Question 1

In considering the payback method, ____.

Accepted Answer

The payback method is used to determine the financial exposure of a firm by calculating how long it will take to recover the initial investment from the cash inflows generated by the project.

Question 2

Should the following project be accepted if the cost of capital is 12%? Initial Investment is $50,000.
? $$\begin{array} { | l | l | } 
\hline \text { Years } & \text { Cash Flows } \
\hline 1 & \$ 25,000 \
\hline 2 & \$ 35,000 \
\hline 3 & \$ 55,000 \
\hline
\end{array}$$

Accepted Answer

The answer of Should the following project be accepted if...

Question 3

A firm's capital expenditures may be limited due to externally imposed constraints. All but which of the following are external constraints?

Accepted Answer

Option A) The firm's loan agreement may contain restrictive constraints, which is an external constraint on capital expenditures.
Option C) If the firm has a weak financial position, it may be too expensive to float a new bond issue, which is also an external constraint on capital expenditures.
Option D) There may be market-imposed difficulties such as a tight money policy on the part of the Federal Reserve System, which is also an external constraint on capital expenditures.
Option B) is not an external constraint since the firm itself decides to place an upper limit on the amount of funds allocated to capital investment.

Question 4

Colex wishes to bid on a contract that is expected to yield after-tax net cash flows of $25,000 in year 1, $30,000 in year 2, and $35,000 per year in years 3-8. To obtain the contract, Colex will need to invest $110,000 to reconfigure a packaging system, $20,000 (after-tax) to retrain current employees, and $15,000 (after-tax) on an environmental impact study that is required to be completed on acceptance of the contract. What is the project's internal rate of return?

Accepted Answer

The internal rate of return (IRR) is calculated using the net present value (NPV) equation set to zero, with cash flows discounted at the project's IRR. Given the complexity and the specific numbers involved, the IRR calculation would typically require financial calculator or spreadsheet software to solve. The correct answer, 14.9%, is obtained by inputting the initial investment and the series of net cash flows into an IRR calculation formula or tool.

Question 5

Which of the following statements about comparing capital budget techniques is (are) correct?
I. The payback period is easy to understand and helps the firm identify how long it will be unable to use the initial investment for other projects.
II. Mutually exclusive projects allow a firm to do other like projects (mutually exclusive) simultaneously as long as the budget constraints are met.

Accepted Answer

Statement I is correct because the payback period is a simple measure that tells us how long it will take to recover the initial investment. It helps the firm identify how long it will be unable to use the initial investment for other projects. Statement II is incorrect because mutually exclusive projects compete with each other, so only one can be chosen. It does not allow a firm to do other like projects simultaneously.

Question 6

The payback method has all of the following advantages EXCEPT it ____.

Accepted Answer

The payback method does not consider the time value of money, which is a major disadvantage of this method. It also does not take into account the cash flows beyond the payback period, making it a short-term analysis. However, it does determine a firm's financial exposure and is easy to calculate, and can provide insight into whether the project can recoup its start-up costs within a certain period of time.

Question 7

Barnacle Bob's Fish and Tackle Shop is planning an expansion. The initial investment is $480,000, and anticipated cash inflows are as listed below. The cost of capital is 12.2%. Based on the profitability index, should Barnacle Bob go ahead with the project? ? $$\begin{array} { | l | l | } 
\hline \text { Years } & \text { Cash Inflows } \
\hline 1 & \$ 90,000 \
\hline 2 & 105,000 \
\hline 3 & 105,000 \
\hline 4 & 195,000 \
\hline 5 & 195,000 \
\hline 6 & 195,000 \
\hline
\end{array}$$

Accepted Answer

The profitability index (PI) is calculated by dividing the present value of future cash inflows by the initial investment. The present value of cash inflows can be calculated using the formula PV = CF / (1 + r)^n, where CF is the cash flow in each period, r is the discount rate (12.2% or 0.122), and n is the period. $$ \text{PV of Year 1} = \frac{90,000}{(1 + 0.122)^1} = 80,214.77 $$$$ \text{PV of Year 2} = \frac{105,000}{(1 + 0.122)^2} = 83,516.25 $$$$ \text{PV of Year 3} = \frac{105,000}{(1 + 0.122)^3} = 74,520.59 $$$$ \text{PV of Year 4} = \frac{195,000}{(1 + 0.122)^4} = 124,183.82 $$$$ \text{PV of Year 5} = \frac{195,000}{(1 + 0.122)^5} = 110,783.07 $$$$ \text{PV of Year 6} = \frac{195,000}{(1 + 0.122)^6} = 98,917.47 $$Adding these together gives the total present value of cash inflows:$$ \text{Total PV} = 80,214.77 + 83,516.25 + 74,520.59 + 124,183.82 + 110,783.07 + 98,917.47 = 572,136.97 $$The profitability index (PI) is then calculated as:$$ \text{PI} = \frac{\text{Total PV of Cash Inflows}}{\text{Initial Investment}} = \frac{572,136.97}{480,000} = 1.19 $$Rounding to two decimal places, the profitability index is approximately 1.18, indicating that for every dollar invested, the project returns $1.18. Therefore, the project is profitable and should be undertaken.

Question 8

Based upon the following cash flows, should Chipper Nipper Cookie Company introduce a new product, Rolling In Dough Pies? The initial investment is $180,000, and the cost of capital is 11.5%. ? $$\begin{array} { | l | l | } 
\hline \text { Years } & \text { Cash Flows } \
\hline 1 & \$ 80,000 \
\hline 2 & \$ 95,000 \
\hline 3 & \$ 95,000 \
\hline 4 & \$ 110,000 \
\hline 5 & \$ 110,000 \
\hline 6 & \$ 110,000 \
\hline
\end{array}$$

Accepted Answer

The NPV is positive, indicating that the project is expected to generate a positive return. The IRR is greater than the cost of capital, indicating that the project is expected to generate a return that is greater than the cost of financing the project.

Question 9

What is the net present value of the following project if the required rate of return is 15%? The initial investment is $150,000. ? $$\begin{array} { | l | l | } 
\hline \text { Years } & \text { Cash Flows } \
\hline 1 & \$ 30,000 \
\hline 2 & \$ 80,000 \
\hline 3 & \$ 100,000 \
\hline 4 & \$ 200,000 \
\hline
\end{array}$$

Accepted Answer

The net present value (NPV) is calculated by discounting the future cash flows back to their present value and subtracting the initial investment. Using a discount rate of 15%, the NPV calculation is as follows:$$ NPV = \frac{\$30,000}{(1+0.15)^1} + \frac{\$80,000}{(1+0.15)^2} + \frac{\$100,000}{(1+0.15)^3} + \frac{\$200,000}{(1+0.15)^4} - \$150,000 $$$$ NPV = \$26,086.96 + \$60,273.29 + \$65,843.62 + \$114,475.95 - \$150,000 $$$$ NPV = \$116,679.82 $$Rounded to the nearest dollar, the NPV is approximately \$116,681, which corresponds to option D.

Question 10

TexMex is considering replacing its tortilla machine with a new model that sells for $46,000 including the cost of installation. The old machine has been fully depreciated and has a $0 salvage value. The new machine will be depreciated as a 3-year MACRS asset. Revenues are expected to increase $18,000 per year over the 5-year life of the new machine. At the end of 5 years the new machine is expected to have no salvage value. What is the IRR for this project if TexMex has a required rate of return of 14% and a marginal tax rate of 40%? Operating costs are not expected to increase from the current level of $8,000 per year.

Accepted Answer

To calculate IRR, we need to find the annual cash flows from the project.

Year 0: -$46,000 (initial cost)
Year 1: $18,000 (increase in revenues) - $16,239 (depreciation) - $8,000 (operating costs) = -$6,239
Year 2: $18,000 (increase in revenues) - $24,670 (depreciation) - $8,000 (operating costs) = $-14,670
Year 3: $18,000 (increase in revenues) - $14,803 (depreciation) - $8,000 (operating costs) = -$4,803
Year 4: $18,000 (increase in revenues) - $8,478 (depreciation) - $8,000 (operating costs) = $1,522
Year 5: $18,000 (increase in revenues) - $8,478 (depreciation) - $8,000 (operating costs) = $1,522

To calculate the present value of these cash flows, we need to discount them at the required rate of return (14%). Considering the marginal tax rate of 40%, the depreciation tax shield can be calculated as follows:

Year 1: $16,239 x 0.4 = $6,496
Year 2: $24,670 x 0.4 = $9,868
Year 3: $14,803 x 0.4 = $5,921
Year 4: $8,478 x 0.4 = $3,391
Year 5: $8,478 x 0.4 = $3,391

Now we can calculate the NPV of the cash flows by subtracting the present value of the initial investment from the sum of the present values of the cash flows:

NPV = -$46,000 + $6,239/(1+0.14)^1 + $14,670/(1+0.14)^2 + $4,803/(1+0.14)^3 - $1,522/(1+0.14)^4 - $1,522/(1+0.14)^5 + $6,496/(1+0.14)^1 + $9,868/(1+0.14)^2 + $5,921/(1+0.14)^3 + $3,391/(1+0.14)^4 + $3,391/(1+0.14)^5

NPV = -$6,229.53

To find the IRR, we need to find the discount rate that will make the NPV equal to zero. Using a financial calculator or Excel, the IRR is found to be 19.3%. Therefore, the best choice is C.

Question 11

A digital assembly system that costs $160,000 is expected to operate for 8 years. The estimated salvage value at the end of 8 years is $12,000. The system is expected to save the company $38,000 in labor costs before taxes and depreciation. The company will depreciate this system on a 5-year MACRS schedule. If the firm's cost of capital is 12% and its marginal tax rate is 35%, compute the NPV for the project. (Note: Requires MACRS tables.)

Accepted Answer

The answer of A digital assembly system that costs $160,000...

Question 12

When considering projects for implementation, management generally has three options. All of the following reflect possible managerial options EXCEPT that management could ____.

Accepted Answer

Selling stock is not one of the managerial options when considering projects for implementation. The correct options are A, B, and C.

Question 13

Based upon the following cash flows, should Ooey Gooey Candy Makers introduce a new product, Skinny Minnie Diet Cuisine? The initial investment is $780,000, and the cost of capital is 12.2%. ? $$\begin{array} { | l | l | } 
\hline \text { Years } & \text { Cash Flows } \
\hline 1 & \$ 90,000 \
\hline 2 & \$ 105,000 \
\hline 3 & \$ 105,000 \
\hline 4 & \$ 195,000 \
\hline 5 & \$ 195,000 \
\hline 6 & \$ 195,000 \
\hline
\end{array}$$

Accepted Answer

The answer of Based upon the following cash flows, should...

Question 14

A weakness of the payback period is that it disregards ____.

Accepted Answer

The payback period does not take into account the time value of money, which means that it does not consider the potential inflation or interest rate changes that can affect the value of money over time. This weakness can lead to incorrect investment decisions, as projects with shorter payback periods may appear more attractive than projects with longer payback periods but with higher potential returns.

Question 15

In considering the payback period, ____.

Accepted Answer

The payback period gives some indication of a project's desirability from a liquidity viewpoint. It measures the time required to recover the initial investment in a project. It does not consider the time value of money or cash flows after the payback period. The maximum period allowed by a firm is subjective and varies depending on the firm's policies and objectives.

Question 16

Real options in capital budgeting can be classified. The classification that means that the project is delayed and can be termed "waiting to invest" is the ____ option.

Accepted Answer

The investment timing option refers to the option to delay an investment in order to wait for more favorable conditions. This can include waiting for new technology to be developed, waiting for market conditions to improve, or waiting for competitors to exit the market. This option is often associated with real estate development or new product launches, where timing is crucial for success. The abandonment option refers to the option to abandon a project if it is not performing well. The shutdown option refers to the option to shut down a project if it becomes unprofitable. The growth option refers to the option to invest in a project that has the potential to generate more cash flow in the future.

Question 17

Which of the following statements about comparing the techniques of net present value (NPV) and internal rate of return (IRR) is (are) correct? 
I. The net present value assumes that all cash flows are reinvested at the cost of capital and is therefore realistic.
II. The internal rate of return is stated as a percent and is therefore easy to communicate to decision-makers who may not understand the fine points of finance.

Accepted Answer

Statement I is correct because NPV assumes reinvestment of cash flows at the cost of capital which is a realistic assumption. 
Statement II is also correct because IRR is easy to communicate to decision-makers since it is expressed as a percentage.

Question 18

The choice to accept or reject projects based on the payback period ____.

Accepted Answer

The choice to accept or reject projects based on payback period is a subjective decision because it does not take into account the time value of money, and relies solely on the length of time it takes to recoup the initial investment. It can lead to incorrect decisions if projects with longer payback periods are rejected even though they may have higher net present value or internal rate of return.

Question 19

In comparing the techniques of net present value and internal rate of return: 
I. The NPV and IRR techniques will generate the same accept-reject decision provided the projects have conventional cash flows.
II. The differences between the underlying assumptions of NPV and IRR can cause them to rank projects differently.

Accepted Answer

Statement I is correct because if the projects have conventional cash flows (negative cash flows in the initial period followed by positive cash flows in the subsequent period), the NPV and IRR techniques will generate the same accept-reject decision.

Statement II is also correct because NPV assumes reinvestment of cash flows at the cost of capital, while IRR assumes that cash flows are reinvested at the project's internal rate of return. This difference in assumptions can cause the two techniques to rank projects differently. If the cost of capital is higher than the IRR, the NPV will rank a project lower than the IRR would. On the other hand, if the IRR is higher than the cost of capital, the NPV will rank a project higher than the IRR would.

Question 20

The payback period can be considered justified for which of the following reasons?

Accepted Answer

The payback period is often used to assess the risk of a project, as it measures the time it takes for an investment to generate an amount of income or cash equal to the cost of the investment, thereby indicating the risk associated with the project's cash flow.

Quiz 12: Capital Budgeting: Decision Criteria and Real Option Considerations