31
2) The profitability index can be helpful when a financial manager encounters a situation where capital
rationing is required.
Keywords: Profitability Index, Capital Rationing
Learning Obj.: L.O. 10.3
AACSB: Reflective Thinking
3) Positive NPV projects may be rejected when capital must be rationed.
Keywords: Capital Rationing, Net Present Value (NPV)
Learning Obj.: L.O. 10.3
AACSB: Reflective Thinking
4) Capital rationing generally leads to higher stock prices as management is doing the best job it can in
selecting only the best capital budgeting projects.
Keywords: Capital Rationing, Firm Value
Learning Obj.: L.O. 10.3
AACSB: Analytical Thinking
5) When capital rationing exists, the divisibility of projects is ignored and projects are funded in order of
their PI’s or IRR’s.
Keywords: Capital Rationing, PI, IRR
Learning Obj.: L.O. 10.3
AACSB: Reflective Thinking
6) The net present value always provides the correct decision provided that
A) cash flows are constant over the asset’s life.
B) the required rate of return is greater than the internal rate of return.
C) capital rationing is not imposed.
D) the internal rate of return is positive.
Keywords: Net Present Value, Capital Rationing
Learning Obj.: L.O. 10.3
AACSB: Analytical Thinking
32
7) Capital rationing may be imposed because of all of the following EXCEPT
A) capital market conditions are poor.
B) management has a fear of debt.
C) stockholder control problems prevent issuance of additional stock.
D) the company‘s stock price is at an historically high level.
Keywords: Capital Rationing
Learning Obj.: L.O. 10.3
AACSB: Reflective Thinking
8) You are in charge of one division of Yeti Surplus Inc. Your division is subject to capital rationing. Your
division has 4 indivisible projects available, detailed as follows:
Project
Initial Outlay
IRR
NPV
1
2 million
18%
2,500,000
2
1 million
15%
950,000
3
1 million
10%
600,000
4
3 million
9%
2,000,000
If you must select projects subject to a budget constraint of 5 million dollars, which set of projects should
be accepted so as to maximize firm value?
A) Projects 1, 2 and 3
B) Project 1 only
C) Projects 1 and 4
D) Projects 2, 3 and 4
Keywords: Capital Rationing, Net Present Value (NPV)
Learning Obj.: L.O. 10.3
AACSB: Analytical Thinking
9) Under what condition would you NOT accept a project that has a positive net present value?
A) If the project has a profitability index less than zero.
B) If two or more projects are mutually inclusive.
C) If the firm is limited in the capital it has available (capital rationing).
D) If a project has more than one sign reversal.
Keywords: Net Present Value, Capital Rationing
Learning Obj.: L.O. 10.3
AACSB: Reflective Thinking
33
10) I301 Motors has several investment projects under consideration, all with positive net present values.
However, due to a shortage of trained personnel, a limit of $1,250,000 has been placed on the capital
budget for this year. Which of the projects listed below should be included in this year’s capital budget?
Explain your answer.
Project
Initial Outlay
NPV
A
$250,000
$325,000
B
250,000
350,000
C
100,000
700,000
D
112,500
E
375,000
75,000
Keywords: Capital Rationing, Net Present Value (NPV)
Learning Obj.: L.O. 10.3
AACSB: Reflective Thinking
11) How might capital rationing conflict with the goal of maximizing shareholders‘ wealth?
Keywords: Capital Rationing
Learning Obj.: L.O. 10.3
AACSB: Reflective Thinking
Learning Objective 10.4
1) If two projects are mutually exclusive, then the IRR is more important than the NPV in deciding the
project that should be chosen.
Keywords: Mutually Exclusive, IRR, NPV
Learning Obj.: L.O. 10.4
AACSB: Analytical Thinking
34
2) IRR should not be used to choose between mutually exclusive projects.
Keywords: IRR, Mutually Exclusive Projects
Learning Obj.: L.O. 10.4
AACSB: Reflective Thinking
3) The mutually exclusive project with the highest positive NPV will also have the highest IRR.
Keywords: Mutually Exclusive Projects, NPV, IRR
Learning Obj.: L.O. 10.4
AACSB: Analytical Thinking
4) The size disparity problem occurs when mutually exclusive projects of unequal size are being
examined.
Keywords: Size Disparity, Mutually Exclusive Projects
Learning Obj.: L.O. 10.4
AACSB: Reflective Thinking
5) A project’s equivalent annual annuity (EAA) is the annuity cash flow that yields the same present
value as the project’s NPV.
Keywords: Equivalent Annual Annuity
Learning Obj.: L.O. 10.4
AACSB: Reflective Thinking
6) An infinite-life replacement chain allows projects of different lengths to be compared.
Keywords: Infinite-life Replacement Chain
Learning Obj.: L.O. 10.4
AACSB: Reflective Thinking
7) Two projects are mutually exclusive if the accept/reject decision for one project has no impact on the
accept/reject decision for the other project.
Keywords: Mutually Exclusive Projects
Learning Obj.: L.O. 10.4
AACSB: Reflective Thinking
8) Finance theory suggests that the IRR criterion is the most favorable capital budgeting decision tool.
Keywords: NPV, IRR
Learning Obj.: L.O. 10.4
AACSB: Reflective Thinking
35
9) Both the profitability index (PI) and net present value (NPV) are based on the present value of all
future free cash flows, but the PI is a relative measure while the NPV is an absolute measure of a project’s
desirability.
Keywords: Profitability Index, Net Present Value
Learning Obj.: L.O. 10.4
AACSB: Reflective Thinking
10) If a project’s IRR is equal to its required return, then the project‘s NPV is equal to zero and its PI is
equal to one.
Keywords: NPV, PI, IRR
Learning Obj.: L.O. 10.4
AACSB: Analytical Thinking
11) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is
expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected
to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four.
Lithium, Inc.’s required rate of return for these projects is 10%. The equivalent annual annuity amount for
project A is
A) $12,989.
B) $13,357.
C) $15,024.
D) $18,532.
Keywords: Equivalent Annual Annuity
Learning Obj.: L.O. 10.4
AACSB: Analytical Thinking
36
12) Interstate Appliance Inc. is considering the following 3 mutually exclusive projects. Projected cash
flows for these ventures are as follows:
Plan A
Plan B
Plan C
Initial
Initial
Initial
Outlay = $3,600,000
Outlay = $6,000,000
Outlay = $3,500,000
Cash Flow:
Cash Flow:
Cash Flow:
Yr 1 = $-0-
Yr 1 = $4,000,000
Yr 1 = $2,000,000
Yr 2= -0-
Yr 2 = 3,000,000
Yr 2 = -0-
Yr 3 = -0-
Yr 3 = 2,000,000
Yr 3 = 2,000,000
Yr 4 = -0-
Yr 4 = -0-
Yr 4 = 2,000,000
Yr 5 = $7,000,000
Yr 5 = -0-
Yr 5 = 2,000,000
If Interstate Appliance has a 12% cost of capital, what decision should be made regarding the projects
above?
A) accept plan A
B) accept plan B
C) accept plan C
D) accept Plans A, B and C
Keywords: Net Present Value, Mutually Exclusive Projects
Learning Obj.: L.O. 10.4
AACSB: Analytical Thinking
13) Your company is considering an investment in one of two mutually exclusive projects. Project 1
involves a labor intensive production process. Initial outlay for Project 1 is $1,495 with expected after-tax
cash flows of $500 per year in years 1-5. Project 2 involves a capital intensive process, requiring an initial
outlay of $6,704. After-tax cash flows for Project 2 are expected to be $2,000 per year for years 1-5. Your
firm’s discount rate is 10%. If your company is not subject to capital rationing, which project(s) should
you take on?
A) Project 1
B) Project 2
C) Projects 1 and 2
D) Neither project is acceptable.
Keywords: Mutually Exclusive Projects, Net Present Value
Learning Obj.: L.O. 10.4
AACSB: Reflective Thinking
37
14) Your firm is considering investing in one of two mutually exclusive projects. Project A requires an
initial outlay of $3,500 with expected future cash flows of $2,000 per year for the next three years. Project
B requires an initial outlay of $2,500 with expected future cash flows of $1,500 per year for the next two
years. The appropriate discount rate for your firm is 12% and it is not subject to capital rationing.
Assuming both projects can be replaced with a similar investment at the end of their respective lives,
compute the NPV of the two chain cycle for Project A and three chain cycle for Project B.
A) $2,232 and $85
B) $5,000 and $1,500
C) $2,865 and $94
D) $3,528 and $136
Keywords: Replacement Chain, Net Present Value, Mutually Exclusive Projects
Learning Obj.: L.O. 10.4
AACSB: Analytical Thinking
15) Determine the five-year equivalent annual annuity of the following project if the appropriate discount
rate is 16%.
Initial Outflow = $150,000
Cash Flow Year 1 = $40,000
Cash Flow Year 2 = $90,000
Cash Flow Year 3 = $60,000
Cash Flow Year 4 = $0
Cash Flow Year 5 = $80,000
A) $7,058
B) $8,520
C) $9,454
D) $9,872
Keywords: Equivalent Annual Annuity
Learning Obj.: L.O. 10.4
AACSB: Analytical Thinking
16) Which of the following statements about the net present value is true?
A) It produces a percentage result that is easy to describe.
B) It has an inadequate reinvestment assumption.
C) It is likely that there will be more than one NPV for a project.
D) It may be used to select among projects of different sizes.
Keywords: Net Present Value, Unequal Size Projects
Learning Obj.: L.O. 10.4
AACSB: Reflective Thinking