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Financial Management: Core Concepts, 3e, GE (Brooks)
Chapter 9 Capital Budgeting Decision Models
9.1 Short-Term and Long-Term Decisions
1) ________ is at the heart of corporate finance, because it is concerned with making the best choices about
project selection.
A) Capital budgeting
B) Capital structure
C) Payback period
D) Short-term budgeting
Answer: A
Diff: 2
Topic: 9.1 Short-Term and Long-Term Decisions
AACSB: 6 Reflective Thinking
LO: 9.1 Explain capital budgeting and differentiate between short-term and long-term budgeting decisions.
Hmwrk Questions: * Taken from "Prepping for Exams" questions at the end of the chapter.
2) The ________ model is usually considered the best of the capital budgeting decision-making models.
A) internal rate of return (IRR)
B) net present value (NPV)
C) profitability index (PI)
D) discounted payback period
Answer: B
Diff: 1
3) We can separate short-term and long-term decisions into three dimensions. Which of the below is NOT
one of these?
A) Degree of information gathering prior to the decision
B) Cost
C) Personality of CEO making the decisions
D) Length of impact
Answer: C
Explanation: C) We can separate short-term and long-term decisions into three dimensions: 1. Length of
impact; 2. Cost; 3. Degree of information gathering prior to the decision.
Diff: 1
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4) Because money is often limited, companies must be careful to choose projects that are feasible and
profitable.
Answer: TRUE
Diff: 1
5) Capital budgeting decisions are typically long-term decisions.

Answer: TRUE
Diff: 1
6) Name and describe three key observations that we can make about the capital budgeting decision.
Answer: There are three key observations we can make about the capital budgeting decision:
1) A capital budgeting decision is typically a go or no-go decision on a product, service, facility, or
activity of the firm. That is, we either accept the business proposal or we reject it. The choice of accepting
or rejecting a proposed project is the cornerstone of financial management at all levels of a business.
2) A capital budgeting decision will require sound estimates of the time and amount of appropriate cash
flow for the proposal. Thus, the appropriate future cash flow is a necessary input into all capital
budgeting decisions.
3) The capital budgeting model has predetermined accept or reject criteria. We need to examine the
validity of these criteria within each decision model.
Diff: 3
9.2 Payback Period
1) The ________ model answers one basic question: How soon will I recover my initial investment?
A) payback period
B) IRR
C) NPV
D) profitability index
Answer: A
Diff: 1
Topic: 9.2 Payback Period
LO: 9.2 Explain the payback period model and its two significant weaknesses and how the discounted payback
period model addresses one of the problems.
2
2) The ________ model determines at what point in time cash outflow is recovered by the corresponding
future cash inflow.
A) NPV
B) buyback
C) net present value
D) payback period
Answer: D
Diff: 1
3) Consider the following four-year project. The initial after-tax outlay or after-tax cost is $1,000,000. The
future after-tax cash inflows for years 1, 2, 3 and 4 are: $400,000, $300,000, $200,000 and $200,000,
respectively. What is the payback period without discounting cash flows?
A) 2.5 years
B) 3.0 years
C) 3.5 years
D) 4.0 years
Answer: C
Explanation: C) We can see that after three years, we will have paid back $900,000. Thus, we only need
$100,000 in after-tax cash flows in the 4th year. Because we get $200,000 in the fourth year, the rule of
thumb is to divide what is needed by the cash inflows we will get next period and add the results to the
number of previous periods of cash inflows, e.g., ($100,000 divided by $200,000) + 3 which gives 3.500.
Thus, the payback period is 3.5 years.
Diff: 2
AACSB: 3 Analytical Thinking
4) Consider the following ten-year project. The initial after-tax outlay or after-tax cost is $1,000,000. The
future after-tax cash inflows each year for years 1 through 10 are $200,000 per year. What is the payback
period without discounting cash flows?
A) 10 years
B) 5 years
C) 2.5 years
D) 0.5 years
Answer: B
Explanation: B) $1,000,000/$200,000 per year = 5 years.
Diff: 1
3
5) The initial outlay or cost is $1,000,000 for a four-year project. The respective future cash inflows for
years 1, 2, 3 and 4 are: $500,000, $300,000, $300,000 and $300,000. What is the payback period without
discounting cash flows?
A) About 2.50 years
B) About 2.67 years
C) About 3.67 years
D) About 4.50 years
Answer: B
Explanation: B) We can see that after two years, we will have paid back $800,000. Thus, we only need
$200,000 in after-tax cash flows in the third year. Since we get $300,000 in the third year, the rule of thumb
is to divide what is needed by the cash inflows we will get next period and add the results to the number
of previous periods of cash inflows, e.g., ($200,000 divided by $300,000) + 2, which gives about 2.67. Thus,
the payback period is about .
Diff: 3
6) Acme, Inc. is considering a four-year project that has an initial outlay or cost of $100,000. The respective
future cash inflows from its project for years 1, 2, 3 and 4 are: $50,000, $40,000, $30,000 and $20,000. Will it
accept the project if it's payback period is 31 months?
A) Yes, because it pays back in 25 months.
B) Yes, because it pays back in 28 months.
C) No, because it pays back in over 31 months.
D) No, because it pays back in over 35 months.
Answer: B
Explanation: B) We can see that after two years, we will have paid back $90,000. Thus, we only need
$10,000 in after-tax cash flows in the third year. Since we get $30,000 in the third year, the rule of thumb is
to divide what is needed by the cash inflows we will get next period and add the result to the number of
previous periods of cash inflows, e.g., ($10,000 divided by $30,000) + 2. Doing this gives 2-1/3 years. The
payback period in months is 2-1/3 * 12 = 28 months. Thus, Acme can accept the project as it pays back
within 31 months.
Diff: 3
4
7) Which of the statements below is TRUE of the payback period method?
A) It ignores the cash flow after the initial outflow has been recovered.
B) It is biased against projects with early-term payouts.
C) It incorporates time-value-of-money principles.
D) It focuses on cash flows after the initial outflow has been recovered.
Answer: A
Explanation: A) By ignoring the cash flow after the initial outflow has been recovered, the payback
period is biased toward those projects that have higher early-year cash inflow and against those with
higher late-year inflow.
Diff: 2
8) Which of the statements below is FALSE?

A) Firms rarely use the payback period for small-dollar decisions.
B) Many companies use the payback period for small-dollar decisions because the time spent gathering
the accurate cash flow may be lowered substantially if it is necessary to estimate only through the first
few years.
C) Many companies use the payback period for small-dollar decisions because the future cash flows on
these smaller projects may be quite difficult to accurately estimate far into the future.
D) Many companies use the payback period for small-dollar decisions because it does prevent a serious
error when the future cash flow is insufficient to recover the initial cash outlay.
Answer: A
Explanation: A) Many companies use the payback period for small-dollar decisions. This is because for
small-dollar decisions, the time spent gathering the accurate cash flows may be lowered substantially if it
is necessary to estimate only through the first few years. The future cash flows on these smaller projects
may be quite difficult to accurately estimate far into the future. Therefore, the company establishes a short
arbitrary cut-off date for handling the initial screening of many small-dollar opportunities. And finally, it
does prevent a serious error when the future cash flow is insufficient to recover the initial cash outlay.
Diff: 2
5
9) The initial outlay or cost for a four-year project is $1,000,000. The respective cash inflows for years 1, 2,
3 and 4 are: $500,000, $300,000, $300,000 and $300,000. What is the discounted payback period if the
discount rate is 10%?
A) About 2.67 years
B) About 3.35 years
C) About 3.67 years
D) About 4.50 years
Answer: B
Explanation: B) We first discount all after-tax cash inflows, which gives us after-tax cash inflows of
$454,545.45, $247,933.88, $225,394.44 and $204,904.04. After three years, we will have paid back
$927,873.77 leaving $72,126.23 to pay back in after-tax cash flows in the fourth year. Since we get
$204,904.04 in the fourth year, the rule of thumb is to divide what is needed by the cash inflows we will
get next period and add it to the number of previous periods of cash inflows, e.g., ($72,126.23 divided by
$204,904.04) + 3. Doing this gives 3.352. Thus, the payback period is about 3.35 years.
Diff: 3
10) Acme, Inc. is considering a four-year project that has initial outlay or cost of $100,000. The respective
cash inflows for years 1, 2, 3 and 4 are: $50,000, $40,000, $30,000 and $20,000. Acme uses the discounted
payback period method, and has a discount rate of 11.50%. Will Acme accept the project if it's payback
period is 37 months?
A) Yes, because it pays back in less than 37 months.
B) No, because it pays back in over 37 months.
C) No, because it pays back in over 38 months.
D) No, because it pays back in over 40 months.
Answer: B
Explanation: B) We first discount all after-tax cash inflows, which gives us after-tax cash inflows of
$44,843.05, $32,174.39, $21,641.96, and $12,939.89. After three years or 36 months, we will have paid back
$98,659.40, leaving $1,340.60 to pay back in after-tax cash flows in the fourth year. Since we get $12,939.89
in the fourth year, the rule of thumb is to divide what is needed by the cash inflows we will get next
period and add it to the number of previous periods of cash inflows, e.g., ($1,340.60 divided by
$12,939.89) + 3. Doing this gives 3.104. Thus, the payback period in months is 3.104 × 12 = 37.243 months.
Because this is over 37 months, Acme does not accept the project.
Diff: 3
6
A) In order to account for the time value of money with the Payback Period Model, the future cash flow
needs to be restated in current dollars.
B) The Discounted Payback Period method is the time it takes to recover the initial investment in current
dollars.
C) When we discount a future cash flow with our standard time-value-of-money concepts, we inherently
assume that the entire cash flow was received at the end of the year.
D) The Payback Period method (with no discounting) is the dollar amount that it takes to recover the
initial investment in current dollars.
Answer: D
Explanation: D) The Discounted Payback Period method is the TIME it takes to recover the initial
investment in current dollars.
Diff: 2

A) To account for the time value of money with the Payback Period Model, the future cash flow needs to
be restated in current dollars.
B) The Discounted Payback Period method is the time it takes to recover the initial investment in future
dollars.
C) When we discount a future cash flow with our standard time-value-of-money concepts, we inherently
assume that the entire cash flow was received at the end of the year.
D) The Discounted Payback Period method does not correct for the cash flow after the recovery of the
initial outflow.
Answer: B
Explanation: B) The Discounted Payback Period method is the time it takes to recover the initial
investment in CURRENT dollars.
Diff: 2
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13) Consider the following four-year project. The initial outlay or cost is $180,000. The respective cash
inflows for years 1, 2, 3 and 4 are: $100,000, $80,000, $80,000 and $20,000. What is the discounted payback
period if the discount rate is 11%?
A) About 1.667 years
B) About 2.000 years
C) About 2.135 years
D) About 2.427 years
Answer: D
Explanation: D) We first discount all after-tax cash inflows, which gives us after-tax cash inflows of
$90,090.09, $64,929.79, $58,495.31, and $13,174.62. After two years, we will have paid back $155,019.88,
leaving $24,980.12 to pay back in after-tax cash flows in the third year. Since we get $58,495.31 in the third
year, the rule of thumb is to divide what is needed by the cash inflows we will get next period and add it
to the number of previous periods of cash inflows, e.g., ($24,980.12 divided by $58,495.31) + 2. Doing this
gives 2.427 years as the discounted payback period.
Diff: 3
14) A company usually establishes a short, arbitrary cutoff date for handling the initial screening of many
small-dollar opportunities.
Answer: TRUE
Diff: 1
15) By switching to monthly cash flows, we cannot get a more accurate estimate of the discounted
payback period.
Answer: FALSE
Explanation: By switching to monthly cash flows, we CAN GET a more accurate estimate of the
discounted payback period.
Diff: 2
16) The Discounted Payback Period method is a modified payback period model that considers how long
it takes to recover the initial investment in current dollars.
Answer: TRUE
Diff: 1
8
17) Identify and describe the shortcomings of the payback period model or method (without
discounting).
Answer: The payback period method ignores cash inflows after the initial outflow has been recovered.
Thus, this method is biased toward those projects that have higher cash inflows in earlier years and
against those with higher inflows in later years. The payback period has a fundamental flaw from a
finance perspective: it fails to account for the time value of money. This problem can be easily corrected
by adjusting to a payback period model with discounting.
Diff: 2
18) Acme, Inc. is considering a four-year project that has an initial outlay or cost of $80,000. The respective
future cash inflows for years 1, 2, 3 and 4 are: $40,000, $40,000, $30,000 and $30,000. Acme uses the
discounted payback period method and has a discount rate of 12%. Will Acme accept the project if it's
payback period is two and one-half years?
Answer: We first discount all after-tax cash inflows, which gives us after-tax cash inflows of $35,714.29,
$31,887.76, $21,353.41, and $19,065.54. After two years or 24 months, we will have paid back $67,602.04
leaving $12,397.95 to pay back in after-tax cash flows in the third year. Since we get $21,353.41 in the third
year, the rule of thumb is to divide what is needed by the cash inflows we will get next period and add it
to the number of previous periods of cash inflows, e.g., (12,397.95 divided by $21,353.41) + 2. Doing this
gives 2.581. Thus, the payback period is about 2.58 years (or in months it is 2.581 × 12 = 30.967 months).
Acme does not accept the project because the payback period is over two and one-half years (or over 30
months).
Diff: 3
9.3 Net Present Value
1) The capital budgeting decision model that utilizes all the discounted cash flow of a project is the
________ model, which is one of the single most important models in finance.
A) net present value (NPV)
B) internal rate of return (IRR)
C) profitability index (PI)
D) discounted payback period
Answer: A
Diff: 1
Topic: 9.3 Net Present Value
LO: 9.3 Understand the net present value (NPV) decision model and appreciate why it is the preferred criterion for
evaluating proposed investments.
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2) The net present value of an investment is ________.
A) the present value of all benefits (cash inflows)
B) the present value of all benefits (cash inflows) minus the present value of all costs (cash outflows) of
the project
C) the present value of all costs (cash outflows) of the project
D) the present value of all costs (cash outflow) minus the present value of all benefits (cash inflow) of the
project
Answer: B
Diff: 1
3) In the NPV model, all cash flows are stated ________.

A) in future value dollars, and the total inflow is "netted" against the outflow to see if the net amount is
positive or negative
B) in present value or current dollars, and the outflow is "netted" against the total inflow to see if the
gross amount is positive or negative
C) in present value or current dollars, and the total inflow is "netted" against the initial outflow to see if
the net amount is positive or negative
D) in future dollars, and the initial outflow is "netted" against the total inflow to see if the net amount is
positive
Answer: C
Diff: 2
4) In regard to the NPV method, which of the statements below is TRUE?

A) In the NPV model, if two projects are being compared, the one with the highest IRR is selected.
B) In the NPV model, the present cash flows are discounted at the rate r, the cost of capital.
C) In the NPV model, most future cash flows are stated in present value or current dollars and the inflow
is "netted" against the outflow to see if the net amount is positive or negative.
D) In the NPV model, the net present value of an investment is the present value of all benefits (cash
inflow) minus the present value of all costs (cash outflow) of the project.
Answer: D
Explanation: D) In the NPV model, if two projects are being compared, the one with the highest
POSITIVE NET PRESENT VALUE is selected. In the NPV model, the FUTURE cash flows are discounted
at the rate r, the cost of capital. In the NPV model, ALL cash flows (including the initial costs and future
cash inflows) are stated in present value or current dollars and the total inflow is "netted" against the
outflow to see if the net amount is positive or negative.
Diff: 2
10
A) The NPV decision criterion is true when all projects are independent and the company has a sufficient
source of funds to accept all positive NPV projects.
B) Two projects are mutually exclusive if the acceptance of one project has no bearing on the acceptance
or rejection of the other project.
C) Projects are mutually exclusive if picking one project eliminates the ability to pick the other project.
D) If a company has constrained capital, then it can only take on a limited number of projects.
Answer: B
Explanation: B) Two projects are INDEPENDENT if the acceptance of one project has no bearing on the
acceptance or rejection of the other project.
Diff: 2
6) Projects are mutually exclusive if picking one project eliminates the ability to pick the other project.
This mutually exclusive situation can arise for different reasons. Which of the statements below is NOT
one of these reasons?
A) One project will always have a negative NPV.
B) There is a scarce resource that both projects would need.
C) There is need for only one project, and both projects can fulfill that current need.
D) By using funds for one project, there are not enough funds available for the other project.
Answer: A
Explanation: A) Projects are mutually exclusive if picking one project eliminates the ability to pick the
other project even if BOTH PROJECTS HAVE POSITIVE net present values. This mutually exclusive
situation can arise for one of two reasons: there is need for only one project, and both projects can fulfill
that current need; there is a scarce resource that both projects need, and by using it in one project, it is not
available for the second project.
Diff: 2
7) Which of the following may be TRUE regarding mutually exclusive capital budgeting projects?
A) There is need for only one project, and both projects can fulfill that current need.
B) By using funds for one project, there are not enough funds available for the other project.
C) There is a scarce resource that both projects would need.
D) All of the above
Answer: D
Diff: 2
11
A) The net present value decision model is an economically sound model when comparing different
projects across a wide variety of products, services, and activities under capital constraint.
B) The greater the NPV of a project, the greater the "bag of money" for doing the project, and more money
is better. If a company is short of capital, it would choose those projects that provide the largest "bag of
money."
C) Despite all of the advantages of using the NPV model, it is inconsistent with the concept of the time-
value-of-money.
D) By discounting all future cash flows to the present, adding up all inflows, and subtracting all outflows,
we are determining the net present value of the project.
Answer: C
Explanation: C) One of the important aspects of the NPV model is that it IS CONSISTENT with the
concept of the time-value-of-money.
Diff: 2
9) There are two ways to correct for projects with unequal lives when using the NPV approach. Which of
the answers below is one of these ways?
A) One way is to find a common life, without the need to extend the projects to the least common
multiple of their lives.
B) One way is to find the present value factors and then compare them.
C) One way is to compare the lengths of the projects and take the project with the shortest life.
D) One way is to find a common life by extending the projects to the least common multiple of their lives.
Answer: D
Explanation: D) One way is to find a common life by extending the projects to the least common multiple
of the lives. The other way is to deal with unequal lives is by finding the equivalent annual annuity
(EAA) for the NPV of each project over the life of the project.
Diff: 2
12
A) We calculate the equivalent annual annuity by taking the NPV of the project and find the annuity
stream that equates to the NPV, using the appropriate discount rate for the project and life of the project.
B) In dealing with mutually exclusive projects of unequal lives, we can compute the EAA for the NPV of
the project over the life of the project.
C) One of the advantages of NPV over other decision models is that we can select the appropriate
discount rate for each individual project and still compare the resulting NPVs across different projects.
D) By using the EAA approach for mutually exclusive projects, we overcome all potential problems.
Answer: D
Explanation: D) There are some potential problems with the EAA approach to selecting projects with
unequal lives when dealing with mutually exclusive projects. For example, it is not always proper to
assume that cash flows will be extended into the future. Also, projects that are currently mutually
exclusive due to needs or capital constraints may not be mutually exclusive in the future.
Diff: 2
11) Dweller, Inc. is considering a four-year project that has an initial after-tax outlay or after-tax cost of
$80,000. The future cash inflows from its project are $40,000, $40,000, $30,000 and $30,000 for years 1, 2, 3
and 4, respectively. Dweller uses the net present value method and has a discount rate of 12%. Will
Dweller accept the project?
A) Dweller accepts the project because the NPV is greater than $30,000.
B) Dweller rejects the project because the NPV is less than -$4,000.
C) Dweller rejects the project because the NPV is -$3,021.
D) Dweller accepts the project because it has a positive NPV of over $28,000.
Answer: D
Explanation: D) NPV = -CF0 + + + +
= -$80,000 + + + +
= -$80,000 + $35,714.29 + $31,887.76 + $21,353.41 + $19,065.54
= -$80,000 + $108,020.99 = $28,020.99.
Thus, Dweller accepts the project because it has a positive NPV.
Diff: 3
13
12) Washington Industries Inc. is considering a project that has an initial after-tax outlay or after-tax cost
of $350,000. The respective future cash inflows from its five-year project for years 1 through 5 are $75,000
each year. Washington expects an additional cash flow of $50,000 in the fifth year. The firm uses the net
present value method and has a discount rate of 10%. Will Washington accept the project?
A) Washington accepts the project because it has an NPV greater than $5,000.
B) Washington rejects the project because it has an NPV less than $0.
C) Washington accepts the project because it has an NPV greater than $18,000.
D) There is not enough information to make a decision.
Answer: B
Explanation: B) Using the NPV function in Excel the NPV = -$34,644.93. Because the NPV is less than $0
we reject the project.
Diff: 3
13) Rogue River, Inc. is considering a project that has an initial after-tax outlay or after-tax cost of
$220,000. The respective future cash inflows from its four-year project for years 1 through 4 are: $50,000,
$60,000, $70,000 and $80,000. Rogue River uses the net present value method and has a discount rate of
11%. Will Rogue River accept the project?
A) Rogue River accepts the project because the NPV is greater than $10,000.00.
B) Rogue River rejects the project because the NPV is about -$22,375.73.
C) Rogue River rejects the project because the NPV is about -$12,375.60.
D) Rogue River rejects the project because the NPV is about -$2,375.60.
Answer: B
Explanation: B) NPV = -CF0 + + + +
= -$220,000 + + + +
= -$220,000 + $45,045.05 + $48,697.35 + $51,183.40 + $52,698.48
= -$220,000 + $197,624.27 = -$22,375.73.
Thus, Rogue River rejects the project since it has a negative NPV.
Using the NPV function in Excel yields the same answer.
Diff: 3
14
14) Simpson, Inc. is considering a five-year project that has an initial after-tax outlay or after-tax cost of
$80,000. The respective future cash inflows from its project for years 1, 2, 3, 4 and 5 are: $15,000, $25,000,
$35,000, $45,000 and $55,000. Simpson uses the net present value method and has a discount rate of 9%.
Will Simpson accept the project?
A) Simpson accepts the project because the NPV is $129,455.25.
B) Simpson accepts the project because the NPV is 79,455.25.
C) Simpson accepts the project because the NPV is $49,455.25.
D) Simpson accepts the project because the NPV is less than zero.
Answer: C
Explanation: C) NPV = -CF0 + + + + +
= -$80,000 + + + + +
= -$80,000 + $13,761.47 + $21,042.00 + $27,026.42 + $31,879.13 + $35,746.23
= -$80,000 + $129,455.25 = $49,455.25.
Thus, Simpson accepts the project since it has a positive NPV.
Diff: 3
15) Meyer, Inc. is considering a five-year project that has an initial after-tax outlay or after-tax cost of
$70,000. The future after-tax cash inflows from its project for years 1, 2, 3, 4 and 5 are all the same at
$35,000. Meyer uses the net present value method and has a discount rate of 10%. Will Meyer accept the
project?
A) Meyer accepts the project because the NPV is about $69,455.
B) Meyer accepts the project because the NPV is about $62,678.
C) Meyer rejects the project because the NPV is about -$13,382.
D) Meyer rejects the project because the NPV is less than -$33,021.
Answer: B
Explanation: B) The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -CF0 + (PMT × . Inserting the given values gives:
NPV = -$70,000 + = -$70,000 + ($35,000 × 3.790787)

= -$70,000 + $132,677.54 = $62,677.54. Thus, Meyer accepts the project since it has a positive NPV.
Diff: 3
15
16) Aviary, Inc. is considering a five-year project that has initial after-tax outlay or after-tax cost of
$170,000. The future after-tax cash inflows from its project for years 1 through 5 are $45,000 for each year.
Aviary uses the net present value method and has a discount rate of 11.25%. Will Aviary accept the
project?
A) Aviary accepts the project because the NPV is about $5,455.
B) Aviary accepts the project because the NPV is about $165,275.
C) Aviary rejects the project because the NPV is about -$4,725.
D) Aviary rejects the project because the NPV is about -$154,725.
Answer: C
Explanation: C) The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -CF0 + . Inserting in the given values gives:
NPV = -$170,000 + = -$170,000 + ($45,000 × 3.672771)

= -$170,000 + $165,274.71 = -$4,725.29. Thus, Aviary rejects the project since it has a negative NPV.
Diff: 3
17) Chase, Inc. is considering an eight-year project that has an initial after-tax outlay or after-tax cost of
$180,000. The future after-tax cash inflows from its project for years 1 through 8 are the same at $35,000.
Chase uses the net present value method and has a discount rate of 12%. Will Chase accept the project?
A) Chase accepts the project because the NPV is over $10,000.
B) Chase accepts the project because the NPV is about $6,141.
C) Chase rejects the project because the NPV is about -$6,133.
D) Chase rejects the project because the NPV is below -$7,000.
Answer: C
Explanation: C) The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -$180,000 + = -$180,000 + ($35,000 × 4.967640)

= -$180,000 + $173,867.39 = -$6,132.61. Thus, Chase rejects the project since it has a negative NPV.
Diff: 3
16
18) Manhattan, Inc. is considering an eight-year project that has an initial after-tax outlay or after-tax cost
of $180,000. The future after-tax cash inflows from its project for years 1 through 8 are the same at $38,000.
Manhattan uses the net present value method and has a discount rate of 11.50%. Will Manhattan accept
the project?
A) Manhattan accepts the project because the NPV is about $12,114.
B) Manhattan accepts the project because the NPV is about $11,114.
C) Manhattan rejects the project because the NPV is about -$11,114.
D) Manhattan rejects the project because the NPV is less than -$12,000.
Answer: A
Explanation: A) The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -$180,000 + = -$180,000 + ($38,000 × 5.055637)

= -$180,000 + $192,114.20 = $12,114.20. Thus, Manhattan accepts the project since it has a positive NPV.
Diff: 3
17
19) Allied, Inc. is considering Project A and Project B, which are two mutually exclusive projects with
unequal lives. Project A is an eight-year project that has an initial outlay or cost of $180,000. Its future
cash inflows for years 1 through 8 are $38,000. Project B is a six-year project that has an initial outlay or
cost of $160,000. Its future cash inflows for years 1 through 6 are the same at $36,000. Allied uses the
equivalent annual annuity (EAA) method and has a discount rate of 11.50%. Will Allied accept the
project?
A) Allied accepts Project B because it has a more positive EAA.
B) Allied rejects both projects because both have a negative NPV (and thus negative EAA).
C) Allied accepts Project A because its EAA is about $2,396 and Project B's EAA is only about $1,097.
D) Allied accepts Project A because its NPV (and thus EAA) is positive and Project B's NPV (and thus
EAA) is negative.
Answer: D
Explanation: D) We will compute the EAA for both projects and choose the one with the greater positive
EAA. If both EAAs are negative, then we will reject both projects. If one Project has a negative NPV (and
thus negative EAA), then we will choose the project with the positive NPV (and thus positive EAA).
For Project A, the NPV = -CF0 + . Inserting the given values, we have: NPV = -
$180,000 + = -$180,000 + ($38,000 × 5.055637)

= -$180,000 + $192,114.20 = $12,114.20. The EAA is the NPV divided by the PVIFA.
We have: EAA (Project A) = = $2,396.18.
For Project B, the NPV = -CF0 +
= -$160,000 + = -$160,000 + ($36,000 × 4.170294)

= -$160,000 + $150,130.59 = -$9,869.41. The EAA is the NPV divided by the PVIFA. We have: EAA (Project
B) = = -$2,366.60. Allied will take Project A, not only because its EAA is positive and superior
to Project B's, but because the NPV for Project B is negative. Thus, we can really only consider one project,
and that is Project A.
Diff: 3
18
20) Apple, Inc. is considering Project A and Project B, which are two mutually exclusive projects with
unequal lives. Project A is an eight-year project that has an initial outlay or cost of $140,000. Its future
cash inflows for years 1 through 8 are the same at $36,500. Project B is a six-year project that has an initial
outlay or cost of $160,000. Its future cash inflows for years 1 through 6 are the same at $48,000. Apple uses
the equivalent annual annuity (EAA) method and has a discount rate of 13%. Which project(s), if any, will
Apple accept?
A) Apple will take Project B because it has a positive NPV and its EAA is greater than that for Project A.
B) Apple rejects both projects because both have a negative NPV (and thus negative EAA).
C) Apple accepts both projects because both have a positive NPV (and thus positive EAA).
D) Apple accepts Project A because its EAA of about $7,975 is greater than Project B's EAA of about
$6,440.
Answer: A
Explanation: A) We will compute the EAA for both projects and choose the one with the greater positive
EAA since the projects are mutually exclusive and only one can be taken. If both EAAs are negative then
we will reject both projects. If one Project has a negative NPV (and thus negative EAA), then we will
choose the project with the positive NPV (and thus positive EAA). For Project A, the NPV = -CF 0 +
.
Inserting the given values, we have:
NPV = -$140,000 + = -$140,000 + ($36,500 × 4.79877)

We have: EAA (Project A) = = $7,325.86.
For Project B, the NPV = -CF0 +
= -$160,000 + = -$160,000 + ($48,000 × 3.997550)

= -$160,000 + $191,882.39 = $31,882.39. The EAA is the NPV divided by the PVIFA. We have: EAA (Project
A) = = $7,975.48. Apple will take Project B because it has a positive NPV and its EAA is greater
than that for Project A.
Diff: 3
19
21) The assignment of a discount rate to each project is an integral part of the NPV process.
Answer: TRUE
Diff: 1
22) To determine the current value of a project, discount all future cash flows to the present and add up
all cash inflow and outflow.
Answer: FALSE
Explanation: To determine the current value of a project, discount all future cash flows to the present,
add up all cash inflow, and SUBTRACT all cash outflow.
Diff: 2
23) Finding the equivalent annual annuity (EAA) is a good way to deal with projects with unequal lives
and should only be used with mutually exclusive projects.
Answer: TRUE
Diff: 2
24) To be considered acceptable, a project must have an NPV greater than 1.0.
Answer: FALSE
Explanation: To be considered acceptable, a project must have an NPV greater than $0.0
Diff: 2
20
25) Stanton, Inc. wants to analyze the NPV profile for a five-year project that is considered to be very
risky. The project's initial outlay or cost is $80,000 and it has respective cash inflows for years 1, 2, 3, 4 and
5 of $15,000, $25,000, $35,000, $45,000 and $55,000. Stanton wants to know how the NPV will change for
the following required rates of returns: 9%, 14%, 19%, 24%, and 29%. From the NPV profile, at about what
rate will the NPV be equal to zero?
Answer: Let us first compute the NPV for 9%. We have:
NPV = -CF0 + + + + +
= -$80,000 + + + + +
= -$80,000 + $13,761.47 + $21,042.00 + $27,026.42 + $31,879.13 + $35,746.23
= -$80,000 + $129,455.25 = $49,455.25.
In a similar fashion, for 14%, 19%, 24% and 29%, we get respective NPVs of $31,227.48, $16,516.53,
$4,507.67, and -$5,398.55. Thus, we can see the rate of return where the NPV is zero will be between 24%
and 29%. Using an Excel spreadsheet, one can compute a break-even rate of return (called IRR in the next
section) of about 26.16% (26.159675%, which will give a zero negative present value to two decimal
points). Beginning with a rate of 24%, the rule of thumb when trying various rates is to increase the rate
of return until the NPV becomes zero. If it becomes negative, then one decreases the rate.
Diff: 3
21
26) Ace, Inc. is considering Project A and Project B, which are two mutually exclusive projects with
unequal lives. Project A is an eight-year project that has an initial outlay or cost of $18,000. Its future cash
inflows for years 1 through 8 are the same at $3,800. Project B is a six-year project that has an initial outlay
or cost of $16,000. Its future cash inflows for years 1 through 6 are the same at $3,600. Ace uses the
equivalent annual annuity (EAA) method and has a discount rate of 11.50%. Which, if any, project will
Ace accept?
Answer: We will compute the EAA for both projects and choose the one with the greater positive EAA. If
both EAAs are negative, we will then reject both projects. If one Project has a negative NPV (and thus
negative EAA), we will then choose the project with the positive NPV (and thus positive EAA). For
Project A, the NPV = -CF0 + . Inserting the given values, we have: NPV = -$18,000 +
= -$18,000 + ($3,800 × 5.055637)

We have: EAA (Project A) = = $239.62.
For Project B, the NPV = -CF0 + = -$16,000 +

= -$16,000 + ($3,600 × 4.170294) = -$16,000 + $15,013.06 = -$986.94. The EAA is the NPV divided by the
PVIFA. We have: EAA (Project A) = = -$236.66. Ace will take Project A not only because its EAA
is positive and superior to Project B's, but because the NPV for Project B is negative. Thus, we can really
only consider one project and that is Project A.
Diff: 3
9.4 Internal Rate of Return
1) The most popular alternative to NPV for capital budgeting decisions is the ________ method.
A) internal rate of return (IRR)
B) payback period
C) discounted payback period
Answer: A
Diff: 1
Topic: 9.4 Internal Rate of Return
LO: 9.4 Calculate the most popular capital budgeting alternative to the NPV, the internal rate of return (IRR); explain
how the modified internal rate of return (MIRR) model attempts to address the IRR's problems.
22
2) The IRR is the discount rate that produces a zero NPV or the specific discount rate at which the present
value of the cost equals ________.
A) the future value of the present cash outflows
B) the present value of the future benefits or cash inflows
C) the present value of the cash outflow
D) the investment
Answer: B
Explanation: B) The IRR is defined as the discount rate that produces a zero NPV or the specific discount
rate at which the present value of the cost (the investment or cash outflows) equals the present value of
the future benefits.
Diff: 1
3) Without a computer and special calculator, ________.

A) computing the payback period is much more difficult than computing the IRR
B) finding the IRR will typically be a very easy process
C) finding the IRR may be a very tedious process only if the NPV is negative
D) finding the IRR may be a very tedious process since it is an iterative process
Answer: D
Explanation: D) Computing an IRR without a computer or special calculator is typically much more
difficult than computing the payback period or the NPV.
Diff: 1
4) Which of the statements below describes the IRR decision criterion?

A) The decision criterion is to accept a project if the IRR falls below the desired or required return rate.
B) The decision criterion is to reject a project if the IRR exceeds the desired or required return rate.
C) The decision criterion is to accept a project if the IRR exceeds the desired or required return rate.
D) The decision criterion is to accept a project if the NPV is positive.
Answer: C
Diff: 2
23
5) The hurdle rate should be set so that it reflects the proper risk level for the project. If we have to choose
between two projects with similar risk and therefore similar hurdle rates, we would select the project that
________.
A) has a higher internal rate of return
B) has a lower internal rate of return
C) has a hurdle rate that is consistent with the payback period method
D) has a hurdle rate that is consistent with the discounted payback period model
Answer: A
Diff: 1
6) Which of the statements below is TRUE?

A) The hurdle rate is the cost of debt needed to fund a project.
B) If the IRR exceeds a project's hurdle rate, the project should be rejected.
C) If the IRR clears the hurdle rate, the project is rejected.
D) The hurdle rate should be set so that it reflects the proper risk level for the project.
Answer: D
Explanation: D) The hurdle rate is the COST OF CAPITAL needed to fund a project. If the IRR exceeds a
project's hurdle rate, the project CAN BE ACCEPTED (assuming the NPV method renders the same
decision). If the IRR CANNOT CLEAR the hurdle rate, the project is rejected.
Diff: 2
7) Flynn, Inc. is considering a four-year project that has an initial outlay or cost of $80,000. The future cash
inflows from its project are $40,000, $40,000, $30,000, and $30,000 for years 1, 2, 3 and 4, respectively.
Flynn uses the internal rate of return method to evaluate projects. What is the approximate IRR for this
project?
A) The IRR is less than 12%.
B) The IRR is between 12% and 20%.
C) The IRR is about 24.55%.
D) The IRR is about 28.89%.
Answer: D
Explanation: D) Using a financial calculator or software program like Excel or trial and error, we get IRR
= 28.89% if we round our answer to two decimal places.
Diff: 3
24
8) Washington Industries Inc. is considering a project that has an initial after-tax outlay or after-tax cost of
$350,000. The respective future cash inflows from its five-year project for years 1 through 5 are $75,000
each year. Washington expects an additional cash flow of $50,000 in the fifth year. The firm uses the IRR
method and has a hurdle rate of 10%. Will Washington accept the project?
A) Washington accepts the project because it has an IRR greater than 10%.
B) Washington rejects the project because it has an IRR less than 10%.
C) Washington accepts the project because it has an IRR greater than 5%.
D) There is not enough information to answer this question.
Answer: B
Explanation: B) Using a financial calculator or software program like Excel or trial and error (and
rounding our answer to two decimal places), we get IRR = 6.32%. Thus, Washington will reject the project
as its IRR is less than its hurdle rate.
Diff: 3
9) Rogue River, Inc. is considering a project that has an initial outlay or cost of $220,000. The respective
future cash inflows from its four-year project for years 1 through 4 are: $50,000, $60,000, $70,000, and
$80,000, respectively. Rogue River uses the internal rate of return method to evaluate projects. Will Rogue
River accept the project if its hurdle rate is 10%?
A) Rogue River will not accept this project because its IRR is about 9.70%.
B) Rogue River will not accept this project because its IRR is about 8.70%.
C) Rogue River will not accept this project because its IRR is about 6.50%.
D) Rogue River will not accept this project because its IRR is about 4.60%.
Answer: C
Explanation: C) Using a financial calculator or software program like Excel or trial and error (and
rounding our answer to two decimal places), we get IRR = 6.50%. Thus, Rogue River will reject the project
as its IRR is less than its hurdle rate.
Diff: 3
25
10) Simpson, Inc. is considering a five-year project that has an initial outlay or cost of $80,000. The
respective future cash inflows from its project for years 1, 2, 3, 4 and 5 are: $15,000, $25,000, $35,000,
$45,000, and $55,000. Simpson uses the internal rate of return method to evaluate projects. What is the
project's IRR?
A) The IRR is less than 22.50%.
B) The IRR is about 24.16%.
C) The IRR is about 26.16%.
D) The IRR is over 26.50%.
Answer: C
Explanation: C) Using a financial calculator or software program like Excel or trial and error (and
rounding off to two digits), we get IRR = 26.16%.
Diff: 3
11) Meyer, Inc. is considering a very risky five-year project that has an initial outlay or cost of $70,000.
The future cash inflows from its project for years 1, 2, 3, 4, and 5 are all the same at $35,000. Meyer uses
the internal rate of return method to evaluate projects. Will Meyer accept the project if its hurdle rate is
41.00%?
A) Meyer will probably reject this project because its IRR is about 39.74%, which is slightly below its
hurdle rate.
B) Meyer will probably accept this project because its IRR is about 41.04%, which is slightly above its
hurdle rate.
C) Meyer will accept this project because its IRR is about 41.50%.
D) Meyer will accept this project because its IRR is over 45.50%.
Answer: B
Explanation: B) Using a financial calculator or software program like Excel or trial and error (and
rounding our answer to two decimal places), we get IRR = 41.04%. Thus, it appears that Meyer will accept
this project since Meyer's hurdle rate of 41.00% is slightly less than the project's IRR of 41.04%.
Diff: 3
12) The Internal Rate of Return (IRR) Model suffers from three problems. Which of the below is NOT one
of these problems?
A) Comparing mutually exclusive projects
B) Cumbersome computations not resolvable by the latest technology
C) Incorporates the IRR as the reinvestment rate for the future cash flows
D) Multiple IRRs
Answer: B
Diff: 2
26
13) Which of the following in NOT a potential problem suffered by the IRR method of capital budgeting?
A) Multiple IRRs
B) Disagreement with the NPV as to whether a project with ordinary cash flows is profitable or not
C) Incorporates the IRR as the reinvestment rate for the future cash flows
D) Comparing mutually exclusive projects
Answer: B
Diff: 2
14) Two projects intersect, in terms of NPV, at a discount rate labeled the ________.
A) crossover rate
B) internal rate of return
C) discount rate
D) yield to maturity
Answer: A
Diff: 1
15) The crossover rate is the discount rate where both projects have the same ________.
A) IRR
B) PI
C) NPV
D) length to completion
Answer: C
Diff: 1
27
A) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project B. As long as
the profile of Project A is above the profile of Project B, Project A will have a higher NPV value for that
particular discount rate.
B) Project A and Project B are mutually exclusive. The two projects intersect in terms of NPV at a discount
rate labeled the crossover rate.
C) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project B. As we
proceed past the crossover rate to the right on the x-axis, Project B's profile will be above Project A's
profile.
D) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project B. This
means that Project A has a lower NPV than Project B when the discount rate is zero.
Answer: D
Explanation: D) Project A has a higher y-axis intercept for its NPV profile than mutually exclusive Project
B. This means that Project A has a HIGHER NPV than Project B when the discount rate is zero.
Diff: 2

A) One problem with IRR as a decision rule is that if the cash flow is not standard, there is a possibility of
multiple IRRs for a single project.
B) When we talk about standard cash flow for a project, we assume an initial cash outflow at the
beginning of the project and negative cash flows in the future.
C) When we apply IRR to standard cash flow, we have the potential for more than one IRR solution.
D) For every period that the cash flow has a change of sign (negative to positive or positive to negative),
the NPV profile could cross the y-axis, generating a MIRR.
Answer: A
Explanation: A) When we talk about standard cash flow for a project, we assume an initial cash outflow
at the beginning of the project and POSITIVE cash flows in the future. When we apply IRR to
NONSTANDARD cash flow we have the potential for more than one IRR solution. For every period that
the cash flow has a change of sign (negative to positive or positive to negative), the NPV profile could
cross the X-AXIS GENERATING AN IRR.
Diff: 2
28
18) Suppose you have an investment that costs $80,000 at the beginning of the project, and it generates
$30,000 a year for four years in positive cash flows. The cost of capital is 12%. The IRR of the project is
18.45% and the NPV is about $11,120. The IRR model assumes that at the end of the first year you can
invest the $30,000 at ________.
A) 18.45%
B) 12.00%
C) a rate less than the cost of capital
D) a rate greater than the IRR
Answer: A
Diff: 2
19) Find the Modified Internal Rate of Return (MIRR) for the following series of future cash flows, given a
discount rate of 11%: Year 0: -$22,000; Year 1: $5,000; Year 2: $6,000; Year 3: $7,000; Year 4: $7,500; and,
Year 5: $8,000.
A) About 12.13%
B) About 12.88%
C) About 13.04%
D) About 13.12%
Answer: D
Explanation: D) Step One. Find the future values of all the cash inflows by reinvesting the cash inflows
at the appropriate cost of capital. FV = $5,000 × (1.11)4 + $6,000 × (1.11)3 + $7,000 × (1.11)2 + $7,500 × (1.11)1
+ $8,000 × (1.11)0 = $7,590.35 + $8,205.79 + $8,624.70 + $8,325.00 + $8,000.00. Summing these we get: FV =
$40,745.84.
Step Two. Find the present value of the cash outflow by discounting at the appropriate cost of capital.
This is the initial cash outflow of $22,000 because all investment is made at the start of the project.
Expressing the cash outflow in absolute terms: PV = $22,000.
Step Three. Find the interest rate that equates the present value of the cash outflow with the future value
of the cash inflow given as: MIRR = (FV/PV)1/n - 1 = ($40,745.84/$22,000)1/5 - 1 = (1.852084)1/5 - 1 =
1.131181 - 1 = 0.131181, or about 13.12%.
Diff: 3
29
20) Find the Modified Internal Rate of Return (MIRR) for the following annual series of cash flows, given
a discount rate of 10.50%: Year 0: -$75,000; Year 1: $15,000; Year 2: $16,000; Year 3: $17,000; Year 4: $17,500;
and, Year 5: $18,000.
A) About 6.35%
B) About 6.88%
C) About 7.35%
D) About 7.88%
Answer: A
Explanation: A) Step One. Find the future values of all the cash inflow by reinvesting the cash inflow at
the appropriate cost of capital. FV = $15,000 × (1.1050)4 + $16,000 × (1.1050)3 + $17,000 × (1.1050)2 + $17,500
× (1.1050)1 + $18,000 × (1.1050)0 = $22,363.53 + $21,587.72 + $20,757.43 + $19,337.50 + $18,000.00. Summing
these we get: FV = $102,046.18.
This is the initial cash outflow of $75,000 because all investment is made at the start of the project.
Expressing the cash outflow in absolute terms: PV= $75,000.
of the cash inflow given as: MIRR = (FV / PV)n - 1 = ($102,046.18 / $75,000)1/5 - 1 = (1.360616)1/5 - 1 =
1.063524 - 1 = 0.063524 or about 6.35%.
Diff: 3
30
21) Corbett and Sullivan Enterprises (CSE) use the Modified Internal Rate of Return (MIRR) when
evaluating projects. CSE's cost of capital is 9.5%. What is the MIRR of a project if the initial costs are
$10,200,000 and the project lasts seven years, with each year producing the same after-tax cash inflows of
$1,900,000?
A) About 7.95%
B) About 8.01%
C) About 8.24%
D) About 8.88%
Answer: C
Explanation: C) Step One. Find the future values of all the cash inflow by reinvesting the cash inflow at
the appropriate cost of capital. We can use the future value annuity formula, given that the cash inflow
stream is identical. We have: FV = $1,900,000 × = $1,900,000 × = $1,900,000 ×

9.342648. Thus, FV = $17,751,032.
This is the initial cash outflow of $10,200,000 because all investment is made at the start of the project.
Expressing the cash outflow in absolute terms: PV= $10,200,000.
of the cash inflow given as: MIRR = (FV / PV)n - 1 = ($17,751,032 / $10,200,000)1/ 7 - 1 = (1.740297)1/ 7 - 1 =
1.082368 - 1 = 0.082368, or about 8.24%.
Diff: 3
22) The IRR decision criterion is to accept a project if the IRR exceeds the desired or required return rate
and to reject the project if the IRR is less than the desired or required rate of return.
Answer: TRUE
Diff: 1
23) The IRR is an unpopular capital budgeting decision model because even with the advent of
calculators and spreadsheets, the cumbersome calculation remains.
Answer: FALSE
Explanation: The IRR is very popular because with the advent of calculators and spreadsheets the
cumbersome calculation is a thing of the past. [NOTE: It can also be argued that the IRR is popular
because lenders understand the IRR and know that a firm with an IRR greater than the cost of borrowing
is a good investment.]
Diff: 2
31
24) One problem with the decision criterion of IRR is that if cash flow is not standard, there is a possibility
of multiple IRRs for a single project.
Answer: TRUE
Diff: 1
25) One of the underlying assumptions of the IRR model is that all cash inflow can be reinvested at the
individual project's internal rate of return (IRR) over the remaining life of the project.
Answer: TRUE
Diff: 2
26) Pandora, Inc. is considering a five-year project that has an initial outlay or cost of $70,000. The cash
inflows from its project for years 1, 2, 3, 4 and 5 are all the same at $14,000. The borrowing costs are 10%.
What is the IRR? Should Pandora use the IRR method to evaluate this project? Explain.
Answer: Using a financial calculator or software program like Excel or trial and error, we get an IRR that
is exactly equal to zero percent (this is because the undiscounted sum of all future inflows equals the
initial outlay, e.g., $14,000 × 5 = $70,000). It does not appear that Pandora will accept this project since its
borrowing costs of 10% will be greater than 0%. Thus, Pandora can use the IRR method if it likes because
it does indicate the project should not be accepted. Pandora can verify its rejection decision of the project
by computing its NPV, which is about -$16,929.
Diff: 3
27) Spotify, Inc. is considering a five-year project that has an initial outlay or cost of $22,000. The future
cash inflows from its project for years 1, 2, 3, 4 and 5 are $15,000, $15,000, $15,000, $15,000 and -$41,000,
respectively. Compute both IRRs. Given these IRRs, compute the two NPVs. If Spotify's true cost of
borrowing for this project is 10%, would Spotify choose the project?
Answer: Using a financial calculator or software program like Excel or trial and error (and rounding off
to two digits), we can get two IRRs: 24.88% and 9.34%. If using Excel, you can get 24.88% by typing in a
percentage near 24.88% (like 20%) and you can get 9.34% by typing in a percentage near 9.34% (like 10%).
If we use these two values to compute the Net Present Value, you would get $0 for each IRR used. If the
true cost of capital for this project is 10%, then the NPV would be $90.21 and Spotify would accept the
project.
Diff: 3
32
28) Wyatt and Zachary Enterprises (WZE) uses the Modified Internal Rate of Return (MIRR) when
evaluating projects. WZE's cost of capital is 9.75%. What is the MIRR of a project if the initial cost is
$1,200,000 and the project will last seven years, with each year producing cash inflows of $290,000?
Should WZE accept this project according to the MIRR method? Explain.
Answer:
Step One. Find the future values of all the cash inflow by reinvesting the cash inflow at the appropriate
cost of capital. We can use the future value annuity formula, given that the cash inflow stream is
identical. We have: FV = $290,000 × = $290,000 × = $290,000 × 9.414619. Thus, FV

= $2,730,240.
This is the initial cash outflow of -$1,200,000 because all investment is made at the start of the project.
Expressing the cash outflow in absolute terms: PV= $1,200,000.
of the cash inflow given as: MIRR = (FV / PV)n - 1 = ($2,730,240 / $1,200,000)7 - 1 = (2.2751996)7 - 1 =
1.124612 - 1 = 0.124612 or about 12.46%. Since the MIRR is greater than the cost of capital (e.g., 12.46% >
9.75%), WZE should accept the project. To verify this, WZE can compute the NPV; in doing this, they
would find out that it is positive, e.g., NPV = $223,537.95.
Diff: 3
9.5 Profitability Index
1) Which method is designed to give the dollar amount of return for every $1.00 invested in the project in
terms of current dollars?
A) Profitability Index Method
B) Internal Rate of Return Method
C) Net Present Value Method
D) Discounted Payback Period Method
Answer: A
Diff: 1
Topic: 9.5 Profitability Index
LO: 9.5 Understand the profitability index (PI) as a modification of the NPV model.
33
2) ________ is a modification of NPV to produce the ratio of the present value of the benefits (future cash
inflow) to the present value of the costs (initial investment).
A) Modified Internal Rate of Return Method
B) Profitability Index (PI)
C) Payback Period Method
D) Discounted Cash Flow Method
Answer: B
Diff: 1
3) The ________ method of capital budgeting is a ratio of the present value of cash inflows divided by the
initial investment.
A) payback period
B) net present value
C) internal rate of return
Answer: D
Diff: 1

A) The profitability index (PI) decision criterion states: if PI > 1.0, accept the project.
B) The profitability index (PI) decision criterion states: if PI < 1.0, reject the project.
C) The profitability index (PI) method multiplies the Present Value of Benefits by Present Value of Costs.
D) If the PI is greater than one, the benefits exceed the costs.
Answer: C
Explanation: C) The profitability index method DIVIDES the Present Value of Benefits by Present Value
of Costs.
Diff: 1
34
A) According to the profitability index (PI) decision criterion when the PI is greater than 1, the costs
exceed the benefits.
B) If we realize that NPV is the present value of the benefits minus the present value of the costs, then we
simply need to subtract the costs from the NPV to get the present value of the benefits.
C) There are two acceptable projects, but we can only take one due to a shortage of funds. The PI for these
two projects are: Project A: 2.25; Project B: 1.89. We would take Project B.
D) A PI of 1.50 can be interpreted as meaning that for every $1.00 invested today the firm gets back $1.50
in current dollars.
Answer: D
Explanation: D) According to the profitability index (PI) decision criterion, when the PI is greater than 1,
the BENEFITS exceed the COSTS. If we realize that NPV is the present value of the benefits minus the
present value of the costs, then we simply need to ADD BACK the costs to the NPV to get the present
value of the benefits. There are two acceptable projects, but we can only take one due to a shortage of
funds. The PI for these two projects are: Project A: 2.25; Project B: 1.89. We would take Project A because
it gives back $2.25 for every dollar invested, while Project B only gives back $1.89 for every dollar
invested.
Diff: 2
6) Dakota, Inc. is currently considering an eight-year project that has an initial outlay or cost of $140,000.
The cash inflows from its project for years 1 through 8 are the same at $35,000. Dakota has a discount rate
of 12%. Because there is a shortage of funds to finance all good projects, Dakota wants to compute the
profitability index (PI) for each project. That way Dakota can get an idea as to which project might be a
better choice. What is the PI for Dakota's current project?
A) About 1.24
B) About 1.21
C) About 1.19
D) About 1.09
Answer: A
Explanation: A) The PI is (NPV plus the absolute value of the costs) divided by the absolute value of the
costs. The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -CF0 + . Inserting the given values gives:
NPV = -$140,000 + = -$140,000 + ($35,000 × 4.967640)

= -$140,000 + $173,867.39 = $33,867.39. We can now compute the PI.
We have: PI = = = 1.2419, or about 1.24.

Diff: 3
35
7) Project A has an NPV of $20,000 and a PI of 1.2. Project B has an NPV of $10,000 and a PI of 1.3. Both
projects have equal lives. Which project should be preferred if we are NOT concerned with capital
rationing (that is, we are NOT concerned with being short of funds)?
A) We should prefer Project B since it has a higher PI.
B) We should compute the EAA before we make any decision.
C) We should prefer Project A since it has a higher NPV.
D) We should prefer Project B if it has a higher IRR.
Answer: C
Explanation: C) We should NOT prefer Project B even though it has a higher PI; this is because it has a
lower NPV and we are not facing capital constraints. Computing the EAA is typically used if we have
mutually exclusive projects with unequal lives; we do not know if such is the case for this situation since
we are not told if the projects are mutually exclusive (we are only asked which one we would prefer, i.e.,
which one adds more value to the company). Even if Project B has a higher IRR, this would not tell us to
prefer it because it has a lower NPV.
Diff: 2
8) Hollister, Inc. is currently considering an eight-year project that has an initial outlay or cost of $120,000.
The future cash inflows from its project for years 1 through 8 are the same at $30,000. Hollister has a
discount rate of 11%. Because of capital rationing (shortage of funds for financing), Hollister wants to
compute the profitability index (PI) for each project. What is the PI for Hollister's current project?
A) About 1.29
B) About 1.31
C) About 1.33
D) About 1.39
Answer: A
Explanation: A) The PI is (NPV plus the absolute value of the costs) divided by the absolute value of the
costs (or the present value of all future cash flows divided by the cost). The future after-tax cash inflows
are an annuity. Thus, we can use:
NPV = -CF0 + . Inserting the given values gives:
NPV = -$120,000 + = -$120,000 + ($30,000 × 5.146123)

We have: PI = = = 1.2865 or about 1.29.

Diff: 3
36
9) Birdman, Inc. is currently considering an eight-year project that has an initial outlay or cost of $80,000.
The future cash inflows from its project for years 1 through 8 are the same at $30,000. Birdman has a
discount rate of 13%. Because of concerns about funds being short to finance all good projects, Birdman
wants to compute the profitability index (PI) for each project. What is the PI for Birdman's current
project?
A) About 1.50
B) About 1.60
C) About 1.70
D) About 1.80
Answer: D
Explanation: D) The PI is (NPV plus the absolute value of the costs) divided by the absolute value of the
costs (or the present value of all future cash flows divided by the cost). The future after-tax cash inflows
are an annuity. Thus, we can use:
NPV = -$80,000 + = -$80,000 + ($30,000 × 4.798770)

We have: PI = = = 1.7995, or about 1.80.

Diff: 3
10) The present value of the benefits and costs needed to calculate Profitability Index (PI) is the same
information one finds when computing the NPV.
Answer: TRUE
Diff: 1
11) When the Profitability Index (PI) is greater than 1, the benefits exceed the costs.
Answer: TRUE
Explanation: Ranking projects by PI with different costs levels CAN STILL LEAD to selection problems.
Diff: 2
37
12) A firm is considering four projects with the following PIs, NPVs, and Costs. Project A: PI of 1.3, NPV
of $3,600, and cost of $12,000; Project B: PI of 1.4, NPV of $5,600, and cost of $14,000; Project C: PI of 1.5,
NPV of $5,000, and cost of $10,000; Project D: PI of 2.1, NPV of $8,800, and cost of $8,000. Rank the
projects from best to worst in terms of their NPVs. Now rank the projects from best to worst in terms of
their PIs.
Answer: Ranking by NPV, we get D: $8,000; B: $5,600; C: $5,000; and A: $3,600.
Ranking by PI, we get D: 2.1; C: 1.5; B: 1.4; and A: 1.3.
Explanation: If we could only spend, say, $20,000, then Project D looks great since it has the highest PI
(the biggest bang for our limited bucks), and yet costs only $8,000. Our next pick would then be Project C,
based on the PI. Although it would add another $10,000 to our costs to boost the total to $18,000, we
would still be within our limit. Then, we would use the PI to look at Project B, but we would reject it since
its cost of $14,000 would push us over our limit. We would then look at Project A, and we would also
reject it since its cost of $12,000 would also push us over the limit. The PI is simply a guide that tells us
which projects to look at in what order when you have a capital budgeting cost limit.
Diff: 3
9.6 Overview of Six Decision Models
1) The ________ method is simple and fast but economically unsound as it ignores all cash flow after the
cutoff date and ignores the time-value of money.
A) Payback Period
B) MIRR
C) Net Present Value
D) IRR
Answer: A
Diff: 1
Topic: 9.6 Overview of the Six Decision Models
LO: 9.6 Compare and contrast the strengths and weaknesses of each decision model in a holistic way.
2) The ________ model incorporates the time-value of money but still ignores cash flows after the cutoff
date.
A) Payback Period
B) Discounted Payback Period
C) IRR
D) Modified Internal Rate of Return
Answer: B
Diff: 1
38
3) The ________ method is economically sound and properly ranks projects across various sizes, time
horizons, and levels of risk, without exception for all independent projects.
A) NPV
C) Profitability Index
D) Modified IRR
Answer: A
Diff: 1
4) The ________ model provides a single measure (return) but must apply risk outside the model, thus
allowing for errors in rankings of projects.
A) Payback Period
B) IRR
D) Profitability Index
Answer: B
Diff: 1
5) ________ corrects for most, but not all, of the problems of IRR and gives the solution in terms of a
return.
A) Profitability Index
D) MIRR
Answer: D
Diff: 1
6) The discounted payback method, net present value method (NPV), internal rate of return (IRR),
modified internal rate of return (MIRR), and profitability index (PI) are all consistent with the time value
of money.
Answer: TRUE
Explanation: The IRR method is used by 75.61% of the respondents while the NPV method is used by
74.93% of the respondents. The payback method came in third at 56.74%. From these results one may
conclude that some corporations use more than one method to evaluate their projects.
Diff: 2
39
7) Calculating IRR, NPV, or MIRR is easy and efficient using a spreadsheet once you know the relevant
cash flow, the timing of the cash flow, the cost of capital, and the reinvestment rate.
Answer: TRUE
Diff: 1
8) According to an academic survey of large and small U.S. businesses, the IRR method of capital
budgeting is slightly preferred over NPV by the survey respondents.
Answer: TRUE
Diff: 1
AACSB: 1 Written and Oral Communication
9) Describe three of the six decision models used in capital budgeting decision-making and briefly
evaluate their effectiveness.
Answer:
Payback Period is simple and fast but economically unsound. It ignores all cash flow after the cutoff date
and it ignores the time value of money.
Discounted Payback Period incorporates the time value of money but still ignores cash flow after the
cutoff date.
Net Present Value is economically sound and properly ranks projects across various sizes, time horizons,
and levels of risk, without exception for all independent projects.
IRR provides a single measure (return) but has the potential for errors in ranking projects. It also can lead
to incorrect selection of two mutually exclusive projects or incorrect acceptance or rejection of a project
with more than a single IRR.
Modified Internal Rate of Return, in general, corrects for most of, but not all, the problems of IRR and
gives the solution in terms of a return.
Profitability Index incorporates risk and return, but the benefits-to-cost ratio is actually just another way
of expressing the NPV.
Diff: 2
40
Chapter 10 Cash Flow Estimation
10.1 The Importance of Cash Flow
1) A major metric of a company's health and its prospects for a long life is how much ________ it can
generate.
A) cash flow
B) depreciation
C) tax deferral
D) net income
Answer: A
Diff: 1
Topic: 10.1 The Importance of Cash Flow
LO: 10.1 Understand the importance of cash flow and the distinction between cash flow and profits.
2) Most businesses fail because their ________ dries up.

A) net working capital
B) cash flow
C) liabilities
D) tax shield
Answer: B
Diff: 1
3) The ________ is/are critical to business decisions, business growth, and ultimately business success.
A) risk and timing but not the amount of cash flow
B) currency denomination of profits
C) risk and profits but not the amount of cash flow
D) timing and amount of cash flow
Answer: D
Diff: 2
41
4) ________ are an accounting measure of performance during a specific period of time, while ________ is
the actual inflow or outflow of money.
A) Profits; cash flow
B) Cash flows; profit
C) Dividends; cash flow
D) Profits; a dividend
Answer: A
Diff: 2
5) Consider the case of a business that has had a very profitable year and earned a million dollars in
profits. Can it distribute a million dollars to its owners (via dividends)?
A) Yes, definitely
B) Maybe, maybe not
C) Definitely not
D) It can certainly distribute over a million dollars.
Answer: B
Explanation: B) Maybe, maybe not. It could distribute a million dollars if it had a million dollars of cash
at the end of the year. However, it may have reinvested the million dollars in inventory, or paid off some
debts of the business, leaving its cash account balance near zero. In that case, it cannot pay out a million
dollars to the owners.
Diff: 2

A) A company could show a loss for the operating period but have generated positive cash flow for the
business.
B) Profits are an accounting measure of performance during a specific period of time.
C) To obtain the operating cash flow, given the net income, we add back depreciation and subtract taxes.
D) Cash flow is an accounting measure of performance during a specific period of time.
Answer: D
Explanation: D) CASH FLOW is the timing and amount of cash received or spent, while PROFIT is an
accounting measure of performance during a specific period of time.
Diff: 2
42
7) To get the operating cash flow, given the net income, we add back ________.
A) cost of goods sold
B) depreciation
C) taxes
D) EBIT
Answer: B
Diff: 1
8) The revenue is $24,000, the cost of goods sold is $12,000, other expenses (from selling and
administration) are $6,000, and depreciation is $2,000. What is the EBIT?
A) $12,000
B) $6,000
C) $4,000
D) $2,000
Answer: C
Explanation: C) EBIT = Revenue - Cost of Goods Sold - Other Expenses - Depreciation
= $24,000 - $12,000 - $6,000 - $2,000 = $4,000. Interest is not considered when computing the EBIT.
Diff: 2
9) A firm has revenue of $50,000, the cost of goods sold is $23,000, other expenses (from selling and
administration) are $14,000, interest expenses are $4,000 and depreciation is $5,000. What is the EBIT?
A) $4,000
B) $8,000
C) $13,000
D) $27,000
Answer: B
Explanation: B) EBIT = Revenue - Cost of Goods Sold - Other Expenses - Depreciation
Diff: 2
43
10) The revenue is $25,000, the cost of goods sold is $11,000, other expenses (from selling and
administration) are $7,000, and depreciation is $1,000. What is the EBIT?
A) $13,000
B) $7,000
C) $6,000
D) Cannot tell because we do not know the interest paid.
Answer: C
Explanation: C) EBIT = Revenue - Cost of Goods Sold - Other Expenses - Depreciation
Diff: 2
11) Operating Cash Flow (OCF) is equal to what?

A) EBIT - Depreciation + Taxes
B) EBIT + Depreciation - Taxes
C) EBIT - Depreciation - Taxes
D) EBIT + Depreciation + Taxes
Answer: B
Diff: 2
12) The EBIT is $20,000, depreciation is $5,000, and taxes are $3,000. What is the operating cash flow
(OCF)?
A) $25,000
B) $22,000
C) $14,000
D) $28,000
Answer: B
Explanation: B) OCF = EBIT + Depreciation - Taxes = $20,000 + $5,000 - $3,000 = $22,000.
Diff: 2
13) Profits can be defined as an accounting measure of performance during a specific period of time.
Answer: TRUE
Diff: 1
44
14) A firm can spend its reported profits.
Answer: FALSE
Explanation: A firm can only spend cash. Profits are an accounting measure of performance during a
specific period of time.
Diff: 1
15) If the company had a large depreciation expense during the period, the income statement could show
a loss for the period, even though the cash account may have grown during the same period.
Answer: TRUE
Diff: 1
16) Operating Cash Flow (OCF) = EBIT + Depreciation + Taxes.

Answer: FALSE
Explanation: Operating Cash Flow (OCF) = EBIT + Depreciation - Taxes
Diff: 1
17) On a corporate income statement, interest is paid after taxes are paid.
Answer: FALSE
Explanation: On a corporate income statement, interest is paid BEFORE taxes are paid.
Diff: 1
18) Explain how to compute an operating cash flow (OCF) from a modified income statement.
Answer: We first compute EBIT, which is Revenues - Costs of Goods Sold - General Selling and
Administrative Expenses - Depreciation. We then subtract Taxes to get Modified Net Income. Next, add
back Depreciation to get Operating Cash Flow. Thus, .
Diff: 3
45
19) Explain the distinction between profits and cash flow.
Answer: Profits are an accounting measure of performance during a specific period of time. Cash flow is
the actual inflow or outflow of money. Although you cannot spend "profit," you can spend cash. This is
because profit given on the accounting statement does not account for all cash flows. For example,
depreciation is considered a cost (and is entered in the income statement), but it does not lower the cash
flow that is available to owners.
Diff: 3
10.2 Estimating Cash Flow for Projects: Incremental Cash Flow
1) The projected revenues and costs that form the basis of the potential for a project's acceptance or
rejection are estimates of ________.
A) future activity
B) past activity
C) known activity
D) current activity
Answer: A
Diff: 1
Topic: 10.2 Estimating Cash Flow for Projects: Incremental Cash Flow
LO: 10.2 Identify incremental cash flow.
2) In terms of revenues and costs for a project, which of the statements below is FALSE?
A) Projected revenues and costs are estimates of future activity.
B) Estimates of revenues and costs begin with operating cash flow of the project.
C) Projected revenues and costs form the basis of the potential for a project's acceptance or rejection.
D) Estimates of revenues and costs begin with sales forecasts and the production costs associated with the
sales forecast.
Answer: B
Explanation: B) Estimates of revenues and costs begin with SALES FORECASTS AND THE
PRODUCTION COSTS associated with the sales forecast to arrive at the anticipated operating cash flow
of the project.
Diff: 2
46
3) Managers typically look at the initial outlay for the project as its capital expenditure and determine
________ from this capital expenditure.
A) interest expenses
B) dividends
C) depreciation
D) CEO expenses
Answer: C
Diff: 2
4) ________ cash flow is the increase in cash generated by a new project above the current cash flow
without the new project.
A) Future
B) Current
C) Discounted
D) Incremental
Answer: D
Diff: 1
5) ________ of a project are those that have already been incurred and cannot be reversed.
A) Erosion costs
B) Opportunity costs
C) Sunk costs
D) Working capital costs
Answer: C
Diff: 2
6) ________ involve(s) a cash flow that never occurs, but we need to add it as a cost or outflow of a new
project.
A) Cost recovery of divested assets
B) Capital expenditures
C) Sunk costs
D) Opportunity costs
Answer: D
Diff: 2
47
7) Whenever a new product competes against a company's already existing products and reduces the
sales of those products, ________ occur.
A) erosion costs
B) opportunity costs
C) sunk costs
D) working capital costs
Answer: A
Diff: 2
8) Which of the below statements is FALSE?

A) Whenever a new product competes against a company's already existing products and reduces the
sales of other products, opportunity costs occur.
B) Erosion can provide cost savings.
C) A synergy gain occurs when a new product can be introduced that complements another current
product so that sales for this current product increases.
D) Increases in working capital accounts necessary to support a project add upfront costs, but also
provide for cost reductions at the end of the project.
Answer: A
Explanation: A) Whenever a new product competes against a company's already existing products and
reduces the sales of other products, EROSION OCCURS.
Diff: 2

A) The increase in working capital accounts necessary to support a project also provides for cost increases
at the end of the project.
B) An increase in working capital can be brought about by an increase in inventory.
C) Decreases in accounts receivables constitute a use of cash flow because you are helping your
customers finance their purchases.
D) Decreases in accounts payable constitute a source of cash flow because you are using your suppliers to
help finance your business operations.
Answer: B
Explanation: B) The increase in working capital accounts necessary to support a project also provides for
cost REDUCTIONS at the end of the project. An increase in working capital can be brought about by an
increase in any short-term or current assets account, including inventory or accounts receivables
(similarly, a decrease in working capital can be brought about by a decrease in any short-term or current
liabilities account). INCREASES in accounts receivables constitute a use of cash flow because you are
helping your customers finance their purchases. INCREASES in accounts payable constitute a source of
cash flow because you are using your suppliers to help finance your business operations.
Diff: 3
48
10) Whenever a new product competes against a company's already existing products and reduces the
sales of the other products, net working capital increases occur.
Answer: FALSE
Explanation: Whenever a new product competes against a company's already existing products and
reduces the sales of these other products, EROSION OCCURS. If sales decrease, then it is more likely that
there will be a decrease in net working capital (as opposed to an increase).
Diff: 1
11) Erosion is the additional cash generated by a new project beyond the current cash flow with the
addition of a specific new project.
Answer: FALSE
Explanation: INCREMENTAL CASH FLOW is the additional cash generated by a new project beyond
the current cash flow with the addition of a specific new project.
Diff: 1
12) If four plus five equals ten, that's synergy.

Answer: TRUE
Diff: 1
49
13) Name and describe three issues that can affect the incremental cash flow of a new project.
Answer: Examples of issues that can affect the incremental cash flow of a new project are: Sunk Costs,
Opportunity Costs, Erosion Costs, Synergy Gains, Working Capital, Capital Expenditures, and
Depreciation and Cost Recovery of Divested Assets.
SUNK COSTS: Sunk costs are costs that have already been incurred or would be spent regardless of the
decision to accept or reject the project. Since these costs will be incurred anyway, they are not part of the
decision to accept or reject the project. Sunk costs cannot be reversed.
OPPORTUNITY COSTS: An opportunity cost is a benefit forgone due to the selection of a new project. In
a sense, it is a cash inflow that never occurs but would have occurred had we not undertaken the new
project.
EROSION COSTS: Erosion costs occur whenever a new product competes against a company's already
existing products and reduces the sales of these existing products. Only the net additional revenue and
costs should be included in the incremental cash flow—the increase in overall sales and costs to the
company.
SYNERGY GAINS: Synergy gains are gains that result when a new product is introduced that
complements another current product of the firm, thereby increasing the sales of the current product.
WORKING CAPITAL: Working capital involves the change in current assets and current liabilities that
occurs when a new project is introduced. In many cases, the costs of any increase in working capital will
be at least partially offset with termination of the project when the working capital is "released."
Diff: 3
14) Explain why one must be careful when accounting for erosion costs.
Answer: Erosion costs occur whenever a company's new product competes against its existing products,
thereby reducing the sales of these existing products. One must be careful in including the reduced sales.
This is because the sales could be reduced anyhow if another company introduces a competing product.
Also, if erosion reduces sales, then the costs are also reduced. In brief, one must be careful so that only the
net additional revenue and costs should be included in the incremental cash flow—the increase in overall
sales and costs to the company.
Diff: 3
10.3 Capital Spending and Depreciation
1) ________ is the process of "expiring" the cost of a long-term tangible asset over its useful life.
A) Expiration
B) Depreciation
C) Economic recovery
D) Salvaging
Answer: B
Diff: 2
Topic: 10.3 Capital Spending and Depreciation
LO: 10.3 Calculate depreciation and cost recovery.
50
2) There are two main reasons why we need to deal with depreciation. Which of the below is one of these
reasons?
A) The gain but not the loss when a capital asset is disposed
B) The loss but not the gain when a capital asset is disposed
C) The tax flow implications from the OCF
D) The tax rate implications from the OCF
Answer: C
Explanation: C) There are two main reasons why we need to deal with depreciation. They are the tax
flow implications from the OCF and the gain or loss at disposal of a capital asset.
Diff: 2
3) Which of the methods below is a way to allocate depreciation?

A) The allocation each year is the amount of cost as determined by the actual estimated usage for that
year.
B) Use the government-mandated accelerated depreciation system, which depreciates the capital asset at
the minimum accelerated amount allowed each year.
C) The allocation each year is the same amount of cost as determined by the average expected operating
cash inflow divided by the number of years of useful life of the machines.
D) Use the government-mandated accelerated depreciation system, which depreciates the capital asset at
the maximum accelerated amount allowed each year.
Answer: D
Explanation: D) There are two common ways to allocate the depreciation through the years.
(1) Straight Line Depreciation–Each year is allocated the same amount of cost which is determined by
the total initial cost less salvage value divided by the number of years of useful life of the machines.
(2) MACRS–MACRS is a government-mandated accelerated depreciation system that depreciates the
capital asset at the maximum accelerated amount allowed each year. MACRS stands for modified
accelerated cost recovery system and classifies the "life" of every asset for use in determining the
depreciation cost for each year.
Diff: 3
51
4) A firm is considering purchasing two assets. Asset A will have a useful life of 15 years and cost $3
million; it will have installation costs of $400,000 but no salvage or residual value. Asset B will have a
useful life of 6 years and cost $1.3 million; it will have installation costs of $180,000 and a salvage or
residual value of $300,000. Which asset will have a greater annual straight-line depreciation?
A) Asset A has $30,000 more in depreciation per year.
B) Asset A has $40,000 more in depreciation per year.
C) Asset B has $30,000 more in depreciation per year.
D) Asset B has $40,000 more in depreciation per year.
Answer: A
Explanation: A) Annual depreciation for Asset A = (Asset Cost + Installation Cost - Salvage Value) /
Useful Life = ($3 million + $0.4 million - 0) / 15 years = $226,666.67, or about $226,667 per year.
Annual depreciation for Asset B = (Asset Cost + Installation Cost - Salvage Value) / Useful Life
= ($1.3 million + $0.18 million - $0.3 million) / 6 years = $196,666.67, or about $196,667 per year.
Thus, Asset A has $226,667 - $196,667 = $30,000 more in depreciation per year.
Diff: 2
5) A firm is considering purchasing two assets. Asset L will have a useful life of 20 years and cost $5
million; it will have installation costs of $1 million but no salvage or residual value. Asset S will have a
useful life of 8 years and cost $2 million; it will have installation costs of $500,000 and a salvage or
residual value of $400,000. Which asset will have a greater annual straight-line depreciation?
A) Asset L has $12,500 more in depreciation per year.
B) Asset L has $37,500 more in depreciation per year.
C) Asset S has $12,500 more in depreciation per year.
D) Asset S has $37,500 more in depreciation per year.
Answer: B
Explanation: B) Annual depreciation for Asset L = (Asset Cost + Installation Cost - Salvage Value) /
Useful Life = ($5 million + $1 million - 0) / 20 years = $300,000 per year.
Annual depreciation for Asset S = (Asset Cost + Installation Cost - Salvage Value) / Useful Life
= ($2 million + $0.50 million - $0.4 million) / 8 years = $262,500 per year.
Thus, Asset L has $300,000 -$262,500 = $37,500 more in depreciation per year.
Diff: 2
52
6) A firm is considering purchasing two assets. Asset A will have a useful life of 12 years and cost $4
million; it will have installation costs of $300,000 and a salvage or residual value of $400,000. Asset B will
have a useful life of 8 years and cost $3.5 million; it will have installation costs of $200,000 and a salvage
or residual value of $800,000. Which asset will have a greater annual straight-line depreciation?
A) Asset A has $30,000 more in depreciation per year.
B) Asset A has $37,500 more in depreciation per year.
C) Asset B has $30,000 more in depreciation per year.
D) Asset B has $37,500 more in depreciation per year.
Answer: D
Explanation: D) Annual depreciation for Asset A = (Asset Cost + Installation Cost - Salvage Value) /
Useful Life = ($4 million + $0.3 million - $0.4 million) / 12 years = $325,000 per year.
Annual depreciation for Asset B = (Asset Cost + Installation Cost - Salvage Value) / Useful Life
= ($3.5 million + $0.2 million - $0.8 million) / 8 years = $362,500 per year.
Thus, Asset B has $362,500 - $325,000 = $37,500 more in depreciation per year.
Diff: 2
7) A firm is considering purchasing an asset that will have a useful life of 10 years and cost $5 million; it
will have installation costs of $500,000 and a salvage or residual value of $500,000. What is the annual
straight-line depreciation for this asset?
A) $400,000 per year
B) $500,000 per year
C) $600,000 per year
D) $700,000 per year
Answer: B
Explanation: B) Annual depreciation for Asset = (Asset Cost + Installation Cost - Salvage Value) /
Useful Life = ($5 million + $0.5 million - $0.5 million) / 10 years = $500,000 per year.
Diff: 1
8) A firm is considering purchasing an asset that will have a useful life of 8 years and cost $5.5 million; it
will have installation costs of $90,000 and a salvage or residual value of $1,600,000. What is the annual
straight-line depreciation for this asset?
A) $400,000 per year
B) $422,000 per year
C) $498,750 per year
D) $530,450 per year
Answer: C
Explanation: C) Annual depreciation for Asset = (Asset Cost + Installation Cost - Salvage Value) / Useful
Life = ($5.5 million + $0.09 million - $1.6 million) / 8 years = $498,750 per year.
Diff: 2
53
9) ________ costs each year do not reflect cash flow because the actual purchase and installation (outflow
of dollars) of the asset have already taken place.
A) Depreciation
B) Sunk
C) Opportunity
D) Working Capital
Answer: A
Diff: 1

A) Under the modified accelerated cost recovery system (MACRS) system of depreciation, the
government classifies all assets into groups that are assigned specific "lives" for the purpose of
depreciation.
B) Under the modified accelerated cost recovery system (MACRS) system of depreciation, once the
assigned class life is established, an adjustable percentage of the cost is expensed each year as
depreciation.
C) Under the modified accelerated cost recovery system (MACRS) system of depreciation, it can be
assumed that an asset's assigned life class is the shortest allowable recovery period for allocating the
capital expenditure costs and reducing taxes.
D) Depreciation or "expired" costs each year do not reflect cash flows because the actual purchase and
installation (outflow of dollars) of the machines have already taken place.
Answer: B
Explanation: B) Under the modified accelerated cost recovery system (MACRS) system of depreciation,
once the assigned class life is established, A FIXED percentage of the cost is expensed each year as
depreciation.
Diff: 2
11) The advantage of ________ over ________ depreciation is that you can write off more of your capital
costs in the earlier years.
A) straight-line depreciation; the modified accelerated cost recovery system
B) straight-line depreciation; straight-line deductions
C) MACRS; straight-line depreciation
D) MACRS; straight-line deductions
Answer: C
Diff: 2
54
12) A firm is considering purchasing an asset that will cost $5 million. Other depreciable costs include
$800,000 in installation costs. If the asset is classified in the 5-year class, what is the annual depreciation
for years 1, 3, and 6 for this asset, using the fixed depreciation percentages given by MACRS? (The
percentages are 20.00%, 19.20%, and 5.76%, respectively.)
A) $1,856,000, $1,113,600, and $334,080 for years 1, 3, and 6, respectively
B) $1,160,000, $1,113,600, and $334,080 for years 1, 3, and 6, respectively
C) $1,160,000, $1,113,600, and $668,160 for years 1, 3, and 6, respectively
D) $5,800,000, $1,160,000, and $1,113,600 for years 1, 3, and 6, respectively
Answer: B
Explanation: B) The total depreciable value equals the asset cost plus installation costs. Adding these, we
get $5 million plus $0.8 million = $5.8 million. The factor for year 1 is 20%. Thus, the depreciation for year
1 is: 0.2 × $5.8 million = $1,160,000. The factor for year 3 is 19.20%. Thus, the depreciation for year 3 is:
0.192 × $5.8 million = $1,113,600. The factor for year 6 is 5.76%. Thus, the depreciation for year 6 is: 0.0576
× $5.8 million = $334,080.
Diff: 2
13) A firm is considering purchasing an asset that will cost $1 million. Other depreciable costs include
$100,000 in installation costs. If the asset is classified in the 3-year class, what is the annual depreciation
for each year for this asset using the fixed depreciation percentages given by MACRS? (The percentages
are 33.33%, 44.45%, 14.81%, and 7.41%, respectively.)
A) $366,667, $366,667, $366,667 and $0 for years 1, 2, 3, and 4, respectively
B) $275,000, $275,000, $275,000, and $275,000 for years 1, 2, 3, and 4, respectively
C) $366,630, $488,950, $162,910, and $81,510 for years 1, 2, 3, and 4, respectively
D) $366,630, $488,950, $81,510, and $81,510 for years 1, 2, 3, and 4, respectively
Answer: C
Explanation: C) The total depreciable value equals the asset cost plus installation costs. Adding these, we
get $1 million plus $0.1 million = $1.1 million. The factor for year 1 is 33.33%. Thus, the depreciation for
year 1 is: 0.3333 × $1.1 million = $336,630. The factor for year 2 is 44.45%. Thus, the depreciation for year 1
is: 0.4445 × $1.1 million = $488,950. The factor for year 3 is 14.81%. Thus, the depreciation for year 3 is:
0.1481 × $1.1 million = $162,910. The factor for year 4 is 7.41%. Thus, the depreciation for year 4 is: 0.0741 ×
$1.1 million = $81,510. Summing the depreciation we get $1.1 million because all of the factors add up to
1.00 (or 100%).
Diff: 2
55
14) The advantage of MACRS over straight-line depreciation is that you can write off more of your capital
costs in the ________ years.
A) middle
B) last
C) later
D) earlier
Answer: D
Diff: 2
15) The advantage of straight-line depreciation over MACRS depreciation is that you can write off
________.
A) more of your total capital costs
B) your capital costs in fewer years
C) a larger percentage of your capital costs earlier
D) None of the above
Answer: D
Diff: 2
16) The accelerated write-off of capital costs in MACRS depreciation provides a taxable expense that
reduces taxes at a faster rate than with straight-line depreciation. Therefore, according to ________
concepts, we can surmise that bigger tax cuts in the earlier years and lower tax cuts in the later years are
better than a steady tax cut each year.
A) time-value of money
B) depreciation and sunk costs
C) depreciation and opportunity costs
D) interest rate
Answer: A
Diff: 2
17) The ________ a capital asset is NOT part of the MACRS and is ignored for depreciation expense.
A) salvage value of
B) dividends paid from
C) inventory from
D) straight-line value of
Answer: A
Diff: 1
56
18) Termination is the process of "expiring" the cost of a long-term tangible asset over its useful life.
Answer: FALSE
Explanation: Depreciation is the process of "expiring" the cost of a long-term tangible asset over its useful
life.
Diff: 1
19) The annual straight-line depreciation expense is the total value (cost plus installation) minus any
anticipated salvage value divided by the number of years of service (life) of the machine.
Answer: TRUE
Diff: 1
20) MACRS allocates the same amount of cost each period as determined by the total initial cost divided
by the number of years of useful life of the machines.
Answer: FALSE
Explanation: STRAIGHT LINE DEPRECIATION allocates the same amount of cost each period as
determined by the total initial cost divided by the number of years of useful life of the machines.
Diff: 1
21) MACRS stands for modified accelerated cost recovery system and classifies the "life" of every asset for
use in determining the depreciation expense each year.
Answer: TRUE
Diff: 1
22) Briefly describe straight-line depreciation.

Answer: With straight-line depreciation, capital assets are depreciated by the same amount each year.
The annual depreciation is determined by the initial cost plus installation cost less anticipated salvage
value, and this entire amount divided by the number of years of useful life of the asset.
Diff: 3
57
23) Briefly describe MACRS depreciation.
Answer: MACRS is a government-mandated accelerated depreciation system that depreciates the capital
asset at the maximum accelerated amount allowed each year. MACRS stands for modified accelerated
cost recovery system and classifies the "life" of every asset for use in determining the depreciation
expense each year.
Diff: 3
10.4 Cash Flow and the Disposal of Capital Equipment
1) When a depreciable asset is sold, a tax gain or tax loss on disposal is calculated, based on the ________
of the asset at the time of disposal.
A) book value only
B) market value only
C) difference in book and market values
D) difference in market value and salvage value
Answer: C
Diff: 1
Topic: 10.4 Cash Flow and the Disposal of Capital Equipment
LO: 10.4 Understand the cash flow associated with the disposal of depreciable assets.
2) When a depreciable asset is sold, a tax gain or tax loss on disposal is calculated, based on the book
value of the asset at the time of disposal. If a ________ has occurred, ________ are incurred.
A) gain, tax reductions
B) gain, taxes
C) gain, tax credits
D) loss, taxes
Answer: B
Explanation: B) When a depreciable asset is sold, a tax gain or tax loss on disposal is calculated, based on
the book value of the asset at the time of disposal. If a gain has occurred, taxes are incurred. If a loss has
occurred, a tax credit or tax reduction is recorded.
Diff: 2
58
3) When a depreciable asset is sold, a tax gain or tax loss on disposal is calculated, based on the book
value of the asset at the time of disposal. If a ________ has occurred, a ________ is recorded.
A) gain, tax credit
B) gain, tax reduction
C) loss, tax credit
D) loss, tax increase
Answer: C
Explanation: C) When a depreciable asset is sold, a tax gain or tax loss on disposal is calculated, based on
the book value of the asset at the time of disposal. If a gain has occurred, taxes are incurred. If a loss has
occurred, a tax credit or tax reduction is recorded.
Diff: 2
4) The current book value of an asset serves as the basis for determining the gain or loss ________.
A) at retention
B) at book value
C) at market value
D) at disposal
Answer: D
Diff: 1
5) A gain on disposal is recognized when the selling price of the asset is ________ the book value.
A) greater than
B) equal to
C) less than
D) greater than or equal to
Answer: A
Diff: 2
6) A loss on disposal is recognized when the selling price of the asset is ________ the book value.
A) greater than
B) equal to
C) less than
D) less than or equal to
Answer: C
Diff: 2
59
A) The current book value of an asset serves as the basis for determining the gain or loss at disposal.
B) Book value is the original cost of the asset plus the accumulated depreciation.
C) A gain on disposal is recognized when the selling price of the asset is greater than the book value.
D) A loss on disposal is recognized when the selling price of the asset is less than the book value.
Answer: B
Explanation: B) Book value is the original cost of the asset MINUS the accumulated depreciation.
Diff: 2
8) Western Inc. purchases a machine for $15,000. This machine qualifies as a five-year recovery asset
under MACRS with the fixed depreciation percentages as follows: year 1 = 20.00%; year 2 = 32.00%;
year 3 = 19.20%; year 4 = 11.52%. Western has a tax rate of 33%. If the machine is sold at the end of four
years for $4,000, what is the cash flow from disposal?
A) $3,535.36
B) $3,408.22
C) $2,592.00
D) $1,408.00
Answer: A
Explanation: A) The four-year sale is at $4,000. To begin with, the book value of the machine must be
established to determine if a gain or loss has been incurred at disposal. The depreciation schedule for the
$15,000 machine is:
Year 1: $15,000 × 0.2000 = $3,000
Year 2: $15,000 × 0.3200 = $4,800
Year 3: $15,000 × 0.1920 = $2,880
Year 4: $15,000 × 0.1152 = $1,728
Accumulated Depreciation = $3,000 + $4,800 + $2,880 + $1,728 = $12,408
Book Value of machine = $15,000 - $12,408 = $2,592
Gain on disposal is $4,000 - $2,592 = $1,408
Tax on Gain = Gain on disposal × Tax rate = $1,408 × 0.33 = $464.64
After-Tax Cash Flow at disposal = $4,000 - $464.64 = $3,535.36
Diff: 3
60
9) Eastern Inc. purchases a machine for $70,000. This machine qualifies as a five-year recovery asset under
MACRS with the fixed depreciation percentages as follows: year 1 = 20.00%; year 2 = 32.00%; year 3 =
19.20%; year 4 = 11.52%. The firm has a tax rate of 40%. If the machine is sold at the end of two years for
$50,000, what is the cash flow from disposal?
A) $50,000
B) $43,440
C) $39,875
D) $33,600
Answer: B
Explanation: B) The four-year sale is at $50,000. To begin with, the book value of the machine must be
$70,000 machine is:
Year 1: $70,000 × 0.2000 = $14,000
Year 2: $70,000 × 0.3200 = $22,400
Accumulated Depreciation = $14,000 + $22,400 = $36,400
Book Value of machine = $70,000 - $36,400 = $33,600
Tax on Gain = Gain on disposal × Tax rate = $16,400 × 0.40 = $6,560
After-Tax Cash Flow at disposal = $50,000 - $6,560 = $43,440
Diff: 3
10) Southern Inc. purchases an asset for $150,000. This asset qualifies as a five-year recovery asset under
MACRS with the fixed depreciation percentages as follows: year 1 = 20.00%; year 2 = 32.00%; year 3 =
19.20%; year 4 = 11.52%. Southern has a tax rate of 35%. If the asset is sold at the end of four years for
$40,000, what is the cash flow from disposal?
A) $36,089
B) $35,072
C) $34,931
D) $33,678
Answer: B
Explanation: B) The four-year sale is at $40,000. To begin with, the book value of the asset must be
$150,000 asset is:
Year 1: $150,000 × 0.2000 = $30,000
Year 2: $150,000 × 0.3200 = $48,000
Year 3: $150,000 × 0.1920 = $28,800
Year 4: $150,000 × 0.1152 = $17,280
Accumulated Depreciation = $30,000 + $48,000 + $28,800 + $17,280 = $124,080
Book Value of asset = $150,000 - $124,080 = $25,920
Tax on Gain = Gain on disposal × Tax rate = $14,080 × 0.35 = $4,928
After-Tax Cash Flow at disposal = $40,000 - $4,928 = $35,072
Diff: 3
61
11) Northern Co. purchases an asset for $50,000. This asset qualifies as a five-year recovery asset under
MACRS, with the fixed depreciation percentages as follows: year 1 = 20.00%; year 2 = 32.00%; year 3 =
19.20%; year 4 = 11.52%. Northern has a tax rate of 35%. If the asset is sold at the end of four years for
$5,000, what is the after-tax cash flow from disposal?
A) $3,535.36
B) $3,408.22
C) $2,592.00
D) $6274.00
Answer: D
Explanation: D) The four-year sale is at $50,000. To begin with, the book value of the asset must be
$50,000 asset is:
Year 1: $50,000 × 0.2000 = $10,000
Year 2: $50,000 × 0.3200 = $16,000
Year 3: $50,000 × 0.1920 = $9,600
Year 4: $50,000 × 0.1152 = $5,760
Accumulated depreciation = $10,000 + $16,000 + $9,600 + $5,760 = $41,360
Book value of asset = $50,000 - $41,360 = $8,640
Loss on disposal (expressing loss as positive number) = $8,640 - $5,000 = $3,640
Tax savings = Loss on disposal × Tax rate = $3,640 × 0.35 = $1,274
After-tax cash flow at disposal = $5,000 + $1,274 = $6,274.00
Diff: 3
12) Fully depreciated assets ________ , and so any proceeds from sale at disposal are taxable gains.
A) always have a market value of zero
B) have a positive book value
C) have a negative market value
D) have a book value of zero
Answer: D
Diff: 2
62
13) Which is NOT a step in the estimation of after-tax cash flow at disposal?
A) If selling price is greater than book value: Selling Price - Tax on Gain.
B) If selling price is less than book value: Selling Price + Tax Credit on Loss.
C) If book value is less than selling price: Selling Price + Tax Credit on Loss.
D) If selling price equals book value: Selling Price.
Answer: C
Explanation: C) In general, we have the following steps in the estimation of after-tax cash flow at
disposal:
(1) If selling price is greater than book value: Selling Price - Tax on Gain.
(2) If SELLING PRICE is less than BOOK VALUE: Selling Price + Tax Credit on Loss.
(3) If selling price equals book value: Selling Price.
NOTE: If book value is less than selling price: SELLING PRICE - TAX ON GAIN.
Diff: 2
14) The tax rules for depreciation recapture are much more ________ than a simplified approach for
disposal.
A) basic
B) complicated
C) easy
D) shortened
Answer: B
Diff: 2
15) If the selling price of an asset at disposal is greater than its book value, then the after-tax cash flow is
the selling price minus the tax on the gain.
Answer: TRUE
Diff: 1
16) If the selling price of an asset at disposal is less than its book value, then the after-tax cash flow is the
selling price minus the tax on the gain.
Answer: FALSE
Explanation: If the selling price of an asset at disposal is GREATER than its book value, then the after-tax
cash flow is the selling price minus the tax on the gain.
Diff: 1
63
17) The current book value of an asset serves as the basis for determining the gain or loss at disposal.
Answer: TRUE
Diff: 1
18) Book value is the original cost of an asset plus the accumulated depreciation.
Answer: FALSE
Explanation: Book value is the original cost of the asset MINUS the accumulated depreciation.
Diff: 1
19) Fully depreciated assets have a positive book value, and so any proceeds from sale at disposal are
taxable gains.
Answer: FALSE
Explanation: Fully depreciated assets have A BOOK VALUE OF ZERO, and so any proceeds from sale at
disposal are taxable gains.
Diff: 1
20) Southwest Co. purchases an asset for $60,000. This asset qualifies as a seven-year recovery asset under
MACRS. Winston has a tax rate of 30%. The seven-year fixed depreciation percentages for years 1, 2, 3, 4,
5, and 6 are 14.29%, 24.49%, 17.49%, 12.49%, 8.93%, and 8.93%, respectively. If the asset is sold at the end
of six years for $10,000, what is the cash flow from disposal?
Answer: The six-year sale is at $10,000. To begin with, the book value of the asset must be established to
determine if a gain or loss has been incurred at disposal. The depreciation schedule for the $60,000 asset
is:
Year 1: $60,000 × 0.1429 = $8,574
Year 2: $60,000 × 0.2449 = $14,694
Year 3: $60,000 × 0.1749 = $10,494
Year 4: $60,000 × 0.1249 = $7,494
Year 5: $60,000 × 0.0893 = $5,358
Year 6: $60,000 × 0.0893 = $5,358
Accumulated Depreciation = $8,574 + $14,694 + $10,494 + $7,494 + $5,358 + $5,358 = $51,972
Book value of asset = $60,000 - $51,972 = $8,028
Tax gain = Gain on disposal × tax rate = $1,972 × 0.3 = $591.60
After-tax cash flow at disposal = $10,000 - $591.60 = $9,408.40
Diff: 3
64
21) Northwest Co. purchases an asset for $6,000. This asset qualifies as a seven-year recovery asset under
MACRS. Benson has a tax rate of 30%. The seven-year expense percentages for years 1, 2, 3, 4, 5, and 6 are
14.29%, 24.49%, 17.49%, 12.49%, 8.93%, and 8.93%, respectively. If the asset is sold at the end of six years
for $2,000, what is the cash flow from disposal?
Answer: The six-year sale is at $2,000. To begin with, the book value of the asset must be established to
determine if a gain or loss has been incurred at disposal. The depreciation schedule for the $6,000 asset is:
Year 1: $6,000 × 0.1429 = $857.40
Year 2: $6,000 × 0.2449 = $1,469.40
Year 3: $6,000 × 0.1749 = $1,049.40
Year 4: $6,000 × 0.1249 = $749.40
Year 5: $6,000 × 0.0893 = $535.80
Year 6: $6,000 × 0.0893 = $535.80
Accumulated Depreciation = $857.40 + $1,469.40 + $1,049.40 + $749.40 + $535.80 + $535.80 = $5,197.20
Book Value of asset = $6,000 - $5,197.20 = $802.80
Gain on disposal is $2,000 - $802.80 = $1,197.20
Tax Gain on Loss = Gain on disposal × Tax rate = $1,197.20 × 0.3 = $359.16
After-Tax Cash Flow at disposal = $2,000 - $359.16 = $1,640.84
Diff: 3
10.5 Projected Cash Flow for a New Product
1) To project the appropriate anticipated cash flow for a project, we must put all cash flow knowledge
together. This includes ________ of the incremental cash flow.
A) both the amount and timing
B) the amount
C) the timing
D) the amount but not the timing
Answer: A
Diff: 1
Topic: 10.5 Projected Cash Flow for a New Product
LO: 10.5 Estimate incremental cash flow for capital budgeting decisions.
2) When computing the total cash outflow needed to start a project, we must include ________.
A) any change in net income
B) any change in working capital
C) any change in dividends
D) any change in earnings
Answer: B
Diff: 1
65
3) We assume no ________ costs for a project if a competitor is also introducing a competing product.
A) sunk
B) buyback
C) erosion
D) corrosion
Answer: C
Diff: 1
4) Once the operations for a new project are up and running, we need to estimate the cash flow from
________.
A) sunk costs
B) flotation costs
C) depreciation
D) operations
Answer: D
Diff: 1
5) We can use the ________ to estimate a project's operating cash flows each period.
A) modified income statement format
B) income statement format
C) balance sheet format
D) annual report format
Answer: A
Diff: 2
6) The financial manager needs help in producing the best estimates of the future costs of production.
Where does this help come from?
A) Marketing manager
B) Production manager
C) Human resources manager
D) All of these
Answer: D
Diff: 2
66
7) If we know the ________ and the EBIT, we can estimate the taxes for a project for the year.
A) MACRS percentage
B) sunk costs
C) tax rate
D) salvage value
Answer: C
Diff: 1
8) At the end of a project's life, we will recover any initial changes in ________ from the beginning of the
project.
A) working capital
B) depreciation
C) taxes
D) start-up costs
Answer: A
Diff: 1
9) The remaining book value when a project is terminated is the ________ minus accumulated
depreciation over the life of the project.
A) original cost
B) ending cost
C) salvage cost
D) sunk cost
Answer: A
Diff: 1
10) If an asset's disposal value is less than its ________, a loss on disposal occurs.
A) original market value
B) current book value
C) initial cost or original book value
D) current market value
Answer: B
Diff: 2
67
11) If an asset's ________ is greater than its current book value, a gain on disposal occurs.
A) original book value
B) amount of depreciation
C) disposal value
D) original market value
Answer: C
Diff: 1
12) Cash flow at disposal of an asset can be calculated as the disposal value plus the ________ on the loss.
A) alternative minimum tax
B) statutory tax
C) tax shield
D) tax credit
Answer: D
Diff: 1
13) The building of the ________ cash flow of a project is the cornerstone of the financial decision models.
A) depreciation
B) incremental
C) accounting
D) tax
Answer: B
Diff: 1
14) A financial manager examines concepts such as sunk costs, opportunity costs, and erosion costs to
help understand how to estimate the incremental cash flow of a project, which is ________.
A) the extra money the firm pays from taking on more inventory
B) the additional money the firm receives from taking on a new project
C) the prior money the firm receives from taking on a new project
D) the additional money the firm receives from its choice of financing
Answer: B
Diff: 1
68
15) One examines concepts such as sunk costs, opportunity costs, and erosion costs to help understand
how to estimate the incremental cash flow of a project.
Answer: TRUE
Diff: 1
16) If an asset's disposal value is greater than its current book value, a gain on disposal occurs.
Answer: TRUE
Diff: 1
17) The six financial decision models that you studied in Chapter 9 are valid only if one has the proper
incremental cash flow for the project under consideration.
Answer: TRUE
Diff: 1
18) The output of the capital budgeting decision models is only as good as the inputs that go into them.
Answer: TRUE
Diff: 1
19) What is an incremental cash flow for a project? What concepts do we need to examine to help
understand how to estimate the incremental cash flow of a project? What else is needed for deciding
whether or not to choose a project?
Answer: The incremental cash flow of a project is the additional money the firm receives from taking on
a new project. To estimate the incremental cash flow of a project, we need to examine concepts such as
sunk costs, opportunity costs, and erosion costs. We also need to look at the changes in working capital
that can occur with a new project. Additionally, we should consider the capital spending necessary to
launch the new product and the depreciation process of "expiring" the cost of new production equipment
over time. All of these concepts are instrumental in building the incremental cash flow of a project. We
can then apply the net present value decision rule in order to make a go/no-go decision for a potential
new product.
Diff: 3
69
Chapter 11 The Cost of Capital
11.1 The Cost of Capital: A Starting Point
1) The ________ is the cost of each financing component multiplied by that component's percent of the
total funding amount.
A) NPV
B) IRR
C) cost of capital
D) cost of debt
Answer: C
Diff: 1
Topic: 11.1 The Cost of Capital: A Starting Point
LO: 11.1 Understand the different kinds of financing available to a company: debt financing, equity financing, and
hybrid equity financing.
2) The cost of capital is ________.

A) the cost of debt in a firm that finances with both debt and equity
B) the cost of each financing component multiplied by that component's percent of the total borrowed
C) another name for the IRR
D) All of the above
Answer: B
Diff: 1
3) ________ refers to the way a company finances itself through some combination of loans, bond sales,
preferred stock sales, common stock sales, and retention of earnings.
A) Capital structure
B) Cost of capital
C) Working capital management
D) NPV
Answer: A
Diff: 1
70
4) Which of the following is not considered a part of the firm's capital structure?
A) Long-term debt
B) Retained earnings
C) Inventory
D) Preferred stock
Answer: C
Diff: 1
5) A firm's capital structure can be determined by examining which parts of the firm's balance sheet?
A) The long-term assets
B) The debt and equity
C) The short-term assets and liabilities
D) None of the above because a firm's capital structure is best observed on the income statement.
Answer: B
Explanation: B) Long-term assets speak to the question of capital budgeting, short-term assets and
liabilities speak to net working capital decisions.
Diff: 1
6) Of the following, which is NOT a source of funds for a company?

A) Common shareholders
B) Commercial banks
C) Preferred stockholders
D) All are sources of funds for companies.
Answer: D
Diff: 1
71
7) Which of the following would be classified as debt lenders for a firm?
A) Preferred shareholders, banks, and nonbank lenders
B) Nonbank lenders, common shareholders, and commercial banks
C) Preferred shareholders, common shareholders, and suppliers
D) Suppliers, nonbank lenders, and commercial banks
Answer: D
Explanation: D) Preferred stockholders are hybrid equity lenders, common shareholders are owners, and
the rest of the choices may be considered a form of debt lender.
Diff: 2
8) Which of the following would be classified as equity financing for a firm?

A) Preferred shareholders, banks, and nonbank lenders
B) Nonbank lenders, common shareholders, and commercial banks
C) Preferred shareholders, common shareholders, and retained earnings
D) Suppliers, nonbank lenders, and commercial banks
Answer: C
Explanation: C) Bank and nonbank lenders, as well as suppliers, are sources of debt lending.
Diff: 2
9) When a company borrows money from a bank or sells bonds, it is called ________.
A) capital structure financing
B) stock financing
C) equity financing
D) debt financing
Answer: D
Diff: 1
10) Which of the items below is sometimes termed hybrid equity financing?
A) Retained earnings
B) Preferred stock
C) Callable bonds
D) Variable rate bonds
Answer: B
Diff: 1
72
11) Which of the statements below is NOT true?
A) Preferred stock is a form of hybrid equity financing.
B) Retained earnings are a form of hybrid equity financing.
C) Common stock is a form of equity financing.
D) Corporate bonds are a form of debt financing.
Answer: B
Explanation: B) Retained earnings are internal equity financing.
Diff: 1
12) The weighted average cost of capital is ________.

A) the average of the cost of each financing component, weighted by the proportion of each component
B) the cost of capital for the firm as a whole
C) made up of three financing components: the cost of debt, the cost of preferred stock, and the cost of
equity
D) All of the above
Answer: D
Diff: 2
13) Acme Supply Co. has a new project that will require the company to borrow $3,000,000. Acme has
made an agreement with three lenders for the needed financing. First National Bank will give $1,500,000
and wants 10% interest on the loan. Lockup Bank will give $1,000,000 and wants 12% interest on the loan.
Southern National Bank will give $500,000 and wants 13% interest on the loan. What is the weighted
average cost of capital for this $3,000,000?
A) 10.55%
B) 11.17%
C) 11.66%
D) 12.16%
Answer: B
Explanation: B) WACC = × 10% + × 12% + × 13% = 11.17%.

Diff: 2
73
14) Michigan Manufacturing Inc. (MM) has a new project that will require the company to borrow
$1,000,000. MM has made an agreement with three lenders for the needed financing. First National Bank
will give $500,000 and wants 9% interest on the loan. Key West Bank will give $300,000 and wants 11%
interest on the loan. Chase Bank will give $200,000 and wants 12% interest on the loan. What is the
weighted average cost of capital for this $1,000,000?
A) 10.67%
B) 10.20%
C) 10.00%
D) 9.67%
Answer: B
Explanation: B) WACC = × 9% + × 11% + × 12% = 10.20%.

Diff: 2
15) The choice of the borrowing proportion makes up the capital budgeting of the firm.
Answer: FALSE
Explanation: The choice of the borrowing proportion makes up the capital structure of the firm.
Diff: 1
16) When a company borrows from a bank or sells bonds, it is called equity financing.
Answer: FALSE
Explanation: When a company borrows from a bank or sells bonds, it is called debt financing.
Diff: 1
17) When a company "borrows" money from the owners by selling common stock or using internal funds,
it is called equity financing.
Answer: TRUE
Diff: 1
74
18) When estimating the cost of debt financing from bonds, a firm can use the yield-to-maturity as the
before-tax cost of debt.
Answer: TRUE
Diff: 1
19) The textbook labels preferred stock as "hybrid equity financing." Identify and explain the features of
preferred stock that give it the designation of "hybrid equity financing."
Answer: Preferred stock is identified as a hybrid equity security because even though it is equity, it has
features of debt as well. Like stock, it has no specific maturity and the principal is usually not repaid. Like
debt, preferred stock does not ordinarily have voting rights but under certain conditions it may be
converted to common stock. Preferred stock's annual dividend at a set rate is like the coupon payments
on a bond.
Diff: 1
11.2 Components of the Weighted Average Cost of Capital
1) In capital budgeting, the ________ is the appropriate discount rate to use when calculating the NPV of
an average risk project.
A) WACC
B) IRR
C) cost of debt
D) cost of Equity
Answer: A
Diff: 1
Topic: 11.2 Components of the Weighted Average Cost of Capital
LO: 11.2 Understand the debt and equity components of the weighted average cost of capital (WACC) and explain
the tax implications on debt financing and the adjustment to the WACC.
2) In capital budgeting, the appropriate decision rule for an average-risk project is to accept if the
________ is greater than the WACC.
A) NPV
B) IRR
C) cost of equity
D) cost of debt
Answer: B
Diff: 1
75
3) The ________ is the return that the bank or bondholder demands on new borrowing.
A) IRR
B) WACC
C) cost of equity
D) cost of debt
Answer: D
Diff: 1
4) The cost of debt could be which of the following?

A) The required return on money borrowed as a long-term loan from a bank
B) The required return on money borrowed from a venture capitalist
C) The yield-to-maturity on money raised by selling bonds
D) All of the choices above could be considered the cost of debt.
Answer: D
Diff: 2
5) Which of the following would NOT be considered a cost of debt financing?

A) The required return on a bank loan
B) The required return on preferred stock
C) The yield-to-maturity of a bond issue
D) The required return on money borrowed from a venture capitalist
Answer: B
Diff: 2
76
6) Your firm has just issued a 20-year $1,000.00 par value, 10% annual coupon bond for a net price of
$964.00. What is the yield to maturity? Use a financial calculator to determine your answer.
A) 10.60%
B) 11.10%
C) 10.44%
D) 10.16%
Answer: C
Explanation: C)
Mode = P/Y = 1; C/Y = 1
Input 20 ? -964 100 1,000
Key N I/Y PV PMT FV
CPT 10.44%
Note that APR = EAR.
Diff: 2
7) Your firm has just issued a 20-year $1,000.00 par value, 6% coupon semiannual bond for a net price of
$964.00. What is the yield to maturity? Use a financial calculator to determine your answer.
A) 3.16%
B) 7.33%
C) 6.32%
D) 6.00%
Answer: C
Explanation: C)
Mode = P/Y = 2; C/Y = 2
Input 40 ? -964 30 1,000
Key N I/Y PV PMT FV
CPT 6.32%
Diff: 3
77
8) Your firm has issued a 10-year $1,000.00 par value semiannual 10% coupon bond that sells for $1,000 in
the market place. The proceeds from the sale of the bond issue are $975.00 per bond. What is your firm's
yield to maturity on this new bond issue? Use a financial calculator to determine your answer.
A) 5.15%
B) 10.16%
C) 10.30%
D) 10.41%
Answer: D
Explanation: D)
Mode = P/Y = 2; C/Y = 2
Input 20 ? -975 50 1,000
Key N I/Y PV PMT FV
CPT 10.41%
Diff: 3
9) A/An ________ facilitates the issuing and sale of bonds and for this service is paid a fee.
A) commercial banker
B) investment banker
C) dealer
D) broker
Answer: B
Diff: 1
10) An investment banker's fees are part of the ________ realized for issuing new debt or equity.
A) flotation costs
B) opportunity costs
C) revenues
D) benefits
Answer: A
Diff: 1
78
11) Pricing preferred stock is most similar to pricing ________.
A) constant growth common stock
B) a perpetuity
C) a zero-coupon bond
D) a three-month Treasury bill
Answer: B
Diff: 1
12) Your firm has preferred stock outstanding that pays a current dividend of $3.00 per year and has a
current price of $39.50. You anticipate that the economy will grow steadily at a rate of 3.00% per year for
the foreseeable future. What is the market required rate of return on your firm's preferred stock?
A) 10.82%
B) 10.59%
C) 7.59%
Answer: C
Explanation: C) Rps = = = 7.59%.

Note: the growth rate in the economy is a red herring and has no bearing on the answer.
Diff: 3
13) Your firm has preferred stock outstanding that pays a current dividend of $2.00 per year and has a
current price of $21.50. Currently, preferred stock makes up approximately 15% of your firm's long-term
financing. What is the market required rate of return on your firm's preferred stock?
A) 8.70%
B) 9.00%
C) 9.30%
D) 15.00%
Answer: C
Explanation: C) Rps = = = 9.30%.

Diff: 3
79
14) The riskiness of a future cash flow is measured by ________ , and these are all components of the
SML.
A) the firm's standard deviation, correlation, and the market risk premium
B) beta, the market risk premium, and the firm's standard deviation
C) the market risk premium, beta, and correlation
D) beta, the market risk premium, and the risk-free rate
Answer: D
Diff: 2
15) Use the security market line to determine the required rate of return for the following firm's stock.
The firm has a beta of 1.25, the required return in the market place is 10.50%, the standard deviation of
returns for the market portfolio is 25.00%, and the standard deviation of returns for your firm is also
25.00%.
A) 13.13%
B) 10.50%
C) 31.25%
Answer: D
Explanation: D) Re = E(ri) = rf + [E(rm) - rf] βi.
This problem lacks information about the risk-free rate of return, and so we cannot solve for R e.
Diff: 3
16) Use the security market line to determine the required rate of return for the following firm's stock.
The firm has a beta of 0.80, the required return in the market place is 12.50%, and the risk-free rate of
return is 3.50%.
A) 13.50%
B) 10.70%
C) 7.20%
D) 2.80%
Answer: B
Explanation: B) Re = Rf + β × (Rm - Rf) = 3.50% + 0.80 × (12.50% - 3.50%) = 10.70%.
Diff: 3
80
17) Which of the following is an advantage of the dividend growth approach over the SML in estimating
the required return on equity?
A) The dividend growth model uses market information but the SML does not.
B) Dividend growth is known, whereas estimating beta for the SML is an art form.
C) It is easy to fit flotation costs into the dividend growth model but not the SML.
D) All are advantages of the dividend growth model for estimating the required return on equity.
Answer: C
Explanation: C) The dividend growth model solves for Re via Re = + g, but the SML has no
obvious method to adjust for flotation costs.
Diff: 2
18) Use the dividend growth model to determine the required rate of return for equity. Your firm intends
to pay a dividend of $1.50 per share one year from today. Further, the recent stock price is $31.82 per
share, and you anticipate a growth rate in dividends of 4.00% per year for the foreseeable future.
A) 8.90%
B) 8.71%
C) 9.09%
Answer: B
Explanation: B) Re = + g = Re = + 0.04 = 8.71%.

Diff: 3
19) Use the dividend growth model to determine the required rate of return for equity. Your firm recently
paid a dividend of $2.25 per share, has a recent price of $40.20 per share, and anticipates a growth rate in
dividends of 3.00% per year for the foreseeable future.
A) 8.76%
B) 8.60%
C) 8.44%
Answer: A
Explanation: A) Re = + g = Re = $2.25 ∗ (1.03)/$40.20 + 0.03 = 8.76%.

Diff: 3
81
82
to issue new common stock. Your investment bankers have determined that the stock should be offered
at a price of $45.00 per share and that you should anticipate paying a dividend of $1.50 in one year. If you
anticipate a constant growth in dividends of 3.50% per year and the investment banking firm will take
7.00% per share as flotation costs, what is the required rate of return for this issue of new common stock?
A) 7.19%
B) 6.83%
C) 7.08%
Answer: C
Explanation: C) Re = +g= + 0.035 = 0.03584 + 0.035 ≈ 7.08%.

Diff: 3
to issue new common stock. Your investment bankers have determined that the stock should be offered
at a price of $20.00 per share and that you should anticipate paying a dividend of $0.75 in one year. If you
anticipate a constant growth in dividends of 3.00% per year and the investment banking firm will take
8.00% per share as flotation costs, what is the required rate of return for this issue of new common stock?
A) 6.83%
B) 7.08%
C) 7.19%
D) 10.20%
Answer: B
Explanation: B) Re = +g= + 0.0300 = 0.04076 + 0.0300 ≈ 7.08%.

Diff: 3
83
22) The cost of retained earnings ________.
A) is the loss of the dividend option for the owners
B) is the cost of issuing new common stock without the flotation costs
C) is the appropriate cost of capital for the shareholders
D) All of the above
Answer: D
Explanation: D) Retained earnings are the portion of net income not paid out as dividends. Because the
funds are kept by the firm, the managers have an obligation to meet the opportunity costs of the
shareholders so the cost of retained earnings should be considered the cost of raising new equity without
any additional flotation costs.
Diff: 2
23) When calculating the after-tax weighted average cost of capital (WACC), which of the following costs
is adjusted for taxes in the equation?
A) The before-tax cost of equity
B) The before-tax cost of debt
C) The before-tax cost of preferred stock
D) The after-tax cost of debt
Answer: B
Explanation: B) WACCadj = × Rd × (1 - Tc) + × Rps + × Re.

Diff: 1
24) Which of the following are tax-deductible expenses for corporations?

A) Interest expenses
B) Preferred stock dividends
C) Common stock dividends
D) All are tax-deductible for corporations.
Answer: A
Diff: 1
84
25) Which of the following is the proper way to adjust the cost of debt to estimate the after-tax cost of
debt?
A) Rd ÷ (1 + Tc)
B) Rd ÷ (1 - Tc)
C) Rd × (1 - Tc)
D) Rd × (1 + Tc)
Answer: C
Diff: 1
26) For estimating NPV, the IRR is the appropriate discount rate to use for an average-risk project.
Answer: FALSE
Explanation: For estimating NPV, the WACC is the appropriate discount rate to use for an average-risk
project.
Diff: 1
27) When evaluating an average-risk project using IRR, a firm should use the WACC as the hurdle rate.
Answer: TRUE
Diff: 1
28) Flotation costs reduce the cost of borrowing funds for the firms.
Answer: FALSE
Explanation: Flotation costs INCREASE the cost of borrowing funds for the firms.
Diff: 1
29) When determining the cost of bond financing a firm must determine the net proceeds from the sale of
the bond less the flotation cost charged by the investment banker to estimate the yield-to-maturity.
Answer: TRUE
Diff: 1
85
30) Two techniques for determining the cost of equity include using:
1. The Security Market Line, and 2. The Internal Rate of Return.
Answer: FALSE
Explanation: Two techniques for determining the cost of equity include using:
1. The Security Market Line, and 2. The Dividend Growth Model.
Diff: 1
31) It is easier to incorporate the impact of flotation costs on the cost of equity capital in using the
dividend growth model rather than the Security Market Line.
Answer: TRUE
Diff: 2
32) The cost of retained earnings is the cost of issuing new common stock without flotation costs.
Answer: TRUE
Diff: 1
33) To find the after-tax cost of debt for a corporation, one needs to multiply the before-tax cost of debt by
(1 + Tc), where Tc = the corporate tax rate.
Answer: FALSE
Explanation: To find the after-tax cost of debt for a corporation, one needs to multiply the before-tax cost
of debt by (1 - Tc), where Tc = the corporate tax rate.
Diff: 2
86
34) Theo has been assigned the task of determining the cost of capital for his division of the firm. His first
step is to determine the cost of debt. The firm has $1,000 par value bonds outstanding that have an annual
coupon rate of 8.00% and make semiannual payments. These bonds have twenty-three years remaining to
maturity and currently sell for $1,133.42. What is the yield-to-maturity on these bonds? Use a financial
calculator to determine your answer.
Answer: Mode = P/Y = 2; C/Y = 2
Input 46 ? -1,133.42 40 1,000
Key N I/Y PV PMT FV
CPT 6.84%
Diff: 2
35) Define flotation costs and explain how they are used when estimating a firm's yield-to-maturity.
Answer: Flotation costs are the costs incurred to sell a security. They are the fees charged by the
investment banker to facilitate the issuance and sale of the bond. To determine the yield-to-maturity of a
new issue of bonds, it is proper to use the bond selling price less the flotation cost as the net proceeds to
the firm. The net proceeds become the price used in the equation to determine the yield-to-maturity.
Diff: 2
36) Phillip Enterprises Inc. needs to determine its cost of equity capital. Use the following information to
estimate the firm's cost of equity using both the security market line and the dividend growth model. The
current market price of stock is $22.89, the risk-free rate is 4.00%, the required return on the market
portfolio is 13.50%, the firm has a constant growth rate in dividends of 3.00% per year, current dividends
are $2.00, and the firm's beta is 0.90.
Answer: For the dividend growth model, Re = +g= + .03 = 12.00%

For the SML, E(ri) = rf + [E(rm) - rf] βi = 0.04 + (.135 - .04) × 0.90 = 12.55%.
At this point, the student may choose either answer or to average the two answers.
Diff: 3
87
11.3 Weighting the Components: Book Value or Market Value?
1) The ________ of an asset or liability is its cost carried on the balance sheet.
A) market value
B) book value
C) hybrid value
D) theoretical value
Answer: B
Diff: 1
Topic: 11.3 Weighting the Components: Book Value or Market Value?
LO: 11.3 Calculate the weights of the components using book values or market values.
2) Elway Electronics has debt with a market value of $350,000, preferred stock with a market value of
$150,000, and common stock with a market value of $450,000. If debt has a cost of 8%, preferred stock a
cost of 10%, common stock a cost of 12%, and the firm has a tax rate of 30%, what is the WACC?
A) 8.64%
B) 9.12%
C) 9.33%
D) 9.46%
Answer: C
Explanation: C) WACC = × Rd × (1 - Tc) + × Rps + × R e.
WACC = × 8% × (1 - .30) + × 10% + × 12% = 9.33%.

Diff: 2
3) Rogers' Rotors has debt with a market value of $250,000, preferred stock with a market value of
$50,000, and common stock with a market value of $750,000. If debt has a cost of 7%, preferred stock a
cost of 9%, common stock a cost of 13%, and the firm has a tax rate of 30%, what is the WACC?
A) 8.64%
B) 9.12%
C) 9.33%
D) 10.88%
Answer: D
Explanation: D) WACC = × Rd × (1 - Tc) + × Rps + × R e.
WACC = × 7% × (1 - .30) + × 9% + × 13% = 10.88%.

Diff: 2
88
4) The following information comes from the balance sheet of Roamer Enterprises. The value of common
stock is $60,000, retained earnings equal $40,000, total common equity equals $100,000, preferred stock
has a value of $10,000 and long-term debt totals $120,000. For purposes of estimating the firm's WACC,
what are the weights of long-term debt, preferred stock, and equity?
A) D/V = 52.17%, PS/V = 43.48%, and E/V = 4.35%
B) D/V = 52.17%, PS/V = 4.35%, and E/V = 43.48%
C) D/V = $120,000, PS/V = $10,000, and E/V =$100,000
Answer: B
Explanation: B) D/V = $120,000/$230,000 = 52.17%, P/V = $10,000/$230,000 = 4.35%,
E/V = $100,000/$230,000 = 43.48%.
Diff: 2
5) The following information comes from the Galaxy Construction balance sheet. The value of common
stock is $10,000, retained earnings equals $7,000, total common equity equals $17,000, preferred stock has
a value of $3,000, and long-term debt totals $15,000. If the cost of debt is 8.00%, preferred stock has a cost
of 10.00%, common stock has a cost of 12.00%, and the firm has a corporate tax rate of 30%, calculate the
firm's WACC adjusted for taxes.
A) 10.11%
B) 10.00%
C) 9.09%
Answer: C
Explanation: C) WACCadj = × Rd × (1 - Tc) + × Rps + × R e.
WACCadj = × 8% × (1 - .30) + × 10% + × 12% = 9.09%.

Diff: 3
89
6) The following market information was gathered for the ACME corporation. The common stock is
selling for $40.00 per share and there are 100,000 shares outstanding. Retained earnings equal $400,000,
preferred stock has 1,000 shares outstanding selling at $120.00 per share, and 500 outstanding long-term
bonds are selling for $1,035.00 each. For purposes of estimating the firm's WACC, what are the market
value weights of long-term debt, preferred stock, and equity?
A) D/V = 11.16%, PS/V = 2.59%, and E/V = 86.25%
B) D/V = 10.27%, PS/V = 2.38%, and E/V = 87.34%
C) D/V = 10.78%, PS/V = 3.08%, and E/V = 86.14%
D) D/V = 33.33%, PS/V = 33.33%, and E/V = 33.33%
Answer: A
Explanation: A) E = $40 × 100,000 shares = $4,000,000, P = $120 × 1,000 shares = $120,000, D = $1,035 × 500
bonds = $517,500. E/V = $4,000,000/$4,637,500 = 86.25%, P/V = $120,000/$4,637,500 = 2.59%, D/V =
$517,500/$4,637,500 = 11.16%.
Diff: 3
7) The following market information was gathered for the Blender Corporation. The firm has 1,000 bonds
outstanding, each selling for $1,100.00 with a required rate of return of 8.00%. Blenders has 5,000 shares of
preferred stock outstanding, selling for $40.00 per share and 50,000 shares of common stock outstanding,
selling for $18.00 per share. If the preferred stock has a required rate of return of 11.00% and the common
stock requires a 14.00% return, and the firm has a corporate tax rate of 30%, calculate the firm's WACC
adjusted for taxes.
A) 6.77%
B) 10.73%
C) 9.53%
D) There is not enough information to answer this question because there is no information provided
about the amount of retained earnings held by the firm.
Answer: C
Explanation: C) E = $18 × 50,000 shares = $900,000, PS = $40 × 5,000 shares = $200,000, D = $1,100 × 1,000
bonds = $1,100,000.
E/V = $900,000/$2,200,000 = 0.40909, P/V = $200,000/$2,200,000 = 0.0909, D/V = $1,100,000/$2,200,000 = 0.5.
WACC = × Rd × (1 - Tc) + × Rps + × Re = 0.5 × 8% × (1 - 0.30) + 0.0909 × 11% + 0.40909 × 14% =

9.53%.
Diff: 3
90
8) Market values require multiplying the ________ of each component source of capital by the ________.
A) price; quantity
B) book value; quantity
C) price; book value
D) None of the above
Answer: A
Diff: 1
9) Investors ________ for estimating the WACC.

A) are indifferent between using market and book value
B) prefer book value to market value
C) prefer market value to book value
D) prefer a mix of book and market value
Answer: C
Diff: 1
10) Generally speaking, when the information is available, investors prefer to use ________ rather than
________ when evaluating a firm.
A) past data; current data
B) market values; book values
C) current data; market values
D) book values; market values
Answer: B
Diff: 1
11) The formula for the adjusted WACC = × Rd + × Rps + × Re × (1 - Tc).

Answer: FALSE
Explanation: The formula for the adjusted WACC = × Rd × (1 - Tc) + × Rps + × R e.

Diff: 2
91
12) To estimate the market value of a publicly traded bond that has a broad market with frequent trading,
it is usually best to multiply the number of bonds outstanding by the bond par value.
Answer: FALSE
Explanation: To estimate the market value of a publicly traded bond that has a broad market with
frequent trading, it is usually best to multiply the number of bonds outstanding by the bond market
price.
Diff: 2
13) When possible, investors and analysts prefer to use book value to market value for estimating the
WACC.
Answer: FALSE
Explanation: When possible, investors and analysts prefer to use MARKET value to BOOK value for
estimating the WACC.
Diff: 2
14) Equity is an attractive form of financing for a firm because it has additional tax advantages for the
firm compared to debt.
Answer: FALSE
Explanation: DEBT is an attractive form of financing for a firm because it has additional tax advantages
for the firm compared to EQUITY.
Diff: 2
15) When estimating a weighted average cost of capital, a firm can use either book values or market
values for estimating the value of the component sources of capital. Where would you find book values,
and what value do they represent? How would you calculate market values? In general, would you
prefer to use market or book values for estimating the WACC? Under what circumstances would you use
book values?
Answer: Book values for debt and equity are found on a firm's balance sheet and represent historical
costs. Market values are calculated by multiplying the market price of the debt by the number of
outstanding bonds and multiplying the number of outstanding shares of stock by the current market
price. Market values represent the market's best estimate of the current value of future cash flows to be
realized from owning debt or equity. In general we prefer to use market values because they are forward-
looking rather than historical in nature. However, market values may not be available for privately held
firms or for very small companies and then book value becomes the only practical, although inaccurate,
alternative.
Diff: 2
92
11.4 Using the Weighted Average Cost of Capital in a Budgeting Decision
1) Your firm has an average-risk project under consideration. You choose to fund the project in the same
manner as the firm's existing capital structure. If the cost of debt is 9.00%, the cost of preferred stock is
12.00%, the cost of common stock is 16.00%, and the WACC adjusted for taxes is 14.00%, what is the NPV
of the project, given the expected cash flows listed here?
Category T0 T1 T2 T3
Investment -$2,000,000
NWC -$250,000 $250,000
Operating Cash Flow $850,000 $850,000 $850,000
Salvage $50,000
Total Incremental Cash Flow -$2,250,000 $850,000 $850,000 $1,150,000
A) -$74,121
B) $499,604
C) $2,175,879
D) $2,479,604
Answer: A
Explanation: A) In this problem we have divided the T3 payment into two parts to facilitate ease of
calculation. NPV = PV of cash inflows - the initial investment.
PMT = $850,000, FV = $1,150,000 - $850,000, N = 3, I% = 14.00%. PV = $2,175,879. Then, NPV = $2,175,879 -
$2,250,000 = -$74,121.
Diff: 3
Topic: 11.4 Using the Weighted Average Cost of Capital in a Budgeting Decision
LO: 11.4 Explain how the capital budgeting models use WACC.
93
12.00%, the cost of common stock is 16.00%, and the WACC adjusted for taxes is 14.00%, what is the IRR
of the project given the expected cash flows listed here? Use a financial calculator to determine your
answer.
NWC -$250,000 $250,000
Salvage $50,000
A) About 12.13%
B) About 14.00%
C) About 24.95%
Answer: A
Explanation: A) In this problem we have divided the T3 payment into two parts to facilitate ease of
calculation. To solve for the IRR, input the following values:
PMT = $850,000, FV = $300,000, N = 3, PV = -$2,250,000, and solve for I% to get the IRR = 12.125% or
"about 12.13%."
Diff: 3
94
Investment -$800,000
NWC -$50,000 $50,000
Salvage $20,000
Total Incremental Cash Flow -$850,000 $350,000 $350,000 $420,000
A) $1,150,904
B) $898,415
C) $300,904
D) $48,415
Answer: D
Explanation: D) NPV = PV of cash inflows - the initial investment.
PMT = $350,000, FV = $420,000 - $350,000, N = 3, I% = 11.50%. PV = $898,415. Then, NPV = $898,415 -
$850,000 = $48,415.
Diff: 3
95
of the project, given the expected cash flows listed here? Use a financial calculator to determine your
answer.
Investment -$800,000
NWC -$50,000 $50,000
Salvage $20,000
Total Incremental Cash Flow -$850,000 $350,000 $350,000 $420,000
A) About 11.50%
B) About 28.30%
C) About 14.67%
Answer: C
Explanation: C) To solve for the IRR, input the following values: PMT = $350,000, FV = $70,000, N = 3, PV
= -$850,000, and solve for I% to get the IRR = 14.666% or "about 14.67%."
Diff: 3
96
NWC -$350,000 $350,000
Salvage $50,000
A) -$917,930
B) -$293,289
C) $0
D) $126,471
Answer: A
Explanation: A) NPV = PV of cash inflows - the initial investment.
PMT = $950,000, FV = $1,350,000 - $950,000, N = 3, I% = 15.00%. PV = $2,432,070. Then,
NPV = $2,432,070 -$ 3,350,000 = -$917,930.
Diff: 3
97
of the project, given the expected cash flows listed here? Use a financial calculator to determine your
answer.
NWC -$350,000 $350,000
Operating Cash Flow $1,200,000 $1,200,000 $1,200,000
Salvage $50,000
Total Incremental Cash Flow -$3,350,000 $1,200,000 $1,200,000 $1,600,000
A) About 13.11%
B) About 12.02%
C) About 11.16%
D) About 8.94%
Answer: D
Explanation: D) To solve for the IRR, input the following values: PMT = $1,200,000, FV = $400,000, N = 3,
PV = -$3,350,000, and solve for I% to get the IRR = 8.943%, or "about 8.94%."
Diff: 3
7) If all projects are assigned the same discount rate for purposes of evaluation, which of the following
could occur?
A) Low-risk projects could be rejected when in fact they are good investment choices.
B) High-risk projects could be accepted when in fact they are poor investment choices.
C) High-risk projects could be accepted when in fact they are good investment choices.
D) All of the choices could occur when using a single discount rate for all projects.
Answer: D
Diff: 2
8) It is necessary to assign the appropriate cost of capital for each individual project that reflects that
project's ________ when doing capital budgeting.
A) life
B) cash flows
C) riskiness
D) managers
Answer: C
Diff: 1
98
9) Takelmer Industries has a different WACC for each of three types of projects. Low-risk projects have a
WACC of 8.00%, average-risk projects a WACC of 10.00%, and high-risk projects a WACC of 12%. Which
of the following projects do you recommend the firm accept?
Project Level of Risk IRR

A Low 9.50%
B Average 8.50%
C Average 7.50%
D Low 9.50%
E High 14.50%
F High 17.50%
G Average 11.50%
A) A, B, C, D, G
B) B, C, E, F, G
C) A, D, E, F, G,
D) A, B, C, D, E, F, G
Answer: C
Diff: 2
10) Johnson's Diner has an adjusted WACC of 10.08%. The company has a capital structure consisting of
70% equity and 30% debt, a cost of equity of 12.00%, a before-tax cost of debt of 8.00%, and a tax rate of
30%. Johnson is considering expanding by building a new diner in a distant city and considers the project
to be riskier than his current operation. He estimates his existing beta to be 1.0, the required return on the
market portfolio to be 12.00%, the risk-free rate to be 3.00%, and the beta for the new project to be 1.40.
Given this information, and assuming the cost of debt will not change if Johnson undertakes the new
project, what adjusted WACC should he use in his decision-making?
A) 10.08%
B) 12.60%
C) 13.32%
D) 14.16%
Answer: B
Explanation: B) Re = E(ri) = rf + [E(rm) - rf] βi = 3.00% + [12.00% - 3.00%] × 1.4 = 15.60%.
WACC = × Rd × (1 - Tc) + × Re = 0.30 × (8.00%) × (1 - .30) + 0.70 × (15.60%) = 12.60%.

Diff: 3
99
11) Acme Business Connections (ABC) has an adjusted WACC of 8.56%. The company has a capital
structure consisting of 60% equity and 40% debt, a cost of equity of 11.00%, a before-tax cost of debt of
7.00%, and a tax rate of 30%. ABC is considering expanding by building a new shop in a distant city and
considers the project to be riskier than the current operation. ABC has an existing beta of 1.0, the required
return on the market portfolio to be 11.00%, the risk-free rate to be 3.00%, and the beta for the new project
to be 1.30. Given this information, and assuming the cost of debt will not change if ABC undertakes the
new project, what adjusted WACC should be used in decision-making?
A) 8.56%
B) 9.84%
C) 10.00%
D) 11.24%
Answer: C
Explanation: C) Re = E(ri) = rf + [E(rm) - rf] βi = 3.00% + [11.00% - 3.00%] × 1.3 = 13.40%.
WACC = × Rd × (1 - Tc) + × Re = 0.40 × (7.00%) × (1 - .30) + 0.60 × (13.40%) = 10.00%.

Diff: 3
12) The adjusted WACC is the correct discount rate to use when evaluating a firm's average-risk projects.
Answer: TRUE
Diff: 1
13) Using the WACC to evaluate all projects has the effect of making low-risk projects look MORE
attractive and high-risk projects look LESS attractive.
Answer: FALSE
Explanation: Using the WACC to evaluate all projects has the effect of making low-risk projects look
LESS attractive and high-risk projects look MORE attractive.
Diff: 1
14) You have learned how to use NPV and IRR to evaluate projects as part of a capital budgeting
decision-making process. How is WACC used in each of these capital-budgeting processes?
Answer: When calculating the NPV of a project, the WACC is the appropriate required rate of return if
the project is of average risk. It is also the starting point for making subjective adjustments to the required
rate of return for projects of greater or lesser risk than average. When calculating the IRR, the WACC is
the appropriate hurdle rate for determining if a project meets the investment criteria.
Diff: 2
100
15) Using the WACC to evaluate all projects may lead managers into accepting high-risk projects that do
not compensate adequately for risk and into rejecting low-risk projects that compensate fully for the level
of risk but may not have particularly high rates of return. Describe the situations when using a WACC is
not appropriate and how these incorrect decisions may be made.
Answer: If managers could estimate the beta for every project and thereby a required rate of return for
every project, then the capital budgeting process would always lead to good decision-making. Higher-
risk projects would have a higher required return and lower-risk projects would have a lower required
return. But assigning a "one-size-fits-all" WACC to every project could lead a manager to accept a project
that has an IRR that is greater than the WACC (i.e., a positive NPV) but that is lower than its true
required rate of return. Conversely, a manager might reject a low-risk project with an acceptable return
for that level of risk because the IRR is less than the WACC (implying a negative NPV). In that case, the
WACC would be a value that is too high to correctly evaluate the lower-risk project.
Diff: 2
101
16) Michigan Industries has three projects under consideration. Project L is a lower-than-average-risk
project, project A is an average-risk project, and project H is a higher-than-average-risk project. You have
gathered the following information to determine if one or more of these projects has an acceptable rate of
return for the firm.
• Sources of financing 50% debt and 50% equity

• Rd = 8.00% before taxes
• Tax Rate = 30%
• Average beta for Michigan Industries = 1.0
• Rm = 13.00%
• Rf = 4.00%
• Adjusted WACC = 9.30%
• Beta for project L = 0.80, for project A = 1.00, and for project H = 1.20
• IRRL = 9.00%, IRRA = 10.00%, and IRRH = 11.00%
Calculate the required rate of return for each project and determine which, if any, projects are acceptable
to the firm.
Answer: Adjusted WACC for each project:
For project L, Re = Rf + β × (Rm - Rf) = 4.00% + 0.80 × (13.00% - 4.00%) = 11.20%
RL = 8.00% × (.50) × (1 -.30) + 11.20% × (.50) = 8.40%
IRRL = 9.00% is greater than RL = 8.40%. Therefore, this is an acceptable project.
For project A, Re = Rf + β × (Rm - Rf) = 4.00% + 1.00 × (13.00% - 4.00%) = 13.00%

RA = 8.00% × (.50) × (1 -.30) + 13.00% × (.50) = 9.30%
IRRA = 10.00% is greater than RA = 9.30%. Therefore, this is an acceptable project.
For project H, Re = Rf + β × (Rm - Rf) = 4.00% + 1.20 × (13.00% - 4.00%) = 14.80%

RH = 8.00% × (.50) × (1 -.30) + 14.80% × (.50) = 10.20%
IRRH = 11.00% is greater than RH = 10.20%. Therefore, this is an acceptable project.
Diff: 3
11.5 Selecting Appropriate Betas for Projects
1) The appropriate capital budgeting decision rule is ________.

A) to accept projects with an NPV greater than $0
B) to reject projects with an IRR greater than the required rate of return
C) to reject projects with an NPV greater than $0
D) to reject projects with an IRR greater than the required payback period
Answer: A
Diff: 1
Topic: 11.5 Selecting Appropriate Betas for Projects
LO: 11.5 Determine a project's beta and its implications in capital budgeting problems.
102
2) Clearinghouse Publications is adding a new magazine project to the company portfolio and has the
following information: the expected market return is 12%, the risk-free rate is 4%, and the expected return
on the new project is 20%. What is the beta of the project?
A) 1.00
B) 1.50
C) 1.75
D) 2.00
Answer: D
Explanation: D) This problem requires the student to rearrange the SML equation; it is not specifically
covered in the text.
Re = rf + [E(rm) - rf] β, and therefore, β = = = 2.00.

Diff: 2
3) Penney Fashions is adding a new line of shoes to the company portfolio and has the following
information: the expected market return is 13%, the risk-free rate is 3%, and the expected return on the
new project is 11%. What is the beta of the project?
A) 0.60
B) 0.70
C) 0.80
D) 0.90
Answer: C
Explanation: C) This problem requires the student to rearrange the SML equation; it is not specifically
covered in the text.
Re = rf + [E(rm) - rf] β, and therefore, β = = = 0.80.

Diff: 2
4) Under which of the following circumstances is the pure play method of estimating a project's beta
particularly useful?
A) The firm is looking to expand its current business operations, doing essentially the same work.
B) The firm is looking to expand its current business operations into a brand new area unlike any of its
internal projects.
C) The firm is looking to expand its current business operations. The work will be essentially the same as
current operations but there is no obvious outside provider of the same service or product.
D) The pure play method works equally effectively under each and all of these scenarios.
Answer: B
Diff: 2
103
5) ________ refers to a method of matching a single project of a company to another company with a
single business focus in an effort to assign an appropriate level of risk to the project.
A) Ghosting
B) Pure play
C) Outside assignment
D) Subjective assignment
Answer: B
Diff: 1
6) Richard works for a firm that is expanding into a completely new line of business. He has been asked
to determine an appropriate WACC for an average-risk project in the expansion division. Richard finds
two publicly traded stand-alone firms that produce the same products as his new division. The average of
the two firms' betas is 1.25. Further, he determines that the expected return on the market portfolio is
13.00% and the risk-free rate of return is 4.00%. Richard's firm finances 50% of its projects with equity and
50% with debt, and has a before-tax cost of debt of 9% and a corporate tax rate of 30%. What is the WACC
for the new line of business?
A) About 12.64%
B) About 13.00%
C) About 10.78%
D) About 11.29%
Answer: C
Explanation: C) Re = rf + [E(rm) - rf] β = 4% + (13% - 4%) × 1.25 = 15.25%
WACC = × Rd × (1 - Tc) + × Re = 0.50 × (9.00%) × (1 - .30) + 0.50 × (15.25%) = 10.775%, or about

10.78%.
Diff: 3
7) Fortunately for investors, assigning a beta to individual projects is more of a science than an art.
Answer: FALSE
Explanation: Assigning a beta to individual projects is more of an art than a science.
Diff: 1
8) The simplest application of assigning a beta to an individual project is called a "pure play," in which a
manager finds the beta of a firm whose sole business is similar to the project in question and assigns that
beta to the project.
Answer: TRUE
Diff: 1
104
9) In general, a subjective assessment of betas and projects is preferred to the pure play approach.
Answer: FALSE
Explanation: In general, a pure play approach to assigning betas to projects is preferred to a subjective
assessment.
Diff: 1
10) Using beta as a risk measurement device has not caught on in the real world because finding the value
is nearly impossible for most investors.
Answer: FALSE
Explanation: Most online investment information sources provide estimates of beta for publicly traded
securities; e.g. finance.yahoo.com.
Diff: 1
11) Define "pure play" as it applies to assigning a beta to a project. Under what circumstances do you
think the pure-play approach to assigning project betas would be particularly useful?
Answer: Pure play is the art of determining the beta of an individual project by matching it to a publicly
traded company whose sole business is similar to the project's. This technique is particularly useful when
a company is looking to expand its business into an area where it has no internal projects that it can use
for estimating the new project's beta.
Diff: 2
11.6 Constraints on Borrowing and Selecting Projects for the Portfolio
1) The best rule for choosing projects when a firm has a limited amount of funds is to accept the group of
projects with the greatest combined ________.
A) number of projects
B) IRR
C) NPV
D) time to completion
Answer: C
Diff: 1
Topic: 11.6 Constraints on Borrowing and Selecting Projects for the Portfolio
LO: 11.6 Select optimal project combinations from a company's portfolio of acceptable projects.
105
2) Your firm has $2,000,000 available for investment in capital projects. Which combination of projects is
the best, given this budget constraint?
Project Initial Investment NPV

A $750,000 $100,000
B $1,500,000 $125,000
C $500,000 $75,000
D $500,000 $35,000
A) B, C
B) A, B, C
C) A, B, C, D
D) A, C, D
Answer: D
Diff: 2
3) What could happen to "unused" dollars after a firm has chosen capital projects but still has remaining
unallocated funds?
A) The remaining funds may be invested at the "going rate" of the company.
B) The remaining funds, if internally generated, may be paid back to shareholders as a dividend.
C) If the remaining funds are part of borrowing, then the firm may choose to borrow less money.
D) All of the choices above are potential uses of unallocated funds.
Answer: D
Diff: 2
106
4) Your firm has $4,000,000 available for investment in capital projects. Which combination of projects is
the best, given this budget constraint?
Project Initial Investment NPV

A $1,000,000 $150,000
B $500,000 $200,000
C $1,500,000 $175,000
D $1,750,000 $135,000
A) A, B, C
B) A, B, D
C) A, C, D
D) B, C, D
Answer: A
Diff: 2
5) On a practical basis a, manager should always accept all positive NPV projects even if this means
exceeding a limited budget.
Answer: FALSE
Explanation: On a practical basis, a manager should accept the combination of positive NPV projects that
maximizes the total NPV while still operating within budget.
Diff: 2
6) Unused capital budget funds are assumed to earn the same rate of return as the average IRR of
accepted projects.
Answer: FALSE
Explanation: Unused capital budget funds are assumed to earn the same rate of return as the firm's
"going rate." Or, excess funds may be returned to investors via dividends or lesser amounts of borrowing.
Diff: 2
7) Unused capital budget funds are assumed to earn the same rate of return as the average cost of capital
for the firm. In other words they may be invested in $0.0 NPV projects. (Or, alternatively, excess funds
may be returned to creditors and shareholders.)
Answer: TRUE
Diff: 2
107
8) With an unlimited amount of funds, a firm could accept all positive NPV projects. However, with
limited budgets, managers are forced to accept some positive NPV projects while rejecting others. What
overall financial rule should managers follow when choosing the portfolio of projects to accept? Why?
Answer: Managers should maximize the NPV of the portfolio of accepted projects. NPV measures the
total financial benefit to existing shareholders. Other techniques are flawed in some fashion. For instance,
IRR measures the return per dollar spent, but does not necessarily maximize the total return to
shareholders.
Diff: 2
108

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Financial Management: Core Concepts, 3e, GE (Brooks)

Chapter 9 Capital Budgeting Decision Models

9.1 Short-Term and Long-Term Decisions

5) Capital budgeting decisions are typically long-term decisions.

9.2 Payback Period

8) Which of the statements below is FALSE?

12) Which of the statements below is FALSE?

9.3 Net Present Value

3) In the NPV model, all cash flows are stated ________.

4) In regard to the NPV method, which of the statements below is TRUE?

Explanation: D) NPV = -CF0 + + + +

Explanation: B) NPV = -CF0 + + + +

Explanation: C) NPV = -CF0 + + + + +

NPV = -CF0 + (PMT × . Inserting the given values gives:

NPV = -$70,000 + = -$70,000 + ($35,000 × 3.790787)

NPV = -CF0 + . Inserting in the given values gives:

NPV = -$170,000 + = -$170,000 + ($45,000 × 3.672771)

NPV = -CF0 + . Inserting in the given values gives:

NPV = -$180,000 + = -$180,000 + ($35,000 × 4.967640)

NPV = -CF0 + . Inserting in the given values gives:

NPV = -$180,000 + = -$180,000 + ($38,000 × 5.055637)

$180,000 + = -$180,000 + ($38,000 × 5.055637)

We have: EAA (Project A) = = $2,396.18.

For Project B, the NPV = -CF0 +

= -$160,000 + = -$160,000 + ($36,000 × 4.170294)

NPV = -$140,000 + = -$140,000 + ($36,500 × 4.79877)

We have: EAA (Project A) = = $7,325.86.

For Project B, the NPV = -CF0 +

= -$160,000 + = -$160,000 + ($48,000 × 3.997550)

= -$18,000 + ($3,800 × 5.055637)

We have: EAA (Project A) = = $239.62.

For Project B, the NPV = -CF0 + = -$16,000 +

9.4 Internal Rate of Return

3) Without a computer and special calculator, ________.

4) Which of the statements below describes the IRR decision criterion?

6) Which of the statements below is TRUE?

17) Which of the statements below is TRUE?

stream is identical. We have: FV = $1,900,000 × = $1,900,000 × = $1,900,000 ×

identical. We have: FV = $290,000 × = $290,000 × = $290,000 × 9.414619. Thus, FV

9.5 Profitability Index

4) Which of the statements below is FALSE?

NPV = -CF0 + . Inserting the given values gives:

NPV = -$140,000 + = -$140,000 + ($35,000 × 4.967640)

We have: PI = = = 1.2419, or about 1.24.

NPV = -CF0 + . Inserting the given values gives:

NPV = -$120,000 + = -$120,000 + ($30,000 × 5.146123)

We have: PI = = = 1.2865 or about 1.29.

NPV = -CF0 + . Inserting in the given values gives:

NPV = -$80,000 + = -$80,000 + ($30,000 × 4.798770)

We have: PI = = = 1.7995, or about 1.80.

9.6 Overview of Six Decision Models

10.1 The Importance of Cash Flow

2) Most businesses fail because their ________ dries up.

6) Which of the statements below is FALSE?

11) Operating Cash Flow (OCF) is equal to what?

16) Operating Cash Flow (OCF) = EBIT + Depreciation + Taxes.

10.2 Estimating Cash Flow for Projects: Incremental Cash Flow

8) Which of the below statements is FALSE?

9) Which of the statements below is TRUE?

12) If four plus five equals ten, that's synergy.

10.3 Capital Spending and Depreciation

3) Which of the methods below is a way to allocate depreciation?

10) Which of the statements below is FALSE?