Chapter 14—CAPITAL BUDGETING

MULTIPLE CHOICE

1. Which of the following capital budgeting techniques ignores the time value of money?
a. payback period
b. net present value
c. internal rate of return
d. profitability index

ANS: A DIF: 1

2. Which of the following capital budgeting techniques may potentially ignore part of a project's
relevant cash flows?
a. net present value
b. internal rate of return
c. payback period
d. profitability index

ANS: C DIF: 1

3. In comparing two projects, the ___________ is often used to evaluate the relative riskiness of the
projects.
a. payback period
b. net present value
c. internal rate of return
d. discount rate

ANS: A DIF: 1

4. Which of the following capital budgeting techniques does not routinely rely on the assumption
that all cash flows occur at the end of the period?
a. internal rate of return
b. net present value
c. profitability index
d. payback period

ANS: D DIF: 1

5. Assume that a project consists of an initial cash outlay of $100,000 followed by equal annual
cash inflows of $40,000 for 4 years. In the formula X = $100,000/$40,000, X represents the
a. payback period for the project.
b. profitability index of the project.
c. internal rate of return for the project.
d. project's discount rate.

ANS: A DIF: 1
 6. All other factors equal, a large number is preferred to a smaller number for all capital project
evaluation measures except
a. net present value.
b. payback period.
c. internal rate of return.
d. profitability index.

ANS: B DIF: 1

7. The payback method assumes that all cash inflows are reinvested to yield a return equal to
a. the discount rate.
b. the hurdle rate.
c. the internal rate of return.
d. zero.

ANS: D DIF: 1

8. The payback method measures

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

ANS: A DIF: 1

9. If investment A has a payback period of three years and investment B has a payback period of
four years, then
a. A is more profitable than B.
b. A is less profitable than B.
c. A and B are equally profitable.
d. the relative profitability of A and B cannot be determined from the information given.

ANS: D DIF: 1

10. The payback period is the

a. length of time over which the investment will provide cash inflows.
b. length of time over which the initial investment is recovered.
c. shortest length of time over which an investment may be depreciated.
d. shortest length of time over which the net present value will be positive.

ANS: B DIF: 1

11. Which of the following capital budgeting techniques has been criticized because it fails to
consider investment profitability?
a. payback method
b. accounting rate of return
c. net present value method
d. internal rate of return
 ANS: A DIF: 1

12. The time value of money is explicitly recognized through the process of
a. interpolating.
b. discounting.
c. annuitizing.
d. budgeting.

ANS: B DIF: 1

13. The time value of money is considered in long-range investment decisions by

a. assuming equal annual cash flow patterns.
b. investing only in short-term projects.
c. assigning greater value to more immediate cash flows.
d. ignoring depreciation and tax implications of the investment.

ANS: C DIF: 1

14. When using one of the discounted cash flow methods to evaluate the desirability of a capital
budgeting project, which of the following factors is generally not important?
a. method of financing the project under consideration
b. timing of cash flows relating to the project
c. impact of the project on income taxes to be paid
d. amounts of cash flows relating to the project

ANS: A DIF: 1

15. As to a capital investment, net cash inflow is equal to the

a. cost savings resulting from the investment.
b. sum of all future revenues from the investment.
c. net increase in cash receipts over cash payments.
d. net increase in cash payments over cash receipts.

ANS: C DIF: 1

16. In a discounted cash flow analysis, which of the following would not be consistent with adjusting
a project's cash flows to account for higher-than-normal risk?
a. increasing the expected amount for cash outflows
b. increasing the discounting period for expected cash inflows
c. increasing the discount rate for cash outflows
d. decreasing the amount for expected cash inflows

ANS: C DIF: 3

17. When a project has uneven projected cash inflows over its life, an analyst may be forced to use
___________________ to find the project's internal rate of return.
a. a screening decision
 b. a trial-and-error approach
c. a post investment audit
d. a time line

ANS: B DIF: 1

18. The interest rate used to find the present value of a future cash flow is the
a. prime rate.
b. discount rate.
c. cutoff rate.
d. internal rate of return.

ANS: B DIF: 1

19. A firm's discount rate is typically based on

a. the interest rates related to the firm's bonds.
b. a project's internal rate of return.
c. its cost of capital.
d. the corporate Aa bond yield.

ANS: C DIF: 1

20. In capital budgeting, a firm's cost of capital is frequently used as the

a. internal rate of return.
b. accounting rate of return.
c. discount rate.
d. profitability index.

ANS: C DIF: 1

21. The net present value method assumes that all cash inflows can be immediately reinvested at the
a. cost of capital.
b. discount rate.
c. internal rate of return.
d. rate on the corporation's short-term debt.

ANS: B DIF: 1

22. Which of the following changes would not decrease the present value of the future depreciation
deductions on a specific depreciable asset?
a. a decrease in the marginal tax rate
b. a decrease in the discount rate
c. a decrease in the rate of depreciation
d. an increase in the life expectancy of the depreciable asset

ANS: B DIF: 3

23. To reflect greater uncertainty (greater risk) about a future cash inflow, an analyst could
a. increase the discount rate for the cash flow.
 b. decrease the discounting period for the cash flow.
c. increase the expected value of the future cash flow before it is discounted.
d. extend the acceptable length for the payback period.

ANS: A DIF: 1

24. A change in the discount rate used to evaluate a specific project will affect the project's
a. life.
b. payback period.
c. net present value.
d. total cash flows.

ANS: C DIF: 1

25. For a project such as plant investment, the return that should leave the market price of the firm's
stock unchanged is known as the
a. cost of capital.
b. net present value.
c. payback rate.
d. internal rate of return.

ANS: A DIF: 3

26. The pre-tax cost of capital is higher than the after-tax cost of capital because
a. interest expense is deductible for tax purposes.
b. principal payments on debt are deductible for tax purposes.
c. the cost of capital is a deductible expense for tax purposes.
d. dividend payments to stockholders are deductible for tax purposes.

ANS: A DIF: 1

27. The basis for measuring the cost of capital derived from bonds and preferred stock, respectively,
is the
a. pre-tax rate of interest for bonds and stated annual dividend rate less the expected earnings
per share for preferred stock.
b. pre-tax rate of interest for bonds and stated annual dividend rate for preferred stock.
c. after-tax rate of interest for bonds and stated annual dividend rate less the expected
earnings per share for preferred stock.
d. after-tax rate of interest for bonds and stated annual dividend rate for preferred stock.

ANS: D DIF: 3

28. The combined weighted average interest rate that a firm incurs on its long-term debt, preferred
stock, and common stock is the
a. cost of capital.
b. discount rate.
c. cutoff rate.
d. internal rate of return.
 ANS: A DIF: 1

29. The weighted average cost of capital that is used to evaluate a specific project should be based on
the
a. mix of capital components that was used to finance a project from last year.
b. overall capital structure of the corporation.
c. cost of capital for other corporations with similar investments.
d. mix of capital components for all capital acquired in the most recent fiscal year.

ANS: B DIF: 1

30. Debt in the capital structure could be treated as if it were common equity in computing the
weighted average cost of capital if the debt were
a. callable.
b. participating.
c. cumulative.
d. convertible.

ANS: D DIF: 3

31. The weighted average cost of capital approach to decision making is not directly affected by the
a. value of the common stock.
b. current budget for capital expansion.
c. cost of debt outstanding.
d. proposed mix of debt, equity, and existing funds used to implement the project.

ANS: B DIF: 1

32. The ___________________ is the highest rate of return that can be earned from the most
attractive, alternative capital project available to the firm.
a. accounting rate of return
b. internal rate of return
c. hurdle rate
d. opportunity cost of capital

ANS: D DIF: 3

33. If an analyst desires a conservative net present value estimate, he/she will assume that all cash
inflows occur at
a. mid year.
b. the beginning of the year.
c. year end.
d. irregular intervals.

ANS: C DIF: 1

34. The salvage value of an old lathe is zero. If instead, the salvage value of the old lathe was
$20,000, what would be the impact on the net present value of the proposal to purchase a new
lathe?
 a. It would increase the net present value of the proposal.
b. It would decrease the net present value of the proposal.
c. It would not affect the net present value of the proposal.
d. Potentially it could increase or decrease the net present value of the new lathe.

ANS: A DIF: 1

35. The net present value method of evaluating proposed investments

a. measures a project's internal rate of return.
b. ignores cash flows beyond the payback period.
c. applies only to mutually exclusive investment proposals.
d. discounts cash flows at a minimum desired rate of return.

ANS: D DIF: 1

36. Which of the following statements is true regarding capital budgeting methods?
a. The Fisher rate can never exceed a company's cost of capital.
b. The internal rate of return measure used for capital project evaluation has more
conservative assumptions than the net present value method, especially for projects that
generate a positive net present value.
c. The net present value method of project evaluation will always provide the same ranking
of projects as the profitability index method.
d. The net present value method assumes that all cash inflows can be reinvested at the
project's cost of capital.

ANS: D DIF: 1

37. A company is evaluating three possible investments. Information relating to the company and the
investments follow:

Fisher rate for the three projects 7%

Cost of capital 8%

Based on this information, we know that

a. all three projects are acceptable.
b. none of the projects are acceptable.
c. the capital budgeting evaluation techniques profitability index, net present value, and
internal rate of return will provide a consistent ranking of the projects.
d. the net present value method will provide a ranking of the projects that is superior to the
ranking obtained using the internal rate of return method.

ANS: C DIF: 3

38. If a project generates a net present value of zero, the profitability index for the project will
a. equal zero.
b. equal 1.
c. equal -1.
d. be undefined.
 ANS: B DIF: 1

39. If the profitability index for a project exceeds 1, then the project's
a. net present value is positive.
b. internal rate of return is less than the project's discount rate.
c. payback period is less than 5 years.
d. accounting rate of return is greater than the project's internal rate of return.

ANS: A DIF: 1

40. If a project's profitability index is less than 1, the project's

a. discount rate is above its cost of capital.
b. internal rate of return is less than zero.
c. payback period is infinite.
d. net present value is negative.

ANS: D DIF: 1

41. The profitability index is

a. the ratio of net cash flows to the original investment.
b. the ratio of the present value of cash flows to the original investment.
c. a capital budgeting evaluation technique that doesn't use discounted values.
d. a mandatory technique when capital rationing is used.

ANS: B DIF: 1

42. Which method of evaluating capital projects assumes that cash inflows can be reinvested at the
discount rate?
a. internal rate of return
b. payback period
c. profitability index
d. accounting rate of return

ANS: C DIF: 3

43. If the total cash inflows associated with a project exceed the total cash outflows associated with
the project, the project's
a. net present value is greater than zero.
b. internal rate of return is greater than zero.
c. profitability index is greater than 1.
d. payback period is acceptable.

ANS: B DIF: 1

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

ANS: B DIF: 1

45. If an investment has a positive net present value, the

a. internal rate of return is higher than the discount rate.
b. discount rate is higher than the hurdle rate of return.
c. internal rate of return is lower than the discount rate of return.
d. hurdle rate of return is higher than the discount rate.

ANS: A DIF: 1

46. The rate of interest that produces a zero net present value when a project's discounted cash
operating advantage is netted against its discounted net investment is the
a. cost of capital.
b. discount rate.
c. cutoff rate.
d. internal rate of return.

ANS: D DIF: 1

47. For a profitable company, an increase in the rate of depreciation on a specific project could
a. increase the project's profitability index.
b. increase the project's payback period.
c. decrease the project's net present value.
d. increase the project's internal rate of return.

ANS: D DIF: 3

48. Which of the following capital expenditure planning and control techniques has been criticized
because it might mistakenly imply that earnings are reinvested at the rate of return earned by the
investment?
a. payback method
b. accounting rate of return
c. net present value method
d. internal rate of return

ANS: D DIF: 1

49. If the discount rate that is used to evaluate a project is equal to the project's internal rate of return,
the project's _____________ is zero.
a. profitability index
b. internal rate of return
c. present value of the investment
d. net present value

ANS: D DIF: 1
50. As the marginal tax rate goes up, the benefit from the depreciation tax shield
a. decreases.
b. increases.
c. stays the same.
d. can move up or down depending on whether the firm's cost of capital is high or low.

ANS: B DIF: 3

51. When a profitable corporation sells an asset at a loss, the after-tax cash flow on the sale will
a. exceed the pre-tax cash flow on the sale.
b. be less than the pre-tax cash flow on the sale.
c. be the same as the pre-tax cash flow on the sale.
d. increase the corporation's overall tax liability.

ANS: A DIF: 3

52. In a typical (conservative assumptions) after-tax discounted cash flow analysis, depreciation
expense is assumed to accrue at
a. the beginning of the period.
b. the middle of the period.
c. the end of the period.
d. irregular intervals over the life of the investment.

ANS: C DIF: 1

53. The pre-tax and after-tax cash flows would be the same for all of the following items except
a. the liquidation of working capital at the end of a project's life.
b. the initial (outlay) cost of an investment.
c. the sale of an asset at its book value.
d. a cash payment for salaries and wages.

ANS: D DIF: 1

54. The after-tax net present value of a project is affected by

a. tax-deductible cash flows.
b. non-tax-deductible cash flows.
c. accounting accruals.
d. all of the above.

ANS: D DIF: 3

55. A project's after-tax net present value is increased by all of the following except
a. revenue accruals.
b. cash inflows.
c. depreciation deductions.
d. expense accruals.

ANS: A DIF: 1
56. Multiplying the depreciation deduction by the tax rate yields a measure of the depreciation tax
a. shield.
b. benefit.
c. payable.
d. loss.

ANS: B DIF: 1

57. Annual after-tax corporate net income can be converted to annual after-tax cash flow by
a. adding back the depreciation amount.
b. deducting the depreciation amount.
c. adding back the quantity (t  depreciation deduction), where t is the corporate tax rate.
d. deducting the quantity [(1- t)  depreciation deduction], where t is the corporate tax rate.

ANS: A DIF: 1

58. Income taxes are levied on

a. net cash flow.
b. income as measured by accounting rules.
c. net cash flow plus depreciation.
d. income as measured by tax rules.

ANS: D DIF: 1

59. Which of the following best represents a screening decision?

a. determining which project has the highest net present value
b. determining if a project's internal rate of return exceeds the firm's cost of capital
c. determining which projects are mutually exclusive
d. determining which are the best projects

ANS: B DIF: 1

60. Below are pairs of projects. Which pair best represents independent projects?
a. buy computer; buy software package
b. buy computer #1; buy computer #2
c. buy computer; buy computer security system
d. buy computer; repave parking lot

ANS: D DIF: 1

61. Which of the following are tax deductible under U.S. tax law?
a. interest payments to bondholders
b. preferred stock dividends
c. common stock dividends
d. all of the above

ANS: A DIF: 1

62. Sensitivity analysis is

 a. an appropriate response to uncertainty in cash flow projections.
b. useful in measuring the variance of the Fisher rate.
c. typically conducted in the post investment audit.
d. useful to compare projects requiring vastly different levels of initial investment.

ANS: A DIF: 3

63. If management judges one project in a mutually inclusive set to be acceptable for investment,
a. all the other projects in the set are rejected.
b. only one other project in the set can be accepted.
c. all other projects in the set are also accepted.
d. only one project in the set will be rejected.

ANS: C DIF: 1

64. All other factors equal, which of the following would affect a project's internal rate of return, net
present value, and payback period?
a. an increase in the discount rate
b. a decrease in the life of the project
c. an increase in the initial cost of the project
d. all of the above

ANS: C DIF: 1

65. (Present value tables needed to answer this question.) Tiger Inc. bought a piece of machinery with
the following data:

Useful life 6 years

Yearly net cash inflow $45,000
Salvage value -0-
Internal rate of return 18%
Cost of capital 14%

The initial cost of the machinery was

a. $157,392.
b. $174,992.
c. $165,812.
d. impossible to determine from the information given.

ANS: A DIF: 3

66. Microsoft Co. is considering the purchase of a $100,000 machine that is expected to result in a
decrease of $15,000 per year in cash expenses. This machine, which has no residual value, has an
estimated useful life of 10 years and will be depreciated on a straight-line basis. For this machine,
the accounting rate of return would be
a. 10 percent.
b. 15 percent.
c. 30 percent.
 d. 35 percent.

ANS: C DIF: 3 REF: App 14

67. An investment project is expected to yield $10,000 in annual revenues, has $2,000 in fixed costs
per year, and requires an initial investment of $5,000. Given a cost of goods sold of 60 percent of
sales, what is the payback period in years?
a. 2.50
b. 5.00
c. 2.00
d. 1.25

ANS: A DIF: 3

68. A project has an initial cost of $100,000 and generates a present value of net cash inflows of
$120,000. What is the project's profitability index?
a. .20
b. 1.20
c. .80
d. 5.00

ANS: B DIF: 3

69. (Present value tables needed to answer this question.) C Corp. faces a marginal tax rate of 35
percent. One project that is currently under evaluation has a cash flow in the fourth year of its life
that has a present value of $10,000 (after-tax). C Corp. assumes that all cash flows occur at the
end of the year and the company uses 11 percent as its discount rate. What is the pre-tax amount
of the cash flow in year 4? (Round to the nearest dollar.)
a. $15,181
b. $23,356
c. $9,868
d. $43,375

ANS: B DIF: 5

70. (Present value tables needed to answer this question.) The Salvage Co. is considering the
purchase of a new ocean-going vessel that could potentially reduce labor costs of its operation by
a considerable margin. The new ship would cost $500,000 and would be fully depreciated by the
straight-line method over 10 years. At the end of 10 years, the ship will have no value and will be
sunk in some already polluted harbor. The Salvage Co.'s cost of capital is 12 percent, and its
marginal tax rate is 40 percent. What is the present value of the depreciation tax benefit of the
new ship? (Round to the nearest dollar.)
a. $113,004
b. $282,510
c. $169,506
d. $200,000

ANS: A DIF: 5
71. (Present value tables needed to answer this question.) Salvage Co. is considering the purchase of
a new ocean-going vessel that could potentially reduce labor costs of its operation by a
considerable margin. The new ship would cost $500,000 and would be fully depreciated by the
straight-line method over 10 years. At the end of 10 years, the ship will have no value and will be
sunk in some already polluted harbor. The Salvage Co.'s cost of capital is 12 percent, and its
marginal tax rate is 40 percent. If the ship produces equal annual labor cost savings over its 10-
year life, how much do the annual savings in labor costs need to be to generate a net present
value of $0 on the project? (Round to the nearest dollar.)
a. $68,492
b. $114,154
c. $88,492
d. $147,487

ANS: C DIF: 5

72. Pebble Co. recently sold a used machine for $40,000. The machine had a book value of $60,000
at the time of the sale. What is the after-tax cash flow from the sale, assuming the company's
marginal tax rate is 20 percent?
a. $40,000
b. $60,000
c. $44,000
d. $32,000

ANS: C DIF: 3

Fordem Co.

Fordem Co. is considering an investment in a machine that would reduce annual labor costs by
$30,000. The machine has an expected life of 10 years with no salvage value. The machine would
be depreciated according to the straight-line method over its useful life. The company's marginal
tax rate is 30 percent.

73. Refer to Fordem Co. (Present value tables needed to answer this question.) Assume that the
company will invest in the machine if it generates an internal rate of return of 16 percent. What is
the maximum amount the company can pay for the machine and still meet the internal rate of
return criterion?
a. $180,000
b. $210,000
c. $187,500
d. $144,996

ANS: D DIF: 3

74. Refer to Fordem Co. (Present value tables needed to answer this question.) Assume the company
pays $250,000 for the machine. What is the expected internal rate of return on the machine?
a. between 8 and 9 percent
b. between 3 and 4 percent
c. between 17 and 18 percent
 d. less than 1 percent

ANS: B DIF: 3

Novelle Co.

The net after-tax cash flows associated with two projects under consideration by Novelle Co.
follow:

Project 1  Project 2 
Initial investment $(300,000) $(100,000)
Cash flows years 1-5 80,000  30,000 

75. Refer to Novelle Co. (Present value tables needed to answer this question.) What is the Fisher
rate for these two projects?
a. less than 1 percent
b. between 7 and 8 percent
c. between 4 and 5 percent
d. between 6 and 7 percent

ANS: B DIF: 3

76. Refer to Novelle Co. (Present value tables needed to answer this question.) Assume that the
company can potentially accept both projects, one project, or neither project. Which project(s)
would the company accept if it estimates its weighted average cost of capital is 9 percent?
a. both projects
b. Project 1
c. Project 2
d. neither project

ANS: A DIF: 3

77. (Present value tables needed to answer this question.) A project under consideration by the White
Corp. would require a working capital investment of $200,000. The working capital would be
liquidated at the end of the project's 10-year life. If White Corp. has an after-tax cost of capital of
10 percent and a marginal tax rate of 30 percent, what is the present value of the working capital
cash flow expected to be received in year 10?
a. $36,868
b. $77,100
c. $53,970
d. $23,130

ANS: B DIF: 3

78. (Present value tables needed to answer this question.) B Company is considering two alternative
ways to depreciate a proposed investment. The investment has an initial cost of $100,000 and an
expected five-year life. The two alternative depreciation schedules follow:
 Method 1 Method 2
Year 1 depreciation $20,000 $40,000
Year 2 depreciation $20,000 $30,000
Year 3 depreciation $20,000 $20,000
Year 4 depreciation $20,000 $10,000
Year 5 depreciation $20,000      $0

Assuming that the company faces a marginal tax rate of 40 percent and has a cost of capital of 10
percent, what is the difference between the two methods in the present value of the depreciation
tax benefit?
a. $7,196
b. $0
c. $2,878
d. $6,342

ANS: C DIF: 5

Blues Bros. Inc.

Blues Bros. Inc. is considering an investment in a computer that is capable of producing various
images that are useful in the production of commercial art. The computer would cost $20,000 and
have an expected life of eight years. The computer is expected to generate additional annual net
cash receipts (before-tax) of $6,000 per year. The computer will be depreciated according to the
straight-line method and the firm's marginal tax rate is 25 percent.

79. Refer to Blues Bros. Inc. What is the after-tax payback period for the computer project?
a. 7.62 years
b. 3.90 years
c. 4.44 years
d. 3.11 years

ANS: B DIF: 3

80. Refer to Blues Bros. Inc. (Present value tables needed to answer this question.) What is the after-
tax net present value of the proposed project (using a 16 percent discount rate)?
a. $2,261
b. $(454)
c. $6,062
d. $(4,797)

ANS: A DIF: 3

Hefty Investment

Hefty Investment Co. is considering an investment in a labor-saving machine. Information on this

machine follows:

Cost $30,000
 Salvage value in five years $0
Estimated life 5 years
Annual depreciation $6,000
Annual reduction in existing costs $8,000

81. Refer to Hefty Investment. (Present value tables needed to answer this question.) What is the
internal rate of return on this project (round to the nearest 1/2%)?
a. 37.5%
b. 25.0%
c. 10.5%
d. 13.5%

ANS: C DIF: 3

82. Refer to Hefty Investment. (Present value tables needed to answer this question.) Assume for this
question only that Hefty Co. uses a discount rate of 16 percent to evaluate projects of this type.
What is the project's net present value?
a. $(6,283)
b. $(3,806)
c. $(23,451)
d. $(22,000)

ANS: B DIF: 3

83. Refer to Hefty Investment. What is the payback period on this investment?
a. 4 years
b. 2.14 years
c. 3.75 years
d. 5 years

ANS: C DIF: 3

L&M Ironworks

L&M Ironworks is considering a proposal to sell an existing lathe and purchase a new computer-
operated lathe. Information on the existing lathe and the computer-operated lathe follow:

Existing Computer-operated
lathe lathe
Cost $100,000 $300,000
Accumulated depreciation   60,000        0
Salvage value now   20,000
Salvage value in 4 years        0   60,000
Annual depreciation   10,000   75,000
Annual cash operating costs  200,000   50,000
Remaining useful life  4 years  4 years

84. Refer to L&M Ironworks. What is the payback period for the computer-operated lathe?
 a. 1.87 years
b. 2.00 years
c. 3.53 years
d. 3.29 years

ANS: A DIF: 3

85. Refer to L&M Ironworks. (Present value tables needed to answer this question.) If the company
uses 10 percent as its discount rate, what is the net present value of the proposed new lathe
purchase?
a. $236,465
b. $256,465
c. $195,485
d. $30,422

ANS: A DIF: 3

Allendale Co.

The Allendale Co. has recently evaluated a proposal to invest in cost-reducing production
technology. According to the evaluation, the project would require an initial investment of
$17,166 and would provide equal annual cost savings for five years. Based on a 10 percent
discount rate, the project generates a net present value of $1,788. The project is not expected to
have any salvage value at the end of its five-year life.

86. Refer to Allendale Co. (Present value tables needed to answer this question.) What are the
expected annual cost savings of the project?
a. $3,500
b. $4,000
c. $4,500
d. $5,000

ANS: D DIF: 3

87. Refer to Allendale Co. (Present value tables needed to answer this question.) What is the project's
expected internal rate of return?
a. 10%
b. 11%
c. 13%
d. 14%

ANS: D DIF: 3

R Co.
 R Co. is involved in the evaluation of a new computer-integrated manufacturing system. The
system has a projected initial cost of $1,000,000. It has an expected life of six years, with no
salvage value, and is expected to generate annual cost savings of $250,000. Based on R Co.'s
analysis, the project has a net present value of $57,625.

88. Refer to R Co. (Present value tables needed to answer this question.) What discount rate did the
company use to compute the net present value?
a. 10%
b. 11%
c. 12%
d. 13%

ANS: B DIF: 3

89. Refer to R Co. What is the project's profitability index?

a. 1.058
b. .058
c. .945
d. 1.000

ANS: A DIF: 3

90. Refer to R Co. (Present value tables needed to answer this question.) What is the project's internal
rate of return?
a. between 12.5 and 13.0 percent
b. between 11.0 and 11.5 percent
c. between 11.5 and 12.0 percent
d. between 13.0 and 13.5 percent

ANS: A DIF: 3

91. (Present value tables needed to answer this question.) Ann recently invested in a project that
promised an internal rate of return of 15 percent. If the project has an expected annual cash
inflow of $12,000 for six years, with no salvage value, how much did Ann pay for the project?
a. $35,000
b. $45,414
c. $72,000
d. $31,708

ANS: B DIF: 3

92. Louis recently invested in a project that has an expected annual cash inflow of $7,000 for 10
years, and an expected payback period of 3.6 years. How much did Louis invest in the project?
a. $19,444
b. $36,000
c. $25,200
d. $40,000

ANS: C DIF: 3
93. The McNally Co. is considering an investment in a project that generates a profitability index of
1.3. The present value of the cash inflows on the project is $44,000. What is the net present value
of this project?
a. $10,154
b. $13,200
c. $57,200
d. $33,846

ANS: A DIF: 3

94. If r is the discount rate, the formula [1/(1 + r)] refers to the
a. future value interest factor associated with r for one period.
b. present value of some future cash flow.
c. present value interest factor associated with r for one period.
d. future value interest factor for an annuity with a duration of r periods.

ANS: C DIF: 1 REF: App 14

95. Future value is the

a. sum of dollars-in discounted to time zero.
b. sum of dollars-out discounted to time zero.
c. difference of dollars-in and dollars-out.
d. value of dollars-in minus dollars-out for future periods adjusted for any interest-
compounding factor.

ANS: D DIF: 3 REF: App 14

96. All other things being equal, as the time period for receiving an annuity lengthens,
a. the related present value factors increase.
b. the related present value factors decrease.
c. the related present value factors remain constant.
d. it is impossible to tell what happens to present value factors from the information given.

ANS: A DIF: 1 REF: App 14

97. Which of the following indicates that the first cash flow is at the end of a period?

Ordinary annuity Annuity due

a.  yes no
b.  yes yes
c.  no yes
d.  no no

ANS: A DIF: 1 REF: App 14

98. Assume that X represents a sum of money that Bill has available to invest in a project that will
yield a return of r. In the formula Y = X(1 + r), Y represents the
 a. future value of X in one period.
b. future value interest factor associated with r.
c. present value of X.
d. present value interest factor associated with r.

ANS: A DIF: 1 REF: App 14

99. The capital budgeting technique known as accounting rate of return uses

salvage value time value of money

a.  no no
b.  no yes
c.  yes yes
d.  yes no

ANS: D DIF: 1 REF: App 14

100. In computing the accounting rate of return, the __________ level of investment should be used as
the denominator.
a. average
b. initial
c. residual
d. cumulative

ANS: A DIF: 1 REF: App 14

Jimmy's Retail

Jimmy's Retail is considering an investment in a delivery truck. Jimmy has found a used truck
that he can purchase for $8,000. He estimates the truck would last six years and increase his
store's net cash revenues by $2,000 per year. At the end of six years, the truck would have no
salvage value and would be discarded. Jimmy will depreciate the truck using the straight-line
method.

101. Refer to Jimmy's Retail. What is the accounting rate of return on the truck investment (based on
average profit and average investment)?
a. 25.0%
b. 50.0%
c. 16.7%
d. 8.3%

ANS: A DIF: 3 REF: App 14

102. Refer to Jimmy's Retail. What is the payback period on the investment in the new truck?
a. 12 years
b. 6 years
c. 4 years
 d. 2 years

ANS: C DIF: 3 REF: App 14

103. (Present value tables needed to answer this question.) Debb borrows $50,000 from her bank on
January 1, 2001. She is to repay the loan in equal annual installments over 30 years. How much is
her annual repayment if the bank charges 10 percent interest?
a. $1,667
b. $4,200
c. $2,865
d. $5,304

ANS: D DIF: 3 REF: App 14

104. (Present value tables needed to answer this question.) Bill Hawkins has just turned 65. He has
$100,000 to invest in a retirement annuity. One investment company has offered to pay Bill
$10,000 per year for 15 years (payments to begin in one year) in exchange for an immediate
$100,000 payment. If Bill accepts the offer from the investment company, what is his expected
return on the $100,000 investment (assume a return that is compounded annually)?
a. between 5 and 6 percent
b. between 6 and 7 percent
c. between 7 and 8 percent
d. between 8 and 9 percent

ANS: A DIF: 3 REF: App 14

105. (Present value tables needed to answer this question.) Cramden Armored Car Co. is considering
the acquisition of a new armored truck. The truck is expected to cost $300,000. The company's
discount rate is 12 percent. The firm has determined that the truck generates a positive net present
value of $17,022. However, the firm is uncertain as to whether its has determined a reasonable
estimate of the salvage value of the truck. In computing the net present value, the company
assumed that the truck would be salvaged at the end of the fifth year for $60,000. What expected
salvage value for the truck would cause the investment to generate a net present value of $0?
Ignore taxes.
a. $30,000
b. $0
c. $55,278
d. $42,978

ANS: A DIF: 3 REF: App 14

106. (Present value tables needed to answer this question.) Booker Steel Inc. is considering an
investment that would require an initial cash outlay of $400,000 and would have no salvage
value. The project would generate annual cash inflows of $75,000. The firm's discount rate is 8
percent. How many years must the annual cash flows be generated for the project to generate a
net present value of $0?
a. between 5 and 6 years
b. between 6 and 7 years
 c. between 7 and 8 years
d. between 8 and 9 years

ANS: C DIF: 3 REF: App 14

107. A capital budget is used by management to determine

in what to invest how much to invest

a.  no no
b.  no yes
c.  yes no
d.  yes yes

ANS: D DIF: 1 REF: App 14

108. The weighted average cost of capital represents the

a. cost of bonds, preferred stock, and common stock divided by the three sources.
b. equivalent units of capital used by the organization.
c. overall cost of capital from all organization financing sources.
d. overall cost of dividends plus interest paid by the organization.

ANS: C DIF: 1 REF: App 14

SHORT ANSWER

1. In a net present value analysis, how can an analyst explicitly and formally consider the influence
of risk on the present value of certain cash flows?

ANS:
An analyst could do at least three different things to explicitly account
for risk. The analyst could: (1) adjust the discount rate to reflect the risk of the cash flow, (2)
adjust the discounting period of the cash flow, or (3) adjust the expected amount of the cash flow
up or down to reflect the risk.

DIF: 3

2. What factors influence the present value of the depreciation tax benefit?

ANS:
The depreciation tax benefit is primarily affected by three factors: the depreciation rate or
method, the tax rate, and the discount rate.

DIF: 3

3. Why is it important for managers to be able to rank projects?

 ANS:
Managers need to be able to rank projects for two primary reasons. First, managers need to be
able to select the best project from a set of projects that are directly competing with each other
(particularly in the case of mutually exclusive projects). Second, even when projects are not
directly competing with each other, managers may have a limited supply of capital that has to be
allocated to the most worthy of the projects.

DIF: 3

4. If it is assumed that managers act to maximize the value of the firm, what can also be assumed
about the existing mix of capital components relative to the set of all viable alternative mixes of
capital components?

ANS:
It can be assumed that the existing mix of capital components is the one that minimizes the cost
of capital (which, therefore, maximizes the value of the firm).

DIF: 3

5. Does a project that generates a positive internal rate of return also have a positive net present
value? Explain.

ANS:
No. A positive IRR does not necessarily mean that a project will also have a positive NPV. Only
if the IRR is greater than the discount rate that is used in the NPV calculation will the NPV be
positive.

DIF: 3

6. Why is the profitability index a better basis than net present value to compare projects that
require different levels of investment?

ANS:
The profitability index relates the magnitude of the net present value to the magnitude of the
initial investment. Thus, the PI gives some indication of relative profitability. The NPV itself
provides no direct indication of the level of investment that is required to generate the NPV and
therefore provides no indication of relative profitability.

DIF: 3

7. What is the major advantage of the accounting rate of return relative to the other techniques that
can be used to evaluate capital projects?

ANS:
 The accounting rate of return has two major advantages relative to the other capital budgeting
techniques. First, it may be more compatible as an investment criterion with criteria that are used
to evaluate managerial and segment performance particularly for investment centers that are
evaluated on an ROI or RI basis. Second, the accounting rate of return can be generated from
accounting data and is therefore easy to track over the life of the investment.

DIF: 3 REF: App 14

8. Why is it important for organizations to conduct post investment audits of capital projects?

ANS:
The post investment audit provides management with an opportunity to evaluate the actual
performance of the investment relative to expected performance. If possible, management can
take corrective action when actual performance is poor relative to the expected performance.
Management can also use the post investment audit to evaluate the performance of those who
provided the original information about the investment and those who are in charge of the
investment. In addition, management may use the information from the post investment audit to
improve the evaluation process of future capital projects.

DIF: 3

9. How are capital budgeting models affected by potential investments in automated equipment
investment decisions?

ANS:
Discount rates for present value calculations often far exceed a firm's cost of capital. Automated
machinery is very costly and may be at a disadvantage in discounted cash flow methods.
Qualitative factors associated with automated equipment may not receive any weight or value in
current capital budgeting methods. Automated equipment is often interrelated with other
investments and should be bundled to reflect this synergism. Finally, there is the opportunity cost
of not automating when competitors automate and your firm doesn't.

DIF: 3

10. (Present value tables needed to answer this question.) Managers of the Jonathan Co. realize that
the present value of the depreciation tax benefit is affected by the discount rate, the tax rate, and
the depreciation rate. They have recently purchased a machine for $100,000 and they are trying to
decide which depreciation method to use. There are only two alternatives available, and they
must make an irrevocable selection of one method or the other right now. They have no
uncertainty about the company's discount rate (it is 10 percent), but they are highly uncertain
about the direction of future tax rates. The company's uncertainty stems from the fact that the
existing tax rate is 30 percent, but congress is presently debating tax legislation that would
dramatically increase the rate. If the legislation is passed it would go into affect in two years
(after the Jonathan Co. has claimed two years of depreciation). How high would tax rates need to
be in two years for the Jonathan Co. to be indifferent between depreciation Method 2 and
depreciation Method 1 below?
 Method 1 Method 2 Difference
Year 1 $30,000 $10,000 $(20,000)
Year 2 $40,000 $15,000 $(25,000)
Year 3 $10,000 $25,000 $ 15,000 
Year 4 $10,000 $25,000 $ 15,000 
Year 5 $10,000 $25,000 $ 15,000 

ANS:
No matter what happens, the tax rate for the next two years is 30 percent. Using the differences in
depreciation amounts, one can determine the difference in present values between the two
methods at the end of year 2 when the tax rate is expected to change.

Present value calculations for years 1 and 2:

Year 1 ($20,000)  .30  .9091 = $ (5,455)

Year 2 ($25,000)  .30  .8265 = $ (6,199)
Total present value difference at end $(11,654)

So, after the first two years, Method 1 has generated $11,654 more present value than Method 2.
This simply means that at the point of indifference, Method 2 would be required to generate
$11,654 more present value than Method 1 in the last three years. For the last three years of the
project's life, the difference in depreciation amounts is $15,000. This $15,000 amount can be used
in the following equation to solve for the tax rate that yields a present value of $11,654:

$11,654 = $15,000  tax rate  (.7513 + .6830 + .6209)

$11,654 = $30,828  tax rate
Tax rate = $11,654/$30,828
Tax rate = 37.8%

Thus, an increase in the tax rate to about 37.8 percent would cause management to be indifferent
between the two depreciation methods.

DIF: 5

XL Corp.

XL Corp. is considering an investment that will require an initial cash outlay of $200,000 to
purchase non-depreciable assets. The project promises to return $60,000 per year (after-tax) for
eight years with no salvage value. The company's cost of capital is 11 percent.

11. Refer to XL Corp. (Present value tables needed to answer this question.) The company is
uncertain about its estimate of the life expectancy of the project. How many years must the
project generate the $60,000 per year return for the company to at least be indifferent about its
acceptance? (Do not consider the possibility of partial year returns.)

ANS:
 Dividing $200,000/$60,000, gives the annuity discount factor (3.3333) for 11 percent associated
with the minimal required time for this project to be successful. According to the tables in
Appendix A, the project will have a positive net present value if the cash flows last through year
5.

DIF: 3

Treble Co.

Treble Co. is considering an investment in a new product line. The investment would require an
immediate outlay of $100,000 for equipment and an immediate investment of $200,000 in
working capital. The investment is expected to generate a net cash inflow of $100,000 in year 1,
$150,000 in year 2, and $200,000 in years 3 and 4. The equipment would be scrapped (for no
salvage) at the end of the fourth year and the working capital would be liquidated. The equipment
would be fully depreciated by the straight-line method over its four-year life.

12. Refer to Treble Co. (Present value tables needed to answer this question.) If Treble uses a
discount rate of 16 percent, what is the NPV of the proposed product line investment?

ANS:

Cash flow Year Amount Discount factor Present value

Investment 0 $(100,000)  1.00   $(100,000) 
Working cap. 0 $(200,000)  1.00   (200,000)
Cash inflow 1 100,000  .8621  86,210
Cash inflow 2 150,000  .7432  111,480
Cash inflow 3 200,000  .6407  128,140
Cash inflow 4 200,000  .5523  110,460
Working cap. 4 200,000  .5523  110,460
Net present value $246,750

DIF: 3

13. Refer to Treble Co. What is the payback period for the investment?

ANS:
After the first two years, $250,000 of the original $300,000 investment would be recouped. It
would take one-quarter of the third year ($50,000/$200,000) to recoup the last $50,000. Thus, the
payback period is 2.25 years.

DIF: 3

14. (Present value tables needed to answer this question.) Jane has an opportunity to invest in a
project that will yield four annual payments of $12,000 with no salvage. The first payment will be
received in exactly one year. On low-risk projects of this type, Jane requires a return of 6 percent.
Based on this requirement, the project generates a profitability index of 1.03953.
 a. How much is Jane required to invest in this project?
b. What is the internal rate of return on Jane's project?

ANS:

a. The present value of the $12,000 annuity is found by multiplying $12,000 by the
annuity discount factor associated with 6 percent interest for four years: $12,000 
3.4651 = $41,581.20.

From the information on the profitability index, it is known that the present value of
the cash inflows is 1.03953 times the initial investment. Thus, the initial investment
is $41,581.20/1.03953 = $40,000.

b. By dividing $40,000 by the annual cash inflow of $12,000, it is determined that the
discount factor associated with the IRR is 3.3333. This discount factor is associated
with an interest rate that lies between 7 and 8 percent. Using interpolation, the IRR is
computed to be approximately 7.72 percent.

DIF: 3

15. (Present value tables needed to answer this question.) Wood Productions is considering the
purchase of a new movie camera, which will be used for major motion pictures. The new camera
will cost $30,000, have an eight-year life, and create cost savings of $5,000 per year. The new
camera will require $700 of maintenance each year. Wood Productions uses a discount rate of 9
percent.

a. Compute the net present value of the new camera.

b. Determine the payback period.

ANS:

a. Cost savings per year $5,000 

Maintenance per year   (700)
Net cash flows per year $4,300 

Cash Discount factor Present value

$30,000 1.0000 $(30,000.00)
  4,300 5.5348   23,799.64 
Net present value of investment $ (6,200.36)

b. Payback equals $30,000/$4,300 = 6.976 years

DIF: 3
16. (Present value tables needed to answer this question.) XYZ Co. is interested in purchasing a state-
of-the-art widget machine for its manufacturing plant. The new machine has been designed to
basically eliminate all errors and defects in the widget-making production process. The new
machine will cost $150,000, and have a salvage value of $70,000 at the end of its seven-year
useful life. XYZ has determined that cash inflows for years 1 through 7 will be as follows:
$32,000; $57,000; $15,000; $28,000; $16,000; $10,000, and $15,000, respectively. Maintenance
will be required in years 3 and 6 at $10,000 and $7,000 respectively. XYZ uses a discount rate of
11 percent and wants projects to have a payback period of no longer than five years.

a. Compute the net present value of the new machine.

b. Compute the firm's profitability index.

c. Compute the payback period.

d. Evaluate this investment proposal for XYZ Co.

ANS:

a. Year Cash flow Discount factor Present value

1 $150,000  1.0000  $(150,000.00) 
1  32,000 .9009  28,828.80
2  57,000 .8116  46,261.20
3   5,000 .7312   3,656.00
4  28,000 .6587  18,443.60
5  16,000 .5935   9,496.00
6   3,000 .5346   1,603.80
7  15,000 .4817   7,225.50
7  70,000 .4817   33,719.00 
Net present value $   (766.10)

b. Profitability index equals present value of cash flows divided by investment:

$149,233.90/$150,000 = .995

c. Payback period is 6.11 years, computed as follows:

Year Cash Flow Cumulative Cash Flow

1 $32,000 $ 32,000 
2  57,000  89,000
3   5,000  94,000
4  28,000 122,000
5  16,000 138,000
6   3,000 141,000
7  85,000 226,000

$150,000 - $141,000 = $9,000/$85,000 = .11

 d. The project is quantitatively unacceptable because it has a negative NPV, a less-than-
one PI, and a payback period of over six years. However, the NPV and PI are
extremely close to being acceptable. Because the new machine will provide XYZ
zero-defect production, the investment may be desirable if additional qualitative
factors are considered such as improved competitive position, customer satisfaction,
goodwill generated, improved product quality and reliability, and a desire to be in the
forefront of manufacturing capability. XYZ may want to attempt to quantify these
benefits and reevaluate the machine's acceptability as an investment.

DIF: 5

17. (Present value tables needed to answer this question.) The Ruth Company has been operating a
small lunch counter for the convenience of employees. The counter occupies space that is not
needed for any other business purpose. The lunch counter has been managed by a part-time
employee whose annual salary is $3,000. Yearly operations have consistently shown a loss as
follows:

Receipts $20,000 
Expenses for food, supplies (in cash) $19,000
Salary   3,000  22,000 
        Net Loss $(2,000)

A company has offered to sell Ruth automatic vending machines for a total cost of $12,000. Sales
terms are cash on delivery. The old equipment has zero disposal value.

The predicted useful life of the equipment is 10 years, with zero scrap value. The equipment will
easily serve the same volume that the lunch counter handled. Z catering company will completely
service and supply the machines. Prices and variety of food and drink will be the same as those
that prevailed at the lunch counter. The catering company will pay 5 percent of gross receipts to
the Ruth Company and will bear all costs of food, repairs, and so forth. The part-time employee
will be discharged. Thus, Ruth's only cost will be the initial outlay for the machines.

Consider only the two alternatives mentioned.

Required:
a. What is the annual income difference between alternatives?

b. Compute the payback period.

c. Compute:
1. The net present value if relevant cost of capital is 20 percent.
2. Internal rate of return.

d. Management is very uncertain about the prospective revenue from the vending
equipment. Suppose that the gross receipts amounted to $14,000 instead of $20,000.
Repeat the computation in part c.1.
 e. What would be the minimum amount of annual gross receipts from the vending
equipment that would justify making the investment? Show computations.

ANS:

a. Old loss $(2,000)

New receipts $20,000  5% = $ 1,000 
Depr. $12,000/10 yrs. =  (1,200)
New (Loss) $ (200)

b. Change in annual cash inflow is $3,000

Payback = $12,000/$3,000 = 4 yrs.

c. 1. PV of inflow    $3,000  4.1925 = $12,577.50 

PV of outflow $12,000  1.0 = (12,000.00)
NPV $ 577.50 

2. IRR is approximately 23%

d. Change in inflow = $2,700

        PV inflow $2,700  4.1925 = $11,319.75 
        PV outflow $12,000  1.0 = (12,000.00)
                NPV $  (680.25)

e. $12,000/4.1925 = $2,862.25
Receipts = ($2,862.25 - $2,000)/.05 = $17,245

DIF: 3

18. The Sun Corp. is contemplating the acquisition of an automatic car wash. The following
information is relevant:

The cost of the car wash is $160,000

The anticipated revenue from the car wash is $100,000 per annum.
The useful life of the car wash is 10 years.
Annual operating costs are expected to be:
        Salaries $30,000
        Utilities 9,600
        Water usage 4,400
        Supplies 6,000
        Repairs/maintenance 10,000
The firm uses straight-line
depreciation.
The salvage value for the car
wash is zero.
The company's cutoff points
are as follows:
        Payback 3 years
        Accounting rate of return 18%
        Internal rate of return 18%

Ignore income taxes.

Required:
a. Compute the annual cash inflow.

b. Compute the net present value.

c. Compute internal rate of return.

d. Compute the payback period.

e. Compute the profitability index.

f. Should the car wash be purchased?

ANS:

a. Revenue $100,000 
- cash expenses  (60,000)
Annual inflow $ 40,000 

b. PV inflow $40,000  4.4941 = $179,764 

PV outflow $160,000  1.0 = (160,000)
        NPV = $ 19,764 

c. IRR factor = $160,000/$40,000 = 4.0 which is approximately 23%

d. Payback = $160,000/$40,000 = 4 yrs.

e. $179,764/$160,000 = 1.123525

f. Car wash exceeds minimum on SRR and IRR, but not payback.

DIF: 3