Question 1

Calculate the NPV for a project costing $200,000 and providing $20,000 annually for 40 years.The discount rate is 8%.By how much would the NPV change if the inflows were reduced to 30 years?

Accepted Answer

The answer of Calculate the NPV for a project costing...

Question 2

Because of its age,your car costs $4,000 annually in maintenance expense.You could replace it with a newer vehicle costing $8,000.Both vehicles would be expected to last 4 more years.If your opportunity cost is 8%,by how much must maintenance expense decrease on the newer vehicle to justify its purchase?

Accepted Answer

To determine whether replacing the older car with a newer car is financially justifiable, we need to compare the present value of maintenance expenses associated with both cars.

For the older car, the present value of maintenance expenses for the next four years can be calculated as follows:

PV = $4,000 / 0.08 * (1 - 1 / (1 + 0.08)^4) = $12,676.54

For the newer car, the present value of maintenance expenses will depend on the amount of maintenance cost reduction that justifies the purchase.

Let x be the amount by which the maintenance expense must decrease for the newer car:

PV = ($8,000 - x) / 0.08 * (1 - 1 / (1 + 0.08)^4) = $8,000

Solving for x, we get:

x = $1,584.97

Therefore, the maintenance expense on the newer car must decrease by $1,584.97 to justify the purchase. The closest answer choice to this value is B) $1,585.

Question 3

A new machine will cost $100,000 and generate after-tax cash inflows of $35,000 for 4 years.Find the NPV if the firm uses a 12% opportunity cost of capital.What is the IRR? What is the payback period?

Accepted Answer

The answer of A new machine will cost $100,000 and...

Question 4

The ratio of net present value to initial investment is known as the:

Accepted Answer

The ratio of net present value to initial investment is known as the profitability index. Therefore, option D is the correct answer.

Question 5

The use of a profitability index will always provide results consistent with selecting the project with the:

Accepted Answer

The profitability index measures the return per dollar invested, aligning with the concept of maximizing returns relative to investment.

Question 6

You can continue to use your less efficient machine at a cost of $8,000 annually for the next 5 years.Alternatively,you can purchase a more efficient machine for $12,000 plus $5,000 annual maintenance.At a cost of capital of 15%,you should:

Accepted Answer

The answer of You can continue to use your less...

Question 7

In order for a manager to correctly decide to postpone an investment until one year into the future,the NPV of the investment should:

Accepted Answer

The manager should compare the NPV of the investment to the cost of capital. If the NPV is growing more rapidly than the cost of capital, it may be beneficial to proceed with the investment immediately. However, if the NPV is not growing as rapidly as the cost of capital, it may make more sense to delay the investment until it can generate a higher return.

Question 8

A firm uses the profitability index to select between two mutually exclusive investments.If no capital rationing has been imposed,which project should be selected?

Accepted Answer

Without capital rationing, the firm should select the project with the higher Net Present Value (NPV) rather than relying on the profitability index.

Question 9

A currently used machine costs $10,000 annually to run.What is the maximum that should be paid to replace the machine with one that will last 3 years and cost only $4,000 annually to run? The opportunity cost of capital is 12%.

Accepted Answer

The maximum amount to pay for the new machine is the present value of the cost savings over 3 years. The annual savings is $6,000 ($10,000 - $4,000). The present value of these savings is calculated using the formula for the present value of an annuity: PV = C * [(1 - (1 + r)^-n) / r], where C is the annual savings, r is the opportunity cost of capital, and n is the number of years. Plugging in the values: PV = $6,000 * [(1 - (1 + 0.12)^-3) / 0.12] = $14,411.

Question 10

The investment timing decision is aimed at analyzing whether the:

Accepted Answer

The investment timing decision is specifically concerned with determining whether it is better to invest now or to wait and invest at a later point in time. This decision is critical, as it can greatly impact the overall profitability and success of the investment. Therefore, the best choice is (D) - investment should occur now or at some future point.

Question 11

Use of a profitability index to select projects in the absence of capital rationing:

Accepted Answer

The answer of Use of a profitability index to select...

Question 12

What is the equivalent annual cost for a project that requires a $40,000 investment at time-period zero,and a $10,000 annual expense during each of the next 4 years,if the opportunity cost of capital is 10%?

Accepted Answer

The equivalent annual cost (EAC) is calculated by finding the present value of all costs and then converting it into an annuity over the project's life. The present value of costs is $40,000 + $10,000(PVIFA, 10%, 4). The EAC is then calculated using the annuity formula.

Question 13

What happens to the equivalent annual cost of a project as the opportunity cost of capital decreases?

Accepted Answer

As the opportunity cost of capital decreases, the discount rate used to calculate the equivalent annual cost also decreases. This results in a lower equivalent annual cost, making the project more financially attractive. Therefore, the equivalent annual cost decreases.

Question 14

The profitability index for a project costing $40,000 and returning $15,000 annually for 4 years at an opportunity cost of capital of 12% is:

Accepted Answer

The profitability index is calculated as the present value of the future cash flows divided by the initial investment. In this case, the present value of the future cash flows is $15,000 x (1 - 1/(1 + 0.12)^4)/0.12 = $45,952.38. Therefore, the profitability index is $45,952.38/$40,000 = 1.149.

Question 15

Soft capital rationing is imposed upon a firm from _____ sources,while hard capital rationing is imposed from _____ sources.

Accepted Answer

Soft capital rationing is when a firm imposes limits on its own investments due to internal factors such as budget constraints or risk management, while hard capital rationing is when external factors such as financial markets or government regulations limit the firm's investment opportunities. Therefore, A) internal sources impose soft capital rationing, while external sources impose hard capital rationing.

Question 16

When hard capital rationing exists,projects may be accurately evaluated by use of:

Accepted Answer

When hard capital rationing exists, meaning there is a strict limit on the amount of capital available for investment, projects should be evaluated based on their ability to generate the highest return on investment with limited capital. In this scenario, the profitability index is the best choice as it measures the present value of the expected cash inflows divided by the initial investment. This ratio helps identify the projects that generate the highest return per dollar invested and is most suitable for projects with limited capital resources. Payback period and mutually exclusive IRRs are not effective in evaluating projects under hard capital rationing, as they do not consider the time value of money or the available capital. Borrowing projects may increase the capital available for investment, but they also come with additional costs and risks, making them not the best choice in this situation.

Question 17

Soft capital rationing:

Accepted Answer

Soft capital rationing is an internal constraint set by management, often for strategic reasons, and should not incur additional costs to shareholders.

Question 18

If a project has a cost of $50,000 and a profitability index of 0.4,then:

Accepted Answer

The answer of If a project has a cost of...

Question 19

The NPV of an investment made today is $10,000.If postponed for one year,the NPV at that time will increase by $1,000.Which of the following is correct if the opportunity cost of the investment is 12%?

Accepted Answer

The opportunity cost of 12% means the investment should grow by at least 12% to be worthwhile. The NPV increase of $1,000 on $10,000 is only 10%, which is less than the opportunity cost. Therefore, it is better to invest now.

Question 20

Which of the following best illustrates the problem imposed by capital rationing?

Accepted Answer

Capital rationing is a situation where a firm has a limited amount of capital to invest in projects. Therefore, the firm has to prioritize and select the most profitable projects. Accepting projects with the highest NPVs or IRRs may seem like the best strategy, but it does not address the problem of capital rationing. Bypassing projects that have positive NPVs may be necessary if the expected return is not high enough to meet the firm's required rate of return, but bypassing them solely because of capital rationing means potentially missing out on profitable opportunities. Therefore, the best choice is to bypass projects that have positive NPVs because of the limitation imposed by capital rationing.

Quiz 8: Net Present Value and Other Investment Criteria