Ch9 | Test Bank – – Capital Budgeting Process And Decision - Corporate Finance Asia Pacific 2e Complete Test Bank by Chris Adam. DOCX document preview.
Chapter 9 – Capital budgeting process and decision criteria
MULTIPLE CHOICE
1. The preferred technique for evaluating most capital investments is:
a. | the payback period |
b. | the discount payback period |
c. | the internal rate of return |
d. | the net present value |
REF: 9.1 Introduction to Capital Budgeting NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
Use the following information to answer questions 2 to 6.
Gamma Electronics is considering the purchase of testing equipment that will cost $300 000 to replace old equipment. Assume the new machine will generate after-tax savings of $100 000 per year over the next five years.
2. Refer to Gamma Electronics. What is the payback period for the investment?
a. | 1.8 years |
b. | 2.0 years |
c. | 3.0 years |
d. | 2.8 years |
The investment requires $300 000. In its first three years, this investment generates $300 000.
PTS: 1 DIF: E
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
3. Refer to Gamma Electronics. If the company has a 15% cost of capital, what is the discount payback period of the investment?
a. | 1.5 years |
b. | 3.0 years |
c. | 3.4 years |
d. | 3.7 years |
Present value
PV of year 1 = 100 000/1.10 = 90 909
PV of year 2 = 100 000/1.102 = 82 644
PV of year 3 = 100 000/1.103 = 75 131
PV of year 4 = 100 000/1.104 = 68 301
By the end of year 4, the project produces a cumulative cash flow that is greater than $300 000. Thus, the project earns back the initial $300 000 at some point during the fourth year.
(300 000 – 90 909 – 82 644)/75 131 = 126 447/75 131 = 1.683
The discount payback period is 3.7 years.
PTS: 1 DIF: M
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
4. If Gamma Electronics has a 10% cost of capital, what is the NPV of the investment?
a. | $213 745 |
b. | $185 865 |
c. | $79 079 |
d. | $300 000 |
NPV = -300 000 + 100 000/1.10 + 100 000/1.102 + 100 000/1.103 + 100 000/1.104 + 100 000/1.105
NPV = 16 985
PTS: 1 DIF: E
REF: 9.4 Net Present Value NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
5. If Gamma Electronics has a 15% cost of capital, what is the IRR of the investment?
a. | 23.4% |
b. | 19.8% |
c. | 34.9% |
d. | 100.0% |
Let r represent the IRR of the investment.
–300 000 + 100 000/(1+ r) + 100 000/(1 + r)2 + 100 000/(1 + r)3 + 100 000/(1 + r)4 +100 000/(1+r)5 = 0
r = 0.198 = 19.8%
PTS: 1 DIF: E
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
6. If Gamma Electronics has a 15% cost of capital, what is the profitability index of the investment?
a. | 1.4 |
b. | 0.4 |
c. | 2.0 |
d. | 1.26 |
Profitability index = (100 000/1.10 + 100 000/1.102 + 100 000/1.103 + 100 000/1.104 + 100 000/1.105)/300 000
Profitability index = 379 077/300 000 = 1.26
PTS: 1 DIF: E
REF: 9.6 Profitability Index NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
Use the following information to answer questions 7 to 9.
The cash flows associated with an investment project are as follows:
CF | |
Initial outflow | –$65 000 |
Year 1 | $20 000 |
Year 2 | $30 000 |
Year 3 | $30 000 |
Year 4 | $30 000 |
7. Refer to Exhibit 9-1. What is the payback period of the project? If a company’s cutoff payback period is three years, should it accept or reject the project?
a. | 2.5 years; reject |
b. | 2.5 years; accept |
c. | 3.6 years; reject |
d. | 3.6 years; accept |
By the end of year 3, the project produces a cumulative cash flow of $80 000. Thus, the project earns back the initial $70 000 at some point during the third year.
(65 000 – 20 000 – 30 000)/30 000 = 0.5
The project’s payback period is 2.5 years.
The company should invest in the project.
PTS: 1 DIF: E
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
8. Refer to Exhibit 9-1. If a company uses discounted payback with a 15% discount rate and a three-year cutoff period, what is the discount payback period of the project? Should the company accept or reject the project?
a. | 3.3 years; reject |
b. | 3.6 years; reject |
c. | 3.6 years; accept |
d. | 2.7 years; accept |
Cumulative PV at end of year 3 = 20 000/1.15 + 30 000/1.152 + 30 000/1.153
Cumulative PV at end of year 3 = 59 801
Cumulative PV at end of year 4 = 20 000/1.15 + 30 000/1.152 + 30 000/1.153 + 30 000/1.154
Cumulative PV at end of year 4 = 76 954
By the end of year 4, the project produces a cumulative discounted cash flow of $76 954. Thus, the project earns back the initial $65 000 at some point during the fourth year.
(65 000 – 59 801)/(76 954 – 59 801) = 0.3
The discount payback period is 3.3 years.
PTS: 1 DIF: M
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
9. Which of these is a flaw in the accounting rate of return method?
a. | The choice of an accounting hurdle return rate is essentially arbitrary. |
b. | Depreciation method has a large impact on the accounting rate of return. |
c. | This method makes no adjustment for project risk or for the time value of money |
d. | This method considers all of a project’s cash flows. |
REF: 9.3 Accounting-Based Methods NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
Use the following information to answer questions 10 and 11.
A piece of equipment costs $1.2 million. The equipment has a useful life of four years. In each of the four years, the investment generates a cash inflow of $0.5 million. The impact of the investment project on net income is derived by subtracting depreciation from cash flow each year.
10. Refer to Exhibit 9-2. Assume the equipment is depreciated on a straight-line basis over four years. What is the average contribution to net income across all four years?
a. | $0.2 million |
b. | $0.5 million |
c. | $0.3 million |
d. | $0.8 million |
Depreciation charge per year = 1.2 million /4 = 0.3 million
Net income per year = 0.5 million – 0.3 million = 0.2 million
PTS: 1 DIF: M
REF: 9.3 Accounting-Based Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
11. Refer to Exhibit 9-2. The project’s average accounting rate of return equals the average contribution to net income divided by the average book value of the investment. Assume the equipment is depreciated on a straight-line basis over four years. What is the average accounting rate of return?
a. | 16.7% |
b. | 33.3% |
c. | 66.7% |
d. | There is not enough information to answer the question. |
Depreciation charge per year = 1.2 million/4 = 0.3 million
Net income per year = 0.5 million – 0.3 million = 0.2 million
Average book value = 0.6 million
Average accounting rate of return = 0.2 million/0.6 million = 0.333
PTS: 1 DIF: M
REF: 9.3 Accounting-Based Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
12. Suppose a particular investment project will generate an immediate cash inflow of $1 500 000, followed by cash outflows of $600 000 in each of the next three years. What is the project’s IRR? If a company’s hurdle rate is 15%, should it accept or reject the project?
a. | 97%; reject |
b. | 97%; accept |
c. | 15%; reject |
d. | 15%; accept |
Let r represent the IRR of the investment.
1 500 000 – [600 000/(1 + r) + 600 000/(1 + r)2 + 600 000/(1 + r)3] = 0
r = 0.97
The project has an initial cash inflow and subsequent cash outflows, and its IRR is higher than the hurdle rate. Therefore, the project should be rejected.
PTS: 1 DIF: M
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
13. Future Semiconductors is evaluating a new etching tool. The equipment costs $1.5 million and will generate after-tax cash inflows of $0.6 million per year for six years. Assume the company has a 12% cost of capital. What is the NPV of the investment?
a. | $0.51 million |
b. | $0.97 million |
c. | $1.51 million |
d. | $1.69 million |
NPV = –1.5 + 0.6/1.12 + 0.6/1.122 + 0.6/1.123 + 0.6/1.124 + 0.6/1.125 + 0.6/1.126 = 0.97 million
PTS: 1 DIF: M
REF: 9.4 Net Present Value NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
14. Should a company invest in projects with an NPV of $0?
a. | Yes, it should. |
b. | No, it should not. |
c. | The company is indifferent between accepting or rejecting projects with zero NPVs. |
d. | The company should look at the PI and IRR of the projects. |
REF: 9.4 Net Present Value NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
15. A company has 10 million shares outstanding with a current market price of $20 per share. There is one investment project available to the company. The initial investment of the project is $20 million, and the NPV of the project is $10 million. What will be the company’s share price if capital markets fully reflect the value of undertaking the project?
a. | $19 |
b. | $20 |
c. | $21 |
d. | $22 |
The share price will increase by $1 per share (= $10m/0m shares).
PTS: 1 DIF: M
REF: 9.4 Net Present Value NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
16. Delta Pharmaceuticals has 200 million shares outstanding with a current market price of $30 per share. Its share rose to $33 on the news that Delta Pharmaceuticals’ long-awaited new drug, Zentac, is to hit the market next month. What is the market’s consensus of the NPV that the new drug will generate for Delta Pharmaceuticals?
a. | $400 million |
b. | $6400 million |
c. | $6000 million |
d. | $600 million |
The share price increased by $4 per share.
NPV = 3 × 200 million shares = 600 million
PTS: 1 DIF: M
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
17. Kelley Industries has 100 million ordinary shares outstanding with a current market price of $50. The company is contemplating undertaking an investment project that requires an initial cash outflow of $100 million. The IRR of the project is equal to the company’s cost of capital. What will be the company’s share price if capital markets fully reflect the value of undertaking the project?
a. | $50 |
b. | $49 |
c. | $51 |
d. | There is not enough information to answer the question. |
The NPV of the project is zero because the project’s IRR equals the cost of capital. Therefore, there is no change in share price.
PTS: 1 DIF: M
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
18. Consider a project with the following cash flows:
Year | CF |
0 | –$16 000 |
1 | 42 000 |
2 | –27 000 |
What is the IRR of the project? If a company’s cost of capital is 15%, should the company accept or reject the project?
a. | 50%; accept |
b. | 12.5%; reject |
c. | 12.5% and 50%; accept |
d. | 12.5%, and 50%; reject |
Let r represent the IRR of the investment.
–16 000 + 42 000/(1 + r) – 27 000/(1 + r)2 = 0
r1 = 0.125, r2 = 0.50
When r = 15%, the NPV of the project is greater than 0. The project should be accepted.
PTS: 1 DIF: M
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
19. Consider a project with the following stream of cash flows:
Year | CF ($ in millions) |
0 | +80 |
1 | –388 |
2 | +700 |
3 | –557 |
4 | +165 |
What is the IRR of the project? If a company’s cost of capital is 15%, should the company accept or reject the project?
a. | 10%, 25%, 50%; accept |
b. | 10%, 25%, 50%; reject |
c. | 0%, 10%, 25%, 50%; accept |
d. | 10%, 25%; accept |
A simple way to solve this problem is to take all the IRRs in the answer options and to see whether the IRRs will make the NPV of the project equal to zero.
The NPV of the cash flow at the 15% discount rate has a positive value of $0.01 million. The project should be accepted.
PTS: 1 DIF: H
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
Use the following information to answer questions 20 and 21.
A company is evaluating two investment proposals. The following data is provided for the two investment alternatives:
Initial cash outflow | IRR | NPV (@18%) | |
Project 1 | $250m | 28% | $80m |
Project 2 | $ 50m | 36% | $20m |
20. Refer to Exhibit 9-3. If the two projects are independent, which project should the company choose based on the IRR rule?
a. | Project 1 |
b. | Project 2 |
c. | both projects |
d. | There is not enough information to answer the question. |
The hurdle rate is equal to the discount rate in the NPV calculation, which is 18%. Both projects pass the hurdle rate.
PTS: 1 DIF: M
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
21. Refer to Exhibit 9-3. If the two projects are mutually exclusive, which project should the company choose? What is the problem that the company should be concerned with in making this decision?
a. | Project 1; discount rate |
b. | Project 2; discount rate |
c. | Project 1; project scale |
d. | Project 2; project scale |
Both projects pass the hurdle rate of 18%, but Project 1 has a higher NPV. The company should be concerned with the scale problem that occurs when IRR is used as a decision rule.
PTS: 1 DIF: H
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
22. Kelley Industries is evaluating two investment proposals. The scale of Project 1 is roughly four times that of the Project 2. The following data is provided for the two investment alternatives:
IRR | |
Project 1 | 28% |
Project 2 | 50% |
Incremental project | 26% |
If the two projects are mutually exclusive and the company’s hurdle rate is 18%, which project should the company choose?
a. | Project 1 |
b. | Project 2 |
c. | Incremental project |
d. | Project 1 and Project 2 |
All three projects pass the hurdle rate of 18%, but Project 1 is of bigger scale. The company should invest in Project 1.
PTS: 1 DIF: M
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
23. A project may have multiple IRRs when:
a. | it generates an alternating series of net cash inflows and outflows |
b. | it generates an immediate cash inflow followed by a cash outflow |
c. | it has a negative NPV |
d. | it is of a considerably large scale |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
24. The IRR method assumes that the reinvestment rate of cash flows is:
a. | the cost of capital |
b. | the IRR |
c. | essentially arbitrary |
d. | zero |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
Use the following information to answer questions 25 and 26.
Thompson Manufacturing is considering two investment proposals. The first involves a quality improvement project, and the second is about an advertising campaign. The cash flows associated with each project appear below.
Quality improvement | Advertising campaign | |
Initial cash outflow | $100 000 | $100 000 |
Cash inflows | ||
Year 1 | 10 000 | 80 000 |
Year 2 | 30 000 | 45 000 |
Year 3 | 125 000 | 10 000 |
25. Refer to Thompson Manufacturing. Suppose the hurdle rate of the company is 10%. Calculate the cash flows of the incremental project by subtracting the cash flows of the second project from the cash flows of the first project. What is the IRR of the incremental project?
a. | 20.7% |
b. | 23.1% |
c. | 17.9% |
d. | 10.0% |
Cash flow of the incremental project:
Year 0 | 0 |
Year 1 | –70 000 |
Year 2 | –15 000 |
Year 3 | 115 000 |
Let r represent the IRR of the incremental project.
–70 000/(1 + r) – 15 000/(1 + r)2 + 115 000/(1 + r)3 = 0
r = 17.9%
PTS: 1 DIF: M
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
26. Refer to Thompson Manufacturing. Suppose the hurdle rate of the company is 10%. If the two projects are mutually exclusive, which project should be chosen? What is the problem that the company should be concerned with in making this decision?
a. | Quality improvement project; project scales |
b. | Advertising campaign; project scales |
c. | Quality improvement project; the timing of cash flows |
d. | Advertising campaign; the timing of cash flows |
e. | Advertising campaign; discount rate |
Cash flow of the incremental project (Quality improvement – Advertising campaign):
Year 0 | 0 |
Year 1 | –70 000 |
Year 2 | –15 000 |
Year 3 | 115 000 |
Let r represent the IRR of the incremental project.
–70 000/(1 + r) –15 000/(1 + r)2 + 115 000/(1 + r)3 = 0
r = 17.9%
The incremental project’s IRR passes the hurdle rate. Thompson should invest in the quality improvement project.
PTS: 1 DIF: M REF: 9.5 Internal Rate of Return
NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
27. An entrepreneur is offered a service contract that will cost him $600 000 initially. The contract has a five-year life and will generate an after-tax cash inflow of $160 000 per year. The cost of capital of this project is 12%. What is the NPV of the project? Should the entrepreneur accept or reject the contract?
a. | –$23 236; reject |
b. | $23 236; accept |
c. | –$20 746; reject |
d. | $576 764; reject |
e. | $41 050; accept |
NPV = –600 000 + 160 000/1.12 + 160 000/1.122 + 160 000/1.123 + 160 000/1.124 + 160 000/1.125
NPV = –23 236
PTS: 1 DIF: M
REF: 9.4 Net Present Value NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
28. The following information is given on three mutually exclusive projects. Assume a cost of capital of 15%. Which project has the highest PI?
Project 1 | Project 2 | Project 3 | |
Cash flow | |||
Year 0 | –$400 000 | –$500 000 | –$1 000 000 |
Year 1 | 200 000 | 300 000 | 500 000 |
Year 2 | 300 000 | 300 000 | 700 000 |
Year 3 | 300 000 | 350 000 | 700 000 |
a. | Project 1 |
b. | Project 2 |
c. | Project 3 |
d. | All projects |
PIProject 1 = PV of CFYears 1–3/Initial outlay = 598 011/400 000 = 1.495
PIProject 2 = PV of CFYears 1–3/Initial outlay = 717 843/500 000 = 1.436
PIProject 3 = PV of CFYears 1–3/Initial outlay = 1 424 345/1 000 000 = 1.424
PTS: 1 DIF: M
REF: 9.6 Profitability Index NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
29. You are provided with the following data on two mutually exclusive projects. The cost of capital is 15%.
Project 1 | Project 2 | |
Initial cash outflow | –$5000 | –$1000 |
Year 1 cash inflow | $5000 | $1000 |
Year 2 cash inflow | $2500 | $ 850 |
NPV | $1238 | $ 512 |
PI | 1.25 | 1.51 |
Which project should you accept? What problem should be concerned with in making this decision?
a. | Project 1; the timing of cash flows |
b. | Project 2; the timing of cash flows |
c. | Project 1; project scale |
d. | Project 2; project scale |
Project 1 has a higher NPV than Project 2, although Project 1 has a lower PI. You should be concerned with the project scale problem in making this decision.
PTS: 1 DIF: M
REF: 9.6 Profitability Index NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
30. The profitability index is most useful:
a. | when the NPV method and the IRR method give conflicting signals on mutually exclusive projects |
b. | in capital rationing situations and managers have to decide which project is most profitable to undertake |
c. | when the cash flow pattern is unusual |
d. | when project scales are of concern |
REF: 9.6 Profitability Index NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
31. You have a $1 million capital budget and must make a decision about which investments your company should undertake for the coming year. There are three projects available and the cash flows of each project appear below. Assume a cost of capital of 12%. Which project or projects do you select?
Project 1 | Project 2 | Project 3 | |
Cash flow | |||
Year 0 | –$400 000 | –$500 000 | –$1 000 000 |
Year 1 | 200 000 | 300 000 | 500 000 |
Year 2 | 300 000 | 350 000 | 700 000 |
Year 3 | 300 000 | 350 000 | 700 000 |
a. | Project 1 |
b. | Project 2 |
c. | Project 3 |
d. | Project 1 and Project 2 |
PIProject 1 = PV of CFYears 1–3/Initial outlay = 631 264/400 000 = 1.58
PIProject 2 = PV of CFYears 1–3/Initial outlay = 795 998/500 000 = 1.59
PIProject 3 = PV of CFYears 1–3/Initial outlay = 1502 710/1 000 000 = 1.50
Begin by accepting the project with the highest PI, and then continue to accept additional projects until the $1 million capital constraint is reached. Also, the sum of NPV of Project 1 and Project 2 is greater than the NPV of Project 3.
PTS: 1 DIF: M
REF: 9.6 Profitability Index NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
32. You must know the discount rate of an investment project to compute its:
a. | NPV, IRR, PI and discount payback period |
b. | NPV, PI and discount payback period |
c. | NPV, PI and IRR |
d. | NPV, accounting rate of return, PI and discount payback period |
REF: 9.4 Net Present Value; 9.5 Internal Rate of Return; 9.6 Profitability Index
NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
33. You must know all the cash flows of an investment project to compute its:
a. | NPV, IRR, PI, and discount payback period |
b. | NPV, IRR, PI, payback period and discount payback period |
c. | NPV, PI and IRR |
d. | NPV, accounting rate of return, IRR and PI |
REF: 9.4 Net Present Value; 9.5 Internal Rate of Return; 9.6 Profitability Index
NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
Use the following information to answer questions 34 to 41.
The figure below shows the NPV profile for two investment projects.
34. Refer to the NPV profile. What is the IRR for Project 1?
a. | 12% |
b. | 14% |
c. | 18% |
d. | There is not enough information to answer the question. |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
35. Refer to the NPV profile. What is the IRR for Project 2?
a. | 12% |
b. | 14% |
c. | 18% |
d. | There is not enough information to answer the question. |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
36. Refer to the NPV profile. Which project’s NPV is more sensitive to the discount rate?
a. | Project 1 |
b. | Project 2 |
c. | Equally sensitive |
d. | There is not enough information to answer the question. |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
37. Refer to the NPV profile. Suppose the two projects require about the same initial investment. Which project generates more cash flows in the early years?
a. | Project 1 |
b. | Project 2 |
c. | There is no difference between the two projects. |
d. | There is not enough information to answer the question. |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
38. Refer to the NPV profile. If Gamma Company has a hurdle rate of 11% and the two projects are independent, in which project should Gamma Company invest?
a. | Project 1 |
b. | Project 2 |
c. | both projects |
d. | neither project |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
39. Refer to the NPV profile. If the hurdle rate is 11% and the two projects are mutually exclusive, which project should be accepted?
a. | Project 1 |
b. | Project 2 |
c. | both projects |
d. | neither project |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
40. Refer to the NPV profile. If the hurdle rate is 13% and the two projects are mutually exclusive, which project should be accepted?
a. | Project 1 |
b. | Project 2 |
c. | both projects |
d. | neither project |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
41. Refer to the NPV profile. If the hurdle rate is 19% and the two projects are independent, which project should be accepted?
a. | Project 1 |
b. | Project 2 |
c. | both projects |
d. | neither project |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
42. Capital investment is also known as:
a. | capital budgeting |
b. | capital hedging |
c. | capital spending |
d. | capital savings |
REF: 9.1 Introduction to Capital Budgeting NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
43. The process of identifying which long-lived investment projects a company should undertake is known as:
a. | capital spending |
b. | capital budgeting |
c. | capital hedging |
d. | capital investment |
REF: 9.1 Introduction to Capital Budgeting NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
44. The accounting rate of return is calculated as:
a. | sales divided by share price |
b. | net income divided by share price |
c. | sales divided by book value of assets |
d. | net income divided by book value of assets |
REF: 9.3 Accounting-Based Methods NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
45. The accounting rate of return:
a. | uses net cash flows |
b. | does not take into account the time value of money |
c. | uses an objectively determined hurdle rate |
d. | considers the project risk |
REF: 9.3 Accounting-Based Methods NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
46. The main virtue of the payback method is its:
a. | simplicity |
b. | complexity |
c. | completeness |
d. | thoroughness |
REF: 9.2 Payback Methods NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
47. The payback method:
a. | fails to explicitly consider the time value of money |
b. | is the amount of time it takes for a project to recoup its profits |
c. | is the best method for evaluating complex projects |
d. | is never used by businesses today |
REF: 9.2 Payback Methods NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
48. A problem with the payback method is that it assigns __________________ to cash flows that occur before the cutoff point.
a. | a 0% discount rate |
b. | a 10% discount rate |
c. | a 20% discount rate |
d. | a 30% discount rate |
REF: 9.2 Payback Methods NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
49. As the discount rate increases, the NPV of a project:
a. | increases |
b. | decreases |
c. | is unaffected |
d. | This cannot be determined without the discount rate. |
REF: 9.4 Net Present Value NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
50. As the discount rate increases, the IRR of a project:
a. | increases |
b. | decreases |
c. | is unaffected |
d. | This cannot be determined without the discount rate. |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
51. The NPV method focuses on:
a. | sales |
b. | accounting returns |
c. | profits |
d. | cash flows |
REF: 9.4 Net Present Value NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
52. The IRR method focuses on:
a. | sales |
b. | accounting returns |
c. | profits |
d. | cash flows |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
53. Which method directly estimates the change in shareholder wealth?
a. | Payback |
b. | IRR |
c. | NPV |
d. | PI |
REF: 9.4 Net Present Value NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
54. When the IRR is equal to the discount rate, the NPV is:
a. | positive |
b. | equal to zero |
c. | negative |
d. | This cannot be determined without the discount rate. |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
55. The IRR is analogous to:
a. | a bond’s current yield |
b. | a share’s dividend yield |
c. | a bond’s yield to maturity |
d. | a share’s yield to maturity |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
56. The compound annual return on a project is known as its:
a. | NPV |
b. | PI |
c. | payback |
d. | IRR |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
57. The hurdle rate used in IRR analysis should be:
a. | the risk-free rate |
b. | the current corporate bond rate |
c. | the prime rate |
d. | the discount rate used in NPV analysis |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
58. Which of these is a problem with the IRR?
a. | Appropriately adjusting for the time value of money |
b. | Focus on cash flows |
c. | Multiple IRRs |
d. | Focus on accounting measures of income |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
59. NPV and IRR may give conflicting decisions for mutually exclusive projects because:
a. | the risk of the projects may differ |
b. | the scale of the projects may differ |
c. | the discount rates on the projects may differ |
d. | the duration of the project may differ |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
Use the following information to answer questions 60 to 64.
The Commerce Company is evaluating a project with the following cash flows:
Year | CF |
0 | –$10 000 |
1 | $ 2000 |
2 | $ 3000 |
3 | $ 4000 |
4 | $ 5000 |
5 | $ 6000 |
60. What is the payback period of the proposed Commerce Company project?
a. | 1.5 years |
b. | 2.7 years |
c. | 3.2 years |
d. | 4.5 years |
3 + 1000/5000 = 3.2 years
PTS: 1 DIF: E
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
61. What is the net present value of the proposed Commerce Company project if the discount rate is 7%?
a. | $10 000 |
b. | $9347 |
c. | $6921 |
d. | $5847 |
Year | CF |
0 | –$10 000 |
1 | $ 2000 |
2 | $ 3000 |
3 | $ 4000 |
4 | $ 5000 |
5 | $ 6000 |
I/YR = 7%
NPV = $5487
PTS: 1 DIF: M
REF: 9.4 Net Present Value NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
62. What is the profitability index of the proposed Commerce Company project if the discount rate is 7%?
a. | 0.58 |
b. | 1.58 |
c. | 2.58 |
d. | 3.58 |
Year | CF |
0 | –$10 000 |
1 | $ 2000 |
2 | $ 3000 |
3 | $ 4000 |
4 | $ 5000 |
5 | $ 6000 |
NPV of CF1–CF5 @ 7% = $15 487
PI = $15 487/$10 000 = 1.58
PTS: 1 DIF: M
REF: 9.4 Net Present Value; 9.6 Profitability Index NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
63. What is the IRR of the proposed Commerce Company project?
a. | 7.00% |
b. | 15.24% |
c. | 23.29% |
d. | 42.85% |
Year | CF |
0 | –$10 000 |
1 | $ 2000 |
2 | $ 3000 |
3 | $ 4000 |
4 | $ 5000 |
5 | $ 6000 |
IRR = 23.29%
PTS: 1 DIF: M
REF: 9.4 Net Present Value; 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
64. What is the discounted payback period of the proposed Commerce Company project if the discount rate is 7%?
a. | 3.09 years |
b. | 3.19 years |
c. | 3.39 years |
d. | 3.59 years |
Year | CF | Dis. CF | Cum. CF |
0 | –$10 000 | –$10 000.00 | –$10 000.00 |
1 | $ 2000 | $ 1869.16 | –$ 8130.84 |
2 | $ 3000 | $ 2620.32 | –$ 5510.52 |
3 | $ 4000 | $ 3265.19 | –$ 2245.33 |
4 | $ 5000 | $ 3814.48 | $ 1569.14 |
5 | $ 6000 | $ 4277.92 | $ 5847.06 |
3 + 2245.33/3814.48 = 3.59 years.
PTS: 1 DIF: M
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
Use the following information to answer questions 65 to 69.
Year | CF |
0 | –$20 000 |
1 | $ 3000 |
2 | $ 4000 |
3 | $ 5000 |
4 | $ 6000 |
5 | $ 7000 |
65. What is the payback period of the proposed Swerling Company project?
a. | 1.28 years |
b. | 2.28 years |
c. | 3.28 years |
d. | 4.28 years |
4 + 2000/7000 = 4.28 years
PTS: 1 DIF: E
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
66. What is the net present value of the proposed Swerling Company project if the discount rate is 6%?
a. | $572 |
b. | $1572 |
c. | $10 572 |
d. | $100 572 |
Year | CF |
0 | –$20 000 |
1 | $ 3000 |
2 | $ 4000 |
3 | $ 5000 |
4 | $ 6000 |
5 | $ 7000 |
I/YR = 6%
NPV = $572
PTS: 1 DIF: M
REF: 9.4 Net Present Value NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
67. What is the profitability index of the proposed Swerling Company project if the discount rate is 6%?
a. | 0.03 |
b. | 1.03 |
c. | 2.03 |
d. | 3.03 |
Year | CF |
0 | –$20 000 |
1 | $ 3000 |
2 | $ 4000 |
3 | $ 5000 |
4 | $ 6000 |
5 | $ 7000 |
NPV of CF1–CF5 @ 6% = $20 572
PI = $20 572/$20 000 = 1.03
PTS: 1 DIF: M
REF: 9.4 Net Present Value; 9.6 Profitability Index NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
68. What is the IRR of the proposed Swerling Company project?
a. | 9.57% |
b. | 8.35% |
c. | 7.72% |
d. | 6.91% |
Year | CF |
0 | –$20 000 |
1 | $ 3000 |
2 | $ 4000 |
3 | $ 5000 |
4 | $ 6000 |
5 | $ 7000 |
IRR = 6.91%
PTS: 1 DIF: M
REF: 9.4 Net Present Value; 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
69. What is the discounted payback period of the proposed Swerling Company project if the discount rate is 6%?
a. | 6.89 years |
b. | 5.89 years |
c. | 3.89 years |
d. | 4.89 years |
Year | CF | Dis. CF | Cum. CF |
0 | –$20 000 | –$20 000.00 | –$20 000.00 |
1 | $ 3000 | $ 2830.19 | –$17 169.81 |
2 | $ 4000 | $ 3559.99 | –$13 609.83 |
3 | $ 5000 | $ 4198.10 | –$ 9411.73 |
4 | $ 6000 | $ 4752.56 | –$ 4659.17 |
5 | $ 7000 | $ 5230.81 | $ 571.64 |
4 + 4659.17/5,230.81 = 4.89 years
PTS: 1 DIF: M
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
70. While the NPV approach offers many advantages over some other capital budgeting techniques, several cons exist with respect to the approach. Which of these is a con of the NPV method?
a. | It fails to consider all of a project’s relevant cash flows. |
b. | It fails to consider the time value of money. |
c. | It focuses on net income and not cash flow. |
d. | It seems less intuitive to many users than other methods. |
e. | It fails to consider the risk associated with the project. |
REF: 9.4 Net Present Value NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
71. Which of these statements is false?
a. | Multiple IRRs result when a project’s cash flows alternate between negative and positive values. |
b. | If a project has multiple IRRs, its NPV profile will cross the x-axis more than once. |
c. | The general rule of thumb is that a project will have as many IRRs as there are negative cash flows. |
d. | There are occasions when a project’s IRR may involve imaginary numbers. |
e. | The NPV and IRR techniques focus on cash flows rather than on accounting measures of income. |
REF: 9.5 Internal Rate of Return NAT: Reflective thinking
LOC: acquire knowledge of capital budgeting and the cost of capital
72. Louis is considering a new litter box factory with the following cash flows. What is the payback period?
Year | CF |
0 | –$150 000.00 |
1 | 30 000.00 |
2 | 15 000.00 |
3 | 25 000.00 |
4 | 50 000.00 |
5 | 50 000.00 |
6 | 50 000.00 |
a. | 3.4 years |
b. | 4.6 years |
c. | 4.0 years |
d. | 5.0 years |
Year | CF | Payback | |||
0 | –$150 000.00 | –150 000.00 | |||
1 | 30 000.00 | –120 000.00 | |||
2 | 15 000.00 | –105 000.00 | |||
3 | 25 000.00 | –80 000.00 | |||
4 | 50 000.00 | –30 000.00 | fractional | 30/50 = 0.6 | |
5 | 50 000.00 | 20 000.00 | |||
6 | 50 000.00 | 70 000.00 |
PTS: 1 DIF: E
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
73. Louis is considering a new litter box factory with the following cash flows. If the discount rate is 8%, what is the NPV?
Year | CF |
0 | –$150 000.00 |
1 | 25 000.00 |
2 | 10 000.00 |
3 | 25 000.00 |
4 | 50 000.00 |
5 | 50 000.00 |
6 | 50 000.00 |
a. | $1872.73 |
b. | $4494.70 |
c. | $9942.54 |
d. | $3856.45 |
REF: 9.4 Net Present Value NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
74. Louis is considering a new litter box factory with the following cash flows. What is the IRR?
Year | CF |
0 | –$150 000.00 |
1 | 25 000.00 |
2 | 10 000.00 |
3 | 25 000.00 |
4 | 50 000.00 |
5 | 50 000.00 |
6 | 50 000.00 |
a. | 8.56% |
b. | 8.00% |
c. | 8.36% |
d. | 8.69% |
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
75. Roxy is considering a new cat food factory with the following cash flows. What is the payback period?
Year | CF |
0 | –$250 000.00 |
1 | 40 000.00 |
2 | 120 000.00 |
3 | 80 000.00 |
4 | 30 000.00 |
5 | 25 000.00 |
6 | 15 000.00 |
a. | 3.4 years |
b. | 3.3 years |
c. | 4.0 years |
d. | 5.0 years |
Year | CF | Payback | ||||||||
0 | –$250 000.00 | –$250 000.00 | ||||||||
1 | 40 000.00 | –210 000.00 | ||||||||
2 | 120 000.00 | –90 000.00 | ||||||||
3 | 80 000.00 | –10 000.00 | fractional | 10/30 = | ||||||
4 | 30 000.00 | 20 000.00 | 0.333333 | |||||||
5 | 25 000.00 | 45 000.00 | ||||||||
6 | 15 000.00 | 60 000.00 | ||||||||
PTS: 1 DIF: E
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
76. Roxy is considering a new cat food factory with the following cash flows. If the discount rate is 10%, what is the NPV?
Year | CF | |
0 | –$250 000.00 | |
1 | 50 000.00 | |
2 | 115 000.00 | |
3 | 80 000.00 | |
4 | 30 000.00 | |
5 | 25 000.00 | |
6 | 15 000.00 | |
a. | –$2895.30 |
b. | –$1098.82 |
c. | –$7007.03 |
d. | –$4918.41 |
REF: 9.4 Net Present Value NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
77. Roxy is considering a new cat food factory with the following cash flows. If the discount rate is 10%, what is the PI?
Year | CF |
0 | –$250 000.00 |
1 | 40 000.00 |
2 | 120 000.00 |
3 | 80 000.00 |
4 | 30 000.00 |
5 | 25 000.00 |
6 | 15 000.00 |
a. | 0.960 |
b. | 0.956 |
c. | 0.938 |
d. | 0.917 |
REF: 9.6 Profitability Index NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
78. Roxy is considering a new cat-food factory with the following cash flows, what is the IRR?
Year | CF |
0 | –$250 000.00 |
1 | 50 000.00 |
2 | 115 000.00 |
3 | 80 000.00 |
4 | 30 000.00 |
5 | 25 000.00 |
6 | 15 000.00 |
a. | 9.15% |
b. | 9.42% |
c. | 8.32% |
d. | 10.12% |
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
79. Emma is considering a new cat nip factory with the following cash flows. What is the payback period?
Year | CF |
0 | –$2 000 000.00 |
1 | 200 000.00 |
2 | 650 000.00 |
3 | 500 000.00 |
4 | 500 000.00 |
5 | 500 000.00 |
6 | 350 000.00 |
a. | 5.4 years |
b. | 5.0 years |
c. | 6.0 years |
d. | 5.2 years |
Year | CF | Payback | |||
0 | –$2 000 000.00 | –$2 000 000.00 | |||
1 | 200 000.00 | –1 800 000.00 | |||
2 | 650 000.00 | –1 150 000.00 | |||
3 | 500 000.00 | –650 000.00 | |||
4 | 500 000.00 | –150 000.00 | |||
5 | 500 000.00 | 350 000.00 | fractional | 150/500= | |
6 | 350 000.00 | 700 000.00 | 0.24 |
PTS: 1 DIF: E
REF: 9.2 Payback Methods NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
80. Emma is considering a new cat nip factory with the following cash flows. If the discount rate is 4%, what is the NPV?
Year | CF |
0 | –$2 000 000.00 |
1 | 100 000.00 |
2 | 550 000.00 |
3 | 500 000.00 |
4 | 500 000.00 |
5 | 500 000.00 |
6 | 350 000.00 |
a. | $35 772.42 |
b. | $164 133.96 |
c. | $133 960.47 |
d. | $16 947.33 |
REF: 9.4 Net Present Value NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
81. Emma is considering a new cat nip factory with the following cash flows. If the discount rate is 7%, what is the PI?
Year | CF |
0 | –$2 000 000.00 |
1 | 200 000.00 |
2 | 650 000.00 |
3 | 500 000.00 |
4 | 500 000.00 |
5 | 500 000.00 |
6 | 350 000.00 |
a. | 1.067 |
b. | 1.050 |
c. | 0.943 |
d. | 1.008 |
REF: 9.6 Profitability Index NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
82. Emma is considering a new cat nip factory with the following cash flows. What is the IRR?
Year | CF |
0 | –$2 000 000.00 |
1 | 100 000.00 |
2 | 550 000.00 |
3 | 500 000.00 |
4 | 500 000.00 |
5 | 500 000.00 |
6 | 350 000.00 |
a. | 6.17% |
b. | 6.07% |
c. | 6.27% |
d. | 6.29% |
REF: 9.5 Internal Rate of Return NAT: Analytic skills
LOC: acquire knowledge of capital budgeting and the cost of capital
SHORT ANSWER
1. Explain the process of capital budgeting.
PTS: 1 DIF: E
REF: 9.1 Introduction to Capital Budgeting
2. Explain the process of economic value added (EVA).
PTS: 1 DIF: E
REF: 9.4 Net Present Value
3. What are the problems with IRR?
PTS: 1 DIF: E
REF: 9.5 Internal Rate of Return
4. What are the important flaws that IRR and PI share?
PTS: 1 DIF: E
REF: 9.6 Profitability Index
5. What do NPV and EVA have in common? How do they differ?
PTS: 1 DIF: E
REF: 9.4 Net Present Value
6. Briefly explain the internal rate of return (IRR) metric.
PTS: 1 DIF: E
REF: 9.5 Internal Rate of Return