CH10 TB CAPITAL BUDGETING TECHNIQUES

Question 1

Capital budgeting techniques are used to evaluate a firm’s fixed asset investments which provide the basis for the firm’s earning power and value.

T/F

Answer 1

TRUE

Question 2

The purchase of additional physical facilities, such as additional property or a new factory, is an example of a capital expenditure.

T/F

Answer 2

TRUE

Question 3

Capital budgeting is the process of evaluating and selecting short-term investments that are consistent with the firm’s goal of maximizing owners’ wealth.

T/F

Answer 3

FALSE

long-term investments

Question 4

A capital expenditure is an outlay of funds invested only in fixed assets that is expected to produce benefits over a period of time less than one year.

T/F

Answer 4

FALSE

more than one year

Question 5

An outlay for advertising and management consulting is considered to be a fixed asset expenditure.

T/F

Answer 5

FALSE

Question 6

Capital expenditure proposals are reviewed to assess their appropriateness in light of a firm’s overall objectives and plans, and to evaluate their economic validity.

T/F

Answer 6

TRUE

Question 7

The basic motives for capital expenditures are to expand operations, to replace or renew fixed assets, or to obtain some other, less tangible benefit over a long period.

T/F

Answer 7

TRUE

Question 8

The primary motive for capital expenditures is to refurbish fixed assets.

T/F

Answer 8

FALSE

Question 9

Research and development is considered to be a motive for making capital expenditures.

T/F

Answer 9

TRUE

Question 10

The capital budgeting process consists of five distinct but interrelated steps: proposal generation, review and analysis, decision making, implementation, and follow-up.

T/F

Answer 10

TRUE

Question 11

The capital budgeting process consists of four distinct but interrelated steps: proposal generation, review and analysis, decision making, and termination.

T/F

Answer 11

FALSE

Question 12

Independent projects are projects that compete with one another for a firm’s resources, so that the acceptance of one eliminates the others from further consideration.

T/F

Answer 12

FALSE

Mutually exclusive

Question 13

If a firm has unlimited funds to invest in capital assets, all independent projects that meet its minimum investment criteria should be implemented.

T/F

Answer 13

TRUE

Question 14

In capital budgeting, the preferred approaches in assessing whether a project is acceptable are those that integrate time value procedures, risk and return considerations, and valuation concepts.

T/F

Answer 14

TRUE

Question 15

A $60,000 outlay for a new machine with a usable life of 15 years is an operating expenditure that would appear as a current asset on a firm’s balance sheet.

T/F

Answer 15

FALSE

Capital expenditure

Question 16

A nonconventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by a series of inflows.

T/F

Answer 16

FALSE

conventional

Question 17

Time value of money should be ignored in capital budgeting techniques to make accurate decisions.

T/F

Answer 17

FALSE

Question 18

If a firm has limited funds to invest, all the mutually exclusive projects that meet its minimum investment criteria should be implemented.

T/F

Answer 18

FALSE

Question 19

Mutually exclusive projects are projects whose cash flows are unrelated to one another; the acceptance of one does not eliminate the others from further consideration.

T/F

Answer 19

FALSE

Independent

Question 20

The availability of funds for capital expenditures does not affect a firm’s capital budgeting decisions.

T/F

Answer 20

FALSE

Question 21

Independent projects are those whose cash flows are unrelated to one another; the acceptance of one does not eliminate the others from further consideration.

T/F

Answer 21

TRUE

Question 22

Mutually exclusive projects are those whose cash flows are constant over a specified period of time and more than one project needs to be accepted in order to implement capital budgeting decisions.

T/F

Answer 22

FALSE

Question 23

Independent projects are those whose cash flows compete with one another and therefore more than one project needs to be accepted in order to implement the capital budgeting decision.

T/F

Answer 23

FALSE

Question 24

Mutually exclusive projects are those whose cash flows compete with one another; the acceptance of one eliminates the others from further consideration.

T/F

Answer 24

TRUE

Question 25

If a firm is subject to capital rationing, it is able to accept all independent projects that provide an acceptable return. | T/F

Answer 25

FALSE

Question 26

If a firm has unlimited funds, it is able to accept all independent projects that provide an acceptable return. | T/F

Answer 26

TRUE

Question 27

If a firm is subject to capital rationing, it has only a fixed number of dollars available for capital expenditures and numerous projects compete for these dollars. | T/F

Answer 27

TRUE

Question 28

The ranking approach involves the ranking of capital expenditure projects on the basis of some predetermined measure such as the rate of return. | T/F

Answer 28

TRUE

Question 29

The accept-reject approach involves the ranking of capital expenditure projects on the basis of some predetermined measure, such as the rate of return. | T/F

Answer 29

FALSE

Question 30

A conventional cash flow pattern is one in which an initial outflow is followed only by a series of inflows. | T/F

Answer 30

TRUE

Question 31

Large firms evaluate the merits of individual capital budgeting projects to ensure that the selected projects have the best chance of increasing the firm value. | T/F

Answer 31

TRUE

Question 32

A nonconventional cash flow pattern is one in which an initial flow is followed by a series of inflows and outflows. | T/F

Answer 32

TRUE

Question 33

________ is the process of evaluating and selecting long-term investments that are consistent with a firm's goal of maximizing owners' wealth. A) Recapitalizing assets B) Capital budgeting C) Ratio analysis D) Securitization

Answer 33

B

Question 34

A $60,000 outlay for a new machine with a usable life of 15 years is called ________. A) capital expenditure B) financing expenditure C) replacement expenditure D) operating expenditure

Answer 34

A

Question 35

Fixed assets that provide the basis for a firm's earning and value are often called ________. A) tangible assets B) noncurrent assets C) earning assets D) book assets

Answer 35

C

Question 36

Which of the following is true of a capital expenditure? A) It is an outlay made to replace current assets. B) It is an outlay expected to produce benefits within one year. C) It is commonly used for current asset expansion. D) It is commonly used to expand the level of operations.

Answer 36

D

Question 37

The final step in the capital budgeting process is ________. A) implementation B) follow-up C) review and analysis D) decision making

Answer 37

B

Question 38

The first step in the capital budgeting process is ________. A) review and analysis B) implementation C) decision making D) proposal generation

Answer 38

D

Question 39

________ projects do not compete with each other; the acceptance of one ________ the others from consideration. A) Capital; eliminates B) Independent; does not eliminate C) Mutually exclusive; eliminates D) Replacement; eliminates

Answer 39

B

Question 40

________ projects have the same function; the acceptance of one ________ the others from consideration. A) Capital; eliminates B) Independent; does not eliminate C) Mutually exclusive; eliminates D) Replacement; eliminates

Answer 40

C

Question 41

A firm with limited dollars available for capital expenditures is subject to ________. A) capital dependency B) capital gains C) working capital constraints D) capital rationing

Answer 41

D

Question 42

Projects that compete with one another, so that the acceptance of one eliminates the others from further consideration are called ________. A) independent projects B) mutually exclusive projects C) replacement projects D) capital projects

Answer 42

B

Question 43

A conventional cash flow pattern associated with capital investment projects consists of an initial ________. A) outflow followed by a broken cash series B) inflow followed by a broken series of outlay C) outflow followed by a series of inflows D) outflow followed by a series of outflows

Answer 43

C

Question 44

A nonconventional cash flow pattern associated with capital investment projects consists of an initial ________. A) outflow followed by a series of both cash inflows and outflows B) inflow followed by a series of both cash inflows and outflows C) outflow followed by a series of inflows D) inflow followed by a series of outflows

Answer 44

A

Question 45

Which of the following is an example of a nonconventional pattern of cash flows? A) Year 0 1 2 3 4 cash flow -200 150 310 265 200 B) Year 0 1 2 3 4 cash flow 200 100 -100 200 -300 C) Year 0 1 2 3 4 cash flow -200 100 100 200 300 D) Year 0 1 2 3 4 cash flow -200 150 150 150 150

Answer 45

B

Question 46

in the case of annuity cash inflows, the payback period can be found by dividing the initial investment by the annual cash inflow. | T/F

Answer 46

TRUE

Question 47

The payback period is the amount of time required for a firm to dispose a replaced asset. | T/F

Answer 47

FALSE

Question 48

For calculating payback period for an annuity, all cash flows must be adjusted for time value of money. | T/F

Answer 48

FALSE

Question 49

If a project's payback period is less than the maximum acceptable payback period, we would accept it. | T/F

Answer 49

TRUE

Question 50

If a project's payback period is greater than the maximum acceptable payback period, we would reject it. | T/F

Answer 50

TRUE

Question 51

If a project's payback period is greater than the maximum acceptable payback period, we would accept it. | T/F

Answer 51

FALSE

Question 52

The payback period of a project that costs $1,000 initially and promises after-tax cash inflows of $300 for the next three years is 3.33 years. | T/F

Answer 52

TRUE

Question 53

The payback period of a project that costs $1,000 initially and promises after-tax cash inflows of $300 each year for the next three years is 0.333 years. | T/F

Answer 53

FALSE

Question 54

The payback period of a project that costs $1,000 initially and promises after-tax cash inflows of $3,000 each year for the next three years is 0.333 years. | T/F

Answer 54

TRUE

Question 55

The payback period of a project that costs $1,000 initially and promises after-tax cash inflows of $2,000 each year for the next three years is 0.5 years. | T/F

Answer 55

TRUE

Question 56

The payback period is generally viewed as a flawed capital budgeting technique, because it does not explicitly consider the time value of money by discounting cash flows to find present value. | T/F

Answer 56

TRUE

Question 57

A project must be rejected if its payback period is less than the maximum acceptable payback period. | T/F

Answer 57

FALSE ## Footnote accepted

Question 58

By measuring how quickly a firm recovers its initial investment, the payback period gives implicit consideration to the time value of money and ignores the timing of cash flows. | T/F

Answer 58

FALSE ## Footnote ignores time value of money and gives implicit consideration to the timing of cash flows

Question 59

One strength of payback period is that it fully accounts for the time value of money. | T/F

Answer 59

FALSE

Question 60

One weakness of the payback period approach is its failure to recognize cash flows that occur after the payback period. | T/F

Answer 60

TRUE

Question 61

Since the payback period can be viewed as a measure of risk exposure, many firms use it as a supplement to other decision techniques. | T/F

Answer 61

TRUE

Question 62

A major weakness of payback period in evaluating projects is that it cannot specify the appropriate payback period in light of the wealth maximization goal | T/F

Answer 62

TRUE

Question 63

Which of the following is the capital budgeting technique that has the weakest connection to the goal of value maximization? A) internal rate of return B) payback period C) profitability index D) net present value

Answer 63

B

Question 64

Which of the following capital budgeting techniques ignores the time value of money? A) payback period approach B) net present value C) internal rate of return D) profitability index

Answer 64

A

Question 65

The ________ measures the amount of time it takes a firm to recover its initial investment. A) profitability index B) internal rate of return C) net present value D) payback period

Answer 65

D

Question 66

An annuity is ________. A) a mix of cash flows in conventional and nonconventional B) a stream of perpetual cash flows C) a series of constantly growing cash flows D) a series of equal annual cash flows

Answer 66

D

Question 67

Payback is considered a flawed capital budgeting because it ________. A) gives explicit consideration to the timing of cash flows and therefore the time value of money B) gives explicit consideration to risk exposure due to the use of the cost of capital as a discount rate C) does not gives explicit consideration on the recovery of initial investment and possibility of a calamity D) it does not explicitly consider the time value of money

Answer 67

D

Question 68

Which of the following statements is true of payback period? A) If the payback period is less than the maximum acceptable payback period, management should be indifferent. B) If the payback period is greater than the maximum acceptable payback period, accept the project. C) If the payback period is less than the maximum acceptable payback period, accept the project. D) If the payback period is greater than the maximum acceptable payback period, management should be indifferent.

Answer 68

C

Question 69

Should Tangshan Mining company accept a new project if the company's maximum payback is 3.5 years and the project's initial after-tax cost is $5,000,000 followed by after-tax operating cash inflows of $1,800,000 in year 1, $1,900,000 in year 2, $700,000 in year 3, and $1,800,000 in year 4? A) Yes, since the payback period of the project is less than the maximum acceptable payback period. B) No, since the payback period of the project is more than the maximum acceptable payback period. C) Yes, since the risk exposure of the project is less than the maximum acceptable risk exposure. D) No, since the risk exposure of the project is more than the maximum acceptable risk exposure.

Answer 69

A

Question 70

Should Tangshan Mining company accept a new project if its maximum payback is 3.25 years and its initial after-tax cost is $5,000,000 followed by after-tax operating cash inflows of $1,800,000 in year 1, $1,900,000 in year 2, $700,000 in year 3, and $1,800,000 in year 4? A) Yes, since the payback period of the project is less than the maximum acceptable payback period. B) No, since the payback period of the project is more than the maximum acceptable payback period. C) Yes, since the risk exposure of the project is less than the maximum acceptable risk exposure. D) No, since the risk exposure of the project is more than the maximum acceptable risk exposure.

Answer 70

B

Question 71

Which of the following is a disadvantage of payback period approach? A) It does not examine the size of the initial outlay. B) It does not use net profits as a measure of return. C) It does not explicitly consider the time value of money. D) It does not take into account an unconventional cash flow pattern

Answer 71

C

Question 72

Which of the following is a strength of payback period? A) a disregard for cash flows after the payback period B) only an implicit consideration of the timing of cash flows C) merely a subjectively determined number D) It's simple to calculate and understand.

Answer 72

D

Question 73

Which of the following is a reason for firms not using the payback method as a guideline in capital investment decisions? A) It gives an explicit consideration to the timing of cash flows. B) The optimal payback period cannot be specified in light of the wealth maximization goal. C) It is a measure of risk exposure and projects the possibility of a calamity. D) It is easy to calculate and has intuitive appeal.

Answer 73

B

Question 74

Net present value is considered a superior capital budgeting technique relative to payback since it gives explicit consideration to the time value of money. | T/F

Answer 74

TRUE

Question 75

The discount rate is the return that an investment project must meet or exceed to maintain or increase the firm's value. | T/F

Answer 75

TRUE

Question 76

The net present value is found by subtracting a project's initial investment from the present value of its cash inflows discounted at a rate equal to the project's internal rate of return. | T/F

Answer 76

FALSE ## Footnote cost of capital

Question 77

A capital budgeting technique that can be computed by subtracting a project's initial investment from the present value of its cash inflows discounted at a rate equal to a firm's cost of capital is called net present value. | T/F

Answer 77

TRUE

Question 78

A capital budgeting technique that can be computed by subtracting a project's initial investment from the present value of its cash inflows discounted at a rate equal to a firm's cost of capital is called profitability index. | T/F

Answer 78

FALSE ## Footnote NPV

Question 79

The NPV of a project with an initial investment of $1,000 that provides after-tax operating cash flows of $300 per year for four years where the firm's cost of capital is 15 percent is $856.49. | T/F

Answer 79

FALSE

Question 80

The NPV of a project with an initial investment of $2,500 that provides after-tax operating cash flows of $500 per year for four years where the firm's cost of capital is 15 percent is $427.49. | T/F

Answer 80

FALSE

Question 81

If the net present value of a project is greater than zero, the firm will earn a return greater than its cost of capital. The acceptance of such a project would enhance the wealth of the firm's owners. | T/F

Answer 81

TRUE

Question 82

If the NPV is greater than the initial investment, a project should be rejected. | T/F

Answer 82

FALSE

Question 83

If the NPV is less than the initial investment, a project should be rejected. | T/F

Answer 83

FALSE

Question 84

If the NPV is greater than $0, a project should be accepted. | T/F

Answer 84

TRUE

Question 85

For a project that has an initial cash outflow followed by cash inflows, the profitability index (PI) is equal to the present value of cash inflows divided by the cost of capital. | T/F

Answer 85

FALSE ## Footnote present value of cash inflows divided by the initial investment

Question 86

Economic value added is the difference between an investment's net operating profit after taxes and the accounting profit. | T/F

Answer 86

FALSE

Question 87

The NPV of a project is the difference between an investment's net operating profit after taxes and the cost of funds used to finance the investment, which is found by multiplying the dollar amount of the funds used to finance the investment by the firm's weighted average cost of capital. | T/F

Answer 87

FALSE

Question 88

Which of the following is an advantage of NPV? A) It measures the risk exposure. B) It takes into account the time value of investors' money. C) It is highly sensitive to the discount rates. D) It measures how quickly a firm can breakeven.

Answer 88

B

Question 89

The return that must be earned on a project in order to leave the firm's value unchanged is ________. A) the internal rate of return B) the interest rate C) the cost of capital D) the compound rate

Answer 89

C

Question 90

Thinking in terms of the goal of wealth maximization, a project breaks even for shareholders, meaning that it neither creates nor destroys value, if ________. A) its NPV equals 0 B) its IRR equals 0 C) its net profit after taxes equals 0 D) its payback period is one year or less

Answer 90

A

Question 91

A firm can accept a project with a net present value of zero because ________. A) the project would maintain the wealth of the firm's owners B) the project would enhance the wealth of the firm's owners C) the project would maintain the earnings of the firm D) the project would enhance the earnings of the firm

Answer 91

A

Question 92

The internal rate of return (IRR) is defined as the discount rate that equates the net present value with the initial investment associated with a project. | T/F

Answer 92

FALSE | 0

Question 93

The IRR is the discount rate that equates the NPV of an investment opportunity with $0. | T/F

Answer 93

TRUE

Question 94

The IRR is the compounded annual rate of return that a firm will earn if it invests in a project and receives the estimated cash inflows. | T/F

Answer 94

TRUE

Question 95

An internal rate of return greater than the cost of capital guarantees that the firm will earn at least its required return. | T/F

Answer 95

TRUE

Question 96

A capital budgeting technique that can be computed by solving for the discount rate that equates the present value of a project's inflows to the present value of its outflows is called net present value. | T/F

Answer 96

FALSE ## Footnote IRR

Question 97

A capital budgeting technique that can be computed by solving for the discount rate that equates the present value of a project's inflows to the present value of its outflows is called internal rate of return. | T/F

Answer 97

TRUE

Question 98

If a project's IRR is greater than 0 percent, the project should be accepted. | T/F

Answer 98

FALSE ## Footnote NPV

Question 99

If a project's IRR is greater than the cost of capital, the project should be rejected. | T/F

Answer 99

FALSE

Question 100

The ________ is the discount rate that equates the present value of the cash inflows with the initial investment. A) payback period B) net present value C) cost of capital D) internal rate of return

Answer 100

D

Question 101

The ________ is the compound annual rate of return that a firm will earn if it invests in the project and receives the given cash inflows. A) risk-free rate B) internal rate of return C) opportunity cost D) cost of capital

Answer 101

B

Question 102

A project's net present value profile is a graph that plots a project's NPV for various discount rates. | T/F

Answer 102

TRUE

Question 103

A project's net present value profile is a graph that plots a project's IRR for various discount rates. | T/F

Answer 103

FALSE ## Footnote NPV for various costs of capital

Question 104

Projects A and B both require an initial investment of $100,000. Project A produces $200,000 in cashflows in the subsequent 5 years. Project B produces cash flow of $400,000 next year, $300,000 in year 2, $200,000 in year 3, and $50,000 in years 4 and 5. Which of the following is true? A) The NPV of project A will be more sensitive to changes in the cost of capital compared to the NPV of project B. B) The NPV of project B will be more sensitive to changes in the cost of capital compared to the NPV of project A. C) The two projects have NPVs that are equally sensitive to changes in the cost of capital. D) Neither project's NPV is sensitive to changes in the cost of capital.

Answer 104

A

Question 105

Net present value profiles are most useful when selecting among independent projects. | T/F

Answer 105

FALSE ## Footnote mutually exclusive projects

Question 106

For conventional projects, both NPV and IRR techniques will always generate the same accept-reject decision. | T/F

Answer 106

FALSE

Question 107

Net present value profiles are most useful when selecting among mutually exclusive projects. | T/F

Answer 107

TRUE

Question 108

Consider the following projects, X and Y, where the firm can only choose one. Project X costs $600 and has cash flows of $400 in each of the next 2 years. Project Y also costs $600, and generates cash flows of $500 and $275 for the next 2 years, respectively. Which investment should the firm choose if the cost of capital is 10 percent? A) Project X, since it has a higher NPV than Project Y B) Project Y, since it has a higher NPV than Project X C) Project X, since it has a lower NPV than Project Y D) Project Y, since it has a lower NPV than Project X

Answer 108

A

Question 109

Consider the following projects, X and Y where the firm can only choose one. Project X costs $600 and has cash flows of $400 in each of the next 2 years. Project Y also costs $600, and generates cash flows of $500 and $275 for the next 2 years, respectively. Which investment should the firm choose if the cost of capital is 25 percent? A) Project X, since it has a higher NPV than Project Y B) Project Y, since it has a higher NPV than Project X C) neither, since both the projects have negative NPV D) neither, since both the projects have positive NPV

Answer 109

C

Question 110

Which of the following is true regarding an NPV profile? A) It is used for evaluating and comparing independent projects when conflicting ranking exists. B) It is a graph that illustrates a project's IRR against various values of NPV. C) It shows an inverse relationship between a project's IRR and NPV. D) It charts the net present value of a project as a function of the cost of capital.

Answer 110

D

Question 111

Conflicting rankings in the case of mutually exclusive projects using NPV and IRR often result from differences in the magnitude and/or timing of cash flows. | T/F

Answer 111

TRUE

Question 112

Projects having higher cash inflows in the early years tend to be less sensitive to changes in the cost of capital and are therefore often acceptable at higher discount rates compared to projects with higher cash inflows that occur in the later years. | T/F

Answer 112

TRUE

Question 113

In general, projects with similar-sized investments and lower cash inflows in the early years tend to be preferred at higher discount rates. | T/F

Answer 113

FALSE ## Footnote higher cash inflows in earlier years

Question 114

In general, the greater the difference between the magnitude and/or timing of cash inflows, the greater the likelihood of conflicting ranking between NPV and IRR | T/F

Answer 114

TRUE

Question 115

Certain mathematical properties may cause a project with a nonconventional cash flow pattern to have multiple IRRs; this problem does not occur with the NPV approach. | T/F

Answer 115

TRUE

Question 116

On a purely theoretical basis, NPV is a better approach when selecting among two mutually exclusive projects. | T/F

Answer 116

TRUE

Question 117

On a purely theoretical basis, IRR is a better approach when selecting among two mutually exclusive projects. | T/F

Answer 117

FALSE ## Footnote NPV

Question 118

The appeal of the IRR technique is due to the general disposition of business people to think in terms of rates of return rather than actual dollar returns. | T/F

Answer 118

TRUE

Question 119

When the net present value is negative, the internal rate of return is ________ the cost of capital. A) greater than B) greater than or equal to C) less than D) equal to

Answer 119

C

Question 120

A firm with a cost of capital of 15% is evaluating two independent projects utilizing the internal rate of return technique. Project X has an initial investment of $80,000 and cash inflows at the end of each of the next five years of $25,000. Project Z has an initial investment of $120,000 and cash inflows at the end of each of the next four years of $40,000. The firm should ________. A) accept both the projects because they have equal IRR B) accept Project X and reject project Z C) accept Project Z because its IRR is higher than Project X D) reject both the projects because they have negative IRR

Answer 120

B

Question 121

Comparing net present value and internal rate of return ________. A) always results in the same ranking of projects B) always results in the same accept-reject decision C) may give different accept-reject decisions D) is only necessary on independent projects

Answer 121

C

Question 122

Which capital budgeting method is most useful for evaluating a project that has an initial after-tax cost of $5,000,000 and is expected to provide after-tax operating cash flows of $1,800,000 in year 1, ($2,900,000) in year 2, $2,700,000 in year 3, and $2,300,000 in year 4? A) net present value B) internal rate of return C) payback D) accounting rate of return

Answer 122

A

Question 123

Which of the following is a reason that makes NPV a better approach to capital budgeting on a purely theoretical basis? A) It measures the benefits relative to the amount invested. B) It measures the actual value created by an investment. C) Financial decision makers are inclined to higher rates of return. D) Interest rates are expressed as annual rates of return.

Answer 123

B

Question 124

In comparing the internal rate of return and net present value methods of evaluation, ________. A) internal rate of return is theoretically superior, but financial managers prefer net present value B) net present value is theoretically superior, but financial managers often prefer to use internal rate of return C) financial managers prefer net present value, because it is presented as a rate of return D) financial managers prefer net present value, because it measures benefits relative to the amount invested

Answer 124

B