Chapter 10 Capital Budgeting PDF

CHAPTER 10: CAPITAL BUDGETING: DECISION CRITERIA AND REAL OPTION CONSIDERATIONS 1. Multiple internal rates of return can occur when there is (are): a. large abandonment costs at the end of a project’s life b. a major shutdown and rebuilding of a facility sometime during its life c. more th...

CHAPTER 10: CAPITAL BUDGETING: DECISION CRITERIA AND REAL OPTION CONSIDERATIONS 1. Multiple internal rates of return can occur when there is (are): a. large abandonment costs at the end of a project’s life b. a major shutdown and rebuilding of a facility sometime during its life c. more than one sign change in the pattern of cash flows over a project’s life. d. all of these are correct ANSWER: d 2. The measures the present value return for each dollar of initial investment. a. payback period b. internal rate of return c. net present value d. profitability index ANSWER: d 3. The payback method is at best a crude measure of the risk of a project because it fails to consider the of a project’s returns. a. liquidity b. variability c. timing d. magnitude ANSWER: b 4. According to the profitability index criterion, a project is acceptable if its profitability index is a. greater than 1 plus the cost of capital b. greater than 0 c. greater than or equal to 1 d. greater than 1.1 ANSWER: c 5. The payback period of an investment is defined as: a. the number of years required for cumulative profits from a project to equal the initial outlay. b. the number of years required for the cumulative cash flows from a project to equal the initial outlay. c. the number of years required for the cumulative cash flows from a project to equal the average investment in the project, when depreciation is considered. d. a period of time sufficient to earn a rate of return equal to the firm’s cost of capital. ANSWER: b © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 6. The advantages of the payback approach include all of the following except: a. it is easy to compute b. it considers a project’s liquidity c. it considers cash flows, not net income d. it provides an objective measure of profitability ANSWER: d 7. The disadvantages of the payback approach include: a. cash flows after the payback period are ignored in the calculation b. payback ignores the time value of money c. payback fails to provide an objective decision-making criterion d. all of these ANSWER: d 8. One weakness of the internal rate of return approach is that: a. it does not directly consider the timing of the cash flows from a project b. it fails to provide a straightforward decision-making criterion c. it implicitly assumes that the firm is able to reinvest the interim cash flows from a project at the firm’s cost of capital. d. none of these ANSWER: d 9. The relationship between NPV and IRR is such that: a. both approaches always provide the same ranking of alternative investment projects. b. the IRR of a project is equal to the firm’s cost of capital if the NPV of a project is $0. c. if the NPV of a project is negative, the IRR must be greater than the cost of capital. d. none of these ANSWER: b 10. When a project has multiple internal rates of return: a. the analyst should choose the highest rate to compare with the firm’s cost of capital. b. the analyst should choose the lowest rate to compare with the firm’s cost of capital. c. the analyst should choose the rate that seems most “reasonable”, given the project’s cash flows, to compare with the firm’s cost of capital. d. the analyst should compute the project’s net present value and accept the project if its NPV is greater than $0 ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 11. The profitability index (PI) approach: a. fails to directly consider the timing of a project’s cash flows b. considers only a project’s contributions to net income and does not consider cash flow effects c. always gives the same accept-reject decisions for independent projects as does NPV and IRR d. always gives the same accept-reject decisions for mutually exclusive projects as does NPV and IRR ANSWER: c 12. In the case of mutually exclusive projects, NPV and PI are likely to yield conflicting decisions when: a. the projects require the same net investment b. the projects are significantly different in size c. multiple rates of return are a possibility d. none of these ANSWER: b 13. The objective in solving capital rationing problems is to: a. accept all projects with a PI greater than 1.1 b. maximize the IRR of the projects that are accepted c. maximize the NPV of the projects that are accepted d. minimize the opportunity cost of the firm’s funds ANSWER: c 14. Which of the following is not a technique to handle the capital rationing problem? a. linear programming b. goal programming c. ranking projects according to payback d. ranking projects according to profitability index ANSWER: c 15. In order to compensate for inflation in capital budgeting procedures, it is necessary to: a. use constant dollar estimates of costs and revenues b. use a low discount rate to avoid double counting for inflationary effects c. rely heavily on the payback procedures d. none of these ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 16. If a net present value analysis for a normal project gives an NPV greater than zero, an internal rate of return calculation on the same project would yield an internal rate of return the required rate of return for the firm. a. greater than b. less than c. equal to d. cannot be determined from the information given ANSWER: a 17. When two or more normal projects are under consideration, the profitability index, the net present value, and the internal rate of return methods will yield identical accept/reject signals. a. coincident b. mutually exclusive c. independent d. none of these ANSWER: c 18. The net present value method assumes that the cash flows over the life of the project are reinvested at a. the computed internal rate of return b. the risk-free rate c. the market capitalization rate d. the firm’s cost of capital ANSWER: d 19. The internal rate of return method assumes that the cash flows over the life of the project are reinvested at: a. the risk-free rate b. the firm’s cost of capital c. the computed internal rate of return d. the market capitalization rate ANSWER: c 20. In the absence of capital rationing, the method is normally superior to the method when choosing among mutually exclusive investments. a. net present value, internal rate of return b. internal rate of return, profitability index c. net present value, profitability index d. a and c ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 21. Generally, the is considered to be a more realistic reinvestment rate than the. a. risk-free rate, internal rate of return b. internal rate of return, cost of capital c. cost of capital, internal rate of return d. risk-free rate, cost of capital ANSWER: c 22. The profitability index is the ratio of the to the. a. net present value, net investment b. net investment, net present value c. present value of future net cash flows, net investment d. net investment, present value of future net cash flows ANSWER: c 23. With the net present value approach, all net cash flows are discounted at the a. required rate of return b. discount rate c. cost of capital d. all of these ANSWER: d 24. If the net present value of an investment project is positive then the: a. project would be unacceptable under the internal rate of return method b. project would be acceptable under the payback method c. project’s rate of return is greater than the firm’s cost of capital d. all of these are correct ANSWER: c 25. The “value additivity principle” means that the a. firm should accept all projects with a positive net present value. b. firm’s value is the sum of the value of all the projects undertaken c. firm will grow through the addition of new projects d. positive net present value is added to the firm’s net worth ANSWER: b 26. The internal rate of return does not take into account the a. explicit risk of the net cash flows b. magnitude of cash flows over the project’s life c. net investment d. timing of cash flows over the entire life of a project © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations ANSWER: a 27. The net present value method assumes that cash flows are reinvested at the , whereas the internal rate of return method assumes that cash flows are reinvested at the. a. discount rate, required rate of return b. cost of capital, market rate of return c. firm’s cost of capital, computed internal rate of return d. marginal cost of capital, discount rate ANSWER: c 28. All of the following are reasons why a firm may face capital rationing except: a. reluctant to issue additional debt b. the discount rate is too high c. lacks the managerial resources d. restrictive covenants that limit borrowing ANSWER: b 29. Which of the following would increase the net present value of a project? a. increase in the net investment b. use of straight line depreciation rather than MACRS c. decrease in the expected accounts payable d. decrease in the discount rate ANSWER: d 30. The reason for a postaudit is to a. help financial managers reduce errors in cash flow estimation b. reduce the number of accepted risky projects c. reduce the number of projects submitted d. determine the correct required rate of return ANSWER: a 31. A capital expenditure project has an expected 20 percent internal rate of return and a $10,000 net present value. It has one cash flow sign change. a. The discount rate used to calculate NPV is greater than 20 percent b. The project has another internal rate of return in addition to the 20 percent rate mentioned above c. In the internal rate of return calculation, the project’s cash inflows are assumed to be reinvested at the firm’s required rate of return d. None of these ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 32. The value additivity principle indicates that, when a firm undertakes an independent project, the value of the firm is increased by the from the project. a. present value of the cash inflows b. sum of the cash inflows and outflows c. net present value d. none of these ANSWER: c 33. When dealing with cash flows, the is computed by trial and error. a. uniform; internal rate of return b. perpetual; internal rate of return c. uneven; internal rate of return d. uneven; net present value ANSWER: c 34. The is interpreted as the for each dollar of initial investment. a. net present value; present value return b. profitability index; cash flow return c. profitability index; present value return d. none of these ANSWER: c 35. The of an investment is the period of time for the to equal the initial cash outlay. a. profitability index; present value of the cash inflows b. payback period; cumulative cash inflows c. payback period; present value of the cash inflows d. none of these ANSWER: b 36. The profitability index would be if the present value of the net cash flows (NCF) over the life of a project were ____. a. negative; less than zero b. negative; less than the net investment c. zero; equal to the net investment d. none of these ANSWER: a 37. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 37. Which of the following investment decision rules (if any) assumes that the cash flows generated are reinvested over the life of the project at the firm’s cost of capital? a. payback period b. internal rate of return c. accounting rate of return d. none of these ANSWER: d 38. The approach takes into account both the magnitude and timing of cash flows over the entire life of a project in measuring its economic desirability. a. payback period b. accounting rate of return c. average rate of return d. internal rate of return ANSWER: d 39. There are many reasons why a firm can earn above-normal profits. These reasons include all of the following except: a. access to superior labor or managerial talents b. superior access to financial resources at lower costs c. patent control of superior product designs d. ability of new firms to acquire necessary factors of production ANSWER: d 40. Real options in capital budgeting can be classified in all of the following ways except: a. abandonment option b. investment option c. purchasing power option d. shutdown options ANSWER: c 41. Generally, the existence of a(n) option reduces the downside risk of a project and should be considered in project analysis. a. designed-in b. abandonment c. investment timing d. output expansion ANSWER: b © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 42. When evaluating international capital expenditure projects, the analyst may compute the present value of the net cash flows in the local currency and then. a. discount by one plus the spot rate (1+ S0) b. multiply by the forward exchange rate c. discount by the future exchange rate d. multiply by the spot exchange rate ANSWER: d 43. Capital expenditures levels tend (in real terms) during periods of relatively high inflation than during low inflation times. a. to be higher b. to be lower c. to be the same d. to depend on business risk ANSWER: b 44. The reasons that the amount and timing of the net cash flows to the foreign subsidiary and parent may differ include: a. subsidized loans b. differential tax rates c. legal and political constraints on cash remittance d. all of these ANSWER: d 45. Entrepreneurial firms with a net worth of less than $1 million tend to prefer the method for evaluating capital expenditures. a. NPV b. IRR c. Payback d. Profitability index ANSWER: c 46. An investment project requires a net investment of $100,000. The project is expected to generate annual net cash inflows of $28,000 for the next 5 years. The firm’s cost of capital is 12 percent. Determine the payback period for the project. a. 0.28 years b. 1.4 years c. 3.57 years d. 17.86 years ANSWER: c RATIONALE: Solution: PB = $100,000/$28,000 = 3.57 years © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 47. An investment project requires a net investment of $100,000. The project is expected to generate annual net cash inflows of $28,000 for the next 5 years. The firm’s cost of capital is 12 percent. Determine the net present value for the project. a. $940 b. $100,940 c. $77,884 d. $40,000 ANSWER: a RATIONALE: Solution: NPV = 28,000(PVIF0.12,5) – 100,000 = $28,000(3.605) – 100,000 = $940 48. An investment project requires a net investment of $100,000. The project is expected to generate annual net cash inflows of $28,000 for the next 5 years. The firm’s cost of capital is 12 percent. Determine the internal rate of return for the project (to the nearest tenth of one percent). a. 12.0% b. 12.6% c. 3.6% d. 12.4% ANSWER: d RATIONALE: Solution: $100,000/$28,000 = 3.571 From Table IV, PVIFAr,5 = 3.571, which falls between 3.605 (12%) and 3.517 (13%). r = 12.38% (calculator) or 12.4% (rounded) 49. The Atlantic Company plans to open a new branch office in a suburban area. The building will cost $200,000 and will be depreciated (on a straight-line basis) over a 20 year life to a $0 estimated salvage value. Equipment for the building will cost an additional $100,000. This equipment has a 20-year life and will be depreciated on a straight-line basis to a $0 estimated salvage value. The branch office is expected to generate additional before tax net income of $30,000 per year. The tax rate is 40 percent and the cost of capital is 12 percent. Compute the net present value for the project. a. –$63,523 b. +$246,477 c. +$53,523 d. –$53,523 ANSWER: d RATIONALE: Solution: NPV = $300,000/20 = 15,000 $30,000 ×.60 = 18,000 $33,000(PVIFA0.12,20) – $300,000 = –$53,523 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 50. An investment project requires a net investment of $100,000 and is expected to generate annual net cash inflows of $25,000 for 6 years. The firm’s cost of capital is 12 percent. Determine the profitability index for this project. a. 1.50 b. 1.028 c..028 d..972 ANSWER: b RATIONALE: Solution: PI = [$25,000(PVIFA0.12,6)]/$100,000 = [$25,000(4.111)]/$100,000 = 1.028 51. A project requires a net investment of $450,000. It has a profitability index of 1.25 based on the firm’s 12 percent cost of capital. Determine the net present value of the project. a. $112,500 b. $562,500 c. $1,012,500 d. $140,625 ANSWER: a RATIONALE: Solution: PI = PV of NCF/NINV = 1.25 = PV of NCF/$450,000 PV of NCF = $562,500 NPV = PV of NCF – NINV = $562,500 – $450,000 = $112,500 52. What is the net present value of a project that requires a net investment of $76,000 and produces net cash flows of $22,000 per year for 7 years? Assume the cost of capital is 15 percent. a. $91,520 b. $15,520 c. $78,000 d. $167,474 ANSWER: b RATIONALE: Solution: NPV = $22,000(4.160) – $76,000 = $15,520 53. Would you invest in a project that has a net investment of $14,600 and a single net cash flow of $24,900 in 5 years, if your required rate of return was 12 percent? a. Yes—the NPV is $862.90 b. No—the NPV is –$1,975.70 c. No—the NPV is –$481.70 d. Yes—the NPV is $165.70 ANSWER: c RATIONALE: Solution: NPV = $24,900(0.567) – $14,600 = –$481.70 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 54. Sigma is thinking about purchasing a new clam digger for $14,000. The expected net cash flows resulting from the digger are $9,000 in year 1, $7,000 in the 2nd year, $5,000 in the 3rd year, and $3,000 in the 4th year. Should Sigma purchase this digger if its cost of capital is 12 percent? a. Yes, NPV = $3,176 b. Yes, NPV = $5,084 c. Yes, NPV = $16,605 d. Yes, NPV = $19,084 ANSWER: b RATIONALE: Solution: NPV = $9,000(0.893) + $7,000(0.797) + $5,000(0.712) + $3,000(0.636) – $14,000 = $5,084 55. What is the internal rate of return for a project that has a net investment of $76,000 and net cash flows of $20,507 per year for 7 years? a. 16% b. 17% c. 18.2% d. 19% ANSWER: d RATIONALE: Solution: PVIFAr,7 = $76,000/$20,507 = 3.706 Therefore, IRR = 19% from Table IV 56. What is the internal rate of return for a project that has a net investment of $14,600 and a single net cash flow of $25,750 in 5 years? a. 10% b. 12% c. 15.3% d. 13.1% ANSWER: b RATIONALE: Solution: PVIFr,5 = $14,600/$25,750 = 0.567 Therefore, IRR = 12% from Table II 57. What is the internal rate of return for a project that has a net investment of $150,000 and net cash flows of $40,000 for 5 years? a. between 10% and 11% b. between 9% and 10% c. between 11% and 12% d. between 12% and 13% ANSWER: a RATIONALE: Solution: PVIFAr,5 = $150,000/$40,000 = 3.750, therefore, IRR is between 10% and 11% (from Table IV) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 58. Using the profitability index, which of the following mutually exclusive projects should be accepted? Project A: NPV = $6,000; NINV = $50,000 Project B: NPV = $10,000; NINV = $120,000 Project C: NPV = $8,000; NINV = $80,000 a. A b. B c. C d. all projects should be accepted ANSWER: a RATIONALE: Solution: PIA = $56/$50 = 1.12 PIB = $130/$120 = 1.08 PIC = $88/$80 = 1.1 Therefore, choose project A 59. Turntec is considering replacing an automatic shuttle machine that has a book value of $2,000 and a $0 market value with a more efficient machine that will cost $24,000. The annual net cash flows from the new equipment are expected to be $6,000 for the next 6 years. What is the net present value of this project? Assume the firm’s cost of capital is 12 percent and its marginal tax rate is 40 percent. a. $666 b. $1,466 c. $1,866 d. –$134 ANSWER: b RATIONALE: Solution: NPV = –$24,000 + $2000(.4) + $6,000(4.111) = $1,466 60. GoFlo is a small growing firm that is considering the purchase of another truck to serve GoFlo’s expanding customer base. The new truck will cost $21,000 and should generate annual net cash flows of $6,000 over the truck’s 5-year life. What is the payback period for this project? a. 3 years b. 4.2 years c. 3.5 years d. 3.3 years ANSWER: c RATIONALE: Solution: PB = $21,000/$6,000 = 3.5 years © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 61. Hydroponics is considering adding another greenhouse that would cost $95,000 and generate $20,000 in annual net cash flows over its 8 year expected life. The greenhouse would be depreciated on a straight-line basis to zero and the salvage value is also expected to be zero. If the firm has a marginal tax rate of 40 percent, what is this project’s internal rate of return? a. between 20 and 24% b. between 13 and 14% c. between 28 and 32% d. between 7 and 8% ANSWER: b RATIONALE: Solution: PVIFAr,8 = $95,000/$20,000 = 4.75, which is between 13 and 14 percent in Table IV 62. Red Lake Mines, Inc. is considering adoption of a new project requiring a net investment of $10 million. The project is expected to generate 5 years of net cash inflows of $5 million per year. In the project’s sixth, and final year, it is expected to have a net cash outflow of $1 million. What is the project’s net present value, using a discount rate of 12 percent? a. about $8.52 million b. about $8.00 million c. about $7.52 million d. none of these ANSWER: c RATIONALE: Solution: NPV = –$10 + $5(3.605) – $1(0.507) = 7.52, or $7.5 million 63. Calculate the profitability index for a project that has a net present value equal to –$10,000. The project’s net investment is $20,000, and the firm has a 40 percent marginal tax rate. a. –0.5 b. 0 c. 0.8 d. None of these ANSWER: d RATIONALE: Solution: PI = $10,000/$20,000 = 0.5 64. A project requires a net investment of $100,000. At the firm’s cost of capital of 10%, the project’s profitability index is 1.15. Determine the net present value of the project. a. $15,000 b. $215,000 c. $115,000 d. none of these/cannot be determined ANSWER: a RATIONALE: Solution: PI = PV of NCF/NINV 1.15 = PV of NCF/$100,000 PV of NCF = $115,000 NPV = PV of NCF – NINV = $115,000 – $100,000 = $15,000 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 65. What is the NPV of a project that required a net investment of $500,00 and produced net cash flows of $150,000 per year for 5 years and $110,000 for the next 5 years? Assume the cost of capital is 14%. a. $211,080 b. $392,580 c. $588,710 d. $160,920 ANSWER: a RATIONALE: Solution: NPV = –500,000 + 150,000(3.433) + 110,000(5.216 – 3.433) = 211,080 66. Kinetics is considering a project that has a NINV of $874,000 and generates net cash flows of $170,000 per year for 12 years. What is the NPV of this project if Kinetics cost of capital is 14%? a. $252,760 b. $110,840 c. $88,200 d. $47,570 ANSWER: c RATIONALE: Solution: NPV = –$874,000 + $170,000(5.660) = $88,200 67. Using the profitability index, which of the following projects should be accepted? Project M: NPV = $60,000 NINV = $200,000 Project N: NPV = $10,000 NINV = $30,000 Project O: NPV = $2,000 NINV = $5,000 a. Project M b. Project N c. Project O d. All projects should be accepted ANSWER: d RATIONALE: Solution: PI-M = 260,000/200,000 = 1.3 PI-N = 40,000/30,000 = 1.33 PI-O = 7,000/5,000 = 1.4 68. ZPS Models is considering a project that has a NINV of $564,000 and generates net cash flows of $105,000 per year for 10 years. What is the NPV of this project if ZPS has a cost of capital of 12.45%? a. $47,625 b. $18,503 c. $17,490 d. none of these ANSWER: b RATIONALE: Solution: NPV = –$564,000 + $582,503 = $18,503 (by calculator) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 69. Decode Genetics purchased lab equipment for $600,000 that will generate net cash flows of $130,000 per year for 10 years. What is the IRR for this project? a. 16.76% b. 17.26% c. 18.13% d. 17.76% ANSWER: b RATIONALE: Solution: IRR = 17.26 (by calculator) 70. What is the net present value of a project that has a net investment of $148,000 and net cash flows of $25,000 in the first year, $45,000 in years 2-7 and a negative net cash flow of $27,000 in year 8? Assume the cost of capital is 11 percent. a. $34,302 b. $74,847 c. $57,738 d. –$2,238 ANSWER: a RATIONALE: Solution: NPV = $25,000(0.901) + $45,000(4.712 - 0.901) – $27,000(0.434) – $148,000 = $22,525 + $171,495 – $11,718 – $148,000 = $34,302 71. What is the internal rate of return for a project that has a net investment of $169,165 and net cash flows of $25,000 in the first year and 40,000 in years 2-7? a. 2.5% b. 13% c. 12% d. 13.5% ANSWER: c RATIONALE: Solution: IRR = 12% (calculator) 72. What is the internal rate of return for a project that has a net investment of $60,000 and the following net cash flows: Year 1 = $15,000; Year 2 = $20,000; Year 3 = $25,000; Year 4 = $30,000? a. 17.3% b. 16.7% c. 15.7% d. 16.3% ANSWER: d RATIONALE: Solution: IRR = 16.3% (calculator) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 73. Road Hawk Inc. is adding a new production line that will cost $720,000. The line will be depreciated on a straight- line basis over a 7-year period and will generate net cash flows of $160,000 in each of the 7 years. At the end of the project, it is expected the line can be sold as scrap for $10,000. If the firm’s marginal tax rate is 40% and its required rate of return is 14 percent, what is the net present value of this project? a. $70,091 b. –$27,920 c. $64,091 d. –$31,520 ANSWER: d RATIONALE: Solution: NPV = –$720,000 + $160,000(4.288) + $10,000(0.6)(0.400) = –$31,520 74. Consider a capital expenditure project that has forecasted revenues equal to $32,000 per year; cash expenses are estimated to be $29,000 per year. The cost of the project equipment is $23,000, and the equipment’s estimated salvage value at the end of the project is $9,000. The equipment’s $23,000 cost will be depreciated on a straight-line basis to $0 over a 10-year estimated economic life. Assume that the project requires an initial $7,000 working capital investment. The company’s marginal tax rate is 30%. Calculate the project’s net present value using a 12% discount rate. a. about –$10,610 b. about –$12,530 c. about –$9,954 d. about +$9,462 ANSWER: c RATIONALE: Solution: NINV = $23,000 + $7,000 = $30,000 NCF1-9 = ($32,000 – $29,000 – $2,300)(1 – 0.3) + $2,300 = $2,790 NCF10 = $2,790 + $7,000 + 9,000(0.7) = $16,090 NPV = –$9,954 (using calculator) 75. Calculate the net present value for an investment project with the following cash flows using a 12 percent cost of capital: Year 0 1 2 3 Net Cash Flow –$100,000 $80,000 $80,000 –$30,000 a. $56,560 b. $30,000 c. $13,840 d. cannot be determined with information given ANSWER: c RATIONALE: Solution: NPV = ΣNCFt - NINV = $80,000(0.893) + 80,000(0.797) – $30,000(0.712) – $100,000 = $13,840 38. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 76. Ecogen is considering the purchase of some new equipment that will cost $340,000 installed. The equipment will produce a product that must be FDA approved and this will require at least a year. Net cash flow in Year 1 will be a negative $110,000 but is expected to be a positive $50,000 in Year 2. Net cash flows will be $150,000, $240,000, and $330,000 in the next 3 years. At the end of 5 years the equipment and the product will be obsolete. If the firm’s marginal tax rate is 40% and their costs of capital is 15%, should they invest in the new equipment? a. Yes, NPV = $2,090 b. Yes, NPV = $12,390 c. No, NPV = –$63,210 d. No, NPV = –$12,210 ANSWER: a RATIONALE: Solution: NPV = –$340,000 – $110,000(0.870) + $50,000(0.756) + $150,000(0.658) + $240,000(0.572) + $330,000(0.497) = $2,090 77. G-III Apparel is considering increasing the size of a warehouse. The cost of the expansion is $825,000 and the increase in inventories and accounts payable will be $410,000 and $360,000 respectively. G-III expects that the expansion will increase net cash flows by $150,000 a year for the next 5 years and $200,000 a year for years 6-12. G-III has a 14% cost of capital and a marginal tax rate of 35%. What is the NPV of the warehouse expansion? a. –$3,450 b. $60,050 c. $10,050 d. –$338,570 ANSWER: c RATIONALE: Solution: NPV = –$825,000 – $410,000 + $360,000 + $150,000(3.433) + $200,000(5.216 – 3.433) + $50,000(0.270) = $10,050 78. What is the internal rate of return for a project that has a net investment of $370,000 and net cash flows of $60,000 in year 1, $75,000 in year 2, and $85,000 in years 3 through 8? a. 15.5% b. 13.6% c. 17.4% d. none of these are correct ANSWER: b RATIONALE: Solution: if r = 13% if r = 14% NINV = –$370,000 = –$370,000 60,000(0.885) = 53,100 (0.877) = $ 52,620 75,000(0.783) = 58,725 (0.769) = 57,675 85,000(4.799 – 1.668) = 266,135 (4.639 – 1.647) = 254,320 NPV = $ 7,960 NPV = –$ 5,385 r = 13% + (14% – 13%) = 13.596 or 13.6% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 79. Rollerblade, a manufacturer of skating gear, plans to expand its operation in Brighton, England. The expansion will cost $18.5 million and is expected to generate annual net cash flows of 2.2 million pounds for a period of 15 years and nothing thereafter. The cost of capital for the project is 16%. Using the spot exchange rate of $1.60 per British pound, compute the net present value of the expansion project. a. –$6.235 million b. $2.458 million c. $1.124 million d. –$10.83 million ANSWER: c RATIONALE: Solution: PVNCF = £2.2(PVIFA0.16,15) = £12.265 pounds PVNCFh = £12.265($1.60/£) = $19.624 NPV = $19.624 – $18.5 = $1.124 (million) 80. Zimmer, a manufacturer of modular rooms, plans to expand its operation in Landshut, Germany. The expansion will cost $14.5 million and is expected to generate annual net cash flows of DM4.5 million for a period of 12 years and then the operation will be sold for DM2 million. The cost of capital for the project is 14%. Using the spot exchange rate of $0.60 per DM, compute the NPV of this expansion project. a. $0.78 million b. $1.03 million c. $2.58 million d. $11.39 million ANSWER: b RATIONALE: Solution: PVNCF = DM4.5(5.660) + DM2(0.208) = DM25.886 million PVNCFh = DM25.886($0.60/DM) = $15.5316 NPV = $15.5316 - $14.5 = $1.0316 (million) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 81. A digital assembly system that costs $160,000 is expected to operate for 8 years. The estimated salvage value at the end of 8 years is $12,000. The system is expected to save the company $38,000 in labor costs before taxes and depreciation. The company will depreciate this system on a 5-year MACRS schedule. If the firm’s cost of capital is 12% and its marginal tax rate is 35%, compute the NPV for the project. (Note: Requires MACRS tables) a. $4,045 b. $7,196 c. $20,873 d. $167,196 ANSWER: b RATIONALE: Solution: NPV = $ 7,196 82. TexMex is considering replacing its tortilla machine with a new model that sells for $46,000 including the cost of installation. The old machine has been fully depreciated and has a $0 salvage value. The new machine will be depreciated as a 3-year MACRS asset. Revenues are expected to increase $18,000 per year over the 5 year life of the new machine. At the end of 5 years the new machine is expected to have no salvage value. What is the IRR for this project if TexMex has a required rate of return of 14% and a marginal tax rate of 40%? Operating costs are not expected to increase from the current level of $8,000 per year. a. 21.0% b. 14.0% c. 19.3% d. 5.7% ANSWER: c RATIONALE: Solution: Year NCF 1 ($18,000 – $15,332)(0.60) + $15,332 = $16,933 2 ($18,000 – $20,447)(0.60) + $20,447 = $18,979 3 ($18,000 – $6,813)(0.60) + $6,813 = $13,525 4 ($18,000 – $3,409)(0.60) + $3,409 = $12,164 5 ($18,000 – $0)(0.60) + $0 = $10,800 By calculator, the IRR = 19.27% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 83. Colex wishes to bid on a contract that is expected to yield after-tax net cash flows of $25,000 in year 1, $30,000 in year 2, and $35,000 per year in years 3-8. To obtain the contract, Colex will need to invest $110,000 to reconfigure a packaging system, $20,000 (after-tax) to retrain current employees, and $15,000 (after-tax) on an environmental impact study that is required to be completed on acceptance of the contract. What is the project’s internal rate of return? a. 16.7% b. 14.1% c. 16.2% d. 14.9% ANSWER: d RATIONALE: Solution: NINV = $110,000 + $20,000 + $15,000 = $145,000 NCF1 = $25,000 NCF2 = $30,000 NCF3-8 = $35,000 IRR = 14.9% by calculator 84. Which of the following statements about comparing capital budget techniques is/are correct? I. The payback period is easy to understand and helps the firm identify how long it will be unable to use the initial investment for other projects. II. Mutually exclusive projects allow a firm to do other like projects (mutually exclusive) simultaneously as long as the budget restraints are met. a. I only b. II only c. Both I and II d. Neither I nor II ANSWER: a 85. Which of the following statements about comparing the techniques of net present value (npv) and internal rate of return (irr) is/are correct? I. The net present value assumes that all cash flows are reinvested at the cost of capital and is therefore realistic. II. The internal rate of return is stated as a percent and is therefore easy to communicate to decision-makers who may not understand the fine points of finance. a. I only b. II only c. Both I and II d. Neither I nor II ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 86. What is the net present value of the following project if the required rate of return is 15%? The initial investment is $150,000 Years Cash Flows 1 $30,000 2 $80,000 3 $100,000 4 $200,000 a. $203,690 b. $180,665 c. $150,000 d. $116,681 ANSWER: d 87. Should the following project be accepted if the cost of capital is 12%? Initial Investment is $50,000 Years Cash Flows 1 $25,000 2 $35,000 3 $55,000 a. Yes, because the internal rate of return is 10.5% which is less than 12%. b. Yes, because the internal rate of return is 35% which is more than 12%. c. No, because the internal rate of return is 8.7% which is less than 12%. d. Yes, because the internal rate of return is 48% which is more than 12%. ANSWER: d 88. In comparing the techniques of net present value and internal rate of return: a. The npv and irr techniques will generate the same accept-reject decision provided the projects have conventional cash flows. b. The differences between the underlying assumptions of npv and irr can cause them to rank projects differently. c. Both a and b d. Neither a nor b ANSWER: c 89. In considering the payback period: a. The maximum period allowed by a firm is a specific time period based on objective criteria. b. It considers the time value of money in determining the maximum allowable time period. c. It gives some indication of a project’s desirability from a liquidity viewpoint. d. It is based on cash flows both during and after the payback period. ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 90. In considering the payback method, a. It is a method of determining the financial exposure of a firm for a project. b. It is a complicated but accurate capital budgeting method. c. Both a and b are correct. d. Neither a nor b is correct. ANSWER: a 91. The payback method has all of the following advantages EXCEPT: a. It considers the time value of money b. It determines a firm’s financial exposure c. It is easy to calculate d. It determines if the project under consideration will be able to replace the start-up costs. ANSWER: a 92. A weakness of the payback period is that it disregards: a. Projects with shorter payback periods b. Cash flows during the payback period c. Start-up costs d. The time value of money ANSWER: d 93. Real options in capital budgeting can be classified. The classification that means that the project is delayed and can be termed “waiting to invest” is: a. Investment timing option b. Abandonment option c. Shutdown option d. Growth option ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 94. Barnacle Bob’s Fish and Tackle Shop is planning an expansion. The initial investment is $480,000 and anticipates cash inflows as listed below. The cost of capital is 12.2%. Based on the profitability index, should Barnacle Bob go ahead with the project? Years Cash Inflows 1 $ 90,000 2 105,000 3 105,000 4 195,000 5 195,000 6 195,000 a. No, the profitability index is 2. b. No, the profitability index is.95 c. Yes, the profitability index is 1.18 d. Yes, the profitability index is.78 ANSWER: c RATIONALE: Find the net present value of the cash flows. Solution using a financial calculator (TI BAII) CF0 = 0 CF1 = 90,000 F1 = 1 CF2 = 105,000 F2 = 2 CF3 = 195,000 F3 = 3 I = 12.2 Compute NPV = $568,410.60 568,410.60/480,000 = 1.18 95. Based upon the following cash flows, should Ooey Gooey Candy Makers introduce a new product, Skinny Minnie Diet Cuisine? The initial investment is $780,000 and the cost of capital is 12.2%. Years Cash Flows 1 $ 90,000 2 105,000 3 105,000 4 195,000 5 195,000 6 195,000 a. Yes, the npv is $288,410.60 and the irr is 38.2%. b. Yes, the npv is $175,478.98 and the irr is 20.42%. c. No, the npv is -$211,589.40 and the irr is 3.24%. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations d. No, the npv is -$75,375.18 and the irr is 11.75%. ANSWER: c 96. Based upon the following cash flows, should Chipper Nipper Cookie Company introduce a new product, Rolling In Dough Pies? The initial investment is $180,000 and the cost of capital is 11.5%. Years Cash Flows 1 $ 80,000 2 95,000 3 95,000 4 110,000 5 110,000 6 110,000 a. Yes, the rounded npv is $228, 940 and the irr is 46.62% b. Yes, the rounded npv is $75,428.63 and the irr is 12.27% c. No, the rounded npv is -$57,277.32 and the irr is 8.75% d. No, the rounded npv is -$221,275.39 and the irr is 9.97% ANSWER: a 97. List the advantages and disadvantages of the payback method. ANSWER: The advantages of the payback method are: 1. It is easy and inexpensive to use. 2. It provides a crude measure of project risk. 3. It provides a measure of project liquidity. The disadvantages of the payback method are: 1. There is no objective decision criterion. 2. It gives equal weight to all cash flows within the payback period, regardless of when they occur during the period. It ignores the time value of money. 3. It ignores cash flows occurring after the payback period. 98. Why is the net present value method of evaluating projects better than the internal rate of return method? ANSWER: The net present value method is better for the following reasons: 1. The internal rate of return method can produce multiple internal rates of return which cannot be compared to the firm’s cost of capital in determining a project’s acceptability. 2. The net present value assumes that cash flows are reinvested at the firm’s cost of capital, whereas the internal rate of return method assumes that these cash flows are reinvested at the computed internal rate of return. The cost of capital is considered a more realistic reinvestment rate than the computed internal rate of return. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 99. Explain why the internal rate of return method is more popular than the net present value method. What are some potential problems with relying on the IRR method? ANSWER: The internal rate of return method is more popular because some people feel more comfortable dealing with the concept of a project’s percentage rate of return than with its dollar amount of net present value. The internal rate of return takes into account both the timing and magnitude of cash flows over the entire life of the project in measuring the project’s economic desirability. In spite of this, it is possible to have multiple internal rates of return. Net present value will yield only one internal rate of return. The reinvestment rate of the internal rate of return method is less realistic. 100. How does the profitability index differ from the net present value and when would each method be preferred? ANSWER: The profitability index is the benefit-cost ratio, the ratio of the present value of expected net cash flows over the life of a project to the net investment. When dealing with mutually exclusive investments, conflicts may arise between the net present value and the profitability index criteria. When a conflict arises, the final decision is based on other factors. If there is no capital rationing, the net present value approach is preferred because it will select the projects that are expected to generate the largest total dollar increase in the firm’s wealth and thus maximize shareholder wealth. If the firm must do capital rationing, and capital budgeting id being done for only one period, the profitability index approach may be preferred because it will indicate which projects will maximize the returns per dollar of investment. 101. In working with capital budgeting, what does a post-audit do? ANSWER: A post-audit consists of comparing actual cash flows from an accepted project with projected cash flows that were estimated when the project was adopted. A project review should be concerned with identifying systematic biases or errors in cash flow estimation on the part of individuals, department, plants, or divisions and attempting to determine why these biases or errors exist. A good post-audit can help a company’s decision makers better evaluate investment proposals submitted in the future. 102. There are various reasons why companies may have difficulty in earning a positive net present value. These reasons include barriers to market entry and other factors. List these factors. ANSWER: Reasons why companies may have difficulty in earning a positive npv: 1. Buyer preferences for established brand names. 2. Ownership or control of favored distribution systems (such as exclusive dealerships). 3. Patent control of superior product designs or production techniques. 4. Exclusive ownership of superior natural resource deposits. 5. Inability of new firms to acquire necessary factors of production (management, labor, equipment). 6. Superior access to financial resources at lower costs (economies of scale in attracting capital). 7. Economies of large-scale production and distribution arising from: a. capital intensive production processes. b. high initial start up costs. 8. Access to superior labor or managerial talents at costs that are not fully reflective of their value. 9. Operating synergies when combining two companies in a merger. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10: Capital Budgeting: Decision Criteria and Real Option Considerations 103. Why are there differences in the capital expenditure analysis practice between large and entrepreneurial firms? ANSWER: There are many reasons why there are differences in the capital expenditure analysis practice between large and entrepreneurial firms: 1. Many entrepreneurs may simply lack the expertise needed to implement formal analysis procedures. 2. Managerial talent may tend to be stretched to its limits in many entrepreneurial firms, such that the managers simply cannot find the time to implement better project evaluation techniques. 3. Implementing and maintaining a sophisticated capital budgeting system is expensive. 4. In entrepreneurial firms investment projects tend to be small and cannot justify the cost of a complete formal analysis. 104. The choice to accept or reject projects based on the payback period is: a. an objective decision. b. as subjective decision. c. will always give the same results as using the net present value method. d. will always give the same results as using the internal rate of return method. ANSWER: b 105. The payback period can be considered justified on the basis of: a. it can account for the risk of the project. b. it can account for the time value of the project. c. it can account for the return on investment. d. it can account for the objective rationale of the project. ANSWER: a 106. When considering projects for implementation, management generally has three options. All of the following reflect possible managerial options EXCEPT: a. Management could attempt to find another combination of projects that would allow for a more complete utilization of available funds. b. Management could accept the current project or projects and hope that the preliminary analysis is correct. c. Management could choose to reject the projects under consideration and place the available funds in a short term security until the next period. d. Management could sell stock to raise sufficient capital to invest in the project if it is required to make it profitable. ANSWER: d 107. A firm’s capital expenditures may be limited due to externally imposed constraints. All of the following are external constraints EXCEPT: a. The firm’s loan agreements may contain restrictive restraints. b. The firm may decide to place an upper limit on the amount of funds allocated to capital investment. c. If the firm has a weak financial position, it may be too expensive to float a new bond issue. d. There may be market-imposed difficulties such as a tight money policy of the part of the Federal Reserve System. ANSWER: b © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.