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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
Multiple Choice
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
d
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
d
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
b
4. According to the profitability index criterion, a project is acceptable if its profitability index is greater than ____.
a.
1 plus the cost of capital
b.
0
c.
or equal to 1
d.
1.1
c
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
b
6. The advantages of the payback approach include all of the following EXCEPT it ____.
a.
is easy to compute
b.
considers a project’s liquidity
c.
considers cash flows, not net income
d.
provides an objective measure of profitability
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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
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 are correct
8. One weakness of the internal rate of return approach is that it ____.
a.
does not directly consider the timing of the cash flows from a project
b.
fails to provide a straightforward decision-making criterion
c.
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 are correct
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 are correct
10. When a project has multiple internal rates of return, the analyst should ____.
a.
choose the highest rate to compare with the firm’s cost of capital
b.
choose the lowest rate to compare with the firm’s cost of capital
c.
choose the rate that seems most “reasonable,” given the project’s cash flows, to compare with the firm’s cost of
capital
d.
compute the project’s net present value and accept the project if its NPV is greater than $0
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
c
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 differ significantly in size
c.
multiple rates of return are a possibility
d.
None of these are correct
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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
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
c
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
c
15. Input flexibility, output flexibility, and expansion options are the three types of ____ options.
a.
growth
b.
shutdown
c.
abandonment
d.
designed-in
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
a
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 are correct
c
18. The net present value method assumes that the cash flows over the life of the project are reinvested at the ____.
a.
computed internal rate of return
b.
risk-free rate
c.
market capitalization rate
d.
firm’s cost of capital
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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
19. The internal rate of return method assumes that the cash flows over the life of the project are reinvested at the ____.
a.
risk-free rate
b.
firm’s cost of capital
c.
computed internal rate of return
d.
market capitalization rate
20. In the absence of capital rationing, the net present value method is normally superior to the ____ method when
choosing among mutually exclusive investments.
I. internal rate of return
II. profitability index
a.
Only statement I is correct.
b.
Only statement II is correct.
c.
Both statements I and II are correct.
d.
Neither statement I nor II is correct.
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 are correct
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
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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
d.
All of these are correct
c
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
a
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
c
28. ____ options allow a firm to design into a project the capability of shifting the product mix of the project if demand or
relative product prices dictate such a shift.
a.
Input flexibility
b.
Output flexibility
c.
Expansion
d.
Growth
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 post-audit 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
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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
d.
determine the correct required rate of return
31. If a capital expenditure project has an expected 20% internal rate of return, and a $10,000 net present value, and one
cash flow sign change, then which one of the following statements about the project is true?
a.
The discount rate used to calculate NPV is greater than 20%
b.
The project has another internal rate of return in addition to the 20% 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 is correct
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 are correct
33. When dealing with ____ cash flows, the ____ is computed with the help of a financial calculator or by using capital
budgeting spreadsheet programs.
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 is correct
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 are correct
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
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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
b.
negative; less than the net investment
c.
zero; equal to the net investment
d.
None of these are correct
a
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 are correct
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
c
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
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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. ____ options give a firm the ability to temporarily stop a project in order to avoid negative cash flows..
a.
Abandonment
b.
Shutdown
c.
Designed-in
d.
Growth
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 are correct
45. A negative net present value project that may ultimately lead to a highly positive net present value project is called
a(n) ____ option.
a.
shutdown
b.
expansion
c.
growth
d.
designed-in
c
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%. Determine the payback period for the project.
a.
0.28 years
b.
1.4 years
c.
3.57 years
d.
17.86 years
c
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%. Determine the net present value for the project.
a.
$940
b.
$100,940
c.
$77,884
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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
d.
$40,000
a
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%. 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%, and the cost of capital is 12%. Compute the net present value for the project.
a.
–$63,523
b.
+$246,477
c.
+$53,523
d.
–$53,523
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%. Determine the profitability index for this project.
a.
1.50
b.
1.028
c.
0.028
d.
0.972
51. A project requires a net investment of $450,000. It has a profitability index of 1.25 based on the firm’s 12% cost of
capital. Determine the net present value of the project.
a.
$112,500
b.
$562,500
c.
$1,012,500
d.
$140,625
a
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%.
a.
$91,520
b.
$15,520
c.
$78,000
d.
$167,474
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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
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%?
a.
Yes, as the NPV is $862.90.
b.
No, as the NPV is -$1,975.70.
c.
No, as the NPV is -$481.70.
d.
Yes, as the NPV is $165.70.
c
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%?
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%
a
58. Using the profitability index, which of the following mutually exclusive projects should be accepted?
Project A: NPV = $6,000; NINV = $50,000
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Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations
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
a
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% and
its marginal tax rate is 40%.
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
c
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%, 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%?
a.
about $8.52 million
b.
about $8.00 million
c.
about $7.52 million
d.
None of these are correct
c