Deck 14: Capital Investment Decisions

Question 1

There are different discounting models that can be used for capital investment decisions.

Answer 1

True

Question 2

In capital investment decision making, it is usually assumed that managers should select projects that attempt to maximize the wealth of the owners of the firm.

Answer 2

True

Question 3

Mutually exclusive projects are projects that, if accepted, preclude the acceptance of all other competing projects.

Answer 3

True

Question 4

The interest rate that sets the present value of a project's cash inflows equal to the present values of the project's cost is called the accounting rate of return.

Question 5

If cash flows are uneven, the payback period assumes that the inflows during the last fraction of a year occur evenly.

Question 6

Taxes are an important consideration in forecasting cash flows.

Question 7

Companies considering projects with shorter lives are interested in longer payback periods.

Question 8

An advantage of the payback period is that it considers the time value of money.

Question 9

Both the net present value and the accounting rate of return ignore the time value of money.

Question 10

Sometimes firms require riskier projects to have shorter payback periods.

Question 11

The two major approaches to capital investment decision are nondiscounting models and discounting models.

Question 12

The payback period considers the profitability of a project over its entire life span.

Question 13

One way to use the payback period is to set a maximum payback period for all projects and to reject any project that exceeds this level.

Question 14

A disadvantage of the payback period is that it ignores a project's total profitability.

Question 15

In practice, managers often choose a discount rate that is less than the cost of capital.

Question 16

A critical part of the capital investment process is the forecasting of after-tax cash flows.

Question 17

Projects that affect the cash flows of other projects are called independent projects.

Question 18

The accounting rate of return is used more often than the internal rate of return.

Question 19

In order to use the payback period model, the proposed investment must have even cash inflows.

Question 20

Capital investment decisions are concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets.

Question 21

The internal rate of return model consistently results in choices that maximize firm wealth.

Question 22

Less objective results are obtainable if an independent party performs the postaudit of a capital investment.

Question 23

A disadvantage of postaudits is that they are inexpensive to perform.

Question 24

Because of the postaudit, managers are more likely to make capital investment decisions in the best interests of the firm.

Question 25

A key element in the capital investment process is called a preaudit.

Question 26

One drawback to the internal rate of return model is that cash inflows must occur evenly over the life of the investment.

Question 27

Postaudits ensure that resources are used wisely by evaluating profitability.

Question 28

Net present value analysis and internal rate of return analysis can sometimes produce erroneous choices because they ignore the time value of money.

Question 29

The maximum acceptable rate of return for a project is the required rate of return.

Question 30

The internal rate of return is the least widely used of the capital investment techniques.

Question 31

If the net present value of an investment is zero, the investment earns less than the minimum required rate of return.

Question 32

Postaudits supply feedback to managers that should help improve future decision making.

Question 33

The difference between the present value of the cash inflows and outflows associated with a project is the net present value model.

Question 34

A postaudit evaluates the overall outcome of the investment and proposes corrective action if needed.

Question 35

A postaudit is an analysis of a capital project before it is implemented.

Question 36

For independent projects, net present value analysis and internal rate of return analysis will generally yield similar decisions.

Question 37

Companies that perform postaudits of capital projects do NOT experience any benefits.

Question 38

In general, it is best if postaudits are done by company management, since they understand the actual operating conditions.

Question 39

Suppose that the actual cost of capital is 10%, but the firm chooses a discount rate of 18%. Managers of that company will be more likely to choose relatively short-term investments.

Question 40

Two discounting models for capital investment decision making are net present value and internal rate of return.

Question 41

Why is a discount factor in year 3 less than a discount factor in year 2?

A) because cash flows are even
B) because present value is positive
C) because compounding does not occur
D) because a dollar received in three years is worth less than a dollar received in two years

Question 42

Kendra Van Cleve has just invested $200,000 in a coffee shop. She expects to receive cash income of $50,000 a year. What is the payback period?

A) 2.5 years
B) 3.0 years
C) 3.5 years
D) 4.0 years

Question 43

What is characteristic of capital investment decision making?

A) It is used only for independent projects.
B) It is used only for mutually exclusive projects.
C) It places large amounts of resources at risk for long periods of time.
D) It requires that funding for a project must come from sources with the same opportunity cost of funds.

Question 44

Which term best reflects the earning of interest on interest?

A) the future value of interest
B) the discount rate of interest
C) the present value of interest
D) the compounding of interest

Question 45

An obvious advantage of postaudits is that the assumptions driving the original analysis my often be invalidated by changes in the actual operating environment.

Question 46

Which measure results in the time required for a firm to recover its original investment?

A) the payback period
B) the net present value
C) the life of the project
D) the internal rate of return

Question 47

Evan Cram is considering an investment in a solar-powered irrigation system manufacturer. The initial investment is $200,000. He expects to receive cash income of $100,000 a year. What is the payback period?

A) 1.0 year
B) 1.5 years
C) 2.0 years
D) 2.5 years

Question 48

What is another term for the required rate of return when using the net present value model?

A) the huddle rate
B) the payback rate
C) the discount rate
D) the maximum acceptable rate of return

Question 49

Suppose the cash flows of a project are received evenly over the life of the project. What formula is used to calculate the payback period?

A) original investment / annual cash flow
B) original investment × annual cash flow
C) original investment + annual cash flow
D) original investment - annual cash flow

Question 50

Which term refers to a series of equal future cash flows?

A) an annuity
B) future earnings
C) a future amount
D) earnings to be discounted

Question 51

An internal auditor is usually the best choice for performing a postaudit of a capital investment.

Question 52

Which payback period will managers want when the risk of obsolescence is high?

A) a shorter payback period
B) a longer payback period
C) an extended payback period
D) a payback period equal to the life of the investment

Question 53

What is NOT an advantage of the payback period?

A) It is sometimes used as a crude measure of risk.
B) It cannot be used for investments with unequal cash inflows.
C) It cannot be used if the entire cost of the investment does not occur immediately.
D) It encourages managers to choose projects with quick payback to maximize short-term criteria.

Question 54

In general terms, how much will a sound capital investment earn?

A) It will earn back its original capital outlay.
B) It will earn a return greater than existing capital investments.
C) It will earn back its original capital outlay by the midpoint of its useful life.
D) It will earn back its original capital outlay and provide a reasonable return on the original investment.

Question 55

What is a drawback of the payback period?

A) It uses a set discount rate.
B) It ignores a project's total profitability.
C) It uses before-tax cash flows rather than after-tax cash flows.
D) It considers total profitability, requiring the forecasting of all future cash flows.

Question 56

Which statements best describe payback method and the accounting rate of return method? Profitability Time Value of Money

A) Ignored by both methods Ignored by both methods
B) Ignored by both methods Used in accounting rate of return
Ignored by payback method
C) Considered by accounting method; Ignored by payback method Ignored by both methods
D) Considered by accounting method; Ignored by payback method Considered by both methods

Question 57

Which factor must a manager estimate when making a capital investment decision?

A) the previous spending
B) the timing of cash flows
C) the company's financial history
D) the company's spending on other projects

Question 58

In what way does the payback period provide information to help managers?

A) includes the present value of future cash flows
B) controls the effect of the investment on performance measures
C) controls the risks associated with the uncertainty of past cash flows
D) maximizes the impact of an investment on a company's liquidity problems

Question 59

What is the most widely used non-discounting model for capital investment decision making?

A) payback period
B) net present value
C) internal rate of return
D) accounting rate of return

Question 60

Sarah Lindsay invested $300,000 in a project that pays her an even amount per year for 10 years. The payback period is 8 years. What are Sarah's yearly cash inflows from the project?

A) $15,000
B) $37,500
C) $90,000
D) $150,000

Question 61

Martin Brother
Martin Brother is considering investing $20,000 in a project with the following cash revenues and expenses: $\begin{array}{lll}&\text { Cash Expenses \&}\\&\text { Revenues }&\text { Depreciation }\\\text { Year 1 } & \$ 8,000 & \$ 8,000 \\\text { Year 2 } & \$ 12,000 & \$ 8,000 \\\text { Year 3 } & \$ 15,000 & \$ 9,000 \\\text { Year 4 } & \$ 20,000 & \$ 10,000 \\\text { Year 5 } & \$ 20,000 & \$ 10,000\end{array}$ Assume straight-line depreciation over five years.

-Refer to Martin Brother. What is the accounting rate of return for the project?

A) 30%
B) 45%
C) 75%
D) 150%

Question 62

Which of the following best reflects the formula for the accounting rate of return?

A) average income/initial investment
B) initial investment/average income
C) initial investment/annual cash flow
D) annual cash flow/initial investment

Question 63

An investment of $4,000 provides an average net cash flow of $960 with zero salvage value. Depreciation is $80 per year. What is the accounting rate of return using the original investment?

A) 20%
B) 22%
C) 24%
D) 40%

Question 64

Randy Ritchie
Randy Ritchie is considering investing $20,000 in a project with the following annual cash revenues and expenses: $\begin{array}{lll}&\text { Cash } & \text { Cash } \\&\text { Revenues } & \text { Expenses }\\\text { Year 1 } & \$ 8,000 & \$ 8,000 \\\text { Year 2 } & \$ 12,000 & \$ 8,000 \\\text { Year 3 } & \$ 15,000 & \$ 9,000 \\\text { Year 4 } & \$ 20,000 & \$ 10,000 \\\text { Year 5 } & \$ 20,000 & \$ 10,000\end{array}$ Depreciation will be $4,000 per year.

-Refer to Randy Ritchie. What is the accounting rate of return on the investment?

A) 10%
B) 15%
C) 35%
D) 75%

Question 65

Jerry Costansa has just invested $280,000 in a day spa. He expects to receive income of $70,000 a year and to have the investment for 10 years. What is the accounting rate of return?

A) 2.2%
B) 4.0%
C) 25.0%
D) 28.0%

Question 66

Eagle Investments
Eagle Investments is considering two projects: $\begin{array}{lll}&\text { Project } \mathrm{A}& \text { Project B }\\\text { Initial investment } & \$ 150,000 & \$ 150,000 \\\text { Cash inflow Year 1 } & \$ 50,000 & \$ 40,000 \\\text { Cash inflow Year 2 } & \$ 50,000 & \$ 40,000 \\\text { Cash inflow Year 3 } & \$ 50,000 & \$ 40,000 \\\text { Cash inflow Year 4 } & \$ 50,000 & \$ 60,000 \\\text { Cash inflow Year 5 } & \$ 50,000 & \$ 80,000\end{array}$

-Refer to Eagle Investments. What is the payback period for Project B?

A) 2.0 years
B) 2.5 years
C) 3.0 years
D) 3.5 years

Question 67

Falcons Investments
Falcons Investments is considering two projects: $\begin{array}{lll}&\text { Project I } &\text { Project II }\\\text { Initial investment } & \$ 60,000 & \$ 60,000 \\\text { Cash inflow Year 1 } & \$ 30,000 & \$ 15,000 \\\text { Cash inflow Year 2 } & \$ 30,000 & \$ 15,000 \\\text { Cash inflow Year 3 } & \$ 30,000 & \$ 30,000 \\\text { Cash inflow Year 4 } & \$ 30,000 & \$ 70,000 \\\text { Cash inflow Year 5 } & \$ 30,000 & \$ 70,000\end{array}$

-Refer to Falcons Investments. What is the payback period for Project I?

A) 1.0 year
B) 2.0 years
C) 2.5 years
D) 3.0 years

Question 68

Henkle Company is considering a project with an initial investment of $626,500 in new equipment that will yield annual net cash flows of $90,000 and will be depreciated at $55,000 per year over its nine-year life. What is the accounting rate of return on the investment?

A) 5.59%
B) 18.74%
C) 31.27%
D) 50.0%

Question 69

Cary Swenson
Cary Swenson is considering investing $30,000 in a project with the following cash revenues and expenses: $\begin{array}{lll}&\text { Cash Expenses \&}\\&\text { Revenues }&\text { Depreciation }\\\text { Year 1 } & \$ 10,000 & \$ 12,000 \\\text { Year 2 } & \$ 12,000 & \$ 11,000 \\\text { Year 3 } & \$ 15,000 & \$ 12,000 \\\text { Year 4 } & \$ 20,000 & \$ 12,000 \\\text { Year 5 } & \$ 22,000 & \$ 12,000 \\\text { Year 6 } & \$ 25,000 & \$ 15,000 \\\text { Year 7 } & \$ 25,000 & \$ 15,000 \\\text { Year 8 } & \$ 25,000 & \$ 15,000\end{array}$

-Refer to Cary Swenson. What is the average income for the project?

A) $6,250
B) $13,000
C) $19,250
D) $30,000

Question 70

Cary Swenson
Cary Swenson is considering investing $30,000 in a project with the following cash revenues and expenses: $\begin{array}{lll}&\text { Cash Expenses \&}\\&\text { Revenues }&\text { Depreciation }\\\text { Year 1 } & \$ 10,000 & \$ 12,000 \\\text { Year 2 } & \$ 12,000 & \$ 11,000 \\\text { Year 3 } & \$ 15,000 & \$ 12,000 \\\text { Year 4 } & \$ 20,000 & \$ 12,000 \\\text { Year 5 } & \$ 22,000 & \$ 12,000 \\\text { Year 6 } & \$ 25,000 & \$ 15,000 \\\text { Year 7 } & \$ 25,000 & \$ 15,000 \\\text { Year 8 } & \$ 25,000 & \$ 15,000\end{array}$

-Refer to Cary Swenson. What is the accounting rate of return for the project?

A) 20.00%
B) 20.83%
C) 64.17%
D) 166.70%

Question 71

Why would managers use the accounting rate of return to evaluate potential investment projects?

A) It does not consider the time value of money.
B) Bonuses to managers may be based on accounting income and/or return on assets.
C) It serves as a screening measure to ensure that new investments do affect key financial ratios.
D) Debt contracts require that a company maintain certain ratios that are not affected by income and long-term asset levels.

Question 72

Eagle Investments
Eagle Investments is considering two projects: $\begin{array}{lll}&\text { Project } \mathrm{A}& \text { Project B }\\\text { Initial investment } & \$ 150,000 & \$ 150,000 \\\text { Cash inflow Year 1 } & \$ 50,000 & \$ 40,000 \\\text { Cash inflow Year 2 } & \$ 50,000 & \$ 40,000 \\\text { Cash inflow Year 3 } & \$ 50,000 & \$ 40,000 \\\text { Cash inflow Year 4 } & \$ 50,000 & \$ 60,000 \\\text { Cash inflow Year 5 } & \$ 50,000 & \$ 80,000\end{array}$

-Refer to Eagle Investments. What is the payback period for Project A?

A) 2.0 years
B) 2.5 years
C) 3.0 years
D) 3.5 years

Question 73

Joseph Giovine invested in a project with a payback period of six years. The project brings $40,000 per year for a period of twelve years. What was the initial investment?

A) $7,500
B) $75,000
C) $120,000
D) $240,000

Question 74

Darth Company
Darth Company is considering the purchase of new heavy construction equipment that will cost $2,000,000 and have a life of eight years with no expected salvage value. The expected cash flows associated with the project are as follows: $\begin{array}{lcc}&\text { Cash } & \text {Cash Expenses \& }\\\text { Year } & \text { Revenues } & \text { Depreciation } \\1 & \$ 2,400,000 & \$ 1,900,000 \\2 & \$ 2,400,000 & \$ 1,900,000 \\3 & \$ 2,400,000 & \$ 1,900,000 \\4 & \$ 2,400,000 & \$ 1,900,000 \\5 & \$ 2,400,000 & \$ 1,900,000 \\6 & \$ 2,400,000 & \$ 1,900,000 \\7 & \$ 2,400,000 & \$ 1,900,000 \\8 & \$ 2,400,000 & \$ 1,900,000\end{array}$

-Refer to Darth Company. What is the accounting rate of return for the project?

A) 3.125%
B) 25.000%
C) 83.330%
D) 120.000%

Question 75

A division manager is considering a project that requires a significant initial investment. If accepted, the project could have a negative impact on certain financial ratios that the company is required to maintain to satisfy bond contracts. The manager wants to ensure that the ratios will NOT be adversely affected by the investment. Which capital investment model should the manager use?

A) the payback period
B) the net present value
C) the internal rate of return
D) the accounting rate of return

Question 76

Falcons Investments
Falcons Investments is considering two projects: $\begin{array}{lll}&\text { Project I } &\text { Project II }\\\text { Initial investment } & \$ 60,000 & \$ 60,000 \\\text { Cash inflow Year 1 } & \$ 30,000 & \$ 15,000 \\\text { Cash inflow Year 2 } & \$ 30,000 & \$ 15,000 \\\text { Cash inflow Year 3 } & \$ 30,000 & \$ 30,000 \\\text { Cash inflow Year 4 } & \$ 30,000 & \$ 70,000 \\\text { Cash inflow Year 5 } & \$ 30,000 & \$ 70,000\end{array}$

-Refer to Falcons Investments. What is the payback period for Project II?

A) 1.0 year
B) 2.0 years
C) 2.5 years
D) 3.0 years

Question 77

Refer to Buckhead Shop What would be the accounting rate of return on the original investment in the press?

A) 8.33%
B) 10.00%
C) 21.67%
D) 75.00%

Question 78

Cary Swenson
Cary Swenson is considering investing $30,000 in a project with the following cash revenues and expenses: $\begin{array}{lll}&\text { Cash Expenses \&}\\&\text { Revenues }&\text { Depreciation }\\\text { Year 1 } & \$ 10,000 & \$ 12,000 \\\text { Year 2 } & \$ 12,000 & \$ 11,000 \\\text { Year 3 } & \$ 15,000 & \$ 12,000 \\\text { Year 4 } & \$ 20,000 & \$ 12,000 \\\text { Year 5 } & \$ 22,000 & \$ 12,000 \\\text { Year 6 } & \$ 25,000 & \$ 15,000 \\\text { Year 7 } & \$ 25,000 & \$ 15,000 \\\text { Year 8 } & \$ 25,000 & \$ 15,000\end{array}$

-Refer to Cary Swenson. Assume a straight-line depreciation over eight years. What would be the payback period for the project?

A) between 1 and 2 years
B) between 3 and 4 years
C) between 4 and 5 years
D) between 6 and 7 years

Question 79

Martin Brother
Martin Brother is considering investing $20,000 in a project with the following cash revenues and expenses: $\begin{array}{lll}&\text { Cash Expenses \&}\\&\text { Revenues }&\text { Depreciation }\\\text { Year 1 } & \$ 8,000 & \$ 8,000 \\\text { Year 2 } & \$ 12,000 & \$ 8,000 \\\text { Year 3 } & \$ 15,000 & \$ 9,000 \\\text { Year 4 } & \$ 20,000 & \$ 10,000 \\\text { Year 5 } & \$ 20,000 & \$ 10,000\end{array}$ Assume straight-line depreciation over five years.

-Refer to Martin Brother. What would be the payback period for this investment?

A) between 1 and 2 years
B) between 2 and 3 years
C) between 3 and 4 years
D) between 4 and 5 years

Question 80

Darth Company
Darth Company is considering the purchase of new heavy construction equipment that will cost $2,000,000 and have a life of eight years with no expected salvage value. The expected cash flows associated with the project are as follows: $\begin{array}{lcc}&\text { Cash } & \text {Cash Expenses \& }\\\text { Year } & \text { Revenues } & \text { Depreciation } \\1 & \$ 2,400,000 & \$ 1,900,000 \\2 & \$ 2,400,000 & \$ 1,900,000 \\3 & \$ 2,400,000 & \$ 1,900,000 \\4 & \$ 2,400,000 & \$ 1,900,000 \\5 & \$ 2,400,000 & \$ 1,900,000 \\6 & \$ 2,400,000 & \$ 1,900,000 \\7 & \$ 2,400,000 & \$ 1,900,000 \\8 & \$ 2,400,000 & \$ 1,900,000\end{array}$

-Refer to Darth Company. What is the average annual income for this project?

A) $62,500
B) $300,000
C) $500,000
D) $1,900,000