2. capital budgeting methods

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Question 1 - CIA 590 IV.49 - Capital Budgeting Methods

A firm's optimal capital structure

A. Maximizes the price of the firm's stock.B. Minimizes the firm's tax liability.C. Maximizes the firm's degree of financial leverage.

D. Minimizes the firm's risk.

A. The capital structure that maximizes the share price is the optimal capital structure. If the share price is at itshighest, that means that management has properly balanced the risk and returns in its capital structure andinvestors value this structure the most.

B. The lowest tax liability may not be the best capital structure for the company because the lowest tax rate would beachieved with all debt financing. All debt financing may not provide the lowest cost of capital and it may lead to highlevels of risk for the company because of all of the fixed interest payments.

C. The maximization of financial leverage would lead to high levels of risk and would therefore probably not be the bestcapital structure.

D. The lowest risk may not be the best capital structure for the company because the lowest tax rate would be achievedwith all equity financing. All equity financing may not provide the lowest cost of capital and it may lead to investors notwanting to be owners when the ownership share is so diluted from all of the shares that have been issued.


A firm with an 18% cost of capital is considering the following projects (on January 1, year 1):

January 1, Year 1

Cash Outflow(000's Omitted)

December 31, Year 5Cash Inflow

(000's Omitted)

Year 5Project InternalRate of Return

Project A $3,500 $7,400 16%

Project B 4,000 9,950 ?

Present Value of $1 Due at the End of "N" Periods

N 12% 14% 15% 16% 18% 20% 22%

4 .6355 .5921 .5718 .5523 .5158 .4823 .4230

5 .5674 .5194 .4972 .4761 .4371 .4019 .3411

6 .5066 .4556 .4323 .4104 .3704 .3349 .2751

Using the net-present-value (NPV) method, project A's net present value is

A. $(265,460)B. $23,140C. $316,920D. $(316,920)

A. There is only one cash inflow to this project, and it occurs 5 years after the initial cash outflow. The firm'scost of capital is 18%. Therefore, the correct Present Value of $1 factor (from the table given) to use indiscounting the cash inflow is .4371. The present value of the cash inflow is .4371 × $7,400,000, or $3,234,540.Subtracting the initial investment of $3,500,000 from the present value of the cash inflow of $3,234,540, we get$(265,460).

Part 2 : Capital Budgeting Methods

(c) HOCK international, page 1


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B. An answer of $23,140 results from discounting the cash inflow at the rate of 16%, which is the project's Internal Rateof Return but which is not the appropriate discount rate to use.

C. An answer of $316,920 results from discounting the cash inflow for four years. However, the receipt of the cashoccurs five years after the initial investment.

D. An answer of $(316,920) results from two errors. One, the factor for four years was used to discount the cash inflow,which was not correct. And two, the present value of the cash inflow was subtracted from the initial cash outflow.Instead, the initial cash outflow should be subtracted from the present value of the cash inflow.


A firm with an 18% cost of capital is considering the following projects (on January 1, year 1):

January 1, Year 1

Cash Outflow(000's Omitted)

December 31, Year 5Cash Inflow

(000's Omitted)

Year 5Project InternalRate of Return

Project A $3,500 $7,400 16%

Project B 4,000 9,950 ?

Present Value of $1 Due at the End of "N" Periods

N 12% 14% 15% 16% 18% 20% 22%

4 .6355 .5921 .5718 .5523 .5158 .4823 .4230

5 .5674 .5194 .4972 .4761 .4371 .4019 .3411

6 .5066 .4556 .4323 .4104 .3704 .3349 .2751

Project B's internal rate of return is closest to

A. 18%B. 16%C. 15%D. 20%

A. 18% is the company's cost of capital, which is given in the question.

B. 16% is approximately the internal rate of return for project A, but the question asks for the internal rate of return forproject B.

C.

The internal rate of return is the discount rate at which the present value of the expected cash inflows from a project

equals the present value of the expected cash outflows, or the discount rate at which the net present value is zero. Apositive NPV would result from using a discount rate of 15%, so that cannot be the project's IRR.

D.

The internal rate of return is the discount rate at which the present value of the expected cash inflows from aproject equals the present value of the expected cash outflows, or the discount rate at which the net presentvalue is zero. To determine the internal rate of return from the information given, we need to first know whatdiscount factor for five years would result in a present value of $9,950 that is equal to $4,000. To arrive at thatfactor, we divide $4,000 by $9,950, and we get .402. We then look along the line of factors for five years on the




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factor table given to locate a factor close to .402. That is .4019, which is in the 20% column. Thus, the internalrate of return is closest to 20%.

Question 4 - CMA 1278 5.12 - Capital Budgeting Methods

Future, Inc. is in the enviable situation of having unlimited capital funds. The best decision rule, in an economic sense,for it to follow would be to invest in all projects in which the

A. Net present value is greater than zero.B. Payback reciprocal is greater than the internal rate of return.C. Accounting rate of return is greater than the earnings as a percent of sales.D. Internal rate of return is greater than zero.

A. If a company has unlimited capital funds, it should invest in all projects in which the net present value isgreater than zero, assuming none of the projects are mutually exclusive.

B. The Payback Reciprocal is 1 divided by the payback period. It can be used to give a very rough indication of aninternal rate of return, if the cash flows from the project are equal in every period and if the project life is at least twice aslong as the payback period. However, comparing the payback reciprocal to the internal rate of return is a meaninglesscomparison.

C. Earnings as a percent of sales is meaningless in a capital budgeting analysis. So comparing an accounting rate ofreturn to it is also meaningless.

D. If a project's internal rate of return is greater than zero but lower than the company's required rate of return, theproject should not be undertaken.


Carco, Inc. wants to use discounted cash flow techniques when analyzing its capital investment projects. The companyis aware of the uncertainty involved in estimating future cash flows. A simple method some companies employ to adjustfor the uncertainty inherent in their estimates is to

A. Prepare a direct analysis of the probability of outcomes.B. Use accelerated depreciation.C. Adjust the minimum desired rate of return.D. Increase the estimates of the cash flows.

A. Although the preparation of a direct analysis of the probability of outcomes may be used to address uncertainty, it isnot a simple method, and this question asks for a simple method.

B. The use of accelerated depreciation is not a technique used to address uncertainty in capital budgeting.

C. A company adjusts for the uncertainty inherent in its estimates by increasing the required rate of return usedto discount the future expected cash flows. A higher discount rate will require higher expected future cashflows in order for the investment to be acceptable. As a result, fewer investments will be acceptable.

D. Increasing estimates of future expected cash flows arbitrarily is not an acceptable method of addressing uncertainty inthe capital budgeting process.




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A manager wants to know the effect of a possible change in cash flows on the net present value of a project. Thetechnique used for this purpose is

A. Cost behavior analysis.

B. Sensitivity analysis.C. Risk analysis.D. Return on investment analysis.

A. Cost behavior analysis is not used to determine the effect of a possible change in cash flows on the net present valueof a project.

B. Sensitivity analysis is used to determine how an amount will change if factors that were involved inpredicting that amount change.

C. Risk analysis is not used to determine the effect of a possible change in cash flows on the net present value of aproject.

D. Return on Investment (ROI) is used to analyze the profitability of a company or one of its segments, not for analyzingthe effect of a possible change in cash flows on the net present value of a project.


The technique that recognizes the time value of money by discounting the after-tax cash flows for a project over its life totime period zero using the company's minimum desired rate of return is called the

A. Payback method.B. Net present value method.C. Accounting rate of return method.

D. Average rate of return method.

A. The payback method explicitly does not recognize the time value of money.

B. Net present value of a project is calculated by discounting the after-tax expected cash flows for the projectover its life to time period zero using the company's minimum required rate of return. The present value of thefuture expected cash inflows minus the net initial investment equals the net present value.

C. The accounting rate of return is the ratio of the amount of increased book income to the required investment. Sincethis method uses accrual accounting income, it includes depreciation. However, it does not take into account the timevalue of money.

D. The average rate of return is not a technique that recognizes the time value of money by discounting the after-taxcash flows for a project.


The technique that reflects the time value of money and is calculated by dividing the present value of the future netafter-tax cash inflows that have been discounted at the desired cost of capital by the initial cash outlay for the investmentis called the




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A. Profitability index method.B. Capital rationing method.C. Accounting rate of return method.D. Average rate of return method.

A. The profitability index is a benefit-cost ratio. It is the ratio of the present value of net future expected cashflows, discounted at the required rate of return, to the amount of the initial investment.

B. Capital rationing occurs when the amount of capital funds available to invest is limited.

C. The accounting rate of return is the ratio of the amount of increased book income to the required investment. Sincethis method uses accrual accounting income, it includes depreciation, and it also does not take into account the timevalue of money.

D. The average rate of return method is not a technique that reflects the time value of money.


The technique that measures the estimated performance of a capital investment by dividing the project's annual after-taxnet income by the average investment cost is called the

A. Internal rate of return method.B. Accounting rate of return method.C. Capital asset pricing model.D. Average rate of return method.

A. The internal rate of return is the discount rate at which the net present value of a capital budgeting project is zero. Itdoes not measure the estimated performance of a capital investment by dividing the project's annual after-tax netincome by the average investment cost, however.

B. The accounting rate of return is the ratio of the amount of increased book income to the required investment.

Sometimes the average investment figure is used rather than the total initial investment. This is usuallycalculated as the initial investment divided by 2. The initial investment is divided by 2 because the investmentwill have a book value of 0 at the end of the project, and dividing the initial investment by 2 approximates anaverage of the amount invested over the life of the project.

C. The capital asset pricing model may be used to calculate a company's cost of capital, but it is not used to analyze anindividual project's performance.

D. The average rate of return is not a technique that measures the estimated performance of a capital investment bydividing the project's annual after-tax net income by the average investment cost.


The technique that incorporates the time value of money by determining the compound interest rate of an investmentsuch that the present value of the after-tax cash inflows over the life of the investment is equal to the initial investment iscalled the

A. Accounting rate of return method.B. Internal rate of return method.C. Capital asset pricing model.




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D. Profitability index method.

A. The accounting rate of return is the ratio of the amount of increased book income to the required investment. It doesnot incorporate the time value of money.

B. The internal rate of return is the discount rate at which the net present value of a project is zero. Therefore, itis also the discount rate at which the present value of the after-tax cash inflows over the life of the investment

equal the initial investment, assuming that the future expected cash flows are all positive.

C. The capital asset pricing model may be used to calculate a company's cost of capital. It is not a technique thatincorporates the time value of money by determining the compound interest rate of an investment such that the presentvalue of the after-tax cash inflows over the life of the investment is equal to the initial investment.

D. The profitability index is a benefit-cost ratio. It is the ratio of the present value of net future expected cash flows,discounted at the required rate of return, to the amount of the initial investment. It is not an interest rate.


The technique that measures the number of years required for the after-tax cash flows to recover the initial investment ina project is called the

A. Payback method.B. Net present value method.C. Profitability index method.D. Accounting rate of return method.

A. The Payback Method is used to determine the number of periods that must pass before the net after-tax cashinflows from the investment will equal (or "pay back") the initial investment cost. If the expected cash inflowsare constant over the life of the project, the payback period is the net initial investment divided by the periodicexpected cash flow. If the expected cash inflows are not constant over the life of the project, the cash inflowsare added to determine on a cumulative basis when the inflows will equal the outflows. The payback method

ignores all cash flows beyond the payback period, does not include the time value of money, and does notinclude any factor for the cost of capital. However, it is widely used because it is simple and it can be usefulwhen a project is judged to be very risky with uncertain cash flows in the later years. In this case, it may beused to determine how quickly the investment will be recouped so that if necessary, the company can abandonthe project without too great a loss.

B.

The net present value method does not measure the number of years required for the after-tax cash flows to recover theinitial investment in a project. The net present value method is a discounted cash flow method which calculates the valueof a project by discounting the after-tax expected cash flows for the project over its life to time period zero using thecompany's minimum required rate of return. The present value of the future expected cash inflows minus the net initialinvestment equals the net present value.

C. The profitability index does not measure the number of years required for the after-tax cash flows to recover the initialinvestment in a project. The profitability index is a ratio of the present value of the net future cash flows to the amount ofthe initial investment. If a project has a positive net present value, the profitability index will be above 1.00. If it has anegative net present value, it will have a profitability index of less than 1.00.

D. The accounting rate of return does not measure the number of years required for the after-tax cash flows to recoverthe initial investment in a project. The accounting rate of return is a ratio of the increase in expected annual average aftertax accounting net income to the net initial investment. This method uses accrual accounting income, so depreciation isincluded in the expenses. In addition, it does not take into account the time value of money.




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Yipann Corporation is reviewing an investment proposal. The initial cost as well as other related data for each year arepresented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage value of

the investment at the end of each year is equal to its net book value, and there will be no salvage value at the end of theinvestment's life.

Investment Proposal

Year

InitialCost and

Book Value

Annual Net After-Tax

Cash Flows Annual

Net Income

0 $105,000 $ 0 $ 0

1 70,000 50,000 15,000

2 42,000 45,000 17,000

3 21,000 40,000 19,000

4 7,000 35,000 21,0005 0 30,000 23,000

Yipann uses a 24% after-tax target rate of return for new investment proposals. The discount figures for a 24% rate ofreturn are given.

Year

Present Value of $1 Received at

the End of Period

Present Value of Annuity of $1

Received at Endof Each Period

1 .81 .81

2 .65 1.46

3 .52 1.984 .42 2.40

5 .34 2.74

6 .28 3.02

7 .22 3.24

The traditional payback period for the investment proposal is

A. .875 years.B. 1.833 years.C. Over 5 years.D. 2.250 years.

A. An answer of .875 results from combining the book values and the net after-tax cash flows instead of using the aftertax cash flows alone for the years subsequent to year 0.

B. An answer of 1.833 years results from using the yearly book values instead of the after-tax cash flows for the yearssubsequent to year 0.

C. An answer of "over 5 years" results from using the annual net income amounts instead of the after-tax cash flows forthe years subsequent to year 0.




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D.

The cash flow analysis is set up as follows:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Initial Investment in Equipment (105,000)After-Tax Cash Flow 50,000 45,000 40,000 35,000 30,000

------------ --------- --------- --------- --------- ---------

Total After-Tax Cash Flows (105,000) 50,000 45,000 40,000 35,000 30,000

Cumulative Cash Flow (105,000) (55,000) (10,000) 30,000 65,000 95,000

The cumulative cash flow from the project becomes positive during Year 3. Assuming that the cash flows occurevenly throughout the year, the payback period is 2.25 years, calculated as follows:

Number of the project year in the final year when cash flow is negative: 2

Plus: a fraction consisting of

Numerator = the positive value of the negative cumulative inflow amount from the final negative year, which is10,000

Denominator = cash flow for the following year, which is 40,000

or: 2 + 10,000/40,000 = 2.25

Note that the present value factors given are irrelevant to answering this question, because the paybackmethod is not a discounted cash flow technique.


Crown Corporation has agreed to sell some used computer equipment to Bob Parsons, one of the company'semployees, for $5,000. Crown and Parsons have been discussing alternative financing arrangements for the sale.

Crown Corporation has offered to accept a $1,000 down payment and set up a note receivable for Bob Parsons thatcalls for a $1,000 payment at the end of each of the next 4 years. If Crown uses a 6% discount rate, the present value ofthe note receivable would be

A. $2,940B. $4,465C. $3,465D. $4,212

A. An answer of $2,940 results from discounting the entire amount of the note ($4,000) at 8% for four years. This isincorrect for two reasons: (1) The full principle of the note ($4,000) is assumed to be paid at the maturity date in fouryears. However, the note calls for annual principle payments of $1,000. (2) The discount rate used is 8%. However, thediscount rate to be used is 6%.

B. An answer of $4,465 results from discounting the note receivable using the present value of an annuity of $1,000 anda 6% rate for 4 years and then adding the $1,000 down payment at its undiscounted value of $1,000. However, thequestion asks only for the present value of the note receivable, not the present value of the entire transaction.




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C. The note calls for four annual payments of $1,000. This is an ordinary annuity, since the payments are due atthe end of each period. Therefore, the factor in the present value of an annuity table can be used as it is given,without adjustment. The present value of a four-year ordinary annuity of $1,000, discounted at 6%, is $1,000 ×3.465, or $3,465.

D. An answer of $4,212 results from using the present value of an annuity factor for 6% for 5 years. However, the note is

for four years.


Crown Corporation has agreed to sell some used computer equipment to Bob Parsons, one of the company'semployees, for $5,000. Crown and Parsons have been discussing alternative financing arrangements for the sale.

Crown has offered to accept a $1,000 down payment and to set up a note receivable for Bob Parsons that calls for a$1,000 down payment at the end of this year and the next three years.

Bob Parsons has agreed to the immediate down payment of $1,000 but would like the note for $4,000 to be payable infull at the end of the fourth year. Because of the increased risk associated with the terms of this note, Crown Corporationwould apply an 8% discount rate. The present value of this note would be

A. $2,577B. $2,940C. $3,940D. $3,312

A. An answer of $2,577 results from discounting a series of payments of $1,000 at 8% for three years. However, theterm of the note is four years, and the note is payable at the end of the term, not in annual payments.

B. Using the Present Value of $1 table, the present value of a single $4,000 payment in 4 years is $4,000 × .735,which equals $2,940.

C. An answer of $3,940 results from discounting the principal repayment of $4,000 at 8% for four years and adding thedown payment of $1,000 without discounting it. However, the question asks for the present value of the note, not thepresent value of the whole transaction.

D. An answer of $3,312 results from discounting a series of payments of $1,000 at 8% for four years. However, the noteis payable at the end of the term, not in annual payments.


Yipann Corporation is reviewing an investment proposal. The initial cost as well as other related data for each year arepresented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage value ofthe investment at the end of each year is equal to its net book value, and there will be no salvage value at the end of theinvestment's life.

Investment Proposal

YearInitial Cost

and Book Value


Cash Flows Annual

Net Income

0 $105,000 $ 0 $ 0




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1 70,000 50,000 15,000

2 42,000 45,000 17,000

3 21,000 40,000 19,000

4 7,000 35,000 21,000

5 0 30,000 23,000


Year


the End of Period


Received at Endof Each Period

1 .81 .81

2 .65 1.46

3 .52 1.98

4 .42 2.40

5 .34 2.74

6 .28 3.02

7 .22 3.24

The average annual cash inflow at which Yipann would be indifferent to the investment (rounded to the nearest dollar) is

A. $38,321.B. $40,000.C. $21,000.D. $46,667.

A.

The question is asking for an average annual after-tax cash flow amount that will result in a net present value ofzero for the project, because that will be the average annual cash flow level at which Yipann will be indifferentto the investment. We need to look at this as a present value of an annuity problem, because since we arelooking for an average annual cash flow amount, all the annual cash flow amounts after year 0 will be the sameaverage amount.

The annual cash flows given in the problem are irrelevant, because we are looking for the average annualafter-tax cash flow amount that will result in an NPV of zero, given the initial investment in Year 0.

Since the initial investment is $105,000 and the project's life is 5 years, we need to know what annuity amountwill produce a present value of $105,000 when discounted at 24% for 5 years. Recall that the present value of anannuity is the annuity amount × PV of an annuity factor. We don't know the annuity amount, but we do know thePV of an annuity factor and the present value amount of $105,000. The PV of an annuity factor for 5 years at 24%

is given in the problem: 2.74.

Thus, the formula is: Annuity Amount × 2.74 = $105,000. Therefore, the Annuity Amount = $105,000 ÷ 2.74, whichis equal to $38,321.

This means that if the annual after-tax cash flows are all the same and they are $38,321, the NPV will be zeroand the company will be indifferent to the investment.

B. $40,000 is the average of the five net after tax cash flows already given.




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C. An answer of $21,000 results from dividing the initial cost of the asset by the number of years of the project's life.

D. An answer of $46,667 results from dividing the initial investment amount of $105,000 by the payback period.


Yipann Corporation is reviewing an investment proposal. The initial cost as well as other related data for each year arepresented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage value ofthe investment at the end of each year is equal to its net book value, and there will be no salvage value at the end of theinvestment's life.

Investment Proposal

YearInitial Cost

and Book Value


Cash Flows Annual

Net Income

0 $105,000 $0 $ 0

1 70,000 50,000 15,0002 42,000 45,000 17,000

3 21,000 40,000 19,000

4 7,000 35,000 21,000

5 0 30,000 23,000


Year


the End of Period


Received at End

of Each Period1 .81 .81

2 .65 1.46

3 .52 1.98

4 .42 2.40

5 .34 2.74

6 .28 3.02

7 .22 3.24

The accounting rate of return for the investment proposal over its life using the initial value of the investment is

A. 38.1%.B. 28.1%.C. 18.1%.D. 36.2%.

A. An answer of 38.1% results from the average of the after-tax cash flows divided by the net initial investment. However,the after-tax cash flows are not used in calculating the accounting rate of return.

B. An answer of 28.1% results from averaging the annual after-tax cash flows and then averaging the annual netincomes, then taking the average of the two averages and dividing it by the net initial investment. However, the after-tax




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cash flows and annual net incomes should not be averaged together.

C. The accounting rate of return is the average annual after-tax net income attributable to the project divided bythe net initial investment. The average of the five annual net income amounts given is $19,000 ([$15,000 +$17,000 + $19,000 + $21,000 + $23,000] / 5 = $19,000.) $19,000 / $105,000 = .18095 or 18.1%. (Note: sometimes theaverage of the initial investment over the life of the project is used, calculated as the initial investment dividedby 2. However, this question specifies to use the initial value of the investment, not the average investment.)

D. An answer of 36.2% results from using the average amount of the investment over the life of the project (the net initialinvestment divided by 2). Sometimes, the accounting rate of return is calculated using the average amount of theinvestment over the life of the project. However, this question specifies to use the initial value of the investment, not theaverage investment.


When ranking two mutually exclusive investments with different initial amounts, management should give first priority tothe project

A. Whose net after-tax flows equal the initial investment.B. That has the greater accounting rate of return.C. That has the greater profitability index.D. That generates cash flows for the longer period of time.

A. If the net after-tax flows (discounted, presumably) equal the initial investment, then the net present value of the projectwill be zero and the investor will be indifferent to the project.

B. The investment that has the greater accounting rate of return may not offer the best return on a discounted cash flowbasis.

C. The Profitability Index enables us to compare (or rank) the benefit/cost ratios of different sized investments,since the Profitability Index expresses profitability on a percentage basis rather than a total dollar amount

basis. It is very useful when we must compare multiple investments that are of different investment amounts.

D. The investment that generates cash flows for the longer period of time may not offer the best return.


The net present value (NPV) method and the internal rate of return (IRR) method are used to analyze capitalexpenditures. The IRR method, as contrasted with the NPV method,

A. Is considered inferior because it fails to calculate compounded interest rates.B. Is preferred in practice because it is able to handle multiple desired hurdle rates, which is impossible with the NPVmethod.C. Assumes that the rate of return on the reinvestment of the cash proceeds is at the indicated rate of return of theproject analyzed rather than at the discount rate used.D. Incorporates the time value of money whereas the NPV method does not.

A. The internal rate of return method does utilize compounded interest rates.

B. The internal rate of return method does not handle multiple desired hurdle rates.

C. The internal rate of return is the discount rate at which the net present value of a project is zero. The internal




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rate of return method assumes that the cash proceeds of the investment will be reinvested at the internal rate ofreturn, which may not be the case.

D. Both the IRR method and the NPV method incorporate the time value of money.


Mercken Industries is contemplating four projects, Project P, Project Q, Project R, and Project S. The capital costs andestimated after-tax net cash flows of each project are listed below. Mercken's desired after-tax opportunity cost is 12%,and the company has a capital budget for the year of $450,000. Idle funds cannot be reinvested at greater than 12%.

Project P Project Q Project R Project S

Initial cost $200,000 $235,000 $190,000 $210,000

Annual cash flows

Year 1 $93,000 $90,000 $45,000 $40,000

Year 2 93,000 85,000 55,000 50,000

Year 3 93,000 75,000 65,000 60,000

Year 4 0 55,000 70,000 65,000

Year 5 0 50,000 75,000 75,000

Net present value $23,370 $29,827 $27,333 $(7,854)

Internal rate of return 18.7% 17.6% 17.2% 10.6%

Excess present value index 1.12 1.13 1.14 0.96

During this year, Mercken will choose

A. Projects P and Q.B. Projects P, Q, and R.

C. Projects Q and R.D. Projects P, Q, R, and S.

A. This is a situation where there appears to be a conflict between the NPV results and the IRR results. Projects P and Qhave the higher IRRs, whereas Q and R have the higher NPVs. However, the problem also tells us that the cash inflowsfrom the project will be able to be reinvested at a rate no higher than 12%. Thus, the IRRs for these projects are notaccurate. Furthermore, Projects P and Q do not have the highest excess present value (profitability) indices.

B. If Mercken chooses Projects P, Q and R, it will exceed its capital budget for the year.

C. Project S is not an acceptable project, because it has a negative NPV. That leaves Projects P, Q and R.However, if all three projects were selected, Mercken would exceed its capital budget of $450,000. Therefore,only two of the three projects can be selected. This is a situation where there appears to be a conflict betweenthe NPV results and the IRR results. Projects P and Q have the higher IRRs, whereas Q and R have the higher

NPVs. Remember that the IRR assumes that all cash inflows from the project will be able to be reinvested at theinternal rate of return. However, this problem tells us that the cash inflows from the project will be able to bereinvested at a rate no higher than 12%. Thus, the IRRs for these projects are not accurate. Therefore, theprojects with the highest NPVs should be selected, and those are Projects Q and R. This is confirmed bylooking at the excess present value (profitability) indices. Note that Projects Q and R have the highestprofitability indices.

D. First, if all four projects are accepted, Mercken would exceed its capital budget for the year. And second, Project S iscompletely unacceptable because it has a negative NPV. Therefore, this answer should be rejected.




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The bailout payback method

A. Equals the recovery period from normal operations.B. Measures the risk if a project is terminated.C. Eliminates the disposal value from the payback calculation.D. Incorporates the time value of money.

A. The bailout payback method does not determine the recovery period from normal operations. It determines therecovery period if operations are abnormal.

B. The bailout payback method recognizes the possibility that a project may be ended prematurely and theequipment sold. The after-tax salvage value of the equipment at various dates is included in the cash inflows ofthe project through the same dates. The use of the bailout payback method gives an indication of the result ofterminating the project early.

C. The bailout payback method does not eliminate the disposal value from the payback calculation, but it incorporates it

at various points in the calculation.

D. The bailout payback method, like the payback method, does not incorporate the time value of money.


A weakness of the internal rate of return (IRR) approach for determining the acceptability of investments is that it

A. Does not consider the time value of money.B. Implicitly assumes that the firm is able to reinvest project cash flows at the firm's cost of capital.

C. Implicitly assumes that the firm is able to reinvest project cash flows at the project's internal rate of return.D. Is not a straightforward decision criterion.

A. The Internal Rate of Return does consider the time value of money.

B. If the required rate of return used in an NPV calculation is the firm's cost of capital, the calculation of the NPVassumes that the firm is able to reinvest the project's cash flows at the same rate. However, the IRR is not the firm's costof capital. The IRR may be higher or lower than the firm's required rate of return.

C. The Internal Rate of Return (IRR) is the discount rate at which the Net Present Value (NPV) of a project iszero. As such, it assumes that the cash flows from the project will be reinvested at the same rate. This is adisadvantage, because the cash flows from the project may not be able to be reinvested at the Internal Rate ofReturn.

D. The Internal Rate of Return is a straightforward decision criterion. If a project's IRR is greater than the firm's requiredrate of return, the project is acceptable.


The profitability index approach to investment analysis




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A. Always yields the same accept/reject decisions for mutually exclusive projects as the net present value method.B. Fails to consider the timing of project cash flows.C. Considers only the project's contribution to net income and does not consider cash flow effects.D. Always yields the same accept/reject decisions for independent projects as the net present value method.

A. If projects are mutually exclusive or are of differing time periods and initial investment amounts, the PI method mayresult in a different ranking from that of the NPV method.

B. The PI does not fail to consider the timing of project cash flows. On the contrary, it uses the present value of the cashinflows discounted using the firm's required rate of return. Therefore, the timing of the cash flows is included.

C. The calculation of PI is based upon cash flow, not net income.

D. The Profitability Index (PI) is a benefit/cost ratio. It is the present value of the future net cash inflows dividedby the initial net cash investment. A ratio of greater than 1 indicates an acceptable project. Therefore, wheneverprojects are independent (i.e., not mutually exclusive), the PI will yield the same accept/reject decision as theNPV method, because a positive NPV will result in a PI of greater than 1. The PI method is useful for rankingmultiple investment opportunities that are of different investment amounts if the projects are not mutuallyexclusive.


The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the netpresent value method (NPV) may be different when

A. Multiple projects have unequal lives and the size of the investment for each project is different.B. The lives of the multiple projects are equal and the size of the required investments are equal.C. The required rate of return is higher than the IRR of each project.D. The required rate of return equals the IRR of each project.

A. When projects have unequal lives and the sizes of the investments are different, it is possible that NPV and

IRR will rank the projects in a different order.

B. When the lives of multiple projects are equal and the size the required investments are equal, the IRR method andthe NPV method will return the same accept-reject decision.

C. If the required rate of return is higher than the IRR of each project, NPV will be negative and both NPV and IRR willreturn a decision to reject the project.

D. If the required rate of return equals the IRR of each project, NPV will be zero and the NPV method and the IRRmethod will rank the investments the same.


When using the net present value method for capital budgeting analysis, the required rate of return is called all of thefollowing except the

A. Discount rate.B. Hurdle rate.C. Cost of capital.D. Risk-free rate.




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A. The required rate of return is the discount rate used in a capital budgeting analysis.

B. The required rate of return may be called the "hurdle rate" because it is the minimum rate of return that is acceptablefor an investment. A firm should invest money in a project only if the project provides a higher rate of return than thisrate. Investments with a return higher than the hurdle rate will increase the value of the firm and thus stockholders'wealth.

C. The required rate of return may be equal to the firm's cost of capital, if the firm has not seen fit to adjust its cost ofcapital to reflect higher or lower risk.

D. The required rate of return, which is the rate used to discount future cash flows in a capital budgetinganalysis, is not the risk-free rate. There is risk inherent in all capital budgeting projects, and the required rate ofreturn incorporates a risk premium.


The proper discount rate to use in calculating certainty equivalent net present value is the

A. Cost of capital.B. Risk-adjusted discount rate.C. Risk-free rate.D. Cost of equity capital.

A. The firm's cost of capital is not used in calculating certainty equivalent NPV.

B. A risk-adjusted discount rate is not used in calculating certainty equivalent NPV.

C. The goal of the certainty equivalent approach is to find the smallest cash flow in each period that would beacceptable in place of that period's risky cash flow, if that smaller cash flow can be depended upon absolutely.The certainty equivalent approach adjusts risky after-tax cash flows to a level judged by the decision-maker tobe certain of attainment, by estimating the minimum cash flow for each year of the project. Then the certainty

equivalent cash flows are discounted at the risk-free rate of interest to calculate a Certainty Equivalent NPV.The Certainty Equivalent NPV is then compared with the NPV of the project when its risky cash flows arediscounted at the company's required rate of return. If the two NPVs are equivalent, the decision-maker will beindifferent between them and will accept the certain cash flow in place of the risky cash flow.

D. The firm's cost of equity capital is not used in calculating certainty equivalent NPV.


If an investment project has a prof itability index of 1.15, the

A. Project's internal rate of return is 15%.B. Project's cost of capital is greater than its internal rate of return.C. Project's internal rate of return exceeds its net present value.D. Net present value of the project is positive.

A. The internal rate of return of a project is the discount rate at which a project's net present value is zero. It is notcalculated as the profitability index − 1.

B. A positive profitability index indicates that the project's profitability is higher than its cost of capital. Therefore, theinternal rate of return of the project must be greater than the cost of capital.




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C. The internal rate of return is the rate at which a project's net present value is zero. Since the IRR is a rate and theNPV is a monetary amount, the two are not comparable.

D. The profitability index for an investment project is its discounted annual net cash inflows divided by its initialcash investment. If a project profitability index is greater than 1.00, we know that its discounted annual net cashinflows are greater than its initial cash investment. Since the net present value is the monetary gain (loss) of the

project's cumulative net cash flows, the net present value of a project with a P.I. of greater than 1.00 must bepositive.


The internal rate of return for a project can be determined

A. If the internal rate of return is greater than the firm's cost of capital.B. Only if the project cash flows are constant.C. By finding the discount rate that yields a net present value of zero for the project.D. By subtracting the firm's cost of capital from the project's profitability index.

A. The internal rate of return can be determined regardless of whether it is greater, lesser, or the same as the firm's costof capital.

B. While the internal rate of return is easier to calculate when the project's cash flows are constant each year, it is notimpossible to calculate it when the project's cash flows vary. When the project's cash flows vary, the internal rate ofreturn can be found by trial and error.

C. The internal rate of return is the discount rate which, when used to calculate the net present value of aproject, yields a net present value of zero.

D. The IRR is not calculated by subtracting the firm's cost of capital from the project's profitability index.


A company has unlimited capital funds to invest. The decision rule for the company to follow in order to maximizeshareholders' wealth is to invest in all projects having a(n)

A. Present value greater than zero.B. Accounting rate of return greater than the hurdle rate used in capital budgeting analyses.C. Net present value greater than zero.D. Internal rate of return greater than zero.

A. This is not the description of projects that a company with unlimited capital funds to invest would invest in.

B. The accounting rate of return is the ratio of the amount of increased book income to the required investment. Since ituses book income rather than discounted cash flow, it is not comparable to the hurdle rate, which is another term for thefirm's required rate of return based on discounted cash flow.

C. The net present value of an investment or project is equal to the difference between the present value of allfuture cash inflows and the present value of the initial and any future cash outflows, using the required rate ofreturn. Thus, in order to maximize shareholders' wealth, a company with unlimited capital funds to invest willinvest in all projects having a net present value greater than zero, unless projects are mutually exclusive.




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D. A company with unlimited capital to invest would not maximize shareholders' wealth by investing in all projects with aninternal rate of return greater than zero. Doing so would fail to consider the company's cost of capital.


Sensitivity analysis is used in capital budgeting to

A. Simulate probabilistic customer reactions to a new product.B. Estimate a project's internal rate of return.C. Determine the amount that a variable can change without generating unacceptable results.D. Identify the required market share to make a new product viable and produce acceptable results.

A. Sensitivity analysis is not used in simulation.

B. A project's internal rate of return cannot be estimated by using sensitivity analysis.

C. Sensitivity analysis is used to determine how an amount will change if factors that were involved inpredicting that amount change. If a small change in the value of one of the inputs causes a large change in therecommended decision, then we say it is sensitive to that input. If we know that a particular input makes a bigdifference in the analysis, we can take extra care to make sure the value assigned to that input in the analysis isas accurate as possible. Furthermore, the measure of the sensitivity of a project to a change in one of thevariables is also an indication of the risk of the project. The more sensitive the project is to a change in one ormore variables, the more risky it is.

D. Sensitivity analysis cannot be used to identify required market share to make a new product viable.


If income tax considerations are ignored, how is depreciation handled by the following capital budgeting techniques?

Internal Rate of Return / Accounting Rate of Return / Payback

A. Included / Included / IncludedB. Excluded / Included /ExcludedC. Excluded / Excluded / IncludedD. Included / Excluded / Included

A. If income tax considerations are ignored, depreciation would be excluded from the internal rate of return and paybackcalculations, because the IRR and the payback period are based upon cash flows.

B. If income tax considerations are to be ignored, then the depreciation tax shield is ignored. Therefore, theincome tax savings from the depreciation are not included in the capital budgeting analyses. If the income taxsavings from the depreciation are excluded, then depreciation is ignored in the calculations of internal rate ofreturn and payback. However, depreciation is included in the calculation of the accounting rate of return,because the accounting rate of return is based upon book income, which includes depreciation.

C. If income tax considerations are ignored, depreciation would be included in the accounting rate of return calculation,because the accounting rate of return is based upon book income, which includes depreciation. Furthermore,depreciation would be excluded from the payback period calculation, because the payback period calculation is basedupon cash flows, not book income.

D. If income tax considerations are ignored, depreciation would be excluded from the internal rate of return and payback




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calculations, because the IRR and the payback period are based upon cash flows. Depreciation would be included in thecalculation of the accounting rate of return, because the accounting rate of return is based upon book income, whichincludes depreciation.

Question 31 - CMA 1293 4.18, adapted - Capital Budgeting Methods

The Keego Company is planning a $200,000 equipment investment which has an estimated 5-year life with no estimatedsalvage value. The company has projected the following annual cash flows for the investment.

Year Projected Cash Inflows Present Value of $1

1 $120,000 0.91

2 60,000 0.76

3 40,000 0.63

4 40,000 0.53

5 40,000 0.44

Totals $300,000 3.27

Assuming that the estimated cash inflows occur evenly during each year, the payback period for the investment is

A. 1.50 years.B. 1.67 years.C. 2.50 years.D. 3.94 years.

A. 1.5 years results from dividing the total undiscounted cash flows of $300,000 by the initial cash outflow of $200,000.However, this is not the correct way to calculate the payback period.

B. A payback period of 1.67 years would result if the second year's cash flow were the same as the first year's cash flow.However, that is not the case.

C. The payback period is, first, the number of the project year in the final year when cumulative cash flow(including the initial investment) is negative, plus a fraction consisting of the positive value of the negativecumulative cash inflow amount from the final negative year divided by the cash flow for the following year. Inthis case, the final year in which the cumulative cash flow is zero is Year 2, because $(200,000) + $120,000 +$60,000 = $(20,000). In the third year, the cash flow is $40,000. So $20,000 ÷ $40,000 = .5, and the payback periodis 2 + .5, or 2.5 years.

D. This is the discounted payback period, in which all cash flows are discounted and the cumulative discounted cashflow is used to calculate the payback period. Although the discount factors are given in this problem, the problem doesnot ask for the discounted payback period.


The Keego Company is planning a $200,000 equipment investment which has an estimated 5-year life with no estimatedsalvage value. The company has projected the following annual cash flows for the investment.

Year Projected Cash Inflows Present Value of $1

1 $120,000 0.91




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2 60,000 0.76

3 40,000 0.63

4 40,000 0.53

5 40,000 0.44

Totals $300,000 3.27

The net present value for the investment is

A. $100,000B. $18,800C. $130,800D. $218,800

A. $100,000 results from subtracting the initial investment of $200,000 from the total of the undiscounted cash flows,which is $300,000. This is not the correct way to calculate NPV.

B. The net present value is the net expected monetary gain or loss from a project when all the expected futurecash inflows and outflows are discounted to the point of the investment, using the firm's required rate of return.Discounting the annual cash inflows using the discount factors given results in annual discounted cash inflows

of ($120,000 × .91) + ($60,000 × .76) + ($40,000 × .63) + ($40,000 × .53) + ($40,000 × .44) = $218,800. Thediscounted total annual cash flows minus the initial investment of $200,000 = $18,800, which is the NPV.

C. $130,800 results from discounting the initial investment for 5 years and subtracting the discounted value from thepresent value of the future cash inflows. However, the initial investment which occurs in Year 0 does not need to bediscounted in order to calculate net present value, because it is already expressed at its present value in the analysis.

D. $218,800 is the total of the present values of the future cash inflows, but this is not net present value.


When determining net present value in an inflationary environment, adjustments should be made to

A. Decrease the estimated cash inflows and increase the discount rate.B. Increase the estimated cash inflows but not the discount rate.C. Increase the discount rate, only.D. Increase the estimated cash inflows and increase the discount rate.

A. The estimated future cash inflows need to be increased, not decreased, to reflect the lower value of the dollar in thefuture as a result of the inflation.

B. The estimated future cash inflows do need to be increased, to reflect the lower value of the dollar in the future as aresult of the inflation. However, the discount rate also needs to be increased, because the firm will require a higher rateof return to compensate for the increased inflation.

C. The discount rate does need to be increased, because the firm will require a higher rate of return to compensate forthe increased inflation. However, this is not the only adjustment that is necessary to determine net present value in aninflationary environment.

D. In an environment of inflation, both the discount rate used and the future expected cash flows should beincreased. The discount rate is increased because the firm will require a higher rate of return to compensate forthe increased inflation. The future expected cash flow amounts need to be increased because inflation willcause the dollar to be worth less in the future, and the amounts of cash (both inflows and outflows) willtherefore increase in the future.




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The length of time required to recover the initial cash outlay of a capital project is determined by using the

A. Payback method.B. Weighted net present value method.C. Net present value method.D. Discounted cash flow method.

A.

The Payback Method is used to determine the number of periods that must pass before the net after-tax cashinflows from the investment will equal (or "pay back") the initial investment cost. If the incoming cash flows areconstant over the life of the project, the payback period may be calculated with a simple division as follows:Initial net investment ÷ Periodic constant expected cash flow.

If the cash flows are not constant over the life of the project, we must add up the cash inflows and determine on

a cumulative basis when the inflows equal the outflows.

B. A probability-weighted Net Present Value for a capital project cannot be used to determine the length of time requiredto recover the initial cash outlay of a capital project.

C. The Net Present Value method of capital budgeting analysis cannot be used to determine the length of time requiredto recover the initial cash outlay of the capital project.

D.

Methods of capital budgeting analysis that utilize discounted cash flow concepts are Net Present Value (NPV), InternalRate of Return (IRR), and Profitability Index (PI).

NPV can be used to determine the difference between the present value of all future cash inflows and the present valueof all (the initial as well as all future) cash outflows, using the required rate of return. A project with a positive NPV isacceptable.

The IRR is the discount rate at which the NPV of an investment will be equal to 0, or the discount rate at which thepresent value of the expected cash inflows from a project equals the present value of the expected cash outflows. If thisrate is higher than the required rate of return, the investment is acceptable.

The PI calculation is used to determine the ratio of the PV of net future cash flows (both inflows and outflows) to theamount of the initial investment. It is calculated as follows, using the same information from the NPV calculation: PV offuture net cash flows ÷ Net Initial Investment. If a project has a positive net present value, the profitability index will beabove 1.00 and it will be an acceptable project.

However, none of these discounted cash flow methods can be used to determine the length of time required to recover

the initial cash outlay of a capital project.


In evaluating a capital budget project, the use of the net present value (NPV) model is generally not affected by the

A. Initial cost of the project.




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B. Method of funding the project.C. Type of depreciation used.D. Amount of added working capital needed for operations during the term of the project.

A. The initial cost of the project is a component of a net present value capital budgeting analysis.

B. The method of funding the project is separate from the net present value method of capital budgeting

analysis.

C. The type of depreciation used for the project's fixed assets is a component of a net present value capital budgetinganalysis.

D. Amount of added working capital needed for operations during the term of the project is a component of a netpresent value capital budgeting analysis.


For capital budgeting purposes, management would select a high hurdle rate of return for certain projects becausemanagement

A. Believes bank loans are riskier than capital investments.B. Wants to factor risk into its consideration of projects.C. Believes too many proposals are being rejected.D. Wants to use equity funding exclusively.

A. The method of funding a project is a separate decision from the capital budgeting analysis.

B. A company's Weighted Average Cost of Capital (WACC) — which is the rate of return required by investors inthe company's securities — is the appropriate discount rate (or hurdle rate) to use in capital budgetingdecisions and NPV calculations as long as the riskiness of the project is the same as the riskiness of the firm'sexisting business. If management wants to factor the risk of a project into its analysis, it will increase the

discount rate used in NPV calculations for more risky, or uncertain, investments. A higher discount rate willrequire higher expected future cash flows in order for the company to make the investment, thus making fewerinvestments acceptable.

C. A high hurdle rate of return would require higher future cash inflows from a project in order for the project to beacceptable. Therefore, a high hurdle rate will result in fewer projects being accepted.

D. The method of funding a project is a separate decision from the capital budgeting analysis.


The method that recognizes the time value of money by discounting the after-tax cash flows over the life of a project,using the company's minimum desired rate of return is the

A. Net present value method.B. Internal rate of return method.C. Accounting rate of return method.D. Payback method.

A. The net present value method is used to determine the difference between the present value of all futureexpected cash inflows and the present value of all (the initial as well as all future) expected cash outflows,




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using the required rate of return. A project with a positive NPV is acceptable.

B. The internal rate of return is the discount rate at which the NPV of an investment will be equal to 0, or the discountrate at which the present value of the expected cash inflows from a project equals the present value of the expectedcash outflows. The company's minimum desired rate of return is used only in analyzing the results of the IRR analysis,not in doing the calculation. If the IRR is higher than the company's minimum desired rate of return, the project isacceptable.

C. The accounting rate of return is a ratio of the amount of increased book income to the required investment. It does notrecognize the time value of money and it does not include discounting after-tax cash flows over the life of the project.

D. The payback method does not recognize the time value of money and does not include discounting after-tax cashflows over the life of the project.


The method that divides a project's annual after-tax net income by the average investment cost to measure theestimated performance of a capital investment is the

A. Payback method.B. Accounting rate of return method.C. Internal rate of return method.D. Net present value (NPV) method.

A. The Payback Method is used to determine the number of periods that must pass before the net after-tax cash inflowsfrom the investment will equal (or "pay back") the initial investment cost. If the incoming cash flows are constant over thelife of the project, the payback period may be calculated with a simple division as follows: Initial net investment Periodicconstant expected cash flow If the cash flows are not constant over the life of the project, the Payback Period iscalculated by adding up the cash inflows and determining on a cumulative basis when the inflows equal the outflows.The Payback Method does not utilize a division of the project's annual after-tax net income by the average investmentcost to measure the estimated performance of a capital investment.

B.

The accounting rate of return is a ratio of the amount of increased book income to the required investment. It iscalculated as follows: Increase in Expected Annual Average After Tax Accounting Net Income ÷ Net InitialInvestment. Sometimes the average investment figure is used rather than the total investment. Since thismethod uses accrual accounting income, it includes depreciation. However, it does not take into account thetime value of money.

C. The internal rate of return is the discount rate at which the NPV of an investment will be equal to 0, or the discountrate at which the present value of the expected cash inflows from a project equals the present value of the expectedcash outflows. If the IRR is higher than the company's minimum desired rate of return, the project is acceptable. TheIRR does not utilize a division of the project's annual after-tax net income by the average investment cost to measure theestimated performance of a capital investment.

D. The net present value method is used to determine the difference between the present value of all future cash inflowsand the present value of all (the initial as well as all future) cash outflows, using the required rate of return. A project witha positive NPV is acceptable. It does not utilize a division of the project's annual after-tax net income by the averageinvestment cost to measure the estimated performance of a capital investment.





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The capital budgeting model that is generally considered the best model for long-range decision making is the

A. Unadjusted rate of return model.B. Accounting rate of return model.C. Discounted cash flow model.D. Payback model.

A. The unadjusted rate of return model, or accounting rate of return model, is not generally considered the best modelfor long-range decision making, because it does not incorporate time value of money concepts.

B. The accounting rate of return model, or unadjusted rate of return model, is not generally considered the best modelfor long-range decision making, because it does not incorporate time value of money concepts.

C. Discounted cash flow methods of capital budgeting, including net present value, internal rate of return, andprofitability index, are generally considered the best model for long-range capital budgeting decision making.

D. The payback method is not generally considered the best model for long-range decision making, because it does notincorporate time value of money concepts.


The technique used to evaluate all possible capital projects of different dollar amounts and then rank them according totheir desirability is the

A. Discounted cash flow method.B. Payback method.C. Profitability index method.D. Net present value method.

A. There are three discounted cash flow methods used for capital budgeting. Only one of them can be used to evaluate

all possible capital projects of different dollar amounts and rank them according to their desirability.

B. The Payback Method is used to determine the number of periods that must pass before the net after-tax cash inflowsfrom the investment will equal (or "pay back") the initial investment cost. It is not used to evaluate all possible capitalprojects of different dollar amounts and then rank them according to their desirability.

C. The PI calculation is used to determine the ratio of the PV of net future cash flows (both inflows andoutflows) to the amount of the initial investment. It is calculated as follows, using the same information from theNPV calculation: PV of future net cash flows ÷ Net Initial Investment. If a project has a positive net presentvalue, the profitability index will be above 1.00 and it will be an acceptable project. The profitability index isused to evaluate all possible capital projects of different dollar amounts and then rank them according to theirdesirability.

D. The net present value method is not used to evaluate all possible capital projects of different dollar amounts and thenrank them according to their desirability.


A widely used approach that is used to recognize uncertainty about individual economic variables while obtaining animmediate financial estimate of the consequences of possible prediction errors is




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A. Expected value analysis.B. Sensitivity analysis.C. Learning curve analysis.D. Regression analysis.

A. Expected value is the weighted average of all the possible values of a random variable, with the probabilities of eachof the values used as the weights. The expected value is the mean value, also known as the average value. Expected

value analysis does not yield an immediate financial estimate of the consequences of possible prediction errors.

B. Sensitivity analysis can be used to determine how cash flows can be expected to vary with changes in theunderlying assumptions. Using expected cash flows, the NPV, IRR, and PI of the project are determined. Then,the key assumptions that were used in making the original expected cash flow projections are identified. Oneassumption at a time is then changed, leaving the other assumptions unchanged, and the NPV, IRR and PI arerecalculated to determine what effect changing one assumption would have on those measures.

C. Learning curves describe the fact that the more experience people have with something, the more efficient theybecome in doing that task. Higher costs per unit early in production are part of start-up costs. It is commonly acceptedthat new products and production processes experience a period of low productivity followed by increased productivity.However, learning curve analysis does not provide an immediate financial estimate of the consequences of possibleprediction errors.

D. Regression analysis is a method of forecasting, using trend analysis. However, it does not yield an immediatefinancial estimate of the consequences of possible prediction errors.


Which one of the following statements about the payback method of investment analysis is correct? The paybackmethod

A. Considers cash flows after the payback has been reached.B. Does not consider the time value of money.

C. Uses discounted cash flow techniques.D. Generally leads to the same decision as other methods for long-term projects.

A. The payback method does not take into account any cash flows expected to be received after the payback point hasbeen reached.

B. The payback method uses undiscounted cash flows and thus does not incorporate the time value of moneyin the analysis. That is one of its weaknesses. Another weakness is that it does not take into account any cashflows that are received after the payback point has been reached.

C. The payback method does not use discounted cash flow techniques, and that is one of its weaknesses.

D. The payback method does not necessarily lead to the same decision as other methods of analyzing long-termprojects do.

Question 43 - CMA 1295 4.12 (adapted) - Capital Budgeting Methods

Willis Inc. has a cost of capital of 15% and is considering the acquisition of a new machine which costs $400,000 andhas a useful life of 5 years. Willis projects that earnings and cash flow will increase as follows:




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Net Year After-TaxEarnings Cash Flow

1 $100,000 $160,000

2 100,000 140,000

3 100,000 100,000

4 100,000 100,000

5 200,000 100,000

15% Interest Rate factors

Period Present Value of $1Present Value of an

Annuity of $1

1 0.87 0.87

2 0.76 1.63

3 0.66 2.29

4 0.57 2.86

5 0.50 3.36

The net present value of this investment is

A. Negative, $14,000.B. Positive, $200,000.C. Negative, $64,000.D. Positive, $18,600.

A. An answer of a negative $14,000 results from using the net earnings amounts instead of the after-tax cash flowamounts in the net present value analysis.

B. An answer of $200,000 results from subtracting the initial investment from the total of the undiscounted cash inflows.

C. An answer of a negative $64,000 NPV results from using annual cash flows of $100,000, and forgetting to discountthe additional cash flows of $60,000 in Year 1 and $40,000 in Year 2.

D. The net present value is the present value of all cash flows after Year 0 (positive and negative) less the initialinvestment. To calculate the present value of the cash flows after year 0, you could discount each individualcash flow amount by the appropriate present value of $1 factor. However, that is not the most time-effectiveway to do it. If you recognize that all the annual cash flow amounts contain an amount such as $100,000 and$100,000 is the exact amount of the cash flow for at least two of the years, you can save time by calculating firstthe present value of an annuity for the $100,000; then calculating the present value of $1 individually for anyamounts over the $100,000 amount. In this case, we have 5 years of $100,000 cash flows, and the discountfactor given for the PV of an annuity for 5 years is 3.36. We also have $60,000 to be discounted for one year and$40,000 to be discounted for two years using the appropriate present value of $1 factors. Thus, the presentvalue of the cash inflows is ($100,000 × 3.36) + ($60,000 × .87) + ($40,000 × .76) = $418,600. The net present value

is $418,600 less the initial investment of $400,000, or $18,600.

Question 44 - CMA 1295 4.13 (adapted) - Capital Budgeting Methods

Willis Inc. has a cost of capital of 15% and is considering the acquisition of a new machine which costs $400,000 andhas a useful life of 5 years. Willis projects that earnings and cash flow will increase as follows:




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Net Year After-TaxEarnings Cash Flow

1 $100,000 $160,000

2 100,000 140,000

3 100,000 100,000

4 100,000 100,000

5 200,000 100,000

15% Interest Rate factors

Period Present Value of $1Present Value of an

Annuity of $1

1 0.87 0.87

2 0.76 1.63

3 0.66 2.29

4 0.57 2.86

5 0.50 3.36

What is the payback period of this investment?

A. 4.00 years.B. 3.00 years.C. 1.50 years.D. 4.63 years.

A. An answer of 4.00 years results from using net earnings instead of after-tax cash flows to calculate the paybackperiod.

B. The payback period is the number of periods that must pass before the net after-tax cash inflows from theinvestment will equal (or "pay back") the initial investment. The initial investment of $400,000 is returned inexactly 3 years, because the cash inflows of Years 1 through 3 -- $160,000, $140,000, and $100,000 -- total$400,000.

C. The payback method is used to determine the number of periods that must pass before the net after-tax cash inflowsfrom the investment will equal (or "pay back") the initial investment cost. After 1.5 years has passed, only $230,000 ofthe initial $400,000 investment will have been paid back.

D. 4.63 years is the Discounted Payback Period (also called breakeven time) which results from calculating the paybackperiod using discounted cash flows. However, the Payback Method does not use discounted cash flows.


The net present value of a proposed investment is negative; therefore, the discount rate used must be

A. Less than the risk-free rate.B. Greater than the project's internal rate of return.C. Less than the project's internal rate of return.D. Greater than the firm's cost of equity.

A. The risk-free rate is not relevant to a capital budgeting analysis using net present value.

B. The internal rate of return is the discount rate at which a project's net present value is zero. As the discount




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rate used increases, the net present value of a project decreases. Therefore, if the discount rate used is higherthan the project's internal rate of return, the net present value of the project will be less than zero and thus willbe a negative amount.

C. The internal rate of return is the discount rate at which a project's net present value is zero. As the discount rate useddecreases, the net present value of a project increases. Therefore, if the discount rate used is lower than the project'sinternal rate of return, the net present value of the project will be greater than zero.

D. Use of a discount rate that is greater than the firm's cost of equity may result in a negative net present value for theinvestment, or it may result in a positive net present value for the investment. Which it will be depends upon the cashflows.


A disadvantage of the net present value method of capital expenditure evaluation is that it

A. Computes the true interest rate.B. Is calculated using sensitivity analysis.C. Is difficult to apply because it uses a trial-and-error approach.D. Does not provide the true rate of return on investment.

A. NPV analysis does not compute a true interest rate on an investment.

B. Sensitivity analysis, which is a "what if" technique, can be used with NPV analysis to determine how cash flows andthus NPV can be expected to vary with changes in the underlying assumptions.

C. NPV analysis does not use a trial-and-error approach.

D. NPV analysis provides a dollar amount by which the present value of the return on a project is greater thanthe investment. It does not provide an actual rate of return for the investment.


Barker Inc. has no capital rationing constraint and is analyzing many independent investment alternatives. Barker shouldaccept all investment proposals

A. That have positive cash flows.B. If debt financing is available for them.C. That provide returns greater than the before-tax cost of debt.D. That have a positive net present value.

A. A project might have positive cash flows but have a negative net present value, in which case it would not be a goodinvestment.

B. The availability of financing is a completely separate issue from the capital budgeting process.

C. Since a project may be financed with any combination of debt and equity, it is not appropriate to compare theexpected return from the project to the before-tax cost of debt.

D. If a company has no restrictions on its available capital for investment, and if all the projects underconsideration are independent (i.e., none of the projects are mutually exclusive, meaning if the company investsin one it cannot invest in another for reasons other than capital availability), then the company should accept all




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projects with a positive net present value.


When the risks of the individual components of a project's cash flows are different, an acceptable procedure to evaluatethese cash flows is to

A. Divide each cash flow by the payback period.B. Discount each cash flow using a discount rate that reflects the degree of risk.C. Compute the net present value of each cash flow using the firm's cost of capital.D. Compare the internal rate of return from each cash flow to its risk.

A. The payback period is not relevant to evaluating risk in cash flows.

B. A company's Weighted Average Cost of Capital (WACC) — which is the rate of return required by investors inthe company's securities — is the appropriate discount rate to use in capital budgeting decisions and NPVcalculations as long as the riskiness of the project is the same as the riskiness of the firm's existing business.When the riskiness of the project is different from that of the company's existing business, the discount rateused to calculate NPV needs to be adjusted to reflect the changed risk profile of the firm as a result of theproject under consideration. A higher discount rate is used to reflect higher risk; a lower discount rate reflectslower risk. And when the risks of the individual components of a project's cash flows are different, it isappropriate to use a risk-adjusted discount rate for each component that is specific for the degree of riskinherent in that component of the cash flow.

C. The firm's cost of capital is the appropriate discount rate to use in capital budgeting decisions and NPV calculationsonly if the riskiness of the project is the same as the riskiness of the firm's existing business. When the riskiness of theproject or of any individual component of the project's cash flow is different from that of the company's existing business,the discount rate used to calculate NPV needs to be adjusted to reflect the changed risk profile of the firm as a result ofthe project under consideration.

D. The internal rate of return is the discount rate at which the NPV is zero. It is not used in evaluating risk.


The NPV of a project has been calculated to be $215,000. Which one of the following changes in assumptions woulddecrease the NPV?

A. Decrease the initial investment amount.B. Increase the discount rate.C. Extend the project life and associated cash inflows.D. Decrease the estimated effective income tax rate.

A. Decreasing the initial investment amount will increase the NPV.

B. Increasing the discount rate will decrease the present value of the cash inflows, which will decrease the NPV.

C. Extending the life of the project will increase the cash flows and thus increase the NPV.

D. Decreasing the estimated effective income tax rate will increase the net of tax cash inflows, which will increase theNPV.




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The net present value method of capital budgeting assumes that cash flows are reinvested at

A. The rate of return of the project.

B. The discount rate used in the analysis.C. The risk-free rate.D. The cost of debt.

A. The internal rate of return method of analyzing a capital investment project assumes that the resulting cash flows willbe able to be reinvested at the rate of return of the project, but the net present value method does not.

B. The net present value method of capital budgeting involves the assumption that the resulting cash flows willbe able to be invested at the rate of return that is used as a discount rate in the analysis.

C. The risk-free rate is not a part of net present value analysis of a capital budgeting project.

D. The cost of debt for a capital investment is not the rate that the resulting cash flows are assumed to be reinvested atin net present value analysis.


Capital budgeting methods are often divided into two classifications: project screening and project ranking. Which one ofthe following is considered a ranking method rather than a screening method?

A. Time-adjusted rate of return.B. Accounting rate of return.C. Profitability index.D. Net present value.

A. "Time-adjusted rate of return" is another term that is used to refer to the internal rate of return. The internal rate ofreturn is a project screening method, not a ranking method. If the internal rate of return of a project is equal to or higherthan the required rate of return, then the project is acceptable. However, there are problems associated with trying touse the internal rate of return as a ranking method, so it is not used in that way.

B. The accounting rate of return is not a ranking method of capital budgeting analysis.

C. The profitability index is a benefit/cost ratio. It represents the ratio of the benefits (net cash inflows) to thecosts (net initial investment). The profitability index enables us to compare, or rank, the benefit/cost ratios ofdifferent sized investments, since the profitability index expresses profitability on a percentage basis ratherthan a total dollar amount basis. It is very useful when we must compare multiple investments that are ofdifferent investment amounts, the projects are not mutually exclusive, and we need to rank them. When thereare multiple investment opportunities, we will take the project that has the highest profitability index. When theprojects are independent alternatives of the same length, this method will give us the same accept/rejectdecisions that NPV provides. However, when the projects are of different time periods or amounts of initialinvestments, the profitability index may give different rankings than NPV.

D. Net present value is primarily a screening method (although it may be used as a ranking method in certaincircumstances). The general rule is that any project that has a positive NPV should be accepted, while a project with anegative NPV should be rejected. However, for various reasons such as limited funds to invest or nonfinancial factors,not all projects with positive NPVs will be acceptable. It is probably better to state that any project that has a positive NPVis a candidate for further consideration - it has passed the first screen. A project with a negative NPV should not beconsidered further. This will maximize shareholder wealth. When there are limited funds to invest, NPV is useful



2. capital budgeting methods

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