CH10 TB CAPITAL BUDGETING TECHNIQUES Flashcards
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
TRUE
The purchase of additional physical facilities, such as additional property or a new factory, is an example of a capital expenditure.
T/F
TRUE
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
FALSE
long-term investments
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
FALSE
more than one year
An outlay for advertising and management consulting is considered to be a fixed asset expenditure.
T/F
FALSE
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
TRUE
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
TRUE
The primary motive for capital expenditures is to refurbish fixed assets.
T/F
FALSE
Research and development is considered to be a motive for making capital expenditures.
T/F
TRUE
The capital budgeting process consists of five distinct but interrelated steps: proposal generation, review and analysis, decision making, implementation, and follow-up.
T/F
TRUE
The capital budgeting process consists of four distinct but interrelated steps: proposal generation, review and analysis, decision making, and termination.
T/F
FALSE
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
FALSE
Mutually exclusive
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
TRUE
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
TRUE
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
FALSE
Capital expenditure
A nonconventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by a series of inflows.
T/F
FALSE
conventional
Time value of money should be ignored in capital budgeting techniques to make accurate decisions.
T/F
FALSE
If a firm has limited funds to invest, all the mutually exclusive projects that meet its minimum investment criteria should be implemented.
T/F
FALSE
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
FALSE
Independent
The availability of funds for capital expenditures does not affect a firm’s capital budgeting decisions.
T/F
FALSE
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
TRUE
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
FALSE
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
FALSE
Mutually exclusive projects are those whose cash flows compete with one another; the acceptance of one eliminates the others from further consideration.
T/F
TRUE
If a firm is subject to capital rationing, it is able to accept all independent projects that provide an acceptable return.
T/F
FALSE
If a firm has unlimited funds, it is able to accept all independent projects that provide an acceptable return.
T/F
TRUE
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
TRUE
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
TRUE
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
FALSE
A conventional cash flow pattern is one in which an initial outflow is followed only by a series of inflows.
T/F
TRUE
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
TRUE
A nonconventional cash flow pattern is one in which an initial flow is followed by a series of inflows and outflows.
T/F
TRUE
________ 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
B
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
A
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
C
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.
D
The final step in the capital budgeting process is ________.
A) implementation
B) follow-up
C) review and analysis
D) decision making
B
The first step in the capital budgeting process is ________.
A) review and analysis
B) implementation
C) decision making
D) proposal generation
D
________ 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
B
________ 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
C
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
D
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
B
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
C
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
A
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
B
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
TRUE
The payback period is the amount of time required for a firm to dispose a replaced asset.
T/F
FALSE
For calculating payback period for an annuity, all cash flows must be adjusted for time value of money.
T/F
FALSE
If a project’s payback period is less than the maximum acceptable payback period, we would accept it.
T/F
TRUE
If a project’s payback period is greater than the maximum acceptable payback period, we would reject it.
T/F
TRUE
If a project’s payback period is greater than the maximum acceptable payback period, we would accept it.
T/F
FALSE
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
TRUE
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
FALSE
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
TRUE
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
TRUE
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
TRUE
A project must be rejected if its payback period is less than the maximum acceptable payback period.
T/F
FALSE
accepted
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
FALSE
ignores time value of money and gives implicit consideration to the timing of cash flows
One strength of payback period is that it fully accounts for the time value of money.
T/F
FALSE
One weakness of the payback period approach is its failure to recognize cash flows that occur after the payback period.
T/F
TRUE
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
TRUE
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
TRUE
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
B
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
A
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
D
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
D
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
D
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.
C
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.
A
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.
B
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
C
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.
D
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.
B
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
TRUE
The discount rate is the return that an investment project must meet or exceed to maintain or increase the firm’s value.
T/F
TRUE
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
FALSE
cost of capital
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
TRUE
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
FALSE
NPV
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
FALSE
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
FALSE
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
TRUE
If the NPV is greater than the initial investment, a project should be rejected.
T/F
FALSE
If the NPV is less than the initial investment, a project should be rejected.
T/F
FALSE
If the NPV is greater than $0, a project should be accepted.
T/F
TRUE
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
FALSE
present value of cash inflows divided by the initial investment
Economic value added is the difference between an investment’s net operating profit after taxes and the accounting profit.
T/F
FALSE
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
FALSE
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.
B
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
C
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
A
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
A
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
FALSE
0
The IRR is the discount rate that equates the NPV of an investment opportunity with $0.
T/F
TRUE
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
TRUE
An internal rate of return greater than the cost of capital guarantees that the firm will earn at least its required return.
T/F
TRUE
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
FALSE
IRR
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
TRUE
If a project’s IRR is greater than 0 percent, the project should be accepted.
T/F
FALSE
NPV
If a project’s IRR is greater than the cost of capital, the project should be rejected.
T/F
FALSE
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
D
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
B
A project’s net present value profile is a graph that plots a project’s NPV for various discount rates.
T/F
TRUE
A project’s net present value profile is a graph that plots a project’s IRR for various discount rates.
T/F
FALSE
NPV for various costs of capital
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.
A
Net present value profiles are most useful when selecting among independent projects.
T/F
FALSE
mutually exclusive projects
For conventional projects, both NPV and IRR techniques will always generate the same accept-reject decision.
T/F
FALSE
Net present value profiles are most useful when selecting among mutually exclusive projects.
T/F
TRUE
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
A
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
C
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.
D
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
TRUE
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
TRUE
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
FALSE
higher cash inflows in earlier years
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
TRUE
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
TRUE
On a purely theoretical basis, NPV is a better approach when selecting among two mutually exclusive projects.
T/F
TRUE
On a purely theoretical basis, IRR is a better approach when selecting among two mutually exclusive projects.
T/F
FALSE
NPV
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
TRUE
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
C
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
B
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
C
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
A
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.
B
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
B
