CH 12

CHAPTER 12
PLANNING FOR CAPITAL INVESTMENTS
SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOM’S TAXONOMY

Item SO BT Item SO BT Item S BT Item SO BT Item SO BT
O
True-False Statements
1. 1 K 6. 2 C 11. 4 C 16. 6 K 21. 7 C
2. 1 K 7. 3 K 12. 4 C 17. 6 C 22. 8 C
3. 1 C 8. 3 C 13. 5 K 18. 6 K 23. 8 K
4. 2 C 9. 3 C 14. 5 K 19. 7 K 24. 8 K
5. 2 K 10. 4 K 15. 5 C 20. 7 K 25. 8 C
Multiple Choice Questions
26. 1 K 51. 2 K 76. 4 AN 101. 3 AP 126. 7 C
27. 1 K 52. 2 C 77. 4 K 102. 5 AP 127. 7 C
28. 1 K 53. 2 AP 78. 4 K 103. 7 AP 128. 7 C
29. 1 K 54. 3 K 79. 4 C 104. 3 AP 129. 7 K
30. 1 K 55. 3 K 80. 4 C 105. 5 AP 130. 7 C
31. 1 K 56. 3 C 81. 4 K 106. 7 AP 131. 7 K
32. 1 C 57. 3 C 82. 5 K 107. 2 AP 132. 8 K
33. 1 K 58. 3 AN 83. 5 C 108. 3 AP 133. 8 K
34. 1 K 59. 3 K 84. 5 K 109. 7 AP 134. 8 K
35. 1 K 60. 3 C 85. 5 K 110. 8 AP 135. 8 AN
36. 1 K 61. 3 K 86. 5 C 111. 6 K 136. 8 AN
37. 1 C 62. 3 C 87. 5 K 112. 6 K 137. 8 AN
38. 2 C 63. 3 K 88. 5 AP 113. 6 C 138. 8 AP
39. 2 K 64. 3 C 89. 5 K 114. 7 K 139. 8 AP
40. 2 K 65. 3 C 90. 5 C 115. 7 C 140. 8 AP
41. 2 AP 66. 3 C 91. 5 C 116. 7 AP 141. 8 K
42. 2 AP 67. 3 K 92. 5 C 117. 7 K 142. 8 K
43. 2 AP 68. 3 K 93. 5 AP 118. 7 C 143. 8 C
44. 2 C 69. 3 K 94. 5 AP 119. 7 K 144. 8 AP
45. 2 K 70. 3 C 95. 5 AP 120. 7 C 145. 8 C
46. 2 K 71. 3 AN 96. 5 AP 121. 7 C 146. 8 K
47. 2 AP 72. 3 AP 97. 5 C 122. 7 K 147. 8 C
48. 2 C 73. 3 AP 98. 5 C 123. 7 AP
49. 2 C 74. 3 AN 99. 5 C 124. 7 AP
50. 2 K 75. 4 K 100. 5 C 125. 7 C
Brief Exercises
148. 2 AP 150. 3 AP 152. 7 E
149. 3 E 151. 3,5 E 153. 8 AP
Exercises
154. * E 157. 2,3,8 AP 160. 3,4 E 163. 3,5,8 E
155.. 2,3,8 AP 158. 2,3,8 E 161. 3,5 E 164. 3,6 E
156. 2,3,7 AN 159. ** E 162. 3,5,7 E 165. 3,7 E
Completion Statements
166. 1 K 168. 3 K 170. 3 K 172. 5 K 174. 7 K
12-2 Test Bank for ISV Managerial Accounting, Fourth Edition
167. 2 K 169. 3 K 171. 4 K 173. 6 K 175. 8 K

*1,2,3,5,7
**2,3,5,7,8
SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE

Item Type Item Type Item Type Item Type Item Type Item Type Item Type
Study Objective 1
1. TF 26. MC 29. MC 32. MC 35. MC 154. Ex
2. TF 27. MC 30. MC 33. MC 36. MC 166. C
3. TF 28. MC 31. MC 34. MC 37. MC
Study Objective 2
4. TF 39. MC 43. MC 47. MC 51. MC 148. BE 157. Ex
5. TF 40. MC 44. MC 48. MC 52. MC 154. Ex 158. Ex
6. TF 41. MC 45. MC 49. MC 53. MC 155. Ex 159. Ex
38. MC 42. MC 46. MC 50. MC 107. MC 156. Ex 167. C
Study Objective 3
7. TF 58. MC 65. MC 72. MC 150. BE 159. Ex 168. C
8. TF 59. MC 66. MC 73. MC 151. BE 160. Ex 169. C
9. TF 60. MC 67. MC 74. MC 154. Ex 161. Ex 170. C
54. MC 61. MC 68. MC 101. MC 155. Ex 162. Ex
55. MC 62. MC 69. MC 104. MC 156. Ex 163. Ex
56. MC 63. MC 70. MC 108. MC 157. Ex 164. Ex
57. MC 64. MC 71. MC 149. BE 158. Ex 165. Ex
Study Objective 4
10. TF 12. TF 76. MC 78. MC 80. MC 160. Ex
11. TF 75. MC 77. MC 79. MC 81. MC 171. C
Study Objective 5
13. TF 84. MC 89. MC 94. MC 99. MC 154. Ex 172. C
14. TF 85. MC 90. MC 95. MC 100. MC 159. Ex
15. TF 86. MC 91. MC 96. MC 102. MC 161. Ex
82. MC 87. MC 92. MC 97. MC 105. MC 162. Ex
83. MC 88. MC 93. MC 98. MC 151. BE 163. Ex
Study Objective 6
16. TF 18. TF 112. MC 164. Ex
17. TF 111. MC 113. MC 173. C
Study Objective 7
19. TF 109. MC 118. MC 123. MC 128. MC 154. Ex 174. C
20. TF 114. MC 119. MC 124. MC 129. MC 156. Ex
21. TF 115. MC 120. MC 125. MC 130. MC 159. Ex
103. MC 116. MC 121. MC 126. MC 131. MC 162. Ex
106. MC 117. MC 122. MC 127. MC 152. BE 165. Ex
Study Objective 8
22. TF 110. MC 135. MC 139. MC 143. MC 147. MC 158. Ex
Planning for Capital Investments 12-3
23. TF 132. MC 136. MC 140. MC 144. MC 153. BE 159. Ex

24. TF 133. MC 137. MC 141. MC 145. MC 155. Ex 163. Ex
25. TF 134. MC 138. MC 142. MC 146. MC 157. Ex 175. C
Note: TF = True-False C = Completion Ex = Exercise

MC = Multiple Choice BE = Brief Exercise
The chapter also contains one set of eight Matching questions and three Short-Answer Essay
questions.
CHAPTER STUDY OBJECTIVES

1. Discuss capital budgeting evaluation and explain inputs used in capital budgeting.
Management gathers project proposals from each department; a capital budget committee
screens the proposals and recommends worthy projects. Company officers decide which
projects to fund, and the board of directors approves the capital budget. In capital budgeting,
estimated cash inflows and outflows, rather than accrual-accounting numbers, are the
preferred inputs.
2. Describe the cash payback technique. The cash payback technique identifies the time
period required to recover the cost of the investment. The formula when net annual cash
flows are equal is: Cost of capital investment ÷ Estimated net annual cash flow = Cash
payback period. The shorter the payback period, the more attractive the investment.
3. Explain the net present value method. The net present value method compares the
present value of future cash inflows with the capital investment to determine net present
value. The NPV decision rule is: Accept the project if net present value is zero or positive.
Reject the project if net present value is negative.
4. Identify the challenges presented by intangible benefits in capital budgeting. Intangible
benefits are difficult to quantify, and thus are often ignored in capital budgeting decisions.
This can result in incorrectly rejecting some projects. One method for considering intangible
benefits is to calculate the NPV, ignoring intangible benefits; if the resulting NPV is below
zero, evaluate whether the benefits are worth at least the amount of the negative net present
value. Alternatively, intangible benefits can be incorporated into the NPV calculation, using
conservative estimates of their value.
5. Describe the profitability index. The profitability index is a tool for comparing the relative
merits of alternative capital investment opportunities. It is computed as: Present value of net
cash ÷ Initial investment. The higher the index, the more desirable the project.
6. Indicate the benefits of performing a post-audit. A post-audit is an evaluation of a capital
investment’s actual performance. Post-audits create an incentive for managers to make
accurate estimates. Post-audits also are useful for determining whether a company should
continue, expand, or terminate a project. Finally, post-audits provide feedback that is useful
for improving estimation techniques.
7. Explain the internal rate of return method. The objective of the internal rate of return
method is to find the interest yield of the potential investment, which is expressed as a
percentage rate. The IRR decision rule is: Accept the project when the internal rate of return
is equal to or greater than the required rate of return. Reject the project when the internal
rate of return is less than the required rate of return.
8. Describe the annual rate of return method. The annual rate of return uses accrual
accounting data to indicate the profitability of a capital investment. It is calculated as:
Expected annual net income ÷ Amount of the average investment. The higher the rate of
return, the more attractive the investment.
TRUE-FALSE STATEMENTS
1. Capital budgeting decisions usually involve large investments and often have a significant
impact on a company's future profitability.
2. The capital budgeting committee ultimately approves the capital expenditure budget for
the year.
3. For purposes of capital budgeting, estimated cash inflows and outflows are preferred for
inputs into the capital budgeting decision tools.
4. The cash payback technique is a quick way to calculate a project's net present value.
5. The cash payback period is computed by dividing the cost of the capital investment by the
annual cash inflow.
6. The cash payback method is frequently used as a screening tool but it does not take into
consideration the profitability of a project.
7. The cost of capital is a weighted average of the rates paid on borrowed funds, as well as
on funds provided by investors in the company's stock.
8. Using the net present value method, a net present value of zero indicates that the project
would not be acceptable.
9. The net present value method can only be used in capital budgeting if the expected cash
flows from a project are an equal amount each year.
10. By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate
projects that could be financially beneficial to the company.
11. To avoid accepting projects that actually should be rejected, a company should ignore
intangible benefits in calculating net present value.
12. One way of incorporating intangible benefits into the capital budgeting decision is to
project conservative estimates of the value of the intangible benefits and include them in
the NPV calculation.
13. The profitability index is calculated by dividing the total cash flows by the initial
investment.
14. The profitability index allows comparison of the relative desirability of projects that require
differing initial investments.
15. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability
among potential returns.
16. A well-run organization should perform an evaluation, called a post-audit, of its investment
projects before their completion.
17. Post-audits create an incentive for managers to make accurate estimates, since
managers know that their results will be evaluated.
18. A post-audit is an evaluation of how well a project's actual performance matches the
projections made when the project was proposed.
19. The internal rate of return method is, like the NPV method, a discounted cash flow
technique.
20. The interest yield of a project is a rate that will cause the present value of the proposed
capital expenditure to equal the present value of the expected annual cash inflows.
21. Using the internal rate of return method, a project is rejected when the rate of return is
greater than or equal to the required rate of return.
22. Using the annual rate of return method, a project is acceptable if its rate of return is
greater than management's minimum rate of return.
23. The annual rate of return method requires dividing a project's annual cash inflows by the
economic life of the project.
24. A major advantage of the annual rate of return method is that it considers the time value
of money.
25. An advantage of the annual rate of return method is that it relies on accrual accounting
numbers rather than actual cash flows.
Answers to True-False Statements

Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans.
1. T 5. T 9. F 13. F 17. T 21. F 25. F
2. F 6. T 10. T 14. T 18. T 22. T
3. T 7. T 11. F 15. T 19. T 23. F
4. F 8. F 12. T 16. F 20. T 24. F
MULTIPLE CHOICE QUESTIONS

26. The capital budget for the year is approved by a company's
a. board of directors.
b. capital budgeting committee.
c. officers.
d. stockholders.
27. All of the following are involved in the capital budgeting evaluation process except a
company's
b. capital budgeting committee.
c. officers.
d. stockholders.
28. Most of the capital budgeting methods use

a. accrual accounting numbers.
b. cash flow numbers.
c. net income.
d. accrual accounting revenues.
29. The first step in the capital budgeting evaluation process is to

a. request proposals for projects.
b. screen proposals by a capital budgeting committee.
c. determine which projects are worthy of funding.
d. approve the capital budget.
30. The capital budgeting decision depends in part on the

a. availability of funds.
b. relationships among proposed projects.
c. risk associated with a particular project.
d. all of these.
31. Capital budgeting is the process

a. used in sell or process further decisions.
b. of determining how much capital stock to issue.
c. of making capital expenditure decisions.
d. of eliminating unprofitable product lines.
32. Net annual cash flow can be estimated by

a. deducting credit sales from net income.
b. adding depreciation expense to net income.
c. deducting credit purchases from net income.
d. adding advertising expense to net income.
33. Which of the following is not a typical cash flow related to equipment purchase and
replacement decisions?
a. Increased operating costs
b. Overhaul of equipment
c. Salvage value of equipment when project is complete
d. Depreciation expense
34. Capital expenditure proposals are initially screened by the

b. executive committee.
c. capital budgeting committee.
d. stockholders.
35. Capital budgeting decisions depend in part on all of the following except the
a. relationships among proposed projects.
b. profitability of the company.
c. company’s basic decision making approach.
d. risks associated with a particular project.
36. The corporate capital budget authorization process consists of how many steps?
a. 4
b. 3
c. 2
d. 1
37. Which of the following is not a capital budgeting decision?

a. Constructing new studios
b. Replacing old equipment
c. Scrapping obsolete inventory
d. Remodeling an office building
38. Which of the following is a disadvantage of the cash payback technique?

a. It is difficult to calculate
b. It relies on the time value of money
c. It can only be calculated when there are equal annual net cash flows
d. It ignores the expected profitability of a project
39. The payback period is often compared to an asset’s

a. estimated useful life.
b. warranty period.
c. net present value.
d. internal rate of return.
40. Which of the following ignores the time value of money?

a. Internal rate of return
b. Profitability index
c. Net present value
d. Cash payback
41. Brady Corp. is considering the purchase of a piece of equipment that costs $23,000.
Projected net annual cash flows over the project’s life are:
Year Net Annual Cash Flow
1 $ 3,000
2 8,000
3 15,000
4 9,000
The cash payback period is

a. 2.63 years.
b. 2.80 years.
c. 2.20 years.
d. 2.37 years.
42. Bradshaw Inc. is contemplating a capital investment of $85,000. The cash flows over the
project’s four years are:
Expected Annual Expected Annual
Year Cash Inflows Cash Outflows
1 $30,000 $12,000
2 45,000 20,000
3 60,000 25,000
4 50,000 30,000
a. 2.17 years.
b. 3.35 years.
c. 2.30 years.
d. 3.47 years.
43. Jordan Company is considering the purchase of a machine with the following data:
Initial cost $130,000
One-time training cost 12,000
Annual maintenance costs 15,000
Annual cost savings 75,000
Salvage value 20,000
a. 2.37 years.
b. 2.17 years.
c. 1.89 years.
d. 1.73 years.
44. If project A has a lower payback period than project B, this may indicate that project A
may have a
a. lower NPV and be less profitable.
b. higher NPV and be less profitable.
c. higher NPV and be more profitable.
d. lower NPV and be more profitable.
45. Which of the following does not consider a company’s required rate of return?
a. Net present value
b. Internal rate of return
c. Annual rate of return
d. Cash payback
46. The cash payback technique

a. considers cash flows over the life of a project.
b. cannot be used with uneven cash flows.
c. is superior to the net present value method.
d. may be useful as an initial screening device.
47. If an asset costs $210,000 and is expected to have a $30,000 salvage value at the end of
its ten-year life, and generates annual net cash inflows of $30,000 each year, the cash
payback period is
a. 8 years.
b. 7 years.
c. 6 years.
d. 5 years.
48. If a payback period for a project is greater than its expected useful life, the
a. project will always be profitable.
b. entire initial investment will not be recovered.
c. project would only be acceptable if the company's cost of capital was low.
d. project's return will always exceed the company's cost of capital.
49. The cash payback technique

a. should be used as a final screening tool.
b. can be the only basis for the capital budgeting decision.
c. is relatively easy to compute and understand.
d. considers the expected profitability of a project.
50. The cash payback period is computed by dividing the cost of the capital investment by the
a. annual net income.
b. net annual cash inflow.
c. present value of the cash inflow.
d. present value of the net income.
51. When using the cash payback technique, the payback period is expressed in terms of
a. a percent.
b. dollars.
c. years.
d. months.
52. A disadvantage of the cash payback technique is that it

a. ignores obsolescence factors.
b. ignores the cost of an investment.
c. is complicated to use.
d. ignores the time value of money.
53. Bark Company is considering buying a machine for $180,000 with an estimated life of ten
years and no salvage value. The straight-line method of depreciation will be used. The
machine is expected to generate net income of $12,000 each year. The cash payback
period on this investment is
a. 15 years.
b. 10 years.
c. 6 years.
d. 3 years.
54. The discount rate is referred to by all of the following alternative names except the
a. cost of capital.
b. cutoff rate.
c. hurdle rate.
d. required rate of return.
55. The rate that a company must pay to obtain funds from creditors and stockholders is
known as the
a. hurdle rate.
b. cost of capital.
c. cutoff rate.
d. all of these.
56. The higher the risk element in a project, the

a. more attractive the investment.
b. higher the net present value.
c. higher the cost of capital.
d. higher the discount rate.
57. If a company's required rate of return is 10% and, in using the net present value method,
a project's net present value is zero, this indicates that the
a. project's rate of return exceeds 10%.
b. project's rate of return is less than the minimum rate required.
c. project earns a rate of return of 10%.
d. project earns a rate of return of 0%.
58. Using the profitability index method, the present value of cash inflows for Project Flower is
$88,000 and the present value of cash inflows of Project Plant is $48,000. If Project
Flower and Project Plant require initial investments of $90,000 and $40,000, respectively,
and have the same useful life, the project that should be accepted is
a. Project Flower.
b. Project Plant.
c. Either project may be accepted.
d. Neither project should be accepted.
59. The primary capital budgeting method that uses discounted cash flow techniques is the
a. net present value method.
b. cash payback technique.
c. annual rate of return method.
d. profitability index method.
60. When the annual cash flows from an investment are unequal, the appropriate table to use
is the
a. future value of 1 table.
b. future value of annuity table.
c. present value of 1 table.
d. present value of annuity table.
61. A company's cost of capital refers to the

a. rate the company must pay to obtain funds from creditors and stockholders.
b. total cost of a capital project.
c. cost of printing and registering common stock shares.
d. rate of return earned on common stock.
62. When a capital budgeting project generates a positive net present value, this means that
the project earns a return higher than the
a. internal rate of return.
b. annual rate of return.
c. required rate of return.
d. profitability index.
63. A negative net present value indicates that the

a. project is acceptable.
b. wrong discount rate was used.
c. project’s annual rate of return exceeds the discount rate..
d. present value of the cash inflows was less than the present value of the cash out
flows.
64. A company’s discount rate is based on the

a. cost of capital and the internal rate of return.
b. cost of capital and the risk element.
c. cut-off rate and the risk element.
d. cut-off rate and the internal rate of return.
65. The discount rate that will result in the lowest net present value for a project is
a. any rate lower that the cost of capital.
b. any rate higher than the cost of capital.
c. the lowest rate used to evaluate the project.
d. the highest rate used to evaluate the project.
66. The discount rate that will result in the highest net present value for a project is
a. any rate lower that the cost of capital.
b. any rate higher than the cost of capital.
c. the lowest rate used to evaluate the project.
d. the highest rate used to evaluate the project.
67. Which of the following will increase the net present value of a project?
a. An increase in the initial investment
b. A decrease in annual cash inflows
c. An increase in the discount rate
d. A decrease in the discount rate
68. A project with a zero net present value indicates that it is

a. unacceptable.
b. profitable.
c. acceptable.
d. going to have an acceptable cash payback period.
69. Companies often assume that the risk element in the discount rate is
a. zero.
b. greater that zero.
c. less than zero.
d. known with certainty.
70. If a project has a salvage value greater than zero, the salvage value will
a. have no effect on the net present value.
b. increase the net present value.
c. increase the payback period.
d. decrease the net present value.
71. Sloan Inc. recently invested in a project with a 3-year life span. The net present value was
$3,000 and annual cash inflows were $7,000 for year 1; $8,000 for year 2; and $9,000 for
year 3. The initial investment for the project, assuming a 15% required rate of return, was
Present Value PV of an Annuity
Year of 1 at 15% of 1 at 15%
1 .870 .870
2 .756 1.626
3 .658 2.283
a. $15,264.
b. $15,060.
c. $9,744.
d. $12,792.
72. Mini Inc. is contemplating a capital project costing $31,346. The project will provide annual
cost savings of $12,000 for 3 years and have a salvage value of $2,000. The company’s
required rate of return is 10%. The company uses straight-line depreciation.
1 .909 .909
2 .826 1.736
3 .751 2.487
This project is
a. unacceptable because it earns a rate less than 10%.
b. acceptable because it has a positive NPV.
c. unacceptable because it has a negative NPV.
d. acceptable because it has a zero NPV.
73. Johnson Corp. has an 8% required rate of return. It’s considering a project that would
provide annual cost savings of $20,000 for 5 years. The most that Johnson would be
willing to spend on this project is
1 .926 .926
2 .857 1.783
3 .794 2.577
4 .735 3.312
5 .681 3.993
a. $50,364.
b. $66,240.
c. $79,860.
d. $13,620.
74. Benaflek Co. purchased some equipment 3 years ago. The company’s required rate of
return is 12%, and the net present value of the project was $(450). Annual cost savings
were: $5,000 for year 1; $4,000 for year 2; and $3,000 for year 3. The amount of the initial
investment was
1 .893 .893
2 .797 1.690
3 .712 2.402
a. $10,239.
b. $9,158.
c. $10,058.
d. $9,339.
75. In capital budgeting, intangible benefits should be

a. excluded entirely.
b. included using optimistic estimated values.
c. included using conservative estimated values.
d. included only when benefits are known with certainty.
76. Miles, Inc. is considering the purchase of a new machine for $100,000 that has an
estimated useful life of 5 years and no salvage value. The machine will generate net
annual cash flows of $17,500. It is believed that the new machine will reduce downtime
because of its reliability. Assume the discount rate is 8%. In order to make the project
acceptable, the reduction in downtime must be worth
1 .926 .926
2 .857 1.783
3 .794 2.577
4 .735 3.312
5 .681 3.993
a. $3,993 per year.
b. $8,277 per year.
c. $3,044 per year.
d. $7,544 per year.
77. Intangible benefits in capital budgeting would include all of the following except increased
a. product quality.
b. employee loyalty.
c. salvage value.
d. product safety.
78. Intangible benefits in capital budgeting

a. should be ignored because they are difficult to determine.
b. include increased quality or employee loyalty.
c. are not considered because they are usually not relevant to the decision.
d. have a rate of return in excess of the company’s cost of capital.
79. To avoid rejecting projects that actually should be accepted,

1. intangible benefits should be ignored.
2. conservative estimates of the intangible benefits' value should be incorporated into
the NPV calculation.
3. calculate net present value ignoring intangible benefits and then, if the NPV is
negative, estimate whether the intangible benefits are worth at least the amount of
the negative NPV.
a. 1
b. 2
c. 3
d. both 2 and 3 are correct.
80. All of the following statements about intangible benefits in capital budgeting are correct
except that they
a. include increased quality and employee loyalty.
b. are difficult to quantify.
c. are often ignored in capital budgeting decisions.
d. cannot be incorporated into the NPV calculation.
81. In evaluating high-tech projects,

a. only tangible benefits should be considered.
b. only intangible benefits should be considered.
c. both tangible and intangible benefits should be considered.
d. neither tangible nor intangible benefits should be considered.
82. Using a number of outcome estimates to get a sense of the variability among potential
returns is
a. financial analysis.
b. post-audit analysis.
c. sensitivity analysis.
d. outcome analysis.
83. If a company's required rate of return is 9%, and in using the profitability index method, a
project's index is greater than 1, this indicates that the project's rate of return is
a. equal to 9%.
b. greater than 9%.
c. less than 9%.
d. unacceptable for investment purposes.
84. The profitability index is computed by dividing the

a. total cash flows by the initial investment.
b. present value of cash flows by the initial investment.
c. initial investment by the total cash flows.
d. initial investment by the present value of cash flows.
85. The capital budgeting method that takes into account both the size of the original
investment and the discounted cash flows is the
a. cash payback method.
b. internal rate of return method.
c. net present value method.
86. The profitability index

a. does not take into account the discounted cash flows.
b. is calculated by dividing total cash flows by the initial investment.
c. allows comparison of the relative desirability of projects that require differing initial
investments.
d. will never be greater than 1.
87. The capital budgeting method that allows comparison of the relative desirability of projects
that require differing initial investments is the
a. cash payback method.
88. The following information is available for a potential investment for Panda Company:
Initial investment $80,000
Net annual cash inflow 20,000
Net present value 36,224
Salvage value 10,000
Useful life 10 yrs.
The potential investment’s profitability index is
a. 4.00.
b. 2.85.
c. 2.50.
d. 1.45.
89. An approach that uses a number of outcome estimates to get a sense of the variability
among potential returns is
a. the discounted cash flow technique.
b. the net present value method.
c. risk analysis.
d. sensitivity analysis.
90. If a project’s profitability index is greater than 1, then the

a. project should always be accepted.
b. project’s net present value is negative.
c. project’s internal rate of return is less than the discount rate.
d. project should be accepted if funds are available.
91. If a project’s profitability index is less than 1, then

a. its net present value is zero.
b. its net present value is positive.
c. it should be rejected.
d. its internal rate of return is greater than the discount rate.
92. If a project’s profitability index is equal to 1, then

a. its net present value is zero.
b. its net present value is positive.
c. it should be rejected.
d. its internal rate of return is greater than the discount rate.
93. A project with an initial investment of $50,000 and a profitability index of 1.239 also has an
internal rate of return of 12%. The present value of net cash flows is
a. $56,000.
b. $61,950.
c. $40,355.
d. $50,000.
94. A project with a profitability index of 1.156 also has net cash flows with a present value of
$46,240. The project’s internal rate of return was 10%. The initial investment was
a. $44,000.
b. $53,453.
c. $40,000.
d. $41,616.
Use the following information for questions 95 and 96.
Selma Inc. is comparing several alternative capital budgeting projects as shown below:
Projects
A B C
Initial investment $40,000 $60,000 $ 80,000
Present value of net cash flows 60,000 55,000 100,000
95. Using the profitability index, the projects rank as

a. A, C, B.
b. A, B, C.
c. C, A, B.
d. C, B, A.
96. Using the profitability index, how many of the projects are acceptable?
a. 3
b. 2
c. 1
d. 0
97. If a project has a negative net present value, its profitability index will be
a. one.
b. greater than one.
c. less than one.
d. undeterminable.
98. If a project has a positive net present value, its profitability index will be
a. one.
c. less than one.
d. undeterminable.
99. If a project has a zero net present value, its profitability index will be
a. one.
c. less than one.
d. undeterminable.
100. If a project has a profitability index of 1.20, then the project’s internal rate of return is
a. equal to the discount rate.
b. less than the discount rate.
c. greater than the discount rate.
d. equal to 20%.
Use the following information for questions 101–103.
Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful life. The
equipment will provide cost savings of $7,300 and will be depreciated straight-line over its useful
life with no salvage value. Cleaners requires a 10% rate of return.
Present Value of an Annuity of 1
Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784
101. What is the approximate net present value of this investment?

a. $13,800
b. $1,792
c. $886
d. $2,748
102. What is the approximate profitability index associated with this equipment?
a. 1.23
b. 1.03
c. 1.06
d. .73
103. What is the approximate internal rate of return for this investment?
a. 9%
b. 10%
c. 11%
d. 12%
Use the following table for questions 104–106.

Periods 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487
104. A company has a minimum required rate of return of 9%. It is considering investing in a
project that costs $175,000 and is expected to generate cash inflows of $70,000 at the
end of each year for three years. The net present value of this project is
a. $177,170.
b. $35,000.
c. $17,718.
d. $2,170.
project that costs $75,000 and is expected to generate cash inflows of $30,000 at the end
of each year for three years. The profitability index for this project is
a. .99.
b. 1.00.
c. 1.01.
d. 1.20.
project that costs $91,116 and is expected to generate cash inflows of $36,000 each year
for three years. The approximate internal rate of return on this project is
a. 8%.
b. 9%.
c. 10%.
d. less than the required 8%.
Use the following information for questions 107–110.
Carr Company is considering two capital investment proposals. Estimates regarding each project
are provided below:
Project Soup Project Nuts
Initial investment $600,000 $900,000
Annual net income 30,000 63,000
Net annual cash inflow 150,000 213,000
Estimated useful life 5 years 6 years
Salvage value -0- -0-
The company requires a 10% rate of return on all new investments.

Periods 9% 10% 11% 12%
5 3.890 3.791 3.696 3.605
6 4.486 4.355 4.231 4.111
107. The cash payback period for Project Soup is

a. 20 years.
b. 10 years.
c. 5 years.
d. 4 years.
108. The net present value for Project Nuts is

a. $927,615.
b. $274,368.
c. $150,000.
d. $27,615.
109. The internal rate of return for Project Nuts is approximately

a. 10%.
b. 11%.
c. 12%.
d. 9%.
110. The annual rate of return for Project Soup is

a. 5%.
b. 10%.
c. 25%.
d. 50%.
111. A post-audit should be performed using

a. a different evaluation technique than that used in making the original decision.
b. the same evaluation technique used in making the original decision.
c. estimated amounts instead of actual figures.
d. an independent CPA.
112. A thorough evaluation of how well a project's actual performance matches the projections
made when the project was proposed is called a
a. pre-audit.
b. post-audit.
c. risk analysis.
d. sensitivity analysis.
113. Performing a post-audit is important because

a. managers will be more likely to submit reasonable data when they make investment
proposals if they know their estimates will be compared to actual results.
b. it provides a formal mechanism by which the company can determine whether existing
projects should be terminated.
c. it improves the development of future investment proposals because managers
improve their estimation techniques by evaluating their past successes and failures.
d. all of these.
114. A capital budgeting method that takes into consideration the time value of money is the
a. annual rate of return method.
b. return on stockholders' equity method.
c. cash payback technique.
d. internal rate of return method.
115. The internal rate of return is the interest rate that results in a
a. positive NPV.
b. negative NPV.
c. zero NPV.
d. positive or negative NPV.
116. In using the internal rate of return method, the internal rate of return factor was 4.0 and
the equal annual cash inflows were $16,000. The initial investment in the project must
have been
a. $16,000.
b. $4,000.
c. $64,000.
d. $32,000.
117. The capital budgeting technique that finds the interest yield of the potential investment is
the
a. annual rate of return method.
d. profitability index method.
118. All of the following statements about the internal rate of return method are correct except
that it
a. recognizes the time value of money.
b. is widely used in practice.
c. is easy to interpret.
d. can be used only when the cash inflows are equal.
119. If the internal rate of return is used as the discount rate in the net present value calcula-
tion, the net present value will be
a. zero.
b. positive.
c. negative.
d. undeterminable.
120. If a project costing $50,000 has a profitability index of 1.00 and the discount rate was
12%, then the present value of the net cash flows was
a. $50,000.
b. less than $50,000.
c. greater than $50,000.
d. undeterminable.
121. If a project costing $40,000 has a profitability index of 1.00 and the discount rate was 9%,
then the project’s internal rate of return was
a. less than 9%.
b. equal to 9%.
c. greater than 9%.
d. undeterminable.
122. The internal rate of return factor is equal to the

a. capital investment divided by the net cash flows.
b. present value of net cash flows divided by the capital investment.
c. present value of net cash flows divided by the profitability index.
d. capital investment divided by the present value of the net cash flows.
123. If a 2-year capital project has an internal rate of return factor equal to 1.690 and net
annual cash flows of $25,000, the initial capital investment was
a. $42,250.
b. $14,793.
c. $21,125.
d. $29,586.
124. If a 3-year capital project costing $38,655 has an internal rate of return factor equal to
2.577, the net annual cash flows assuming straight-line depreciation are
a. $12,885.
b. $15,000.
c. $5,000.
d. $19,328.
125. If the internal rate of return exceeds the discount rate, then the net present value of a
project is
a. positive.
b. negative.
c. zero.
d. one.
126. If the internal rate of return is less than the discount rate, then the net present value of a
project is
a. positive.
b. negative.
c. zero.
d. one.
127. If a project has a negative net present value, the internal rate of return will be
a. less than the discount rate.
b. greater than the discount rate.
c. equal to the discount rate.
d. a negative rate of return.
128. If a project has a zero net present value, then the internal rate of return will be
a. less than the discount rate.
b. greater than the discount rate.
c. equal to the discount rate.
d. a negative rate of return.
129. Which of the following will cause the internal rate of return to increase?
a. An increase in the annual cash inflows
b. A decrease in the annual cash inflows
c. An increase in the discount rate
d. A decrease in the discount rate
130. If project A has a lower internal rate of return than project B, then project A will have a
a. lower NPV and a shorter payback period.
b. higher NPV and a longer payback period.
c. lower NPV and a longer payback period.
d. higher NPV and a shorter payback period.
131. The internal rate of return factor is also the

a. annual rate of return.
b. profitability index.
c. cash payback period.
d. present value factor for a single amount.
132. Discounted cash flow techniques include all of the following except
a. profitability index.
b. annual rate of return.
c. internal rate of return.
d. net present value.
133. Which of the following is based directly on accrual accounting data rather than cash
flows?
a. Profitability index
b. Internal rate of return
c. Net present value
d. Annual rate of return
134. When calculating the annual rate of return, the average investment is equal to
a. (initial investment plus $0) divided by 2.
b. initial investment divided by life of project.
c. initial investment divided by 2.
d. (initial investment plus salvage value) divided by 2.
135. A project has an annual rate of return of 15%. The project cost $60,000, has a 5-year
useful life, and no salvage value. Straight-line depreciation is used. The annual net
income, exclusive of depreciation, was
a. $21,000.
b. $16,500.
c. $31,800.
d. $9,000.
136. A project that cost $50,000 has a useful life of 5 years and a salvage value of $2,000. The
internal rate of return is 12% and the annual rate of return is 18%. The amount of the
annual net income was
a. $4,680.
b. $4,320.
c. $3,120.
d. $2,880.
137. A project has annual income exclusive of depreciation of $48,000. The annual rate of
return is 15% and annual depreciation is $12,000. There is no salvage value. The internal
rate of return is 12%. The initial cost of the project was
a. $240,000.
b. $300,000.
c. $600,000.
d. $480,000.
138. A project that cost $80,000 with a useful life of 5 years is being considered. Straight-line
depreciation is being used and salvage value is $5,000. The project will generate annual
cash flows of $21,375. The annual rate of return is
a. 15%.
b. 50.3%.
c. 16%.
d. 17%.
Use the following information for questions 139 and 140.
A company is considering purchasing factory equipment that costs $480,000 and is estimated to
have no salvage value at the end of its 8-year useful life. If the equipment is purchased, annual
revenues are expected to be $135,000 and annual operating expenses exclusive of depreciation
expense are expected to be $57,000. The straight-line method of depreciation would be used.
139. If the equipment is purchased, the annual rate of return expected on this equipment is
a. 32.5%.
b. 3.8%.
c. 7.5%.
d. 16.3%.
140. The cash payback period on the equipment is

a. 13.3 years.
b. 8.0 years.
c. 6.2 years.
d. 3.1 years.
141. The capital budgeting technique that indicates the profitability of a capital expenditure is
the
a. profitability index method.
b. net present value method.
c. internal rate of return method.
d. annual rate of return method.
142. The annual rate of return method is based on

a. accounting data.
b. the time value of money data.
c. market values.
d. cash flow data.
143. Disadvantages of the annual rate of return method include all of the following except that
a. it relies on accrual accounting numbers instead of actual cash flows.
b. it does not consider the time value of money.
c. no consideration is given as to when the cash inflows occur.
d. management is unfamiliar with the information used in the computation.
144. A company projects an increase in net income of $90,000 each year for the next five
years if it invests $450,000 in new equipment. The equipment has a five-year life and an
estimated salvage value of $150,000. What is the annual rate of return on this
investment?
a. 20%
b. 30%
c. 25%
d. 50%
145. Colaw Company is considering buying equipment for $60,000 with a useful life of five
years and an estimated salvage value of $4,000. If annual expected income is $5,000, the
denominator in computing the annual rate of return is
a. $60,000.
b. $30,000.
c. $32,000.
d. $28,000.
146. The annual rate of return is computed by dividing expected annual

a. cash inflows by average investment.
b. net income by average investment.
c. cash inflows by original investment.
d. net income by original investment.
147. All of the following statements about the annual rate of return method are correct except
that it
a. indicates the profitability of a capital expenditure.
b. ignores the salvage value of an investment.
c. does not consider the time value of money.
d. compares the annual rate of return to management’s minimum rate of return.
Answers to Multiple Choice Questions

Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans.
26. a 44. c 62. c 80. d 98. b 116. c 134. d
27. d 45. d 63. d 81. c 99. a 117. b 135. b
28. b 46. d 64. b 82. c 100. c 118. d 136. a
29. a 47. b 65. d 83. b 101. b 119. a 137. d
30. d 48. b 66. c 84. b 102. c 120. a 138. a
31. c 49. c 67. d 85. d 103. d 121. b 139. c
32. b 50. b 68. c 86. c 104. d 122. a 140. c
33. d 51. c 69. a 87. d 105. c 123. a 141. d
34. c 52. d 70. b 88. d 106. b 124. b 142. a
35. b 53. c 71. b 89. d 107. d 125. a 143. d
36. a 54. a 72. d 90. d 108. d 126. b 144. b
37. c 55. b 73. c 91. c 109. b 127. a 145. c
38. d 56. d 74. a 92. a 110. b 128. c 146. b
39. a 57. c 75. c 93. b 111. b 129. a 147. b
40. d 58. b 76. d 94. c 112. b 130. c
41. b 59. a 77. c 95. a 113. d 131. c
42. b 60. c 78. b 96. b 114. d 132. b
43. a 61. a 79. d 97. c 115. c 133. d
BRIEF EXERCISES
BE 148
Diamond Company is considering investing in new equipment that will cost $600,000 with a 10-
year useful life. The new equipment is expected to produce annual net income of $40,000 over its
useful life. Depreciation expense, using the straight-line rate, is $60,000 per year.
Instructions
Compute the cash payback period.
Solution 148 (5 min.)

$600,000 ÷ ($40,000 + $60,000) = 6 years
BE 149
Madeline Company is proposing to spend $160,000 to purchase a machine that will provide
annual cash flows of $30,000. The appropriate present value factor for 10 periods is 5.65.
Instructions
Compute the proposed investment’s net present value and indicate whether the investment
should be made by Madeline Company.

Present Value
Cash inflows ($30,000 × 5.65) $169,500
Cash outflow—investment ($160,000 × 1.00) 160,000
Net present value $ 9,500
The investment should be made because the net present value is positive.
BE 150
LakeFront Company is considering investing in a new dock that will cost $280,000. The company
expects to use the dock for 5 years, after which it will be sold for $150,000. LakeFront anticipates
annual cash flows of $55,000 resulting from the new dock. The company’s borrowing rate is 8%,
while its cost of capital is 10%.
Instructions
Calculate the net present value of the dock and indicate whether LakeFront should make the
investment.

Cash Flows × 10% Discount Factor = Present Value
Present value of annual cash flows $55,000 × 3.79079 = $208,493
Present value of salvage value 150,000 × .62092 = 93,138
301,631
Capital investment 280,000
Solution 150 (cont.)

Since the net present value is positive, LakeFront should accept the project.
BE 151
Mobil Company has hired a consultant to propose a way to increase the company’s revenues.
The consultant has evaluated two mutually exclusive projects with the following information
provided for each project:
Project Turtle Project Snake
Capital investment $790,000 $440,000
Annual cash flows 130,000 75,000
Mobil Company uses a discount rate of 9% to evaluate both projects.
Instructions
(a) Calculate the net present value of both projects.
(b) Calculate the profitability for each project.
(c) Which project should Mobil accept?
Solution 151 (10–15 min.)

Project Turtle
Present value of salvage value 0 × .42241 = 0
834,296
Capital investment (790,000)
Profitability index = $834,296 ÷ $790,000 = 1.06
Project Snake
Present value of salvage value 0 × .42241 = 0
481,325
Capital investment (440,000)
Profitability index = $481,325 ÷ $440,000 = 1.09
Project Snake has a lower net present value than Project Turtle, but because of its lower capital
investment, it has a higher profitability index. Based on its profitability index, Project Snake should
be accepted.
BE 152
Mint Company is contemplating an investment costing $90,000. The investment will have a life of
8 years with no salvage value and will produce annual cash flows of $18,150.
BE 152 (cont.)
Instructions
What is the approximate internal rate of return associated with this investment?

When net annual cash inflows are expected to be equal, the internal rate of return can be
approximated by dividing the capital investment by the net annual cash inflows to determine the
discount factor and then locating this discount factor on the present value of an annuity table.
$90,000 ÷ $18,150 = 4.96
By tracing across on the 8-year row, we see that the discount factor of 12% is 4.96764. Thus the
internal rate of return on this project is approximately 12%.
BE 153
Salt Company is considering investing in a new facility to extract and produce salt. The facility will
increase revenues by $250,000, but it will also increase annual expenses by $160,000. The
facility will cost $980,000 to build, and it will have a $20,000 salvage value at the end of its useful
life.
Instructions
Calculate the annual rate of return on this facility.

The annual rate of return is calculated by dividing expected annual income by the average
investment. The company’s annual income is $250,000 – $160,000 = $90,000. Its average
investment is ($980,000 + $20,000) ÷ 2 = $500,000. Therefore, it annual rate of return is $90,000
÷ $500,000 = 18%.
EXERCISES
Ex. 154
Corn Doggy, Inc. produces and sells corn dogs. The corn dogs are dipped by hand. Austin
Beagle, production manager, is considering purchasing a machine that will make the corn dogs.
Austin has shopped for machines and found that the machine he wants will cost $262,000. In
addition, Austin estimates that the new machine will increase the company’s annual net cash
inflows by $40,300. The machine will have a 12-year useful life and no salvage value.
Instructions
(a) Calculate the cash payback period.
(b) Calculate the machine’s internal rate of return.
(c) Calculate the machine’s net present value using a discount rate of 10%.
(d) Assuming Corn Doggy, Inc.’s cost of capital is 10%, is the investment acceptable? Why or
why not?

(a) Cash payback period: $262,000 ÷ $40,300 = 6.50124 years
(b) Internal rate of return: Scanning the 12-year line, a factor of 6.50124 represents an internal
rate of return of approximately 11%.
(c) Net present value using a discount rate of 10%:
Time Period Cash Flow PV Factor Present Value
-0- $(262,000) 1.00000 $(262,000)
1-12 40,300 6.81369 274,592
Net Present Value $ 12,592
(d) Yes, the investment is acceptable. Indications are that the investment will earn a greater
return than 10%. The internal rate of return is estimated to be 11%, and the net present
value is positive.
Ex. 155
Top Growth Farms, a farming cooperative, is considering purchasing a tractor for $455,500. The
machine has a 10-year life and an estimated salvage value of $32,000. Delivery costs and set-up
charges will be $12,100 and $400, respectively. Top Growth uses straight-line depreciation.
Top Growth estimates that the tractor will be used five times a week with the average charge to
the individual farmers of $350. Fuel is $50 for each use of the tractor. The present value of an
annuity of 1 for 10 years at 9% is 6.418.
Instructions
For the new tractor, compute the:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.

(a) Cost of the tractor: $455,500 + $12,100 + $400 = $468,000
Annual Cash Flow:

Number of uses: 52 × 5 = 260
Contribution margin per use: $350 – $50 = $300
Total annual cash flow: 260 × $300 = $78,000
$468,000
Cash payback: ———— = 6 years
$78,000
(b) Present value of cash flow ($78,000 × 6.418) = $500,604

(c) $468,000 + $32,000

Average Investment: ————————— = $250,000
2

$468,000 – $32,000
Annual Depreciation: ————————— = $43,600
10 years
Annual Net Income: $78,000 – $43,600 = $34,400
$34,400
Average Annual Rate of Return: ———— = 13.76%
$250,000
Ex. 156
Tom Bat became a baseball enthusiast at a very early age. All of his baseball experience has
provided him valuable knowledge of the sport, and he is thinking about going into the batting cage
business. He estimates the construction of a state-of-the-art building and the purchase of
necessary equipment will cost $630,000. Both the facility and the equipment will be depreciated
over 12 years using the straight-line method and are expected to have zero salvage values. His
required rate of return is 10% (present value factor of 6.8137). Estimated annual net income and
cash flows are as follows:
Revenue $329,000
Less:
Utility cost 40,000
Supplies 8,000
Labor 141,000
Depreciation 52,500
Other 38,500 280,000
Net income $ 49,000
Instructions
For this investment, calculate:
(a) The net present value.
(b) The internal rate of return.
(c) The cash payback period.

(a) Net present value of the investment:
Item Present Value Cash Flow Factor Present Value
Initial Investment $(630,000) 1.0000 $(630,000)
Revenue $329,000
Expense (227,500)* 101,500 6.8137 691,591
Net Present Value $ 61,591
*$40,000 + $8,000 + $141,000 + $38,500
(b) Internal rate of return of the investment:

$630,000 ÷ $101,500 = 6.2069
Scanning the 12-year line, a factor of 6.2069 represents an IRR of approximately 12%.
(c) Cash payback period of the investment:

$630,000 ÷ $101,500 = 6.21 years.
Ex. 157
Mimi Company is considering a capital investment of $250,000 in new equipment. The equipment
is expected to have a 5-year useful life with no salvage value. Depreciation is computed by the
straight-line method. During the life of the investment, annual net income and cash inflows are
expected to be $25,000 and $75,000, respectively. Mimi's minimum required rate of return is
10%. The present value of 1 for 5 periods at 10% is .621 and the present value of an annuity of 1
for 5 periods at 10% is 3.791.
Instructions
Compute each of the following:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.

(a) Cash payback period = $250,000 ÷ $75,000 = 3.33 years
(b) Present value of cash inflows ($75,000 × 3.791) = $284,325

(c) Annual rate of return = $25,000 ÷ [($250,000 + $0) ÷ 2] = 20%
Ex. 158
Savanna Company is considering two capital investment proposals. Relevant data on each
project are as follows:
Project Red Project Blue
Capital investment $400,000 $560,000
Annual net income 50,000 80,000
Depreciation is computed by the straight-line method with no salvage value. Savanna requires an
8% rate of return on all new investments. The present value of 1 for 8 periods at 8% is .540 and
the present value of an annuity of 1 for 8 periods is 5.747.
Instructions
(a) Compute the cash payback period for each project.
(b) Compute the net present value for each project.
(c) Compute the annual rate of return for each project.
(d) Which project should Savanna select?

(a) Project Red Project Blue
Annual net income $ 50,000 $ 80,000
Annual depreciation 50,000* 70,000**
Annual cash inflow $100,000 $150,000
*($400,000 ÷ 8) **($560,000 ÷ 8)

$400,000 $560,000
Cash payback period: ———— = 4.0 years ———— = 3.7 years
$100,000 $150,000
(b) Project Red Project Blue

Present value of cash inflows: $574,700* $862,050**
Capital investment 400,000 560,000
Net present value $174,700 $302,050
*($100,000 × 5.747) **(150,000 × 5.747)
(c) Annual rate of return: Project Red Project Blue

$50,000 $80,000
————————— = 25% ————————— = 28.6%
($400,000 + $0) ÷ 2 ($560,000 + $0) ÷ 2
(d) Savanna should select Project Blue because it has a larger positive net present value and a
higher annual rate of return. In addition, Project Blue has a slightly shorter cash payback
period.
Ex. 159
Yappy Company is considering a capital investment of $320,000 in additional equipment. The
new equipment is expected to have a useful life of 8 years with no salvage value. Depreciation is
computed by the straight-line method. During the life of the investment, annual net income and
cash inflows are expected to be $25,000 and $65,000, respectively. Yappy requires a 10% return
on all new investments.
Period 8% 9% 10% 11% 12% 15%
8 5.747 5.535 5.335 5.146 4.968 4.487
Instructions
(a) Compute each of the following:
1. Cash payback period.
2. Net present value.
3. Profitability index.
4 Internal rate of return.
5. Annual rate of return.
(b) Indicate whether the investment should be accepted or rejected.

(a) 1. Cash payback period: $320,000 ÷ $65,000 = 4.92 years
2. Present value of cash inflows ($65,000 × 5.335) $346,775
3. Profitability index: $346,775 ÷ $320,000 = 1.08
4. Internal rate of return factor: $320,000 ÷ $65,000 = 4.92
Internal rate of return = 12% (4.968 factor)

5. Annual rate of return: $25,000 ÷ [($320,000 + $0) ÷ 2] = 15.63%
(b) Yappy should accept the investment, since its net present value is positive and its internal
rate of return of 12% is greater than the company's required rate of return of 10%. In
addition, its cash payback period of 4.92 years is significantly shorter than the equipment's
useful life of 8 years.
Ex. 160
Sophie’s Pet Shop is considering the purchase of a new delivery van. Sophie Smith, owner of the
shop, has compiled the following estimates in trying to determine whether the delivery van should
be purchased:
Cost of the van $25,000

Annual net cash flows 4,000
Salvage value 3,000
Estimated useful life 8 years
Cost of capital 10%
Present value of an annuity of 1 5.335
Present value of 1 .467
Sophie's assistant manager is trying to convince Sophie that the van has other benefits that she
hasn't considered in the initial estimates. These additional benefits, including the free advertising
the store's name painted on the van's doors will provide, are expected to increase net cash flows
by $500 each year.
Instructions
(a) Calculate the net present value of the van, based on the initial estimates. Should the van be
purchased?
(b) Calculate the net present value, incorporating the additional benefits suggested by the
assistant manager. Should the van be purchased?
(c) Determine how much the additional benefits would have to be worth in order for the van to
be purchased.

(a) Present value of annual cash flows ($4,000 × 5.335) $21,340
Present value of salvage value ($3,000 × .467) 1,401
$22,741
Net present value $( 2,259)
Based on the negative net present value of $2,259, the van should not be purchased.
(b) Present value of annual cash flows [($4,000 + $500) × 5.335] $24,008
Present value of salvage value ($3,000 × .467) 1,401
$25,409
Net present value $ 409

Incorporating the additional benefits of $500/year into the calculation produces a positive net
present value of $409. Therefore, the van should be purchased.
(c) The additional benefits would need to have a total present value of at least $2,259 in order
for the van to be purchased.
Ex. 161
Vista Company is considering two new projects, each requiring an equipment investment of
$95,000. Each project will last for three years and produce the following cash inflows:
Year Cool Hot

1 $ 38,000 $ 42,000
2 42,000 42,000
3 48,000 42,000
$128,000 $126,000
The equipment will have no salvage value at the end of its three-year life. Vista Company uses
straight-line depreciation and requires a minimum rate of return of 12%.
Present value data are as follows:
Present Value of 1 Present Value of an Annuity of 1

Period 12% Period 12%
1 .893 1 .893
2 .797 2 1.690
3 .712 3 2.402
Instructions
(a) Compute the net present value of each project.
(b) Compute the profitability index of each project.
(c) Which project should be selected? Why?

(a) Project Cool
Year Annual Cash Inflows Present Value of 1 Present Value
1 $ 38,000 .893 $ 33,934
2 42,000 .797 33,474
3 48,000 .712 34,176
$128,000 $101,584
Present value of cash inflows $101,584


Project Hot
Present value of cash inflows ($42,000 × 2.402) $100,884
(b) Cool Hot

Profitability index: $101,584 ÷ $95,000 = 1.07 ($100,884 ÷ $95,000) = 1.06
(c) Both projects are acceptable because both show a positive net present value. Project Cool
is the preferred project because its net present value is greater than project Hot's net present
value and it has a slightly higher profitability index.
Ex. 162
Santana Company is considering investing in a project that will cost $110,000 and have no
salvage value at the end of its 5-year life. It is estimated that the project will generate annual cash
inflows of $30,000 each year. The company requires a 10% rate of return and uses the following
compound interest table:

Period 6% 8% 9% 10% 11% 12% 15%
5 4.212 3.993 3.890 3.791 3.696 3.605 3.352
Instructions
(a) Compute (1) the net present value and (2) the profitability index of the project.
(b) Compute the internal rate of return on this project.
(c) Should Santana invest in this project?

(a) (1) Present value of cash inflows ($30,000 × 3.791) $113,730
(2) Profitability index: $113,730 ÷ $110,000 = 1.03
(b) Capital Investment

—————————— = Internal Rate of Return Factor
Net Annual Cash Inflow
$110,000
———— = 3.67
$30,000
Since the calculated internal rate of return factor of 3.67 is very near the factor 3.696 for five
periods and 11% interest, this project has an approximate interest yield of 11%.
(c) Santana should invest in this project because it has a positive net present value, a
profitability index above 1, and its internal rate of return of 11% is greater than the company's
10% required rate of return.
Ex. 163
Johnson Company is considering purchasing one of two new machines. The following estimates
are available for each machine:
Machine 1 Machine 2
Initial cost $148,000 $165,000
Annual cash inflows 50,000 60,000
Annual cash outflows 15,000 20,000
The company's minimum required rate of return is 10%.

Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784
Instructions
(a) Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for
each machine.
(b) Which machine should be purchased?

(a) Machine 1 Machine 2
(1) Present value of net cash flows $152,425* $174,200**
Capital investment 148,000 165,000
Net present value $ 4,425 $ 9,200
*($35,000 × 4.355) **($40,000 × 4.355)
Machine 1 Machine 2
$152,425 $174,200
(2) Profitability index ———— = 1.03 ———— = 1.06
$148,000 $165,000
(3) Machine 1 Machine 2

Internal rate of return factor $148,000 $165,000
———— = 4.23 ———— = 4.13
$35,000 $40,000
Internal rate of return 11% (4.231 factor) 12% (4.111 factor)
(b) Both machines are acceptable because both show a positive net present value, have a
profitability index above 1, and have an internal rate of return greater than the company's
minimum required rate of return. Machine 2 is preferred because its net present value,
profitability index, and internal rate of return are all greater than Machine 1's amounts.
Ex. 164
Platoon Company is performing a post-audit of a project that was estimated to cost $300,000,
have a useful life of 6 years with a zero salvage value, and result in net cash inflows of $75,000
per year. After the investment was in operation for a year, revised figures indicate that it actually
cost $345,000, will have a 9-year useful life, and will produce net cash inflows of $58,000. The
present value of an annuity of 1 for 6 years at 10% is 4.355 and for 9 years is 5.759.
Ex. 164 (cont.)

Instructions
Determine whether the project should have been accepted based on (a) the original estimates
and then on (b) the actual amounts.

(a) Present value of the estimated net cash inflows ($75,000 × 4.355) $326,625
Estimated capital investment 300,000
Yes, Platoon Company should have invested in the project based on the original estimates,
since the net present value is positive.
(b) Present value of the actual net cash inflows ($58,000 × 5.759) $334,022
Actual capital investment 345,000
Net present value $ (10,978)
Platoon should not have invested in the project based on the actual amounts, since the net
present value is negative. The decrease of $37,603 in net present value was caused due to
a decrease of $17,000 per year in net cash inflows and a $45,000 increase in the cost of the
capital investment. This more than offsets the 3-year increase in useful life.
Ex. 165
Shilling Corp. is thinking about opening a baseball camp in Florida. In order to start the camp, the
company would need to purchase land, build five baseball fields, and a dormitory-type sleeping
and dining facility to house 100 players. Each year the camp would be run for 10 sessions of 1
week each. The company would hire college baseball players as coaches. The camp attendees
would be baseball players age 12-18. Property values in Florida have enjoyed a steady increase
in value. It is expected that after using the facility for 20 years, Shilling can sell the property for
more than it was originally purchased for. The following amounts have been estimated:
Cost of land $ 600,000
Cost to build dorm and dining facility 2,100,000
Annual cash inflows assuming 100 players and 10 weeks 2,520,000
Annual cash outflows 2,260,000
Estimated useful life 20 years
Salvage value 3,900,000
Discount rate 10%
Present value of an annuity of 1 8.514
Present value of 1 .149
Instructions
(a) Calculate the net present value of the project.
(b) To gauge the sensitivity of the project to these estimates, assume that if only 80 campers
attend each week, revenues will be $2,085,000 and expenses will be $1,865,000. What is
the net present value using these alternative estimates? Discuss your findings.
(c) Assuming the original facts, what is the net present value if the project is actually riskier than
first assumed, and a 12% discount rate is more appropriate? The present value of 1 at 12%
is .104 and the present value of an annuity of 1 is 7.469.

(a) Present value of net cash flows ($260,000 × 8.514) $2,213,640
Present value of salvage value ($3,900,000 × .149) 581,100
$2,794,740
Capital investment ($600,000 + $2,100,000) 2,700,000
(b) Present value of net cash flows ($220,000 × 8.514) $1,873,080

Present value of salvage value 581,100
$2,454,180
Capital investment 2,700,000
If the number of campers attending each week is only 80 instead of 100, the net present
value decreases by $340,560 (from a positive $94,740 to a negative $245,820). This
indicates that the camp should not be invested in unless the number attending is closer to
100.
(c) Present value of net cash flows ($260,000 × 7.469) $1,941,940

Present value of salvage value ($3,900,000 × .104) 405,600
$2,347,540
Capital investment 2,700,000
COMPLETION STATEMENTS
166. For purposes of capital budgeting, estimated ____________ and outflows are preferred
for inputs into the capital budgeting decision tools.
167. The technique which identifies the time period required to recover the cost of the
investment is called the ________________ method.
168. The two discounted cash flow techniques used in capital budgeting are (1) the
_______________________ method and (2) the ______________________ method.
169. Under the net present value method, the interest rate to be used in discounting the future
cash inflows is the ________________.
170. In using the net present value approach, a project is acceptable if the project's net present
value is ____________ or_______________.
171. A project’s ________________, such as increased quality or safety, are often incorrectly
ignored in capital budgeting decisions.
172. The _______________ is a method of comparing alternative projects that takes into
account both the size of the investment and its discounted future cash flows.
173. A well-run organization should perform an evaluation, called a _____________, of its

investment projects after their completion.
174. The internal rate of return method differs from the net present value method in that it
results in finding the ___________________ of the potential investment.
175. A major limitation of the annual rate of return approach is that it does not consider the
_______________ of money.
Answers to Completion Statements

166. cash inflows
167. cash payback
168. net present value, internal rate of return
169. required rate of return
170. zero, positive
171. intangible benefits
172. profitability index
173. post audit
174. interest yield
175. time value
MATCHING
176. Match the items below by entering the appropriate code letter in the space provided.
A. Profitability index E. Annual rate of return method

B. Internal rate of return method F. Cash payback technique
C. Discounted cash flow techniques G. Cost of capital
D. Capital budgeting H. Net present value method
____ 1. A capital budgeting technique that identifies the time period required to recover the
cost of a capital investment from the annual cash inflow produced by the investment.
____ 2. Capital budgeting techniques that consider both the estimated total cash inflows from
the investment and the time value of money.
____ 3. A method used in capital budgeting in which cash inflows are discounted to their
present value and then compared to the capital outlay required by the capital
investment.
____ 4. A method of comparing alternative projects that take into account both the size of the
investment and its discounted cash flows.
____ 5. A method used in capital budgeting that results in finding the interest yield of the
potential investment.
____ 6. The average rate of return that the firm must pay to obtain borrowed and equity funds.
____ 7. The determination of the profitability of a capital expenditure by dividing expected

annual net income by the average investment.
____ 8. The process of making capital expenditure decisions in business.
Answers to Matching
1. F 5. B
2. C 6. G
3. H 7. E
4. A 8. D
SHORT-ANSWER ESSAY QUESTIONS

S-A E 177
Management uses several capital budgeting methods in evaluating projects for possible
investment. Identify those methods that are more desirable from a conceptual standpoint, and
briefly explain what features these methods have that make them more desirable than other
methods. Also identify the least desirable method and explain its major weaknesses.
Solution 177
From a conceptual standpoint, the discounted cash flow methods (net present value and internal
rate of return) are considered more desirable because they consider both the estimated cash
flows and the time value of money. The time value of money is critical because of the long-term
impact of capital budgeting decisions. Capital budgeting methods which do not consider the time
value of money include annual rate of return and cash payback. The cash payback method is the
least desirable because it also ignores the expected profitability of the project.
S-A E 178 (Ethics)

Sam Stanton is on the capital budgeting committee for his company, Canton Tile. Ed Rhodes is
an engineer for the firm. Ed expresses his disappointment to Sam that a project that was given to
him to review before submission looks extremely good on paper. "I really hoped that the cost
projections wouldn't pan out," he tells his friend. "The technology used in this is pie in the sky kind
of stuff. There are a hundred things that could go wrong. But the figures are very convincing. I
haven't sent it on yet, though I probably should."
"You can keep it if it's really that bad," assures Sam. "Anyway, you can probably get it shot out of
the water pretty easily, and not have the guy who submitted it mad at you for not turning it in. Just
fix the numbers. If you figure, for instance, that a cost is only 50% likely to be that low, then
double it. We do it all the time, informally. Best of all, the rank and file don't get to come to those
sessions. Your engineering genius need never know. He'll just think someone else's project was
even better than his."
Required:
1. Who are the stakeholders in this situation?
2. Is it ethical to adjust the figures to compensate for risk? Explain.
3. Is it ethical to change the proposal before submitting it? Explain.
Solution 178
1. The stakeholders include:
Ed Rhodes
Canton Tile
the engineer who submitted the proposal.
2. It is ethical, in general, to adjust projections to compensate for risk. However, it should be

clearly stated that the projections have been adjusted for risk, and the method used should be
available for review. Otherwise, the entire selection process is undermined, and it becomes
entirely subjective.

3. It is probably not ethical to modify a proposal at all; certainly not in the way described. The
person submitting the proposal should have the right to know about any changes that were
made, and should have the right to review those changes.
S-A E 179 (Communication)

You are the general accountant for Word Systems, Inc., a typing service based in Los Angeles,
California. The company has decided to upgrade its equipment. It currently has a widely used
version of a word processing program. The company wishes to invest in more up-to-date software
and to improve its printing capabilities.
Two options have emerged. Option #1 is for the company to keep its existing computer system,
and upgrade its word processing program. The memory of each work station would be enhanced,
and a larger, more efficient printer would be used. Better telecommunications equipment would
allow for the electronic transmission of some documents as well.
Option #2 would be for the company to invest in an entirely different computer system. The
software for this system is impressive, and it comes with individual laser printers. However, the
company is not well known, and the software does not connect well with well-known software.
The net present value information for these options follows:
Option #1 Option #2
Initial Investment $(95,000) $(270,000)
Returns Year 1 55,000 90,000
Year 2 30,000 90,000
Year 3 10,000 90,000
Net present value 0 0
Required:
Prepare a brief report for management in which you make a recommendation for one system or
the other, using the information given.
Solution 179
The company should accept Option #1, to purchase upgrades to its present system and to buy a
more efficient printer. In the first place, the changes will be easier to implement because the
equipment is similar to that which is already in use. Secondly, the company will have less money
invested in the project, which decreases the risk of loss should the project fail. Option #2 appears
to be too risky.

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CHAPTER 12

PLANNING FOR CAPITAL INVESTMENTS

SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOM’S TAXONOMY

167. 2 K 169. 3 K 171. 4 K 173. 6 K 175. 8 K

SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE

23. TF 132. MC 136. MC 140. MC 144. MC 153. BE 159. Ex

Note: TF = True-False C = Completion Ex = Exercise

CHAPTER STUDY OBJECTIVES

Answers to True-False Statements

MULTIPLE CHOICE QUESTIONS

28. Most of the capital budgeting methods use

29. The first step in the capital budgeting evaluation process is to

30. The capital budgeting decision depends in part on the

31. Capital budgeting is the process

32. Net annual cash flow can be estimated by

34. Capital expenditure proposals are initially screened by the

37. Which of the following is not a capital budgeting decision?

38. Which of the following is a disadvantage of the cash payback technique?

39. The payback period is often compared to an asset’s

40. Which of the following ignores the time value of money?

The cash payback period is

46. The cash payback technique

49. The cash payback technique

52. A disadvantage of the cash payback technique is that it

56. The higher the risk element in a project, the

61. A company's cost of capital refers to the

63. A negative net present value indicates that the

64. A company’s discount rate is based on the

68. A project with a zero net present value indicates that it is

75. In capital budgeting, intangible benefits should be

78. Intangible benefits in capital budgeting

79. To avoid rejecting projects that actually should be accepted,

81. In evaluating high-tech projects,

84. The profitability index is computed by dividing the

86. The profitability index

90. If a project’s profitability index is greater than 1, then the

91. If a project’s profitability index is less than 1, then

92. If a project’s profitability index is equal to 1, then

Use the following information for questions 95 and 96.

95. Using the profitability index, the projects rank as

Use the following information for questions 101–103.

101. What is the approximate net present value of this investment?

Use the following table for questions 104–106.

Present Value of an Annuity of 1

Use the following information for questions 107–110.

The company requires a 10% rate of return on all new investments.

107. The cash payback period for Project Soup is

108. The net present value for Project Nuts is

109. The internal rate of return for Project Nuts is approximately

110. The annual rate of return for Project Soup is

111. A post-audit should be performed using

113. Performing a post-audit is important because

122. The internal rate of return factor is equal to the

131. The internal rate of return factor is also the

Use the following information for questions 139 and 140.

140. The cash payback period on the equipment is

142. The annual rate of return method is based on

146. The annual rate of return is computed by dividing expected annual

Answers to Multiple Choice Questions

Solution 148 (5 min.)

Solution 149 (5 min.)

Solution 150 (5 min.)