Principles of Managerial Finance, 15e (Zutter)
Chapter 10 Capital Budgeting Techniques
10.1 Overview of capital budgeting
1) Capital budgeting techniques are used to evaluate a firm’s fixed asset investments which provide the
basis for the firm’s earning power and value.
2) The purchase of additional physical facilities, such as additional property or a new factory, is an
example of a capital expenditure.
3) Capital budgeting is the process of evaluating and selecting short-term investments that are consistent
with the firm’s goal of maximizing owners’ wealth.
4) A capital expenditure is an outlay of funds invested only in fixed assets that is expected to produce
benefits over a period of time less than one year.
5) An outlay for advertising and management consulting is considered to be a fixed asset expenditure.
6) Capital expenditure proposals are reviewed to assess their appropriateness in light of a firm’s overall
objectives and plans, and to evaluate their economic validity.
7) The basic motives for capital expenditures are to expand operations, to replace or renew fixed assets, or
to obtain some other, less tangible benefit over a long period.
8) The primary motive for capital expenditures is to refurbish fixed assets.
9) Research and development is considered to be a motive for making capital expenditures.
10) The capital budgeting process consists of five distinct but interrelated steps: proposal generation,
review and analysis, decision making, implementation, and follow–up.
11) The capital budgeting process consists of four distinct but interrelated steps: proposal generation,
review and analysis, decision making, and termination.
12) Independent projects are projects that compete with one another for a firm’s resources, so that the
acceptance of one eliminates the others from further consideration.
13) If a firm has unlimited funds to invest in capital assets, all independent projects that meet its
minimum investment criteria should be implemented.
14) In capital budgeting, the preferred approaches in assessing whether a project is acceptable are those
that integrate time value procedures, risk and return considerations, and valuation concepts.
15) A $60,000 outlay for a new machine with a usable life of 15 years is an operating expenditure that
would appear as a current asset on a firm’s balance sheet.
16) A nonconventional cash flow pattern associated with capital investment projects consists of an initial
outflow followed by a series of inflows.
17) Time value of money should be ignored in capital budgeting techniques to make accurate decisions.
18) If a firm has limited funds to invest, all the mutually exclusive projects that meet its minimum
investment criteria should be implemented.
19) Mutually exclusive projects are projects whose cash flows are unrelated to one another; the acceptance
of one does not eliminate the others from further consideration.
20) The availability of funds for capital expenditures does not affect a firm’s capital budgeting decisions.
21) Independent projects are those whose cash flows are unrelated to one another; the acceptance of one
does not eliminate the others from further consideration.
22) Mutually exclusive projects are those whose cash flows are constant over a specified period of time
and more than one project needs to be accepted in order to implement capital budgeting decisions.
23) Independent projects are those whose cash flows compete with one another and therefore more than
one project needs to be accepted in order to implement the capital budgeting decision.
24) Mutually exclusive projects are those whose cash flows compete with one another; the acceptance of
one eliminates the others from further consideration.
25) If a firm is subject to capital rationing, it is able to accept all independent projects that provide an
acceptable return.
26) If a firm has unlimited funds, it is able to accept all independent projects that provide an acceptable
return.
27) If a firm is subject to capital rationing, it has only a fixed number of dollars available for capital
expenditures and numerous projects compete for these dollars.
28) The ranking approach involves the ranking of capital expenditure projects on the basis of some
predetermined measure such as the rate of return.
29) The accept-reject approach involves the ranking of capital expenditure projects on the basis of some
predetermined measure, such as the rate of return.
30) A conventional cash flow pattern is one in which an initial outflow is followed only by a series of
inflows.
31) Large firms evaluate the merits of individual capital budgeting projects to ensure that the selected
projects have the best chance of increasing the firm value.
32) A nonconventional cash flow pattern is one in which an initial inflow is followed by a series of
inflows and outflows.
33) ________ is the process of evaluating and selecting long-term investments that are consistent with a
firm’s goal of maximizing owners’ wealth.
A) Recapitalizing assets
B) Capital budgeting
C) Ratio analysis
D) Securitization
34) A $60,000 outlay for a new machine with a usable life of 15 years is called ________.
A) capital expenditure
B) financing expenditure
C) replacement expenditure
D) operating expenditure
35) Fixed assets that provide the basis for a firm’s earning and value are often called ________.
A) tangible assets
B) noncurrent assets
C) earning assets
D) book assets
36) Which of the following is true of a capital expenditure?
A) It is an outlay made to replace current assets.
B) It is an outlay expected to produce benefits within one year.
C) It is commonly used for current asset expansion.
D) It is commonly used to expand the level of operations.
37) The final step in the capital budgeting process is ________.
A) implementation
B) follow-up
C) review and analysis
D) decision making
38) The first step in the capital budgeting process is ________.
A) review and analysis
B) implementation
C) decision making
D) proposal generation
39) ________ projects do not compete with each other; the acceptance of one ________ the others from
consideration.
A) Capital; eliminates
B) Independent; does not eliminate
C) Mutually exclusive; eliminates
D) Replacement; eliminates
40) ________ projects have the same function; the acceptance of one ________ the others from
consideration.
A) Capital; eliminates
B) Independent; does not eliminate
C) Mutually exclusive; eliminates
D) Replacement; eliminates
41) A firm with limited dollars available for capital expenditures is subject to ________.
A) capital dependency
B) capital gains
C) working capital constraints
D) capital rationing
42) Projects that compete with one another, so that the acceptance of one eliminates the others from
further consideration are called ________.
A) independent projects
B) mutually exclusive projects
C) replacement projects
D) capital projects
43) A conventional cash flow pattern associated with capital investment projects consists of an initial
________.
A) outflow followed by a broken cash series
B) inflow followed by a broken series of outlay
C) outflow followed by a series of inflows
D) outflow followed by a series of outflows
44) A nonconventional cash flow pattern associated with capital investment projects consists of an initial
________.
A) outflow followed by a series of both cash inflows and outflows
B) inflow followed by a series of both cash inflows and outflows
C) outflow followed by a series of inflows
D) inflow followed by a series of outflows
45) Which of the following is an example of a nonconventional pattern of cash flows?
A)
Year
0
1
2
3
4
cash flow
–200
150
310
265
200
B)
Year
0
1
2
3
4
cash flow
200
100
–100
200
–300
C)
Year
0
1
2
3
4
cash flow
–200
100
100
200
300
D)
Year
0
1
2
3
4
cash flow
–200
150
150
150
150
10.2 Payback period
1) In the case of annuity cash inflows, the payback period can be found by dividing the initial investment
by the annual cash inflow.
2) The payback period is the amount of time required for a firm to dispose a replaced asset.
3) For calculating payback period for an annuity, all cash flows must be adjusted for time value of money.
4) If a project’s payback period is less than the maximum acceptable payback period, we would accept it.
5) If a project’s payback period is greater than the maximum acceptable payback period, we would reject
it.
6) If a project’s payback period is greater than the maximum acceptable payback period, we would accept
it.
7) The payback period of a project that costs $1,000 initially and promises after-tax cash inflows of $300
for the next three years is 3.33 years.
8) The payback period of a project that costs $1,000 initially and promises after-tax cash inflows of $300
each year for the next three years is 0.333 years.
9) The payback period of a project that costs $1,000 initially and promises after-tax cash inflows of $3,000
each year for the next three years is 0.333 years.
10) The payback period of a project that costs $1,000 initially and promises after-tax cash inflows of $2,000
each year for the next three years is 0.5 years.
11) The payback period is generally viewed as a flawed capital budgeting technique, because it does not
explicitly consider the time value of money by discounting cash flows to find present value.
12) A project must be rejected if its payback period is less than the maximum acceptable payback period.
13) By measuring how quickly a firm recovers its initial investment, the payback period gives implicit
consideration to the time value of money and ignores the timing of cash flows.
14) One strength of payback period is that it fully accounts for the time value of money.
15) One weakness of the payback period approach is its failure to recognize cash flows that occur after the
payback period.
16) Since the payback period can be viewed as a measure of risk exposure, many firms use it as a
supplement to other decision techniques.
17) A major weakness of payback period in evaluating projects is that it cannot specify the appropriate
payback period in light of the wealth maximization goal.
18) Which of the following is the capital budgeting technique that has the weakest connection to the goal
of value maximization?
A) internal rate of return
B) payback period
C) profitability index
D) net present value
19) Which of the following capital budgeting techniques ignores the time value of money?
A) payback period approach
B) net present value
C) internal rate of return
D) profitability index
20) The ________ measures the amount of time it takes a firm to recover its initial investment.
A) profitability index
B) internal rate of return
C) net present value
D) payback period
21) An annuity is ________.
A) a mix of cash flows in conventional and nonconventional
B) a stream of perpetual cash flows
C) a series of constantly growing cash flows
D) a series of equal annual cash flows
Table 10.1
22) The cash flow pattern depicted is associated with a capital investment and may be characterized as
________. (See Table 10.1)
A) an annuity and a conventional cash flow
B) a mixed stream and a nonconventional cash flow
C) an annuity and a nonconventional cash flow
D) a mixed stream and a conventional cash flow
Table 10.2
23) The cash flow pattern depicted is associated with a capital investment and may be characterized as
________. (See Table 10.2)
A) an annuity and a conventional cash flow
B) a mixed stream and a nonconventional cash flow
C) an annuity and a nonconventional cash flow
D) a mixed stream and a conventional cash flow
24) Payback is considered a flawed capital budgeting because it ________.
A) gives explicit consideration to the timing of cash flows and therefore the time value of money
B) gives explicit consideration to risk exposure due to the use of the cost of capital as a discount rate
C) does not gives explicit consideration on the recovery of initial investment and possibility of a calamity
D) it does not explicitly consider the time value of money
25) A firm is evaluating a proposal which has an initial investment of $35,000 and has cash flows of
$10,000 in year 1, $20,000 in year 2, and $10,000 in year 3. The payback period of the project is ________.
A) 1 year
B) 2 years
C) between 1 and 2 years
D) between 2 and 3 years
26) A firm is evaluating a proposal which has an initial investment of $50,000 and has cash flows of
$15,000 per year for five years. The payback period of the project is ________.
A) 1.5 years
B) 2 years
C) 3.3 years
D) 4 years
27) Which of the following statements is true of payback period?
A) If the payback period is less than the maximum acceptable payback period, management should be
indifferent.
B) If the payback period is greater than the maximum acceptable payback period, accept the project.
C) If the payback period is less than the maximum acceptable payback period, accept the project.
D) If the payback period is greater than the maximum acceptable payback period, management should be
indifferent.
28) What is the payback period for Tangshan Mining company’s new project if its initial after-tax cost is
$5,000,000 and it is expected to provide after-tax operating cash inflows of $1,800,000 in year 1, $1,900,000
in year 2, $700,000 in year 3, and $1,800,000 in year 4?
A) 4.33 years
B) 3.33 years
C) 2.33 years
D) 1.33 years
29) Should Tangshan Mining company accept a new project if the company’s maximum payback is 3.5
years and the project’s initial after-tax cost is $5,000,000 followed by after-tax operating cash inflows of
$1,800,000 in year 1, $1,900,000 in year 2, $700,000 in year 3, and $1,800,000 in year 4?
A) Yes, since the payback period of the project is less than the maximum acceptable payback period.
B) No, since the payback period of the project is more than the maximum acceptable payback period.
C) Yes, since the risk exposure of the project is less than the maximum acceptable risk exposure.
D) No, since the risk exposure of the project is more than the maximum acceptable risk exposure.
30) Should Tangshan Mining company accept a new project if its maximum payback is 3.25 years and its
initial after-tax cost is $5,000,000 followed by after-tax operating cash inflows of $1,800,000 in year 1,
$1,900,000 in year 2, $700,000 in year 3, and $1,800,000 in year 4?
A) Yes, since the payback period of the project is less than the maximum acceptable payback period.
B) No, since the payback period of the project is more than the maximum acceptable payback period.
C) Yes, since the risk exposure of the project is less than the maximum acceptable risk exposure.
D) No, since the risk exposure of the project is more than the maximum acceptable risk exposure.
31) Evaluate the following projects using the payback method assuming a rule of 3 years for payback.
Year
Project B
0
-10,000
1
4,000
2
3,000
3
2,000
4
1,000,000
A) Project A can be accepted because the payback period is 2.5 years but Project B cannot be accepted
because its payback period is longer than 3 years.
B) Project B should be accepted because even though the payback period is 2.5 years for Project A and
3.001 for project B, there is a $1,000,000 payoff in the 4th year in Project B.
C) Project B should be accepted because you get more money paid back in the long run.
D) Both projects can be accepted because the payback is less than 3 years.
32) Which of the following is a disadvantage of payback period approach?
A) It does not examine the size of the initial outlay.
B) It does not use net profits as a measure of return.
C) It does not explicitly consider the time value of money.
D) It does not take into account an unconventional cash flow pattern.
33) Which of the following is a strength of payback period?
A) a disregard for cash flows after the payback period
B) only an implicit consideration of the timing of cash flows
C) merely a subjectively determined number
D) It’s simple to calculate and understand.
34) Which of the following is a reason for firms not using the payback method as a guideline in capital
investment decisions?
A) It gives an explicit consideration to the timing of cash flows.
B) The optimal payback period cannot be specified in light of the wealth maximization goal.
C) It is a measure of risk exposure and projects the possibility of a calamity.
D) It is easy to calculate and has intuitive appeal.
10.3 Net present value (NPV)
1) Net present value is considered a superior capital budgeting technique relative to payback since it
gives explicit consideration to the time value of money.
2) The discount rate is the return that an investment project must meet or exceed to maintain or increase
the firm’s value.
3) The net present value is found by subtracting a project’s initial investment from the present value of its
cash inflows discounted at a rate equal to the project’s internal rate of return.
4) A capital budgeting technique that can be computed by subtracting a project’s initial investment from
the present value of its cash inflows discounted at a rate equal to a firm’s cost of capital is called net
present value.
5) A capital budgeting technique that can be computed by subtracting a project’s initial investment from
the present value of its cash inflows discounted at a rate equal to a firm’s cost of capital is called
profitability index.
6) The NPV of a project with an initial investment of $1,000 that provides after-tax operating cash flows of
$300 per year for four years where the firm’s cost of capital is 15 percent is $856.49.
7) The NPV of a project with an initial investment of $2,500 that provides after-tax operating cash flows of
$500 per year for four years where the firm’s cost of capital is 15 percent is $427.49.
8) If the net present value of a project is greater than zero, the firm will earn a return greater than its cost
of capital. The acceptance of such a project would enhance the wealth of the firm’s owners.
9) If the NPV is greater than the initial investment, a project should be rejected.
10) If the NPV is less than the initial investment, a project should be rejected.
11) If the NPV is greater than $0, a project should be accepted.