Deck 12: The Capital Budgeting Decision

Question 1

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

Answer 1

True

Question 2

It is the difference in the discount rate assumptions that can be significant in determining when to use the present value or internal rate of return methods.

Answer 2

True

Question 3

Under the capital cost allowance system of amortization, cash flow tends to decline with the passage of time.

Answer 3

True

Question 4

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

Question 5

The payback period is easy to understand and places a heavy emphasis on liquidity.

Question 6

The internal rate of return is the average annual rate of return from the investment.

Question 7

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

Question 8

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

Question 9

With a higher CCA rate, the present value of tax savings increases.

Question 10

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.

Question 11

The first administrative consideration in any capital budgeting process is collection of data.

Question 12

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

Question 13

With nonmutually 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 14

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

Question 15

The selection of a mutually exclusive project means that all other projects with a positive net present value may also be selected.

Question 16

We add amortization to net income to arrive at a true profit picture.

Question 17

The payback period is not really a theoretically correct approach.

Question 18

Under capital rationing, a firm will maximize profitability.

Question 19

Capital budgeting decisions involve a minimum time horizon of five years.

Question 20

In most capital budgeting decisions the emphasis is on reported earnings rather than cash flows.

Question 21

The cash inflow from the sale of an old asset decreases the cost of the new asset.

Question 22

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

Question 23

The net present value profile allows a firm to examine the project's net present value over time.

Question 24

CCA amortization schedules have superseded other amortization methods for tax purposes.

Question 25

Most real estate property is amortized over a 10 year period.

Question 26

CCA standards have decreased the life span over which an asset may be amortized.

Question 27

If an asset is sold before its useful life is complete, part of the ITC must be returned to the Canada Revenue Agency.

Question 28

An investment tax credit (ITC) is assumed to be earned at the rate of 2% per year up to 10%.

Question 29

The capital cost allowance rate for an asset is identical to the asset's estimated useful life.

Question 30

Any asset with a life of 3 years or greater is entitled to a 10% investment tax credit.

Question 31

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

Question 32

The investment tax credit, when applicable, changes the amortization base for tax purposes.

Question 33

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

Question 34

The investment tax credit lowers the present value of the inflows from the CCA tax shield because of a decreased amortization base (UCC).

Question 35

A tax loss on the sale of the last asset in a CCA pool used in business or trade may be written off against ordinary income (even it is a capital loss).

Question 36

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

Question 37

Under CCA amortization you must first subtract out salvage value to determine the amortization base (UCC).

Question 38

The net present value profile examines the relationship of the discount rate to the net present value.

Question 39

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
B.

Question 40

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

Question 41

Which of the following is not a time-adjusted method for ranking investment proposals?

A) net present value method
B) payback period
C) internal rate of return method
D) All of these are time-adjusted methods

Question 42

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

Question 43

Using higher discount rates,

A) accelerated amortization is more valuable than straight line amortization.
B) straight-line amortization is more valuable than accelerated amortization.
C) amortization policy makes no difference.
D) later year amortization has a higher net present value.

Question 44

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

Question 45

For high-IRR investments, it is perfectly acceptable to assume that reinvestment will occur at an equally high, if not higher, rate.

Question 46

Which statement, or statements, is true about amortization?

A) amortization is a non-cash expense that provides tax shield benefits
B) the greater the amortization expenses in earlier years, the higher the present value of the project
C) the CCA amortization schedules supersede other methods for tax purposes
D) all of the other answers are correct

Question 47

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

Question 48

The payback method considers all cash flows.

Question 49

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

Question 50

An investment project has a positive net present value. 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; it depends on the length of the project.

Question 51

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 52

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

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

Question 53

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) the net present-value should be used.

Question 54

A strength of the average accounting return is that it uses accounting numbers in its calculation.

Question 55

Use of the CCA tax shield formula assumes that the tax shields continue forever.

Question 56

Capital rationing

A) is a way of preserving the assets of the firm over the long term.
B) is a less than optimal way to arrive at capital budgeting decisions.
C) assures shareholder wealth maximization.
D) assures maximum potential profitability.

Question 57

Which of the following statements about the "payback period" is true?

A) The payback period considers cash flows after the payback has been reached.
B) The payback period does not consider the time value of money
C) The payback period uses discounted cash-flow techniques.
D) The payback period generally leads to the same decision as other investment selection methods.

Question 58

Cash flow can be said to equal

A) income before amortization and taxes minus taxes.
B) income before amortization and taxes plus taxes.
C) income before amortization and taxes plus amortization.
D) income after taxes minus amortization.

Question 59

The CCA tax shield formula produces the present value of all changes to a CCA pool.

Question 60

Which of the following is not a step in creating the net present value profile?

A) determining the net present value at a zero discount rate
B) determining the net present value at a normal discount rate
C) determining the project's internal rate of return
D) determining the payback period for the project

Question 61

The net present value profile

A) doesn't work if projects have a negative net present value.
B) is a substitute for the IRR.
C) graphically portrays the relationship between the discount rate and the net present value.
D) two of the other answers are correct

Question 62

An equipment replacement decision, under resultant cash flow analysis, requires

A) calculating the present value of all cash flows associated with the new equipment minus the salvage value of the old asset.
B) calculating the present value of all changes in cash flows from the old equipment to the new equipment.
C) subtracting the purchase price of the old equipment from the purchase price of the new equipment.
D) two of the other answers are correct

Question 63

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 aftertax cost of debt.

Question 64

There are several disadvantages to the payback period, one of which is that

A) payback ignores the time value of money.
B) payback emphasizes receiving money back as fast as possible for reinvestment.
C) payback is easy to use and to understand.
D) payback can be used in conjunction with time adjusted methods of evaluation.

Question 65

As the cost of capital increases

A) fewer projects are accepted.
B) more projects are accepted.
C) project selection remains unchanged.
D) none of the other answers are correct

Question 66

Under the capital cost allowance system

A) the life span over which an asset may be amortized is fixed at five years.
B) all assets are amortized down to their salvage value.
C) recovery periods for different types of assets are broken down into categories.
D) all of the other answers are correct.

Question 67

A firm is selling an old asset below book value in a replacement decision. As the firm's tax rate is raised, the net cash outflow (purchase price less proceeds from the sale of the old asset plus CCA effects) would

A) go up.
B) go down.
C) remain the same.
D) more information required

Question 68

The Wet Corp. has an investment project that will reduce expenses by $15,000 per year for 3 years. The project's cost is $20,000, with a 20% CCA rate. Using a 40% tax rate, calculate the net cash flow at the end of year 1?

A) $-15,000
B) $+11,000
C) $+9,000
D) $+9,800

Question 69

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 amortization ignores the cash flow provided by the machine which should be reinvested to replace old worn out machines.
D) all of the other answers are correct

Question 70

The longer the life of an investment

A) the more significant the discount rate.
B) the less significant the discount rate.
C) makes no difference.
D) none of the other answers are correct.

Question 71

The payback period has several disadvantages, which include

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) two of the answers are correct
D) none of the other answers are correct

Question 72

For CCA amortization, automobiles and light trucks fit into the

A) 30% category.
B) 20% category.
C) 10% category.
D) 5% category.

Question 73

The net present value method is a better method of evaluation than the internal rate of return method because

A) the NPV method discounts cash flows at the internal rate of return.
B) the NPV method is a more liberal method of analysis.
C) the NPV method discounts cash flows at the firm's more conservative cost of capital.
D) none of the other answers are correct

Question 74

Firm X is considering the replacement of an old machine with one that has a purchase price of $70,000. The current market value of the old machine is $25,000 but the book value is $32,000. What is the net cash outflow for the new machine with consideration for the sale of the old machine?

A) $70,000
B) $45,000
C) $38,000
D) $32,000

Question 75

If the capital budgeting decision includes a replacement analysis, then

A) a gain from the sale of the old asset will represent a tax savings inflow.
B) only incremental cash flows should be looked at.
C) the sale price and tax savings will increase the cash inflows throughout the asset's life.
D) two of the other answers are correct

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) discounts cash flows at the project's internal rate of return.
B) concentrates on the liquidity aspects of investment projects.
C) discounts cash flows at the firm's weighted average cost of capital.
D) none of the other answers are correct

Question 77

The Dammon Corp. has the following investment opportunities: $\begin{array}{rrrr}&\text { Machine A}&\text { Machine B }&\text { Machine C }\\&(\$ 15,000)&(\$ 22,500)&(\$ 37,500)\\&\text { Inflows}&\text { Inflows }&\text { Inflows }\\\text { year 1 } & \$ 6,000 & \$ 12,000 & \$-0- \\\text { year 2 } & 9,000 & 12,000 & 30,000 \\\text { year 3 } & 3,000 & 10,500 & 30,000 \\\text { year 4 } & -0- & 10,500 & 15,000 \\\text { year 5 } & -0- & -0- & 15,000\end{array}$ Under the payback period 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

Question 78

An investment tax credit (ITC)

A) increases the amortization base for tax purposes.
B) decreases the amortization base for tax purposes.
C) does not affect the amortization base for tax purposes.
D) may increase or decrease the amortization base for tax purposes.

Question 79

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 period analysis.
B) uses net present value analysis.
C) uses internal rate of return analysis.
D) uses profitability indexes.

Question 80

For acceptable investments, the discount rate 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