Chapter 8—Capital Budgeting Process and Decision Criteria
MULTIPLE CHOICE
1. The capital budgeting process involves
a.
identifying potential investments and estimating the incremental cash inflows and
outflows of cash associated with each investment
b.
analyzing and prioritizing the investments utilizing various decision criteria
c.
implementing and monitoring the selected investment projects
d.
estimating a fair rate of return on each investment given its risk
e.
all of the above
2. The preferred technique for evaluating most capital investments is
a.
payback period
b.
discount payback period
c.
internal rate of return
d.
net present value
NARRBEGIN: Gamma Electronics
Gamma Electronics
Gamma Electronics is considering the purchase of testing equipment that will cost $500,000 to replace
old equipment. Assume the new machine will generate after-tax savings of $250,000 per year over the
next four years.
NARREND
3. Refer to Gamma Electronics. What’s the payback period for the investment?
a.
1.8 years
b.
2.0 years
c.
2.5 years
d.
2.8 years
4. Refer to Gamma Electronics. If the firm has a 15% cost of capital, what’s the discount payback period
of the investment?
a.
1.5 years
b.
2.0 years
c.
2.4 years
d.
2.6 years
5. If Gamma Electronics has a 15% cost of capital, what’s the NPV of the investment?
a.
$213,745
b.
$185,865
c.
$713,745
d.
$500,000
6. If Gamma Electronics has a 15% cost of capital, what’s the IRR of the investment?
a.
23.4%
b.
15.0%
c.
34.9%
d.
100.0%
7. If Gamma Electronics has a 15% cost of capital, what’s the profitability index of the investment?
a.
1.4
b.
0.4
c.
2.0
d.
1.0
Exhibit 8-1
The cash flows associated with an investment project are as follows:
Cash Flows
Initial Outflow
-$70,000
Year 1
$20,000
Year 2
$30,000
Year 3
$30,000
Year 4
$30,000
NARREND
8. Refer to Exhibit 8-1. What’s the payback period of the project? If a firm’s cutoff payback period is 3
years, should it accept the project?
a.
2.7 years; reject the project
b.
2.7 years; accept the project
c.
3.6 years; reject the project
d.
3.6 years; accept the project
9. Refer to Exhibit 8-1. If a firm uses discounted payback with a 15% discount rate and a 3-year cutoff
period, what’s the discount payback period of the project? Should the firm accept the project?
a.
3.3 years; reject
b.
3.6 years; reject
c.
3.6 years; accept
d.
2.7 years; accept
10. Flaws of the accounting rate of return method include:
a.
the choice of accounting g hurdle return rate is essentially arbitrary
b.
depreciation method has a large impact on the accounting rate of return
c.
this method makes no adjustment for project risk or for the time value of money
d.
all of the above
11. Refer to Exhibit 8-2. Assume the equipment is depreciated on a straight-line basis over 4 years, what is
the average contribution to net income across all four years?
a.
$0.2m
b.
$0.5m
c.
$0.3m
d.
$0.8m
12. Refer to Exhibit 8-2. The project’s average accounting rate of return equals the average contribution to
net income divided by the average book value of the investment.
Assume the equipment is depreciated on a straight-line basis over 4 years, what is the average
accounting rate of return?
a.
16.7%
b.
33.3%
c.
66.7%
d.
Cannot tell from the given information
13. Suppose a particular investment project will generate an immediate cash inflow of $1,000,000
followed by cash outflows of $500,000 in each of the next three years. What is the project’s IRR?
Suppose a company’s hurdle rate is 15%, should it accept the project?
a.
23%; reject the project
b.
23%; accept the project
c.
15%; reject the project
d.
15%; accept the project
14. Suppose a particular investment project will require an initial cash outlay of $1,000,000 and will
generate a cash inflow of $500,000 in each of the next three years. What is the project’s IRR? Suppose
a company’s hurdle rate is 15%, should it accept the project?
a.
23%; reject the project
b.
23%; accept the project
c.
15%; reject the project
d.
15%; accept the project
15. Future Semiconductors is evaluating a new etching tool. The equipment costs $1.0m and will generate
after-tax cash inflows of $0.4m per year for six years. Assume the firm has a 15% cost of capital.
What’s the NPV of the investment?
a.
$0.51m
b.
$0.45m
c.
$1.51m
d.
$1.69m
16. Should a firm invest in projects with NPV = $0?
a.
Yes
b.
No
c.
The firm is indifferent between accepting or rejecting projects with zero NPVs
d.
The firm should look at the PI and IRR of the projects
17. A firm has 10 million shares outstanding with a current market price of $20 per share. There is one
investment project available to the firm. The initial investment of the project is $20 million, and the
NPV of the project is $10 million. What will be the firm’s stock price if capital markets fully reflect
the value of undertaking the project?
a.
$19
b.
$20
c.
$21
d.
$22
18. Delta Pharmaceuticals has 200 million shares outstanding with a current market price of $30 per share.
Its stock rose to $32 on the news that Delta Pharmaceuticals’ long-awaited new drug Zentac is to hit
the market next month. What’s the market’s consensus of the NPV that the new drug will generate for
Delta Pharmaceuticals?
a.
$400 million
b.
$6,400 million
c.
$6,000 million
d.
None of the above
19. Kelley Industries has 100 million shares of common stock outstanding with a current market price of
$50. The firm is contemplating undertaking an investment project which requires an initial cash
outflow of $100 million. The IRR of the project is equal to the firm’s cost of capital. What will be the
firm’s stock price if capital markets fully reflect the value of undertaking the project?
a.
$50
b.
$49
c.
$51
d.
Cannot tell from the given information
20. Consider a project with the following cash flows.
Year
Cash Flow
0
-$16,000
1
42,000
2
-27,000
What’s the IRR of the project? If a firm’s cost of capital is 15%, should the firm accept the project?
a.
50%; accept the project
b.
12.5%; reject the project
c.
12.5% and 50%; accept the project
d.
12.5%, and 50%; reject the project
21. Consider a project with the following stream of cash flows.
Year
Cash Flow ($ in millions)
0
+80
1
-388
2
+700
3
-557
4
+165
What’s the IRR of the project? If a firm’s cost of capital is 15%, should the firm accept the project?
a.
10%, 25%, 50%; accept the project
b.
10%, 25%, 50%; reject the project
c.
0%, 10%, 25%, 50%; accept the project
d.
10%, 25%; accept the project
NARRBEGIN: Exhibit 8-3 Invst Prpsals
Exhibit 8-3
A firm is evaluating two investment proposals. The following data is provided for the two investment
alternatives.
Initial cash outflow
IRR
NPV(@18%)
Project 1
$250m
28%
$80m
Project 2
$ 50m
36%
$20m
NARREND
22. Refer to Exhibit 8-3. If the two projects are independent, which project should the firm choose based
on the IRR rule?
a.
project 1
b.
project 2
c.
both projects
d.
cannot decide because the hurdle rate is unknown
23. Refer to Exhibit 8-3. If the two projects are mutually exclusive, which project should the firm choose?
What is the problem that the firm should be concerned with in making this decision?
a.
project 1; discount rate
b.
project 2; discount rate
c.
project 1; project scale
d.
project 2; project scale
24. Kelley Industries is evaluating two investment proposals. The scale of Project 1 is roughly 4 times that
of the Project 2. The following data is provided for the two investment alternatives.
IRR
Project 1
28%
Project 2
50%
Incremental project
26%
If the two projects are mutually exclusive, and the firm’s hurdle rate is 18%, which project should the
firm choose?
a.
project 1
b.
project 2
c.
the incremental project
d.
both projects
25. A project may have multiple IRRs when
a.
the project generates an alternating series of net cash inflows and outflows
b.
the project generates an immediate cash inflow followed by cash outflow
c.
the project has a negative NPV
d.
the project is of considerably large scale
26. The IRR method assumes that the reinvestment rate of cash flows is
a.
the cost of capital
b.
the IRR
c.
essentially arbitrary
d.
zero
27. Potential problems in using the IRR as a capital budgeting technique include:
a.
the timing problem
b.
multiple IRRs
c.
the scale problem
d.
all of the above
NARRBEGIN: Thompson Manufacturing
Thompson Manufacturing
Thompson Manufacturing is considering two investment proposals. The first involves a quality
improvement project, and the second is about an advertising campaign. The cash flows associated with
each project appear below.
Quality
Improvement
Advertising
Campaign
Initial cash outflow
$100,000
$100,000
Cash Inflows
Year 1
10,000
80,000
Year 2
30,000
45,000
Year 3
125,000
10,000
NARREND
28. Refer to Tompson Manufacturing. Suppose the hurdle rate of the firm is 10%. Calculate the cash flows
of the “incremental project” by subtracting the cash flows of the second project from the cash flows of
the first project. What is the IRR of the incremental project?
a.
20.7%
b.
23.1%
c.
17.9%
d.
10.0%
29. Refer to Tompson Manufacturing. Suppose the hurdle rate of the firm is 10%. If the two projects are
mutually exclusive, which project should be chosen? What is the problem that the firm should be
concerned with in making this decision?
a.
Quality improvement project; project scales
b.
Advertising campaign; project scales
c.
Quality improvement project; the timing of cash flows
d.
Advertising campaign; the timing of cash flows
e.
Advertising campaign; discount rate
Year 0
Year 1
Year 2
Year 3
Year 0
Year 1
Year 2
Year 3
30. An entrepreneur is offered a service contract that will cost him $600,000 initially. The contract has a 5
years of life and will generate an after tax cash inflow of $160,000 per year. The cost of capital of this
project is 12%. What’s the NPV of the project? Should the entrepreneur accept the contract?
a.
-$23,236; reject
b.
$23,236; accept
c.
-$20,746; reject
d.
$576,764; reject
e.
$41,050; accept
31. The following information is given on three mutually exclusive projects. Assume a cost of capital of
15%. Which project has the highest PI?
Project 1
Project 2
Project 3
Cash flow
Year 0
-$400,000
-$500,000
-$1,000,000
Year 1
200,000
300,000
500,000
Year 2
300,000
300,000
700,000
Year 3
300,000
350,000
700,000
a.
Project 1
b.
Project 2
c.
Project 3
d.
All projects
32. You are provided with the following data on two mutually exclusive projects. The cost of capital is
15%.
Project 1
Project 2
Initial cash outflow
-$5,000
-$1,000
Year 1 cash inflow
$5,000
$1,000
Year 2 cash inflow
$2,500
$ 850
NPV
$1,238
$ 512
PI
1.25
1.51
Which project should you accept? What is the problem that you should be concerned with in making
this decision?
a.
Project 1; the timing of cash flows
b.
Project 2; the timing of cash flows
c.
Project 1; project scale
d.
Project 2; project scale
33. The profitability index is most useful
a.
when the NPV method and the IRR method give conflicting signals on mutually exclusive
projects
b.
in capital rationing situations
c.
when the cash flow pattern is unusual
d.
when project scales are of concern
34. You have a $1 million capital budget and must make the decision about which investments your firm
should undertake for the coming year. There are three projects available and the cash flows of each
project appear below. Assume a cost of capital of 12%. Which project or projects do you select?
Project 1
Project 2
Project 3
Cash flow
Year 0
-$400,000
-$500,000
-$1,000,000
Year 1
200,000
300,000
500,000
Year 2
300,000
350,000
700,000
Year 3
300,000
350,000
700,000
a.
Project 1
b.
Project 2
c.
Project 3
d.
Project 1 & Project 2
35. You must know the discount rate of an investment project to compute its
a.
NPV, IRR, PI, and discount payback period
b.
NPV, PI, discount payback period
c.
NPV, PI, IRR
d.
NPV, accounting rate of return, PI, discount payback period
36. You must know all the cash flows of an investment project to compute its
a.
NPV, IRR, PI, and discount payback period
b.
NPV, IRR, PI, payback period, and discount payback period,
c.
NPV, PI, IRR
d.
NPV, accounting rate of return, IRR, PI
NARRBEGIN: NPV Profile
NPV Profile
The figure below shows the NPV profile for two investment projects.
NARREND
37. Refer to NPV Profile. What’s the IRR for project 1?
a.
12%
b.
14%
c.
18%
d.
Cannot tell from the given information
38. Refer to NPV Profile. What’s the IRR for project 2?
a.
12%
b.
14%
c.
18%
d.
Cannot tell from the given information
39. Refer to NPV Profile. The NPV of which project is more sensitive to the discount rate?
a.
Project 1
b.
Project 2
c.
Equally sensitive
d.
Cannot tell from the given information
40. Refer to NPV Profile. Suppose the two projects require about the same initial investment. Which
project generates more cash flows in the early years?
a.
Project 1
b.
Project 2
c.
There is no difference between the two projects
d.
Cannot tell from the given information
41. Refer to NPV Profile. If Gamma Company has a hurdle rate of 11%, and the two projects are
independent, which project should Gamma Company invest?
a.
Project 1
b.
Project 2
c.
Both project 1 and project 2.
d.
Neither project
42. Refer to NPV Profile. If the hurdle rate is 11%, and the two projects are mutually exclusive, which
project should be accepted?
a.
Project 1
b.
Project 2
c.
Both projects
d.
Neither project
43. Refer to NPV Profile. If the hurdle rate is 13%, and the two projects are mutually exclusive, which
project should be accepted?
a.
Project 1
b.
Project 2
c.
Both projects
d.
Neither project
44. Refer to NPV Profile. If the hurdle rate is 19%, and the two projects are independent, which project
should be accepted?
a.
Project 1
b.
Project 2
c.
Both projects
d.
Neither project
45. Capital investment is also known as:
a.
capital budgeting.
b.
capital hedging.
c.
capital spending.
d.
capital savings.
46. The process of identifying which long-lived investment projects a firm should undertake is known as:
a.
capital spending.
b.
capital budgeting.
c.
capital hedging.
d.
capital investment.
47. Capital budgeting techniques should:
a.
fully account for expected risk and return.
b.
recognize the time value of money.
c.
lead to higher stock prices when applied.
d.
all of the above.
48. The accounting rate of return is calculated as:
a.
sales/stock price
b.
net income/stock price
c.
sales/book value of assets
d.
net income/book value of assets
49. The accounting rate of return:
a.
uses net cash flows.
b.
does not take into account the time value of money.
c.
uses an objectively determined hurdle rate.
d.
all of the above.
50. The main virtue of the payback method is its:
a.
simplicity.
b.
complexity.
c.
completeness.
d.
thoroughness.
51. The payback method:
a.
fails to explicitly consider the time value of money.
b.
is the amount of time it takes for a project to recoup its profits.
c.
is the best method for evaluating complex projects.
d.
is never used by businesses today.
52. A problem with the payback method is:
a.
it assigns a 0 percent discount rate to cash flows that occur before the cutoff point.
b.
it assigns a 10 percent discount rate to cash flows that occur before the cutoff point.
c.
it assigns a 20 percent discount rate to cash flows that occur before the cutoff point.
d.
it assigns a 30 percent discount rate to cash flows that occur before the cutoff point.
53. As the discount rate increases, the NPV of a project:
a.
increases.
b.
decreases.
c.
is unaffected.
d.
cannot be determined with out knowing the discount rate.
54. As the discount rate increases, the IRR of a project: