Chapter 11—CAPITAL BUDGETING DECISION CRITERIA AND RISK
ANALYSIS
MULTIPLE CHOICE
1. Multiple internal rates of return can occur when there is (are):
a.
large abandonment costs at the end of a project’s life
b.
a major shutdown and rebuilding of a facility sometime during its life
c.
more than one sign change in the pattern of cash flows over a project’s life.
d.
All of these answers are correct.
2. The ____ measures the present value return for each dollar of initial investment.
a.
payback period
b.
internal rate of return
c.
net present value
d.
profitability index
3. The payback method is at best a crude measure of the risk of a project because it fails to consider the
____ of a project’s returns.
a.
liquidity
b.
variability
c.
timing
d.
magnitude
4. According to the profitability index criterion, a project is acceptable if its profitability index is
a.
greater than 1 plus the cost of capital
b.
greater than 0
c.
greater than or equal to 1
d.
greater than 1.1
5. The payback period of an investment is defined as:
a.
the number of years required for cumulative profits from a project to equal the initial
outlay.
b.
the number of years required for the cumulative cash flows from a project to equal the
initial outlay.
c.
the number of years required for the cumulative cash flows from a project to equal the
average investment in the project, when depreciation is considered.
d.
a period of time sufficient to earn a rate of return equal to the firm’s cost of capital.
6. The advantages of the payback approach include all of the following except:
a.
it is easy to compute
b.
it considers a project’s liquidity
c.
it considers cash flows, not net income
d.
it provides an objective measure of profitability
7. The disadvantages of the payback approach include:
a.
cash flows after the payback period are ignored in the calculation
b.
payback ignores the time value of money
c.
payback fails to provide an objective decision-making criterion
d.
All of these answers are correct.
8. One weakness of the internal rate of return approach is that:
a.
it does not directly consider the timing of the cash flows from a project
b.
it fails to provide a straightforward decision-making criterion
c.
it implicitly assumes that the firm is able to reinvest the interim cash flows from a project
at the firm’s cost of capital.
d.
it is possible to have multiple internal rates of return.
9. The relationship between NPV and IRR is such that:
a.
both approaches always provide the same ranking of alternative investment projects.
b.
the IRR of a project is equal to the firm’s cost of capital if the NPV of a project is $0.
c.
if the NPV of a project is negative, the IRR must be greater than the cost of capital.
d.
the IRR approach is normally superior to the NPV approach
10. When a project has multiple internal rates of return:
a.
the analyst should choose the highest rate to compare with the firm’s cost of capital.
b.
the analyst should choose the lowest rate to compare with the firm’s cost of capital
c.
the analyst should choose the rate that seems most “reasonable“, given the project’s cash
flows, to compare with the firm’s cost of capital.
d.
the analyst should compute the project’s net present value and accept the project if its NPV
is greater than $0
11. The profitability index (PI) approach:
a.
fails to directly consider the timing of a project’s cash flows
b.
considers only a project’s contributions to net income and does not consider cash flow
effects
c.
always gives the same accept-reject decisions for independent projects as does NPV and
IRR
d.
always gives the same accept-reject decisions for mutually exclusive projects as does NPV
and IRR
12. In the case of mutually exclusive projects, NPV and PI are likely to yield conflicting decisions when:
a.
the projects require the same net investment
b.
the projects are significantly different in size
c.
multiple rates of return are a possibility
d.
none of these are correct
13. The objective in solving capital rationing problems is to:
a.
accept all projects with a PI greater than 1.1
b.
maximize the IRR of the projects that are accepted
c.
maximize the NPV of the projects that are accepted
d.
minimize the opportunity cost of the firm’s funds
14. In order to compensate for inflation in capital budgeting procedures, it is necessary to:
a.
use constant dollar estimates of costs and revenues
b.
use a low discount rate to avoid double counting for inflationary effects
c.
rely heavily on the payback procedures
d.
adjust for inflation, because the discount rate used in evaluating project net cash flows
incorporates an inflation premium.
15. If a net present value analysis for a normal project gives an NPV greater than zero, an internal rate of
return calculation on the same project would yield an internal rate of return ____ the required rate of
return for the firm.
a.
greater than
b.
less than
c.
equal to
d.
cannot be determined from the information given
16. When two or more normal ____ projects are under consideration, the profitability index, the net
present value, and the internal rate of return methods will yield identical accept/reject signals.
a.
coincident
b.
mutually exclusive
c.
independent
d.
expansion
17. The net present value method assumes that the cash flows over the life of the project are reinvested at
a.
the computed internal rate of return
b.
the risk-free rate
c.
the market capitalization rate
d.
the firm’s cost of capital
18. The internal rate of return method assumes that the cash flows over the life of the project are
reinvested at:
a.
the risk-free rate
b.
the firm’s cost of capital
c.
the computed internal rate of return
d.
the market capitalization rate
19. In the absence of capital rationing, the ____ method is normally superior to the ____ method when
choosing among mutually exclusive investments.
a.
net present value, internal rate of return
b.
internal rate of return, profitability index
c.
net present value, profitability index
d.
a and c
20. Generally, the ____ is considered to be a more realistic reinvestment rate than the ____.
a.
risk-free rate, internal rate of return
b.
internal rate of return, cost of capital
c.
cost of capital, internal rate of return
d.
risk-free rate, cost of capital
21. The profitability index is the ratio of the ____ to the ____.
a.
net present value, net investment
b.
net investment, net present value
c.
present value of future net cash flows, net investment
d.
net investment, present value of future net cash flows
22. With the net present value approach, all net cash flows are discounted at the
a.
required rate of return
b.
discount rate
c.
cost of capital
d.
required rate of return, the discount rate, and the cost of capital
23. If the net present value of an investment project is positive then the:
a.
project would be unacceptable under the internal rate of return method
b.
project would be acceptable under the payback method
c.
project’s rate of return is greater than the firm’s cost of capital
d.
all of these are correct
24. The internal rate of return does not take into account the
a.
explicit risk of the net cash flows
b.
magnitude of cash flows over the project’s life
c.
net investment
d.
timing of cash flows over the entire life of a project
25. The net present value method assumes that cash flows are reinvested at the ____, whereas the internal
rate of return method assumes that cash flows are reinvested at the ____.
a.
discount rate, required rate of return
b.
cost of capital, market rate of return
c.
firm’s cost of capital, computed internal rate of return
d.
marginal cost of capital, discount rate
26. Which of the following would increase the net present value of a project?
a.
increase in the net investment
b.
use of straight line depreciation rather than MACRS
c.
decrease in the expected accounts payable
d.
decrease in the discount rate
27. A capital expenditure project has an expected 20 percent internal rate of return and a $10,000 net
present value. It has one cash flow sign change.
a.
The discount rate used to calculate NPV is greater than 20 percent
b.
The project has another internal rate of return in addition to the 20 percent rate mentioned
above
c.
In the internal rate of return calculation, the project’s cash inflows are assumed to be
reinvested at the firm’s required rate of return
d.
None of these answers are correct.
28. When dealing with ____ cash flows, the ____ is computed by trial and error.
a.
uniform; internal rate of return
b.
perpetual; internal rate of return
c.
uneven; internal rate of return
d.
uneven; net present value
29. The ____ is interpreted as the ____ for each dollar of initial investment.
a.
net present value; present value return
b.
profitability index; cash flow return
c.
profitability index; present value return
d.
present value return, cash flow return
30. The ____ of an investment is the period of time for the ____ to equal the initial cash outlay.
a.
profitability index; present value of the cash inflows
b.
payback period; cumulative cash inflows
c.
payback period; present value of the cash inflows
d.
profitability index, payback period
31. The profitability index would be ____ if the present value of the net cash flows (NCF) over the life of
a project were ____.
a.
negative; less than zero
b.
negative; less than the net investment
c.
zero; equal to the net investment
d.
less than zero; equal to the net investment
32. Which of the following investment decision rules (if any) assumes that the cash flows generated are
reinvested over the life of the project at the firm’s cost of capital?
a.
payback period
b.
internal rate of return
c.
accounting rate of return
d.
the NPV approach
33. The ____ approach takes into account both the magnitude and timing of cash flows over the entire life
of a project in measuring its economic desirability.
a.
payback period
b.
accounting rate of return
c.
average rate of return
d.
internal rate of return
34. Real options in capital budgeting can be classified in all of the following ways except:
a.
abandonment option
b.
investment option
c.
purchasing power option
d.
shutdown options
35. Generally, the existence of a(n) ____ option reduces the downside risk of a project and should be
considered in project analysis.
a.
designed-in
b.
abandonment
c.
investment timing
d.
output expansion
36. Capital expenditures levels tend ____ (in real terms) during periods of relatively high inflation than
during low inflation times.
a.
to be higher
b.
to be lower
c.
to be the same
d.
to depend on business risk
37. The basic capital budgeting decision models, that is, NPV and IRR, handle risk by
a.
ignoring it
b.
assuming all cash flows are known with certainty
c.
assuming all projects are of average risk and evaluating them based on expected values
d.
using risk-adjusted discount rates to evaluate projects
38. Simulation techniques are
a.
cheap to apply
b.
widely used
c.
mostly beneficial for large projects
d.
identical to sensitivity analysis
39. The use of sensitivity analysis requires that
a.
a model of a project’s cash flows be developed
b.
probability distributions of the determinants of a project’s cash flows be estimated
c.
the firms have access to a very large computer
d.
the firm is greatly interested in the portfolio risk reduction characteristics of a project
40. Project C has been classified into risk class II by the analyst of a major firm. The risk premium
required for projects in this risk class is 8%. The current risk-free rate measured by the analyst is 10%.
If the project has an estimated return of 20%, the analyst would recommend
a.
accepting project C
b.
rejecting project C
c.
reestimating the risk premiums for class II projects
d.
not enough information given to provide an answer
41. The risk-adjusted discount rate approach is preferable to the weighted cost of capital approach when
a.
all projects have the same risk characteristics
b.
the risk-free rate is known with certainty
c.
the projects under consideration have different risk characteristics
d.
the firm is unlevered
42. In a simulation analysis, a model is simulated on a computer program and run through several
iterations. The results of these iterations are used to
a.
plot a required rate of return value profile
b.
compute a mean and a standard deviation of returns
c.
provide the decision maker with a measure of beta risk
d.
plot the coefficient of variation of the annual net cash flows
43. Sensitivity analysis is a procedure that can be used in the capital budgeting process to indicate how
sensitive the ____ is to changes in a particular variable.
a.
probability
b.
return distribution
c.
net present value
d.
standard deviation
44. When analyzing a sensitivity curve, the ____ the slope, the more sensitive the net present value is to a
change in the computed variable.
a.
more negative
b.
steeper
c.
more general
d.
smaller
45. The ____ approach is widely used by firms that attempt to consider differential project risk in their
capital budgeting procedures.
a.
net present value
b.
internal rate of return
c.
risk-adjusted discount rate
d.
profitability index
46. The most expensive method of adjusting for total project risk in the evaluation of capital budgeting
projects is the
a.
sensitivity analysis method
b.
simulation approach
c.
net present value/payback method
d.
risk-adjusted discount rate approach
47. An investment project requires a net investment of $100,000. The project is expected to generate
annual net cash inflows of $28,000 for the next 5 years. The firm’s cost of capital is 12 percent.
Determine the payback period for the project.
a.
0.28 years
b.
1.4 years
c.
3.57 years
d.
17.86 years
48. An investment project requires a net investment of $100,000. The project is expected to generate
annual net cash inflows of $28,000 for the next 5 years. The firm’s cost of capital is 12 percent.
Determine the net present value for the project.
a.
$940
b.
$100,940
c.
$ 77,884
d.
$ 40,000
49. An investment project requires a net investment of $100,000. The project is expected to generate
annual net cash inflows of $28,000 for the next 5 years. The firm’s cost of capital is 12 percent.
Determine the internal rate of return for the project (to the nearest tenth of one percent).
a.
12.0%
b.
12.6%
c.
3.6%
d.
12.4%
50. The Atlantic Company plans to open a new branch office in a suburban area. The building will cost
$200,000 and will be depreciated (on a straight-line basis) over a 20 year life to a $0 estimated salvage
value. Equipment for the building will cost an additional $100,000. This equipment has a 20-year life
and will be depreciated on a straight-line basis to a $0 estimated salvage value. The branch office is
expected to generate additional before tax net income of $30,000 per year. The tax rate is 40 percent
and the cost of capital is 12 percent. Compute the net present value for the project.
a.
$-63,523
b.
$+246,477
c.
$+53,523
d.
$-53,523
51. An investment project requires a net investment of $100,000 and is expected to generate annual net
cash inflows of $25,000 for 6 years. The firm’s cost of capital is 12 percent. Determine the profitability
index for this project.
a.
1.50
b.
1.028
c.
.028
d.
.972
52. A project requires a net investment of $450,000. It has a profitability index of 1.25 based on the firm’s
12 percent cost of capital. Determine the net present value of the project.
a.
$ 112,500
b.
$ 562,500
c.
$1,012,500
d.
$ 140,625
53. What is the net present value of a project that requires a net investment of $76,000 and produces net
cash flows of $22,000 per year for 7 years? Assume the cost of capital is 15 percent.
a.
$ 91,520
b.
$ 15,520
c.
$ 78,000
d.
$167,474
54. Would you invest in a project that has a net investment of $14,600 and a single net cash flow of
$24,900 in 5 years, if your required rate of return was 12 percent?
a.
Yes – the NPV is $862.90
b.
No – the NPV is -$1,975.70
c.
No – the NPV is -$481.70
d.
Yes – the NPV is $165.70
55. Sigma is thinking about purchasing a new clam digger for $14,000. The expected net cash flows
resulting from the digger are $9,000 in year 1, $7,000 in year 2, $5,000 in year 3, and $3,000 in year 4.
Should Sigma purchase this digger if its cost of capital is 12 percent?
a.
Yes, NPV = $3,176
b.
Yes, NPV = $5,084
c.
Yes, NPV = $16,605
d.
Yes, NPV = $19,084
56. What is the internal rate of return for a project that has a net investment of $76,000 and net cash flows
of $20,507 per year for 7 years?
a.
16%
b.
17%
c.
18.2%
d.
19%
57. What is the internal rate of return for a project that has a net investment of $14,600 and a single net
cash flow of $25,750 in 5 years?
a.
10%
b.
12%
c.
15.3%
d.
13.1%
58. What is the internal rate of return for a project that has a net investment of $150,000 and net cash
flows of $40,000 for 5 years?
a.
between 10% and 11%
b.
between 9% and 10%
c.
between 11% and 12%
d.
between 12% and 13%
59. Using the profitability index, which of the following mutually exclusive projects should be accepted?
Project A: NPV = $6,000; NINV = $50,000
Project B: NPV = $10,000; NINV = $120,000
Project C: NPV = $8,000; NINV = $80,000
a.
A
b.
B
c.
C
d.
all projects should be accepted
60. Turntec is considering replacing an automatic shuttle machine that has a book value of $2,000 and a $0
market value with a more efficient machine that will cost $24,000. The annual net cash flows from the
new equipment are expected to be $6,000 for the next 6 years. What is the net present value of this
project? Assume the firm’s cost of capital is 12 percent and it’s marginal tax rate is 40 percent.
a.
$666
b.
$1,466
c.
$1,866
d.
– $134
61. GoFlo is a small growing firm that is considering the purchase of another truck to serve GoFlo’s
expanding customer base. The new truck will cost $21,000 and should generate annual net cash flows
of $6,000 over the truck’s 5-year life. What is the payback period for this project?
a.
3 years
b.
4.2 years
c.
3.5 years
d.
3.3 years
62. Hydroponics is considering adding another greenhouse that would cost $95,000 and generate $20,000
in annual net cash flows over it’s 8 year expected life. The greenhouse would be depreciated on a
straight-line basis to zero and the salvage value is also expected to be zero. If the firm has a marginal
tax rate of 40 percent, what is this project’s internal rate of return?
a.
between 20 and 24%
b.
between 13 and 14%
c.
between 28 and 32%
d.
between 7 and 8%
63. Red Lake Mines, Inc. is considering adoption of a new project requiring a net investment of $10
million. The project is expected to generate 5 years of net cash inflows of $5 million per year. In the
project’s sixth, and final, year it is expected to have a net cash outflow of $1 million. What is the
project’s net present value, using a discount rate of 12 percent?
a.
about $8.52 million
b.
about $8.00 million
c.
about $7.52 million
d.
about $6.00 million
64. Calculate the profitability index for a project that has a net present value equal to -$10,000. The
project’s net investment is $20,000, and the firm has a 40 percent marginal tax rate.
a.
-0.5
b.
0
c.
0.8
d.
0.5
65. A project requires a net investment of $100,000. At the firm’s cost of capital of 10%, the project’s
profitability index is 1.15. Determine the net present value of the project.
a.
$15,000
b.
$215,000
c.
$115,000
d.
cannot be determined from the information given
66. What is the NPV of a project that required a net investment of $500,00 and produced net cash flows of
$150,000 per year for 5 years and $110,000 for the next 5 years? Assume the cost of capital is 14%.
a.
$211,080
b.
$392,580
c.
$588,710
d.
$160,920
67. Calco is a multi-divisional firm with a weighted cost of capital of 14 percent and a risk-adjusted
discount rate for its can division of 17 percent. A planned expansion in the can division requires a net
investment of $170,000 and results in expected cash inflows of $42,000 a year for seven years. Should
Calco invest in this expansion?
a.
Yes, NPV = $10,096
b.
Yes, NPV = $ 9,896
c.
No, NPV = –$5,276
d.
Yes, NPV = $3,840
68. Kinetics is considering a project that has a NINV of $874,000 and generates net cash flows of
$170,000 per year for 12 years. What is the NPV of this project if Kinetics cost of capital is 14%?
a.
$252,760
b.
$110,840
c.
$88,200
d.
$47,570
69. Using the profitability index, which of the following projects should be accepted?
Project M:
NPV = $60,000
NINV = $200,000
Project N:
NPV = $10,000
NINV = $30,000
Project O:
NPV = $2,000
NINV = $5,000
a.
Project M
b.
Project N
c.
Project O
d.
All projects should be accepted
70. ZPS Models is considering a project that has a NINV of $564,000 and generates net cash flows of
$105,000 per year for 10 years. What is the NPV of this project if ZPS has a cost of capital of 12.45%?
a.
$47,625
b.
$18,503
c.
$17,490
d.
$8,329
71. Decode Genetics purchased lab equipment for $600,000 that will generate net cash flows of $130,000
per year for 10 years. What is the IRR for this project?
a.
16.76%
b.
17.26%
c.
18.13%
d.
17.76%
72. What is the net present value of a project that has a net investment of $148,000 and net cash flows of
$25,000 in the first year, $45,000 in years 2-7 and a negative net cash flow of $27,000 in year 8?
Assume the cost of capital is 11 percent.
a.
$34,302
b.
$74,847
c.
$57,738
d.
–$2,238
73. What is the internal rate of return for a project that has a net investment of $169,165 and net cash
flows of $25,000 in the first year and 40,000 in years 2-7?
a.
12.5%
b.
13%
c.
12%
d.
13.5%
74. What is the internal rate of return for a project that has a net investment of $60,000 and the following
net cash flows: Year 1 = $15,000; Year 2 = $20,000; Year 3 = $25,000; Year 4 = $30,000?
a.
17.3%
b.
16.7%
c.
15.7%
d.
16.3%
75. Road Hawk Inc. is adding a new production line that will cost $720,000. The line will be depreciated
on a straight-line basis over a 7-year period and will generate net cash flows of $160,000 in each of the
7 years. At the end of the project, it is expected the line can be sold as scrap for $10,000. If the firm’s
marginal tax rate is 40% and it’s required rate of return is 14 percent, what is the net present value of
this project?
a.
$70,091
b.
-$27,920
c.
$64,091
d.
-$31,520
76. Consider a capital expenditure project that has forecasted revenues equal to $32,000 per year; cash
expenses are estimated to be $29,000 per year. The cost of the project equipment is $23,000, and the
equipment’s estimated salvage value at the end of the project is $9,000. The equipment’s $23,000 cost
will be depreciated on a straight-line basis to $0 over a 10-year estimated economic life. Assume that
the project requires an initial $7,000 working capital investment. The company’s marginal tax rate is
30%. Calculate the project’s net present value using a 12% discount rate.
a.
about -$10,610
b.
about -$12,530
c.
about -$ 9,954
d.
about +$9,462
77. Calculate the net present value for an investment project with the following cash flows using a 12
percent cost of capital:
Year
0
2
Net Cash Flow
$-100,000
$80,000
a.
$56,560
b.
$30,000
c.
$13,840
d.
cannot be determined with information given
78. Ecogen is considering the purchase of some new equipment that will cost $340,000 installed. The
equipment will produce a product that must be FDA approved and this will require at least a year. Net
cash flow in Year 1 will be a negative $110,000 but is expected to be a positive $50,000 in Year 2. Net
cash flows will be $150,000, $240,000, and $330,000 in the next 3 years. At the end of 5 years the
equipment and the product will be obsolete. If the firm’s marginal tax rate is 40% and their costs of
capital is 15%, should they invest in the new equipment?
a.
Yes, NPV = $2,090
b.
Yes, NPV = $12,390
c.
No, NPV = -$63,210
d.
No, NPV = -$12,210
79. G-III Apparel is considering increasing the size of a warehouse. The cost of the expansion is $825,000
and the increase in inventories and accounts payable will be $410,000 and $360,000 respectively. G-III
expects that the expansion will increase net cash flows by $150,000 a year for the next 5 years and
$200,000 a year for years 6-12. G-III has a 14% cost of capital and a marginal tax rate of 35%. What is
the NPV of the warehouse expansion?
a.
-$3,450
b.
$60,050
c.
$10,050
d.
-$338,570
80. What is the internal rate of return for a project that has a net investment of $370,000 and net cash
flows of $60,000 in year 1, $75,000 in year 2, and $85,000 in years 3 through 8?
a.
15.5%
b.
13.6%
c.
17.4%
d.
19.0%
81. Colex wishes to bid on a contract that is expected to yield after-tax net cash flows of $25,000 in year 1,
$30,000 in year 2, and $35,000 per year in years 3 – 8. To obtain the contract, Colex will need to invest
$110,0000 to reconfigure a packaging system, $20,000 (after-tax) to retrain current employees, and
$15,000 (after-tax) on an environmental impact study that is required to be completed on acceptance of
the contract. What is the project’s internal rate of return?
a.
16.7%
b.
14.1%
c.
16.2%
d.
14.9%
82. Quick Flick is considering two investments. Both require a net investment of $120,000 and have the
following net cash flows:
Year
Project X
Project Y
1
$50,000
$25,000
2
40,000
45,000
3
30,000
50,000
4
25,000
60,000
5
20,000
70,000
Quick uses a combination of the net present value approach and the payback approach to evaluate
investment alternatives. The firm uses a discount rate of 14 percent and requires that all projects have a
payback period no longer than 3 years. Which investment or investments should Quick accept?
a.
only Project X
b.
only Project Y
c.
both projects X and Y
d.
reject both projects
Year
NCF:X
PVIF
NCF:Y
83. American Biodyne (AB) is considering expanding into a new line of business. The expansion will
require an investment of $500,000 in new equipment. This equipment which will cost another
$300,000 to install, will be depreciated on a straight-line basis over an 8-year period to an estimated
salvage value of zero. If the expansion project is accepted, working capital will increase by $100,000
immediately. Revenues for the first 3 years are forecasted at $650,000 per year and at $800,000 in
years 4-8. Operating costs exclusive of depreciation are expected to be $310,000 per year for 3 years
and increase to $400,000 per year for the following 5 years. AB has a marginal tax rate of 40% and its
required rate of return for the project under consideration is 16%. If AB assumes that the new
equipment will have an actual market value of $50,000 at the end of the 8th year, should the expansion
be undertaken?
a.
Yes, NPV = $275,114
b.
Yes, NPV = $265,964
c.
Yes, NPV = $302,934
d.
Yes, NPV = $272,434
ESSAY
1. Name the four decision models for evaluating capital expenditures and indicate what criteria is used to
determine the acceptability of a project?
2. List the strengths and weaknesses of each of the four capital budgeting methods.