Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 10 Capital-Budgeting Techniques and Practice
10.1 Learning Objective 1
1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal.
10.2 Learning Objective 2
1) The most critical aspect in determining the acceptability of a capital budgeting project is the
impact the project will have on the company’s net income over the projects entire useful life.
2) Advantages of the payback period include that it is easy to calculate, easy to understand, and
that it is based on cash flows rather than on accounting profits.
3) If project A generates $10 million of free cash flow over its five year useful life and project B
generates $8 million of free cash flow over its useful life, then Project A will have a shorter
payback period than Project B, assuming both projects require the same initial investment.
4) A project with a payback period of four years is acceptable as long as the company’s target
payback period is greater than or equal to four years.
5) Two projects that have the same cost and the same expected cash flows will have the same net
present value.
6) The profitability index is the ratio of the company’s net income (or profits) to the initial outlay
or cost of a capital budgeting project.
7) If a project is acceptable using the net present value criteria, then it will also be acceptable
under the less stringent criteria of the payback period.
8) An acceptable project should have a net present value greater than or equal to zero and a
profitability index greater than or equal to one.
9) If a project’s internal rate of return is greater than the project’s required return, then the
project’s profitability index will be greater than one.
10) The net present value profile clearly demonstrates that the NPV of a project increases as the
discount rate increases.
11) The modified internal rate of return represents the project’s internal rate of return assuming
that intermediate cash flows from the project can be reinvested at the project’s required return.
12) One drawback of the payback method is that some cash flows may be ignored.
13) The required rate of return reflects the costs of funds needed to finance a project.
14) The profitability index provides an advantage over the net present value method by reporting
the present value of benefits per dollar invested.
15) The net present value of a project will increase as the required rate of return is decreased
(assume only one sign reversal).
16) Whenever the internal rate of return on a project equals that project’s required rate of return,
the net present value equals zero.
17) One of the disadvantages of the payback method is that it ignores time value of money.
18) The capital budgeting decision-making process involves measuring the incremental cash
flows of an investment proposal and evaluating the attractiveness of these cash flows relative to
the project’s cost.
19) When several sign reversals in the cash flow stream occur, a project can have more than one
IRR.
20) Many firms today continue to use the payback method but also employ the NPV or IRR
methods especially when large projects are being analyzed.
21) NPV is the most theoretically correct capital budgeting decision tool examined in the text.
22) If the net present value of a project is zero, then the profitability index will equal one.
23) The internal rate of return will equal the discount rate when the net present value equals zero.
24) Mutually exclusive projects have more than one IRR.
25) For a project with multiple sign reversals in its cash flows, the net present value can be the
same for two entirely different discount rates.
26) The internal rate of return is the discount rate that equates the present value of the project’s
future free cash flows with the project’s initial outlay.
27) If a project’s profitability index is less than one then the project should be rejected.
28) If a project is acceptable using the NPV criteria, it will also be acceptable when using the
profitability index and IRR criteria.
29) If a firm imposes a capital constraint on investment projects, the appropriate decision
criterion is to select the set of projects that has the highest positive net present value subject to
the capital constraint.
30) For any individual project, if the project is acceptable based on its internal rate of return, then
the project will also be acceptable based on its modified internal rate of return.
31) One positive feature of the payback period is it emphasizes the earliest forecasted free cash
flows, which are less uncertain than later cash flows and provide for the liquidity needs of the
firm.
32) The main disadvantage of the NPV method is the need for detailed, long-term forecasts of
free cash flows generated by prospective projects.
33) The profitability index is the ratio of the present value of the future free cash flows to the
initial investment.
34) Marketing is crucial to capital budgeting success because the goal of a good capital
budgeting project is to maximize the company’s sales.
35) Because the NPV and PI methods both yield the same accept/reject decision, a company
attempting to rank capital budgeting projects for funding consideration can use either method
and get the same results.
36) A project’s IRR is analogous to the concept of the yield to maturity for bonds.
37) NPV assumes reinvestment of intermediate free cash flows at the cost of capital, while IRR
assumes reinvestment of intermediate free cash flows at the IRR.
38) A project’s net present value profile shows how sensitive the project is to the choice of a
discount rate.
39) If a project has multiple internal rates of return, the lowest rate should be used for decision
making purposes.
40) The payback period ignores the time value of money and therefore should not be used as a
screening device for the selection of capital budgeting projects.
41) Many financial managers believe the payback period is of limited usefulness because it
ignores the time value of money; hence, it is referred to as the discounted payback period.
42) The discounted payback period takes the time value of money into account in that it uses
discounted free cash flows rather than actual undiscounted free cash flows in calculating the
payback period.
43) Any project deemed acceptable using the discounted payback period will also be acceptable
if using the traditional payback period.
44) A major disadvantage of the discounted payback period is the arbitrariness of the process
used to select the maximum desired payback period.
45) A project with a NPV of zero should be rejected since even the returns on U.S. Treasury bill
are greater than zero.
46) NPV may be calculated on an Excel spreadsheet simply by entering the project’s free cash
flows into Excel’s NPV function.
47) The internal rate of return is the discount rate that equates the present value of the project’s
free cash flows with the project’s initial cash outlay.
48) A project that is very sensitive to the selection of a discount rate will have a steep net present
value profile.
49) Because the MIRR assumes reinvestment at the cost of capital while IRR assumes
reinvestment at the project’s IRR, the MIRR will always be less than the IRR.
50) Calculating the modified internal rate of return on an Excel spreadsheet involves the use of
the IRR function multiple times, once using the financing rate, and once using the reinvestment
rate.
51) The capital budgeting manager for XYZ Corporation, a very profitable high technology
company, completed her analysis of Project A assuming 5-year depreciation. Her accountant
reviews the analysis and changes the depreciation method to 3-year depreciation. This change
will
A) increase the present value of the NCFs.
B) decrease the present value of the NCFs.
C) have no effect on the NCFs because depreciation is a non-cash expense.
D) only change the NCFs if the useful life of the depreciable asset is greater than 5 years.
52) Project C requires a net investment of $1,000,000 and has a payback period of 5.6 years. You
analyze Project C and decide that Year 1 free cash flow is $100,000 too low, and Year 3 free
cash flow is $100,000 too high. After making the necessary adjustments
A) the payback period for Project C will be longer than 5.6 years.
B) the payback period for Project C will be shorter than 5.6 years.
C) the IRR of Project C will increase.
D) the NPV of Project C will decrease.
53) Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14
percent. Both projects have a required return of 12 percent. Which of the following statements is
most correct?
A) Both projects have a positive net present value (NPV).
B) Project A must have a higher NPV than project B.
C) If the required return were less than 12 percent, Project B would have a higher IRR than
Project A.
D) Project B has a higher profitability index than Project A.
54) Which of the following statements is most correct?
A) If a project’s internal rate of return (IRR) exceeds the required return, then the project’s net
present value (NPV) must be negative.
B) If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
C) The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return
equal to the IRR.
D) A project with a NPV = 0 is not acceptable.
55) Rent-to-Own Equipment Co. is considering a new inventory system that will cost $750,000.
The system is expected to generate positive cash flows over the next four years in the amounts of
$350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four.
Rent-to-Own’s required rate of return is 8%. What is the payback period of this project?
A) 4.00 years
B) 3.09 years
C) 2.91 years
D) 2.50 years
56) Rent-to-Own Equipment Co. is considering a new inventory system that will cost $750,000.
The system is expected to generate positive cash flows over the next four years in the amounts of
$350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four.
Rent-to-Own’s required rate of return is 8%. What is the net present value of this project?
A) $104,089
B) $100,328
C) $96,320
D) $87,417
57) Rent-to-Own Equipment Co. is considering a new inventory system that will cost $750,000.
The system is expected to generate positive cash flows over the next four years in the amounts of
$350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four.
Rent-to-Own’s required rate of return is 8%. What is the internal rate of return of this project?
A) 10.87%
B) 11.57%
C) 13.68%
D) 15.13%
58) Rent-to-Own Equipment Co. is considering a new inventory system that will cost $750,000.
The system is expected to generate positive cash flows over the next four years in the amounts of
$350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four.
Rent-to-Own’s required rate of return is 8%. What is the modified internal rate of return of this
project?
A) 10.87%
B) 11.57%
C) 13.68%
D) 15.13%
59) Project XYZ requires an initial outlay of $400,000 and has a profitability index of 1.5. The
project is expected to generate equal annual cash flows over the next twelve years. The required
return for this project is 20%. What is project XYZ’s net present value?
A) $600,000
B) $150,000
C) $120,000
D) $80,000
60) Project ZZQ requires an initial outlay of $500,000 and has a profitability index of 1.4. The
project is expected to generate equal annual cash flows over the next ten years. The required
return for this project is 16%. What is project ZZQ’s internal rate of return?
A) 19.88%
B) 22.69%
C) 24.78%
D) 26.12%
61) A capital budgeting project has a net present value of $30,000 and a modified internal rate of
return of 15%. The project’s required rate of return is 13%. The internal rate of return is
A) greater than $30,000.
B) less than 13%.
C) between 13% and 15%.
D) greater than 15%
62) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
The net present value for Project A is
A) $12,358.
B) $16,947.
C) $19,458.
D) $26,074.
63) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
The net present value for Project B is
A) $58,097.
B) $66,363.
C) $74,538.
D) $112,000.
64) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
The profitability index for Project A is
A) 1.27.
B) 1.22.
C) 1.17.
D) 1.12.
65) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
The profitability index for Project B is
A) 1.55.
B) 1.48.
C) 1.39.
D) 1.33.
66) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
The internal rate of return for Project A is
A) 31.43%.
B) 29.42%.
C) 25.88%.
D) 19.45%.
67) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
The internal rate of return for Project B is
A) 29.74%.
B) 30.79%.
C) 35.27%.
D) 36.77%.
68) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is
10%.The modified internal rate of return for Project A is
A) 19.19%.
B) 24.18%.
C) 26.89%.
D) 29.63%.
69) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
The modified internal rate of return for Project B is
A) 17.84%.
B) 18.52%.
C) 19.75%.
D) 22.80%.
70) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
Which project would you recommend using the replacement chain method to evaluate the
projects with different lives?
A) Project B because its NPV is higher than Project A’s replacement chain NPV of $47,623.
B) Project A because its replacement chain NPV is $76,652, which exceeds the NPV for Project
B.
C) Project A because its replacement chain NPV is $45,642, which is less than the NPV for
Project B.
D) Both projects will be valued the same since they are now both four year projects.
71) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%.
The equivalent annual annuity amount for project B, rounded to the nearest dollar, is
A) $17,385.
B) $20,936.
C) $22,789.
D) $26,551.
72) The net present value method
A) is consistent with the goal of shareholder wealth maximization.
B) recognizes the time value of money.
C) uses all of a project’s cash flows.
D) all of the above.
73) Arguments against using the net present value and internal rate of return methods include
that
A) they fail to use accounting profits.
B) they require detailed long-term forecasts of the incremental benefits and costs.
C) they fail to consider how the investment project is to be financed.
D) they fail to use the cash flow of the project.
74) All of the following are sufficient indications to accept a project except (assume that there is
no capital rationing constraint, and no consideration is given to payback as a decision tool):
A) The net present value of an independent project is positive.
B) The profitability index of an independent project exceeds one.
C) The IRR of a mutually exclusive project exceeds the required rate of return.
D) The NPV of a mutually exclusive project is positive and exceeds that of all other projects.
75) When reviewing the net present profile for a project
A) the higher the discount rate, the higher the NPV.
B) the higher the discount rate, the higher the IRR.
C) the IRR will always be a point on the horizontal axis line where NPV = 0.
D) the IRR will always be a point on the horizontal axis equal to the required return.
76) A project requires an initial investment of $389,600. The project generates free cash flow of
$540,000 at the end of year 4. What is the internal rate of return for the project?
A) 138.6%
B) 38.6%
C) 8.5%
D) 6.9%
77) Welltran Corp.can purchase a new machine for $1,875,000 that will provide an annual net
cash flow of $650,000 per year for five years. The machine will be sold for $120,000 after taxes
at the end of year five. What is the net present value of the machine if the required rate of return
is 13.5%.
A) $558,378
B) $513,859
C) $473,498
D) $447,292
78) Given the following annual net cash flows, determine the internal rate of return to the nearest
whole percent of a project with an initial outlay of $750,000.
YEAR NET CASH FLOW
1 $500,000
2 $150,000
3 $250,000
A) 9%
B) 11%
C) 13%
D) 15%
79) A machine that costs $1,500,000 has a 3-year life. It will generate after tax annual cash flows
of $700,000 at the end of each year. It will be salvaged for $200,000 at the end of year 3. If your
required rate of return for the project is 13%, what is the NPV of this investment?
A) $291,417
B) $400,000
C) $600,000
D) $338,395
80) Initial Outlay Cash Flow in Period
1 2 3 4
$4,000,000 $1,546,170 $1,546,170 $1,546,170 $1,546,170
The Internal Rate of Return (to nearest whole percent) is:
A) 10%.
B) 18%.
C) 20%.
D) 24%.
81) We compute the profitability index of a capital budgeting proposal by
A) multiplying the internal rate of return by the cost of capital.
B) dividing the present value of the annual after tax cash flows by the cost of capital.
C) dividing the present value of the annual after tax cash flows by the cash investment in the
project.
D) multiplying the cash inflow by the internal rate of return.
82) What is the payback period for a project with an initial investment of $180,000 that provides
an annual cash inflow of $40,000 for the first three years and $25,000 per year for years four and
five, and $50,000 per year for years six through eight?
A) 5.80 years
B) 5.20 years
C) 5.40 years
D) 5.59 years
83) The advantages of NPV are all of the following except:
A) it can be used as a rough screening device to eliminate those projects whose returns do not
materialize until later years.
B) it provides the amount by which positive NPV projects will increase the value of the firm.
C) it allows the comparison of benefits and costs in a logical manner through the use of time
value of money principles.
D) it recognizes the timing of the benefits resulting from the project.
84) The disadvantage of the IRR method is that:
A) the IRR deals with cash flows.
B) the IRR gives equal regard to all returns within a project’s life.
C) the IRR will always give the same project accept/reject decision as the NPV.
D) the IRR requires long, detailed cash flow forecasts.
85) The internal rate of return is
A) the discount rate that makes the NPV positive.
B) the discount rate that equates the present value of the cash inflows with the present value of
the cash outflows.
C) the discount rate that makes NPV negative and the PI greater than one.
D) the rate of return that makes the NPV positive.
86) All of the following are criticisms of the payback period criterion except:
A) Time value of money is not accounted for.
B) Cash flows occurring after the payback are ignored.
C) It deals with accounting profits as opposed to cash flows.
D) None of the above; they are all criticisms of the payback period criteria.
87) Northwest Industries is considering a project with the following cash flows:
Initial Outlay = $126,000
Cash Flows: Year 1 = $44,000
Year 2 = $59,000
Year 3 = $64,000
Compute the net present value of this project if the company’s discount rate is 14%.
A) -$249,335
B) -$138,561
C) $239,209
D) $725,000
88) Simplicity Printers is considering a project with the following cash flows:
Initial Outlay = $126,000
Cash Flows: Year 1 = $44,000
Year 2 = $59,000
Year 3 = $64,000
If the appropriate discount rate is 11.5%, compute the NPV of this project.
A) -$14,947
B) $2,892
C) $7,089
D) $41,000
89) Your company is considering a project with the following cash flows:
Initial Outlay = $3,000,000
Cash Flows Year 1-8 = $547,000
Compute the internal rate of return on the project.
A) 6.38%
B) 8.95%
C) 9.25%
D) 12.34%
90) For the net present value (NPV) criteria, a project is acceptable if NPV is ________, while
for the profitability index a project is acceptable if PI is ________.
A) greater than zero; greater than the required return
B) greater than or equal to zero; greater than zero
C) greater than one; greater than or equal to one
D) greater than or equal to zero; greater than or equal to one