978-0134083285 Chapter 10 Part 1

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Foundations of Finance, 9e (Keown/Martin/Petty)

Chapter 10 Capital-Budgeting Techniques and Practice

Learning Objective 10.1

1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal.

Keywords: Capital Budgeting, Free Cash Flow

Learning Obj.: L.O. 10.1

AACSB: Reflective Thinking

2) Why is the search for new profitable projects so important?

Keywords: Capital Budgeting

Learning Obj.: L.O. 10.1

AACSB: Reflective Thinking

Learning Objective 10.2

1) The most critical aspect in determining the acceptability of a capital budgeting project is the impact the

project will have on the company‘s net income over the projects entire useful life.

Keywords: Income vs. Cash Flow

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

2) Advantages of the payback period include that it is easy to calculate, easy to understand, and that it is

based on cash flows rather than on accounting profits.

Keywords: Payback Period

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

3) If project A generates $10 million of free cash flow over its five year useful life and project B generates

$8 million of free cash flow over its five year useful life, then Project A will have a shorter payback period

than Project B, assuming both projects require the same initial investment.

Keywords: Payback Period

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

4) A project with a payback period of four years is acceptable as long as the company‘s target payback

period is greater than or equal to four years.

Keywords: Payback Period

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

5) Two projects that have the same cost and the same expected cash flows will have the same net present

value.

Keywords: Net Present Value, Discount Rate

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

6) The profitability index is the ratio of the company‘s net income (or profits) to the initial outlay or cost

of a capital budgeting project.

Keywords: Profitability Index

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

7) If a project is acceptable using the net present value criteria, then it will also be acceptable under the

less stringent criteria of the payback period.

Keywords: Net Present Value, Payback Period

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

8) An acceptable project should have a net present value greater than or equal to zero and a profitability

index greater than or equal to one.

Keywords: Net Present Value, Profitability Index

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

9) If a project‘s internal rate of return is greater than the project’s required return, then the project’s

profitability index will be greater than one.

Keywords: Internal Rate of Return, Profitability Index

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

10) The net present value profile clearly demonstrates that the NPV of a project increases as the discount

rate increases.

Keywords: Net Present Value Profile, Discount Rate

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

11) The modified internal rate of return represents the project’s internal rate of return assuming that

intermediate cash flows from the project can be reinvested at the project’s required return.

Keywords: Modified Internal Rate of Return, Required Return

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

12) One drawback of the payback method is that some cash flows may be ignored.

Keywords: Payback Period

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

13) The required rate of return reflects the costs of funds needed to finance a project.

Keywords: Required Return

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

14) The profitability index provides an advantage over the net present value method by reporting the

present value of benefits per dollar invested.

Keywords: Profitability Index, Net Present Value

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

15) The net present value of a project will increase as the required rate of return is decreased (assume

only one sign reversal).

Keywords: Net Present Value, Required Return

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

16) Whenever the internal rate of return on a project equals that project’s required rate of return, the net

present value equals zero.

Keywords: Internal Rate of Return, Net Present Value, Required Return

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

17) One of the disadvantages of the payback method is that it ignores time value of money.

Keywords: Payback Period, Time Value of Money

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

18) The capital budgeting decision-making process involves measuring the incremental cash flows of an

investment proposal and evaluating the attractiveness of these cash flows relative to the project’s cost.

Keywords: Capital Budgeting, Incremental Cash Flows

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

19) When several sign reversals in the cash flow stream occur, a project can have more than one IRR.

Keywords: Multiple Internal Rates of Return, Sign Reversals

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

20) Many firms today continue to use the payback method but also employ the NPV or IRR methods,

especially when large projects are being analyzed.

Keywords: Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR)

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

21) NPV is the most theoretically correct capital budgeting decision tool examined in the text.

Keywords: NPV

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

22) If the net present value of a project is zero, then the profitability index will equal one.

Keywords: Net Present Value, Profitability Index, Decision Rules

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

23) The internal rate of return will equal the discount rate when the net present value equals zero.

Keywords: Internal Rate of Return, Discount Rate, Net Present Value

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

24) Mutually exclusive projects have more than one IRR.

Keywords: Mutually Exclusive Projects, IRR

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

25) For a project with multiple sign reversals in its cash flows, the net present value can be the same for

two entirely different discount rates.

Keywords: Sign Reversals, Net Present Value, Discount Rates

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

26) The internal rate of return is the discount rate that equates the present value of the project’s future free

cash flows with the project’s initial outlay.

Keywords: Internal Rate of Return

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

27) If a project’s profitability index is less than one, then the project should be rejected.

Keywords: Profitability Index

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

28) If a project is acceptable using the NPV criteria, it will also be acceptable when using the profitability

index and IRR criteria.

Keywords: NPV, PI, IRR

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

29) If a firm imposes a capital constraint on investment projects, the appropriate decision criterion is to

select the set of projects that has the highest positive net present value subject to the capital constraint.

Keywords: Capital Constraint, Net Present Value

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

30) For any individual project, if the project is acceptable based on its internal rate of return, then the

project will also be acceptable based on its modified internal rate of return.

Keywords: Internal Rate of Return, Modified Internal Rate of Return

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

31) One positive feature of the payback period is it emphasizes the earliest forecasted free cash flows,

which are less uncertain than later cash flows and provide for the liquidity needs of the firm.

Keywords: Payback Period

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

32) The main disadvantage of the NPV method is the need for detailed, long-term forecasts of free cash

flows generated by prospective projects.

Keywords: NPV, Free Cash Flow

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

33) The profitability index is the ratio of the present value of the future free cash flows to the initial

investment.

Keywords: Profitability Index

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

34) Marketing is crucial to capital budgeting success because the goal of a good capital budgeting project

is to maximize the company‘s sales.

Keywords: Capital Budgeting, Shareholder Wealth Maximization

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

35) Because the NPV and PI methods both yield the same accept/reject decision, a company attempting to

rank capital budgeting projects for funding consideration can use either method and get the same results.

Keywords: NPV, PI

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

36) A project‘s IRR is analogous to the concept of the yield to maturity for bonds.

Keywords: IRR, Yield to Maturity

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

37) NPV assumes reinvestment of intermediate free cash flows at the cost of capital, while IRR assumes

reinvestment of intermediate free cash flows at the IRR.

Keywords: NPV, IRR, Reinvestment Rate

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

38) A project‘s net present value profile shows how sensitive the project is to the choice of a discount rate.

Keywords: Net Present Value Profile, Discount Rate

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

39) If a project has multiple internal rates of return, the lowest rate should be used for decision–making

purposes.

Keywords: Internal Rate of Return, Multiple IRRs

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

40) The payback period ignores the time value of money and therefore should not be used as a screening

device for the selection of capital budgeting projects.

Keywords: Payback Period, Time Value of Money

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

41) Many financial managers believe the payback period is of limited usefulness because it ignores the

time value of money; hence, it is referred to as the discounted payback period.

Keywords: Discounted Payback Period, Payback Period, Time Value of Money

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

42) The discounted payback period takes the time value of money into account in that it uses discounted

free cash flows rather than actual undiscounted free cash flows in calculating the payback period.

Keywords: Discounted Payback Period, Time Value of Money

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

43) Any project deemed acceptable using the discounted payback period will also be acceptable if using

the traditional payback period.

Keywords: Discounted Payback Period, Payback Period

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

44) A major disadvantage of the discounted payback period is the arbitrariness of the process used to

select the maximum desired payback period.

Keywords: Discounted Payback Period, Arbitrary Decision Rule

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

45) A project with a NPV of zero should be rejected since even the returns on U.S. Treasury bills are

greater than zero.

Keywords: NPV, Decision Rule

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

46) NPV may be calculated on an Excel spreadsheet simply by entering the project’s free cash flows into

Excel’s NPV function.

Keywords: NPV, Excel

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

47) The internal rate of return is the discount rate that equates the present value of the project’s free cash

flows with the project’s initial cash outlay.

Keywords: Internal Rate of Return

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

48) A project that is very sensitive to the selection of a discount rate will have a steep net present value

profile.

Keywords: Net Present Value Profile

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

49) Because the MIRR assumes reinvestment at the cost of capital while IRR assumes reinvestment at the

project’s IRR, the MIRR will always be less than the IRR.

Keywords: IRR, MIRR, Reinvestment Rate

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

50) Calculating the modified internal rate of return on an Excel spreadsheet involves the use of the IRR

function multiple times, once using the financing rate, and once using the reinvestment rate.

Keywords: MIRR, Excel, Reinvestment Rate

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking

51) If a project is acceptable using the NPV criterion, then it will also be acceptable using the discounted

payback period since both methods use discounted cash flows to make the accept/reject decision.

Keywords: NPV, Discounted Payback Period

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

52) If a project is acceptable using the IRR criterion, it will also be acceptable using the MIRR criterion.

Keywords: IRR, MIRR

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

53) The capital budgeting manager for XYZ Corporation, a very profitable high technology company,

completed her analysis of Project A assuming 5-year depreciation. Her accountant reviews the analysis

and changes the depreciation method to 3-year depreciation. This change will

A) increase the present value of the NCFs.

B) decrease the present value of the NCFs.

C) have no effect on the NCFs because depreciation is a non-cash expense.

D) only change the NCFs if the useful life of the depreciable asset is greater than 5 years.

Keywords: Net Present Value, Depreciation Expense

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

54) Project W requires a net investment of $1,000,000 and has a payback period of 5.6 years. You analyze

Project W and decide that Year 1 free cash flow is $100,000 too low, and Year 3 free cash flow is $100,000

too high. After making the necessary adjustments,

A) the payback period for Project W will be longer than 5.6 years.

B) the payback period for Project W will be shorter than 5.6 years.

C) the IRR of Project W will increase.

D) the NPV of Project W will decrease.

Keywords: Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR)

Learning Obj.: L.O. 10.2

AACSB: Analytical Thinking

55) Project Alpha has an internal rate of return (IRR) of 15 percent. Project Beta has an IRR of 14 percent.

Both projects have a required return of 12 percent. Which of the following statements is MOST correct?

A) Both projects have a positive net present value (NPV).

B) Project Alpha must have a higher NPV than Project Beta.

C) If the required return were less than 12 percent, Project Beta would have a higher IRR than Project

Alpha.

D) Project Beta has a higher profitability index than Project Alpha.

Keywords: Internal Rate of Return, Net Present Value, Required Return

Learning Obj.: L.O. 10.2

AACSB: Reflective Thinking