Chapter 25 – Capital Investment Analysis
TRUE/FALSE
1. Capital investment analysis can be applied in case of expensive and long-term projects.
2. Capital investment analysis ensures that the resources are used wisely.
3. The net present value method and other methods of capital investment analysis can be used for taking
short-term decisions.
4. Capital facilities and projects are not expensive.
5. Capital investment analysis is also known as capital budgeting.
6. Managers must be careful while making capital budgeting decisions so that the selected alternative
will contribute the most to future profits.
7. Capital investment analysis is a decision process for the purchase of capital facilities, such as buildings
and equipment.
8. The objective of capital budgeting is to help only in the preparation of reports that will be submitted to
the managers.
9. The six steps of capital investment analysis can be used for both long-term as well as short-term
planning purposes.
10. Identifying the need for a new capital investment is the last step in the six step process of capital
investment analysis.
11. Automating the existing production process does not come under the purview of capital investment
analysis.
12. An organization with several branches and a highly developed system for capital investment analysis
requires that all proposals should go through preliminary screening.
13. The proposals that will either meet company strategic goals or produce the minimum rate of return will
receive serious review in the preliminary screening process.
14. Cost of capital information is not at all necessary to establish the minimum rate of return on
investments.
15. The minimum rates of return or a minimum cash flow payback period are two standards established in
capital investment analysis.
16. Net present value method, payback period method and accounting rate of return method are the three
important decision variables used in the evaluation of proposals.
17. The expected life, estimated cash flow and investment cost are the three methods used in the
evaluation of capital investment proposals.
18. The most commonly used methods in the evaluation of capital investment proposals are net present
value method, payback period method and the accounting rate-of-return method.
19. Qualitative factors will not be considered in the evaluation of capital investment proposals.
20. Competition, availability and training of employees, anticipated future technological improvements are
some of the examples of qualitative factors.
21. Availability of funds is not the criteria for deciding on the capital investment proposals.
22. The proposals with the highest rank are funded first in the capital investment decisions.
23. The acceptable proposals are ranked in order of net present value, payback period or rate of return in
capital investment decisions.
24. Any proposal that fails to produce minimum rate but produces the hurdle rate will be accepted.
25. The minimum rate of return is also known as the hurdle rate.
26. The minimum rate of return is fixed by the stockholders.
27. The proposals that will produce poor returns will have a positive impact on the organization’s
profitability.
28. Depending on the mixture of sources of capital, a company’s cost of capital will vary.
29. Only large corporations benefit from capital investment analysis.
30. Employees from every part of the organization participate in capital investment analysis.
31. The cost of debt, the cost of preferred stock, the cost of common stock and the cost of retained
earnings are the components of cost of capital.
32. Cost of capital of a company will be determined in four steps.
33. The cost of capital is the simple average rate of return that a company must pay to its long-term
creditors and the shareholders.
34. Projected cash flows could vary each year of an asset’s life.
35. When deciding whether to keep or replace a fixed asset, the asset’s carrying value could be relevant to
the decision.
36. The carrying value of the old asset in a machine replacement decision is irrelevant.
37. The future value of a cash flow is always larger than the present value of that cash flow.
38. Simple interest is the interest earned on a principal sum that is increased at the end of each period by
the interest for that period.
39. Present value is the amount that must be invested today at a given rate of compound interest to
produce a given future value.
40. Ordinary annuity cash flows occur at the beginning of the interest period.
41. To use an annuity table, the cash flows for each interest period must be equal.
42. Net present value analysis is based on a project’s cash flows.
43. An advantage of the net present value method is that it considers the time value of money.
44. The most beneficial projects are the ones with the lowest net present value.
45. The discount rate used in net present value calculations is the company’s minimum rate of return.
46. The company’s minimum rate of return is also referred to as its cost of capital.
47. A project with a net present value of zero should not be accepted.
48. The three techniques used to evaluate capital investment alternatives all use the project’s expected net
income.
49. The accounting rate-of-return method is difficult to comprehend and apply.
50. When using the accounting rate-of-return method, the net income has to be averaged over the life of
the investment.
51. The accounting rate-of-return method implements the effects of the time value of money.
52. The purpose of establishing a desired rate of return on investment is to set a point below which the best
alternative will be considered acceptable.
53. Supporting poor-return proposals that fall below the minimum rate of return eventually lowers the
entire company’s profitability.
54. The accounting rate of return is calculated by dividing the project’s investment by its net income.
55. The payback period is based on a project’s net income.
56. The accounting rate-of-return method is widely used to measure the estimated performance of a capital
investment, primarily because it is very accurate.
57. When two or more capital investment proposals are being evaluated using the accounting
rate-of-return method, the proposal that yields the highest ratio of net income to average cost of
investment is selected.
58. The accounting rate-of-return method does not consider the time value of money.
59. The payback period method of evaluating proposed capital investment does not take into account the
time value of money.
60. The payback period equals the cost of the capital investment divided by annual sales revenue.
61. The alternative with the highest payback period is the most desirable.
62. To analyze a capital investment using the accounting rate–of-return method, one can use an estimated
amount for the annual net income.
MULTIPLE CHOICE
1. Various parts of the organization that are involved in capital investment analysis include all of the
following except
a.
financial analysts
b.
marketing specialists
c.
creditors
d.
managers
2. Qualitative factors that are considered by decision makers include all of the following except
a.
impact on other company operations
b.
revenue from fees
c.
anticipated future technological improvements
d.
competition.
3. The key steps followed by the managers in capital investment analysis include all of the following
except
a.
identification of capital investment needs
b.
preliminary screening
c.
formal requests for capital investments
d.
sunk costs.
4. A minimum rate of return will be set by the organizations to guard
a.
the minimum costs
b.
the profitability
c.
fixed costs
d.
variable costs
5. Which of the following could not be the appropriate method used in evaluating proposed capital
investments
a.
Net present value method
b.
Payback period method
c.
The carrying value of the department’s equipment
d.
Accounting rate of return method
6. The minimum rate of return is also known as
a.
hurdle rate
b.
payback period
c.
net present value
d.
cost of debt
7. The components of cost of capital include all of the following except
a.
the cost of debt
b.
the cost of preferred stock
c.
the cost of common stock and retained earnings
d.
the minimum rate of return
8. The financing structure of Taylor communications is as follows:
Source of Capital Proportion of capital Cost of Capital
Debt financing, $300,000 30% 6%
Preferred stock, $100,000 10% 8%
Common stock, $400,000 40% 12%
Retained earnings, $200,000 20% 12%
The cost of equity capital is the return required by
a.
stockholders
b.
preferred shareholders
c.
creditors
d.
financial institutions
9. The financing structure of Taylor communications is as follows:
Source of Capital Proportion of capital Cost of Capital
Debt financing, $300,000 30% 6%
Preferred stock, $100,000 10% 8%
Common stock, $400,000 40% 12%
Retained earnings, $200,000 20% 12%
The weighted cost of debt is
a.
2.4%
b.
4.8%
c.
.8%
d.
1.8%
10. The financing structure of Taylor communications is as follows:
Source of Capital Proportion of capital Cost of Capital
Debt financing, $300,000 30% 6%
Preferred stock, $100,000 10% 8%
Common stock, $400,000 40% 12%
Retained earnings, $200,000 20% 12%
The weighted cost of preferred stock is
a.
.8%
b.
4.8%
c.
2.4%
d.
9.8%
11. Smile Industries capital structure consists of $1,000,000 of debt at 6 percent interest and 1,500,000 of
stockholders equity at 2 percent.
The overall cost of capital is
a.
2.4%
b.
4.8%
c.
.8%
d.
9.8%
12. Smile Industries capital structure consists of $1,000,000 of debt at 6 percent interest and 1,500,000 of
stockholders equity at 2 percent.
The proportion of Debt in the total capital structure is
a.
10%
b.
15%
c.
40%
d.
100%
13. Smile Industries capital structure consists of $1,000,000 of debt at 6 percent interest and 1,500,000 of
stockholders equity at 2 percent.
The proportion of Equity in the total capital structure is
a.
40%
b.
60%
c.
100%
d.
15%
14. The average cost of capital of Smile Industries is
a.
2.4%
b.
1.2%
c.
.6%
d.
3.6%
15. Decisions to install new equipment, replace old equipment, and purchase or construct a new building
are examples of
a.
capital investment decisions.
b.
incremental analysis.
c.
sales mix analysis.
d.
direct costing decisions.
16. Capital investment analysis involves all of the following except
a.
preparing reports for management.
b.
analyzing the sales mix.
c.
selecting the best alternative.
d.
dividing available capital investment funds.
17. Depreciation expense influences cash flows because it directly affects
a.
the amount of income taxes paid by the company.
b.
cash received from revenues during the current period.
c.
the carrying value of the asset.
d.
accumulated depreciation.
18. If an equipment replacement decision would not affect revenue, its benefits could still be measured by
analyzing its
a.
cost savings.
b.
net cash flows.
c.
effect on net income.
d.
net cash outflows.
19. The undepreciated portion of the original cost of a fixed asset is the
a.
carrying value.
b.
depreciation expense.
c.
residual value.
d.
accumulated depreciation.
20. What role do marketing specialists play in capital investment analysis?
a.
They predict sales trends and new product demands.
b.
They provide estimates as to how much money can be spent on capital facilities.
c.
They supply a target cost of capital.
d.
They designate the desired rate of return.
21. Depreciation is a unique expense because it
a.
does not require a cash outlay.
b.
does not affect income taxes.
c.
is the same amount every accounting period.
d.
has to be calculated.
22. Cost analysis for capital investment decisions is best accomplished by techniques that
a.
discount cash flows over a project’s life.
b.
emphasize the liquidity of invested costs.
c.
clearly distinguish different cost behavior patterns.
d.
accrue, defer, and allocate costs to short time periods.
23. The time value of money concept is given consideration in long-range investment decisions by
a.
investing only in short-term projects.
b.
weighting cash flows with subjective probabilities.
c.
assuming equal annual cash flow patterns.
d.
assigning greater value to more immediate cash flows.
24. With regard to the time value of money,
a.
amounts are adjusted for inflation over the period of the investment.
b.
the amount of the present value is always higher than the future value.
c.
the future value amount is always higher than the present value amount.
d.
the present value and the future value have to be equal.
25. When considering the time value of money, use compounding to find the __________ value of money
now held.
a.
present
b.
historical
c.
future
d.
discounted
26. Discounting calculates the __________ value of an amount to be received.
a.
future
b.
compounded
c.
present
d.
book
27. The net present value method of evaluating proposed investments
a.
measures a project’s time-adjusted rate of return.
b.
discounts cash flows at the minimum desired rate of return.
c.
ignores cash flows beyond the payback period.
d.
applies only to mutually exclusive investment proposals.
28. In the capital investment decision process, the management accountant’s responsibilities lie in the area
of
a.
methods of computation and final screening.
b.
final selection of alternatives.
c.
detection of facility need.
d.
initial screening.
29. A project is accepted under the net present value method when
a.
the percentage return is greater than a predetermined minimum percentage.
b.
total net cash inflows exceed the purchase price of the asset.
c.
the purchase price of the asset is less than the present value of net cash inflows.
d.
the present value of net cash inflows exceeds a predetermined minimum amount.
30. A company is considering a project with annual after-tax cash flows of $5,600.00 per year for six
years. The company’s cost of capital is 14 percent. Present and future value factors for a 14 percent
interest rate for six years are as follows:
Future value of $1
2.195
Present value of $1
0.456
Future value of a series of equal payments
8.536
Present value of a series of equal payments
3.889
Using the net present value method, what is the maximum amount that the company should invest?
a.
$21,778.40
b.
$47,801.60
c.
$12,292.00
d.
$2,553.60
31. When using the net present value method to compare keeping an old building or disposing of it and
acquiring a new building, the current cash residual value of the old building should be
a.
a subtraction from the price paid for the new building.
b.
viewed as a cash flow.
c.
an addition to the price paid for the new building.
d.
irrelevant to the decision.
32. Annual net cash flows are defined as
a.
annual cash inflows minus annual cash outflows.
b.
annual cash inflows minus annual cash outflows minus depreciation expense.
c.
annual revenues minus expenses.
d.
annual cash inflows minus capital investment.
33. Assuming revenues are received in cash and expenses, except for depreciation, are paid in cash, net
cash flows for a period are equal to
a.
net income minus depreciation expense.
b.
net income.
c.
net income plus depreciation expense.
d.
net income plus income tax expense.
34. Omaha, Inc., is expected to have the following cash revenues and expenses (other than depreciation) in
20xx:
Sales
$82,000
Depreciation expense
$ 5,000
Selling, general, and
Income tax expense
3,000
administrative expenses
Cost of goods sold
45,000
(excluding depreciation)
10,000
Omaha’s estimated 20xx net cash flows are
a.
$21,000.
b.
$19,000.
c.
$24,000.
d.
$14,000.
35. Chicago Co. is interested in purchasing a machine that would improve its operational efficiency. The
cost is $200,000 with an estimated residual value of $20,000 and a useful life of eight years. Cash
inflows are expected to increase by $40,000 a year. The company’s minimum rate of return is 10
percent. The present value of $1 for eight years at 10 percent is 0.467, and the present value of an
annuity of $1 at 10 percent and eight years is 5.335.
The net present value of the project is
a.
$74,520.
b.
$120,100.
c.
$93,400.