Ch 11 Flashcards
Capital budgeting is used to evaluate the purchase of:
a machine
List the steps involved in capital budgeting process, with the first step on top.
Submit proposal
Evaluate proposal
Approve or reject proposals
All of the following are cash flows over the life of an asset except:
depreciation
An investment’s … period is the expected time to recover the initial investment amount.
payback
A company is considering two capital investments. Each requires an initial investment of $15,000 and has a 4 year useful life. Investment A has expected cash inflows of $5,000 each year for the 4 years for total cash inflows of $20,000. Investment B has the following expected cash flows: Year 1: $8,000; Year 2: $6,000; Year 3: $4,000; Year 4: $2,000; Total cash flows: $20,000. Calculate the payback period for Investment A.
3 years
Reason: $15,000 / $5,000 = 3 years.
The process of evaluating and planning for long-term investments is called … budgeting.
capital
A company is considering two capital investments. Each requires an initial investment of $15,000 and has a 4 year useful life. Investment A has expected cash inflows of $5,000 each year for the 4 years for total cash inflows of $20,000. Investment B has the following expected cash flows: Year 1: $8,000; Year 2: $6,000; Year 3: $4,000; Year 4: $2,000; Total cash flows: $20,000. Calculate the payback period for Investment B.
2.25 years
HOW
Characteristics of capital budgeting include: (Check all that apply.)
long-term investment
large amount of money is involved
outcome is uncertain
A company is considering two capital investments. Each requires an initial investment of $15,000 and has a 4 year useful life. Investment A has expected cash inflows of $5,000 each year for the 4 years for total cash inflows of $20,000. Investment B has the following expected cash flows: Year 1: $8,000; Year 2: $6,000; Year 3: $4,000; Year 4: $2,000; Total cash flows: $20,000. Using the payback period as the evaluation method, which investment should be chosen by management?
Investment B
Shortest payback
Place the following cash flows in the order that they would occur in a capital investment:
Acquisition
Use
Disposal
The formula to calculate the accounting rate of return is:
annual income/average investment
The capital budgeting evaluation method that measures the expected amount of time to recover the initial investment amount is the:
payback period.
Assume straight-line depreciation. A company plans to purchase machinery costing $1,000,000 with salvage value of $200,000 after 4 years. Annual income is expected to be $40,000 during the 4 years. Calculate the accounting rate of return. Round your answer to the nearest tenth of a percent.
6.7 %
Reason: Average investment = (1,000,000 + 200,000)/2 = 600,000. $40,000/600,000 = 6.7%
A company is considering a capital investment of $45,000 in new equipment which will improve production and increase cash flows by $15,000 per year for 6 years. The payback period is … years.
3 years
45,000÷15,000
A company is considering a capital investment of $16,000 in new equipment which will improve production and increase cash flows for the next five years at the following amounts: Year 1: $8,000; Year 2: $6,000; Year 3: $5,000; Year 4: $6,000; Year 5: $5,000. The payback period is … years.
2.4 years.
2+(2,000÷5,000)
Weaknesses of the payback period as a capital budgeting evaluation method include that it: (Check all that apply.)
ignores time value of money.
Weaknesses of the accounting rate of return as a capital budgeting evaluation method include that it: (Check all that apply.)
ignores time value of money.
does not directly consider cash flows and their timing.
If a company uses straight-line depreciation, the average investment is calculated as: (Check all that apply.)
(initial investment + salvage value)/2.
(beginning book value + salvage value)/2.
Assume straight-line depreciation and equal cash flows. A company plans to purchase equipment for $25,000. The equipment will have $0 salvage value and increase income by $7,500 annually during its 5-year life. The accounting rate of return is
…%.
60%
(7,500÷(25,000÷2))×100
A company’s required rate of return computed as an average of the rate the company must pay to its lenders and investors is called:
hurdle rate
A company is considering two capital investments. Each requires an initial investment of $15,000 and has a 4 year useful life. Investment A has expected cash inflows of $5,000 each year for the 4 years for total cash inflows of $20,000. Investment B has the following expected cash flows: Year 1: $8,000; Year 2: $6,000; Year 3: $4,000; Year 4: $2,000; Total cash flows: $20,000. Calculate the payback period for Investment B.
2.25yrs
2+(1,000÷4,000)
The accounting rate of return:
does not directly consider cash flows and their timing.
An investment that costs $30,000 will produce annual cash flows of $10,000 for 4 years. Using a required return of 8%, the investment will generate (rounded to the nearest dollar) a:
Present Value of 1
Rate
Periods
7%
8%
9%
4
0.7629
0.7350
0.7084
Present Value of an Annuity of 1
Rate
Periods
7%
8%
9%
4
3.3872
3.3121
3.2397
positive NPV of $3,121.
Reason: $10,000 x 3.3121=$33,121. $33,121-$30,000=$3,121.
Or. (10,000×3.3121)−30,000
Bc used pres.value of annuity
The formula to calculate the accounting rate of return is:
annual income/average investment
The decision rule for NPV includes: (Check all that apply).
if an asset’s future net cash flows yield a positive net present value, invest.
when comparing projects with similar initial investments and risk, select the one with the highest net present value.
A company is evaluating an investment which has an initial investment of $4,000. Annual net cash flows is expected to be $2,000 over the next three years. The company requires a 10% annual return. The present value of an annuity factor for 10% and 3 periods is 2.4869. The present value of $1 factor for 10% and 3 periods is 0.7513. The net present value is $….
(round your answer to the nearest whole dollar).
$974
(2,000×2.4869)−4,000
The capital investment evaluation method that subtracts the initial investment from the discounted future net cash flows from the investment at the required rate of return is the:
net present value
A company is considering an investment opportunity with a cost of $5,000 that will provide future cash flows of $8,000. The cash flows for the investment for the next 4 years are: $1,000, $1,000, $2,000 and $4,000. Assume a required rate of return of 10%. The NPV is $……
(rounded to nearest dollar).
Present Value of 1
Rate
Periods
10%
1
0.9091
2
0.8264
3
0.7513
4
0.6830
Present Value of an Annuity of 1
Rate
Periods
10%
4
3.1699
$970
((1,000×0.9091)+(1,000
×0.8264)+(2,000×0.7513)
+(4,000×0.6830))−5,000
A company is considering a capital investment of $16,000 in new equipment which will improve production and increase cash flows for the next five years at the following amounts: Year 1: $8,000; Year 2: $6,000; Year 3: $5,000; Year 4: $6,000; Year 5: $5,000. The payback period is … years.
2.4 years
((16,000−8,000−6,000)
÷5,000)+2
The formula to calculate the profitability index is:
present value of net cash flows/initial investment
An investment that costs $5,000 will produce annual cash flows of $3,000 for 3 years. Using a required return of 8%, the investment will generate a NPV of $….
(rounded to nearest dollar).
Present Value of 1
Rate
Periods
7%
8%
9%
1
0.9346
0.9259
0.9174
2
0.8734
0.8573
0.8417
3
0.8163
0.7938
0.7722
4
0.7629
0.7350
0.7084
5
0.7130
0.6806
0.6499
Present Value of an Annuity of 1
Rate
Periods
7%
8%
9%
1
0.9346
0.9259
0.9174
2
1.8080
1.7833
1.7591
3
2.6243
2.5771
2.5313
4
3.3872
3.3121
3.2397
2731
(3,000×2.5771)−5,000
Consider the following projects: Project A: cost = $30,000, NPV of cash flows = $10,000; Project B: cost = $45,000, NPV of cash flows = $10,000; Project C: cost = $30,000, NPV of cash flows = $20,000; Project D: cost = $40,000, NPV of cash flows = $5,000. Using profitability index as the evaluation method, rank the projects in order of preference with the best choice on top.
Project C (20,000÷30,000 = 0.67)
Project A (10,000÷30,000 = 0.33)
Project B (10,000÷45,000 = 0.22)
Project D (5,000÷40,000 = 0.125)
A company has evaluated several projects using net present value. All projects are similar in amount invested and risk. Rank the projects in the order they should be accepted.
NPV = $340
NPV = ($615)
NPV = $62
NPV = $2,067
NPV = $340: second choice
NPV = ($615): not acceptable
NPV = $62: third choice
NPV = $2,067: first choice
The discount rate that results in a net present value of $0 is the:
internal rate of return
A company is evaluating an investment which has an initial investment of $15,000. Expected annual net cash flows over four years is $5,000. The company would like to earn a 10% return on the investment. The present value of an annuity factor for 10% and 4 periods is 3.1699. The present value of $1 factor for 10% and 4 periods is 0.6830. The net present value is $….
(round your answer to the nearest whole dollar).
$850
(5,000×3.1699)−15,000
Which of the following is the approximate internal rate of return for an investment that costs $45,880 and has net cash flows of $4,000 for 20 years?
Present Value of 1
Rate
Periods
5%
6%
8%
10%
20
0.3769
0.3118
0.2145
0.1486
Present Value of an Annuity of 1
Rate
Periods
5%
6%
8%
10%
20
12.4622
11.4699
9.8181
8.5136
6%
45,880÷4,000 = 11.47 which is closest to the present value annuity rate, period 20, of Rate 6% (which is 11.4699)
A company is considering an investment opportunity with a cost of $5,000 that will provide future cash flows of $8,000. The cash flows for the investment for the next 4 years are: $1,000, $2,000, $3,000 and $2,000. Assume a required rate of return of 10%. The NPV is $…
(rounded to nearest dollar).
Present Value of 1
Rate
Periods
10%
1
0.9091
2
0.8264
3
0.7513
4
0.6830
Present Value of an Annuity of 1
Rate
Periods
10%
4
3.1699
$1182
((1,000×0.9091)+(2,000
×0.8264)+(3,000×0.7513)
+(2,000×0.6830))−5,000
A company has a hurdle rate of 12%. Using IRR as the evaluation method, determine which projects should be accepted.
Project B with IRR 12.5%
Project D with IRR -12.5%
Project B with IRR 12.5%: accept
Project D with IRR -12.5%: reject
It is appropriate to use the profitability index to evaluate investment decisions when:
the amounts invested differ substantially
Of the four capital budgeting methods, which ones reflect the time value of money? (Check all that apply).
net present value
internal rate of return
A company needs to choose between two investment opportunities. Project 1 has a cost of $500,000 and expected NPV of cash flows of $450,000. Project 2 has a cost of $800,000 and expected NPV of cash flows of $750,000. Using profitability index as the evaluation method, the company should choose:
Project 2 because it has a higher index
Project 1: 450,000÷500,000 = 0.9
Project 2: 750,000÷800,000 = 0.9375
Which of the following are correct statements about the internal rate of return (IRR)? (Check all that apply.)
The higher the IRR, the better.
IRR uses the time value of money.
Which of the following is the approximate internal rate of return for an investment that costs $12,680 and has net cash flows of $4,000 for 4 years?
Present Value of 1
Rate
Periods
8%
10%
12%
4
0.7350
0.6830
0.6355
Present Value of an Annuity of 1
Rate
Period
8%
10%
12%
4
3.3121
3.1699
3.0373
10%
12,680÷4,000 = 3.17 which is closest to 10% pres Val annuity rate (3.1699)
A company is considering two investment projects. Both have an initial cost of $50,000. One project has even cash flows and the other uneven cash flows. Which evaluation method would be most appropriate?
Net present value
A predetermined, minimum acceptable rate of return is known as a(n):
hurdle rate
A capital investment evaluation method that measures the expected time until the present value of the net cash flows equals the initial investment is:
break-even time
Match the capital budgeting method to its specific characteristic.
PBP:
ARR:
NPV:
IRR:
PBP: ignores time value of money
ARR: Uses income rather than cash flows.
NPV: can reflect changes in risk over projects life.
IRR: allows comparison of profess of different sizes.
A company is evaluating an investment which has an initial investment of $4,000. Annual net cash flows are expected to be $2,000 over the next three years. The company requires a 10% annual return. The present value of $1 factor for 10% and 1 period is 0.9091; 2 periods is 0.8264; and for 3 periods is 0.7513. The break-even time is between:
2 and 3 years
Reason: Year 1: $(4,000) - ($2,000 x 0.9091) = $(2,181.80). Year 2: $(2,181.80) - ($2,000 x .8264) = ($529). Year 3: ($529) - ($2,000 x 0.7513) = $973.60. So, they break even between years 2 and 3 at 2.35.
Consider the following projects: Project A: cost = $30,000, NPV of cash flows = $10,000; Project B: cost = $45,000, NPV of cash flows = $10,000; Project C: cost = $30,000, NPV of cash flows = $20,000; Project D: cost = $40,000, NPV of cash flows = $5,000. Using profitability index as the evaluation method, rank the projects in order of preference with the best choice on top.
Project C
Project A
Project B
Project D
The discount rate that results in a net present value of $0 is the:
internal rate of return
A company is considering two similar investment projects. One has an initial cost of $50,000 and the other an initial cost of $450,000. Which evaluation method would be most appropriate?
Internal rate of return
A company is considering several investment opportunities. The investments have been evaluated using payback period and break-even time. Only one project will be chosen and time value of money is important. The company should choose the project which the:
shortest break-even time
A company is considering a capital investment of $45,000 in new equipment which will improve production and increase cash flows by $15,000 per year for 6 years. The company has a hurdle rate of 10%. The break-even time is approximately:
Present Value of 1 at 10%: Period 1: 0.9091; Period 2: 0.8264; Period 3: 0.7513; Period 4: 0.6830; Period 5: 0.6209; Period 6: 0.5645.
3.75 years
Reason: ($45,000)-(15,000x.9091)=($31,363).( $31,363)-(15,000x.8264)=($18,967).( $18,967)-(15,000x.7513)=($7,697). $7,697/(15,000x.6830)=.75. 3 years +0.75=3.75 years.
A company is evaluating an investment which has an initial investment of $4,000. Annual net cash flows are expected to be $2,000 over the next three years. The company requires a 10% annual return. The present value of $1 factor for 10% and 1 period is 0.9091; 2 periods is 0.8264; and for 3 periods is 0.7513. The break-even time is between:
Ch 11. CV
An investment has a cost $40,000 with net cash flows of $20,000 each year for 4 years. The company has a required rate of return of 8%. If the first four periods’ discount factors, based on 8%, taken from a “present value of 1” table are 0.9259, 0.8573, 0.7938, 0.7350, what is the break-even time of the investment?
Between years 2 and 3
Capital budgeting is risky because:
the decision is difficult to reverse
Mint Company is considering purchasing a machine with a cost of $10,000 and a useful life of 20 years. Mint expects the machine to produce net annual cash flows of $2,000 each year. What is the cash payback period of the machine?
5 years
10,000÷2,000
Jelly Company is considering purchasing a machine with a cost of $20,000 and a useful life of 10 years. Jelly expects the machine to produce net annual cash flows of $2,000 in year 1, $10,000 in year 2, $5,000 in year 3, $12,000 in year 4, and $8,000 in year 5. What is the cash payback period of the machine?
3.25 years
((20,000−(2,000+10,000
+5,000))÷12,000)+3
All of the following are strengths of the payback period except:
it ignores the time value of money.
Chilly Company is considering investing $110,000 in a new refrigerator, designed to keep food extra crispy. The refrigerator will have a useful life of 10 years, a salvage value of $10,000, and is expected to generate an annual income of $15,000 in each year of its useful life. Chilly will use the straight-line method of depreciation. What is the accounting rate of return?
25%
(15,000÷((110,000
+10,000)÷2))×100
All of the following are weaknesses of the accounting rate of return except:it is easy to compute.
An investment has a cost of $40,000 with net cash flows of $15,000 each year for 4 years. The company has a required rate of return of 8%. If the first four periods’ discount factors, based on 8%, from a “present value of 1” table are 0.9259, 0.8573, 0.7938, and 0.7350, what is the net present value of the investment?
$9,680
((15,000×0.9259)
+(15,000×0.8573)
+(15,000×0.7938)
+(15,000×0.7350))
−40,000
If the net present value is greater than zero, the company should:
invest
A company is evaluating two separate projects, both with the same $15,000 initial investment.
Year Net Cash Flows Project 1 Net Cash Flows Project 2 Present Value of 1 at 10%
1 $ 10,000 $ 20,000 0.9091
2 $ 10,000 $ 7,000 0.8264
3 $ 10,000 $ 3,000 0.7513
What is the net present value of Project 1?
$9,868
((10,000×0.9091)+(10,000
×0.8264)+(10,000
×0.7513))−15,000
Salvage value is treated as:
an addition to net cash inflows at the end of the final year.
An investment has an initial cost of $40,000, and the present value of net cash flows of $10,000. What is the profitability index?
0.25
10,000÷40,000
When internal rate of return is used to evaluate a capital investment, the present value factor is computed as:
initial investment divided by annual net cash flows
When internal rate of return is used to evaluate a capital investment, the present value factor is computed as:
initial investment divided by annual net cash flows
