CHAPTER7:CAPITALBUDGETINGDECISIONSPARTI

MultipleChoice
d1.Calculatingthepaybackperiodforacapitalprojectrequiresknowing
whichofthefollowing?
a.Usefullifeoftheproject.
b.Thecompany'sminimumrequiredrateofreturn.
c.Theproject'sNPV.
d.Theproject'sannualcashflow.
c2.Thepaybackcriterionforcapitalinvestmentdecisions
a.isconceptuallysuperiortotheIRRcriterion.
b.takesintoconsiderationthetimevalueofmoney.
c.givesprioritytorapidrecoveryofcash.
d.emphasizesthemostprofitableprojects.
a3.WhichofthefollowingisNOTrelevantincalculatingannualnetcash
flowsforaninvestment?
a.Interestpaymentsonfundsborrowedtofinancetheproject.
b.Depreciationonfixedassetspurchasedfortheproject.
c.Theincometaxrate.
d.Lostcontributionmarginifsalesoftheproductinvestedinwill
reducesalesofotherproducts.
a4.Ifthepresentvalueofthefuturecashflowsforaninvestmentequals
therequiredinvestment,theIRRis
a.equaltothecutoffrate.
b.equaltothecostofborrowedcapital.
c.equaltozero.
d.lowerthanthecompany'scutoffrateofreturn.
b5.TherelationshipbetweenpaybackperiodandIRRisthat
a.apaybackperiodoflessthanonehalfthelifeofaprojectwill
yieldanIRRlowerthanthetargetrate.
b.thepaybackperiodisthepresentvaluefactorfortheIRR.
c.aprojectwhosepaybackperioddoesnotmeetthecompany'scutoff
rateforpaybackwillnotmeetthecompany'scriterionforIRR.
d.noneoftheabove.
c6.WhichofthefollowingeventsismostlikelytoreducetheexpectedNPV
ofaninvestment?
a.Themajorcompetitorfortheproducttobemanufacturedwiththe
machinerybeingconsideredforpurchasehasbeenrated
"unsatisfactory"byaconsumergroup.
b.Theinterestrateonlongtermdebtdeclines.
c.TheincometaxrateisraisedbytheCongress.
d.Congressapprovestheuseoffasterdepreciationthanwaspreviously
available.
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a7.IfaninvestmenthasapositiveNPV,
a.itsIRRisgreaterthanthecompany'scostofcapital.
b.costofcapitalexceedsthecutoffrateofreturn.
c.itsIRRislessthanthecompany'scutoffrateofreturn.
d.thecutoffrateofreturnexceedscostofcapital.
c8.Whichofthefollowingdescribestheannualreturnsthatarediscounted
indeterminingtheNPVofaninvestment?
a.Netincomesexpectedtobeearnedbytheproject.
b.Pretaxcashflowsexpectedfromtheproject.
c.Aftertaxcashflowsexpectedfromtheproject.
d.Aftertaxcashflowsadjustedforthetimevalueofmoney.
b9.WhichofthefollowingcapitalbudgetingmethodsdoesNOTconsiderthe
timevalueofmoney?
a.IRR.
b.Bookrateofreturn.
c.Timeadjustedrateofreturn.
d.NPV.
b10.Allotherthingsbeingequal,ascostofcapitalincreases
a.morecapitalprojectswillprobablybeacceptable.
b.fewercapitalprojectswillprobablybeacceptable.
c.thenumberofcapitalprojectsthatareacceptablewillchange,but
thedirectionofthechangeisnotdeterminablejustbyknowingthe
directionofthechangeincostofcapital.
d.thecompanywillprobablywanttoborrowmoneyratherthanissue
stock.
d11.WhichofthefollowingisabasicdifferencebetweentheIRRandthe
bookrateofreturn(BRR)criteriaforevaluatinginvestments?
a.IRRemphasizesexpensesandBRRemphasizesexpenditures.
b.IRRemphasizesrevenuesandBRRemphasizesreceipts.
c.IRRisusedforinternalinvestmentsandBRRisusedforexternal
investments.
d.IRRconcentratesonreceiptsandexpendituresandBRRconcentrateson
revenuesandexpenses.
a12.Ifaprojecthasapaybackperiodshorterthanitslife,
a.itsNPVmaybenegative.
b.itsIRRisgreaterthancostofcapital.
c.itwillhaveapositiveNPV.
d.itsincrementalcashflowsmaynotcoveritscost.
c13.Costofcapitalis
a.theamountthecompanymustpayforitsplantassets.
b.thedividendsacompanymustpayonitsequitysecurities.
c.thecostthecompanymustincurtoobtainitscapitalresources.
d.thecostthecompanyischargedbyinvestmentbankerswhohandlethe
issuanceofequityorlongtermdebtsecurities.
d14.Thenormalmethodsofanalyzinginvestments
a.cannotbeusedbynotforprofitentities.
b.donotapplyiftheprojectwillnotproducerevenues.
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c.cannotbeusedifthecompanyplanstofinancetheprojectwithfunds
alreadyavailableinternally.
d.requireforecastsofcashflowsexpectedfromtheproject.
a15.WhichofthefollowingisNOTadefectofthepaybackmethod?
a.Itignorescashflowsbecauseitusesnetincome.
b.Itignoresprofitability.
c.Itignoresthepresentvaluesofcashflows.
d.Itignoresthepatternofcashflowsbeyondthepaybackperiod.
b16.Acompanywithcostofcapitalof15%planstofinanceaninvestment
withdebtthatbears10%interest.Therateitshouldusetodiscount
thecashflowsis
a.10%.
b.15%.
c.25%.
d.someotherrate.
c17.WhichofthefollowingeventswillincreasetheNPVofaninvestment
involvinganewproduct?
a.Anincreaseintheincometaxrate.
b.Anincreaseintheexpectedperunitvariablecostoftheproduct.
c.Anincreaseintheexpectedannualunitvolumeoftheproduct.
d.Adecreaseintheexpectedsalvagevalueofequipment.
b18.AninvestmenthasapositiveNPVdiscountingthecashflowsata14%
costofcapital.Whichstatementistrue?
a.TheIRRislowerthan14%.
b.TheIRRishigherthan14%.
c.Thepaybackperiodislessthan14years.
d.Thebookrateofreturnis14%.
a19.Thetechniquemostconcernedwithliquidityis
a.payback.
b.NPV.
c.IRR.
d.bookrateofreturn.
d20.ThetechniquethatdoesNOTusecashflowsis
a.payback.
b.NPV.
c.IRR.
d.bookrateofreturn.
a21.Iftherewerenoincometaxes,
a.depreciationwouldbeignoredincapitalbudgeting.
b.theNPVmethodwouldnotwork.
c.incomewouldbediscountedinsteadofcashflow.
d.allpotentialinvestmentswouldbedesirable.
a22.Twonewproducts,XandY,arealikeineverywayexceptthatthesales
ofXwillstartlowandrisethroughoutitslife,whilethoseofYwill
bethesameeachyear.Totalvolumesovertheirfiveyearliveswillbe
thesame,aswillsellingprices,unitvariablecosts,cashfixedcosts,
93

andinvestment.TheNPVofproductX
a.willbelessthanthatofproductY.
b.willbethesameasthatofproductY.
c.willbegreaterthanthatofproductY.
d.noneoftheabove.
d23.Whichofthefollowingeventsismostlikelytoincreasethenumberof
investmentsthatmeetacompany'sacceptancecriteria?
a.Topmanagementraisesthetargetrateofreturn.
b.Theinterestrateonlongtermdebtrises.
c.Theincometaxraterises.
d.TheIRSallowscompaniestoexpensepurchasesoffixedassets,
insteadofdepreciatingthemovertheirlives.
d24.InvestmentAhasapaybackperiodof5.4years,investmentBoneof6.7
years.Fromthisinformationwecanconclude
a.thatinvestmentAhasahigherNPVthanB.
b.thatinvestmentAhasahigherIRRthanB.
c.thatinvestmentA'sbookrateofreturnishigherthanB's.
d.noneoftheabove.
d25.InvestmentAhasabookrateofreturnof26%,investmentBoneof18%.
Fromthisinformationwecanconclude
a.thatinvestmentAhasahigherNPVthanB.
b.thatinvestmentAhasahigherIRRthanB.
c.thatinvestmentAhasashorterpaybackperiodthanB.
d.noneoftheabove.
c26.Adollarnowisworthmorethanadollartobereceivedinthefuture
becauseof
a.inflation.
b.uncertainty.
c.theopportunitycostofwaiting.
d.noneoftheabove.
a27.Incontrasttothepaybackandbookrateofreturnmethods,theNPVand
IRRmethods
a.considerthetimevalueofmoney.
b.ignoredepreciation.
c.useaftertaxcashflows.
d.alloftheabove.
a28.Whichofthefollowingisadiscountedcashflowmethod?
a.NPV.
b.Payback.
c.Bookrateofreturn.
d.Alloftheabove.

a29.Whichstatementdescribestherelevanceofdepreciationincalculating
cashflows?
a.Depreciationisrelevantonlywhenincometaxesexist.
b.Depreciationisalwaysrelevant.
c.Depreciationisneverrelevant.
d.Depreciationisrelevantonlywithdiscountedcashflowmethods.
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b30.Asthediscountrateincreases
a.presentvaluefactorsincrease.
b.presentvaluefactorsdecrease.
c.presentvaluefactorsremainconstant.
d.itisimpossibletotellwhathappenstothefactors.

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a31.Asthelengthofanannuityincreases
a.presentvaluefactorsincrease.
b.presentvaluefactorsdecrease.
c.presentvaluefactorsremainconstant.
d.itisimpossibletotellwhathappenstopresentvaluefactors.
a32.Theonlyfuturecoststhatarerelevanttodecidingwhethertoacceptan
investmentarethosethatwill
a.bedifferentiftheprojectisacceptedratherthanrejected.
b.besavediftheprojectisacceptedratherthanrejected.
c.bedeductiblefortaxpurposes.
d.affectnetincomeintheperiodthattheyareincurred.
a33.Whichofthefollowingistrueofaninvestment?
a.Thelowerthecostofcapital,thehighertheNPV.
b.Thelowerthecostofcapital,thehighertheIRR.
c.Thelongertheproject'slife,theshorteritspaybackperiod.
d.Thehighertheproject'sNPV,theshorteritslife.
c34.WhichofthefollowingmethodsFAILStodistinguishbetweenreturnof
investmentandreturnoninvestment?
a.NPV.
b.IRR.
c.Payback.
d.Bookrateofreturn.
c35.IfacompanyisNOTsubjecttoincometax,whichofthefollowingis
trueofaproposedinvestment?
a.Theproject'sIRRequalstheentity'scostofcapital.
b.Theproject'sNPViszero.
c.Depreciationonassetsrequiredfortheprojectisirrelevanttothe
evaluation.
d.Theexpectedannualincreaseinfuturecashflowsequalsthe
investmentrequiredtoundertaketheproject.
d36.WhichofthefollowingincreasesNPVandIRR?
a.Anupwardrevisioninexpectedannualnetcashflows.
b.Anupwardrevisionofexpectedlife.
c.Anupwardrevisionoftheresidualvalueofthelonglivedassets
beingacquiredfortheproject.
d.Alloftheabove.
d37.Qualitativeissuescouldincreasetheacceptabilityofaprojectunder
whichofthefollowingconditions?
a.TheIRRislessthanthecompany'scutoffrate.
b.TheprojecthasanegativeNPV.
c.Thepaybackperiodislongerthanthecompany'scutoffperiod.
d.Alloftheabove.
a38.IfCo.XwantstouseIRRtoevaluatelongtermdecisionsandto
establishacutoffrateofreturn,Xmustbesurethecutoffrateis
a.atleastequaltoitscostofcapital.
b.atleastequaltotherateusedbysimilarcompanies.
c.greaterthantheIRRonprojectsacceptedinthepast.
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d.greaterthanthecurrentbookrateofreturn.

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a39.WhichofthefollowingisNOTrelevantincalculatingnetcashflowsfor
ProjectN?
a.InterestpaymentsonfundsthatwouldbeborrowedtofinanceProject
N.
b.DepreciationonassetspurchasedforProjectN.
c.Thecontributionmarginthecompanywouldloseifsalesofthe
productintroducedbyProjectNwillreducesalesofotherproducts.
d.Theincometaxrateapplicabletotheentity.
b40.IftheIRRonaninvestmentiszero,
a.itsNPVispositive.
b.itsannualcashflowsequalitsrequiredinvestment.
c.itisgenerallyawiseinvestment.
d.itscashflowsdecreaseoveritslife.
d41.Ifdepreciationonanewassetexceedsitssavingsincashoperating
costs,whichofthefollowingistrue?
a.Theprojectisusuallyunacceptable.
b.Theannualaftertaxcashflowonthenewassetwillbegreaterthan
thesavingsincashoperatingcosts.
c.TheprojecthasanegativeNPV.
d.Alloftheabove.
d42.Costofcapitalis
a.theinterestrateanentitymustpaytoborrowmoney.
b.thereturnanentity'sstockholdersexpectontheirinvestment.
c.therateofreturntheentitycanearnfrominvestingavailablecash.
d.aconceptofmanagerialfinanceincorporatingalloftheaboveideas.
b43. Aninvestmentopportunitycosting$75,000isexpectedtoyieldnetcash
flowsof$23,000annuallyforfiveyears.TheNPVoftheinvestmentata
cutoffrateof14%wouldbe
a.$(3,959).
b.$3,959.
c.$75,000.
d.$78,959.
b44.Aninvestmentopportunitycosting$55,000isexpectedtoyieldnetcash
flowsof$22,000annuallyforfiveyears.Thepaybackperiodofthe
investmentis
a.0.4years.
b.2.5years.
c.$33,000.
d.someothernumber.
c45.Aninvestmentopportunitycosting$180,000isexpectedtoyieldnetcash
flowsof$53,000annuallyforfiveyears.TheIRRoftheinvestmentis
between
a.10and12%.
b.12and14%.
c.14and16%.
d.16and18%.

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b46. Aninvestmentopportunitycosting$150,000isexpectedtoyieldnetcash
flowsof$45,000annuallyforfiveyears.Thecostofcapitalis10%.
Thebookrateofreturnwouldbe
a.10%.
b.20%.
c.30%.
d.33.3%.
a47. Aninvestmentopportunitycosting$150,000isexpectedtoyieldnetcash
flowsof$36,000annuallyforsixyears.TheNPVoftheinvestmentata
cutoffrateof12%wouldbe
a.$(2,004).
b.$2,004.
c.$150,000.
d.$147,996.
c48.Aninvestmentopportunitycosting$100,000isexpectedtoyieldnetcash
flowsof$22,000annuallyforsevenyears.Thepaybackperiodofthe
investmentis
a.0.22years.
b.3.08years.
c.4.55years.
d.someothernumber.
a49.Aninvestmentopportunitycosting$200,000isexpectedtoyieldnetcash
flowsof$39,000annuallyforeightyears.TheIRRoftheinvestmentis
between
a.10and12%.
b.12and14%.
c.14and16%.
d.16and18%.
b50. Aninvestmentopportunitycosting$80,000isexpectedtoyieldnetcash
flowsof$25,000annuallyforfouryears.Thecostofcapitalis10%.
Thebookrateofreturnwouldbe
a.10.0%.
b.12.5%.
c.21.3%.
d.32.0%.

TrueFalse
T1.Paybackperiodisthelengthoftimeitwilltakeacompanytorecoup
itsoutlayforaninvestment.
T2.Discountedcashflowtechniquesapplytoinvestmentsthatinvolveeither
costsonly,orbothcostsandrevenues.
F3.Costofcapitalistheinterestratethatacompanyexpectstopayto
financeaparticularcapitalinvestmentproject.
F4.Thehigherthecostofcapital,thehigherthepresentvalueoffuture
cashinflows.
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F5.IftheIRRonacapitalprojectispositive,itsNPVwillbepositive.
T6.Salvagevalueisusuallyignoredincomputingthetaxdepreciationonan
investmentindepreciableassets.
F7.IRRcanbecomputedforevencashflows,butnotforunevencashflows.
T8.IfIRRislessthanthecostofcapital,theNPVwillbenegative.
F9.IFNPVisnegative,IRRisequaltothecostofcapital.
T10.Paybackemphasizesthereturnoftheinvestmentandignoresthereturn
ontheinvestment.

Problems

1.Aninvestmentopportunitycosting$180,000isexpectedtoyieldnetcash
flowsof$60,000annuallyforfiveyears.

a.FindtheNPVoftheinvestmentatacutoffrateof12%.

b.Findthepaybackperiodoftheinvestment.

c.FindtheIRRontheinvestment.

SOLUTION:
a.NPV:$36,300[(3.605x$60,000)$180,000]
b.Paybackperiod:3years($180,000/$60,000)
c.IRR:between18%and20%(3.0isbetween3.127and2.991)

2.Tofteisconsideringthepurchaseofamachine.Dataareasfollows:
Cost$100,000
Usefullife10years
Annualstraightlinedepreciation$10,000
Expectedannualsavingsincash
operationcosts$18,000
Tofte'scutoffrateis12%anditstaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.
b.ComputetheNPVoftheproject.

SOLUTION:
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a.Annualnetcashflows:$14,800[$18,000pretax40%x($18,000
$10,000depreciation)]
b.NPV:Negative$16,380[($14,800x5.650)$100,000]

3.WillowCompanyisconsideringthepurchaseofamachinewiththefollowing
characteristics.
Cost$150,000
Estimatedusefullife10years
Expectedannualcashcostsavings$35,000
Marquette'staxrateis40%,itscostofcapitalis12%,anditwilluse
straightlinedepreciationforthenewmachine.
a.Computetheannualaftertaxcashflowsforthisproject.
b.Findthepaybackperiodforthisproject.

SOLUTION:
a.Annualcashflows:$27,000[$35,00040%x($35,000$15,000)]
b.Paybackperiod:5.56years($150,000/$27,000)

4.BiltRiteCo.hastheopportunitytointroduceanewproduct.BiltRite
expectstheproducttosellfor$60andtohaveperunitvariablecostsof
$40andannualcashfixedcostsof$3,000,000.Expectedannualsales
volumeis250,000units.Theequipmentneededtobringoutthenewproduct
costs$5,000,000,hasafouryearlifeandnosalvagevalue,andwouldbe
depreciatedonastraightlinebasis.BiltRite'scostofcapitalis10%
anditsincometaxrateis40%.
a.Findtheincreaseinannualaftertaxcashflowsforthisopportunity.
b.Findthepaybackperiodonthisproject.
c.FindtheNPVforthisproject.

SOLUTION:
a.Increaseinannualcashflows:$1,700,000

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

Netincome$450,000
Plusdepreciation1,250,000
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Netcashflow$1,700,000
==========

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

5.Aninvestmentopportunitycosting$600,000isexpectedtoyieldnetcash
flowsof$120,000annuallyfortenyears.

a.FindtheNPVoftheinvestmentatacutoffrateof12%.

b.Findthepaybackperiodoftheinvestment.

c.FindtheIRRontheinvestment.

SOLUTION:
a.NPV:$78,000[(5.650x$120,000)$600,000]
b.Paybackperiod:5years($600,000/$120,000)
c.IRR:15%(5.0isabouthalfwaybetween5.216and4.833)

6. Scottsohasaninvestmentopportunitycosting$300,000thatisexpectedto
yieldthefollowingcashflowsoverthenextsixyears:
YearOne
YearTwo
YearThree
YearFour
YearFive
YearSix

$75,000
$90,000
$115,000
$130,000
$100,000
$90,000

a. Findthepaybackperiodoftheinvestment.
b. Findthebookrateofreturnoftheinvestment.
c. FindtheNPVoftheinvestmentatacutoffrateof10%.

SOLUTION:
a. Paybackperiod:3.15years(75,000+90,000+115,000+.15x130,000)
b. Bookrateofreturn:33.3%
Averagereturn:$100,000($600,000total/6years)
Depreciation:50,000($30,000/6years)

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Averageincome$50,000
Averageinvestment:$300,000/2=$150,000
Bookrateofreturn=$50,000/150,000=33.3%
c. NPV:$130,530

1
2
3
4
5
6

Cash

75,000
90,000
115,000
130,000
100,000
90,000

Investment
NPV

Factor

.909
.826
.751
.683
.621
.564

PV

68,175
74,340
86,365
88,790
62,100
50,760

430,530
300,000

130,530
======

7.Acmeisconsideringthepurchaseofamachine.Dataareasfollows:
Cost$160,000
Usefullife10years
Annualstraightlinedepreciation$???
Expectedannualsavingsincash
operationcosts$33,000
Acme'scutoffrateis12%anditstaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.
b.ComputetheNPVoftheproject.
c.ComputetheIRRoftheproject.

SOLUTION:
a.Annualnetcashflows:$26,200[$33,000pretax40%x($33,000
$16,000depreciation)]
b.NPV:Negative$11,970[($26,200x5.650)$160,000]
c. IRR:between10%and12%[factorof6.107(160,000/26,200)isbetween
6.145and5.650]

8. Scottsohasaninvestmentopportunitycosting$180,000thatisexpectedto
yieldthefollowingcashflowsoverthenextfiveyears:
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YearOne
YearTwo
YearThree
YearFour
YearFive

$30,000
$60,000
$90,000
$60,000
$30,000

a. Findthepaybackperiodoftheinvestment.
b. Findthebookrateofreturnoftheinvestment.
c. FindtheNPVoftheinvestmentatacutoffrateof12%.

SOLUTION:
a. Paybackperiod:3.0years(30,000+60,000+90,000)
b. Bookrateofreturn:20%
Averagereturn:$54,000($270,000total/5years)
Depreciation:36,000($180,000/5years)

Averageincome$18,000
Averageinvestment:$180,000/2=$90,000
Bookrateofreturn=$18,000/$90,000=20%
c. NPV:$6,930

1
2
3
4
5

Cash

30,000
60,000
90,000
60,000
30,000

Investment
NPV

Factor

.893
.797
.712
.636
.567

PV

26,790
47,820
64,080
38,160
17,010

193,860
180,000

13,860
======

9.RenoCompanyisconsideringthepurchaseofamachinewiththefollowing
characteristics.
Cost$160,000
Estimatedusefullife5years
Expectedannualcashcostsavings$56,000
Expectedsalvagevaluenone

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Reno'staxrateis40%,itscostofcapitalis12%,anditwilluse
straightlinedepreciationforthenewmachine.
a.Computetheannualaftertaxcashflowsforthisproject.
b.Findthepaybackperiodforthisproject.
c.ComputetheNPVforthisproject.

SOLUTION:
a.Annualcashflows:$46,400[$56,00040%x($56,00032,000)]
b.Paybackperiod:3.45years($160,000/$46,400)
c.NPV:$7,272[($46,400x3.605)$160,000]

10.WhitehallCo.hastheopportunitytointroduceanewproduct.Whitehall
expectstheprojecttosellfor$40andtohaveperunitvariablecostsof
$27andannualcashfixedcostsof$1,500,000.Expectedannualsales
volumeis200,000units.Theequipmentneededtobringoutthenewproduct
costs$3,500,000,hasafouryearlifeandnosalvagevalue,andwouldbe
depreciatedonastraightlinebasis.Whitehall'scutoffrateis10%and
itsincometaxrateis40%.
a.Findtheincreaseinannualaftertaxcashflowsforthisopportunity.
b.Findthepaybackperiodonthisproject.
c.FindtheNPVforthisproject.

SOLUTION:
a.Increaseinannualcashflows:$1,100,000

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

Netincome$135,000
Plusdepreciation875,000

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

b.Paybackperiod:3.47years($3,500,000/$1,010,000)
c.NPV:negative$298,300[($1,010,000x3.170)$3,500,000]

105