CHAPTER 25. Planning for Capital Investments

Question 1

Which of the following is not an example of a capital budgeting decision?

a. Decision to build a new plant.
b. Decision to renovate an existing facility.
c. Decision to buy a piece of machinery.
d. All of these are capital budgeting decisions.

Answer 1

d. All of these are capital budgeting decisions.

Question 2

What is the order of involvement of the following parties in the capital budgeting authorization process?

a. Plant managers, officers, capital budget committee, board of directors.
b. Board of directors, plant managers, officers, capital budget committee.
c. Plant managers, capital budget committee, officers, board of directors.
d. Officers, plant managers, capital budget committee, board of directors.

Answer 2

c. Plant managers, capital budget committee, officers, board of directors.

Question 3

What is a weakness of the cash payback approach?

a. It uses accrual-based accounting numbers.
b. It ignores the time value of money.
c. It ignores the useful life of alternative projects.
d. Both (b) and (c) are true.

Answer 3

d. Both (b) and (c) are true.

Question 4

Siegel Industries is considering two capital budgeting projects. Project A requires an initial investment of $48,000. It is expected to produce net annual cash flows of $7,000. Project B requires an initial investment of $75,000 and is expected to produce net annual cash flows of $12,000. Using the cash payback technique to evaluate the two projects, Siegel should accept:

a. Project A because it has a shorter cash payback period.
b. Project B because it has a shorter cash payback period.
c. Project A because it requires a smaller initial investment.
d. Project B because it produces a larger net annual cash flow.

Answer 4

b. Project B because it has a shorter cash payback period.

Question 5

Which is a true statement regarding using a higher discount rate to calculate the net present value of a project?

a. It will make it less likely that the project will be accepted.
b. It will make it more likely that the project will be accepted.
c. It is appropriate to use a higher rate if the project is perceived as being less risky than other projects being considered.
d. It is appropriate to use a higher rate if the project will have a short useful life relative to other projects being considered.

Answer 5

a. It will make it less likely that the project will be accepted.

Note: higher discount rate = lower net present value

Question 6

A positive net present value means that the:

a. project’s rate of return is less than the cutoff rate.
b. project’s rate of return exceeds the required rate of return.
c. project’s rate of return equals the required rate of return.
d. project is unacceptable.

Answer 6

b. project’s rate of return exceeds the required rate of return.

Question 7

Which of the following is not an alternative name for the discount rate?

a. Hurdle rate.
b. Required rate of return.
c. Cutoff rate.
d. All of these are alternative names for the discount rate.

Answer 7

d. All of these are alternative names for the discount rate.

Question 8

If a project has intangible benefits whose value is hard to estimate, the best thing to do is:

a. ignore these benefits, since any estimate of their value will most likely be wrong.
b. include a conservative estimate of their value.
c. ignore their value in your initial net present value calculation, but then estimate whether their potential value is worth at least the amount of the net present value deficiency.
d. Either (b) or (c) is correct.

Answer 8

d. Either (b) or (c) is correct.

Question 9

An example of an intangible benefit provided by a capital budgeting project is:

a. the salvage value of the capital investment.
b. a positive net present value.
c. a decrease in customer complaints regarding poor quality.
d. an internal rate of return greater than zero.

Answer 9

c. a decrease in customer complaints regarding poor quality.

Question 10

The following information is available for a potential capital investment:

Initial investment: $80,000
Present value of net annual cash flows: $98,112

The potential investment’s profitability index (rounded to two decimals) is:

a. 5.40.
b. 1.19.
c. 1.23.
d. 1.40.

Answer 10

c. 1.23

(98,112 ÷ 80,000)

Profitability index = Present Value of Net Cash Flows / Initial Investment

Question 11

A post-audit of an investment project should be performed:

a. on all significant capital expenditure projects.
b. on all projects that management feels might be financial failures.
c. on randomly selected projects.
d. only on projects that enjoy tremendous success.

Answer 11

a. on all significant capital expenditure projects.

Question 12

A project should be accepted if its internal rate of return exceeds:

a. zero.
b. the rate of return on a government bond.
c. the company’s required rate of return.
d. the rate the company pays on borrowed funds.

Answer 12

c. the company’s required rate of return.

Question 13

Which of the following is incorrect about the annual rate of return technique?

a. The calculation is simple.
b. The accounting terms used are familiar to management.
c. The timing of the cash inflows is not considered.
d. The time value of money is considered.

Answer 13

d. The time value of money is considered.

Question 14

The first step in the capital budgeting evaluation process is to

a. approve the capital budget.
b. determine which projects are worthy of funding.
c. screen proposals by a capital budgeting committee.
d. request proposals for projects.

Answer 14

d. request proposals for projects.

Question 15

Which of the following ignores the time value of money?

a. Profitability index
b. Cash payback
c. Internal rate of return
d. Net present value

Answer 15

b. Cash payback

Question 16

The higher the risk element in a project, the

a. higher the cost of capital.
b. higher the net present value.
c. higher the discount rate.
d. more attractive the investment.

Answer 16

c. higher the discount rate.

Question 17

The primary capital budgeting method that uses discounted cash flow techniques is the

a. profitability index method.
b. cash payback technique.
c. net present value method.
d. annual rate of return method.

Answer 17

c. net present value method.

Question 18

If a project’s profitability index is less than 1, then

a. its net present value is positive.
b. its net present value is zero.
c. its internal rate of return is greater than the discount rate.
d. it should be rejected.

Answer 18

d. it should be rejected.

Question 19

A thorough evaluation of how well a project’s actual performance matches the projections made when the project was proposed is called a

a. risk analysis.
b. pre-audit.
c. sensitivity analysis.
d. post-audit.

Answer 19

d. post-audit.

Question 20

The internal rate of return factor is equal to the

a. capital investment divided by the net cash flows.
b. present value of net cash flows divided by the profitability index.
c. present value of net cash flows divided by the capital investment.
d. capital investment divided by the present value of the net cash flows.

Answer 20

a. capital investment divided by the net cash flows.

Question 21

If project A has a lower internal rate of return than project B, then project A will have a

a. higher NPV and a shorter payback period.
b. lower NPV and a shorter payback period.
c. higher NPV and a longer payback period.
d. lower NPV and a longer payback period.

Answer 21

d. lower NPV and a longer payback period.

Question 22

The annual rate of return is computed by dividing expected annual

a. cash inflows by average investment.
b. cash inflows by original investment.
c. net income by average investment.
d. net income by original investment.

Answer 22

c. net income by average investment.

Question 23

Annual rate of return is computed by dividing

a. expected annual net income by average investment.
b. expected cash flows by total investment.
c. expected annual net income by total investment.
d. expected cash flows by average investment.

Answer 23

a. expected annual net income by average investment.