CHAPTER7:CAPITALBUDGETINGDECISIONSPARTI

MultipleChoice
d1.Calculatingthepaybackperiodforacapitalprojectrequiresknowingwhichofthefollowing?
a.Usefullifeoftheproject.
b.Thecompany'sminimumrequiredrateofreturn.
c.Theproject'sNPV.
d.Theproject'sannualcashflow.
c2.Thepaybackcriterionforcapitalinvestmentdecisions
a.isconceptuallysuperiortotheIRRcriterion.
b.takesintoconsiderationthetimevalueofmoney.
c.givesprioritytorapidrecoveryofcash.
d.emphasizesthemostprofitableprojects.
a3.WhichofthefollowingisNOTrelevantincalculatingannualnetcashflowsforaninvestment?
a.Interestpaymentsonfundsborrowedtofinancetheproject.
b.Depreciationonfixedassetspurchasedfortheproject.
c.Theincometaxrate.
d.Lostcontributionmarginifsalesoftheproductinvestedinwillreducesalesofotherproducts.
a4.Ifthepresentvalueofthefuturecashflowsforaninvestmentequalstherequiredinvestment,theIRRis
a.equaltothecutoffrate.
b.equaltothecostofborrowedcapital.
c.equaltozero.
d.lowerthanthecompany'scutoffrateofreturn.
b5.TherelationshipbetweenpaybackperiodandIRRisthat
a.apaybackperiodoflessthanonehalfthelifeofaprojectwillyieldanIRRlowerthanthetarget
rate.
b.thepaybackperiodisthepresentvaluefactorfortheIRR.
c.aprojectwhosepaybackperioddoesnotmeetthecompany'scutoffrateforpaybackwillnotmeetthe
company'scriterionforIRR.
d.noneoftheabove.
c6.WhichofthefollowingeventsismostlikelytoreducetheexpectedNPVofaninvestment?
a.Themajorcompetitorfortheproducttobemanufacturedwiththemachinerybeingconsideredfor
purchasehasbeenrated"unsatisfactory"byaconsumergroup.
b.Theinterestrateonlongtermdebtdeclines.
c.TheincometaxrateisraisedbytheCongress.
d.Congressapprovestheuseoffasterdepreciationthanwaspreviouslyavailable.
a7.IfaninvestmenthasapositiveNPV,
a.itsIRRisgreaterthanthecompany'scostofcapital.
b.costofcapitalexceedsthecutoffrateofreturn.
c.itsIRRislessthanthecompany'scutoffrateofreturn.
d.thecutoffrateofreturnexceedscostofcapital.
c8.WhichofthefollowingdescribestheannualreturnsthatarediscountedindeterminingtheNPVofan
investment?
a.Netincomesexpectedtobeearnedbytheproject.
b.Pretaxcashflowsexpectedfromtheproject.
c.Aftertaxcashflowsexpectedfromtheproject.
d.Aftertaxcashflowsadjustedforthetimevalueofmoney.
b9.WhichofthefollowingcapitalbudgetingmethodsdoesNOTconsiderthetimevalueofmoney?
a.IRR.
b.Bookrateofreturn.
c.Timeadjustedrateofreturn.
d.NPV.
b10.Allotherthingsbeingequal,ascostofcapitalincreases
a.morecapitalprojectswillprobablybeacceptable.
b.fewercapitalprojectswillprobablybeacceptable.
c.thenumberofcapitalprojectsthatareacceptablewillchange,butthedirectionofthechangeisnot
determinablejustbyknowingthedirectionofthechangeincostofcapital.
d.thecompanywillprobablywanttoborrowmoneyratherthanissuestock.
d11.WhichofthefollowingisabasicdifferencebetweentheIRRandthebookrateofreturn(BRR)criteria
forevaluatinginvestments?
a.IRRemphasizesexpensesandBRRemphasizesexpenditures.
b.IRRemphasizesrevenuesandBRRemphasizesreceipts.
c.IRRisusedforinternalinvestmentsandBRRisusedforexternalinvestments.
d.IRRconcentratesonreceiptsandexpendituresandBRRconcentratesonrevenuesandexpenses.
a12.Ifaprojecthasapaybackperiodshorterthanitslife,
a.itsNPVmaybenegative.
b.itsIRRisgreaterthancostofcapital.
c.itwillhaveapositiveNPV.
d.itsincrementalcashflowsmaynotcoveritscost.
c13.Costofcapitalis
a.theamountthecompanymustpayforitsplantassets.
b.thedividendsacompanymustpayonitsequitysecurities.
c.thecostthecompanymustincurtoobtainitscapitalresources.
d.thecostthecompanyischargedbyinvestmentbankerswhohandletheissuanceofequityorlongterm

38

debtsecurities.
d14.Thenormalmethodsofanalyzinginvestments
a.cannotbeusedbynotforprofitentities.
b.donotapplyiftheprojectwillnotproducerevenues.
c.cannotbeusedifthecompanyplanstofinancetheprojectwithfundsalreadyavailableinternally.
d.requireforecastsofcashflowsexpectedfromtheproject.
a15.WhichofthefollowingisNOTadefectofthepaybackmethod?
a.Itignorescashflowsbecauseitusesnetincome.
b.Itignoresprofitability.
c.Itignoresthepresentvaluesofcashflows.
d.Itignoresthepatternofcashflowsbeyondthepaybackperiod.
b16.Acompanywithcostofcapitalof15%planstofinanceaninvestmentwithdebtthatbears10%interest.
Therateitshouldusetodiscountthecashflowsis
a.10%.
b.15%.
c.25%.
d.someotherrate.
c17.WhichofthefollowingeventswillincreasetheNPVofaninvestmentinvolvinganewproduct?
a.Anincreaseintheincometaxrate.
b.Anincreaseintheexpectedperunitvariablecostoftheproduct.
c.Anincreaseintheexpectedannualunitvolumeoftheproduct.
d.Adecreaseintheexpectedsalvagevalueofequipment.
b18.AninvestmenthasapositiveNPVdiscountingthecashflowsata14%costofcapital.Whichstatementis
true?
a.TheIRRislowerthan14%.
b.TheIRRishigherthan14%.
c.Thepaybackperiodislessthan14years.
d.Thebookrateofreturnis14%.
a19.Thetechniquemostconcernedwithliquidityis
a.payback.
b.NPV.
c.IRR.
d.bookrateofreturn.
d20.ThetechniquethatdoesNOTusecashflowsis
a.payback.
b.NPV.
c.IRR.
d.bookrateofreturn.
a21.Iftherewerenoincometaxes,
a.depreciationwouldbeignoredincapitalbudgeting.
b.theNPVmethodwouldnotwork.
c.incomewouldbediscountedinsteadofcashflow.
d.allpotentialinvestmentswouldbedesirable.
a22.Twonewproducts,XandY,arealikeineverywayexceptthatthesalesofXwillstartlowandrise
throughoutitslife,whilethoseofYwillbethesameeachyear.Totalvolumesovertheirfiveyear
liveswillbethesame,aswillsellingprices,unitvariablecosts,cashfixedcosts,andinvestment.
TheNPVofproductX
a.willbelessthanthatofproductY.
b.willbethesameasthatofproductY.
c.willbegreaterthanthatofproductY.
d.noneoftheabove.
d23.Whichofthefollowingeventsismostlikelytoincreasethenumberofinvestmentsthatmeetacompany's
acceptancecriteria?
a.Topmanagementraisesthetargetrateofreturn.
b.Theinterestrateonlongtermdebtrises.
c.Theincometaxraterises.
d.TheIRSallowscompaniestoexpensepurchasesoffixedassets,insteadofdepreciatingthemovertheir
lives.
d24.InvestmentAhasapaybackperiodof5.4years,investmentBoneof6.7years.Fromthisinformationwe
canconclude
a.thatinvestmentAhasahigherNPVthanB.
b.thatinvestmentAhasahigherIRRthanB.
c.thatinvestmentA'sbookrateofreturnishigherthanB's.
d.noneoftheabove.
d25.InvestmentAhasabookrateofreturnof26%,investmentBoneof18%.Fromthisinformationwecan
conclude
a.thatinvestmentAhasahigherNPVthanB.
b.thatinvestmentAhasahigherIRRthanB.
c.thatinvestmentAhasashorterpaybackperiodthanB.
d.noneoftheabove.
c26.Adollarnowisworthmorethanadollartobereceivedinthefuturebecauseof
a.inflation.
b.uncertainty.
c.theopportunitycostofwaiting.
d.noneoftheabove.

39

a27.Incontrasttothepaybackandbookrateofreturnmethods,theNPVandIRRmethods
a.considerthetimevalueofmoney.
b.ignoredepreciation.
c.useaftertaxcashflows.
d.alloftheabove.
a28.Whichofthefollowingisadiscountedcashflowmethod?
a.NPV.
b.Payback.
c.Bookrateofreturn.
d.Alloftheabove.

a29.Whichstatementdescribestherelevanceofdepreciationincalculatingcashflows?
a.Depreciationisrelevantonlywhenincometaxesexist.
b.Depreciationisalwaysrelevant.
c.Depreciationisneverrelevant.
d.Depreciationisrelevantonlywithdiscountedcashflowmethods.
b30.Asthediscountrateincreases
a.presentvaluefactorsincrease.
b.presentvaluefactorsdecrease.
c.presentvaluefactorsremainconstant.
d.itisimpossibletotellwhathappenstothefactors.
a31.Asthelengthofanannuityincreases
a.presentvaluefactorsincrease.
b.presentvaluefactorsdecrease.
c.presentvaluefactorsremainconstant.
d.itisimpossibletotellwhathappenstopresentvaluefactors.
a32.Theonlyfuturecoststhatarerelevanttodecidingwhethertoacceptaninvestmentarethosethatwill
a.bedifferentiftheprojectisacceptedratherthanrejected.
b.besavediftheprojectisacceptedratherthanrejected.
c.bedeductiblefortaxpurposes.
d.affectnetincomeintheperiodthattheyareincurred.
a33.Whichofthefollowingistrueofaninvestment?
a.Thelowerthecostofcapital,thehighertheNPV.
b.Thelowerthecostofcapital,thehighertheIRR.
c.Thelongertheproject'slife,theshorteritspaybackperiod.
d.Thehighertheproject'sNPV,theshorteritslife.
c34.WhichofthefollowingmethodsFAILStodistinguishbetweenreturnofinvestmentandreturnoninvestment?
a.NPV.
b.IRR.
c.Payback.
d.Bookrateofreturn.
c35.IfacompanyisNOTsubjecttoincometax,whichofthefollowingistrueofaproposedinvestment?
a.Theproject'sIRRequalstheentity'scostofcapital.
b.Theproject'sNPViszero.
c.Depreciationonassetsrequiredfortheprojectisirrelevanttotheevaluation.
d.Theexpectedannualincreaseinfuturecashflowsequalstheinvestmentrequiredtoundertakethe
project.
d36.WhichofthefollowingincreasesNPVandIRR?
a.Anupwardrevisioninexpectedannualnetcashflows.
b.Anupwardrevisionofexpectedlife.
c.Anupwardrevisionoftheresidualvalueofthelonglivedassetsbeingacquiredfortheproject.
d.Alloftheabove.
d37.Qualitativeissuescouldincreasetheacceptabilityofaprojectunderwhichofthefollowingconditions?
a.TheIRRislessthanthecompany'scutoffrate.
b.TheprojecthasanegativeNPV.
c.Thepaybackperiodislongerthanthecompany'scutoffperiod.
d.Alloftheabove.
a38.IfCo.XwantstouseIRRtoevaluatelongtermdecisionsandtoestablishacutoffrateofreturn,Xmust
besurethecutoffrateis
a.atleastequaltoitscostofcapital.
b.atleastequaltotherateusedbysimilarcompanies.
c.greaterthantheIRRonprojectsacceptedinthepast.
d.greaterthanthecurrentbookrateofreturn.
a39.WhichofthefollowingisNOTrelevantincalculatingnetcashflowsforProjectN?
a.InterestpaymentsonfundsthatwouldbeborrowedtofinanceProjectN.
b.DepreciationonassetspurchasedforProjectN.
c.ThecontributionmarginthecompanywouldloseifsalesoftheproductintroducedbyProjectNwill
reducesalesofotherproducts.
d.Theincometaxrateapplicabletotheentity.
b40.IftheIRRonaninvestmentiszero,
a.itsNPVispositive.
b.itsannualcashflowsequalitsrequiredinvestment.
c.itisgenerallyawiseinvestment.
d.itscashflowsdecreaseoveritslife.

40

d41.Ifdepreciationonanewassetexceedsitssavingsincashoperatingcosts,whichofthefollowingis
true?
a.Theprojectisusuallyunacceptable.
b.Theannualaftertaxcashflowonthenewassetwillbegreaterthanthesavingsincashoperating
costs.
c.TheprojecthasanegativeNPV.
d.Alloftheabove.
d42.Costofcapitalis
a.theinterestrateanentitymustpaytoborrowmoney.
b.thereturnanentity'sstockholdersexpectontheirinvestment.
c.therateofreturntheentitycanearnfrominvestingavailablecash.
d.aconceptofmanagerialfinanceincorporatingalloftheaboveideas.
b43.

Aninvestmentopportunitycosting$75,000isexpectedtoyieldnetcashflowsof$23,000annuallyfor
fiveyears.TheNPVoftheinvestmentatacutoffrateof14%wouldbe
a.$(3,959).
b.$3,959.
c.$75,000.
d.$78,959.

b44.Aninvestmentopportunitycosting$55,000isexpectedtoyieldnetcashflowsof$22,000annuallyforfive
years.Thepaybackperiodoftheinvestmentis
a.0.4years.
b.2.5years.
c.$33,000.
d.someothernumber.
c45.Aninvestmentopportunitycosting$180,000isexpectedtoyieldnetcashflowsof$53,000annuallyfor
fiveyears.TheIRRoftheinvestmentisbetween
a.10and12%.
b.12and14%.
c.14and16%.
d.16and18%.
b46.

Aninvestmentopportunitycosting$150,000isexpectedtoyieldnetcashflowsof$45,000annuallyfor
fiveyears.Thecostofcapitalis10%.Thebookrateofreturnwouldbe
a.10%.
b.20%.
c.30%.
d.33.3%.

a47.

Aninvestmentopportunitycosting$150,000isexpectedtoyieldnetcashflowsof$36,000annuallyfor
sixyears.TheNPVoftheinvestmentatacutoffrateof12%wouldbe
a.$(2,004).
b.$2,004.
c.$150,000.
d.$147,996.

c48.Aninvestmentopportunitycosting$100,000isexpectedtoyieldnetcashflowsof$22,000annuallyfor
sevenyears.Thepaybackperiodoftheinvestmentis
a.0.22years.
b.3.08years.
c.4.55years.
d.someothernumber.
a49.Aninvestmentopportunitycosting$200,000isexpectedtoyieldnetcashflowsof$39,000annuallyfor
eightyears.TheIRRoftheinvestmentisbetween
a.10and12%.
b.12and14%.
c.14and16%.
d.16and18%.
b50.

Aninvestmentopportunitycosting$80,000isexpectedtoyieldnetcashflowsof$25,000annuallyfor
fouryears.Thecostofcapitalis10%.Thebookrateofreturnwouldbe
a.10.0%.
b.12.5%.
c.21.3%.
d.32.0%.

TrueFalse
T1.Paybackperiodisthelengthoftimeitwilltakeacompanytorecoupitsoutlayforaninvestment.
T2.Discountedcashflowtechniquesapplytoinvestmentsthatinvolveeithercostsonly,orbothcostsand
revenues.
F3.Costofcapitalistheinterestratethatacompanyexpectstopaytofinanceaparticularcapital
investmentproject.
F4.Thehigherthecostofcapital,thehigherthepresentvalueoffuturecashinflows.
F5.IftheIRRonacapitalprojectispositive,itsNPVwillbepositive.
T6.Salvagevalueisusuallyignoredincomputingthetaxdepreciationonaninvestmentindepreciableassets.
F7.IRRcanbecomputedforevencashflows,butnotforunevencashflows.

41

T8.IfIRRislessthanthecostofcapital,theNPVwillbenegative.
F9.IFNPVisnegative,IRRisequaltothecostofcapital.
T10.Paybackemphasizesthereturnoftheinvestmentandignoresthereturnontheinvestment.

Problems

1.Aninvestmentopportunitycosting$180,000isexpectedtoyieldnetcashflowsof$60,000annuallyforfive
years.

a.FindtheNPVoftheinvestmentatacutoffrateof12%.

b.Findthepaybackperiodoftheinvestment.

c.FindtheIRRontheinvestment.

SOLUTION:
a.NPV:$36,300[(3.605x$60,000)$180,000]
b.Paybackperiod:3years($180,000/$60,000)
c.IRR:between18%and20%(3.0isbetween3.127and2.991)

2.Tofteisconsideringthepurchaseofamachine.Dataareasfollows:
Cost$100,000
Usefullife10years
Annualstraightlinedepreciation$10,000
Expectedannualsavingsincash
operationcosts$18,000
Tofte'scutoffrateis12%anditstaxrateis40%.

a.Computetheannualnetcashflowsfortheinvestment.
b.ComputetheNPVoftheproject.

SOLUTION:
a.Annualnetcashflows:$14,800[$18,000pretax40%x($18,000$10,000depreciation)]
b.NPV:Negative$16,380[($14,800x5.650)$100,000]

3.WillowCompanyisconsideringthepurchaseofamachinewiththefollowingcharacteristics.
Cost$150,000
Estimatedusefullife10years
Expectedannualcashcostsavings$35,000
Marquette'staxrateis40%,itscostofcapitalis12%,anditwillusestraightlinedepreciationforthe
newmachine.
a.Computetheannualaftertaxcashflowsforthisproject.
b.Findthepaybackperiodforthisproject.

SOLUTION:
a.Annualcashflows:$27,000[$35,00040%x($35,000$15,000)]
b.Paybackperiod:5.56years($150,000/$27,000)

4.BiltRiteCo.hastheopportunitytointroduceanewproduct.BiltRiteexpectstheproducttosellfor$60
andtohaveperunitvariablecostsof$40andannualcashfixedcostsof$3,000,000.Expectedannualsales
volumeis250,000units.Theequipmentneededtobringoutthenewproductcosts$5,000,000,hasafour
yearlifeandnosalvagevalue,andwouldbedepreciatedonastraightlinebasis.BiltRite'scostof
capitalis10%anditsincometaxrateis40%.
a.Findtheincreaseinannualaftertaxcashflowsforthisopportunity.
b.Findthepaybackperiodonthisproject.
c.FindtheNPVforthisproject.

SOLUTION:

42

a.Increaseinannualcashflows:$1,700,000

Incomebeforetaxes,250,000x($60$40)
$3,000,000$5,000,000/4$750,000
Incometax(300,000)

Netincome$450,000
Plusdepreciation1,250,000

Netcashflow$1,700,000
==========

b.Paybackperiod:2.94years($5,000,000/$1,700,000)
c.NPV:$389,000[($1,700,000x3.170)$5,000,000]
5.Aninvestmentopportunitycosting$600,000isexpectedtoyieldnetcashflowsof$120,000annuallyforten
years.

a.FindtheNPVoftheinvestmentatacutoffrateof12%.

b.Findthepaybackperiodoftheinvestment.

c.FindtheIRRontheinvestment.

SOLUTION:
a.NPV:$78,000[(5.650x$120,000)$600,000]
b.Paybackperiod:5years($600,000/$120,000)
c.IRR:15%(5.0isabouthalfwaybetween5.216and4.833)

6.

Scottsohasaninvestmentopportunitycosting$300,000thatisexpectedtoyieldthefollowingcashflows
overthenextsixyears:
YearOne
YearTwo
YearThree
YearFour
YearFive
YearSix

$75,000
$90,000
$115,000
$130,000
$100,000
$90,000

a.

Findthepaybackperiodoftheinvestment.

b.

Findthebookrateofreturnoftheinvestment.

c.

FindtheNPVoftheinvestmentatacutoffrateof10%.

SOLUTION:
a.

Paybackperiod:3.15years(75,000+90,000+115,000+.15x130,000)

b.

Bookrateofreturn:33.3%
Averagereturn:$100,000($600,000total/6years)
Depreciation:50,000($30,000/6years)

Averageincome$50,000
Averageinvestment:$300,000/2=$150,000
Bookrateofreturn=$50,000/150,000=33.3%

c.

NPV:$130,530

1
2
3
4
5
6

Cash

75,000
90,000
115,000
130,000
100,000
90,000

Investment
NPV

Factor

.909
.826
.751
.683
.621
.564

PV

68,175
74,340
86,365
88,790
62,100
50,760

430,530

300,000

130,530
======

7.Acmeisconsideringthepurchaseofamachine.Dataareasfollows:
Cost$160,000
Usefullife10years
Annualstraightlinedepreciation$???
Expectedannualsavingsincash

43

operationcosts$33,000
Acme'scutoffrateis12%anditstaxrateis40%.
a.Computetheannualnetcashflowsfortheinvestment.
b.ComputetheNPVoftheproject.
c.ComputetheIRRoftheproject.

SOLUTION:
a.Annualnetcashflows:$26,200[$33,000pretax40%x($33,000$16,000depreciation)]
b.NPV:Negative$11,970[($26,200x5.650)$160,000]
c.

IRR:between10%and12%[factorof6.107(160,000/26,200)isbetween6.145and5.650]

8.

Scottsohasaninvestmentopportunitycosting$180,000thatisexpectedtoyieldthefollowingcashflows
overthenextfiveyears:
YearOne
YearTwo
YearThree
YearFour
YearFive

$30,000
$60,000
$90,000
$60,000
$30,000

a.

Findthepaybackperiodoftheinvestment.

b.

Findthebookrateofreturnoftheinvestment.

c.

FindtheNPVoftheinvestmentatacutoffrateof12%.

SOLUTION:
a.

Paybackperiod:3.0years(30,000+60,000+90,000)

b.

Bookrateofreturn:20%
Averagereturn:$54,000($270,000total/5years)
Depreciation:36,000($180,000/5years)

Averageincome$18,000
Averageinvestment:$180,000/2=$90,000
Bookrateofreturn=$18,000/$90,000=20%

c.

NPV:$6,930

1
2
3
4
5

Cash

30,000
60,000
90,000
60,000
30,000

Investment
NPV

Factor

.893
.797
.712
.636
.567

PV

26,790
47,820
64,080
38,160
17,010

193,860

180,000

13,860
======

9.RenoCompanyisconsideringthepurchaseofamachinewiththefollowingcharacteristics.
Cost$160,000
Estimatedusefullife5years
Expectedannualcashcostsavings$56,000
Expectedsalvagevaluenone
Reno'staxrateis40%,itscostofcapitalis12%,anditwillusestraightlinedepreciationforthenew
machine.
a.Computetheannualaftertaxcashflowsforthisproject.
b.Findthepaybackperiodforthisproject.
c.ComputetheNPVforthisproject.

SOLUTION:
a.Annualcashflows:$46,400[$56,00040%x($56,00032,000)]
b.Paybackperiod:3.45years($160,000/$46,400)

44

c.NPV:$7,272[($46,400x3.605)$160,000]

10.WhitehallCo.hastheopportunitytointroduceanewproduct.Whitehallexpectstheprojecttosellfor$40
andtohaveperunitvariablecostsof$27andannualcashfixedcostsof$1,500,000.Expectedannualsales
volumeis200,000units.Theequipmentneededtobringoutthenewproductcosts$3,500,000,hasafour
yearlifeandnosalvagevalue,andwouldbedepreciatedonastraightlinebasis.Whitehall'scutoffrate
is10%anditsincometaxrateis40%.
a.Findtheincreaseinannualaftertaxcashflowsforthisopportunity.
b.Findthepaybackperiodonthisproject.
c.FindtheNPVforthisproject.

SOLUTION:
a.Increaseinannualcashflows:$1,100,000

Incomebeforetaxes,[200,000x($40$27)
$1,500,000$3,500,000/4]$225,000
Incometax(90,000)

Netincome$135,000
Plusdepreciation875,000

Netcashflow$1,010,000
==========

b.Paybackperiod:3.47years($3,500,000/$1,010,000)
c.NPV:negative$298,300[($1,010,000x3.170)$3,500,000]

45