Chapter 14—Capital Investment Decisions
TRUE/FALSE
1. Projects that do not affect the cash flows of other projects are called mutually exclusive projects.
2. The process of planning, setting goals and priorities, arranging financing, and using certain criteria to
select long-term assets is called capital investment decisions.
3. Projects that if accepted preclude the acceptance of all other competing projects are called mutually
exclusive projects.
4. In capital investment decision making, it is usually assumed that managers should select projects that
attempt to maximize the wealth of the owners of the firm.
5. Taxes are important consideration in forecasting cash flows.
6. Before-tax cash flows must be forecasted and used in capital investment decision making.
7. The two major categories of capital investment decision models are independent and mutually
exclusive.
8. In order to use the payback period model, the proposed investment must have even cash inflows.
9. If cash flows are uneven, the payback period assumes that the inflows during the last fraction of a year
occur evenly.
10. One way to use the payback period is to set a maximum payback period for all projects and to reject
any project that exceeds this level.
11. Sometimes firms require riskier projects to have longer payback periods.
12. Companies considering projects with shorter lives are interested in longer payback periods.
13. A disadvantage of the payback period is that it ignores a project’s total profitability.
14. A disadvantage of the payback period is that it ignores the time value of money.
15. Only accounting rate of return ignores the time value of money.
16. The payback period considers the profitability of a project over its entire life span.
17. Two discounting models for capital investment decision making are net present value and internal rate
of return.
18. The difference between the present value of the cash inflows and outflows associated with a project is
the internal rate of return model.
19. The minimum acceptable rate of return for a project is the required rate of return.
20. In practice, managers often choose a discount rate that is higher than the cost of capital.
21. Suppose that the actual cost of capital is 10%, but the firm chooses a discount rate of 18%. Managers
of that company will be more likely to choose relatively short term investments.
22. If the net present value of an investment is zero, the investment earns less than the minimum required
rate of return.
23. The interest rate that sets the present value of a project’s cash inflows equal to the present value of the
project’s cost is called the internal rate of return.
24. The internal rate of return is the least widely used of the capital investment techniques.
25. One drawback to the internal rate of return model is that cash inflows must occur evenly over the life
of the investment.
26. The internal rate of return is the most widely used of the capital investment techniques.
27. A postaudit evaluates the overall outcome of the investment and proposes corrective action if needed.
28. In general, it is best if postaudits are done by company management, since they understand the actual
operating conditions.
29. A disadvantage of postaudits is that they are costly.
30. A postaudit is an analysis of a capital project before it is implemented.
31. A key element in the capital investment process is called a postaudit.
32. Companies that perform postaudits of capital projects experience a number of benefits.
33. Postaudits ensure that resources are used wisely by evaluating profitability.
34. Because of the postaudit, managers are more likely to make capital investment decisions in the best
interests of the firm.
35. Postaudits supply feedback to managers that should help improve future decision making.
36. Less objective results are obtainable if an independent party performs the postaudit of a capital
investment.
37. The internal audit staff is usually the best choice for performing a postaudit of a capital investment.
38. An obvious problem with postaudits is that the assumptions driving the original analysis may often be
invalidated by changes in the actual operating environment.
39. Net present value analysis and internal rate of return analysis can sometimes produce erroneous
choices because they ignore the time value of money.
40. For independent projects, net present value analysis and internal rate of return analysis yield the same
decision.
41. The internal rate of return model does not consistently result in choices that maximize firm wealth.
MATCHING
Match each item with the correct statement below.
a.
Payback period
b.
Accounting rate of return
c.
Net present value
d.
Internal rate of return
e.
Discount rate
f.
Annuity
g.
Post-audit
h.
Compounding of interest
1. can be used as a rough measure of risk and liquidity
2. can be used to determine whether or not an investment will negatively affect key financial ratios
3. interest rate used to discount future cash flows
4. assumes that all future cash inflows earn the minimum rate of return
5. assumes that all future cash inflows earn the same rate of return as the project itself
6. a series of equal future cash flows
7. comparison of actual benefits and costs of a project with the expected benefits and costs
8. is the best method discounting model to use for mutually exclusive competing projects
9. earning of interest on interest
COMPLETION
1. _______________________ are concerned with the process of planning, setting goals and priorities,
arranging financing, and using certain criteria to select long-term assets.
2. The process of making capital investment decisions often is referred to as ________________.
3. The two types of capital budgeting projects are ________________ and _______________.
4. ______________________ are projects that, if accepted or rejected, do not affect the cash flows of
other projects.
5. _____________________ explicitly consider the time value of money.
6. _______________________ ignore the time value of money.
7. The ______________ is the time required for a firm to recover its original investment.
8. The _________________________ measures the return on a project in terms of income.
9. _______________________ are the future cash flows expressed in terms of their present value.
10. The difference between the present value of the cash inflows and the outflows associated with a project
is known as the ___________________.
11. The ___________________ is the minimum acceptable rate of return.
12. The _______________________ is defined as the interest rate that sets the present value of a project’s
cash inflows equal to the present value of the project’s cost.
13. If the internal rate of return (IRR) is greater than the required rate, the project is deemed ___________.
14. If the internal rate of return (IRR) is less than the required rate of return, the project is __________.
15. A key element in the capital investment process is a follow-up analysis of a capital project once it is
implemented; this analysis is a called a _____________.
16. The major disadvantage of a postaudit is that it is ____________.
17. When choosing among competing projects, the ___________________ model correctly identifies the
best investment alternative.
18. When choosing among competing alternatives the ________________ model may choose an inferior
project.
19. The amount that must be invested now to produce a future value is known as the ____________ of the
future amount.
20. The value of an investment at the end of its life is called its ________________.
MULTIPLE CHOICE
1. Which of the following is true of capital investment decision making?
a.
It is used only for independent projects.
b.
It is used only for mutually exclusive projects.
c.
It requires that funding for a project must come from sources with the same opportunity
cost of funds.
d.
It is used to determine whether or not a firm should accept a special order.
e.
None of these.
2. In general terms, a sound capital investment will earn
a.
back its original capital outlay.
b.
a return greater than existing capital investments.
c.
back its original capital outlay and provide a reasonable return on the original investment.
d.
back its original capital outlay by the midpoint of its useful life.
e.
None of these.
3. To make a capital investment decision, a manager must estimate the
a.
quantity of cash flows.
b.
timing of cash flows.
c.
risk of the investment.
d.
impact of the investment on the firm’s profitability.
e.
All of these.
4. If the cash flows of a project are received evenly over the life of the project, the formula for the
calculating the payback period is
a.
original investment/annual cash flow.
b.
original investment annual cash flow.
c.
original investment + annual cash flow.
d.
original investment − annual cash flow.
e.
(original investment + annual cash flow)/annual cash flow.
5. The payback period provides information to managers that can be used to help
a.
control the risks associated with the uncertainty of future cash flows.
b.
minimize the impact of an investment on a firm’s liquidity problems.
c.
control the risk of obsolescence.
d.
control the effect of the investment on performance measures.
e.
All of these.
6. Which of the following is a drawback of the payback period?
a.
It ignores a project’s total profitability.
b.
It uses a set discount rate.
c.
It considers total profitability, requiring the forecasting of all future cash flows.
d.
It uses before-tax cash flows rather than after-tax cash flows.
e.
It uses operating income rather than cash flows.
7. A formula for the accounting rate of return is
a.
average income/initial investment.
b.
initial investment/annual cash flow.
c.
annual cash flow/initial investment.
d.
initial investment/average income.
e.
(average income + initial investment)/initial investment.
8. Managers may use the accounting rate of return to evaluate potential investment projects because
a.
debt contracts require that a firm maintain certain ratios that are affected by income and
long-term asset levels.
b.
it serves as a screening measure to insure that new investments do not affect key financial
ratios.
c.
bonuses to managers may be based on accounting income and/or return on assets.
d.
it can be tied to the manager’s personal income.
e.
All of these.
9. The time required for a firm to recover its original investment is the
a.
internal rate of return.
b.
net present value.
c.
life of the project.
d.
accounting rate of return.
e.
payback period.
10. When the risk of obsolescence is high, managers will want
a.
a shorter payback period.
b.
a longer payback period.
c.
a payback period equal to the life of the investment.
d.
All of these.
e.
None of these.
11. One disadvantage of the payback period is that
a.
it is sometimes used as a crude measure of risk.
b.
managers may choose investments with quick payback periods to maximize short term
criteria on which their own bonuses, etc. may be based.
c.
it cannot be used for investments with unequal cash inflows.
d.
it cannot be used if the entire cost of the investment does not occur immediately.
e.
All of these.
12. A division manager was considering a project that required a significant initial investment. If accepted,
the project could have a negative impact on certain financial ratios that the firm was required to
maintain to satisfy debt contracts. To ensure that the ratios would not be adversely affected by the
investment, the manager would use which of the following capital investment models?
a.
payback period
b.
accounting rate of return
c.
net present value
d.
internal rate of return
e.
None of these.
13. Greg Moss has just invested $120,000 in a coffee shop. He expects to receive cash income of $15,000
a year. What is the payback period?
a.
5 years
b.
7.7 years
c.
4.5 years
d.
6.5 years
e.
8 years
14. Carol Harrison is considering an investment in a retail shopping mall. The initial investment is
$400,000. She expects to receive cash income of $80,000 a year. What is the payback period?
a.
4 year
b.
3.5 years
c.
5 years
d.
2.5 years
e.
6 years
15. Elena Wallace invested $150,000 in a project that pays her an even amount per year for 10 years. The
payback period is 6 years. What are Elena’s yearly cash inflows from the project?
a.
$150,000
b.
$15,000
c.
$25,000
d.
$90,000
e.
Cannot be determined from this information.
16. Tessa Wilson invested in a project with a payback period of 6 years. The project brings $18,000 per
year for a period of 9 years. What was the initial investment?
a.
$108,000
b.
$107,500
c.
$162,000
d.
$240,000
e.
Cannot be determined from this information.
17. Neil Morrison has just invested $130,000 in a restaurant. He expects to receive income of $24,000 a
year, and to have the investment for 8 years. What is the accounting rate of return?
a.
5.60%
b.
18.46%
c.
14.52%
d.
12.41%
e.
4.50%
18. An investment of $5,000 provides an average net cash flows of $320 with zero salvage value.
Depreciation is $35 per year. The accounting rate of return using the original investment is
a.
4.0%
b.
5.1%
c.
5.7%
d.
3.2%
e.
2.4%
19. Buster Evans is considering investing $20,000 in a project with the following annual cash revenues
and expenses:
Cash
Cash
Revenues
Expenses
Year 1
$ 8,000
$ 8,000
Year 2
$12,000
$ 8,000
Year 3
$15,000
$ 9,000
Year 4
$20,000
$10,000
Year 5
$20,000
$10,000
Depreciation will be $4,000 per year.
What is the accounting rate of return on the investment?
a.
15%
b.
35%
c.
70%
d.
75%
e.
None of these.
20. Coriander Company is considering a project with an initial investment of $426,800 in new equipment
that will yield annual net cash flows of $80,000, and will be depreciated at $53,350 per year over its
eight year life. What is the accounting rate of return?
a.
320%
b.
18.74%
c.
6.24%
d.
31.27%
e.
50.0%
21. When comparing the payback method and the accounting rate of return methods, which of the
following is true?
Profitability
Time Value of Money
i
Ignored by both methods
Ignored by both methods
ii
Ignored by both methods
Used in accounting rate of return; ignored
by payback method
iii
Considered by accounting method, not by
payback
Ignored by both methods
iv
Considered by accounting method, not by
payback
Considered by both methods
Year 1
Year 2
Year 3
Year 4
Year 5
Total Income
a.
i
b.
ii
c.
iii
d.
iv
22. Oakland Shop is considering the purchase of a used printing press costing $9,600. The printing press
would generate a net cash inflow of $4,000 per year for three years. At the end of three years, the press
would have no salvage value. The company’s cost of capital is 10%. The company uses straight-line
depreciation with no mid-year convention.
What is the accounting rate of return on the original investment in the press to the nearest percent,
assuming no taxes are paid?
a.
41.67%
b.
8.33%
c.
75.00%
d.
10.00%
Figure 14-1.
A company is considering two projects.
Project I
Project II
Initial investment
$120,000
$120,000
Cash inflow Year 1
$40,000
$20,000
Cash inflow Year 2
$40,000
$20,000
Cash inflow Year 3
$40,000
$32,000
Cash inflow Year 4
$40,000
$48,000
Cash inflow Year 5
$40,000
$50,000
23. Refer to Figure 14-1. What is the payback period for Project I?
a.
1 year
b.
3 years
c.
2.5 years
d.
3.5 years
e.
5 years
24. Refer to Figure 14-1. What is the payback period for Project II?
a.
1 year
b.
2 years
c.
3.5 years
d.
4 years
e.
5 years
Figure 14-2.
A company is considering two projects.
Project A
Project B
Initial investment
$200,000
$200,000
Cash inflow Year 1
$50,000
$90,000
Cash inflow Year 2
$50,000
$90,000
Cash inflow Year 3
$50,000
$40,000
Cash inflow Year 4
$50,000
$30,000
Cash inflow Year 5
$50,000
$30,000
25. Refer to Figure 14-2. What is the payback period for Project A?
a.
4.5 year
b.
2.5 years
c.
5 years
d.
3.5 years
e.
4 years
26. Refer to Figure 14-2. What is the payback period for Project B?
a.
2 years
b.
4.5 years
c.
3.5 years
d.
2.5 years
e.
3 years