Deck 12: The Capital Budgeting Decision

Question 1

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

Answer 1

False
Explanation: Project expenditures are planned for at least one year.

Question 2

Depreciation is important in calculating projected cash flows because it lowers the profits, but does not affect the cash account.

Answer 2

True

Question 3

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

Answer 3

False
Explanation: By definition, mutually exclusive means that the selection of one project precludes the selection of any other alternative.

Question 4

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

Question 5

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

Question 6

The payback method is very basic but it gives the user an understanding of when the cost of the initial project will be completely paid off.

Question 7

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

Question 8

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

Question 9

To find the exact internal rate of return for projects with uneven cash flows, we can interpolate between two factors from the time value of money table: present value of a $1.

Question 10

We add depreciation to net income to arrive at a true earnings picture.

Question 11

The payback method is not really a theoretically correct approach.

Question 12

The net present value's primary advantage over the internal rate of return method is that it does not require the time value of money calculations that the internal rate of return requires.

Question 13

It is not unusual for a corporate president to be as sensitive to after-tax income as cash flows.

Question 14

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

Question 15

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

Question 16

Using the payback method can be appropriate when the time value of money is considered.

Question 17

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 18

In most capital budgeting decisions, the emphasis should be on reported earnings rather than cash flows.

Question 19

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

Question 20

With non-mutually 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 21

Under MACRS depreciation, taxes paid in the first year of an asset's life are subtracted from the base used to calculate depreciation expense.

Question 22

Although firms can elect to use straight-line depreciation for their external financial reporting, the MACRS depreciation schedules have exceeded in use over other depreciation methods for tax purposes.

Question 23

Under MACRS depreciation, there are no tax credits for the purpose of calculating the base for depreciation expenses.

Question 24

The internal rate of return (IRR) measures the profitability of investments as a return percentage.

Question 25

Most real estate property is depreciated over a 10-year period.

Question 26

When using accelerated depreciation, the present value of future cash flows increases.

Question 27

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

Question 28

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

Question 29

Under the "modified accelerated-cost-recovery system" (MACRS) of depreciation, cash flow tends to decline with the passage of time.

Question 30

For a small business, it is possible for the purchase price of an asset to be expensed rather than depreciated.

Question 31

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

Question 32

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

Question 33

The net present value profile allows a firm to examine the project's net present value over time without any adjustments.

Question 34

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

Question 35

The profitability index is calculated by dividing the project's net present value by the present value of the projected cash outflows.

Question 36

Net present value (NPV) is considered a theoretically correct method and is also often the preferred investment selection method in practice.

Question 37

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

Question 38

In most cases, asset lives are shorter under MACRS depreciation than they would be with straight-line depreciation.

Question 39

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

Question 40

Under capital rationing, a firm will maximize profitability.

Question 41

Investors discount the later years of a long-term project at a lower rate because they are generally less precise.

Question 42

When net present value and internal rate of return analysis provide inconsistent rankings of projects, the financial manager should generally move forward with the project that has the highest internal rate of return.

Question 43

There are several disadvantages to the payback method, among them:

A) Payback ignores the interest that is earned during the period of time the project is in place.
B) Payback emphasizes receiving money back as fast as possible for reinvestment.
C) Payback is basic to use and understand.
D) Payback can be used in conjunction with time-adjusted methods of evaluation.

Question 44

Which of the following is not a step in the capital budgeting decision-making process?

A) Search for and discovery of investment opportunities.
B) Collection of data.
C) Evaluation and decision making.
D) All of the above are steps used in this process

Question 45

The first step in the capital budgeting process is

A) collection of data.
B) idea development.
C) assign probabilities.
D) determine cash flows.

Question 46

The dollar amount of losses incurred when an old asset is sold below book value is added to the purchase price of a new asset in calculating the base for depreciation.

Question 47

A tax loss on the sale of a depreciable asset used in business or trade may be written off against income.

Question 48

Capital budgeting is primarily concerned with

A) capital formation in the economy.
B) planning future financing needs.
C) evaluating investment alternatives.
D) minimizing the cost of capital.

Question 49

The reinvestment assumption is a downside of the internal rate of return method of analysis because it assumes that cash flows are reinvested at the cost of capital.

Question 50

In a general sense, "cash flow" can be said to equal

A) operating income less taxes plus depreciation.
B) operating income less taxes.
C) operating income before depreciation and taxes plus depreciation.
D) operating income after taxes minus depreciation.

Question 51

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

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

Question 52

Capital rationing is generally a positive action for a firm because it prevents rapid growth, which can drive up the cost of capital.

Question 53

Assume a project has earnings before depreciation and taxes of $15,000, depreciation of $25,000, and that the firm has a 25% combined tax bracket. What are the after-tax cash flows for the project?

A) A positive $17,500
B) A positive $19,000
C) A loss of $21,000
D) A positive $28,000

Question 54

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

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

Question 55

It is more likely for financial managers to focus on cash flow and corporate executives to focus on earnings of the company.

Question 56

Assume a corporation has earnings before depreciation and taxes of $82,000, depreciation of $45,000, and that it has a 25% combined tax bracket. What are the after-tax cash flows for the company?

A) $72,750
B) $82,000
C) $42,000
D) $127,000

Question 57

An appropriate capital budgeting process requires that the following steps be taken in which order?
A) Collection of data
B) Reevaluation and adjustment
C) Evaluation and decision making
D) Search for and discovery of investment opportunities

A) d, a, c, b
B) d, a, b, c
C) d, b, a, c
D) b, d, a, c

Question 58

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 depreciation would ignore the cash flow provided by the machine, which should be reinvested to replace older machines.
D) All of these options are true.

Question 59

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

Question 60

Cash flow is used for a net present value analysis, while earnings are used for the internal rate of return and payback analysis.

Question 61

Stone Inc. is evaluating a project with an initial cost of $9,500. Cash inflows are expected to be $1,500, $1,500, and $10,000 in the three years over which the project will produce cash flows. If the discount rate is 6%, what is the net present value of the project?

A) $11,150
B) $26,930
C) $8,430
D) $1,650

Question 62

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 method analysis.
B) uses net present value analysis.
C) uses internal rate of return analysis.
D) uses profitability indices.

Question 63

The payback method has several disadvantages, among them:

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) Payback fails to choose the optimum or most economic solution to a capital budgeting problem, and it ignores cash inflows after the payback period.
D) None of these options are disadvantages.

Question 64

The internal rate of return assumes that funds are reinvested at the

A) cost of capital.
B) yield on the investment.
C) minimal acceptable rate to the corporation.
D) yield to maturity.

Question 65

The Dammon Corp. has the following investment opportunities:
$\begin{array}{cccrr}\text { Machine A } && \text { Machine B } && \text { Machine C } \\(\$ 10,000 \operatorname{cost})&&(\$ 22,500 \operatorname{cost})&&(\$ 35,500 \operatorname{cost})\\\text { Inflows }&&\text { Inflows }&&\text { Inflows }\\\text { year 1 } & \$ 6,000 & \text { year } 1 & \$ 12,000 & \text { year 1 } &\%-0-\\\text { year 2 } & 3,000 & \text { year 2 } & 7,500 & \text { year 2 }&30,000 \\\text { year 3 } & 3,000 & \text { year 3 } & 1,500 & \text { year 3 } &5,000\\\text { year 4 } & -0- & \text { year 4 } & 1,500 & \text { year 4 }&20,000\end{array}$
Under the payback method 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 66

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) only the net present value method can be used.

Question 67

You require an internal rate of return of 8% to accept a project. If the project will yield $10,000 per year for 10 years, what is the maximum amount that you would be willing to invest in the project?

A) $51,400
B) $67,100
C) $100,000
D) $144,870

Question 68

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 69

A project requires an investment of $2,500 and has a net present value of $430. If the internal rate of return is 10%, what is the profitability index for the project?

A) 0.25
B) 2.33
C) 0.70
D) 1.17

Question 70

How would the salvage value be treated in a net present value calculation?

A) Disregard the salvage
B) As a positive cash flow in the final year that the asset is used
C) As a negative cash flow in the final year that the asset is used
D) As a negative cash flow in the first year that the asset is used

Question 71

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

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

Question 72

The longer the life of an investment

A) the more significant the discount rate.
B) the less significant the discount rate.
C) the more it can initially cost.
D) the less it can initially cost.

Question 73

You buy a new piece of equipment for $7,360, and you receive a cash inflow of $1,000 per year for 10 years. What is the internal rate of return?

A) 4%
B) 6%
C) 8%
D) 10%

Question 74

Assume a $6,500 investment and the following cash flows for two alternatives.
$\begin{array}{llll}\text { Year } & \text { Investment X }& \text { Investment Y }\\1 & \$ 1,000 & \$ 1,300 \\2 & 1,800 & 2,000 \\3 & 1,700& 1,100 \\4 & 2,000 & 1,500 \\5 & & 600\end{array}$
Under the payback method, which of the following could be concluded?

A) Investment X should be selected.
B) Investment Y should be selected.
C) Investment X and Y provide the same payback period.
D) The investments are not comparable since they have different time frames.

Question 75

A characteristic of capital budgeting is that

A) a large amount of money is always involved.
B) the net present value must be negative to be accepted.
C) the internal rate of return must be greater than the cost of capital.
D) the time horizon is at least five years.

Question 76

With non-mutually exclusive projects,

A) the payback method will select the best project.
B) only one project can be accepted.
C) the IRR, NPV, and payback methods are all treated equally in the decision making process.
D) the net present value and the internal rate of return methods will accept or reject the same projects.

Question 77

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 after-tax cost of debt.

Question 78

The net present value method (NPV) is a more conservative technique for selecting investment projects than the internal rate of return method because the NPV method

A) assumes that cash flows are reinvested at the project's internal rate of return.
B) concentrates on the liquidity aspects of investment projects.
C) assumes that cash flows are reinvested at the firm's weighted average cost of capital.
D) None of these options are true.

Question 79

The internal rate of return and net present value methods

A) always give the same investment decision answer.
B) never give the same investment decision answer.
C) usually give the same investment decision answer.
D) always give conclusions different from the payback method.

Question 80

For acceptable investments, the reinvestment assumption under the internal rate of return is generally

A) higher acceptance than under the net present value method.
B) lower acceptance than under the net present value method.
C) at the cost of capital.
D) below the cost of capital.