Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
Chapter 21 Capital Budgeting: Methods of Investment Analysis
21.1 Apply the concept of the time value of money to capital budgeting decisions.
1) In capital budgeting decisions, revenues and costs are analyzed over the short-run.
2) Accrual accounting measures income on a year–to-year basis.
3) Cost systems with an exclusive period–by-period focus are more likely to identify project costs over
multiple periods.
4) Identify capital expenditures relevant to accomplishing strategic goals is the first step in the capital
budgeting decision process model.
5) The rate of return is the ratio of net future cash flows to the investment outflow.
6) Both financial and nonfinancial factors associated with proposed capital budgeting opportunities need
to be considered as part of the capital budgeting decision process.
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
7) Capital budgeting emphasizes the role of financial information in investment decisions.
8) Discounted cash flow measures the cash inflows and outflows of a project as if they occurred at a single
point in time in order to facilitate a proper comparison.
9) The required rate of return is the minimum acceptable percentage return on an investment before
taking into account the risk of the investment.
10) The net present value method is a discounted cash flow method that concentrates only on cash flows.
11) Capital budgeting focuses on projects over their entire lives to consider all the cash flows or cash
savings from investing in a single project.
12) Discounted cash flow methods measure all the expected future cash inflows and outflows of a project
as if they occurred at equal intervals over the life of the project.
13) Discounted cash flow methods focus on operating income.
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
14) A capital budgeting project will have a positive net present value if its return is less than the hurdle
rate.
15) The net present value method calculates the expected monetary gain or loss from a project by
discounting all expected future cash inflows and outflows to the present point in time using the hurdle
rate.
16) Cost analysis has two dimensions, which are
A) financial and non-financial.
B) present and the future.
C) project and financial.
D) project and non-financial.
E) project and time.
17) The time value of money
A) is equal to the rate of inflation.
B) includes the rate of inflation.
C) is the same value for all companies.
D) is equal to the bank prime rate.
E) is the opportunity cost of not having the money today.
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
18) Life cycle costing is the accounting system that corresponds to
A) the non-financial dimension of costs analysis.
B) the project dimension of costs analysis.
C) the cost dimension of costs analysis.
D) the financial dimension of costs analysis.
E) the time dimension of costs analysis.
19) Which of the following is not a part of the capital budgeting decision process model?
A) establish assumptions common for each potential capital investment
B) obtain appropriate sources of financing for investments
C) identify capital expenditures relevant to accomplishing strategic goals
D) manage the control of non-quantitative factors
E) analyze the present value of future cash inflow and outflow and relevant qualitative factors
20) The consequences of capital expenditures are
A) quantitative and financial.
B) quantitative and qualitative.
C) qualitative and nonfinancial.
D) appropriate and inappropriate.
E) nonfinancial and irrelevant.
21) In selecting capital projects, organizations choose
A) the alternative that matches the RRR.
B) the alternative that has revenues that exceed its costs.
C) the alternative that has the highest revenues.
D) the alternative that has the longest time horizon, but also exceeds the RRR.
E) the alternative that provides benefits that exceed predicted costs by the greatest amount.
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
22) The first step in the capital budgeting decision process model is to
A) establish assumptions common for each potential capital investment.
B) obtain appropriate sources of financing for investments.
C) identify capital expenditures relevant to accomplishing strategic goals.
D) manage the control of non-quantitative factors.
E) analyze the present value of future cash inflow and outflow and relevant qualitative factors.
23) In capital budgeting analysis, opportunity considers as a minimum
A) sources of internally generated cash flow.
B) the profit gained from choosing the next best investment.
C) the profit lost from choosing the next best investment.
D) interest foregone on risk-free investments.
E) lost sales during the analysis phase.
24) The time value of money refers to the concept that
A) saving money has value for the business.
B) both time and money are valuable resources to any organization.
C) money invested today will grow.
D) the value of a monetary unit today is worth less than the same unit in the future.
E) the value of a monetary unit today is worth more than the same unit in the future.
25) Net present value is calculated using the
A) internal rate of return.
B) required rate of return.
C) rate of return required by the investment bankers.
D) after tax cost of debt.
E) coupon interest rate on the firm’s debt.
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
Use the information below to answer the following question(s).
Hawkeye Cleaners has been considering the purchase of an industrial dry-cleaning machine. The existing
machine is operable for three more years and will have a zero disposal price. If the machine is disposed of
now, it may be sold for $30,000. The new machine will cost $200,000, an additional cash investment in
working capital of $60,000 will be required. The machine is expected to last 3 years and has an estimated
disposal value at that time of $20,000. The new machine will reduce the average amount of time required
to wash clothing and will decrease labour costs. The investment is expected to net $50,000 in additional
cash inflows during the year of acquisition and $150,000 each additional year of use. These cash flows
will generally occur throughout the year and are recognized at the end of each year. Income taxes are not
considered in this problem.
26) What is the net present value (rounded to the nearest thousand) of the investment assuming the
required rate of return is 10 percent? Would Hawkeye Cleaners want to purchase the new machine?
A) $112,000; yes
B) $52,000; yes
C) $(52,000); no
D) $(67,000); no
E) $127,000; yes
27) What is the net present value (rounded to the nearest thousand) of the investment assuming the
required rate of return is 24 percent? Would Hawkeye Cleaners want to purchase the new machine?
A) $57,000; yes
B) $(57,000); no
C) $(3,000); no
D) $29,000; yes
E) $(13,000); no
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
28) Shirt Company wants to purchase a new cutting machine for its sewing plant. The investment is
expected to generate annual cash inflows of $300,000 recognized at the end of each year. The required
rate of return is 12 percent and the new machine is expected to last for 4 years. What is the maximum
dollar amount Shirt Company would be willing to spend for the machine?
A) $507,000
B) $720,600
C) $791,740
D) $911,205
E) $957,600
29) When the net present value method is used, only projects with ________ are ________.
A) negative net present value; acceptable
B) negative net future value; not acceptable
C) positive net future value; acceptable
D) positive net present value; acceptable
E) positive net value; not acceptable
30) Which of the following statements about the net present value method is true?
A) Projects with higher net present values are preferred when all other factors are equal.
B) Projects with negative NPV are acceptable, if no positive NPV projects are available.
C) It focuses on operating income.
D) The origination of cash flows is not important in the analysis.
E) Acceptable projects are those with the highest discount rate.
31) Which of the following results of net present value analyses is the least acceptable?
A) $(15,000)
B) $(1,000)
C) $12,000
D) $0
E) $20,000
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
Use the information below to answer the following question(s).
Wet Water Company drills residential and commercial wells. The company is in the process of analyzing
the purchase of a new drill. Information on the proposal is provided below:
Initial investment:
Asset
$80,000
Working capital
$16,000
Operations (per year for four years):
Cash receipts
$80,000
Cash expenditures
$44,000
Disinvestment: Salvage value of drill
(end of year four)
$8,000
Discount rate 10 percent
Note: Other than the initial investment, cash flows are end of period.
32) What is the net present value of the investment?
A) $(25,540)
B) $39,579
C) $34,507
D) $44,000
E) $18,115
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
33) Project ABC is under consideration. Annual cash flows equal $50,000 per year for 5 years. During the
first three years the required rate of return is 2 percent. The required rate of return for cash flows in the
final two years is 10 percent.
What is the present value of cash inflows?
A) $250,000
B) $247,730
C) $235,650
D) $209,391
E) $203,642
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
34) Use the following information to determine which machine to purchase based on net present value.
Machine 1
Machine 2
Machine 3
Initial investment
$225,000
$235,000
$210,000
Annual cash inflows
$50,000
$50,000
$50,000
Useful lives
5 years
4 years
8 years
Cost of capital is 10 percent.
A) purchase machine 3
B) purchase machine 2
C) purchase machine 1
D) purchase any of the three machines
E) purchase all three machines
35) Investment A requires a net investment of $600,000. The required rate of return is 10 percent for the
three-year annuity.
What are the annual cash inflows if the net present value equals 0?
A) $184,842
B) $241,269
C) $249,791
D) $271,316
E) $360,000
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
36) Upper Darby Park Department is considering a new capital investment. The following information is
available on the investment. The cost of the machine will be $150,000. The annual cost savings if the new
machine is acquired will be $40,000. The machine will have a 5-year life, at which time the terminal
disposal value is expected to be $20,000. Upper Darby Park Department is assuming no tax consequences.
If Upper Darby Park Department has a required rate of return of 10%, which of the following is closest to
the present value of the project?
A) $1,632
B) $12,418
C) $14,050
D) $150,000
E) $70,000
37) The Zeron Corporation wants to purchase a new machine for its factory operations at a cost of
$950,000. The investment is expected to generate $350,000 in annual cash flows for a period of four years.
The required rate of return is 14%. The old machine can be sold for $50,000. The machine is expected to
have zero value at the end of the four-year period. What is the net present value of the investment?
Would the company want to purchase the new machine? Income taxes are not considered.
A) $119,550; yes
B) $69,550; no
C) $1,019,550; yes
D) $326,750; no
E) $500,000; yes
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
38) Wagner Ltd. is considering investing in a new piece of equipment for its factory. It estimates that
annual cash flows would be $17,000 and the equipment would last for 8 years. The company’s required
rate of return is 12%. What is the most that the company should be willing to invest in this equipment?
(Ignore income taxes.)
A) $84,450
B) $136,000
C) $61,280
D) $128,115
E) $94,580
39) Easton Ltd. is considering investing in a new piece of machinery for its factory. The machine costs
$340,000 and is expected to last 7 years. It estimates that annual cash flows would be $82,000 and the
equipment would have a salvage value of $13,000. The company’s hurdle rate is 11%. What is the NPV of
this investment? (Ignore income taxes.)
A) $87,625
B) $46,400
C) $52,660
D) $234,000
E) $247,000
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
40) Weston Ltd. is considering investing in a new piece of equipment for its factory. It estimates that the
machine will generate an additional $120,000 per year in revenues. The contribution margin on these
incremental revenues is estimated at 40%. Incremental annual fixed costs are estimated to be $8,200. The
equipment would have a salvage value of $14,000 at the end of 6 years. The company’s required rate of
return is 13%. What is the NPV of this investment if the equipment costs $250,000? (Ignore income taxes.)
A) $2,800
B) ($51,393)
C) $204,803
D) $11,768
E) ($84,173)
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
41) Lion Enterprises Inc. is evaluating 3 investment alternatives. Each alternative requires a cash outflow
of $102,000. The cash inflows are summarized below (ignore taxes):
Project A
Project B
Project C
Year 1
$55,000
$30,000
$0
Year 2
$40,000
$30,000
$0
Year 3
$20,000
$30,000
$45,000
Year 4
$5,000
$30,000
$55,000
Year 5
$2,000
$30,000
$65,000
The company has a required rate of return of 9%.
Required:
Evaluate and rank each alternative using net present value (NPV).
42) Briefly describe the processes in the Capital Budgeting Decision Process Model.
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
43) Cast Iron Stove Company wants to buy a molding machine that can be integrated into its
computerized manufacturing process. It has received three bids for the machine and related
manufacturer’s specifications. The bids range from $3,500,000 to $3,550,000. The estimated annual savings
of the machines range from $260,000 to $270,000. The payback periods are almost identical and the net
present values are all within $8,000 of each other. The president just doesn’t know what to do about
which vendor to choose since all of the selection criteria are so close together.
Required:
What suggestions do you have for the president?
44) Explain capital budgeting, and then briefly discuss each of the six processes of the capital budgeting
decision process model?
21.2 Evaluate discounted cash flow (DCF) and non-DCF methods to calculate rate of
return (ROR).
1) Internal rate–of-return is a method of calculating the expected net monetary gain or loss from a project
by discounting all expected future cash inflows and outflows to the present point in time.
2) The primary advantage of the internal rate of return method is that the end result of the computation is
in dollars instead of percentages.
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
3) The net present value method is extremely useful when an organization does not require the same rate
of return each year of the project.
4) The payback method measures the time required to recoup the total dollars invested in the project
through cash inflows.
5) The payback method discounts cash flows prior to the payback date.
6) The accrual accounting rate of return is an accounting measure of income divided by an accounting
measure of investment.
7) A capital budgeting project is accepted if the required rate of return equals or exceeds the internal rate
of return.
8) The net present value method can on occasion indicate erroneous decisions as it implicitly assumes
that project cash flows can be reinvested at the project’s rate of return.
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
9) The payback method allows for managers to highlight liquidity.
10) The accrual accounting rate–of–return method has a significant weakness for use in making capital
budgeting decisions because it does not track cash flows and it ignores the time value of money.
11) Projects with shorter paybacks always generate more cash flows.
12) If the internal rate of return is less than the hurdle rate, the net present value of the project will be
negative.
13) Which of the following is not one of the methods that aid management in analyzing the expected
results of capital budgeting decisions?
A) accrual accounting rate of return
B) discounted cash flow
C) future-value cash flow
D) payback method
E) breakeven method
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
14) The discount rate, hurdle rate, or (opportunity) cost of capital all refer to the
A) required rate of return.
B) internal rate of return.
C) net present value.
D) discounted cash flow.
E) payback period.
15) When all future cash inflows and outflows are discounted to the present using the required rate of
return, the method used is
A) capital budgeting.
B) discounted cash flow.
C) net present value.
D) required rate of return.
E) payback method.
16) If the net present value analyses of a project resulted in a positive value and the company does not
accept the project, it may be assumed that
A) qualitative factors outweigh the benefit of the investment.
B) An alternative project has a lower NPV.
C) the net initial investment cannot be recovered.
D) the return is greater than that required by the company.
E) quantitative factors outweigh the benefit of the investment.
17) When the present value of expected cash inflows from a project equals the present value of expected
cash outflows of a project, the discount rate is the
A) universal rate.
B) internal rate of return.
C) required rate.
D) net present value rate.
E) inflation rate.
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
Use the information below to answer the following question(s).
Wet Water Company drills residential and commercial wells. The company is in the process of analyzing
the purchase of a new drill. Information on the proposal is provided below:
Initial investment:
Asset
$80,000
Working capital
$16,000
Operations (per year for four years):
Cash receipts
$80,000
Cash expenditures
$44,000
Disinvestment: Salvage value of drill
(end of year four)
$8,000
Discount rate 10 percent
Note: Other than the initial investment, cash flows are end of period.
18) In what range is the internal rate of return?
A) 8 percent to 12 percent
B) 12 percent to 16 percent
C) 16 percent to 20 percent
D) 20 percent to 24%
E) greater than 24%
Cost Accounting: A Managerial Emphasis, 6e
Chapter 21 – Capital Budgeting: Methods of Investment Analysis
19) Brown Corporation recently purchased a new machine for $339,013.20. The new equipment has a
useful life of 10 years. Net cash flows will be $60,000 per year, end of year payments.
What is the internal rate of return?
A) 10 percent
B) 12 percent
C) 14 percent
D) 16 percent
E) 18 percent
20) Soda Manufacturing Company provides vending machines for soft-drink manufacturers. The
company has been investigating a new piece of machinery for its production department. The old
equipment has a remaining life of 1 year and no sales value. The new equipment has a value of $52,650
with a three-year life. The expected additional cash inflows are $25,000 per year, end of year payments.
What is the internal rate of return?
A) 24 percent
B) 20 percent
C) 16 percent
D) 12 percent
E) 8 percent
21) Which of the following is true, concerning NPV?
A) When the NPV is positive, the sum of the cash flows from the project equal the initial investment.
B) When the NPV is negative, the sum of the cash flows from the project must also be negative
C) The project just recovers the initial investment, discounted by the hurdle rate.
D) The IRR is less than the RRR when the NPV is positive, after using the RRR as the discount rate.
E) The project recovers the initial investment and earns a return greater than the RRR.