Chapter 11

Capital Budgeting Decisions

 

True / False Questions

 
1. In comparing two investment alternatives, the difference between the net present values of the two
alternatives obtained using the total cost approach will be the same as the net present value
obtained using the incremental cost approach.  T
 
2. If two projects require the same amount of investment, then the preference ranking computed
using either the project profitability index or the net present value will be the same.  T
 
3. In preference decisions, the profitability index and internal rate of return methods may produce
conflicting rankings of projects.  T
 
4. The project profitability index is used to compare the internal rates of return of two companies with
different investment amounts.  F
 
5. Preference decisions attempt to determine which of many alternative investment projects would be
the best for the company to accept.  T
 
6. Projects with shorter payback periods are always more profitable than projects with longer payback
periods.  F
 
7. One criticism of the payback method is that it ignores cash flows that occur after the payback point
has been reached.  T
 
8. A very useful guide for making investment decisions is: The shorter the payback period, the more
profitable the project.  F
 
9. If new equipment is replacing old equipment, any salvage received from sale of the old equipment
should not be considered in computing the payback period of the new equipment.  F
 
10. The simple rate of return focuses on accounting net operating income rather than on cash flows. T

 
11. The simple rate of return method places its focus on cash flows instead of on accounting net
operating income.  F
 
 Multiple Choice Questions
 
12. The capital budgeting method that recognizes the time value of money by discounting cash flows
over the life of the project, using the company's required rate of return as the discount rate is called
the:  

A. simple rate of return method.

 B. the net present value method.

C. the financing method.

D. the payback method.

 
13. If an investment has a project profitability index of 0.15, then the:  

A. project's internal rate of return is 15%.

B. discount rate is greater than the project's internal rate of return.

C. net present value of the project is positive.

D. the discount rate is 15%.

 
14. If investment A has a payback period of 3 years and investment B has a payback period of 4 years,
then:  

A. A has a higher net present value than B.

B. A has a lower net present value than B.

C. A and B have the same net present value.

D. the relation between investment A's net present value and investment B's net present value
cannot be determined from the given information.
 

15. Which one of the following statements about the payback method of capital budgeting is correct? 
 

A. The payback method does not consider the time value of money.

B. The payback method considers cash flows after the payback has been reached.

C. The payback method uses discounted cash flow techniques.

D. The payback method will lead to the same decision as other methods of capital budgeting.

16. The length of time required to recover the initial cash outlay for a project is determined by using
the:  

A. discounted cash flow method.

B. the payback method.

C. the net present value method.

 D. the simple rate of return method.
 
17. (Ignore income taxes in this problem.) A piece of new equipment will cost $70,000. The equipment
will provide a cost savings of $15,000 per year for ten years, after which it will have a $3,000 salvage
value. If the required rate of return is 14%, the equipment's net present value is:  

A. $8,240

B. $(8,240)

C. $23,888

D. $9,050

 (70,000) + 15,000@5.216 + 3,000 @ .27 = 9,050

18. (Ignore income taxes in this problem.) Sibble Corporation is considering the purchase of a machine
that would cost $330,000 and would last for 5 years. At the end of 5 years, the machine would have
a salvage value of $50,000. By reducing labor and other operating costs, the machine would provide
annual cost savings of $76,000. The company requires a minimum pretax return of 12% on all
investment projects. The net present value of the proposed project is closest to:  

A. -$56,020

B. -$6,020

C. -$48,764

D. -$27,670

 (330,000) + 50,000@.567 + 76,000 @ 3.605 = -27,670

 
19. (Ignore income taxes in this problem.) Benz Company is considering the purchase of a machine that
costs $100,000, has a useful life of 18 years, and no salvage value. The company's discount rate is
12%. If the machine's net present value is $5,850, then the annual cash inflows associated with the
machine must be (round to the nearest whole dollar):  

A. $42,413

B. $14,600

C. $13,760

D. It is impossible to determine from the data given.

Now (100,000) + …….= $5,850

 Discounted cash inflows = 105,850
Annuity 12%, 18 years factor 7.25
105850/7.25 = 14,600
 
20. (Ignore income taxes in this problem.) Sam Weller is thinking of investing $70,000 to start a
bookstore. Sam plans to withdraw $15,000 from the business at the end of each year for the next
five years. At the end of the fifth year, Sam plans to sell the business for $110,000 cash. At a 12%
discount rate, what is the net present value of the investment?  

A. $54,075

B. $62,370

C. $46,445

D. $70,000
 
(70,000)+ 15,000@12%;5 yrs +
110,000@12%;in 5 yrs =
(70,000)+54,075+62,370=46,44
5
(Ignore income taxes in this problem.) The following data pertain to an
21. investment proposal:

   

The net present value of the proposed investment is:  

A. $1,720

B. $6,064

C. $2,154

D. $2,025
 (20,000) +v 5,000 x 4.344 + 1,000 x .305 = 2,205

22. (Ignore income taxes in this problem) The management of Serpas Corporation is considering the
purchase of a machine that would cost $180,000, would last for 5 years, and would have no salvage
value. The machine would reduce labor and other costs by $46,000 per year. The company requires
a minimum pretax return of 13% on all investment projects. The net present value of the proposed
project is closest to:  

A. $27,138
 B. $50,000

C. -$18,218

D. -$33,565
 
(180,000) + 46,000 @ 13%;5 yrs = (180,000) + 46000 x 3.517 = -18,218

23. (Ignore income taxes in this problem.) The Gage Company purchased a machine which will be
depreciated by the straight-line method over its estimated 6 year life. The machine will have no
salvage value. It will generate cash inflows of $7,000 each year over the next 6 years. Gage
Company's required rate of return is 14%. If the net present value of this investment is $12,016, the
purchase price of the machine was:  
A. $30,016

B. $15,20
7

C. $17,916

D. $18,000
 
24. (Ignore income taxes in this problem.) Stutz Company purchased a machine with an estimated
useful life of seven years. The machine will generate cash inflows of $8,000 each year over the next
seven years. If the machine has no salvage value at the end of seven years, if Stutz's discount rate is
12%, and if the net present value of this investment is $15,000, then the purchase price of the
machine was:  

A. $17,888

B. $36,512

C. $15,000

D. $21,512
 
25. (Ignore income taxes in this problem.) Mcclam, Inc., is considering the purchase of a machine that
would cost $100,000 and would last for 9 years. At the end of 9 years, the machine would have a
salvage value of $23,000. The machine would reduce labor and other costs by $19,000 per year.
Additional working capital of $2,000 would be needed immediately. All of this working capital would
be recovered at the end of the life of the machine. The company requires a minimum pretax return
of 13% on all investment projects. The net present value of the proposed project is closest to:  

A. $3,833

B. $5,167
C. -$2,492

D. $11,514