Question 1

Which of the following statements is necessarily true?

Accepted Answer

The profitability index is calculated as the present value of future cash flows divided by the initial investment. If the profitability index is equal to 1.0, it means that the present value of future cash flows is equal to the initial investment, so there is no net gain or loss (i.e. the net present value is equal to 0). The profitability index is calculated as the ratio of the present value of future cash flows to the initial investment. If the profitability index is 1.0, it means that the present value of future cash flows is equal to the initial investment. Therefore, the net present value of the project is also equal to 0.

Question 2

In practice, what evaluation techniques are most often used to make capital budgeting
decisions? Do these techniques lead to value maximization? Explain.

Accepted Answer

The answer of In practice, what evaluation techniques are most...

Question 3

The Carter project has a net present value of $6,000. Its only cash outflow is its cost of $8,000. The profitability index is

Accepted Answer

The profitability index is calculated by dividing the present value of the project's cash inflows by the initial investment. In this case, the present value of the cash inflows is $6,000 and the initial investment is $8,000, so the profitability index is $6,000/$8,000 = 1.75.

Question 4

Which of the following set of calculations must be erroneous if the required rate of return is 12%?

Accepted Answer

Since the required rate of return is 12%, the calculation that results in a rate of return higher than 12% must be erroneous. In the case of Project C, the calculated rate of return is 20%, which is higher than the required rate of return, indicating errors in the calculation. Therefore, Project C must be the erroneous set of calculations. Projects A, B, and D do not have a rate of return greater than 12%.

Question 5

Which of the following set of calculations must be erroneous if the required rate of return for all the projects is 10%?

Accepted Answer

The set of calculations that must be erroneous if the required rate of return for all the projects is 10% is the one that provides a project with a negative net present value (NPV) at a discount rate of 10%. Project C has a NPV of -$2,062 at a discount rate of 10%, which means that the project's cash outflows are higher than its cash inflows at this required rate of return. Therefore, Project C is the best choice for this question, as it has an erroneous calculation. To check the accuracy of the calculations, we need to compare the present value of the cash inflows with the initial investment using the required rate of return of 10%. Only Project C has a present value of cash inflows lower than the initial investment, indicating an erroneous calculation. Projects A, B, and D have present values of cash inflows higher than the initial investment, suggesting accurate calculations.

Question 6

Consider the following mutually exclusive projects, all of which have a 12% required
return.  Which project should be undertaken? Why?

Accepted Answer

The answer of Consider the following mutually exclusive projects, all...

Question 7

Consider the following three mutually exclusive projects:  If the appropriate cost of capital is 10% for all three projects, which project should be undertaken?

Accepted Answer

The appropriate cost of capital for all three projects is 10%, which makes the comparison of the three projects easier. Project A has the highest NPV, indicating that it will contribute the most value to the company. Therefore, Project A should be undertaken. The IRR and payback period are important factors to consider, but NPV is the most comprehensive measure of a project's value. Since all three projects have the same cost of capital, the best project to undertake is the one with the highest net present value (NPV). Project A has the highest NPV, making it the best choice. The internal rate of return (IRR) and payback period are also important considerations, but they are not as reliable as NPV in determining the relative value of each project. Without knowing the actual cash flows from each project, we cannot make a definitive decision based on IRR or payback period alone.

Question 8

Which of the following is not considered to be an advantage associated with the payback evaluation technique?

Accepted Answer

The payback evaluation technique does not take the time value of money into consideration, which means it does not adjust for the fact that receiving cash flows sooner is more valuable than receiving them later due to the potential for investment and earning interest. The other options are advantages of the payback evaluation technique. The payback evaluation technique does not take time value of money into consideration, making it less accurate compared to other evaluation methods that do consider the time value of money. Options A and C are advantages of the payback evaluation technique. Therefore, the correct answer is B.

Question 9

Project Bertha requires an initial cost outlay of $5,200 and is expected to produce cash flows of $2,000 at the end of the following three years. If the hurdle rate is 10%, should the project be
Undertaken?

Accepted Answer

The answer of Project Bertha requires an initial cost outlay...

Question 10

Which of the following statements about the payback period evaluation technique is true?

Accepted Answer

The payback period technique favors investments that return large cash flows in the initial years of the investment's life, without considering the time value of money or the cash flows beyond the payback period. As a result, it may lead to incorrect investment decisions. Option A is incorrect because the payback period technique does not take risk into consideration. Option B is incorrect because the net present value technique and the payback period technique can lead to different investment decisions, especially when cash flows are uneven. The payback period technique favors investments that return large cash flows in the initial years of the investment's life. This can result in overlooking investments that have a longer payback period but greater overall returns. Therefore, the payback period evaluation technique is not a reliable method for making investment decisions.

Question 11

What evaluation technique attempts to compare your project's earnings to the earnings of other firms?

Accepted Answer

Earning multiples, also known as price/earnings ratios, compare a company's earnings to those of similar firms in the industry. This allows for a more accurate comparison and evaluation of the project's potential earnings. Internal rate of return and profitability index are both useful metrics for evaluating the project's profitability, but they do not take into account the earnings of other firms. Accounting rate of return measures the average annual income generated by an investment, but it does not compare it to earnings of other firms in the industry. The evaluation technique that attempts to compare your project's earnings to the earnings of other firms is earning multiples. This technique involves comparing your project's price-to-earnings (P/E) ratio or enterprise value-to-EBITDA (EV/EBITDA) ratio to the same ratios of other companies in the same industry. This provides an indication of how the market values your project relative to other companies in the same industry. Choice A (internal rate of return) is a technique that measures the profitability of a project based on the time value of money. Choice B (accounting rate of return) is a technique that measures the average annual accounting profit of a project as a percentage of the initial investment. Choice D (profitability index) is a technique that measures the present value of future cash flows relative to the initial investment.

Question 12

Project Kappa will cost $80,000 and is expected to pay back $20,000, $30,000, $25,000, $25,000, $10,000, and $10,000 at the end of each of the following six years. What is its payback period?

Accepted Answer

To calculate the payback period, we add up the cash inflows until we reach the initial investment cost of $80,000. 
Year 1: $20,000
Year 2: $20,000 + $30,000 = $50,000
Year 3: $50,000 + $25,000 = $75,000
Year 4: $75,000 + $25,000 = $100,000 - this is where we reach the initial investment cost, so the payback period is 4 years. 
Since the payback period is shorter than the project's life span (6 years), this project could be considered acceptable. To determine the payback period, we need to calculate the cumulative cash inflows each year until the initial investment of $80,000 is fully recovered. 
Year 1: $20,000 (cumulative cash inflow = $20,000)
Year 2: $30,000 (cumulative cash inflow = $50,000)
Year 3: $25,000 (cumulative cash inflow = $75,000)
Year 4: $25,000 (cumulative cash inflow = $100,000)
Since the payback period is defined as the time it takes to recover the initial investment, we can see that the $80,000 investment is fully recovered by the end of Year 4, with a cumulative cash inflow of $100,000. Therefore, the payback period is 4 years. Option C is the correct answer.

Question 13

The payback period of Project A is 2 years while that of Project B is 4 years. Which of the following statements is true?

Accepted Answer

The payback period alone does not determine the riskiness of a project, the Internal Rate of Return (IRR), or the value it adds to the company. Other factors such as cash flow patterns, cost of capital, and overall profitability need to be considered.

Question 14

A certain project has a net present value of $3,200. The only cash outflow is the initial investment of $17,000. What is the project's profitability index? Round your answer to the
Nearest hundredth.

Accepted Answer

The profitability index is calculated by dividing the present value of the cash inflows by the initial investment. In this case, the present value of the cash inflows is $20,200 ($17,000 initial investment + $3,200 net present value). So the profitability index is 20,200/17,000 = 1.19. A profitability index greater than 1 indicates that the project is profitable, so in this case, the best choice is to undertake the project. The profitability index is calculated as the present value of cash inflows divided by the initial investment. 
Profitability index = (Net present value + Initial investment) / Initial investment 
Profitability index = (3200 + 17000) / 17000 
Profitability index = 1.19 
Therefore, the best choice is C.

Question 15

Project Mars' only cash outlay is its cost of $15,000. The project has a net present value of $18,000. Its profitability index is

Accepted Answer

The answer of Project Mars' only cash outlay is its...

Question 16

Which of the following capital budgeting techniques is most favored by CFOs?

Accepted Answer

CFOs most favor the internal rate of return (IRR) capital budgeting technique because it considers the time value of money and provides a measure of the project's overall profitability. The payback period, profitability index, and P/E ratios are also used, but not as frequently as IRR. Internal rate of return (IRR) is generally favored by CFOs as it takes into account the time value of money and provides a percentage rate of return on the investment. This helps in comparing and selecting among different investment options. Payback period and profitability index are less favored as they do not consider the time value of money and P/E ratios are not a capital budgeting technique.

Question 17

Two projects have the following projected cash flows: 
-Refer to the information above. Which one would be selected if the payback evaluation
technique were used? Will this necessarily be a value-maximizing decision?

Accepted Answer

The answer of Two projects have the following projected cash...

Question 18

Two projects have the following projected cash flows: 
-Refer to the information above. Assume that the appropriate discount rate for both
projects is 10%. Calculate the profitability index for each project. Which, if either,
project should be undertaken based on your calculations? If the projects are mutually
exclusive, can you choose between them using this method? Why or why not?

Accepted Answer

The answer of Two projects have the following projected cash...

Question 19

Project A has a net present value of $1,500, a payback period of 2 years, and an internal rate of return of 12%. Project B has a net present value of $1,800, a payback period of 4 years, and an
Internal rate of return of 10%. Project C has a net present value of $1,750, a payback period of 3
Years, and an internal rate of return of 11%. If the projects are mutually exclusive, which
Project should be undertaken?

Accepted Answer

When projects are mutually exclusive, the project with the highest Net Present Value (NPV) should be selected because NPV directly measures the increase in value to the firm. Project B has the highest NPV at $1,800.

Question 20

The Thunderstruck Corporation paid $130,000 for an asset. The asset is expected to generate end-of-year cash flows of $50,000, $50,000, $32,000, $28,000, and $25,000 in years one through
Five, respectively. Calculate the payback period for the project, assuming all the cash flows
From the project occur at the end of the year.

Accepted Answer

The payback period is the time it takes for the cumulative cash flows to equal the initial investment. After 3 years, the cumulative cash flow is $132,000 ($50,000 + $50,000 + $32,000), which exceeds the initial investment of $130,000.

Quiz 4: A First Encounter With Capital Budgeting Rules

Which of the following statements is necessarily true?

In practice, what evaluation techniques are most often used to make capital budgeting decisions? Do these techniques lead to value maximization? Explain.

The Carter project has a net present value of $6,000. Its only cash outflow is its cost of $8,000. The profitability index is

Which of the following set of calculations must be erroneous if the required rate of return is 12%?

Which of the following set of calculations must be erroneous if the required rate of return for all the projects is 10%?

Consider the following mutually exclusive projects, all of which have a 12% required return. Which project should be undertaken? Why?

Consider the following three mutually exclusive projects: If the appropriate cost of capital is 10% for all three projects, which project should be undertaken?