Capital Budgeting Decisions—Part i

CHAPTER 7:

CAPITAL BUDGETING DECISIONS—PART I

Multiple Choice

d

1. Calculating the payback period for a capital project requires knowing which of the following? a. Useful life of the project. b. The company's minimum required rate of return. c. The project's NPV. d. The project's annual cash flow.

c

2. The payback criterion for capital investment decisions a. is conceptually superior to the IRR criterion. b. takes into consideration the time value of money. c. gives priority to rapid recovery of cash. d. emphasizes the most profitable projects.

a

3. Which of the following is NOT relevant in calculating annual net cash flows for an investment? a. Interest payments on funds borrowed to finance the project. b. Depreciation on fixed assets purchased for the project. c. The income tax rate. d. Lost contribution margin if sales of the product invested in will reduce sales of other products.

a

4. If the present value of the future cash flows for an investment equals the required investment, the IRR is a. equal to the cutoff rate. b. equal to the cost of borrowed capital. c. equal to zero. d. lower than the company's cutoff rate of return.

b

5. The relationship between payback period and IRR is that a. a payback period of less than one-half the life of a project will yield an IRR lower than the target rate. b. the payback period is the present value factor for the IRR. c. a project whose payback period does not meet the company's cutoff rate for payback will not meet the company's criterion for IRR. d. none of the above.

c

6. Which of the following events is most likely to reduce the expected NPV of an investment? a. The major competitor for the product to be manufactured with the machinery being considered for purchase has been rated "unsatisfactory" by a consumer group. b. The interest rate on long-term debt declines. c. The income tax rate is raised by the Congress. d. Congress approves the use of faster depreciation than was previously available.

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a

7. If a. b. c. d.

an investment has a positive NPV, its IRR is greater than the company's cost of capital. cost of capital exceeds the cutoff rate of return. its IRR is less than the company's cutoff rate of return. the cutoff rate of return exceeds cost of capital.

c

8. Which of the following describes the annual returns that are discounted in determining the NPV of an investment? a. Net incomes expected to be earned by the project. b. Pre-tax cash flows expected from the project. c. After-tax cash flows expected from the project. d. After-tax cash flows adjusted for the time value of money.

b

9. Which of the following capital budgeting methods does NOT consider the time value of money? a. IRR. b. Book rate of return. c. Time-adjusted rate of return. d. NPV.

b 10. All other things being equal, as cost of capital increases a. more capital projects will probably be acceptable. b. fewer capital projects will probably be acceptable. c. the number of capital projects that are acceptable will change, but the direction of the change is not determinable just by knowing the direction of the change in cost of capital. d. the company will probably want to borrow money rather than issue stock. d 11. Which of the following is a basic difference between the IRR and the book rate of return (BRR) criteria for evaluating investments? a. IRR emphasizes expenses and BRR emphasizes expenditures. b. IRR emphasizes revenues and BRR emphasizes receipts. c. IRR is used for internal investments and BRR is used for external investments. d. IRR concentrates on receipts and expenditures and BRR concentrates on revenues and expenses. a 12. If a. b. c. d.

a project has a payback period shorter than its life, its NPV may be negative. its IRR is greater than cost of capital. it will have a positive NPV. its incremental cash flows may not cover its cost.

c 13. Cost of capital is a. the amount the company must pay for its plant assets. b. the dividends a company must pay on its equity securities. c. the cost the company must incur to obtain its capital resources. d. the cost the company is charged by investment bankers who handle the issuance of equity or long-term debt securities. d 14. The normal methods of analyzing investments a. cannot be used by not-for-profit entities. b. do not apply if the project will not produce revenues.

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c. cannot be used if the company plans to finance the project with funds already available internally. d. require forecasts of cash flows expected from the project. a 15. Which a. It b. It c. It d. It

of the following is NOT a defect of the payback method? ignores cash flows because it uses net income. ignores profitability. ignores the present values of cash flows. ignores the pattern of cash flows beyond the payback period.

b 16. A company with cost of capital of 15% plans to finance an investment with debt that bears 10% interest. The rate it should use to discount the cash flows is a. 10%. b. 15%. c. 25%. d. some other rate. c 17. Which of the following events will increase the NPV of an investment involving a new product? a. An increase in the income tax rate. b. An increase in the expected per-unit variable cost of the product. c. An increase in the expected annual unit volume of the product. d. A decrease in the expected salvage value of equipment. b 18. An investment has a positive NPV discounting the cash flows at a 14% cost of capital. Which statement is true? a. The IRR is lower than 14%. b. The IRR is higher than 14%. c. The payback period is less than 14 years. d. The book rate of return is 14%. a 19. The technique most concerned with liquidity is a. payback. b. NPV. c. IRR. d. book rate of return. d 20. The technique that does NOT use cash flows is a. payback. b. NPV. c. IRR. d. book rate of return. a 21. If a. b. c. d.

there were no income taxes, depreciation would be ignored in capital budgeting. the NPV method would not work. income would be discounted instead of cash flow. all potential investments would be desirable.

a 22. Two new products, X and Y, are alike in every way except that the sales of X will start low and rise throughout its life, while those of Y will be the same each year. Total volumes over their five-year lives will be the same, as will selling prices, unit variable costs, cash fixed costs,

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and investment. The NPV of product X a. will be less than that of product Y. b. will be the same as that of product Y. c. will be greater than that of product Y. d. none of the above. d 23. Which of the following events is most likely to increase the number of investments that meet a company's acceptance criteria? a. Top management raises the target rate of return. b. The interest rate on long-term debt rises. c. The income tax rate rises. d. The IRS allows companies to expense purchases of fixed assets, instead of depreciating them over their lives. d 24. Investment A has a payback period of 5.4 years, investment B one of 6.7 years. From this information we can conclude a. that investment A has a higher NPV than B. b. that investment A has a higher IRR than B. c. that investment A's book rate of return is higher than B's. d. none of the above. d 25. Investment A has a book rate of return of 26%, investment B one of 18%. From this information we can conclude a. that investment A has a higher NPV than B. b. that investment A has a higher IRR than B. c. that investment A has a shorter payback period than B. d. none of the above. c 26. A dollar now is worth more than a dollar to be received in the future because of a. inflation. b. uncertainty. c. the opportunity cost of waiting. d. none of the above. a 27. In contrast to the payback and book rate of return methods, the NPV and IRR methods a. consider the time value of money. b. ignore depreciation. c. use after-tax cash flows. d. all of the above. a 28. Which of the following is a discounted cash flow method? a. NPV. b. Payback. c. Book rate of return. d. All of the above. a 29. Which statement cash flows? a. Depreciation b. Depreciation c. Depreciation d. Depreciation

describes the relevance of depreciation in calculating is is is is

relevant only when income taxes exist. always relevant. never relevant. relevant only with discounted cash flow methods.

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b 30. As a. b. c. d.

the discount rate increases present value factors increase. present value factors decrease. present value factors remain constant. it is impossible to tell what happens to the factors.

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a 31. As a. b. c. d.

the length of an annuity increases present value factors increase. present value factors decrease. present value factors remain constant. it is impossible to tell what happens to present value factors.

a 32. The only future costs that are relevant to deciding whether to accept an investment are those that will a. be different if the project is accepted rather than rejected. b. be saved if the project is accepted rather than rejected. c. be deductible for tax purposes. d. affect net income in the period that they are incurred. a 33. Which of the following is true of an investment? a. The lower the cost of capital, the higher the NPV. b. The lower the cost of capital, the higher the IRR. c. The longer the project's life, the shorter its payback period. d. The higher the project's NPV, the shorter its life. c 34. Which of the following methods FAILS to distinguish between return of investment and return on investment? a. NPV. b. IRR. c. Payback. d. Book rate of return. c 35. If a company is NOT subject to income tax, which of the following is true of a proposed investment? a. The project's IRR equals the entity's cost of capital. b. The project's NPV is zero. c. Depreciation on assets required for the project is irrelevant to the evaluation. d. The expected annual increase in future cash flows equals the investment required to undertake the project. d 36. Which of the following increases NPV and IRR? a. An upward revision in expected annual net cash flows. b. An upward revision of expected life. c. An upward revision of the residual value of the long-lived assets being acquired for the project. d. All of the above. d 37. Qualitative issues could increase the acceptability of a project under which of the following conditions? a. The IRR is less than the company's cutoff rate. b. The project has a negative NPV. c. The payback period is longer than the company's cutoff period. d. All of the above. a 38. If Co. X wants to use IRR to evaluate long-term decisions and to establish a cutoff rate of return, X must be sure the cutoff rate is a. at least equal to its cost of capital. b. at least equal to the rate used by similar companies. c. greater than the IRR on projects accepted in the past.

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d. greater than the current book rate of return.

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a 39. Which of the following is NOT relevant in calculating net cash flows for Project N? a. Interest payments on funds that would be borrowed to finance Project N. b. Depreciation on assets purchased for Project N. c. The contribution margin the company would lose if sales of the product introduced by Project N will reduce sales of other products. d. The income tax rate applicable to the entity. b 40. If a. b. c. d.

the IRR on an investment is zero, its NPV is positive. its annual cash flows equal its required investment. it is generally a wise investment. its cash flows decrease over its life.

d 41. If depreciation on a new asset exceeds its savings in cash operating costs, which of the following is true? a. The project is usually unacceptable. b. The annual after-tax cash flow on the new asset will be greater than the savings in cash operating costs. c. The project has a negative NPV. d. All of the above. d 42. Cost of capital is a. the interest rate an entity must pay to borrow money. b. the return an entity's stockholders expect on their investment. c. the rate of return the entity can earn from investing available cash. d. a concept of managerial finance incorporating all of the above ideas. b 43. An investment opportunity costing $75,000 is expected to yield net cash flows of $23,000 annually for five years. The NPV of the investment at a cutoff rate of 14% would be a. $(3,959). b. $3,959. c. $75,000. d. $78,959. b 44. An investment opportunity costing $55,000 is expected to yield net cash flows of $22,000 annually for five years. The payback period of the investment is a. 0.4 years. b. 2.5 years. c. $33,000. d. some other number. c 45. An investment opportunity costing $180,000 is expected to yield net cash flows of $53,000 annually for five years. The IRR of the investment is between a. 10 and 12%. b. 12 and 14%. c. 14 and 16%. d. 16 and 18%.

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b 46. An investment opportunity costing $150,000 is expected to yield net cash flows of $45,000 annually for five years. The cost of capital is 10%. The book rate of return would be a. 10%. b. 20%. c. 30%. d. 33.3%. a 47. An investment opportunity costing $150,000 is expected to yield net cash flows of $36,000 annually for six years. The NPV of the investment at a cutoff rate of 12% would be a. $(2,004). b. $2,004. c. $150,000. d. $147,996. c 48. An investment opportunity costing $100,000 is expected to yield net cash flows of $22,000 annually for seven years. The payback period of the investment is a. 0.22 years. b. 3.08 years. c. 4.55 years. d. some other number. a 49. An investment opportunity costing $200,000 is expected to yield net cash flows of $39,000 annually for eight years. The IRR of the investment is between a. 10 and 12%. b. 12 and 14%. c. 14 and 16%. d. 16 and 18%. b 50. An investment opportunity costing $80,000 is expected to yield net cash flows of $25,000 annually for four years. The cost of capital is 10%. The book rate of return would be a. 10.0%. b. 12.5%. c. 21.3%. d. 32.0%.

True-False

T

1. Payback period is the length of time it will take a company to recoup its outlay for an investment.

T

2. Discounted cash flow techniques apply to investments that involve either costs only, or both costs and revenues.

F

3. Cost of capital is the interest rate that a company expects to pay to finance a particular capital investment project.

F

4. The higher the cost of capital, the higher the present value of future cash inflows.

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F

5. If the IRR on a capital project is positive, its NPV will be positive.

T

6. Salvage value is usually ignored in computing the tax depreciation on an investment in depreciable assets.

F

7. IRR can be computed for even cash flows, but not for uneven cash flows.

T

8. If IRR is less than the cost of capital, the NPV will be negative.

F

9. IF NPV is negative, IRR is equal to the cost of capital.

T 10. Payback emphasizes the return of the investment and ignores the return on the investment.

Problems

1. An investment opportunity costing $180,000 is expected to yield net cash flows of $60,000 annually for five years. a. Find the NPV of the investment at a cutoff rate of 12%. b. Find the payback period of the investment. c. Find the IRR on the investment.

SOLUTION: a. NPV:

$36,300

b. Payback period: c. IRR:

[(3.605 x $60,000) - $180,000] 3 years

between 18 % and 20%

($180,000/$60,000) (3.0 is between 3.127 and 2.991)

2. Tofte is considering the purchase of a machine. Data are as follows: Cost Useful life Annual straight-line depreciation Expected annual savings in cash operation costs

$100,000 10 years $ 10,000 $ 18,000

Tofte's cutoff rate is 12% and its tax rate is 40%. a. Compute the annual net cash flows for the investment. b. Compute the NPV of the project.

SOLUTION:

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a. Annual net cash flows: $10,000 depreciation)] b. NPV:

Negative $16,380

$14,800

[$18,000 pretax - 40% x ($18,000 -

[($14,800 x 5.650) - $100,000]

3. Willow Company is considering the purchase of a machine with the following characteristics. Cost Estimated useful life Expected annual cash cost savings

$150,000 10 years $35,000

Marquette's tax rate is 40%, its cost of capital is 12%, and it will use straight-line depreciation for the new machine. a. Compute the annual after-tax cash flows for this project. b. Find the payback period for this project.

SOLUTION: a. Annual cash flows: b. Payback period:

$27,000

5.56 years

[$35,000 - 40% x ($35,000 - $15,000)] ($150,000/$27,000)

4. Bilt-Rite Co. has the opportunity to introduce a new product. Bilt-Rite expects the product to sell for $60 and to have per-unit variable costs of $40 and annual cash fixed costs of $3,000,000. Expected annual sales volume is 250,000 units. The equipment needed to bring out the new product costs $5,000,000, has a four-year life and no salvage value, and would be depreciated on a straight-line basis. Bilt-Rite's cost of capital is 10% and its income tax rate is 40%. a. Find the increase in annual after-tax cash flows for this opportunity. b. Find the payback period on this project. c. Find the NPV for this project.

SOLUTION: a. Increase in annual cash flows:

$1,700,000

Income before taxes, 250,000 x ($60 - $40) - $3,000,000 - $5,000,000/4 Income tax   Net income Plus depreciation

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$

750,000 (300,000) ---------$ 450,000 1,250,000

  Net cash flow  

---------$1,700,000 ==========

b. Payback period:

2.94 years

c. NPV:

[($1,700,000 x 3.170) - $5,000,000]

$389,000

($5,000,000/$1,700,000)

5. An investment opportunity costing $600,000 is expected to yield net cash flows of $120,000 annually for ten years. a. Find the NPV of the investment at a cutoff rate of 12%. b. Find the payback period of the investment. c. Find the IRR on the investment.

SOLUTION: a. NPV:

$78,000

b. Payback period: c. IRR:

15%

[(5.650 x $120,000) - $600,000] 5 years

($600,000/$120,000)

(5.0 is about halfway between 5.216 and 4.833)

6. Scottso has an investment opportunity costing $300,000 that is expected to yield the following cash flows over the next six years: Year Year Year Year Year Year

One Two Three Four Five Six

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

a. Find the payback period of the investment. b. Find the book rate of return of the investment. c. Find the NPV of the investment at a cutoff rate of 10%.

SOLUTION: a. Payback period:

3.15 years

b. Book rate of return: Average return: Depreciation:  

(75,000 + 90,000 + 115,000 + .15 x 130,000)

33.3%

$100,000 ($600,000 total / 6 years) 50,000 ($30,000 / 6 years) -------

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Average income

$50,000

Average investment: $300,000 / 2 = $150,000 Book rate of return = $50,000 / 150,000 = 33.3% c. NPV: $130,530

1 2 3 4 5 6

Cash -----75,000 90,000 115,000 130,000 100,000 90,000

Factor -----.909 .826 .751 .683 .621 .564

Investment NPV

PV -----68,175 74,340 86,365 88,790 62,100 50,760 ------430,530 300,000 ------130,530 ======

7. Acme is considering the purchase of a machine. Data are as follows: Cost Useful life Annual straight-line depreciation Expected annual savings in cash operation costs

$160,000 10 years $ ??? $ 33,000

Acme's cutoff rate is 12% and its tax rate is 40%. a. Compute the annual net cash flows for the investment. b. Compute the NPV of the project. c. Compute the IRR of the project.

SOLUTION: a. Annual net cash flows: $16,000 depreciation)] b. NPV:

$26,200

Negative $11,970

c. IRR: between 10% and 12% 6.145 and 5.650]

[$33,000 pretax - 40% x ($33,000 -

[($26,200 x 5.650) - $160,000] [factor of 6.107 (160,000/26,200) is between

8. Scottso has an investment opportunity costing $180,000 that is expected to yield the following cash flows over the next five years:

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Year Year Year Year Year

One Two Three Four Five

$ $ $ $ $

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

a. Find the payback period of the investment. b. Find the book rate of return of the investment. c. Find the NPV of the investment at a cutoff rate of 12%.

SOLUTION: a. Payback period:

3.0 years

b. Book rate of return: Average return: Depreciation:   Average income

(30,000 + 60,000 + 90,000)

20%

$54,000 ($270,000 total / 5 years) 36,000 ($180,000 / 5 years) -----$18,000

Average investment: $180,000 / 2 = $90,000 Book rate of return = $18,000 / $90,000 = 20% c. NPV: $6,930

1 2 3 4 5

Cash -----30,000 60,000 90,000 60,000 30,000

Investment NPV

Factor -----.893 .797 .712 .636 .567

PV -----26,790 47,820 64,080 38,160 17,010 ------193,860 180,000 ------13,860 ======

9. Reno Company is considering the purchase of a machine with the following characteristics. Cost Estimated useful life Expected annual cash cost savings Expected salvage value

$160,000 5 years $56,000 none

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Reno's tax rate is 40%, its cost of capital is 12%, and it will use straight-line depreciation for the new machine. a. Compute the annual after-tax cash flows for this project. b. Find the payback period for this project. c. Compute the NPV for this project.

SOLUTION: a. Annual cash flows: b. Payback period: c. NPV: $7,272

$46,400

3.45 years

[$56,000 - 40% x ($56,000 - 32,000)] ($160,000/$46,400)

[($46,400 x 3.605) - $160,000]

10. Whitehall Co. has the opportunity to introduce a new product. Whitehall expects the project to sell for $40 and to have per-unit variable costs of $27 and annual cash fixed costs of $1,500,000. Expected annual sales volume is 200,000 units. The equipment needed to bring out the new product costs $3,500,000, has a four-year life and no salvage value, and would be depreciated on a straight-line basis. Whitehall's cutoff rate is 10% and its income tax rate is 40%. a. Find the increase in annual after-tax cash flows for this opportunity. b. Find the payback period on this project. c. Find the NPV for this project.

SOLUTION: a. Increase in annual cash flows:

$1,100,000

Income before taxes, [200,000 x ($40 - $27) - $1,500,000 - $3,500,000/4] Income tax   Net income Plus depreciation   Net cash flow   b. Payback period:

3.47 years

c. NPV: negative $298,300

$

225,000 ( 90,000) ---------$ 135,000 875,000 ---------$1,010,000 ==========

($3,500,000/$1,010,000)

[($1,010,000 x 3.170) - $3,500,000]

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