Chapter 14

An investment of $1,000 produces a net cash inflow of $500 in the first year and $750 in the second year. What is the payback period? a. 1.67 years b. 0.50 year c. 2.00 years d. 1.20 years e. Cannot be determined.

a. 1.67 years

Assume that there are two competing projects, A and B. Project A has an NPV of $1,000 and an IRR of 15%. Project B has an NPV of $800 and an IRR of 20%. Which of the following is true? a. Project A should be chosen because it has a higher NPV. b. Project B should be chosen because it has a higher IRR. c. It is not possible to use NPV or IRR to choose between the two projects. d. Neither project should be chosen. e. None of these choices are correct.

a. Project A should be chosen because it has a higher NPV.

The process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets is called capital investment decisions. True False

True

Wilson Company is considering replacing an existing piece of capital equipment. Relevant information includes: New equipment cost $250,000; Expected annual savings $75,000; Incremental working capital $25,000 (To be recovered at the end of the project's life.). In an NPV analysis, the incremental working capital will be considered as: a cash outflow at the project's inception. a cash inflow at the project's inception. a cash outflow at the project's completion. All of these choices are correct.

a cash outflow at the project's inception.

Wilson Company is considering replacing an existing piece of capital equipment. Relevant information includes: New equipment cost $250,000; Expected annual savings $75,000; Incremental working capital $25,000 (To be recovered at the end of the project's life). Based on this information, an NPV analysis will show year -0- as a: $275,000 outflow. $225,000 outflow. $200,000 outflow. $150,000 outflow. $300,000 outflow.

$275,000 outflow.

The present value of the following series of cash flows which occur at the end of each year, discounted at 10%, is closest to: $52,174 $72,572 $79,829 Cannot be determined from the information provided.

$72,572

Greg Moss has just invested $120,000 in a coffee shop. He expects to receive cash income of $15,000 a year. What is the payback period? 5 years 7.7 years 6.5 years 8 years 4.5 years

8 years

Suppose that a project requires $500,000 investment and will produce cash flow savings of $62,500 per year. The payback period is: 6 years. 9 years. 8 years. 10 years.

8 years.

Which of the following statements is incorrect? An annuity is a series of future cash flows. A dollar today is worth the same as a dollar tomorrow. The present value of an annuity is found by computing the present value of each cash flow and then summing these values. The discount rate is the rate used to compute present value.

A dollar today is worth the same as a dollar tomorrow.

When the risk of obsolescence is high, managers will want A longer payback period. A shorter payback period. A payback period equal to the life of the investment. All of these choices are correct. None of these choices are correct.

A shorter payback period.

A division manager was considering a project that required a significant initial investment. If accepted, the project could have a negative impact on certain financial ratios that the firm was required to maintain to satisfy debt contracts. To ensure that the ratios would not be adversely affected by the investment, the manager would use which of the following capital investment models? Payback period Net present value Accounting rate of return Internal rate of return None of these choices are correct.

Accounting rate of return

The internal rate of return (IRR): sets the project's net present value to the project's cost. is a widely used capital investment technique. uses the firm's required rate of return. All of these choices are correct.

All of these choices are correct.

Which of the following is a potential use of the payback method? Help managers control the risks of estimating cash flows Help minimize the impact of the investment on liquidity Help control the risk of obsolescence Help control the effect of the investment on performance evaluation All of these choices are correct.

All of these choices are correct.

Which of the following represents the biggest challenge in the decision to purchase new equipment? Estimating employee training for the new project Estimating cash flows for the future Estimating transportation costs of the new equipment Estimating maintenance costs for the new equipment

Estimating cash flows for the future

In order to use the payback period model, the proposed investment must have even cash inflows. True False

False

Which of the following is not a deficiency in using the payback method for capital budgeting decisions? It ignores the time value of money It cannot be applied to capital budgeting projects with uneven cash flows It ignores cash flows after the payback period All of these choices are deficiencies of the payback method.

It cannot be applied to capital budgeting projects with uneven cash flows

If net present value is negative, it means that the return on the investment is: More than the discount rate. Meaningless since the return on the investment bears no relationship to the discount rate. Acceptable. Equal to the discount rate. Less than the discount rate.

Less than the discount rate.

Which of the following is not a definition of the minimum required rate of return? The discount rate The accounting rate of return The hurdle rate The cost of capital

The accounting rate of return

NPV is calculated by using a. the required rate of return. b. accounting income. c. the IRR. d. the future value of cash flows. e. none of these choices are correct.

a. the required rate of return.

Using IRR, a project is rejected if the IRR a. is equal to the required rate of return. b. is less than the required rate of return. c. is greater than the cost of capital. d. is greater than the required rate of return. e. produces an NPV equal to zero.

b. is less than the required rate of return.

An investment of $2,000 provides an average net income of $400. Depreciation is $40 per year with zero salvage value. The ARR using the original investment is a. 44%. b. 22%. c. 20%. d. 40%. e. None of these choices are correct.

c. 20%.

The payback period suffers from which of the following deficiencies? a. It ignores the cost of the initial capital outlay. b. It is a complicated way of evaluating projects. c. It ignores the financial performance of a project beyond the payback period. d. It is a rough measure of the uncertainty of future cash flows. e. Both "It is a rough measure of the uncertainty of future cash flows" and "It is a complicated way of evaluating projects" are correct.

c. It ignores the financial performance of a project beyond the payback period.

For competing projects, NPV is preferred to IRR because a. maximizing IRR maximizes the wealth of the owners. b. in the final analysis, relative profitability is what counts. c. choosing the project with the largest NPV maximizes the wealth of the shareholders. d. assuming that cash flows are reinvested at the computed IRR is more realistic than assuming that cash flows are reinvested at the required rate of return. e. all of these choices are correct.

c. choosing the project with the largest NPV maximizes the wealth of the shareholders.

Capital investments should a. always produce an increase in market share. b. always be done using a payback criterion. c. earn back their original capital outlay plus a reasonable return. d. only be analyzed using the ARR. e. None of these choices are correct.

c. earn back their original capital outlay plus a reasonable return.

If the present value of future cash flows is $4,200 for an investment that requires an outlay of $3,000, the NPV a. is $200. b. is $1,000. c. is $1,200. d. is $2,200. e. cannot be determined.

c. is $1,200.

Intangible factors such as customer satisfaction and improved lead time: should not be considered in capital budgeting decisions. can be significant in estimating cash flows. are not the responsibility of the capital budgeting manager. can be forecasted with remarkable accuracy.

can be significant in estimating cash flows.

The following information pertains to an investment: Investment $140,000 Annual revenues $96,000 Annual variable costs $32,000 Annual fixed out-of-pocket costs $20,000 Discount rate 12% Expected life of project 8 years The present value of the annual cash flow (rounded) is: a. $152,538 b. $136,822 c. $204,884 d. $218,592

d. $218,592

An investment of $6,000 produces a net annual cash inflow of $2,000 for each of 5 years. What is the payback period? a. 2 years b. 1.5 year c. Unacceptable d. 3 years e. Cannot be determined.

d. 3 years

Postaudits of capital projects are useful because a. they are not very costly. b. they have no significant limitations. c. the assumptions underlying the original analyses are often invalidated by changes in the actual working environment. d. they help to ensure that resources are used wisely. e. all of these choices are correct.

d. they help to ensure that resources are used wisely.

If the NPV is positive, it signals a. that the required rate of return has been earned. b. that the value of the firm has increased. c. that the initial investment has been recovered. d. Both "that the initial investment has been recovered" and "that the value of the firm has increased" are correct. e. All of these choices are correct.

e. All of these choices are correct.

NPV measures a. the change in wealth. b. the change in firm value. c. difference between the present value of the cash inflows and outflows associated with a project. d. the profitability of an investment. e. All of these choices are correct.

e. All of these choices are correct.

To make a capital investment decision, a manager must: a. estimate the quantity and timing of cash flows. b. assess the risk of the investment. c. consider the impact of the investment on the firm's profits. d. choose a decision criterion to assess viability of the investment (such as payback period or NPV). e. All of these choices are correct.

e. All of these choices are correct.

The internal rate of return is defined as the interest rate that sets the present value of a project's cash inflows equal to the present value of the project's cost.

internal rate of return

When choosing among competing alternatives the internal rate of return model may choose an inferior project in terms of maximizing firm wealth.

internal rate of return

In the advanced automated manufacturing environments: investment is simpler than standard manufacturing processes of the past. direct costs are typically 20-25 percent of the total investment. software and other implementation costs can be substantial. software and other implementation costs can be ignored.

software and other implementation costs can be substantial.

Wilson Company is considering replacing an existing piece of capital equipment. Relevant information includes: New equipment cost $250,000; Expected annual savings $75,000; Incremental working capital $25,000 (To be recovered at the end of the project's life); Salvage value at the end of 4 years $15,000. In an NPV analysis, the equipment's salvage value will be computed as: $15,000 $25,000 the discounted value of $15,000 to be received 4 years in the future. the discounted value of $25,000 to be received 4 years in the future. the future value of $15,000 to be received 4 years in the future.

the discounted value of $15,000 to be received 4 years in the future.

Wilson Company is considering a new capital acquisition to support capacity expansion. Relevant information includes: New equipment cost $250,000; Incremental revenues $150,000; Incremental operating expenses $75,000; Incremental working capital $25,000 (To be recovered at the end of the project's life). Based on this information, an NPV analysis will show years 1 through 3 as a: $150,000 inflow discounted using the present value annuity factor for the required rate of return. $75,000 inflow discounted using the present value annuity factor for the required rate of return. $150,000 inflow discounted using the future value annuity factor for the required rate of return. $75,000 inflow discounted using the future value annuity factor for the required rate of return.

$75,000 inflow discounted using the present value annuity factor for the required rate of return.

A firm is considering a project with an annual cash flow of $200,000. The project would have a seven year life, and the company uses a discount rate of 10%. What is the maximum amount the company could invest in the project and have the project still be acceptable? $1,400,000 $718,200 $200,000 $973,600

$973,600

The earning of interest on interest is: Present value. Discount rate. Interest earned. Compounding of interest. Future value.

Compounding of interest.

The earning of interest on interest is: Present value. Future value. Discount rate. Interest earned. Compounding of interest.

Compounding of interest.

A disadvantage of the payback period is that it ignores a project's total profitability. True False

True

A postaudit evaluates the overall outcome of the investment and proposes corrective action if needed. True False

True

Companies that perform postaudits of capital projects experience a number of benefits. True False

True

If cash flows are uneven, the payback period assumes that the inflows during the last fraction of a year occur evenly. True False

True

In practice, managers often choose a discount rate that is higher than the cost of capital. True False

True

Postaudits ensure that resources are used wisely by evaluating profitability. True False

True

Taxes are important consideration in forecasting cash flows. True False

True

The minimum acceptable rate of return for a project is the required rate of return. True False

True

If a company invests $100,000 in equipment and it is expected to generate $41,632 in cash flows savings for three years, the Internal Rate of Return will be closest to: 12% 2.4% 41.63% 14%

12%

One drawback to the internal rate of return model is that cash inflows must occur evenly over the life of the investment. True False

False

Which of the following statements is correct? NPV and IRR yield similar decisions for mutually exclusive projects. The project with the lowest IRR should be chosen. The project with the lowest NPV should be chosen. NPV and IRR yield similar decisions for independent projects.

NPV and IRR yield similar decisions for independent projects.

In order for a company to accept a project based on Net Present Value (NPV): NPV must be less or equal to zero. NPV must be greater or equal to zero. NPV must be greater than zero. NPV must be greater than IRR. NPV cannot be used to accept projects.

NPV must be greater or equal to zero.

A division manager is considering a project that requires a significant initial investment. The company's top management will not approve any project that does not return at least 12%. The manager will most likely use which of the following capital investment models? Payback period Net present value Accounting rate of return Internal rate of return None of these choices are correct.

Net present value

The best model for choosing the best of several competing projects is: Internal rate of return. Net present value. Accounting rate of return. Payback period. None of these choices are correct

Net present value.

The capital investment decision making model that assumes that each cash inflow is reinvested at the required rate of return is: Payback period. Net present value. Internal rate of return. Accounting rate of return. None of these choices are correct.

Net present value.

Which of the following is true of capital investment decision making? It is used only for independent projects. It is used only for mutually exclusive projects. It requires that funding for a project must come from sources with the same opportunity cost of funds. It is used to determine whether or not a firm should accept a special order. None of these choices are correct.

None of these choices are correct.

The time required for a firm to recover its original investment is the Internal rate of return. Life of the project. Accounting rate of return. Net present value. Payback period.

Payback period.

Which of the following is not a purpose of a postaudit? Compare actual costs with estimated costs Compare actual cash flows with estimated cash flows Propose corrective action, if needed Punish managers for their bad estimates Learn to conduct better future estimates

Punish managers for their bad estimates

Which of the following is not an example of a capital budgeting decision? Purchase equipment for production Purchase land Purchase a building Purchase bonds as an investment

Purchase bonds as an investment

Mutually exclusive capital budgeting projects are those that: a. if accepted will produce a negative IRR. b. if accepted preclude the acceptance of all other competing projects. c. if rejected preclude the acceptance of all other mutually exclusive projects. d. if accepted or rejected do not affect the cash flows of other projects. e. if rejected imply that all other competing projects have a positive NPV.

b. if accepted preclude the acceptance of all other competing projects.

Using NPV, a project is rejected if it is a. equal to zero. b. negative. c. positive. d. equal to the required rate of return. e. greater than the cost of capital.

b. negative.

Assume that an investment of $1,000 produces a future cash flow of $1,000. The discount factor for this future cash flow is 0.80. The NPV is a. $0. b. $110. c. ($200). d. $911. e. none of these choices are correct.

c. ($200).

Postaudit benefits include all of the following except: positive impact on managers' behavior. independent perspective. cost. resource allocation.

cost.

Which of the following is not true regarding the IRR? a. The IRR is the interest rate that sets the present value of a project's cash inflows equal to the present value of the project's cost. b. The IRR is the interest rate that sets the NPV equal to zero. c. The popularity of IRR may be attributable to the fact that it is a rate of return, a concept that is comfortably used by managers. d. If the IRR is greater than the required rate of return, then the project is acceptable. e. The IRR is the most reliable of the capital budgeting methods.

e. The IRR is the most reliable of the capital budgeting methods.

A postaudit a. is a follow-up analysis of a capital project, once implemented. b. compares the actual benefits with the estimated benefits. c. evaluates the overall outcome of the investment. d. proposes corrective action, if needed. e. all of these choices are correct.

e. all of these choices are correct.

The ARR has one specific advantage not possessed by the payback period in that it a. considers the time value of money. b. measures the value added by a project. c. is always an accurate measure of profitability. d. is more widely accepted by financial managers. e. considers the profitability of a project beyond the payback period.

e. considers the profitability of a project beyond the payback period.

The value of an investment at the end of its life is called its

future value

Mutually exclusive projects are those that: if accepted preclude the acceptance of competing projects. if accepted, can have an negative effect on the company's profit. if accepted, can also lead to the acceptance of a competing projects. require consideration by all managers.

if accepted preclude the acceptance of competing projects.