Foundations of Financial Management, 17e (Block)
Chapter 12 The Capital Budgeting Decision
1) Capital budgeting decisions involve a minimum time horizon of five years.
2) A good capital budgeting program requires that a number of steps be taken in the decision-
making process. The first step is the explanation of data.
3) Possibly the most overlooked part of the capital budgeting process is the search for new
opportunities through innovation and creative thinking.
4) In most capital budgeting decisions, the emphasis should be on reported earnings rather than
cash flows.
5) Even though one project may have superior cash flows, top management may sometimes
choose a project that inflates earnings instead of cash flow.
6) The first administrative consideration in any capital budgeting process is collection of data.
7) It is not unusual for a corporate president to be as sensitive to after-tax income as cash flows.
8) Capital budgeting is only a concern of finance and accounting personnel.
9) We add depreciation to net income to arrive at a true earnings picture.
10) The payback method is very basic but it gives the user an understanding of when the cost of
the initial project will be completely paid off.
11) The payback method is not really a theoretically correct approach.
12) A rapid payback may be important to firms having rapid technological development.
13) Using the payback method can be appropriate when the time value of money is considered.
14) Depreciation is important in calculating projected cash flows because it lowers the profits,
but does not affect the cash account.
15) To find the exact internal rate of return for projects with uneven cash flows, we can
interpolate between two factors from the time value of money table: present value of a $1.
16) With non-mutually exclusive events and no capital rationing, we will usually arrive at the
same conclusions using either the net present value or internal rate of return methods.
17) The internal rate of return is the interest rate that equates the cash outflows of an investment
with the subsequent cash inflows.
18) The net present value’s primary advantage over the internal rate of return method is that it
does not require the time value of money calculations that the internal rate of return requires.
19) Non-mutually exclusive alternatives can be accepted at the same time.
20) The selection of a mutually exclusive project means that all other projects with a positive net
present value may also be selected.
21) The profitability index is calculated by dividing the project’s net present value by the present
value of the projected cash outflows.
22) It is the difference in the reinvestment assumptions that can be significant in determining
when to use the net present value or internal rate of return methods.
23) Under the net present value method, cash flows are assumed to be reinvested at the firm’s
weighted average cost of capital.
24) For high-internal rate of return investments, it is perfectly acceptable to assume that
reinvestment will occur at an equally high, if not higher, rate.
25) The modified internal rate of return method assumes that inflows are reinvested at 80% of
the internal rate of return.
26) Under capital rationing, a firm will maximize profitability.
27) The net present value profile allows a firm to examine the project’s net present value over
time without any adjustments.
28) The net present values’ weakness is that it does not provide a decision for mutually exclusive
investments.
29) Net present value (NPV) is considered a theoretically correct method and is also often the
preferred investment selection method in practice.
30) When using accelerated depreciation, the present value of future cash flows increases.
31) The internal rate of return (IRR) measures the profitability of investments as a return
percentage.
32) Under the “modified accelerated-cost-recovery system” (MACRS) of depreciation, cash flow
tends to decline with the passage of time.
33) Although firms can elect to use straight-line depreciation for their external financial
reporting, the MACRS depreciation schedules have exceeded in use over other depreciation
methods for tax purposes.
34) In most cases, asset lives are shorter under MACRS depreciation than they would be with
straight-line depreciation.
35) Most real estate property is depreciated over a 10-year period.
36) For a small business, it is possible for the purchase price of an asset to be expensed rather
than depreciated.
37) Under MACRS depreciation, taxes paid in the first year of an asset’s life are subtracted from
the base used to calculate depreciation expense.
38) Under MACRS depreciation, there are no tax credits for the purpose of calculating the base
for depreciation expenses.
39) Under MACRS depreciation, the tax life of an asset and its economically useful life are
assumed to be the same.
40) If an asset is sold for a price above its book value, the difference is considered taxable
income to the firm.
41) A tax loss on the sale of a depreciable asset used in business or trade may be written off
against income.
42) In a replacement decision, a book loss on an old asset can be a valuable feature.
43) The dollar amount of losses incurred when an old asset is sold below book value is added to
the purchase price of a new asset in calculating the base for depreciation.
44) Cash flow is used for a net present value analysis, while earnings are used for the internal
rate of return and payback analysis.
45) When net present value and internal rate of return analysis provide inconsistent rankings of
projects, the financial manager should generally move forward with the project that has the
highest internal rate of return.
46) Investors discount the later years of a long-term project at a lower rate because they are
generally less precise.
47) It is more likely for financial managers to focus on cash flow and corporate executives to
focus on earnings of the company.
48) Capital rationing is generally a positive action for a firm because it prevents rapid growth,
which can drive up the cost of capital.
49) The reinvestment assumption is a downside of the internal rate of return method of analysis
because it assumes that cash flows are reinvested at the cost of capital.
50) In a general sense, “cash flow” can be said to equal
A) operating income less taxes plus depreciation.
B) operating income less taxes.
C) operating income before depreciation and taxes plus depreciation.
D) operating income after taxes minus depreciation.
51) The reason cash flow is used in capital budgeting is because
A) cash rather than income is used to purchase new machines.
B) cash outlays need to be evaluated in terms of the present value of the resultant cash inflows.
C) to ignore the tax shield provided from depreciation would ignore the cash flow provided by
the machine, which should be reinvested to replace older machines.
D) All of these options are true.
52) The first step in the capital budgeting process is
A) collection of data.
B) idea development.
C) assign probabilities.
D) determine cash flows.
53) Which of the following is not a step in the capital budgeting decision-making process?
A) Search for and discovery of investment opportunities.
B) Collection of data.
C) Evaluation and decision making.
D) All of the above are steps used in this process
54) Capital budgeting is primarily concerned with
A) capital formation in the economy.
B) planning future financing needs.
C) evaluating investment alternatives.
D) minimizing the cost of capital.
55) An appropriate capital budgeting process requires that the following steps be taken in which
order?
a) Collection of data
b) Reevaluation and adjustment
c) Evaluation and decision making
d) Search for and discovery of investment opportunities
A) d, a, c, b
B) d, a, b, c
C) d, b, a, c
D) b, d, a, c
56) Assume a corporation has earnings before depreciation and taxes of $82,000, depreciation of
$45,000, and that it has a 25% combined tax bracket. What are the after-tax cash flows for the
company?
A) $72,750
B) $82,000
C) $42,000
D) $127,000
57) Assume a project has earnings before depreciation and taxes of $15,000, depreciation of
$25,000, and that the firm has a 25% combined tax bracket. What are the after-tax cash flows for
the project?
A) A positive $17,500
B) A positive $19,000
C) A loss of $21,000
D) A positive $28,000
58) Which of the following is not a time-adjusted method for ranking investment proposals?
A) The net present value method
B) The payback method
C) The internal rate of return method
D) All of these options are time-adjusted methods.
59) Which of the following statements about the “payback method” is true?
A) The payback method considers cash flows after the payback has been reached.
B) The payback method does not consider the time value of money.
C) The payback method uses discounted cash-flow techniques.
D) The payback method generally leads to the same decision as other investment selection
methods.
60) There are several disadvantages to the payback method, among them:
A) Payback ignores the interest that is earned during the period of time the project is in place.
B) Payback emphasizes receiving money back as fast as possible for reinvestment.
C) Payback is basic to use and understand.
D) Payback can be used in conjunction with time-adjusted methods of evaluation.
61) The payback method has several disadvantages, among them:
A) Payback fails to choose the optimum or most economic solution to a capital budgeting
problem.
B) Payback ignores cash inflows after the payback period.
C) Payback fails to choose the optimum or most economic solution to a capital budgeting
problem, and it ignores cash inflows after the payback period.
D) None of these options are disadvantages.