Question 1

The net present value (NPV) method and the internal rate of return (IRR) method are used to analyze proposed capital expenditures. The IRR method, as contrasted with the NPV method:

Accepted Answer

The IRR method is not considered inferior, and both methods incorporate the time value of money. The NPV and IRR methods generally provide the same decision as to the acceptability of a proposed investment. However, the IRR method assumes that the rate of return on the reinvestment of the cash proceeds is at the indicated rate of return of the project analyzed rather than at the discount rate used, according to some commentators. This can lead to incorrect results in some cases, making the NPV method a better choice for decision-making.

Question 2

The profitability index (PI) for a proposed project is calculated as:

Accepted Answer

The profitability index (PI) is the ratio of the present value of expected future cash flows to the initial investment. Therefore, the correct formula for calculating PI is net present value (NPV) divided by initial investment (I). Choice B is the only one that presents the correct formula.

Question 3

Western Electronics (WE) is reviewing the following data relating to a new equipment proposal: $\begin{array}{|l|c|}
\hline \text { Net initial investment } & \$ 50,000 \
\hline \text { After-tax cash inflow from disposal of the investment after } 5 \text { years } & \$ 10,000 \
\hline \text { Present value of an annuity of } \$ 1 \text { at } 12 \% \text { for } 5 \text { years } & 3.605 \
\hline \text { Present value of } \$ 1 \text { at } 12 \% \text { in } 5 \text { years } & 0.567 \
\hline
\end{array}$ WE expects the net after-tax savings in cash outflows from the investment to be equal in each of the 5 years.What is the minimum amount of after-tax annual savings (including depreciation effects) needed to make the investment yield a 12% return (rounded to the nearest whole dollar)?

Accepted Answer

To find the minimum after-tax annual savings needed, we use the formula for the present value of an annuity: $ \text{Net initial investment} = \text{Annual savings} \times \text{Present value of an annuity factor} $. Solving for the annual savings: $ \$50,000 = \text{Annual savings} \times 3.605 $. Thus, $ \text{Annual savings} = \frac{\$50,000}{3.605} \approx \$13,879 $. However, this calculation seems incorrect as it doesn't match any option. Let's correct it: $ \text{Annual savings} = \frac{\$50,000 - (\$10,000 \times 0.567)}{3.605} \approx \$12,297 $.

Question 4

Within the context of capital budgeting, a primary goal-congruency problem exists when discounted cash flow (DCF) models are used for decision-making purposes, but accrual-based earnings figures are used for subsequent performance-evaluation purposes. Which of the following items is not likely to be useful for addressing this goal-congruency problem?

Accepted Answer

Monte Carlo simulation is a useful method for assessing the range of potential outcomes and risks associated with different capital investment decisions. However, it is not directly relevant to addressing the goal-congruency problem of using DCF models for decision-making and accrual-based earnings for performance evaluation. The other options (B, C, and D) are all potential solutions for this problem: using EVA as a financial-performance metric can align incentives with long-term value creation; separating incentive compensation from budgeted performance can ensure that managers are not rewarded for meeting short-term goals at the expense of long-term value; and conducting post-audits of capital investment decisions can help identify areas for improvement and ensure that investments are evaluated based on their actual, rather than anticipated, performance.

Question 5

LaVar, Inc. has obtained probability estimates from its production and sales departments regarding the costs and selling prices it can anticipate for a new product line. The company is uncertain as to which combination of costs and selling prices will occur. The best method for determining the expected outcome of the investment, based on an assumed probability distribution associated both sales and costs, is:

Accepted Answer

Monte Carlo simulation (MCS) is the best method for determining the expected outcome of an investment based on probability distributions associated with sales and costs. MCS uses random sampling techniques to generate thousands of possible outcomes based on different combinations of sales and cost probabilities. This provides a range of possible outcomes and their likelihood, which can help in decision-making and risk analysis.

Question 6

GuSont Inc. was considering an investment in the following project:$\begin{array}{lrr}
\text { Required initial investment } & \$ 990,000 \
\text { Net annual after-tax cash inflow } & \$  165,000 \
\text { Annual depreciation expense }(\$ 990,000-\$ 165,000) / 15 \text { years } & \$  55,000 \
\text { Estimated salvage value } & \$  165,000 \
\text { Life of the project in years } &  15
\end{array}$The internal rate of return (IRR) is (Note: to solve this problem students will need access either to Appendix C, Table 2 (Chapter 12) or to Excel):

Accepted Answer

The answer of GuSont Inc. was considering an investment in...

Question 7

A profitable company pays $100,000 wages and has depreciation expense of $100,000. The company's income tax rate, t, is 40%. The after-tax cash flows from these two items are calculated as follows:

Accepted Answer

Wages are a cash outflow, and the after-tax amount is $100,000 * (1 - 0.4) = $60,000. Depreciation is a non-cash expense, but it reduces taxable income, resulting in a tax saving of $100,000 * 0.4 = $40,000.

Question 8

When we assume in our calculations for capital budgeting decisions that all cash flows occur at the end of individual years during the life of an investment project when, in fact, they flow more or less continuously during those years, which of the following statements is true?

Accepted Answer

The answer of When we assume in our calculations for...

Question 9

Within the context of capital budgeting, a primary goal-congruency problem exists when discounted cash flow (DCF) models are used for decision-making purposes, but accrual-based earnings figures are used for subsequent performance-evaluation purposes. Which of the following items is not likely to be useful for addressing this goal-congruency problem?

Accepted Answer

Separating incentive compensation from budgeted performance does not directly address the goal-congruency problem related to using different metrics (DCF for decision-making and accrual-based earnings for performance evaluation). Monte Carlo simulation, EVA® as a performance metric, and post-audits all help align or evaluate decisions and performance more consistently.

Question 10

Which of the following is an example of a sunk cost in a capital budgeting decision regarding the replacement of an existing piece of equipment for a profitable business that pays taxes?

Accepted Answer

A sunk cost is a cost that has already been incurred and cannot be recovered or changed by any future actions. Therefore, the original purchase price of the equipment to be replaced is a sunk cost as it cannot be recovered or changed by the decision of replacing the equipment. The other choices are not sunk costs as they are either future costs or can be recovered/changed by the decision of replacing the equipment.

Question 11

The decision technique that measures the estimated performance of a capital investment by dividing the project's annual after-tax income by the average investment cost is called the:

Accepted Answer

The technique described is the accounting or book rate of return, which measures the profitability of a project by dividing the annual after-tax income by the average investment cost. This is also known as the accounting rate of return (ARR). The other options are not correct: A is the break-even point, B is the internal rate of return (IRR), D is the capital asset pricing rate of return, and E is the profitability index (PI).

Question 12

Which of the following characteristics is not true of the modified internal rate of return (MIRR)?

Accepted Answer

Unlike IRR, MIRR does consider the time value of money. This statement is incorrect.

Question 13

Conceptually, a firm's capital structure is its:

Accepted Answer

A firm's capital structure refers to the way it finances its operations through a mix of debt and equity capital. The mix can be expressed in terms of book value or market value. Market value is generally considered a more accurate representation of a company's actual capital structure because it reflects the current market price of the company's outstanding securities.

Question 14

In situations where a firm specifies different required rates of return (i.e., discount rates) over the years, it is advantageous to use:

Accepted Answer

The NPV method is advantageous in situations where different required rates of return over the years are specified because it can accommodate varying discount rates over different time periods, accurately reflecting the changing cost of capital or risk profile of the project.

Question 15

If the present value payback period is less than the life of the project, one may conclude that:

Accepted Answer

If the present value payback period is less than the life of the project, it means that the project generates enough cash flows to recover its initial investment within its lifetime. This implies that the project has a positive net present value (NPV) since the present value of its cash inflows is greater than the present value of its initial investment. Therefore, option D is the correct choice. Options A, B, and E do not necessarily hold true based on the given information, and option C is incorrect.

Question 16

Which of the following items has no after-tax consequences in the analysis of a capital investment proposal?

Accepted Answer

Reduction of net working capital at the termination of a project typically involves recovering the initial investment in working capital, which does not have tax consequences.

Question 17

Which of the following is not an important advantage of the net present value (NPV) method over the internal rate of return (IRR) method in evaluating capital investment proposals?

Accepted Answer

The answer of Which of the following is not an...

Question 18

When ranking two mutually exclusive investments with different initial amounts but approximately the same useful life, and assuming no capital rationing, management should give priority to the project:

Accepted Answer

The best choice would be the project with the higher net present value (NPV). NPV takes into account the time value of money and provides a more accurate analysis of the profitability of the investment. Projects with positive NPV will increase the value of the firm. Thus, E is the best answer.

Question 19

The internal rate of return (IRR) for an investment:

Accepted Answer

The IRR method can rank projects differently than the NPV method, especially for mutually exclusive projects, due to differences in cash flow timing and scale.

Question 20

GuSont Inc. was considering an investment in the following project:$\begin{array}{lrr}
\text { Required initial investment } & \$ 990,000 \
\text { Net annual after-tax cash inflow } & \$  165,000 \
\text { Annual depreciation expense }(\$ 990,000-\$ 165,000) / 15 \text { years } & \$  55,000 \
\text { Estimated salvage value } & \$  165,000 \
\text { Life of the project in years } &  15
\end{array}$Assume that cash inflows occur evenly throughout the year. The estimated payback period in years (rounded to one decimal place) for the proposed project is:

Accepted Answer

The payback period is calculated by dividing the initial investment by the annual cash inflow. Here, it's $990,000 / $165,000 = 6 years.

Quiz 12: Strategy and the Analysis of Capital Investments