CHAPTER 10: CAPITAL BUDGETING: DECISION CRITERIA AND REAL
OPTION CONSIDERATIONS
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 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.
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
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
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. none of these
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. none of these
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
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
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
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. Which of the following is not a technique to handle the capital rationing problem?
a. linear programming
b. goal programming
c. ranking projects according to payback
d. ranking projects according to profitability index
15. 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. none of these
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
16. 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
17. 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. none of these
18. 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
19. 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
20. 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
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
21. 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
22. 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
23. 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. all of these
24. 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
25. The “value additivity principle” means that the
a. firm should accept all projects with a positive net present value.
b. firm’s value is the sum of the value of all the projects undertaken
c. firm will grow through the addition of new projects
d. positive net present value is added to the firm’s net worth
26. 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
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
27. 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
28. All of the following are reasons why a firm may face capital rationing except:
a. reluctant to issue additional debt
b. the discount rate is too high
c. lacks the managerial resources
d. restrictive covenants that limit borrowing
29. 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
30. The reason for a postaudit is to
a. help financial managers reduce errors in cash flow estimation
b. reduce the number of accepted risky projects
c. reduce the number of projects submitted
d. determine the correct required rate of return
31. 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
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
32. The value additivity principle indicates that, when a firm undertakes an independent project, the value of the
firm is increased by the from the project.
a. present value of the cash inflows
b. sum of the cash inflows and outflows
c. net present value
d. none of these
33. 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
34. 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. none of these
35. 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. none of these
36. 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. none of these
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
37. 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. none of these
38. 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
39. There are many reasons why a firm can earn above-normal profits. These reasons include all of the following
except:
a. access to superior labor or managerial talents
b. superior access to financial resources at lower costs
c. patent control of superior product designs
d. ability of new firms to acquire necessary factors of production
40. 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
41. 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
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
42. When evaluating international capital expenditure projects, the analyst may compute the present value of the
net cash flows in the local currency and then .
a. discount by one plus the spot rate (1+ S0)
b. multiply by the forward exchange rate
c. discount by the future exchange rate
d. multiply by the spot exchange rate
43. 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
44. The reasons that the amount and timing of the net cash flows to the foreign subsidiary and parent may differ
include:
a. subsidized loans
b. differential tax rates
c. legal and political constraints on cash remittance
d. all of these
45. Entrepreneurial firms with a net worth of less than $1 million tend to prefer the method for evaluating
capital expenditures.
a. NPV
b. IRR
c. Payback
d. Profitability index
46. 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
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
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 net
present value for the project.
a. $940
b. $100,940
c. $77,884
d. $40,000
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 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%
49. 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
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
50. 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
51. 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
52. 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
53. 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
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
54. 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 the 2nd year, $5,000 in the 3rd year, and $3,000 in the 4th
year. 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
55. 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%
56. 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%
57. 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%
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
58. 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
59. 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 its marginal tax rate is 40 percent.
a. $666
b. $1,466
c. $1,866
d. –$134
60. 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
Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
61. Hydroponics is considering adding another greenhouse that would cost $95,000 and generate $20,000 in
annual net cash flows over its 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%
62. 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. none of these
63. 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. None of these
64. 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. none of these/cannot be determined