Deck 12: The Capital Budgeting Decision

Question 1

The first administrative consideration in any capital budgeting process is collection of data.
The first step is the search for opportunities among alternatives.

Answer 1

False

Question 2

Even though one project may have superior cash flows, top management may sometimes choose a project that inflates earnings instead of cash flow.

Answer 2

True

Question 3

The net present value profile's primary advantage over the internal rate of return method is that it does not require the time-consuming, trial-and-error calculations of the IRR.

Answer 3

False

Question 4

To find the exact internal rate of return for projects with uneven cash flows, we can interpolate between two present value annuity factors from Appendix
D.
Appendix D can only be used for an even and unchanging series of periodic cash flows (an "annuity").

Question 5

Possibly the most overlooked part of the capital budgeting process is the search for new opportunities through innovation and creative thinking.

Question 6

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.
The first step involves searching for investment opportunities.

Question 7

Depreciation is important in calculating projected cash flows because it generates a tax deduction.

Question 8

Capital budgeting decisions involve a minimum time horizon of five years.
Project expenditures are planned for at least one year.

Question 9

Non-mutually exclusive alternatives can be accepted at the same time.

Question 10

The payback method is not really a theoretically correct approach.

Question 11

The internal rate of return is the interest rate that equates the cash outflows of an investment with the subsequent inflows.

Question 12

We add depreciation to net income to arrive at a true earnings picture.
Depreciation is re-added to net income to move closer to a "cash basis" earnings number, since it represents a "non-cash" expense.

Question 13

Capital budgeting is only a concern of finance and accounting personnel.

Question 14

In most capital budgeting decisions, the emphasis should be on reported earnings rather than cash flows.
Cash flow is given more emphasis in capital budgeting decisions than earnings.

Question 15

A rapid payback may be important to firms having rapid technological development.

Question 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.

Question 17

It is not unusual for a corporate president, who deals with security analysts, to be as sensitive to after-tax income as to cash flow.

Question 18

The payback method considers all cash inflows.
The payback method does not consider any cash flows that occur after the point of payback has been reached.

Question 19

The payback method is basic to understand and places a heavy emphasis on liquidity.

Question 20

Using the payback method can be appropriate when the time value of money is very low.

Question 21

In most cases, asset lives are shorter under MACRS depreciation than they would be with straight-line depreciation.
Asset lives will be generally comparable under alternative methods.

Question 22

For a small business, it is possible for the purchase price of an asset to be expensed rather than depreciated.

Question 23

Most real estate property is depreciated over a 10-year period.
Under the MACRS regulations, depreciation on real estate typically begins at no less than 27.5 years.

Question 24

Under MACRS depreciation, the tax life of an asset and its economically useful life are assumed to be the same.

Question 25

Under the net present value method, cash flows are assumed to be reinvested at the firm's weighted average cost of capital.

Question 26

If an asset is sold for a price above its book value, the difference is considered taxable income to the firm.

Question 27

The selection of a mutually exclusive project means that all other projects with a positive net present value may also be selected.
By definition, mutually exclusive means that the selection of one project precludes the selection of any other alternative.

Question 28

The net present value profile allows a firm to examine the project's net present value over time.
The method provides a comparison at the investment origin point between current cash flows and future discounted cash flows.

Question 29

The modified internal rate of return method assumes that inflows are reinvested at 80% of the internal rate of return.

Question 30

The net present value profile's weakness is that it does not provide a decision for mutually exclusive investments.

Question 31

The net present value profile examines the relationship of the discount rate to the net present value.
It represents the graphic portrayal of a project using different discount rates.

Question 32

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.

Question 33

When using accelerated depreciation, the present value of future cash flows increases.
By moving greater tax deductions into earlier years that carry a greater PV effect, with all other things being equal, the PV of cash inflows in earlier years is then amplified.

Question 34

Under MACRS depreciation, taxes paid in the first year of an asset's life are subtracted from the base used to calculate depreciation expense.
It would be inaccurate and inappropriate to adjust for tax savings in calculating a depreciable base.

Question 35

Although firms can elect to use straight-line depreciation for their external financial reporting, the MACRS depreciation schedules have superseded other depreciation methods for tax purposes.

Question 36

For high-IRR investments, it is perfectly acceptable to assume that reinvestment will occur at an equally high, if not higher, rate.
Under the IRR assumption, it may be unrealistic to assume reinvestment at that high resulting rate can occur.

Question 37

Under MACRS depreciation, there are no tax credits for the purpose of calculating the base for depreciation expenses.

Question 38

The profitability index is calculated by dividing the project's net present value by the present value of the projected cash outflows.

Question 39

Under the "modified accelerated-cost-recovery system" (MACRS) of depreciation, cash flow tends to decline with the passage of time.

Question 40

Under capital rationing, a firm will maximize profitability.
Capital rationing is a management-imposed constraint, rather than a result of marginal analysis.

Question 41

Cash flow is used for a net present value analysis, and earnings are used for an IRR and payback analysis.
Cash flow is used for all such analyses.

Question 42

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.

Question 43

A tax loss on the sale of a depreciable asset used in business or trade may be written off against income.

Question 44

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

Question 45

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

Question 46

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.

Question 47

Assume a corporation has earnings before depreciation and taxes of $82,000, depreciation of $45,000, and that it has a 30% tax bracket. What are the after-tax cash flows for the company?

A)$70,900
B)$82,000
C)$42,000
D)None of these options

Question 48

The reinvestment assumption is a downside of the IRR method of analysis because it assumes that cash flows are reinvested at the cost of capital.
It actually assumes that cash flows are reinvested at the IRR rate, which can sometimes be excessively high, rendering this assumption unrealistic.

Question 49

There are several disadvantages to the payback method, among them:

A)Payback ignores the time value of money.
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.

Question 50

In a replacement decision, a book loss on an old asset can be a valuable feature.

Question 51

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.

Question 52

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.
All else being equal, the new asset is typically depreciated separately, although the tax benefits of writing off losses on older assets might provide a net benefit to the company.

Question 53

Investors discount the later years of a long-term project at a lower rate because they are generally less precise.
While uncertainty increases as the time horizon increases of course, later years are discounted at a lower TVM factor primarily because of the time over which the discounting rate works.

Question 54

Assume a project has earnings before depreciation and taxes of $15,000, depreciation of $25,000, and that the firm has a 30% tax bracket. What are the after-tax cash flows for the project?

A)A positive $18,000
B)A positive $19,000
C)A loss of $21,000
D)None of these options

Question 55

It is more likely for financial managers to focus on cash flow and corporate executives to focus on earnings of the company.

Question 56

When NPV and IRR analysis provide inconsistent rankings of projects, the financial manager should generally select the project with the highest IRR.
In the event of such a conflict, all facts must be reconsidered, including the discount rate.

Question 57

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.

Question 58

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

Question 59

The first step in the capital budgeting process is

A)collection of data.
B)idea development.
C)assign probabilities.
D)determine cash flows.

Question 60

Capital rationing is generally a positive action for a firm because it prevents rapid growth, which can drive up the cost of capital.
Capital rationing is used for "macromanagement" purposes, including debt constraints or economic concerns. It is generally considered a negative action since it can impede achieving maximum profitability.

Question 61

The longer the life of an investment

A)the more significant the discount rate.
B)the less significant the discount rate.
C)make no difference to the discount rate.
D)None of these options

Question 62

Stone Inc. is evaluating a project with an initial cost of $9,500. Cash inflows are expected to be $1,500, $1,500, and $10,000 in the three years over which the project will produce cash flows. If the discount rate is 9%, what is the net present value of the project?

A)Less than $0
B)Between $0 and $400
C)Between $400 and $800
D)More than $800

Question 63

Suppose that interest rates (and, therefore, the firm's weighted average cost of capital) increase. This WOULD NOT CHANGE the capital budgeting choices a firm would make if it

A)uses payback method analysis.
B)uses net present value analysis.
C)uses internal rate of return analysis.
D)uses profitability indices.

Question 64

If an investment project has a positive net present value, then the internal rate of return is

A)less than the cost of capital.
B)greater than the cost of capital.
C)equal to the cost of capital.
D)indeterminate, because it depends on the length of the project.

Question 65

In using the internal rate of return method, it is assumed that cash flows can be reinvested at

A)the cost of equity.
B)the cost of capital.
C)the internal rate of return.
D)the prevailing interest rate.

Question 66

If projects are mutually exclusive

A)they can only be accepted under capital rationing.
B)the selection of one alternative precludes the selection of other alternatives.
C)the payback method should be used.
D)only the net present value method can be used.

Question 67

As the cost of capital increases

A)fewer projects are accepted.
B)more projects are accepted.
C)project selection remains unchanged.
D)None of these options

Question 68

Assume a $6,500 investment and the following cash flows for two alternatives. $$\begin{array} { l l l } \text { Year } & \text { Investment } \mathbf { X } & \text { Investment Y } \\1 & \$ 1,000 & \$ 1,300 \\2 & 1,800 & 2,000 \\3 & 1,700 & 1,100 \\4 & 2,000 & 1,500 \\5 & & 600\end{array}$$ Under the payback method, which of the following could be concluded?

A)Investment X should be selected.
B)Investment Y should be selected.
C)Investment X and Y provide the same payback period.
D)Neither investment is acceptable under the payback method

Question 69

You require an IRR of 14% to accept a project. If the project will yield $10,000 per year for 10 years, what is the maximum amount that you would be willing to invest in the project?

A)Less than $50,000
B)More than $50,000 and less than $60,000
C)More than $60,000 and less than $70,000
D)More than $70,000

Question 70

A characteristic of capital budgeting is that

A)a large amount of money is always involved.
B)the internal rate of return must be less than the cost of capital.
C)the internal rate of return must be greater than the cost of capital.
D)the time horizon is at least five years.

Question 71

With non-mutually exclusive projects,

A)the payback method will select the best project.
B)the net present value is not acceptable.
C)the internal rate of return method will always select the best project.
D)the net present value and the internal rate of return methods will accept or reject the same project.

Question 72

The internal rate of return and net present value methods

A)always give the same investment decision answer.
B)never give the same investment decision answer.
C)usually give the same investment decision answer.
D)always give conclusions different from the payback method.

Question 73

The internal rate of return assumes that funds are reinvested at the

A)cost of capital.
B)yield on the investment.
C)minimal acceptable rate to the corporation.
D)yield to maturity.

Question 74

Assuming that a firm has no capital rationing constraint and that a firm's investment alternatives are not mutually exclusive, the firm should accept all investment proposals

A)for which it can obtain financing.
B)that have a positive net present value.
C)that have positive cash flows.
D)that provide returns greater than the after-tax cost of debt.

Question 75

For acceptable investments, the reinvestment assumption under the internal rate of return is generally

A)higher than under the net present value method.
B)lower than under the net present value method.
C)at the cost of capital.
D)below the cost of capital.

Question 76

The net present value method is a more conservative technique for selecting investment projects than the internal rate of return method because the NPV method

A)assumes that cash flows are reinvested at the project's internal rate of return.
B)concentrates on the liquidity aspects of investment projects.
C)assumes that cash flows are reinvested at the firm's weighted average cost of capital.
D)None of these options

Question 77

A project requires an investment of $2,500 and has a net present value of $430. If the IRR is 10%, what is the profitability index for the project?

A)0.25
B)2.33
C)0.70
D)1.17

Question 78

The _________ assumes returns are reinvested at the cost of capital.

A)payback method
B)internal rate of return method
C)net present value method
D)capital rationing procedure

Question 79

You buy a new piece of equipment for $7,360, and you receive a cash inflow of $1,000 per year for 10 years. What is the internal rate of return?

A)5%
B)6%
C)7%
D)More than 7%

Question 80

The Dammon Corp. has the following investment opportunities: $\begin{array}{lccc}\text { Machine A }&\text { Machine B }&\text { Machine C }\\\text { (\$ 10.000) }&\text {(\$ 22.500)}&\text { (\$ 35.500) }\\\text { Inflows }&\text { Inflows }&\text { Inflows }\\\text { year 1 }\quad \$ 6,000 &\text { year } 1 \quad \$ 12,000 &\text { year 1 } \quad-0-\\\text { year 2 }\quad 3,000& \text { year } 2 \quad7,500 &\text { year 2 }\quad 30,000\\\text { year } 3 \quad 3,000 & \text { year } 3 \quad 1,500& \text { year 3 }\quad 5,000\\\text { year } 4 \quad-0- &\text { year } 4\quad 1,500&\text { year 4 }\quad 20,000\end{array}$ Under the payback method and assuming these machines are mutually exclusive, which machine(s) would Dammon Corp. choose?

A)Machine A
B)Machine B
C)Machine C
D)Machine A and B