Question 1

When selecting a capital investment project from three alternatives, the project with the highest net present value will always be preferable.

Accepted Answer

While a higher net present value (NPV) indicates a potentially more profitable investment, other factors such as risk, strategic alignment, and resource constraints must also be considered when selecting a capital investment project.

Question 2

If the discount rate is increased from 8% to 10%, what will happen to the net present value (NPV) of a project (assume all future cash flows are positive)?

Accepted Answer

Increasing the discount rate will result in a higher discount factor being applied to each cash flow, causing their present values to be lower. This means that the NPV of the project will decrease.

Question 3

If the discount rate is decreased from 9% to 7%, what will happen to the internal rate of return (IRR) of a project?

Accepted Answer

The internal rate of return (IRR) is the rate of return at which the net present value (NPV) of all cash flows of a project is equal to zero. It is purely based on the project's cash flows and does not depend on the discount rate. Therefore, a change in the discount rate will not affect the IRR.

Question 4

When evaluating capital investment projects, if the internal rate of return is less than the required rate of return, the project will be rejected.

Accepted Answer

If the internal rate of return (IRR) of a capital investment project is less than the required rate of return (RRR), it implies that the project is not generating returns at the desired or acceptable level. Hence, the project should be rejected or not undertaken.

Question 5

When the profitability index is greater than 1.00 for a project, that project has a positive net present value.

Accepted Answer

The profitability index is the ratio of the present value of future cash flows to the initial investment. It is calculated as:

Profitability Index = Present Value of Future Cash Flows / Initial Investment

When the profitability index is greater than 1.00, it means that the present value of future cash flows is greater than the initial investment, and the project has a positive net present value. Therefore, the answer is true.

Question 6

The internal rate of return is used as the discount rate when calculating the net present value of a project.

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. It is not used as the discount rate when calculating the NPV; instead, the NPV is calculated using a discount rate determined by the investor, often the required rate of return.

Question 7

A series of equal payments or deposits made at equal time intervals are called annuities.

Accepted Answer

Annuities are defined as a series of equal payments or deposits made at equal time intervals.

Question 8

The residual value is not considered in a NPV computation.

Accepted Answer

The residual value is considered in a NPV computation as it represents the value of the asset at the end of its useful life, which can be sold or salvaged for cash. The cash flow from the residual value is included in the final year of the NPV calculation.

Question 9

A company finds that the residual value of $10,000 for the equipment in a capital budgeting project has been inadvertently omitted from the calculation of the net present value (NPV) for that project. How does this omission affect the NPV of that project?

Accepted Answer

The residual value should be discounted to its present value, which would be less than $10,000, thus increasing the NPV by less than $10,000.

Question 10

Stensels, a plastics processor, is considering the purchase of a high-speed extruder as one option. The new extruder would cost $50,000 and would have a residual value of $5,000 at the end of its 8 year life. The annual operating expenses of the new extruder would be $8,000. The other option that Stensels has is to rebuild its existing extruder. The rebuilding would require an investment of $30,000 and would extend the life of the existing extruder by 8 years. The existing extruder has annual operating costs of $11,000 per year and does not have a residual value. Stensels' discount rate is 14%. Using net present value analysis, which option is the better option and by how much?

Accepted Answer

The NPV of the new extruder is -$1,669 and the NPV of the rebuilt extruder is $2,661. Therefore, the better option is to rebuild the existing extruder, and the difference in NPV is $4,330.

Question 11

Mansfield Motors is evaluating a capital investment opportunity. This project would require an initial investment of $30,000 to purchase one machine and $10,000 to purchase the other machine (both machines are required). The project equipment will have a residual value at the end of its life of $3,000. The useful life of the equipment is 5 years. The new project is expected to generate additional net cash inflows of $12,000 per year for each of the five years. Mansfield Motors' required rate of return is 14%. The net present value of this project is closest to

Accepted Answer

The net present value (NPV) of the project can be calculated using the formula for NPV, which involves discounting the future cash inflows back to their present value at the required rate of return and subtracting the initial investment. The initial investment is the sum of the costs of both machines, which is $30,000 + $10,000 = $40,000. The annual net cash inflow is $12,000 for 5 years, and the residual value of $3,000 at the end of year 5 also needs to be considered. Using a financial calculator or NPV formula with a 14% discount rate, the NPV of this project is closest to $(361), indicating that the project would slightly decrease the value of the company if undertaken.

Question 12

Baker Enterprises is evaluating the purchase of a new computer network system. The new system would cost $24,000 and have a useful life of 6 years. At the end of the system's life, it would have a residual value of $3,000. Annual operating cost savings from the new system would be $8,800 per year for each of the six years of its life. Baker Enterprises has a minimum required rate of return of 12% on all new projects. The net present value of the new network system would be closest to

Accepted Answer

C) Calculator $37,700.28 - $24,000 = $13,700.28

Question 13

The profitability index equals the present value of net cash inflows from the investment divided by the cost of the investment.

Accepted Answer

This is the correct definition of profitability index.

Question 14

A project has an internal rate of return which is equal to the company's discount rate. The project's profitability index

Accepted Answer

If a project's IRR is equal to the company's discount rate, then the NPV of the project would be zero. In this case, the profitability index would be equal to 1 (i.e. PV of cash inflows / PV of cash outflows = 1), which indicates that the project is expected to break even.

Question 15

The interest rate that makes the net present value of the investment equal to zero is the internal rate of return.

Accepted Answer

This statement is true. The internal rate of return is the interest rate at which the cash inflows from an investment equal the cash outflows, resulting in a net present value of zero.

Question 16

Discount rate, hurdle rate, and required rate of return have the same meaning when calculating net present value.

Accepted Answer

Discount rate, hurdle rate, and required rate of return are all used interchangeably when calculating net present value. They are the rate of return required to make an investment worthwhile or profitable.

Question 17

When evaluating the cash flows from an investment, a reduction in cash flows is also considered.

Accepted Answer

A reduction in cash flows is considered when evaluating the overall cash flows from an investment. This could happen due to various reasons such as increased expenses or decreased revenues. It is important to consider both positive and negative cash flows when making investment decisions.

Question 18

Home Products, Inc. is evaluating the purchase of a new machine to use in its manufacturing process. The new machine would cost $40,000 and have a useful life of 6 years. At the end of the machine's life, it would have a residual value of $2,500. Annual cost savings from the new machine would be $12,400 per year for each of the six years of its life. Home Products, Inc. has a minimum required rate of return of 16% on all new projects. The net present value of the new machine would be closest to

Accepted Answer

To calculate the net present value (NPV) of the new machine, we need to discount the annual cost savings by the minimum required rate of return of 16%.

The annual cost savings of $12,400 is the cash inflow for each of the six years of the machine's life. We can use the present value of an annuity formula to calculate the present value of this cash inflow stream:

PV = C x [(1 - (1 + r)^-n) / r]

Where: 
PV = present value 
C = cash inflow per period 
r = discount rate 
n = number of periods

Using this formula, we get: 
PV = $12,400 x [(1 - (1+0.16)^-6) / 0.16] 
PV = $50,855.13

Next, we need to subtract the initial cost of the machine and the residual value at the end of its life: 
NPV = PV - initial cost + residual value 
NPV = $50,855.13 - $40,000 + $2,500 
NPV = $12,355.13

Since the NPV is positive, the investment in the new machine is acceptable, and the closest answer is C, $6,719.

Question 19

In calculating the net present value of an investment in equipment, the required investment and its terminal residual value should be subtracted from the present value of all future cash inflows.

Accepted Answer

In calculating the net present value (NPV) of an investment in equipment, the required investment is subtracted from the present value of all future cash inflows, but the terminal residual value (if any) is added to the present value of future cash inflows, not subtracted.

Question 20

In computing the IRR of an investment, a company would not consider

Accepted Answer

The Internal Rate of Return (IRR) calculation is based on predicting cash inflows over the life of a project and comparing these to the project's cost. Present value factors are also used to discount future cash flows to their present value. However, the calculation of IRR does not take into account depreciation on the assets of the project.

Quiz 12: Capital Investment Decisions and the Time Value of Money