Capital Budgeting
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MODULE 9
CAPITAL BUDGETING
THEORIES:
Basic Concepts
Decision Making Process
2. The first step in the decision-making process is to
A. determine and evaluate possible courses of action.
B. identify the problem and assign responsibility.
C. make a decision.
D. review results of the decision.
Strategic planning
39. Strategic planning is the process of deciding on an organization’
A. minor programs and the approximate resources to be devoted to them
B. major programs and the approximate resources to be devoted to them
C. minor programs prior to consideration of resources that might be needed
D. major programs prior to consideration of resources that might be needed
Capital budgeting defined
1. The long-term planning process for making and financing investments that affect a company’s
financial results over a number of years is referred to as
A. capital budgeting C. master budgeting
B. strategic planning D. long-range planning
3. Capital budgeting is the process
A. used in sell or process further decisions.
B. of determining how much capital stock to issue
C. of making capital expenditure decisions
D. of eliminating unprofitable product line
5. A capital investment decision is essentially a decision to:
A. exchange current assets for current liabilities.
B. exchange current cash outflows for the promise of receiving future cash inflows.
C. exchange current cash flow from operating activities for future cash inflows from investing
activities.
D. exchange current cash inflows for future cash outflows.
Risk & return
6. The higher the risk element in a project, the
A. more attractive the investment is.
B. higher the net present value is.
C. higher the cost of capital is.
D. higher the discount rate is.
9. Cost of capital is the
A. amount the company must pay for its plant assets.
B. dividends a company must pay on its equity securities.
C. cost the company must incur to obtain its capital resources.
D. cost the company is charged by investment bankers who handle the issuance of equity or
long-term debt securities.
14. How should the following projects be listed in order of increasing risk?
A. New venture, replacement, expansion.
B. Replacement, new venture, expansion.
C. Replacement, expansion, new venture.
D. Expansion, replacement, new venture.
41. Problems associated with justifying investments in high-tech projects often include discount
rates that are too
A. low and time horizons that are too long
B. high and time horizons that are too long
C. high and time horizons that are too short
D. low and time horizons that are too short
60. In evaluating high-tech projects,
A. only tangible benefits should be considered.
B. only intangible benefits should be considered.
C. both tangible and intangible benefits should be considered.
D. neither tangible nor intangible benefits should be considered.
Types of capital projects
4. A project that when accepted or rejected will not affect the cash flows of another project.
A. Independent projects C. Mutually exclusive projects
B. Dependent projects D. Both b and c
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Capital budgeting process
7. The normal methods of analyzing investments
A. cannot be used by not-for-profit entities.
B. do not apply if the project will not produce revenues.
C. cannot be used if the company plans to finance the project with funds already available
internally.
D. require forecasts of cash flows expected from the project.
Investments
Sale of old asset
38. When disposing of an old asset and replacing it with a new one, tax effect on
A. gain on sale of the old asset reduces the basis of the new asset
B. gain on sale of the old asset increases the basis of the new asset
C. loss on sale of the old asset reduces the basis of the new asset
D. b and c
Working capital
18. A major difference between an investment in working capital and one in depreciable assets is
that
A. an investment in working capital is never returned, while most depreciable assets have
some residual value.
B. an investment in working capital is returned in full at the end of a project’s life, while an
investment in depreciable assets has no residual value.
C. an investment in working capital is not tax-deductible when made, nor taxable when
returned, while an investment in depreciable assets does allow tax deductions.
D. because an investment in working capital is usually returned in full at the end of the
project’s life, it is ignored in computing the amount of the investment required for the
project.
30. The proper treatment of an investment in receivables and inventory is to
A. ignore it
B. add it to the required investment in fixed assets
C. add it to the required investment in fixed assets and subtract it from the annual cash flows
D. add it to the investment in fixed assets and add the present value of the recovery to the
present value of the annual cash flows
31. In connection with a capital budgeting project, an investment in working capital is normally
recovered
A. at the end of the project’s life
B. in the first year of the project’s life
C. evenly through the project’s life
D. when the company goes out of businessA
32. XYZ Co. is adopting just-in-time principles. When evaluating an investment project that would
reduce inventory, how should XYZ treat the reduction?
A. Ignore it.
B. Decrease the cost of the investment and decrease cash flows at the end of the project’s
life.
C. Decrease the cost of the investment.
D. Decrease the cost of the investment and increase the cash flow at the end of the project’s
life.
Relevant cash flows
72. Which of the following represents the biggest challenge in the decision to purchase new
equipment?
A. Estimating employee training for the new project.
B. Estimating cash flows for the future.
C. Estimating transportation costs of the new equipment.
D. Estimating maintenance costs for the new equipment.
51. When a firm has the opportunity to add a project that will utilize factory capacity that is
currently not being used, which costs should be used to determine if the added project should
be undertaken?
A. Opportunity costs C. Net present costs
B. Historical costs D. Incremental costs
11. The only future costs that are relevant to deciding whether to accept an investment are those
that will
A. be different if the project is accepted rather than rejected.
B. be saved if the project is accepted rather than rejected.
C. be deductible for tax purposes.
D. affect net income in the period that they are incurred.
Cash inflow
66. Which of the following is not a typical cash inflow in capital investment decisions?
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A. Incremental revenues C. Salvage value
B. Cost reductions D. Additional working capital
Out-of-pocket costs
45. Which of the following is a cost that requires a future outlay of cash that is which relevant for
future decision-making?
A. Opportunity cost C. Sunk costs
B. Out-of-pocket cost D. Relevant benefits
Depreciation & Tax
22. If there were no income taxes,
A. depreciation would be ignored in capital budgeting.
B. the NPV method would not work.
C. income would be discounted instead of cash flow.
D. all potential investments would be desirable.
21. Relevant cash flows for net present value (NPV) models include all of the following except
A. outflows to purchase new equipment
B. depreciation expense on the newly acquired piece of equipment
C. reductions in operating cash flows as a result of using the new equipment.
D. cash outflows related to purchasing additional inventories for another retail store.
55. When evaluating depreciation methods, managers who are concerned about capital
investment decisions will:
A. choose straight line depreciation so there is minimum impact on the decision.
B. use units of production so more depreciation expense will be allocated to the later years.
C. use accelerated methods to have as much depreciation in the early years of an asset’s
life.
D. choice of depreciation method has no impact on the capital investment decision.
70. The tax consequences should be considered under which circumstances when making capital
investment decisions?
A. Positive net income C. Depreciation
B. Disposal of an asset D. All of the above
Irrelevant cash flows
Loan financing
43. In addition to incremental revenues, cash inflows from capital investments can be generated
from all of the following sources except:
A. debt financing
B. cost savings
C. salvage value
D. reduction in the amount of working capital
10. If Helena Company expects to get a one-year bank loan to help cover the initial financing of
one of its capital projects, the analysis of the project should
A. offset the loan against any investment in inventory or receivables required by the project.
B. show the loan as an increase in the investment.
C. show the loan as a cash outflow in the second year of the project’s life.
D. ignore the loan
Sunk cost
29. In deciding whether to replace a machine, which of the following is NOT a sunk cost?
A. The expected resale price of the existing machine.
B. The book value of the existing machine.
C. The original cost of the existing machine.
D. The depreciated cost of the existing machine.
Accounting rate of return
54. The primary advantages of the average rate of return method are its ease of computation and
the fact that:
A. It is especially useful to managers whose primary concern is liquidity
B. There is less possibility of loss from changes in economic conditions and obsolescence
when the commitment is short-term
C. It emphasizes the amount of income earned over the life of the proposal
D. Rankings of proposals are necessary
Nondiscounted cash flow method
Payback method
36. There are several capital budgeting decision models that do not use discounted cash flows.
What is the name of the simple technique that calculates the total time it will take to recover,
using cash inflows from operations, the amount of cash invested in a project?
A. Recovery period C. External rate of return
B. Payback model D. Accounting rate of return
34. The technique most concerned with liquidity is
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A. Payback method.
B. Net present value technique.
C. Internal rate of return.
D. book rate of return.
73. Which of the following is a potential use of the payback method?
A. Help managers control the risks of estimating cash flows
B. Help minimize the impact of the investment on liquidity
C. Help control the risk of obsolescence
D. All of the answers are correct
47. The cash payback technique:
A. should be used as a final screening tool.
B. can be the only basis for the capital budgeting decision.
C. is relatively easy to compute and understand.
D. considers the expected profitability of a project.
33. Which of the following is NOT a defect of the payback method?
A. It ignores cash flows because it uses net income.
B. It ignores profitability.
C. It ignores the present values of cash flows.
D. It ignores the pattern of cash flows beyond the payback period.
48. The payback method, as a capital budgeting technique, assumes that all intermediate cash
inflows are reinvested to yield a return equal to:
A. Zero C. The Discount Rate
B. The Time-Adjusted-Rate-of-Return D. The Cost-of-Capital
52. Which of the following capital budgeting methods is the least theoretically correct?
A. payback method C. internal rate of return
B. net present value D. none of the above
Discounted cash flow method
49. Which of the following methods of evaluating capital investment projects incorporates the time
value of money?
A. Payback period, accounting rate of return, and internal rate of return
B. Accounting rate of return, net present value, and internal rate of return
C. Payback period and accounting rate of return
D. Net present value and internal rate of return
Net present value
69. Discounted cash flow analysis is used in which of the following techniques?
A. Net present value C. Cost of capital
B. Payback period D. All of the above
8. The primary capital budgeting method that uses discounted cash flow techniques is the
A. net present value method.
B. cash payback technique.
C. annual rate of return method.
D. profitability index method.
20. The net present value (NPV) model can be used to evaluate and rank two or more proposed
projects. The approach that computes the total impact on cash flows for each option and then
converts these total cash flows to their present values is called the
A. differential approach C. contribution approach
B. incremental approach. D. total project approach.
40. The discount rate commonly used in present value calculations is the
A. treasury bill rate
B. weighted average return on assets adjusted for risk
C. risk free rate plus inflation rate
D. shareholders’ expected return on equity
44. Which is true of the net present value method of determining the acceptability of an
investment?
A. The initial cost of the investment is subtracted from the present value of net cash flows
B. The net cash flows are not adjusted to present value
C. A negative net present value indicates the investment should be undertaken
D. The net present value method requires no subjective judgments
Profitability index
35. The profitability index
A. does not take into account the discounted cash flows.
B. Is calculated by dividing total cash flows by the initial investment.
C. allows comparison of the relative desirability of projects that require differing initial
investments.
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D. will never be greater than 1.0.
Internal rate of return
56. According to the reinvestment rate assumption, which method of capital budgeting assumes
cash flows are reinvested at the project’s rate of return?
A. payback period C. internal rate of return
B. net present value D. none of the above
62. The rate of interest that produces a zero net present value when a project’s discounted cash
operating advantage is netted against its discounted net investment is the:
A. Cost of capital C. Cutoff rate
B. Discount rate D. Internal rate of return
57. A weakness of the internal rate of return method for screening investment projects is that it:
A. Does not consider the time value of money
B. Implicitly assumes that the company is able to reinvest cash flows from the project at
the company’s discount rate
C. Implicitly assumes that the company is able to reinvest cash flows from the project at the
internal rate of return
D. Fails to consider the timing of cash flows
Comprehensive
50. Which of the following methods of evaluating capital investment projects do not use a
percentage as a measurement unit?
A. Payback period and net present value
B. Accounting rate of return and payback period
C. Net present value and internal rate of return
D. Internal rate of return and payback period
Relationships among NPV, PI & IRR
24. If a company’s required rate of return is 12 percent and in using the profitability index method,
a project’s index is greater than 1.0, this indicates that the project’s rate of return is
A. equal to 12 percent. C. less than 12 percent.
B. greater than 12 percent. D. dependent on the size of the investment.
25. If the present value of the future cash flows for an investment equals the required investment,
the IRR is
A. equal to the cutoff rate.
B. equal to the cost of borrowed capital.
C. equal to zero.
D. lower than the company’s cutoff rate return.
27. The relationship between payback period and IRR is that
A. a payback period of less than one-half the life of a project will yield an IRR lower than the
target rate.
B. the payback period is the present value factor for the IRR.
C. a project whose payback period does not meet the company’s cutoff rate for payback will
not meet the company’s criterion for IRR.
D. none of the above.
67. When comparing NPV and IRR, which is not true?
A. With NPV, the discount rate can be adjusted to take into account increased risk and the
uncertainty of cash flows
B. With IRR, cash flows can be adjusted to account for risk
C. NPV can be used to compare investments of various size or magnitude
D. Both NPV and IRR can be used for screening decisions
Sensitivity analysis
13. In capital budgeting, sensitivity analysis is used
A. to determine whether an investment is profitable.
B. to see how a decision would be affected by changes in variables.
C. to test the relationship of the IRR and NPV.
D. to evaluate mutually exclusive investments.
15. An approach that uses a number of outcome estimates to get a sense of the variability among
potential returns is
A. the discounted cash flow technique.
B. the net present value method.
C. risk analysis.
D. sensitivity analysis.
42. Sensitivity analysis is the study of how the outcome of a decision making process
A. changes as one or more of the assumptions change
B. remains the same even though one or more of the assumptions change
C. changes even though one or more of the assumptions do not change
D. does not change as the assumptions do not change either
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64. Sensitivity analysis is:
A. An appropriate response to uncertainty in cash flow projections
B. Useful in measuring the variance of the Fisher rate
C. Typically conducted in the post investment audit
D. Useful to compare projects requiring vastly different levels of initial investment
IRR = 0
58. if the internal rate of return on an investment is zero:
A. its NPV is positive.
B. its annual cash flows equal its required investment.
C. it is generally a wise investment.
D. its cash flows decrease over its life.
Change in NPV
59. Which of the following would decrease the net present value of a project?
A. A decrease in the income tax rate
B. A decrease in the initial investment
C. An increase in the useful life of the project
D. An increase in the discount rate
Effect of change in cost of capital
26. All other things being equal, as cost of capital increases
A. more capital projects will probably be acceptable.
B. fewer capital projects will probably be acceptable.
C. the number of capital projects that are acceptable will change, but the direction of the
change is not determinable just by knowing the direction of the change in cost of capital.
D. the company will probably want to borrow money rather than issue stock.
Effect of change in residual value
23. Assuming that a project has already been evaluated using the following techniques, the
evaluation under which technique is least likely to be affected by an increase in the estimated
residual value of the project?
A. Payback Period. C. Net Present Value.
B. Internal Rate of Return. D. Profitability Index.
Decision rules – independent projects
68. What type of decision involves deciding if an investment meets a predetermined standard?
A. Investment decisions C. Management decisions
B. Screening decisions D. Preference decisions
Payback period
46. If a payback period for a project is greater than its expected useful life, the
A. project will always be profitable.
B. entire initial investment will not be recovered.
C. project would only be acceptable if the company’s cost of capital was low.
D. project’s return will always exceed the company’s cost of capital.
Net present value
61. An analysis of a proposal by the net present value method indicated that the present value of
future cash inflows exceeded the amount to be invested. Which of the following statements
best describes the results of this analysis?
A. The proposal is desirable and the rate of return expected from the proposal exceeds the
minimum rate used for the analysis
B. The proposal is desirable and the rate of return expected from the proposal is less than
the minimum rate used for the analysis
C. The proposal is undesirable and the rate of return expected from the proposal is less than
the minimum rate used for the analysis
D. The proposal is undesirable and the rate of return expected from the proposal exceeds
the minimum rate used for the analysis
63. NPV indicates a project is deemed desirable (acceptable) when the NPV is
A. greater than or equal to zero
B. less than zero
C. greater than or equal to the risk-adjusted cost of capital
D. less than or equal to the risk-adjusted cost of capital
Internal rate of return
12. If Arbitrary Company wants to use IRR to evaluate long-term decisions and to establish a
cutoff rate of return, it must be sure that the cutoff rate is
A. at least equal to its cost of capital.
B. at least equal to the rate used by similar companies.
C. greater than the IRR on projects accepted in the past.
D. greater than the current book rate of return.
NPV & IRR
Capital Budgeting
19. The NPV and IRR methods give
A. the same decision (accept or reject) for any single investment.
B. the same choice from among mutually exclusive investments.
C. different rankings of projects with unequal lives.
D. the same rankings of projects with different required investments.
Decision rule – mutually exclusive projects
71. Mutually exclusive projects are those that:
A. if accepted, preclude the acceptance of competing projects.
B. if accepted, can have a negative effect on the company’s profit.
C. if accepted, can also lead to the acceptance of a competing project.
D. require all managers to consider.
28. In choosing from among mutually exclusive investments the manager should normally select
the one with the highest
A. Net present value. C. Profitability index.
B. Internal rate return. D. Book rate of return.
53. Why do the NPV method and the IRR method sometimes produce different rankings of
17. A thorough evaluation of how well a project’s actual performance matches the projections
made when the project was proposed is called a
A. pre-audit. C. sensitivity analysis.
B. post-audit. D. risk analysis.
37. A follow-up evaluation of a capital project is performed to see that investment expenditures are
proceeding on time and on budget, to compare actual cash flows with those originally
predicted, and to evaluate continuation of the project. This follow-up is called a
A. postaudit. C. management audit
B. performance evaluation D. project review
65. Companies use post audits to:
A. chastise managers whose project does not exceed projections.
B. prove to managers that they should have accepted projects they previously rejected.
C. have the managers revise poorly performing projects so the projects will have larger
return in the future.
D. provide feedback that enables managers to improve the accuracy of the projections of
future cash flows, thereby maximizing the quality of the firm’s capital investments.
