11.1 An Overview of Capital Budgeting
1) Which of the following are typical consequences of good
capital budgeting decisions?
A) The firm increases in value.
B) The firm gains knowledge and experience that may be
useful in future decisions.
C) Good capital budgeting decisions help a company define
its core competencies.
D) All of the above.
2) Errors in capital budgeting decisions
A) tend to average out over time.
B) decrease the firm's value.
C) are diminished because the time value of money makes
future cash flows less important.
D) are easily reversed.
3) Which of the following factors is least important to
capital budgeting decisions?
A) The time value of money
B) The riskreturn tradeoff
C) Net income based on accrual accounting principles
D) Cash flows directly resulting from the decision
4) Which of the following would be considered a capital
budgeting decision?
A) Walmart purchases inventory for resale to customers.
B) Apple sells bonds and uses the proceeds to repurchase
stock.
C) Goldman Sachs obtains shortterm loans to finance day to
day operations.
D) Pfizer develops a new therapy and brings it to market.
5) Which of the following is a typical capital budgeting
decision?
A) Purchase of office supplies
B) Granting credit to a new customer
C) Replacement of manufacturing equipment with more modern and
efficient equipment
D) Financing the firm with more longterm debt and less
equity
6) Good capital investment opportunities are most likely to
exist when
A) many firms compete to sell similar products.
B) interest rates are high and rising.
C) goods and services can be produced cheaply using readily
available tools and technologies.
D) a line of business is expensive to enter and uses
proprietary technology.
7) Errors resulting from a capital budgeting decision are
not considered major since the consequences of such errors average out over the
life of the investment.
Answer: FALSE
8) Competitive market forces make it imperative for a firm
to have a systematic strategy for generating capitalbudgeting projects.
Answer: TRUE
9) The size of capital investments and the difficulty in
reversing them once they are made make capitalbudgeting decisions very
important to the firm.
Answer: TRUE
10) Capital budgeting is the decisionmaking process with
respect to investment in working capital.
Answer: FALSE
11) Some capital budgeting decisions may be mandated by
government regulations.
Answer: TRUE
12) The primary objective of all capital budgeting
decisions is to increase the size of the firm.
Answer: FALSE
13) Why are capital budgeting decisions among the most
important decisions made by any company? Give a few examples from recent
business developments.
Answer: The main
objective of financial management is to maximize the value of the firm. The
main source of value is the company's cash flows discounted at rates that
reflect their risk. Both the firm's cash flows and their level of risk are
determined by the projects the company chooses to undertake. Recent examples
include Apples string of "I" products (pod, phones, pad), and
Amazon's Kindle which have added tremendous value to those companies. Students
may cite examples from the text such as KimberlyClark's Huggies or Walmart's
use of central distribution centers. Examples of less than successful
decisions, at least so far, might include the Segue or the Gap's ephemeral
redesigned logo. (Students' answers will vary their experience and recent events.)
14) Distinguish between revenue enhancement investments,
costreduction investments, and mandated investments.
Answer: Revenue
enhancements investments may include new product lines such as Amazon's Kindle
or GM's Chevy Volt undertaken, obviously, to increase cash flows by increasing
sales. Companies such as Walmart may expand internationally or enter new
businesses such as groceries for the same reason. Cost reduction investments
such as improved distribution, energy saving equipment or loss prevention
systems may not increase sales, but increase cash flows by reducing costs.
Mandated investments may include such issues as access for the handicapped,
pollution abatement, or employee safety. They are unavoidable because required
by federal, state, or local laws. In these cases, companies will seek the least
expensive way to comply.
15) Why is it so difficult for firms to find good
investment ideas?
Answer: All firms
are competing to maximize their value, so if an idea is obvious, many companies
will pursue it at the same time. The Blackberry, for example, soon faced
intense competition from any number of smart phones. Companies often find the
best opportunities in areas where they have some protection from competition
because they possess proprietary technology (Pfizer, Merck), strong brand
loyalty (Coca Cola), or because the business is very expensive to enter
(Toyota, Disney).
11.2 Net Present Value
1) Project Sigma requires an investment of $1 million and
has a NPV of $10. Project Delta requires an investment of $500,000 and has a
NPV of $150,000. The projects involve unrelated new product lines.
A) Both projects should be accepted because they have
positive NPV's.
B) Neither project should be accepted because they might
compete with one another.
C) Only project Delta should be accepted. Alpha's NPV is
too low for the investment.
D) The company should look at other investment criteria,
not just NPV.
Answer: A
2) ABC Service can purchase a new assembler for $15,052
that will provide an annual net cash flow of $6,000 per year for five years.
Calculate the NPV of the assembler if the required rate of return is 12%.
(Round your answer to the nearest $1.)
A) $1,056
B) $4,568
C) $7,621
D) $6,577
3) Central Mass Ambulance Service can purchase a new
ambulance for $200,000 that will provide an annual net cash flow of $50,000 per
year for five years. Calculate the NPV of the ambulance if the required rate of
return is 9%. (Round your answer to the nearest $1.)
A) $50,000
B) $(5,061)
C) $(5,517)
D) $5,517
4) Central Mass Ambulance Service can purchase a new
ambulance for $200,000 that will provide an annual net cash flow of $50,000 per
year for five years. The salvage value of the ambulance will be $25,000. Assume
the ambulance is sold at the end of year 5. Calculate the NPV of the ambulance
if the required rate of return is 9%. (Round your answer to the nearest $1.)
A) $(10,731)
B) $10,731
C) $(5,517)
D) $5,517
5) Fitchminster Armored Car can purchase a new vehicle for
$200,000 that will provide annual net cash flow over the next five years of
$40,000, $45,000, $50,000, $55,000, $60,000. The salvage value of the vehicle
will be $25,000. Assume that the vehicle is sold at the end of year 5.
Calculate the NPV of the ambulance if the required rate of return is 9%. (Round
your answer to the nearest $1.)
A) $7,390
B) $6,048
C) $6,780
D) $19,483
6) Project H requires an initial investment of $100,000 and
the produces annual cash flows of $50,000, $40,000, and $30,000. Project T
requires an initial investment of $100,000 and the produces annual cash flows
of $30,000, $40,000, and $50,000. If the required rate of return is greater
than 0% and the projects are mutually exclusive
A) H will always be preferable to T.
B) T will always be preferable to H.
C) H and T are equally attractive.
D) The project rankings will change with different discount
rates.
7) Project H requires an initial investment of $100,000 and
the produces annual cash flows of $45,000 per year for each of the next 3
years. Project T also requires an initial investment of $100,000 and produces
cash flows of $30,000 in year 1, $40,000 in year 2, and $70,000 in year 3. If
the discount rate is 10% and the projects are mutually exclusive
A) Project H should be chosen.
B) Project T should be chosen.
C) H and T are equally attractive.
D) Both projects should be chosen.
8) Project H requires an initial investment of $100,000 and
the produces annual cash flows of $45,000 per year for each of the next 3
years. Project T also requires an initial investment of $100,000 and produces
cash flows of $30,000 in year 1, $40,000 in year 2, and $70,000 in year 3. If
the discount rate is 10% and the projects are not mutually exclusive
A) Project H should be chosen.
B) Project T should be chosen.
C) H and T are equally attractive.
D) Both projects should be accepted.
9) Project H requires an initial investment of $100,000 and
the produces annual cash flows of $45,000 per year for each of the next 3
years. Project T also requires an initial investment of $100,000 and produces
cash flows of $30,000 in year 1, $40,000 in year 2, and $70,000 in year 3. If
the discount rate increases from 10% to 16%
A) Project T should be chosen.
B) Both projects should be rejected.
C) H and T are equally attractive.
D) The project rankings will change.
10) A machine costs $1,000, has a threeyear life, and has
an estimated salvage value of $100. It will generate aftertax annual cash
flows (ACF) of $600 a year, starting next year. If your required rate of return
for the project is 10%, what is the NPV of this investment? (Round your answer
to the nearest $10.)
A) $490
B) $570
C) $900
D) $150
11) Suppose you determine that the NPV of a project is
$1,525,855. What does that mean?
A) In all cases, investing in this project would be better
than investing in a project that has an NPV of $850,000.
B) The project would add value to the firm.
C) Under all conditions, the project's payback would be
less than the profitability index.
D) Other investment criteria might need to be considered.
12) Project January has a NPV of $50,000, project December
has a NPV of $40,000. Which of the following circumstances could make it
possible to choose December over January?
A) January has a shorter payback period.
B) The projects are mutually exclusive.
C) The projects have unequal lives.
D) The projects are mandated.
13) The present value of the total costs over a five year
period for Project April is $50,000. The net present value of total costs over
a 4 year period for Project October is $40,000. The company uses a discount
rate of 9%. Which project should it choose and why?
A) April because it has a higher net present value (NPV).
B) April because is has a higher equivalent annual cost
(EAC).
C) October because it has a shorter life.
D) October because it has a lower equivalent annual cost
(EAC).
14) Warchester Inc. is considering the purchase of copying
equipment that will require an initial investment of $15,000 and $4,000 per
year in annual operating costs over the equipment's estimated useful life of 5
years. The company will use a discount rate of 8.5%. What is the equivalent
annual cost?
A) $4,000
B) $7,000
C) $6,152.51
D) $7,806.49
Answer: D
15) Artie's Soccer Ball Company is considering a project
with the following cash flows:
Initial
outlay = $750,000
Incremental
aftertax cash flows from operations Years 14 = $250,000 per year
Compute the NPV of this project if the company's discount
rate is 12%.
A) $9,337
B) $7,758
C) $4,337
D) $2,534
Use the following to answer the following question(s).
The information below describes a project with an initial
cash outlay of $10,000 and a required return of 12%.
Aftertax cash inflow
Year 1 $6,000
Year 2 $2,000
Year 3 $2,000
Year 4 $2,000
16) Which of the following statements is correct?
A) The project should be accepted since its NPV is $353.87.
B) The project should be rejected since its NPV is
$353.87.
C) The project should be accepted since it has a payback of
less than four years.
D) The project should be rejected since its NPV is $23.91.
17) You have been asked to analyze a capital investment
proposal. The project's cost is $2,775,000. Cash inflows are projected to be
$925,000 in Year 1; $1,000,000 in Year 2; $1,000,000 in Year 3; $1,000,000 in
Year 4; and $1,225,000 in Year 5. Assume that your firm discounts capital
projects at 15.5%. What is the project's NPV?
A) $101,247
B) $285,106
C) $473,904
D) $582,380
18) Which of the following is a correct equation to solve
for the NPV of the project that has an initial outlay of $30,000, followed by
incremental cash inflows in the next 3 years of $15,000, $20,000, and $30,000?
Assume a discount rate of 10%.
A) NPV =  $30,000 + $15,000(1.10)1 + $20,000(1.10)2 + $30,000(1.10)3
B) NPV =  $30,000 + $15,000/(1.10)1 + $20,000/(1.10)2 + $30,000/(1.10)3
C) NPV =  $30,000 + $15,000/(1.01).10 + $20,000/(1.02).10 + $30,000/(1.03).10
D) NPV =  $30,000 + $15,000/(1.1).10 + $20,000(1.2).10 + $30,000(1.3).10
19) Project EH! requires an initial investment of $50,000,
and has a net present value of $12,000. Project BE requires an initial
investment of $100,000, and has a net present value of $13,000. The projects
are mutually exclusive. The firm should accept
A) project EH!.
B) project BE.
C) both projects.
D) neither project.
20) Project Eh! requires an initial investment of $50,000,
and has a net present value of $12,000. Project B requires an initial investment
of $100,000, and has a net present value of $13,000. The projects are proposals
for increasing revenue and are not mutually exclusive. The firm should accept
A) project Eh!.
B) project B.
C) both projects.
D) neither project.
21) A machine has a cost of $5,375,000. It will produce
cash inflows of $1,825,000 (Year 1); $1,775,000 (Year 2); $1,630,000 (Year 3);
$1,585,000 (Year 4); and $1,650,000 (Year 5). At a discount rate of 16.25%,
what is the NPV?
A) $81,724
B) $257,106
C) $416,912
D) $190,939
22) A machine has a cost of $5,575,000. It will produce
cash inflows of $1,825,000 (Year 1); $1,775,000 (Year 2); $1,630,000 (Year 3);
$1,585,000 (Year 4); and $1,650,000 (Year 5). At a discount rate of 16.25%, the
project should be
A) accepted.
B) rejected.
C) discounted at a lower rate.
D) abandoned after the first year.
23) Which of the following is the correct equation to solve
for the NPV of the project that has an initial outlay of $30,000, followed by
three years of $20,000 in incremental cash inflow? Assume a discount rate of
10%.
A) NPV = 30,000 + (3 × 20,000)/(1.10)3
B) NPV = $30,000 + $20,000/(1.10)1 + $20,000/(1.10)2 + $20,000/(1.10)3
C) NPV = $30,000 + $20,000/(1.01).10 + $20,000/(1.02).10 + $20,000/(1.03).10
D) NPV = $30,000 + $20,000/(1.1).10 + $20,000(1.2).10 + $20,000(1.3).10
24) Project Full Moon has an initial outlay of $30,000,
followed by positive cash flows of $10,000 in year 1, $15,000 in year 2, and
$15,000 in year 3. The project should be accepted if the required rate of
return is
A) greater than 0.
B) less than 14.6%.
C) less than 16.25%.
D) greater than 12%.
25) Which of the following is a correct EXCEL formula to
solve for the net present value of a project.
A) =NPV (k,CF1, CF2,...CFn)+CF0
B) =NPV (k,CF0,CF1, CF2,...CFn)
C) =NPV (CF0,CF1, CF2,...CFn)
D) =NPV (CF1, CF2,...CFn)+CF0
26) WSU Inc. has various options for replacing a piece of
manufacturing equipment. The present value of costs for option Ell is $84,000.
Option Ell has a useful life of 5 years; annual operating costs were discounted
at 9%. What is the equivalent annual cost?
A) $16,800
B) $21,595.77
C) $14,035.77
D) $18,312
27) The equivalent annual cost (EAC) method is appropriate
for evaluating accessibility projects mandated by the Americans With
Disabilities Act.
Answer: TRUE
28) The required rate of return represents the cost of
capital for a project.
Answer: TRUE
29) The higher the discount rate, the greater the
importance of the early cash flows.
Answer: TRUE
30) The equivalent annual cost (EAC) method is helpful for
mutually exclusive projects with unequal economic lives.
Answer: TRUE
31) What is the NPV of a $45,000 project that is expected
to have an aftertax cash flow of $14,000 for the first two years, $10,000 for
the next two years, and $8,000 for the fifth year? Use a 10% discount rate.
Would you accept the project?
Answer:
Aftertax PVIF Present
Year Cash Flow at
10% Value
1 $14,000 .909 $12,726
2 14,000 .826 11,564
3 10,000 .751 7,510
4 10,000 .683 6,830
5 8,000 .621 4,968
Present value cash flow $43,598
Initial outlay 45,000
Net present value $1,402
Project should be rejected.
32) Dieyard Battery Recyclers is considering a project with
the following cash flows:
Initial outlay = $13,000
Cash flows: Year 1 = $5,000
Year
2 = $3,000
Year
3 = $9,000
If the appropriate discount rate is 15%, compute the NPV of
this project.
Answer: NPV=13,000 +
5,000/(1.15) + 3,000/(1.15)2 +
9,000/(1.15)3
33) Two projects are under consideration by the same
company at the same time. Project Alpha has a NPV of $20 million and an
estimated useful life of 10 years. Project Beta has a NPV of $12 million and
also an estimated useful life of 10 years. What should the company's decision
be
a) if the project's involve unrelated expansion decisions
or
b) if the project's are mutually exclusive because they
would have to occupy the same space?
Answer: If the
projects involve unrelated expansion decisions, they should both be accepted
because they both add significant value to the firm. If they are mutually
exclusive, they cannot both be accepted so the company should accept project
Alpha because it has the higher NPV and reject project Beta.
34) Dudster Manufacturing has 2 options for installing
legally required safety equipment. Option Ex has an initial cost of $25,000 and
annual operating costs over 3 years of $5,000, $5,250, $5,600. Option WYE has
an initial cost of $40,000 and annual operating costs of $4,000, $4,200,
$4,450, $4,750, $5,100. Whether Dudster chooses Ex or Wye, the equipment is
always needed and must be replaced at the end of its useful life. Which choice
is least expensive over the long run? Use a discount rate of 9%.
Answer:
NPV Project X = $25,000  $5,000/(1.09)1  $5,250/(1.09)2  $5,600/(1.09)3 =$38,330.20
NPV = $40,000  $4,000/(1.09)1  $4,200/(1.09)2  $4,450/(1.09)3  $4,750/(1.09)4  $5,100/(1.09)5 =
$57,320.67. Using a financial calculator, the EAC for project Ex is N = 3, i =
9,PV = 38,330.20, PMT = 15,138.57, FV = 0. For Project Wye N = 5, i = 9,PV =
57,320.67, PMT = 14,736.71, FV = 0. Project Wye has the lower EAC (PMT) and
should be selected.
35) What is the NPV of a $45,000 project that is expected
to have an aftertax cash flow of $14,000 for the first two years, $10,000 for
the next two years, and $8,000 for the fifth year? Use a discount rate of 8%.
Would you accept or reject the investment?
Answer:
Aftertax PVIF Present
Year Cash Flow at
8% Value
1 $14,000 .926 $12,964
2 14,000 .857 11,998
3 10,000 .794 7,940
4 10,000 .735 7,350
5 8,000 .681 5,448
Present value of cash flows $45,700
Initial outlay $45,000
Net present value $ 700
The project is acceptable.
11.3 Other Investment Criteria
1) Webley Corp. is considering two expansion options, but
does not have enough capital to undertake both, Project W requires an
investment of $100,000 and has an NPV of $10,000. Project D requires an
investment of $80,000 and has an NPV of $8,200. If Webley uses the
profitability index to decide, it would
A) choose D because it has a higher profitability index.
B) choose W because it has a higher profitability index.
C) choose D because it has a lower profitability index.
D) choose W because it has a lower profitability index.
2) If a project has a profitability index greater than 1
A) the npv will also be positive.
B) the irr will be higher than the required rate of return.
C) the present value of future cash flows will exceed the
amount invested in the project.
D) all of the above.
3) A project has an initial outlay of $4,000. It has a
single payoff at the end of Year 4 of $6,996.46. What is the IRR for the
project (round to the nearest percent)?
A) 16%
B) 13%
C) 21%
D) 15%
4) Given the following annual net cash flows, determine the
IRR to the nearest whole percent of a project with an initial outlay of $1,800.
Year Net Cash Flow
1 $1,000
2 $750
3 $500
A) 14%
B) 12%
C) 8%
D) 25%
5) Initial Outlay Cash
Flow in Period
1 2 3 4
$4,000 $1,546.17 $1,546.17 $1,546.17 $1,546.17
The IRR (to the nearest whole percent) is
A) 10%.
B) 18%.
C) 20%.
D) 16%.
6) Your company is considering a project with the following
cash flows:
Initial outlay = $1,748.80
Cash flows Years 16 = $500
Compute the IRR on the project.
A) 9%
B) 11%
C) 18%
D) 24%
7) Project Black Swan requires an initial investment of
$115,000. It has positive cash flows of $140,000 for each of the next two
years. Because of major demolition and environmental cleanup costs, cash flow
for the third and final year of the project is $(170,000). If the company 's
required rate of return is 12%, the project should be
A) rejected because the IRR is less than 12%.
B) accepted because the NPV is positive at 12%.
C) the project is unacceptable at any discount rate.
D) rejected because there may be more than one IRR.
8) Project Black Swan requires an initial investment of
$115,000. It has positive cash flows of $140,000 for each of the next two years.
Because of major demolition and environmental cleanup costs, cash flow for the
third and final year of the project is $(170,000).
A) All possible IRR's for this project are negative.
B) It is not possible to compute an IRR for this project.
C) The project is unacceptable at any required rate of
return.
D) This project might have more than one IRR.
9) Compute the payback period for a project with the
following cash flows, if the company's discount rate is 12%.
Initial outlay = $450
Cash flows: Year 1 = $325
Year
2 = $65
Year
3 = $100
A) 3.43 years
B) 3.17 years
C) 2.88 years
D) 2.6 years
10) Project Black Swan requires an initial investment of
$115,000. It has positive cash flows of $140,000 for each of the next two
years. Because of major demolition and environmental cleanup costs, cash flow
for the third and final year of the project is $(170,000).
A) All possible IRR's for this project are negative.
B) It is not possible to compute an IRR for this project.
C) This project might have more than one IRR, but only one
MIRR.
D) The project is unacceptable at any required rate of
return. This project might have more than one IRR.
11) Project Black Swan requires an initial investment of
$115,000. It has positive cash flows of $140,000 for each of the next two
years. Because of major demolition and environmental cleanup costs, cash flow
for the third and final year of the project is $(170,000). The company accepts
all projects with a payback period of 2 years or less.
A) The payback rule would reject this project because of
its risks are too high.
B) The payback rule would reject this project because all
negative cash flows are added together.
C) If strictly applied, the payback rule would reject this
project.
D) If strictly applied, the payback rule would accept this
project.
12) Consider a
project with the following cash flows:
AfterTax AfterTax
Accounting Cash Flow
Year Profits from Operations
1 $799 $750
2 $150 $1,000
3 $200 $1,200
Initial outlay =
$1,500
Terminal cash flow =
0
Compute the profitability index if the company's discount
rate is 10%.
A) 15.8
B) 1.61
C) 1.81
D) 0.62
13) Manheim Candles is considering a project with the
following incremental cash flows. Assume a discount rate of 10%.
Year Cash
Flow
0 ($20,000)
1 0
2 $30,000
3 $30,000
Calculate the project's MIRR. (Round to the nearest whole
percentage.)
A) 31%
B) 47%
C) 53%
D) 61%
14) Project H requires an initial investment of $100,000
and produces annual cash flows of $50,000, $40,000, and $30,000. Project T
requires an initial investment of $100,000 and the produces annual cash flows
of $30,000, $40,000, and $50,000. The projects are mutually exclusive. The
company accepts projects with payback periods of 3 years or less.
A) Project H will be accepted.
B) Project T will be accepted.
C) H and T will both be accepted.
D) Neither projected will be accepted.
15) A new forklift under consideration by Home Warehouse
requires an initial investment of $100,000 and produces annual cash flows of
$50,000, $40,000, and $30,000. Which of the following will not change if the
required rate of return is increased from 10% to 12%.
A) The net present value.
B) The internal rate of return.
C) The profitability index.
D) The modified internal rate of return.
16) Project Ell requires an initial investment of $50,000
and the produces annual cash flows of $30,000, $25,000, and $15,000. Project
Ess requires an initial investment of $60,000 and then produces annual cash
flows of $25,000 per year for the next ten years. The company ranks projects by
their payback periods.
A) Projects with unequal lives cannot be ranked using the
payback method.
B) Ess will be ranked higher than Ell.
C) Ell and Ess will be ranked equally.
D) Ell will be ranked higher than Ess.
17) Which of the following series of cash flows could have
more than one IRR? (Negative cash flows are in parentheses.)
A) $(XX,XXX), $X,XXX , $X,XXX, $X,XXX
B) $(XX,XXX), $X,XXX , $X,XXX, $X,XXX, $(XX,XXX)
C) $X,XXX, $X,XXX , $X,XXX, $X,XXX, $(XX,XXX)
D) $XX,XXX, $X,XXX , $X,XXX, $X,XXX
Use the following information to answer the following
question.
Below are the expected aftertax cash flows for Projects Y
and Z. Both projects have an initial cash outlay of $20,000 and a required rate
of return of 17%.
Project Y Project Z
Year 1 $12,000 $10,000
Year 2 $8,000 $10,000
Year 3 $6,000 0
Year 4 $2,000 0
Year 5 $2,000 0
18) Payback for Project Y is
A) two years.
B) one year.
C) three years.
D) four years.
19) What is payback for Project Z?
A) Two years
B) One year
C) Zero years
D) Project Z does not payback the original investment.
20) MacHinery Manufacturing Company is considering a
threeyear project that has a cost of $75,000. The project will generate
aftertax cash flows of $33,100 in Year 1, $31,500 in Year 2, and $31,200 in
Year 3. Assume that the firm's proper rate of discount is 10% and that the
firm's tax rate is 40%. What is the project's payback?
A) 0.33 years
B) 1.22 years
C) 2.33 years
D) Three years
21) MacHinery Manufacturing Company is considering a
threeyear project that has a cost of $75,000. The project will generate
aftertax cash flows of $33,100 in Year 1, $31,500 in Year 2, and $31,200 in
Year 3. Assume that the appropriate discount rate is 10% and that the firm's
tax rate is 40%. What is the project's discounted payback period?
A) 2.81 years
B) 2.33 years
C) 1.22 years
D) The project never reaches payback.
22) Analysis of a machine indicates that it has a cost of
$5,375,000. The machine is expected to produce cash inflows of $1,825,000 in
Year 1; $1,775,000 in Year 2; $1,630,000 in Year 3; $1,585,000 in Year 4; and
$1,650,000 in Year 5. What is the machine's IRR?
A) 12.16%
B) 17.81%
C) 23.00%
D) 11.11%
Use the following information to answer the following
question.
Below are the expected aftertax cash flows for Projects Y
and Z. Both projects have an initial cash outlay of $20,000 and a required rate
of return of 17%.
Project Y Project Z
Year 1 $12,000 $10,000
Year 2 $8,000 $10,000
Year 3 $6,000 0
Year 4 $2,000 0
Year 5 $2,000 0
23) Discounted payback periods for projects Y and Z are
A) 1.64 and 1.71 years.
B) 3.14 years and never.
C) 2 years and 2 years.
D) 5 years and never.
24) You are considering investing in a project with the
following yearend aftertax cash flows:
Year 1: $5,000
Year 2: $3,200
Year 3: $7,800
If the initial outlay for the project is $12,113, compute
the project's IRR.
A) 14%
B) 10%
C) 32%
D) 24%
25) WKW, Inc. is analyzing a project that requires an
initial investment of $10,000, followed by cash inflows of $1,000 in Year 1,
$4,000 in Year 2, and $15,000 in Year 3. The cost of capital is 10%. What is
the profitability index of the project?
A) 1.04
B) 1.55
C) 1.78
D) 1.97
26) Frazier Fudge has a project with an initial outlay of
$40,000, followed by three years of annual incremental cash flows of $35,000.
At the end of the third year, equipment will be sold producing additional cash
flow of $10,000. Assuming a cost of capital of 10%, calculate the MIRR of the
project.
A) 46.5%
B) 51.3%
C) 62.9%
D) 74.7%
27) Frazier Fudge has a project with an initial outlay of
$40,000, followed by three years of annual incremental cash flows of $35,000.
At the end of the third year, equipment will be sold producing additional cash
flow of $10,000. Assuming a discount rate of 10%, which of the following is the
correct equation to solve for the IRR of the project?
A) $40,000 = $35,000(1.12)1 + $35,000(1.12)2 + $45,000(1.12)3
B) $40,000 = $35,000(1 + IRR)1 + $35,000(1 + IRR)2 + $45,000(1 + IRR)3
C) $40,000 = $35,000/(1.12)IRR + $35,000/(1.12)IRR + $45,000/(1.12)IRR
D) $40,000 = $35,000/(1 + IRR) + $35,000/(1.IRR) +
$45,000/(1 + IRR)
28) The Seattle Corporation has been presented with an
investment opportunity which will yield cash flows of $30,000 per year in Years
1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10.
This investment will cost the firm $100,000 today, and the firm's cost of
capital is 10%. Assume cash flows occur evenly during the year.
A) 5.23 years
B) 4.26 years
C) 4.35 years
D) 3.72 years
29) The director of capital budgeting of South Park
Development Corporation is evaluating a project that will cost $200,000; it is
expected to last for 10 years and produce aftertax cash flows, including
depreciation, of $44,503 per year. If the firm's cost of capital is 14% and its
tax rate is 40%, what is the project's IRR?
A) 8%
B) 14%
C) 18%
D) 5%
30) The owner of a small construction business has asked
you to evaluate the purchase of a new front end loader. You have determined
that this investment has a large, positive, NPV, but are afraid that your
client will not understand the method. A good alternative method in this
circumstance might be
A) the payback method.
B) the profitability index.
C) the internal rate of return.
D) the modified internal rate of return.
31) Whenever the IRR on a project equals that project's
required rate of return
A) the NPV equals 0.
B) The NPV equals the initial investment.
C) The profitability index equals 0.
D) The NPV equals 1.
32) Aroma Candles, Inc. is evaluating a project with the
following cash flows. Calculate the IRR of the project. (Round to the nearest
whole percentage.)
Year Cash Flows
0 ($120,000)
1 $30,000
2 $70,000
3 $90,000
A) 18%
B) 23%
C) 28%
D) 33%
33) Aroma Candles, Inc. is evaluating a project with the
following cash flows. The project involves a new product that will not affect
the sales of any other project. Which two methods would always lead to the same
accept/reject decision for this project, regardless of the discount rate.
Year Cash Flows
0 ($120,000)
1 $30,000
2 $70,000
3 $90,000
A) Payback and Discounted Payback
B) NPV and Payback
C) NPV and IRR
D) Discounted Payback and IRR
34) Which of the following is considered to be a deficiency
of the IRR?
A) It fails to properly rank capital projects.
B) It could produce more than one rate of return.
C) It fails to utilize the time value of money.
D) It is not useful in accounting for risk in capital
budgeting.
35) You have been asked to analyze a capital investment
proposal. The project's cost is $2,775,000. Cash inflows are projected to be
$925,000 in Year 1; $1,000,000 in Year 2; $1,000,000 in Year 3; $1,000,000 in
Year 4; and $1,225,000 in Year 5. Assume that your firm discounts capital
projects at 15.5%. What is the project's MIRR?
A) 12.62%
B) 10.44%
C) 16.73%
D) 19.99%
36) Dizzyland Enterprises has been presented with an
investment opportunity which will yield endofyear cash flows of $30,000 per
year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000
in Year 10. This investment will cost the firm $150,000 today, and the firm's
cost of capital is 10%. What is the profitability index for this investment?
A) 1.34
B) 0.87
C) 1.85
D) 0.21
37) We compute the profitability index of a
capitalbudgeting proposal by
A) multiplying the IRR by the cost of capital.
B) dividing the present value of the annual aftertax cash
flows by the cost of capital.
C) dividing the present value of the annual aftertax cash
flows by the cost of the project.
D) multiplying the cash inflow by the IRR.
38) What is the payback period for a $20,000 project that
is expected to return $6,000 for the first two years and $3,000 for Years 3
through 5?
A) 3 1/2
B) 4 1/2
C) 4 2/3
D) 5
39) The payback method focuses primarily on the length of
time required to recover the cost of the investment rather than estimating the
total value the project will add to the firm.
Answer: TRUE
40) One advantage of the payback method is that it can be
readily understood by people with no special training in finance.
Answer: TRUE
41) When several sign reversals in the cash flow stream
occur, the IRR equation can have more than one positive IRR.
Answer: TRUE
42) If the project's internal rate of return is greater
than or equal to zero, the project should always be accepted.
Answer: FALSE
43) The profitability index provides the same accept/reject
decision result as the net present value (NPV) method but would not necessarily
rank mutually exclusive projects the same way.
Answer: TRUE
44) The internal rate of return (IRR) will increase as the
required rate of return of a project is increased.
Answer: FALSE
45) The IRR assumes that cash flows are reinvested at the
cost of capital.
Answer: FALSE
46) If the NPV of a project is zero, then the profitability
index should equal one.
Answer: TRUE
47) Unlike the basic IRR method, the MIRR method allows the
analyst to specify a reinvestment rate for positive cash flows.
Answer: TRUE
48) According to the modified internal rate of return
(MIRR) technique, when a project's MIRR is greater than its cost of capital,
the project should be accepted.
Answer: TRUE
49) The IRR is the discount rate that equates the present
value of the project's future net cash flows with the project's initial outlay.
Answer: TRUE
50) Determine the IRR on the following projects:
a. Initial
outlay of $35,000 with an aftertax cash flow at the end of the year of $5,836
for seven years
b. Initial
outlay of $350,000 with an aftertax cash flow at the end of the year of
$70,000 for seven years
c. Initial
outlay of $3,500 with an aftertax cash flow at the end of the year of $1,500
for three years
Answer:
Using a financial calculator
a. N=7,
PV=35,000, PMT=5,836, FV= 0, solve for i=4.02%
b. N=7,
PV=350,000, PMT=70,000, solve for i=9.2%
c. N=7,
PV=3,500, PMT=1,500, FV= 0, solve for i=13.7%
51) Discuss the merits and shortcomings of using the
payback period for capital budgeting decisions.
Answer: The payback
period is intuitive and easily understood even by those with no training in
finance. It also provides a quick assessment of a project's risk because cash
flow forecasts are likely to be more accurate for the nearterm.
On the other hand, there is no clearcut decision rule
associated with this method; it does not specifically take the time value of
money into account, and it ignores cash flows that occur after the payback
period.
52) Project November requires an initial investment of
$500,000. The present value of operating cash flows is $550,000. Project
December requires an initial investment of $750,000. The present value of
operating cash flows is $810,000.
a. Compute the profitability index for each project.
b. If the projects are mutually exclusive, does the
profitability index rank them correctly?
Answer:
a. The PI for November is 550,000/500,000 = 1.1. The PI for
December is 810,000/750,000 = 1.08.
b. The PI criterion would select project November because
it has the higher PI. December, however, has the higher NPV ($60,000 v.
$50,000) and should be selected, so the method does not rank the projects
correctly.
53) Black Friday Inc. has estimated the following cash
flows for a project it is considering:
Period

Cash Flow

0

($150,000)

1

$70,000

2

$80,000

3

($100,0000)

a. What is the payback period for this project?
b. What is the obvious problem with using the payback
method in this case?
Answer: The payback
period is exactly 2 years (70,000+80,000) = 150,000. However, the project
obviously has a negative NPV at any discount rate. One major problem with the
payback method is that it ignores cash flows occurring after the payback
period.
54) Tinker Tools, Inc. is considering a project with the
following cash flows. Calculate the MIRR of the project assuming a reinvestment
rate of 8%.
Year Cash
Flows
0 ($70,000)
1 ($55,000)
2 $40,000
3 $60,000
4 $100,000
Answer:
PV Cash Outflows
Year 0
= $70,000
Year
1: Calculator Steps' →
N=1, i=8, FV=55,000, solve for PV = $50,926
PV
Outflows = $70,000  $50,926 = $120,926
FV of Cash Inflows
N=2,
i=8, PV=40000, PMT =0, solve for FV = $46,656
N=1,
i=8, PV=60000, PMT =0, solve for FV = $64,800
FV of
Inflows = $46,656 +$64,800 + $100,000 = $211,456
MIRR: N=4, PV=$120,926,FV= $211,456 solve for
i=15%
11.4 A Glance at Actual CapitalBudgeting
Practices
1) Recent surveys of the CFOs of large U.S. companies rank
the popularity of major capital budgeting methods in which order?
A) IRR, NPV, Payback, Discounted Payback, Profitability
Index
B) Payback, Discounted Payback, Profitability Index, IRR,
NPV
C) NPV, IRR, Profitability Index, Discounted Payback,
Payback
D) NPV, IRR,
Payback, Discounted Payback, Profitability Index
2) Which of the following best explains the continuing
popularity of the payback method?
A) Mathematical simplicity and some insight into the riskiness
of cash flows.
B) Uses all cash flows and takes into account the time
value of money.
C) Reliably selects the projects that add most value to the
firm.
D) It provides objective selection criteria and is taught
as the primary method in most business schools.
3) With respect to the capital budgeting practices of large
U. S. corporations
A) the profitability index has been gaining in popularity.
B) IRR and NPV have been gaining in popularity.
C) payback and discounted payback have been gaining in
popularity.
D) IRR and NPV have declined in popularity.
4) Which of the following techniques will always produce a
single rate of return estimate?
A) IRR
B) MIRR
C) PI
D) Discounted payback
5) Which of the following techniques might be useful in
situations where the economic life of a project is highly uncertain?
A) IRR
B) MIRR
C) PI
D) Discounted payback
6) Which of the following techniques might be useful in
situations where mutually exclusive projects have unequal lives?
A) IRR
B) Equivalent annual cost (EAC).
C) PI
D) Discounted payback
7) When various capital budgeting techniques rank mutually
exclusive projects differently, which of the following is theoretically most
reliable?
A) IRR
B) Equivalent annual cost (EAC).
C) NPV
D) Discounted payback
8) Many firms today continue to use the payback method but
employ the NPV or IRR methods as secondary decision methods of control for
risk.
Answer: FALSE
9) Currently, most firms use NPV and IRR as their primary
capitalbudgeting technique.
Answer: TRUE
10) Most firms use the payback period as a secondary capitalbudgeting
technique, which in a sense allows them to control for risk.
Answer: TRUE
11) Although discounted cash flow decision techniques have
become widely accepted, their use depends to some degree on the size of the
project and where within the firm the decision is being made.
Answer: TRUE
12) Briefly describe the actual capital budgeting methods
of large U.S. corporations.
Answer: According to
recent surveys of CFOs, the most common methods are IRR and NPV used by more
than 70% of large corporations. The payback method remains popular and is used
as a primary or secondary method by almost 60% of those surveyed, perhaps
because of its simplicity and for a quick calculation of risk.
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