieldnetcashflowsof$22,000annuallyfor
sevenyears.Thepaybackperiodoftheinvestmentis
a.0.22years.
b.3.08years.
c.4.55years.
d.someothernumber.

a49.Aninvestmentopportunitycosting$200,000isexpectedtoyieldnetcashflowsof$39,000annuallyfor
eightyears.TheIRRoftheinvestmentisbetween
a.10and12%.
b.12and14%.
c.14and16%.
d.16and18%.

b50. Aninvestmentopportunitycosting$80,000isexpectedtoyieldnetcashflowsof$25,000annuallyfor
fouryears.Thecostofcapitalis10%.Thebookrateofreturnwouldbe
a.10.0%.
b.12.5%.
c.21.3%.
d.32.0%.

TrueFalse

T1.Paybackperiodisthelengthoftimeitwilltakeacompanytorecoupitsoutlayforaninvestment.

T2.Discountedcashflowtechniquesapplytoinvestmentsthatinvolveeithercostsonly,orbothcostsand
revenues.

F3.Costofcapitalistheinterestratethatacompanyexpectstopaytofinanceaparticularcapital
investmentproject.

F4.Thehigherthecostofcapital,thehigherthepresentvalueoffuturecashinflows.

F5.IftheIRRonacapitalprojectispositive,itsNPVwillbepositive.

T6.Salvagevalueisusuallyignoredincomputingthetaxdepreciationonaninvestmentindepreciableassets.

F7.IRRcanbecomputedforevencashflows,butnotforunevencashflows.
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T8.IfIRRislessthanthecostofcapital,theNPVwillbenegative.

F9.IFNPVisnegative,IRRisequaltothecostofcapital.

T10.Paybackemphasizesthereturnoftheinvestmentandignoresthereturnontheinvestment.

Problems

1.Aninvestmentopportunitycosting$180,000isexpectedtoyieldnetcashflowsof$60,000annuallyforfive
years.

a.FindtheNPVoftheinvestmentatacutoffrateof12%.

b.Findthepaybackperiodoftheinvestment.

c.FindtheIRRontheinvestment.

SOLUTION:

a.NPV:$36,300[(3.605x$60,000)$180,000]

b.Paybackperiod:3years($180,000/$60,000)

c.IRR:between18%and20%(3.0isbetween3.127and2.991)

2.Tofteisconsideringthepurchaseofamachine.Dataareasfollows:

Cost$100,000
Usefullife10years
Annualstraightlinedepreciation$10,000
Expectedannualsavingsincash
operationcosts$18,000

Tofte'scutoffrateis12%anditstaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.

b.ComputetheNPVoftheproject.

SOLUTION:

a.Annualnetcashflows:$14,800[$18,000pretax40%x($18,000$10,000depreciation)]

b.NPV:Negative$16,380[($14,800x5.650)$100,000]

3.WillowCompanyisconsideringthepurchaseofamachinewiththefollowingcharacteristics.

Cost$150,000
Estimatedusefullife10years
Expectedannualcashcostsavings$35,000

Marquette'staxrateis40%,itscostofcapitalis12%,anditwillusestraightlinedepreciationforthe
newmachine.

a.Computetheannualaftertaxcashflowsforthisproject.

b.Findthepaybackperiodforthisproject.

SOLUTION:

a.Annualcashflows:$27,000[$35,00040%x($35,000$15,000)]

b.Paybackperiod:5.56years($150,000/$27,000)

4.BiltRiteCo.hastheopportunitytointroduceanewproduct.BiltRiteexpectstheproducttosellfor$60
andtohaveperunitvariablecostsof$40andannualcashfixedcostsof$3,000,000.Expectedannualsales
volumeis250,000units.Theequipmentneededtobringoutthenewproductcosts$5,000,000,hasafour
yearlifeandnosalvagevalue,andwouldbedepreciatedonastraightlinebasis.BiltRite'scostof
capitalis10%anditsincometaxrateis40%.

a.Findtheincreaseinannualaftertaxcashflowsforthisopportunity.

b.Findthepaybackperiodonthisproject.

c.FindtheNPVforthisproject.

SOLUTION:

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a.Increaseinannualcashflows:$1,700,000

Incomebeforetaxes,250,000x($60$40)
$3,000,000$5,000,000/4$750,000
Incometax(300,000)

Netincome$450,000
Plusdepreciation1,250,000

Netcashflow$1,700,000
==========

b.Paybackperiod:2.94years($5,000,000/$1,700,000)
c.NPV:$389,000[($1,700,000x3.170)$5,000,000]
5.Aninvestmentopportunitycosting$600,000isexpectedtoyieldnetcashflowsof$120,000annuallyforten
years.

a.FindtheNPVoftheinvestmentatacutoffrateof12%.

b.Findthepaybackperiodoftheinvestment.

c.FindtheIRRontheinvestment.

SOLUTION:

a.NPV:$78,000[(5.650x$120,000)$600,000]

b.Paybackperiod:5years($600,000/$120,000)

c.IRR:15%(5.0isabouthalfwaybetween5.216and4.833)

6. Scottsohasaninvestmentopportunitycosting$300,000thatisexpectedtoyieldthefollowingcashflows
overthenextsixyears:

YearOne $75,000
YearTwo $90,000
YearThree $115,000
YearFour $130,000
YearFive $100,000
YearSix $90,000

a. Findthepaybackperiodoftheinvestment.

b. Findthebookrateofreturnoftheinvestment.

c. FindtheNPVoftheinvestmentatacutoffrateof10%.

SOLUTION:

a. Paybackperiod:3.15years(75,000+90,000+115,000+.15x130,000)

b. Bookrateofreturn:33.3%

Averagereturn:$100,000($600,000total/6years)
Depreciation:50,000($30,000/6years)

Averageincome$50,000

Averageinvestment:$300,000/2=$150,000

Bookrateofreturn=$50,000/150,000=33.3%

c. NPV:$130,530

Cash Factor PV

1 75,000 .909 68,175
2 90,000 .826 74,340
3 115,000 .751 86,365
4 130,000 .683 88,790
5 100,000 .621 62,100
6 90,000 .564 50,760

430,530
Investment 300,000

NPV 130,530
======

7.Acmeisconsideringthepurchaseofamachine.Dataareasfollows:

Cost$160,000
Usefullife10years
Annualstraightlinedepreciation$???
Expectedannualsavingsincash
43
operationcosts$33,000

Acme'scutoffrateis12%anditstaxrateis40%.
a.Computetheannualnetcashflowsfortheinvestment.

b.ComputetheNPVoftheproject.

c.ComputetheIRRoftheproject.

SOLUTION:

a.Annualnetcashflows:$26,200[$33,000pretax40%x($33,000$16,000depreciation)]

b.NPV:Negative$11,970[($26,200x5.650)$160,000]

c. IRR:between10%and12%[factorof6.107(160,000/26,200)isbetween6.145and5.650]

8. Scottsohasaninvestmentopportunitycosting$180,000thatisexpectedtoyieldthefollowingcashflows
overthenextfiveyears:

YearOne $30,000
YearTwo $60,000
YearThree $90,000
YearFour $60,000
YearFive $30,000

a. Findthepaybackperiodoftheinvestment.

b. Findthebookrateofreturnoftheinvestment.

c. FindtheNPVoftheinvestmentatacutoffrateof12%.

SOLUTION:

a. Paybackperiod:3.0years(30,000+60,000+90,000)

b. Bookrateofreturn:20%

Averagereturn:$54,000($270,000total/5years)
Depreciation:36,000($180,000/5years)

Averageincome$18,000

Averageinvestment:$180,000/2=$90,000

Bookrateofreturn=$18,000/$90,000=20%

c. NPV:$6,930

Cash Factor PV

1 30,000 .893 26,790
2 60,000 .797 47,820
3 90,000 .712 64,080
4 60,000 .636 38,160
5 30,000 .567 17,010

193,860
Investment 180,000

NPV 13,860
======

9.RenoCompanyisconsideringthepurchaseofamachinewiththefollowingcharacteristics.

Cost$160,000
Estimatedusefullife5years
Expectedannualcashcostsavings$56,000
Expectedsalvagevaluenone

Reno'staxrateis40%,itscostofcapitalis12%,anditwillusestraightlinedepreciationforthenew
machine.

a.Computetheannualaftertaxcashflowsforthisproject.

b.Findthepaybackperiodforthisproject.
c.ComputetheNPVforthisproject.

SOLUTION:

a.Annualcashflows:$46,400[$56,00040%x($56,00032,000)]

b.Paybackperiod:3.45years($160,000/$46,400)
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c.NPV:$7,272[($46,400x3.605)$160,000]

10.WhitehallCo.hastheopportunitytointroduceanewproduct.Whitehallexpectstheprojecttosellfor$40
andtohaveperunitvariablecostsof$27andannualcashfixedcostsof$1,500,000.Expectedannualsales
volumeis200,000units.Theequipmentneededtobringoutthenewproductcosts$3,500,000,hasafour
yearlifeandnosalvagevalue,andwouldbedepreciatedonastraightlinebasis.Whitehall'scutoffrate
is10%anditsincometaxrateis40%.

a.Findtheincreaseinannualaftertaxcashflowsforthisopportunity.

b.Findthepaybackperiodonthisproject.

c.FindtheNPVforthisproject.

SOLUTION:

a.Increaseinannualcashflows:$1,100,000

Incomebeforetaxes,[200,000x($40$27)
$1,500,000$3,500,000/4]$225,000
Incometax(90,000)

Netincome$135,000
Plusdepreciation875,000

Netcashflow$1,010,000
==========

b.Paybackperiod:3.47years($3,500,000/$1,010,000)

c.NPV:negative$298,300[($1,010,000x3.170)$3,500,000]

45