Chapter 25
CAPITAL BUDGETING AND MANAGERIAL DECISIONS
1. Capital budgeting is the process of analyzing alternative long-term investments and deciding
which assets to acquire or sell.
2. Capital budgeting decisions are risky because the outcome is uncertain, large amounts are
usually involved, the investment involves a long-term commitment, and the decision could be
difficult or impossible to reverse.
3. If the internal rate of return (IRR) of an investment is below the hurdle rate, the project should
be accepted.
4. Neither the payback period nor the accounting rate of return methods of evaluating
investments considers the time value of money.
5. An opportunity cost is the potential benefit that is lost by taking a specific action when two or
more alternative choices are available.
6. A sunk cost will change with a future course of action.
7. An out-of-pocket cost requires a current and/or future outlay of cash.
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8. Another name for relevant cost is unavoidable cost.
9. Relevant benefits refer to the additional or incremental revenue generated by selecting a
particular course or action over another.
10. Significant sunk costs are relevant to decisions about the future.
11. The concept of incremental cost is the same as the concept of differential cost.
12. A special order of goods or services should always be accepted when the incremental
revenue exceeds the incremental costs.
13. In a make or buy decision, management should focus on costs that are constant under the two
alternatives.
14. Part of the decision to accept additional business should be based on a comparison of the
incremental (differential) costs of the added production with the additional revenues to be
received.
15. Incremental costs should be considered in a make or buy decision.
16. If a company has the capacity to produce either 10,000 units of Product X or 10,000 units of
Product Y; assuming fixed costs remain constant, production restrictions are the same for both
products, and the markets for both products are unlimited; the company should commit 100% of
its capacity to the product that has the higher contribution margin.
17. The decision to accept an additional volume of business should be based on a comparison of
the revenue from the additional business with the sunk costs of producing that revenue.
18. An advantage of the break-even time (BET) method over the payback period method is that it
recognizes the time value of money.
19. In ranking choices with the break-even time (BET) method, the investment with the highest
BET measure gets the highest rank.
20. When computing payback period, the year in which a capital investment is made is year 1.
21. The payback method of evaluating an investment fails to consider how long the investment
will generate cash inflows beyond the payback period.
22. The time value of money is considered when calculating the payback period of an
investment.
23. Two investments with exactly the same payback periods are always equally valuable to an
investor.
24. The payback method, unlike the net present value method, does not ignore cash flows after
the point of cost recovery.
25. If two projects have the same risks, the same payback periods, and the same initial
investments, they are equally attractive.
26. A disadvantage of an investment with a short payback period is that it will produce revenue
for only a short period of time.
27. If the straight-line depreciation method is used, the annual average investment amount used
in calculating rate of return is calculated as (beginning book value + ending book value)/2.
28. The accounting rate of return uses cash flows in its calculation.
29. If net present values are used to evaluate two investments that have equal costs and equal
total cash flows, the one with more cash flows in the early years has the higher net present
value.
30. The net present value decision rule is: When an asset’s expected cash flows are discounted at
the required rate and yield a positive net present value, the asset should be acquired.
31. The internal rate of return equals the rate that yields a net present value of zero for an
investment.
32. Use of the internal rate of return method cannot be used with uneven cash flows.
33. Capital budgeting decisions usually involve analysis of:
A. Cash outflows only.
B. Short-term investments.
C. Long-term investments.
D. Investments with certain outcomes only.
E. Operating revenues.
34. The process of analyzing alternative investments and deciding which assets to acquire or sell
is known as:
A. Planning and control.
B. Capital budgeting.
C. Variance analysis.
D. Master budgeting.
E. Managerial accounting.
35. Capital budgeting decisions are generally based on:
A. Tentative predictions of future outcomes.
B. Perfect predictions of future outcomes.
C. Results from past outcomes only.
D. Results from current outcomes only.
E. Speculation of interest rates and economic performance only.
36. The calculation of annual net cash flow from a particular investment project should include
all of the following except:
A. Income taxes.
B. Revenues generated by the investment.
C. Cost of products generated by the investment.
D. Depreciation expense.
E. General and administrative expenses.
37. Capital budgeting decisions are risky because:
A. The outcome is uncertain.
B. Large amounts of money are usually involved.
C. The investment involves a long-term commitment.
D. The decision could be difficult or impossible to reverse.
E. All of the options listed are correct.
38. The process of restating future cash flows in today’s dollars is known as:
A. Budgeting.
B. Annualization.
C. Discounting.
D. Payback period.
E. Capitalizing.
39. A minimum acceptable rate of return for an investment decision is called the:
A. Internal rate of return.
B. Average rate of return.
C. Hurdle rate.
D. Maximum rate.
E. Payback rate.
40. In business decision-making, managers typically examine the two fundamental factors of:
A. Risk and capital investment.
B. Risk and rate of return.
C. Capital investment and rate of return.
D. Risk and payback.
E. Payback and rate of return.
41. A limitation of the internal rate of return method is:
A. Failure to measure time value of money.
B. Failure to measure results as a percent.
C. Failure to consider the payback period.
D. Failure to reflect changes in risk levels over project life.
E. Failure to compare dissimilar projects.
42. An opportunity cost:
A. Is an unavoidable cost.
B. Requires a current outlay of cash.
C. Results from past managerial decisions.
D. Is the lost benefit of choosing an alternative course of action.
E. Is irrelevant in decision making.
43. The potential benefits of one alternative that are lost by choosing another is known as a(n):
A. Alternative cost.
B. Sunk cost.
C. Out-of-pocket cost.
D. Differential cost.
E. Opportunity cost.
44. A cost that requires a current and/or future outlay of cash, and is usually an incremental cost,
is a(n):
A. Out-of-pocket cost.
B. Sunk cost.
C. Opportunity cost.
D. Operating cost.
E. Uncontrollable cost.
45. A cost that cannot be avoided or changed because it arises from a past decision, and is
irrelevant to future decisions, is called a(n):
A. Uncontrollable cost.
B. Incremental cost.
C. Opportunity cost.
D. Out-of-pocket cost.
E. Sunk cost.
46. A company paid $200,000 ten years ago for a specialized machine that has no salvage value
and is being depreciated at the rate of $10,000 per year. The company is considering using the
machine in a new project that will have incremental revenues of $28,000 per year and annual
cash expenses of $20,000. In analyzing the new project, the $10,000 depreciation on the machine
is an example of a(n):
A. Incremental cost.
B. Opportunity cost.
C. Variable cost.
D. Sunk cost.
E. Out-of-pocket cost.
47. An additional cost incurred only if a particular action is taken is a(n):
A. Period cost.
B. Pocket cost.
C. Discount cost.
D. Incremental cost.
E. Sunk cost.
48. A company is considering a new project that will cost $19,000. This project would result in
additional annual revenues of $6,000 for the next 5 years. The $19,000 cost is an example of
a(n):
A. Sunk cost.
B. Fixed cost.
C. Incremental cost.
D. Uncontrollable cost.
E. Opportunity cost.
49. Patrick Corporation inadvertently produced 10,000 defective personal radios. The radios cost
$8 each to produce. A salvage company will purchase the defective units as they are for $3 each.
Patrick’s production manager reports that the defects can be corrected for $5 per unit, enabling
them to be sold at their regular market price of $12.50. Patrick should:
A. Sell the radios for $3 per unit.
B. Correct the defects and sell the radios at the regular price.
C. Sell the radios as they are because repairing them will cause their total cost to exceed their
selling price.
D. Sell 5,000 radios to the salvage company and repair the remainder.
E. Throw the radios away.
50. Product A requires 5 machine hours per unit to be produced, Product B requires only 3
machine hours per unit, and the company’s productive capacity is limited to 240,000 machine
hours. Product A sells for $16 per unit and has variable costs of $6 per unit. Product B sells for
$12 per unit and has variable costs of $5 per unit. Assuming the company can sell as many units
of either product as it produces, the company should:
A. Produce only Product A.
B. Produce only Product B.
C. Produce equal amounts of A and B.
D. Produce A and B in the ratio of 62.5% A to 37.5% B.
E. Produce A and B in the ratio of 40% A and 60% B.
51. Alpha Co. can produce a unit of Beta for the following costs:
Direct material $ 8
Direct labor 24
Overhead 40
Total costs per unit $72
An outside supplier offers to provide Alpha with all the Beta units it needs at $60 per unit. If
Alpha buys from the supplier, Alpha will still incur 40% of its overhead. Alpha should:
A. Buy Beta since the relevant cost to make it is $72.
B. Make Beta since the relevant cost to make it is $56.
C. Buy Beta since the relevant cost to make it is $48.
D. Make Beta since the relevant cost to make it is $48.
E. Buy Beta since the relevant cost to make it is $56.
52. Marcus processes four different products that can either be sold as is or processed further.
Listed below are sales and additional cost data:
Sales
Sales Value Additional Value after
with no further Processing further
Product Processing Costs processing
Acta $1,350 $900 $2,700
Corda 450 225 630
Fando 900 450 1,800
Limo 90 45 180
Which product(s) should not be processed further?
A. Acta.
B. Corda.
C. Fando.
D. Limo.
E. None of the products should be processed further.
53. Marsden manufactures a cat food product called Special Export. Marsden currently has
10,000 bags of Special Export on hand. The variable production costs per bag are $1.80 and total
fixed costs are $10,000. The cat food can be sold as it is for $9.00 per bag or be processed further
into Prime Cat Food and Feline Surprise at an additional $2,000 cost. The additional processing
will yield 10,000 bags of Prime Cat Food and 3,000 bags of Feline Surprise, which can be sold
for $8 and $6 per bag, respectively. The net advantage (incremental income) of processing
Special Export further into Prime and Feline Surprise would be:
A. $98,000.
B. $96,000.
C. $ 8,000.
D. $ 6,000.
E. $ 2,000.