Question 1

A firm is considering a project with annual cash flows of £40,000. The project would have a 10-year life, and the company uses a discount rate of 8 percent. What is the maximum amount the company could invest in the project and the project still be acceptable?

Accepted Answer

To find the maximum amount the company can invest, we need to calculate the net present value (NPV) of the project when discounted at 8 percent over 10 years.

NPV = (CF1/ (1+r)^1) + (CF2/ (1+r)^2) + ... + (CF10/ (1+r)^10)

where CF is the cash flow for each year, r is the discount rate, and the numbers in the exponent denote the year.

Plugging in the values, we get:

NPV = (40,000)/(1+0.08)^1 + (40,000)/(1+0.08)^2 + ... + (40,000)/(1+0.08)^10
NPV = 268,393.14

Therefore, the maximum amount the company could invest in the project and still achieve a positive NPV is £268,400. Choice B is the correct answer.

Question 2

Lewis Manufacturing Company is planning to invest in equipment costing £240,000. The estimated cash flows from this equipment are expected to be as follows: Assume that the cash inflows occur evenly over the year. The payback period for this investment is

Accepted Answer

To calculate the payback period, we need to keep track of the cumulative cash flows.

Cumulative cash flow for Year 1 = -£240,000 + £80,000 = -£160,000
Cumulative cash flow for Year 2 = -£240,000 + £80,000 * 2 = -£80,000 
Cumulative cash flow for Year 3 = -£240,000 + £80,000 * 3 = £80,000

The payback period is the time it takes for the cumulative cash flows to equal the initial investment. In this case, it takes 3 years and 3 months (or 3.25 years) for the cumulative cash flows to equal the initial investment of £240,000.

Therefore, the best choice is B.

Question 3

Kaylin Company purchased a piece of equipment for £100,000 that had a useful life of 5 years. The equipment had no salvage value. It saves the company £40,000 a year and costs the company £5,000 a year to operate. What is the accounting rate of return on the equipment?

Accepted Answer

The accounting rate of return (ARR) is calculated as the average annual profit divided by the initial investment. The annual profit is the savings minus the operating costs, which is £40,000 - £5,000 = £35,000. Over 5 years, this totals £175,000, but since ARR is based on annual figures, we use the annual profit of £35,000. The initial investment is £100,000. Thus, ARR = (£35,000 / £100,000) * 100% = 35%.

Question 4

The present value of £2,000 to be received each year for three years and earning a 10 percent return is

Accepted Answer

To calculate the present value of an annuity, we can use the following formula:

PV = Payment x (1 - (1 + r)^-n) / r

Where: 
PV = Present value 
Payment = Amount of each payment 
r = Interest rate (10% or 0.10) 
n = Number of periods (3)

Plugging in the numbers, we get:

PV = £2,000 x (1 - (1 + 0.10)^-3) / 0.10 
PV = £4,974.03

Therefore, choice B is the correct answer.

Question 5

A firm is considering a project with annual cash flows of £75,000. The project would have a 7-year life, and the company uses a discount rate of 10 percent. What is the maximum amount the company could invest in the project and the project still be acceptable?

Accepted Answer

To calculate the present value of the cash flows, we can use the formula:
PV = CF/(1+r)^n, where CF is the cash flow, r is the discount rate, and n is the number of years.
So the present value of the annual cash flows would be:
PV = £75,000/(1+0.1)^1 + £75,000/(1+0.1)^2 + ... + £75,000/(1+0.1)^7
PV= £329,330.29
Therefore, the maximum amount the firm can invest would be the present value of the cash flows:
Max Investment = £329,330.29
So the best choice is B.

Question 6

A firm is considering a project requiring an investment of £100,000. The project would generate annual cash inflows of £26,380 per year for the next five years. The approximate internal rate of return for the project is

Accepted Answer

The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. Given the investment and the annual cash inflows, the IRR can be approximated using the formula for the IRR of an annuity: IRR ≈ (Annual Cash Inflow / Initial Investment) * 100. Plugging in the given numbers: (26,380 / 100,000) * 100 = 26.38%. However, this simple calculation does not directly apply here due to the compounding effect over multiple years. The correct IRR is closer to 10% when properly calculated using the IRR formula or financial calculator, which takes into account the time value of money over the five-year period.

Question 7

A firm is considering a project with annual cash flows of £120,000. The project would have an 8-year life, and the company uses a discount rate of 12 percent. What is the maximum amount the company could invest in the project and the project still be acceptable?

Accepted Answer

The answer of A firm is considering a project with...

Question 8

A firm is considering a project requiring an investment of £14,150. The project would generate annual cash inflows of £3,300 per year for the next seven years. The approximate internal rate of return for the project is

Accepted Answer

The answer of A firm is considering a project requiring...

Question 9

The present value of £2,000 to be received three years from now and earning a 12 percent return is

Accepted Answer

The present value can be calculated using the formula: PV = FV / (1 + r)^n, where PV is the present value, FV is the future value, r is the interest rate, and n is the number of years.
So, in this case, PV = 2,000 / (1 + 0.12)^3 = £1,424.

Question 10

Ducky Pizza Restaurant purchases a van to deliver pizzas to their customers. The van costs £28,000 and is projected to increase revenues by £10,000 a year and to increase costs by £4,500. The payback period for this van is

Accepted Answer

Payback period = Cost of Investment / Annual Cash Inflows

Cost of investment = £28,000
Annual cash inflows = £10,000 - £4,500 = £5,500

Payback period = £28,000 / £5,500 = 5.09 years (rounded to one decimal place)

Therefore, the best choice is C as it represents the closest answer.

Question 11

The internal rate of return is the

Accepted Answer

The internal rate of return is the discount rate at which the net present value of a project's cash inflows equals the net present value of its cash outflows, which means that the project is neither generating a profit nor incurring a loss. In other words, it is the rate of return that sets the project's net present value equal to zero. The other options (B, C, and D) are different types of rates, but not the internal rate of return.

Question 12

The Bradshaw Company is considering purchasing equipment for £78,000. This equipment will save the company £22,000 in operating costs annually. The payback period for this equipment is

Accepted Answer

The payback period is calculated by dividing the initial investment by the annual savings. So, £78,000 / £22,000 = 3.5 years.

Question 13

If NPV and IRR produce different rankings, which method should be used in choosing investment projects?

Accepted Answer

Net present value (NPV) is generally considered the best method for choosing investment projects because it takes into account the time value of money, which is not considered in the internal rate of return (IRR) method. In addition, NPV considers all cash flows (both inflows and outflows) and provides a dollar amount for the net value of the investment. In contrast, IRR only considers the cash inflows and is based on a percentage rate of return. Therefore, if NPV and IRR produce different rankings, NPV should be used to choose investment projects. Payback and accounting rate of return are less reliable methods that do not take into account the time value of money or all cash flows.

Question 14

Brooks Company invested in a project that is expected to have an annual cash flow of £10,000. The project's life is five years and has an IRR of 14 percent. How much was the initial investment in the project?

Accepted Answer

The answer of Brooks Company invested in a project that...

Question 15

Which of the following is NOT included in the calculation of net present value of a proposed project? (Ignore income taxes.)

Accepted Answer

Depreciation expense is not included in the calculation of net present value (NPV) because NPV focuses on cash flows, not accounting expenses. Depreciation is a non-cash expense that allocates the cost of an asset over its useful life for accounting purposes.

Question 16

The present value of £8,000 to be received each year for ten years and earning a 16 percent return is

Accepted Answer

The answer of The present value of £8,000 to be...

Question 17

The present value of £10,000 to be received five years from now and earning a 12 percent return is

Accepted Answer

The present value can be calculated using the formula PV = FV / (1 + r)n where PV is the present value, FV is the future value, r is the interest rate, and n is the number of years. Plugging in the values, we get PV = £10,000 / (1 + 0.12)5 = £5,670. Therefore, the best choice is B.

Question 18

If the investment's internal rate of return is more than the required rate of return, the investment should be

Accepted Answer

If the investment's internal rate of return is more than the required rate of return, it means that the project is generating a return greater than what the investors or the company's cost of capital requires. Thus, accepting the investment would lead to an increase in the value of the firm and the shareholders' wealth.

Question 19

How is working capital needed in the operations of investments treated in discounted cash flow analysis?

Accepted Answer

Working capital needed in the operations of investments is necessary to keep the operations running smoothly. This is added to the cost of investment in the initial years, but it becomes recoverable over time. Hence, it is added to cash inflows when recovery occurs. Therefore, both A and B options are correct.

Question 20

Why do the NPV method and the IRR method sometimes produce different rankings of mutually exclusive investment projects?

Accepted Answer

The NPV and IRR methods assume different reinvestment rates. The NPV assumes a reinvestment rate equal to the discount rate, while the IRR assumes a reinvestment rate equal to the internal rate of return. Therefore, if the projects have different cash flow patterns, the NPV and IRR methods may rank the projects differently. This is because the NPV assumes a constant reinvestment rate, while the IRR assumes a varying reinvestment rate based on the cash flows of the project.

Quiz 6: Capital Investment Decisions