Accounting, 9e (Horngren)
Chapter 21 Capital Investment Decisions and the Time Value of Money
Learning Objective 21-1
1) A post-audit is an analysis of an investment that is made after the investment is underway or completed.
2) Capital rationing is when a company has limited resources, and it must find ways to reduce operating expenses in
all of its divisions and units.
3) All else being equal, investments with longer payback periods are more desirable.
4) The further into the future the investment cash flows extend, the more likely it is that actual results will differ
from the initial predictions.
5) Short-term investment decisions are inherently riskier than long-term decisions because they have a shorter period
in which to recoup the investment.
6) The payback period and rate of return (ROR) methods are more suitable to investments with a shorter time span.
7) The payback method and the rate of return method are often used to perform an initial screening of investments,
rather than a detailed in-depth analysis.
8) Most capital budgeting methods focus on cash flows rather than book income.
9) When projecting the cash flows of an investment, the inflows are netted against the outflows.
10) Capital budgeting methods which do NOT incorporate time value of money are generally used for the initial
stage of screening investment alternatives.
11) Which of the following BEST describes a post-audit?
A) An audit of an operating unit of a company
B) An audit performed after financial statements have been issued
C) An analysis of an investment’s cash flows prior to committing to the initial investment
D) An analysis of an investment that is made after the investment is underway or completed
12) Which of the following BEST describes the term capital rationing?
A) When a company’s resources are limited, it is choosing between alternative investment opportunities.
B) When a company has unlimited resources, it is finding the most number of profitable investment opportunities.
C) When a company is encountering cash flow shortages, it is finding ways of increasing revenues.
D) When a company has limited resources, it is finding ways to cut operating costs.
13) After a company invests in capital assets, which of the following activities will it perform in order to compare
the actual to the projected net cash inflows?
A) Cash flow analysis
B) Post-audit
C) Pre and post analysis
D) Post-cash flow
14) Which of the following capital budgeting models is most likely to be used if a company’s goal is to maximize
their operating book income?
A) Payback
B) Net present value
C) Internal rate of return
D) Rate of return
15) Capital budgeting applies to which of the following?
A) Budgeting for yearly operational expenses
B) Making decisions about sales budgets for the coming year
C) Deciding among various long-term investment decisions
D) Making decisions about the financing of operations
16) Which of the following is a common capital budgeting method?
A) Return on assets
B) Net present value
C) Inventory turnover
D) Debt-to-equity ratio
17) Which of the following is a common capital budgeting method?
A) Return on assets
B) Acid test ratio
C) Internal rate of return
D) Debt-to-equity ratio
18) Which of the following is the ONLY capital budgeting method which uses accrual accounting information?
A) Payback period
B) Rate of return (ROR)
C) Net present value (NPV)
D) Internal rate of return (IRR)
19) Which two methods are typically used for initial screening of investments, rather than for detailed in–depth
analysis?
A) Payback and rate of return
B) Net present value and payback
C) Internal rate of return and net present value
D) Rate of return and net present value
20) When projecting future cash flows of an investment, which of the following is TRUE?
A) Cash flow data must also include non-cash transactions like depreciation.
B) Cash inflows and cash outflows are treated separately, rather than being netted together.
C) Cash flows are typically projected by accounting personnel without input from other business functions.
D) The initial investment is always treated separately from all other cash flows.
21) Which of the following describes the purpose of a post-audit?
A) To screen initial investment alternatives
B) To determine whether investments are going as planned, or whether they should be abandoned
C) To determine the amount of the initial investment outlay
D) To evaluate the company’s internal controls
22) Capital budgeting is:
A) planning how to invest in long-term assets.
B) budgeting for operating expenses.
C) evaluating the ongoing profitability of a business.
D) making pricing decisions for products.
Learning Objective 21-2
1) The rate of return method and the payback method are often used as preliminary screening measures, but are
insufficient to fully evaluate a capital investment.
2) The payback method can only be used when the net cash inflows from a capital investment are the same for each
period.
3) A criticism of the rate of return method is that it ignores the time value of money.
4) The payback method is a very thorough and comprehensive way to choose the best investment among
alternatives.
5) The payback method uses discounted cash flows to make investment decisions.
6) The payback method ignores cash flows after the payback period, whereas the rate of return includes them.
7) Neither the payback period nor the rate of return capital budgeting method recognizes the time value of money.
8) The payback method and the rate of return method are both conceptually better than the discounted cash flow
models because they are based on cash flows.
9) The rate of return is the only capital budgeting method that uses accrual accounting.
10) The rate of return calculations ignores the time value of money, but the payback period does include
consideration of the time value of money.
11) The payback method and the rate of return method are powerful, comprehensive evaluation tools, and would
normally be sufficient to make a final investment decision.
12) Which of the following methods ignores the time value of money?
A) Payback
B) Internal rate of return
C) Return on assets
D) Net present value
13) Which capital budgeting method uses accrual accounting, rather than net cash flows, as a basis for calculations?
A) Payback
B) Rate of return
C) Net present value
D) Internal rate of return
14) Which of the following is TRUE regarding capital rationing decisions for capital assets?
A) Companies should always choose the investment with the shortest payback period.
B) Companies should always choose the investment with the highest net present value.
C) Companies should always choose the investment with the highest rate of return.
D) Companies should consider several different methods of evaluation before choosing an investment.
15) Simms Manufacturing is considering two alternative investment proposals with the following data:
Proposal X Proposal Y
Investment $620,000 $400,000
Useful life 8 years 8 years
Estimated annual net cash inflows for 8 years $130,000 $80,000
Residual value $60,000 $0
Depreciation method Straight-line Straight-line
Required rate of return 14% 10%
How long is the payback period for Proposal X?
A) 4.50 years
B) 4.77 years
C) 8 years
D) 10.33 years
16) Simms Manufacturing is considering two alternative investment proposals with the following data:
Proposal X Proposal Y
Investment $620,000 $400,000
Useful life 8 years 8 years
Estimated annual net cash inflows for 8 years $130,000 $80,000
Residual value $60,000 $0
Depreciation method Straight-line Straight-line
Required rate of return 14% 10%
What is the accounting rate of return for Proposal Y?
A) 15.0%
B) 16.0%
C) 20.0%
D) 40.0%
17) ABC Company is adding a new product line that will require an investment of $1,500,000. The product line is
estimated to generate cash inflows of $300,000 the first year, $250,000 the second year, and $200,000 each year
thereafter for ten more years. What is the payback period?
A) 2.73 years
B) 6.00 years
C) 6.75 years
D) 7.25 years
18) Logan, Inc. is evaluating two possible investments in depreciable plant assets. The company uses the straight–
line method of depreciation. The following information is available:
Investment A Investment B
Initial capital investment $60,000 $90,000
Estimated useful life 3 years 3 years
Estimated residual value — 0 — — 0 —
Estimated annual net cash inflow for 3 years $25,000 $40,000
Required rate of return 10% 12%
How long is the payback period for Investment A?
A) 0.4 years
B) 2.4 years
C) 2.5 years
D) 3.0 years
19) Logan, Inc. is evaluating two possible investments in depreciable plant assets. The company uses the straight–
line method of depreciation. The following information is available:
Investment A Investment B
Initial capital investment $60,000 $90,000
Estimated useful life 3 years 3 years
Estimated residual value — 0 — — 0 —
Estimated annual net cash inflow for 3 years $25,000 $40,000
Required rate of return 10% 12%
How long is the payback period for Investment B?
A) 0.44 years
B) 2.25 years
C) 2.35 years
D) 3.00 years
20) Atlantic Company is considering investing in specialized equipment costing $360,000. The equipment has a
useful life of 5 years and a residual value of $45,000. Depreciation is calculated using the straight-line method. The
expected net cash inflows from the investment are:
Year 1 $160,000
Year 2 130,000
Year 3 100,000
Year 4 55,000
Year 5 40,000
$485,000
What is the rate of return on the investment?
A) 16.8%
B) 23.9%
C) 18.9%
D) 12.4%
21) Landmark Company is considering an investment in new equipment costing $360,000. The equipment will be
depreciated on a straight-line basis over a five-year life and is expected to generate net cash inflows of $70,000 the
first year, $80,000 the second year, and $120,000 every year thereafter until the fifth year. What is the payback
period for this investment? The residual value is zero.
A) 3.25 years
B) 3.50 years
C) 3.75 years
D) 4 years
22) Pearl Manufacturing is considering an investment in equipment costing $660,000. The equipment will be
depreciated on the straight-line basis over an eight-year period with an estimated residual value of $120,000. The
investment is expected to generate annual net cash inflows of $135,000 for 8 years. Using the rate of return model,
what is the minimum average annual operating income that must be generated from this investment in order to
achieve a 14% rate of return?
A) $18,900
B) $37,800
C) $54,600
D) $92,400
23) Sun Company is considering purchasing new equipment costing $350,000. Sun’s management has estimated that
the equipment will generate cash flows as follows:
Year 1 $100,000
Year 2 $100,000
Year 3 $125,000
Year 4 $125,000
Year 5 $75,000
What is the payback period?
A) 4 years
B) 3.2 years
C) 3.5 years
D) 3 years
24) Sullivan Company is considering the purchase of a new machine costing $80,000. Sullivan’s management is
estimating that the new machine will generate additional cash flows of $12,000 a year for ten years and have a
salvage value of $3,000 at the end of ten years. What is the machine’s payback period?
A) 7 years
B) 6.7 years
C) 6 years
D) 5.33 years
25) Dylan Company is considering an investment in new equipment costing $720,000. The equipment will be
depreciated on a straight-line basis over a five-year life and is expected to have a salvage value of $45,000. The
equipment is expected to generate net cash flows totaling $970,000 during the five years. What is the rate of return
associated with the equipment investment?
A) 15.4%
B) 16.4%
C) 30.4%
D) 13.9%
26) Clapton Corporation is considering an investment in new equipment costing $900,000. The equipment will be
depreciated on a straight-line basis over a ten-year life and is expected to have a salvage value of $90,000. The
equipment is expected to generate net cash flows of $140,000 for each of the first five years and $100,000 for each
of the last five years. What is the accounting rate of return associated with the equipment investment?
A) 12.1%
B) 7.9%
C) 17.3%
D) 9.7%
27) Wasson Corporation is considering an investment project costing $520,000. The project is estimated to have an
eight-year life, generate annual cash flows of $120,000, and have a salvage value of $40,000 after eight years. What
is the project’s payback period?
A) 2.8 years
B) 4.3 years
C) 4 years
D) 6.5 years
28) A company is evaluating 3 possible investments. Each uses straight-line depreciation. See data below:
Project A Project B Project C
Investment $400,000 $20,000 $100,000
Salvage value $0 $2,000 $5,000
Net cash flows:
Year 1 $100,000 $10,000 $40,000
Year 2 $100,000 $8,000 $25,000
Year 3 $100,000 $5,000 $30,000
Year 4 $100,000 $3,000 $10,000
Year 5 $100,000 $0 $0
What is the payback period for Project A?
A) 3.5 years
B) 4.5 years
C) 4.0 years
D) 5.0 years
29) A company is evaluating 3 possible investments. Each uses straight-line depreciation. See data below:
Project A Project B Project C
Investment $400,000 $20,000 $100,000
Salvage value $0 $2,000 $5,000
Net cash flows:
Year 1 $100,000 $10,000 $40,000
Year 2 $100,000 $8,000 $25,000
Year 3 $100,000 $5,000 $30,000
Year 4 $100,000 $3,000 $10,000
Year 5 $100,000 $0 $0
What is the payback period for Project B?
A) 3.5 years
B) 2.5 years
C) 2.4 years
D) 3.0 years
30) A company is evaluating 3 possible investments. Each uses straight-line depreciation. See data below:
Project A Project B Project C
Investment $400,000 $20,000 $100,000
Salvage value $0 $2,000 $5,000
Net cash flows:
Year 1 $100,000 $10,000 $40,000
Year 2 $100,000 $8,000 $25,000
Year 3 $100,000 $5,000 $30,000
Year 4 $100,000 $3,000 $10,000
Year 5 $100,000 $0 $0
What is the payback period for Project C?
A) 3.5 years
B) 2.5 years
C) 2.4 years
D) 3.0 years
31) A company is evaluating 3 possible investments. Each uses straight-line depreciation. See data below:
Project A Project B Project C
Investment $400,000 $20,000 $100,000
Salvage value $0 $2,000 $5,000
Net cash flows:
Year 1 $100,000 $10,000 $40,000
Year 2 $100,000 $8,000 $25,000
Year 3 $100,000 $5,000 $30,000
Year 4 $100,000 $3,000 $10,000
Year 5 $100,000 $0 $0
What is the rate of return for Project A?
A) 50%
B) 4%
C) 16%
D) 10%
32) A company is evaluating 3 possible investments. Each uses straight-line depreciation. See data below:
Project A Project B Project C
Investment $400,000 $20,000 $100,000
Salvage value $0 $2,000 $5,000
Net cash flows:
Year 1 $100,000 $10,000 $40,000
Year 2 $100,000 $8,000 $25,000
Year 3 $100,000 $5,000 $30,000
Year 4 $100,000 $3,000 $10,000
Year 5 $100,000 $0 $0
What is the rate of return for Project B?
A) 50%
B) 4%
C) 18%
D) 10%
33) A company is evaluating 3 possible investments. Each uses straight-line depreciation. See data below:
Project A Project B Project C
Investment $400,000 $20,000 $100,000
Salvage value $0 $2,000 $5,000
Net cash flows:
Year 1 $100,000 $10,000 $40,000
Year 2 $100,000 $8,000 $25,000
Year 3 $100,000 $5,000 $30,000
Year 4 $100,000 $3,000 $10,000
Year 5 $100,000 $0 $0
What is the rate of return for Project C?
A) 5%
B) 4%
C) 18%
D) 10%