Question 1

- CIA 590 IV.49 - Capital Budgeting Methods A firm's optimal capital structure
A. Maximizes the price of the firm's stock.
B. Minimizes the firm's tax liability.
C. Maximizes the firm's degree of financial leverage.
D. Minimizes the firm's risk.
A. The capital structure that maximizes the share price is the optimal capital structure. If the share price is at its
highest, that means that management has properly balanced the risk and returns in its capital structure and
investors value this structure the most.

Question 2
- CIA 597 IV.40 - Capital Budgeting Methods A firm with an 18% cost of capital is considering the following projects
(on January 1, year 1):

Using the net-present-value (NPV) method, project A's net present value is
A. $(265,460)
B. $23,140
C. $316,920
D. $(316,920)
A. There is only one cash inflow to this project, and it occurs 5 years after the initial cash outflow. The firm's cost of
capital is 18%. Therefore, the correct Present Value of $1 factor (from the table given) to use in discounting the cash
inflow is .4371. The present value of the cash inflow is .4371 × $7,400,000, or $3,234,540. Subtracting the initial
investment of $3,500,000 from the present value of the cash inflow of $3,234,540, we get $(265,460
Question 3
A firm with an 18% cost of capital is considering the following projects (on January 1, year 1):

Project B's internal rate of return is closest to

A. 18%
B. 16%
C. 15%
D. 20% .
D. The internal rate of return is the discount rate at which the present value of the expected cash inflows from a
project equals the present value of the expected cash outflows, or the discount rate at which the net present value is
zero. To determine the internal rate of return from the information given, we need to first know what discount
factor for five years would result in a present value of $9,950 that is equal to $4,000. To arrive at that factor, we
divide $4,000 by $9,950, and we get .402. We then look along the line of factors for five years on the Part 2 : Capital
Budgeting Methods(c) HOCK international, page 2
factor table given to locate a factor close to .402. That is .4019, which is in the 20% column. Thus, the internal rate of
return is closest to 20%

Question 4
. is in the enviable situation of having unlimited capital funds. The best decision rule, in an economic sense, for it to
follow would be to invest in all projects in which the
A. Net present value is greater than zero
.B. Payback reciprocal is greater than the internal rate of return.
C. Accounting rate of return is greater than the earnings as a percent of sales.
D. Internal rate of return is greater than zero.
A. If a company has unlimited capital funds, it should invest in all projects in which the net present value is greater
than zero, assuming none of the projects are mutually exclusive.
.
Question 5
Inc. wants to use discounted cash flow techniques when analyzing its capital investment projects. The company is
aware of the uncertainty involved in estimating future cash flows. A simple method some companies employ to
adjust for the uncertainty inherent in their estimates is to
A. Prepare a direct analysis of the probability of outcomes.
B. Use accelerated depreciation.
C. Adjust the minimum desired rate of return.
D. Increase the estimates of the cash flows.

C. A company adjusts for the uncertainty inherent in its estimates by increasing the required rate of return used to
discount the future expected cash flows. A higher discount rate will require higher expected future cash flows in
order for the investment to be acceptable. As a result, fewer investments will be acceptable.

Question 6
A manager wants to know the effect of a possible change in cash flows on the net present value of a project. The
technique used for this purpose is
A. Cost behavior analysis.
B. Sensitivity analysis.
C. Risk analysis.
B. Sensitivity analysis is used to determine how an amount will change if factors that were involved in predicting that
amount change.

Question 7
The technique that recognizes the time value of money by discounting the after-tax cash flows for a project over its
life to time period zero using the company's minimum desired rate of return is called the
A. Payback method.
B. Net present value method.
C. Accounting rate of return method.
D. Average rate of return method.
B. Net present value of a project is calculated by discounting the after-tax expected cash flows for the project over its
life to time period zero using the company's minimum required rate of return. The present value of the future
expected cash inflows minus the net initial investment equals the net present value.

Question 8
The technique that reflects the time value of money and is calculated by dividing the present value of the future net
after-tax cash inflows that have been discounted at the desired cost of capital by the initial cash outlay for the
investment is called the
A. Profitability index method.
B. Capital rationing method.
C. Accounting rate of return method.
D. Average rate of return method.
A. The profitability index is a benefit-cost ratio. It is the ratio of the present value of net future expected cash flows,
discounted at the required rate of return, to the amount of the initial investment.

Question 9
The technique that measures the estimated performance of a capital investment by dividing the project's annual
after-tax net income by the average investment cost is called the
A. Internal rate of return method.
B. Accounting rate of return method.
C. Capital asset pricing model
.D. Average rate of return method.
B. The accounting rate of return is the ratio of the amount of increased book income to the required investment.
Sometimes the average investment figure is used rather than the total initial investment. This is usually calculated as
the initial investment divided by 2. The initial investment is divided by 2 because the investment will have a book
value of 0 at the end of the project, and dividing the initial investment by 2 approximates an average of the amount
invested over the life of the project.
Question 10
The technique that incorporates the time value of money by determining the compound interest rate of an
investment such that the present value of the after-tax cash inflows over the life of the investment is equal to the
initial investment is called the
A. Accounting rate of return method.
B. Internal rate of return method.
C. Capital asset pricing model.
D. Profitability index method.
B. The internal rate of return is the discount rate at which the net present value of a project is zero. Therefore, it is
also the discount rate at which the present value of the after-tax cash inflows over the life of the investment equal
the initial investment, assuming that the future expected cash flows are all positive.

Question 11
The technique that measures the number of years required for the after-tax cash flows to recover the initial
investment in a project is called the
A. Payback method.
B. Net present value method.
C. Profitability index method.
D. Accounting rate of return method.
A. The Payback Method is used to determine the number of periods that must pass before the net after-tax cash
inflows from the investment will equal (or "pay back") the initial investment cost. If the expected cash inflows are
constant over the life of the project, the payback period is the net initial investment divided by the periodic expected
cash flow. If the expected cash inflows are not constant over the life of the project, the cash inflows are added to
determine on a cumulative basis when the inflows will equal the outflows. The payback method ignores all cash
flows beyond the payback period, does not include the time value of money, and does not include any factor for the
cost of capital. However, it is widely used because it is simple and it can be useful when a project is judged to be very
risky with uncertain cash flows in the later years. In this case, it may be used to determine how quickly the
investment will be recouped so that if necessary, the company can abandon the project without too great a loss

Question 12
Yipann Corporation is reviewing an investment proposal. The initial cost as well as other related data for each year
are presented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage
value of the investment at the end of each year is equal to its net book value, and there will be no salvage value at
the end of the investment's life.

The traditional payback period for the investment proposal is

A. .875 years.
B. 1.833 years.
C. Over 5 years.
D. 2.250 years.
D. The cash flow analysis is set up as
follows:

, which is 40,000 or: 2 + 10,000/40,000 = 2.25Note that the present value factors given are irrelevant to answering
this question, because the payback method is not a discounted cash flow technique.

Question 13
Crown Corporation has agreed to sell some used computer equipment to Bob Parsons, one of the company's
employees, for $5,000. Crown and Parsons have been discussing alternative financing arrangements for the
sale.Crown Corporation has offered to accept a $1,000 down payment and set up a note receivable for Bob Parsons
that calls for a $1,000 payment at the end of each of the next 4 years. If Crown uses a 6% discount rate, the present
value of the note receivable would be
A. $2,940
B. $4,465
C. $3,465
D. $4,212

C. The note calls for four annual payments of $1,000. This is an ordinary annuity, since the payments are due at the
end of each period. Therefore, the factor in the present value of an annuity table can be used as it is given, without
adjustment. The present value of a four-year ordinary annuity of $1,000, discounted at 6%, is $1,000 × 3.465, or
$3,465.
Question 14
Crown Corporation has agreed to sell some used computer equipment to Bob Parsons, one of the company's
employees, for $5,000. Crown and Parsons have been discussing alternative financing arrangements for the
sale.Crown has offered to accept a $1,000 down payment and to set up a note receivable for Bob Parsons that calls
for a $1,000 down payment at the end of this year and the next three years. Bob Parsons has agreed to the
immediate down payment of $1,000 but would like the note for $4,000 to be payable in full at the end of the fourth
year. Because of the increased risk associated with the terms of this note, Crown Corporation would apply an 8%
discount rate. The present value of this note would be
A. $2,577
B. $2,940
C. $3,940
D. $3,312

B. Using the Present Value of $1 table, the present value of a single $4,000 payment in 4 years is $4,000 × .735,
which equals $2,940.
.
Question 15
Yipann Corporation is reviewing an investment proposal. The initial cost as well as other related data for each year
are presented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage
value of the investment at the end of each year is equal to its net book value, and there will be no salvage value at
the end of the investment's life.

Yipann uses a 24% after-tax target rate of return for new investment proposals. The discount figures for a 24% rate
of return are given
The average annual cash inflow at which Yipann would be indifferent to the investment (rounded to the nearest
dollar) is
A. $38,321.
B. $40,000.
C. $21,000.
D. $46,667.
A. The question is asking for an average annual after-tax cash flow amount that will result in a net present value of
zero for the project, because that will be the average annual cash flow level at which Yipann will be indifferent to the
investment. We need to look at this as a present value of an annuity problem, because since we are looking for an
average annual cash flow amount, all the annual cash flow amounts after year 0 will be the same average amount.
The annual cash flows given in the problem are irrelevant, because we are looking for the average annual after-tax
cash flow amount that will result in an NPV of zero, given the initial investment in Year 0. Since the initial investment
is $105,000 and the project's life is 5 years, we need to know what annuity amount will produce a present value of
$105,000 when discounted at 24% for 5 years. Recall that the present value of an annuity is the annuity amount × PV
of an annuity factor. We don't know the annuity amount, but we do know the PV of an annuity factor and the
present value amount of $105,000. The PV of an annuity factor for 5 years at 24% is given in the problem: 2.74.Thus,
the formula is: Annuity Amount × 2.74 = $105,000. Therefore, the Annuity Amount = $105,000 ÷ 2.74, which is equal
to $38,321.This means that if the annual after-tax cash flows are all the same and they are $38,321, the NPV will be
zero and the company will be indifferent to the investment.

Question 16
Yipann Corporation is reviewing an investment proposal. The initial cost as well as other related data for each year
are presented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage
value of the investment at the end of each year is equal to its net book value, and there will be no salvage value at
the end of the investment's life.
Yipann uses a 24% after-tax target rate of return for new investment proposals. The discount figures for a 24% rate
of return are given

A. 38.1%
.B. 28.1%
.C. 18.1%
.D. 36.2%
C. The accounting rate of return is the average annual after-tax net income attributable to the project divided by the
net initial investment. The average of the five annual net income amounts given is $19,000 ([$15,000 + $17,000 +
$19,000 + $21,000 + $23,000] / 5 = $19,000.) $19,000 / $105,000 = .18095 or 18.1%. (Note: sometimes the average
of the initial investment over the life of the project is used, calculated as the initial investment divided by 2.
However, this question specifies to use the initial value of the investment, not the average investment.
.
Question 17
When ranking two mutually exclusive investments with different initial amounts, management should give first
priority to the project
A. Whose net after-tax flows equal the initial investment.
B. That has the greater accounting rate of return.
C. That has the greater profitability index.
D. That generates cash flows for the longer period of time.
C. The Profitability Index enables us to compare (or rank) the benefit/cost ratios of different sized investments, since
the Profitability Index expresses profitability on a percentage basis rather than a total dollar amount basis. It is very
useful when we must compare multiple investments that are of different investment amounts.
Question 18
The net present value (NPV) method and the internal rate of return (IRR) method are used to analyze capital
expenditures. The IRR method, as contrasted with the NPV method,
A. Is considered inferior because it fails to calculate compounded interest rates.
B. Is preferred in practice because it is able to handle multiple desired hurdle rates, which is impossible with the NPV
method.
C. Assumes that the rate of return on the reinvestment of the cash proceeds is at the indicated rate of return of the
project analyzed rather than at the discount rate used.
D. Incorporates the time value of money whereas the NPV method does not.
B. The internal rate of return method does not handle multiple desired hurdle rates.

rate of return method assumes that the cash proceeds of the investment will be reinvested at the internal rate of
return, which may not be the case.

Question 19
Mercken Industries is contemplating four projects, Project P, Project Q, Project R, and Project S. The capital costs and
estimated after-tax net cash flows of each project are listed below. Mercken's desired after-tax opportunity cost is
12%, and the company has a capital budget for the year of $450,000. Idle funds cannot be reinvested at greater than
12%

C. Project S is not an acceptable project, because it has a negative NPV. That leaves Projects P, Q and R. However,
if all three projects were selected, Mercken would exceed its capital budget of $450,000. Therefore, only two of the
three projects can be selected. This is a situation where there appears to be a conflict between the NPV results and
the IRR results. Projects P and Q have the higher IRRs, whereas Q and R have the higher NPVs. Remember that the
IRR assumes that all cash inflows from the project will be able to be reinvested at the internal rate of return.
However, this problem tells us that the cash inflows from the project will be able to be reinvested at a rate no higher
than 12%. Thus, the IRRs for these projects are not accurate. Therefore, the projects with the highest NPVs should be
selected, and those are Projects Q and R. This is confirmed by looking at the excess present value (profitability)
indices. Note that Projects Q and R have the highest profitability indices.
.

Question 20
The bailout payback method
A. Equals the recovery period from normal operations.
B. Measures the risk if a project is terminated.
C. Eliminates the disposal value from the payback calculation.
D. Incorporates the time value of money.
B. The bailout payback method recognizes the possibility that a project may be ended prematurely and the
equipment sold. The after-tax salvage value of the equipment at various dates is included in the cash inflows of the
project through the same dates. The use of the bailout payback method gives an indication of the result of
terminating the project early.

Question 21
A weakness of the internal rate of return (IRR) approach for determining the acceptability of investments is that it
A. Does not consider the time value of money.
B. Implicitly assumes that the firm is able to reinvest project cash flows at the firm's cost of capital.
C. Implicitly assumes that the firm is able to reinvest project cash flows at the project's internal rate of return.
D. Is not a straightforward decision criterion.
C. The Internal Rate of Return (IRR) is the discount rate at which the Net Present Value (NPV) of a project is zero. As
such, it assumes that the cash flows from the project will be reinvested at the same rate. This is a disadvantage,
because the cash flows from the project may not be able to be reinvested at the Internal Rate of Return.

Question 22
The profitability index approach to investment analysis

A. Always yields the same accept/reject decisions for mutually exclusive projects as the net present value method
.B. Fails to consider the timing of project cash flows.
C. Considers only the project's contribution to net income and does not consider cash flow effects.
D. Always yields the same accept/reject decisions for independent projects as the net present value method.
D. The Profitability Index (PI) is a benefit/cost ratio. It is the present value of the future net cash inflows divided by
the initial net cash investment. A ratio of greater than 1 indicates an acceptable project. Therefore, whenever
projects are independent (i.e., not mutually exclusive), the PI will yield the same accept/reject decision as the NPV
method, because a positive NPV will result in a PI of greater than 1. The PI method is useful for ranking multiple
investment opportunities that are of different investment amounts if the projects are not mutually exclusive.
Question 23
The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the
net present value method (NPV) may be different when
A. Multiple projects have unequal lives and the size of the investment for each project is different.
B. The lives of the multiple projects are equal and the size of the required investments are equal.
C. The required rate of return is higher than the IRR of each project.
D. The required rate of return equals the IRR of each project.
A. When projects have unequal lives and the sizes of the investments are different, it is possible that NPV and IRR
will rank the projects in a different order.

Question 24
When using the net present value method for capital budgeting analysis, the required rate of return is called all of
the following except the
A. Discount rate.
B. Hurdle rate.
C. Cost of capital.
D. Risk-free rate.

D. The required rate of return, which is the rate used to discount future cash flows in a capital budgeting analysis, is
not the risk-free rate. There is risk inherent in all capital budgeting projects, and the required rate of return
incorporates a risk premium.

Question 25
The proper discount rate to use in calculating certainty equivalent net present value is the
A. Cost of capital.
B. Risk-adjusted discount rate.
C. Risk-free rate.
D. Cost of equity capital.
C. The goal of the certainty equivalent approach is to find the smallest cash flow in each period that would be
acceptable in place of that period's risky cash flow, if that smaller cash flow can be depended upon absolutely. The
certainty equivalent approach adjusts risky after-tax cash flows to a level judged by the decision-maker to be certain
of attainment, by estimating the minimum cash flow for each year of the project. Then the certainty equivalent cash
flows are discounted at the risk-free rate of interest to calculate a Certainty Equivalent NPV. The Certainty Equivalent
NPV is then compared with the NPV of the project when its risky cash flows are discounted at the company's
required rate of return. If the two NPVs are equivalent, the decision-maker will be indifferent between them and will
accept the certain cash flow in place of the risky cash flow.

Question 26
If an investment project has a profitability index of 1.15, the
A. Project's internal rate of return is 15%.
B. Project's cost of capital is greater than its internal rate of return.
C. Project's internal rate of return exceeds its net present value.
D. Net present value of the project is positive.

D. The profitability index for an investment project is its discounted annual net cash inflows divided by its initial cash
investment. If a project profitability index is greater than 1.00, we know that its discounted annual net cash inflows
are greater than its initial cash investment. Since the net present value is the monetary gain (loss) of the project's
cumulative net cash flows, the net present value of a project with a P.I. of greater than 1.00 must be positive.

Question 27
The internal rate of return for a project can be determined
A. If the internal rate of return is greater than the firm's cost of capital.
B. Only if the project cash flows are constant.
C. By finding the discount rate that yields a net present value of zero for the project.
D. By subtracting the firm's cost of capital from the project's profitability index.

C. The internal rate of return is the discount rate which, when used to calculate the net present value of a project,
yields a net present value of zero

Question 28
A company has unlimited capital funds to invest. The decision rule for the company to follow in order to maximize
shareholders' wealth is to invest in all projects having a(n)
A. Present value greater than zero.
B. Accounting rate of return greater than the hurdle rate used in capital budgeting analyses.
C. Net present value greater than zero.
D. Internal rate of return greater than zero.
C. The net present value of an investment or project is equal to the difference between the present value of all
future cash inflows and the present value of the initial and any future cash outflows, using the required rate of
return. Thus, in order to maximize shareholders' wealth, a company with unlimited capital funds to invest will invest
in all projects having a net present value greater than zero, unless projects are mutually exclusive
Question 29
Sensitivity analysis is used in capital budgeting to
A. Simulate probabilistic customer reactions to a new product.
B. Estimate a project's internal rate of return.
C. Determine the amount that a variable can change without generating unacceptable results.
D. Identify the required market share to make a new product viable and produce acceptable results.
C. Sensitivity analysis is used to determine how an amount will change if factors that were involved in predicting that
amount change. If a small change in the value of one of the inputs causes a large change in the recommended
decision, then we say it is sensitive to that input. If we know that a particular input makes a big difference in the
analysis, we can take extra care to make sure the value assigned to that input in the analysis is as accurate as
possible. Furthermore, the measure of the sensitivity of a project to a change in one of the variables is also an
indication of the risk of the project. The more sensitive the project is to a change in one or more variables, the more
risky it is.

Question 30
If income tax considerations are ignored, how is depreciation handled by the following capital budgeting
techniques?Internal Rate of Return / Accounting Rate of Return / Payback
A. Included / Included / Included
B. Excluded / Included /Excluded
C. Excluded / Excluded / Included
D. Included / Excluded / Included
.
B. If income tax considerations are to be ignored, then the depreciation tax shield is ignored. Therefore, the income
tax savings from the depreciation are not included in the capital budgeting analyses. If the income tax savings from
the depreciation are excluded, then depreciation is ignored in the calculations of internal rate of return and payback.
However, depreciation is included in the calculation of the accounting rate of return, because the accounting rate of
return is based upon book income, which includes depreciation.

Question 31
The Keego Company is planning a $200,000 equipment investment which has an estimated 5-year life with no
estimated salvage value. The company has projected the following annual cash flows for the investment.
C. The payback period is, first, the number of the project year in the final year when cumulative cash flow (including
the initial investment) is negative, plus a fraction consisting of the positive value of the negative cumulative cash
inflow amount from the final negative year divided by the cash flow for the following year. In this case, the final year
in which the cumulative cash flow is zero is Year 2, because $(200,000) + $120,000 + $60,000 = $(20,000). In the third
year, the cash flow is $40,000. So $20,000 ÷ $40,000 = .5, and the payback period is 2 + .5, or 2.5 years.

Question 32
The Keego Company
The net present value for the investment is
A. $100,000
B. $18,800
C. $130,800
D. $218,800
B. The net present value is the net expected monetary gain or loss from a project when all the expected future cash
inflows and outflows are discounted to the point of the investment, using the firm's required rate of return.
Discounting the annual cash inflows using the discount factors given results in annual discounted cash inflows of
($120,000 × .91) + ($60,000 × .76) + ($40,000 × .63) + ($40,000 × .53) + ($40,000 × .44) = $218,800. The discounted
total annual cash flows minus the initial investment of $200,000 = $18,800, which is the NPV.

Question 33
When determining net present value in an inflationary environment, adjustments should be made to
A. Decrease the estimated cash inflows and increase the discount rate.
B. Increase the estimated cash inflows but not the discount rate.
C. Increase the discount rate, only.
D. Increase the estimated cash inflows and increase the discount rate.
D. In an environment of inflation, both the discount rate used and the future expected cash flows should be
increased. The discount rate is increased because the firm will require a higher rate of return to compensate for the
increased inflation. The future expected cash flow amounts need to be increased because inflation will cause the
dollar to be worth less in the future, and the amounts of cash (both inflows and outflows) will therefore increase in
the future

Question 34
The length of time required to recover the initial cash outlay of a capital project is determined by using the
A. Payback method.
B. Weighted net present value method.
C. Net present value method.
D. Discounted cash flow method
A. The Payback Method is used to determine the number of periods that must pass before the net after-tax cash
inflows from the investment will equal (or "pay back") the initial investment cost. If the incoming cash flows are
constant over the life of the project, the payback period may be calculated with a simple division as follows: Initial
net investment ÷ Periodic constant expected cash flow. If the cash flows are not constant over the life of the project,
we must add up the cash inflows and determine on a cumulative basis when the inflows equal the outflows

Question 35
In evaluating a capital budget project, the use of the net present value (NPV) model is generally not affected by the
A. Initial cost of the project.
B. Method of funding the project.
C. Type of depreciation used.
D. Amount of added working capital needed for operations during the term of the project.
B. The method of funding the project is separate from the net present value method of capital budgeting analysis

Question 36
For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because
management
A. Believes bank loans are riskier than capital investments.
B. Wants to factor risk into its consideration of projects.
C. Believes too many proposals are being rejected.
D. Wants to use equity funding exclusively.
B. A company's Weighted Average Cost of Capital (WACC) — which is the rate of return required by investors in the
company's securities — is the appropriate discount rate (or hurdle rate) to use in capital budgeting decisions and
NPV calculations as long as the riskiness of the project is the same as the riskiness of the firm's existing business. If
management wants to factor the risk of a project into its analysis, it will increase the discount rate used in NPV
calculations for more risky, or uncertain, investments. A higher discount rate will require higher expected future cash
flows in order for the company to make the investment, thus making fewer investments acceptable.
Question 37
The method that recognizes the time value of money by discounting the after-tax cash flows over the life of a
project, using the company's minimum desired rate of return is the
A. Net present value method.
B. Internal rate of return method.
C. Accounting rate of return method.
D. Payback method.
A. The net present value method is used to determine the difference between the present value of all future
expected cash inflows and the present value of all (the initial as well as all future) expected cash outflows, Part 2 :
using the required rate of return. A project with a positive NPV is acceptable.

Question 38
The method that divides a project's annual after-tax net income by the average investment cost to measure the
estimated performance of a capital investment is the
A. Payback method.
B. Accounting rate of return method.
C. Internal rate of return method.
D. Net present value (NPV) method

B-The accounting rate of return is a ratio of the amount of increased book income to the required investment. It is
calculated as follows: Increase in Expected Annual Average After Tax Accounting Net Income ÷ Net Initial Investment.
Sometimes the average investment figure is used rather than the total investment. Since this method uses accrual
accounting income, it includes depreciation. However, it does not take into account the time value of money

Question 39
The capital budgeting model that is generally considered the best model for long-range decision making is the
A. Unadjusted rate of return model.
B. Accounting rate of return model.
C. Discounted cash flow model.
D. Payback model.

C. Discounted cash flow methods of capital budgeting, including net present value, internal rate of return, and
profitability index, are generally considered the best model for long-range capital budgeting decision making
Question 40
The technique used to evaluate all possible capital projects of different dollar amounts and then rank them
according to their desirability is the
A. Discounted cash flow method.
B. Payback method.
C. Profitability index method.
D. Net present value method
C. The PI calculation is used to determine the ratio of the PV of net future cash flows (both inflows and outflows) to
the amount of the initial investment. It is calculated as follows, using the same information from the NPV calculation:
PV of future net cash flows ÷ Net Initial Investment. If a project has a positive net present value, the profitability
index will be above 1.00 and it will be an acceptable project. The profitability index is used to evaluate all possible
capital projects of different dollar amounts and then rank them according to their desirability

Question 41
A widely used approach that is used to recognize uncertainty about individual economic variables while obtaining an
immediate financial estimate of the consequences of possible prediction errors is
A. Expected value analysis.
B. Sensitivity analysis.
C. Learning curve analysis
.D. Regression analysis

B. Sensitivity analysis can be used to determine how cash flows can be expected to vary with changes in the
underlying assumptions. Using expected cash flows, the NPV, IRR, and PI of the project are determined. Then, the
key assumptions that were used in making the original expected cash flow projections are identified. One assumption
at a time is then changed, leaving the other assumptions unchanged, and the NPV, IRR and PI are recalculated to determine what
effect changing one assumption would have on those measures

Question 42
Which one of the following statements about the payback method of investment analysis is correct? The payback
method
A. Considers cash flows after the payback has been reached.
B. Does not consider the time value of money.
C. Uses discounted cash flow techniques.
D. Generally leads to the same decision as other methods for long-term projects
B. The payback method uses undiscounted cash flows and thus does not incorporate the time value of money in the
analysis. That is one of its weaknesses. Another weakness is that it does not take into account any cash flows that
are received after the payback point has been reached.
Question 43
Willis Inc. has a cost of capital of 15% and is considering the acquisition of a new machine which costs $400,000 and
has a useful life of 5 years. Willis projects that earnings and cash flow will increase as follows:

D. The net present value is the present value of all cash flows after Year 0 (positive and negative) less the initial
investment. To calculate the present value of the cash flows after year 0, you could discount each individual cash
flow amount by the appropriate present value of $1 factor. However, that is not the most time-effective way to do it.
If you recognize that all the annual cash flow amounts contain an amount such as $100,000 and $100,000 is the
exact amount of the cash flow for at least two of the years, you can save time by calculating first the present value of
an annuity for the $100,000; then calculating the present value of $1 individually for any amounts over the $100,000
amount. In this case, we have 5 years of $100,000 cash flows, and the discount factor given for the PV of an annuity
for 5 years is 3.36. We also have $60,000 to be discounted for one year and $40,000 to be discounted for two years
using the appropriate present value of $1 factors. Thus, the present value of the cash inflows is ($100,000 × 3.36) +
($60,000 × .87) + ($40,000 × .76) = $418,600. The net present value is $418,600 less the initial investment of
$400,000, or $18,600.

Question 44
Willis Inc. has a cost of capital of 15% and is considering the acquisition of a new machine which costs $400,000 and
has a useful life of 5 years.
What is the payback period of this investment?
A. 4.00 years.
B. 3.00 years.
C. 1.50 years.
D. 4.63 years.
B. The payback period is the number of periods that must pass before the net after-tax cash inflows from the
investment will equal (or "pay back") the initial investment. The initial investment of $400,000 is returned in exactly
3 years, because the cash inflows of Years 1 through 3 -- $160,000, $140,000, and $100,000 -- total $400,000.

Question 45
The net present value of a proposed investment is negative; therefore, the discount rate used must be
A. Less than the risk-free rate.
B. Greater than the project's internal rate of return.
C. Less than the project's internal rate of return.
D. Greater than the firm's cost of equity.
B. The internal rate of return is the discount rate at which a project's net present value is zero. As the discount Part 2

rate used increases, the net present value of a project decreases. Therefore, if the discount rate used is higher than
the project's internal rate of return, the net present value of the project will be less than zero and thus will be a
negative amount.

Question 46
A disadvantage of the net present value method of capital expenditure evaluation is that it
A. Computes the true interest rate.
B. Is calculated using sensitivity analysis.
C. Is difficult to apply because it uses a trial-and-error approach.
D. Does not provide the true rate of return on investment.

D. NPV analysis provides a dollar amount by which the present value of the return on a project is greater than the
investment. It does not provide an actual rate of return for the investment.

Question 47
Barker Inc. has no capital rationing constraint and is analyzing many independent investment alternatives. Barker
should accept all investment proposals
A. That have positive cash flows.
B. If debt financing is available for them.
C. That provide returns greater than the before-tax cost of debt.
D. That have a positive net present value.
D. If a company has no restrictions on its available capital for investment, and if all the projects under consideration
are independent (i.e., none of the projects are mutually exclusive, meaning if the company invests in one it cannot
invest in another for reasons other than capital availability), then the company should accept all Part 2 : Capital
projects with a positive net present value

.Question 48
When the risks of the individual components of a project's cash flows are different, an acceptable procedure to
evaluate these cash flows is to
A. Divide each cash flow by the payback period.
B. Discount each cash flow using a discount rate that reflects the degree of risk.
C. Compute the net present value of each cash flow using the firm's cost of capital.
D. Compare the internal rate of return from each cash flow to its risk.
B. A company's Weighted Average Cost of Capital (WACC) — which is the rate of return required by investors in the
company's securities — is the appropriate discount rate to use in capital budgeting decisions and NPV calculations as
long as the riskiness of the project is the same as the riskiness of the firm's existing business. When the riskiness of
the project is different from that of the company's existing business, the discount rate used to calculate NPV needs
to be adjusted to reflect the changed risk profile of the firm as a result of the project under consideration. A higher
discount rate is used to reflect higher risk; a lower discount rate reflects lower risk. And when the risks of the
individual components of a project's cash flows are different, it is appropriate to use a risk-adjusted discount rate for
each component that is specific for the degree of risk inherent in that component of the cash flow.

Question 49
The NPV of a project has been calculated to be $215,000. Which one of the following changes in assumptions would
decrease the NPV?
A. Decrease the initial investment amount.
B. Increase the discount rate.
C. Extend the project life and associated cash inflows
.D. Decrease the estimated effective income tax rate.
B. Increasing the discount rate will decrease the present value of the cash inflows, which will decrease the NPV.
Question 50
The net present value method of capital budgeting assumes that cash flows are reinvested at
A. The rate of return of the project.
B. The discount rate used in the analysis.
C. The risk-free rate.
D. The cost of debt.
B. The net present value method of capital budgeting involves the assumption that the resulting cash flows will be
able to be invested at the rate of return that is used as a discount rate in the analysis

Question 51
Capital budgeting methods are often divided into two classifications: project screening and project ranking. Which
one of the following is considered a ranking method rather than a screening method?
A. Time-adjusted rate of return.
B. Accounting rate of return.
C. Profitability index.
D. Net present value.
C. The profitability index is a benefit/cost ratio. It represents the ratio of the benefits (net cash inflows) to the costs
(net initial investment). The profitability index enables us to compare, or rank, the benefit/cost ratios of different
sized investments, since the profitability index expresses profitability on a percentage basis rather than a total dollar
amount basis. It is very useful when we must compare multiple investments that are of different investment
amounts, the projects are not mutually exclusive, and we need to rank them. When there are multiple investment
opportunities, we will take the project that has the highest profitability index. When the projects are independent
alternatives of the same length, this method will give us the same accept/reject decisions that NPV provides.
However, when the projects are of different time periods or amounts of initial investments, the profitability index
may give different rankings than NPV.

Question 52
The accounting rate of return
A. Is synonymous with the internal rate of return.
B. Is inconsistent with the divisional performance measure known as return on investment.
C. Recognizes the time value of money.
D. Focuses on income as opposed to cash flows.
D. The accounting rate of return uses accrual accounting income, including depreciation, rather than cash flows. It
does not take into account the time value of money, and for that reason it is also called the unadjusted rate of return
model.
Question 53
The internal rate of return on an investment
A. Would tend to be reduced if a company used an accelerated method of depreciation for tax purposes rather than
the straight-line method.
B. May produce different rankings from the net present value method on mutually exclusive projects.
C. Disregards discounted cash flows.
D. Usually coincides with the company's hurdle rate.
B. If two investments are mutually exclusive, then accepting one means we cannot accept the other. This can occur
if, for example, the cash flows of one will be adversely impacted by the acceptance of the other; or if the use of land
for one project precludes its use for another project. When mutually exclusive investments are being considered,
there may be a conflict between the NPV results and the IRR results in determining which of the two mutually
exclusive projects should be accepted. One may have a higher IRR, while the other has a higher NPV

Question 54
On January 1, Crane Company will acquire a new asset that costs $400,000 and is anticipated to have a salvage value
of $30,000 at the end of 4 years. The new asset
Qualifies as 3-year property under the Modified Accelerated Cost Recovery System (MACRS).
Will replace an old asset that currently has a tax basis of $80,000 and can be sold now for $60,000.
Will continue to generate the same operating revenues as the old asset ($200,000 per year).
However, savings in operating costs will be experienced as follows: a total of $120,000 in each of the first 3 years and
$90,000 in the fourth year.
Crane is subject to a 40% tax rate and rounds all computations to the nearest dollar. Assume that any gain or loss
affects the taxes paid at the end of the year in which it occurred. The company uses the net present value method to
analyze projects using the following factors and rates:

C. Although this question involves replacing one asset with another asset, we are not given information that would
enable us to do an incremental analysis of the difference (if any) between the depreciation on the new asset versus
the depreciation on the old asset. Thus, we will analyze this as if it were a new asset purchase, not a replacement of an
existing asset. Since depreciation under MACRS is applied to the gross purchase price of the asset ($400,000) and the fourth year's
depreciation will be 7% of $400,000, the fourth year's depreciation will be $28,000. Crane's tax rate is 40%, so the
depreciation tax shield is $28,000 × .40, or $11,200. Since the question asks for the present value of the depreciation
tax shield for the fourth year, we will discount it using .59 from the table (the PV of $1 at 14% for 4 years). $11,200 ×
.59 = $6,608, which is the present value of the depreciation tax shield for the fourth year of MACRS depreciation

Question 55
On January 1, Crane Company will acquire a new asset that costs $400,000 and is anticipated to have a salvage value
of $30,000 at the end of 4 years. The new asset
Qualifies as 3-year property under the Modified Accelerated Cost Recovery System (MACRS).
Will replace an old asset that currently has a tax basis of $80,000 and can be sold now for $60,000.
Will continue to generate the same operating revenues as the old asset ($200,000 per year).
However, savings in operating costs will be experienced as follows: a total of $120,000 in each of the first 3 years and
$90,000 in the fourth year.
Crane is subject to a 40% tax rate and rounds all computations to the nearest dollar. Assume that any gain or loss
affects the taxes paid at the end of the year in which it occurred. The company uses the net present value method to
analyze projects using the following factors and rates:

B. We are told in the question, "Assume that any gain or loss affects the taxes paid at the end of the year in which it
occurred." Therefore, the tax savings that results from the $20,000 loss on the sale of the old equipment that occurs
in year 0 must be discounted for one year. The tax savings is $8,000 ($20,000 × .40). Discounted for one year at 14%,
it is $8,000 × .88, or $7,040. Cash flow from the disposal in year 0 is $60,000, and no discounting is necessary. Thus,
the discounted net of tax amount to factor into Crane Company's analysis for the disposal transaction is $60,000 +
$7,040, or $67,040
Question 56
The recommended technique for evaluating projects when capital is rationed and there are no mutually exclusive
projects from which to choose is to rank the projects by
A. Internal rate of return.
B. Profitability index.
C. Payback.
D. Accounting rate of return.
B. When capital is limited and the projects from which to choose are not mutually exclusive, the decision as to which
project should receive money first is made using the Profitability Indexes of the different proposed projects. The
Profitability Index is a variation of the benefit/cost ratio. It represents the ratio of the benefits (present value of net
cash inflows) to the costs (net initial investment). The Profitability Index enables us to compare (or rank) the
benefit/cost ratios of different sized investments, since the Profitability Index expresses profitability on a percentage
basis rather than a total dollar amount basis. It is very useful when we must compare multiple investments that are
of different investment amounts, the projects are not mutually exclusive, and we need to prioritize them.

Question 57
The net present value (NPV) method of investment project analysis assumes that the project's cash flows are
reinvested at the
A. Risk-free interest rate.
B. Firm's accounting rate of return.
C. Computed internal rate of return.
D. Discount rate used in the NPV calculation
D. The Net Present Value (NPV) method calculates the expected monetary gain or loss from a project by discounting
all expected future cash inflows and outflows to the present point in time, using the required rate of return. This use
of a required rate of return in discounting assumes that all the future cash inflows from the project will be able to be
reinvested at the same required rate of return, which may not be the situation

Question 58
The technique that measures the estimated performance of a capital investment by dividing the project's annual
after-tax net income by the average investment cost is called the
A. Accounting rate of return method.
B. Internal rate of return method.
C. Bail-out payback method.
D. Profitability index method.
A. The accounting rate of return method is a ratio of the amount of increased book income as a result of the project
under consideration to the required investment. It is calculated as: Increase in Expected Annual Average After Tax
Accounting Net Income ÷ Net Initial Investment OR Average Investment

Question 59
Amster Corporation has not yet decided on its hurdle rate for use in the evaluation of capital budgeting projects.
This lack of information will prohibit Amster from calculating a project's
A. Not knowing the hurdle rate will not prevent the calculation of the Accounting Rate of Return or the Internal Rate
of Return. However, it will prohibit the company from calculating NPV, because in order to calculate NPV, the future
cash flows need to be discounted using the hurdle rate

Question 60
The following selected data pertain to a 4-year project being considered by Metro Industries:
• A depreciable asset that costs $1,200,000 will be acquired on January 1. The asset, which is expected to have a
$200,000 salvage value at the end of 4 years, qualifies as 3-year property under the Modified Accelerated Cost
Recovery System (MACRS).
• The new asset will replace an existing asset that has a tax basis of $150,000 and can be sold on the same January 1
for $180,000.
• The project is expected to provide added annual sales of 30,000 units at $20. Additional cash operating costs are:
variable, $12 per unit; fixed, $90,000 per year.
• A $50,000 working capital investment that is fully recoverable at the end of the fourth year is required.Metro is
subject to a 40% income tax rate and rounds all computations to the nearest dollar. Assume that any gain or loss
affects the taxes paid at the end of the year in which it occurred. The company uses the net present value method to
analyze investments and will employ the following factors and rates.

D. Under MACRS depreciation using the half-year convention, 100% of an asset's cost is depreciated. One-half of one
year's depreciation is taken in the first year the asset is owned, one-half of one year's depreciation is taken in the
last year it is depreciated, and one year's depreciation is taken in each of the other years of the asset's life. According
to the table given, 7% of the cost will be taken as depreciation in the fourth year. Since the asset cost $1,200,000, 7%
of that is equal to $84,000. With a 40% tax rate, $84,000 × .40, or $33,600 of other income will be shielded from
taxation by the depreciation in the fourth year. The present value of $33,600 in four years, discounted at 12%, is
$33,600 × .64, or $21,504.

Question 61
Same 62
The discounted, net-of-tax amount that relates to disposal of the existing asset is
A. $180,000.
B. $168,000.
C. $169,320
.D. $190,680.
C. Cash received from the sale of the existing asset on January 1 will be $180,000. The tax basis of the asset on that
date will be $150,000. Therefore, income tax will be due on the gain of $30,000 at the rate of 40%, so income tax will
be $12,000. However, the problem states that any gain or loss affects the taxes paid at the end of the year in which
it occurred. Therefore, tax on the January 1 gain will not be due until year end. Thus, we discount the $12,000
income tax liability for one year at the 12% rate given in the Present Value of $1 factor table. $12,000 × .89 =
$10,680, so the present value of the income tax liability is $10,680. The discounted, net-of-tax amount that relates to
disposal of the existing asset is $180,000 − $10,680, which equals $169,320

Question 62
Same 60
The expected incremental sales will provide a discounted, net-of-tax contribution margin over 4 years of
A. $273,600.
B. $92,160.
C. $437,760.
D. $57,600

C. Incremental revenue per year is expected to be 30,000 units × $20 per unit, or $600,000 per year. Incremental
variable expense is expected to be 30,000 units × $12 per unit, or $360,000 per year. The incremental (before tax)
contribution margin is $600,000 minus $360,000 per year, or $240,000. Income tax is 40%, so the after-tax
contribution margin is $240,000 × (1 − .40), or $144,000 per year. Since the amount is the same for each year, the
annual amount can be discounted as an annuity. So the discounted, net-of-tax contribution margin over 4 years,
using the present value of an annuity factor of 3.04 for four years, is (144,000 × 3.04) = $437,760
Question 63
Same 60
The overall discounted-cash-flow impact of the working capital investment on Metro's project is
A. $(50,000).
B. $(18,000).
C. $(59,200)

B. The Year 0 cash outflow will be $50,000. The $50,000 working capital investment will be recovered at the end of
the fourth year. Therefore, the discounted cash inflow will be ($50,000 × .64), or $32,000. So the net overall
discounted cash flow impact of the working capital investment will be $32,000 − $50,000, or $(18,000)

Question 64
The payback reciprocal can be used to approximate a project's
A. Internal rate of return if the cash flow pattern is relatively stable.
B. Net present value.
C. Accounting rate of return if the cash flow pattern is relatively stable.
D. Profitability index.
A. The Payback Reciprocal is 1/Payback Period. (Note: the reciprocal of any number is the number which, when
multiplied by the first number, returns a product of 1.) The payback reciprocal can be used to approximate the
internal rate of return if (1) the cash flows are equal in every period, and (2) the project's life is at least twice as long
as the Payback Period

Question 65
When evaluating projects, breakeven time is best described as
A. The point where cumulative cash inflows on a project equal total cash outflows.
B. Annual fixed costs ÷ monthly contribution margin.
C. The point at which discounted cumulative cash inflows on a project equal discounted total cash outflows.
D. Project investment ÷ annual net cash inflows.

C. The breakeven point is also called the discounted payback period. The payback method (undiscounted)
determines the number of periods that must pass before the net after-tax cash inflows from the investment will
equal (or "pay back") the initial investment cost. However, the payback method has a weakness: it does not consider
the time value of money. The breakeven time, or discounted payback method, is an attempt to deal with that
weakness. The discounted payback method uses the present value of cash flows instead of cash flows in calculating
the payback period. Each year's cash flow is discounted using the required rate of return, and those discounted cash
flows are used to calculate the payback period
Question 66
Flex Corporation is studying a capital acquisition proposal in which newly acquired assets will be depreciated using
the straight-line method. Which one of the following statements about the proposal would be
incorrect
if a switch is made to the Modified Accelerated Cost Recovery System (MACRS)?
A. The internal rate of return will increase.
B. The profitability index will decrease.
C. The payback period will be shortened.
D. The net present value will increase

B. The profitability index will increase. Since MACRS is an accelerated depreciation method used in calculating
income tax liability, its use will result in lower tax liability during the early years of the asset's life than if the
depreciation is calculated using the straight-line method. The decreased income tax liability will result in higher cash
inflows during the early years of the project. The higher cash inflows during the early years of the project will result
in a higher present value of the cash inflows for the project. Since the profitability index is the present value of the
future net cash flows divided by the initial investment, the higher present value for the cash inflows will result in a
higher profitability index.

Question 67
Jasper Company has a payback goal of 3 years on new equipment acquisitions. A new sorter is being evaluated that
costs $450,000 and has a 5-year life. Straight-line depreciation will be used; no salvage is anticipated. Jasper is
subject to a 40% income tax rate. To meet the company's payback goal, the sorter must generate reductions in
annual cash operating costs of
A. $100,000.
B. $114,000.
C. $190,000.
D. $150,000

C. The payback period is the number of years it takes for the initial investment in a project to be returned, without
considering the time value of money. The new equipment will cost $450,000, and the company needs that amount
returned within three years. The depreciation tax shield will be $36,000 per year ($450,000 ÷ 5 × .40). Therefore, in
three years, $108,000 of the investment will have been returned by means of the depreciation tax shield, leaving
$342,000 to be returned in increased cash flow after taxes. Jasper's tax rate is 40%. Therefore, the before-tax
increased cash flow over the three year payback period needs to be $342,000 ÷ (1 − .40), or $570,000. The annual
increase in cash flow needed, then, is $570,000 ÷ 3, or $190,000.
Question 68
All of the following are the rates used in net present value analysis except for the
A. Discount rate
.B. Accounting rate of return.
C. Hurdle rate.
D. Cost of capital.
B. In net present value analysis, the present value of future cash flows less the net cost of the investment equals the
NPV. The rate used to discount the future cash flows to their present value is called the required rate of return. It
can also be referred to as the discount rate or the hurdle rate. The cost of capital is frequently used as the required
rate of return. The accounting rate of return is not a part of net present value analysis, however

Question 69
The internal rate of return (IRR) is the
A. Rate of interest for which the net present value is greater than 1.0.
B. Rate of return generated from the operational cash flows.
C. Rate of interest for which the net present value is equal to zero.
D. Hurdle rate.
C. The internal rate of return is the discount rate at which the net present value of the project is zero. This means
that at that particular discount rate used to discount the future cash inflows to their present value, the present value
of the cash inflows equals the initial cash outflow.

Question 70
An advantage of the net present value method over the internal rate of return model in discounted cash flow
analysis is that the net present value method
A. Can be used when there is no constant rate of return required for each year of the project.
B. Uses a discount rate that equates the discounted cash inflows with the outflows.
C. Uses discounted cash flows whereas the internal rate of return model does not.
D. Computes a desired rate of return for capital projects.
A. Since each year's net cash flow is calculated individually and may be discounted individually using net present
value analysis, the net present value method can incorporate varying rates of returns during the various years of the
project's life. In contrast, the internal rate of return method is used to determine the single discount rate at which
the net present value of a project is zero. Thus, the internal rate of return model cannot be used when there is no
constant rate of return required for each year of a project.
Question 71
Sensitivity analysis, if used with capital projects,
A. Is used extensively when cash flows are known with certainty.
B. Measures the change in the discounted cash flows when using the discounted payback method rather than the
net present value method.
C. Is a "what-if" technique that asks how a given outcome will change if the original estimates of the capital
budgeting model are changed.
D. Is a technique used to rank capital expenditure requests.
C. Sensitivity analysis can be used in capital budgeting to determine how cash flows can be expected to vary with
changes in the underlying assumptions. Sensitivity analysis is a "what if" technique. Using expected cash flows, the
NPV, IRR, and PI of the project are determined. Then, the key assumptions that were used in making the original
expected cash flow projections are identified. One assumption at a time is then changed, leaving the other
assumptions unchanged, and the NPV, IRR and PI are recalculated to determine what effect changing one
assumption would have on those measures.

Question 72
The use of an accelerated method instead of the straight-line method of depreciation in computing the net present
value of a project has the effect of
A. Increasing the cash outflows at the initial point of the project.
B. Lowering the net present value of the project.
C. Increasing the present value of the depreciation tax shield
.D. Raising the hurdle rate necessary to justify the project.
C. The depreciation tax shield is the amount by which the tax payment owed by the company will be reduced as a
result of the tax deductibility of the depreciation. This reduction of the tax payable is essentially a cash inflow for the
company. The use of an accelerated method of depreciation for tax purposes will result in higher depreciation in the
early years of a project and lower depreciation in the later years, when compared with straight-line depreciation.
Higher cash flow in the early years of a project has a greater present value than higher cash flow in the later years.
Thus, accelerated depreciation for tax purposes will increase the present value of the depreciation tax shield.

Question 73
The profitability index (present value index)
A. Is calculated by dividing the discounted profits by the cash outflows.
B. Represents the ratio of the discounted net cash outflows to cash inflows.
C. Is the relationship between the net discounted cash inflows less the discounted cash outflows divided by the
discounted cash outflows.
D. Is the ratio of the discounted net cash inflows to discounted cash outflows.
D. The Profitability Index is a benefit-cost ratio. It is the ratio of the present value of cash inflows to the present
value of cash outflows.

Question 74
McLean Inc. is considering the purchase of a new machine that will cost $160,000. The machine has an estimated
useful life of 3 years. Assume that 30% of the depreciable base will be depreciated in the first year, 40% in the
second year, and 30% in the third year. The new machine will have a $10,000 resale value at the end of its estimated
useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a
40% estimated income tax rate and a 16% hurdle rate to evaluate capital projects

Question 75
McLean Inc. is considering the purchase of a new machine that will cost $160,000. The machine has an estimated
useful life of 3 years. Assume that 30% of the depreciable base will be depreciated in the first year, 40% in the
second year, and 30% in the third year. The new machine will have a $10,000 resale value at the end of its estimated
useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a
40% estimated income tax rate and a 16% hurdle rate to evaluate capital projects
When calculating the payback period, operating cash flows are usually assumed to be received evenly throughout
each year of the project's life. However, the $6,000 received from disposition of the asset is not received until the
end of the project, which is at the end of Year 3. Therefore, it is handled differently from operating cash flows. It is
not included in the calculation of the payback period in this case, because it occurs at the end of the year, while
operating cash flows are assumed to occur evenly throughout the year. Thus, the payback period would end before
the disposition occurs. Note that it is not a part of the net cash flow used to calculate the payback period. The
cumulative cash flow from the project becomes positive during year 3. The payback period is 2.19 years, calculated
as follows: Number of the project year in the final year when cash flow is negative, which is 2 Plus: a fraction
consisting of Numerator = the positive value of the negative cumulative inflow amount from the final negative year -
13,200 Denominator = cash flow (excluding disposition) for the following year: 70,200 OR : 2 + (13,200/70,200) =
2.19 Since the disposition of the asset occurs after the payback period, it is not a part of the payback period
calculation

Question 76
Capital Invest Inc. uses a 12% hurdle rate for all capital expenditures and has done the followinganalysis for four
projects for the upcoming year.
B. When a company has no restrictions on its capital investments, it should undertake all projects with positive NPVs,
because any project with a positive NPV will increase shareholder wealth. Projects 2, 3 and 4 all have positive NPVs,
so all should be accepted. Note also that the Internal Rates of Return for Projects 2, 3 and 4 are all greater than
Capital Invest's 12% hurdle rate; and the Profitability Indices for Projects 2, 3 and 4 are greater than 100%

Question 77
Same 76
Which project(s) should Capital Invest Inc. undertake during the upcoming year if it has only $600,000 of funds
available?
A. Projects 3 and 4.
B. Projects 2 and 3.
C. Projects 2, 3, and 4.
D. Projects 1 and 3.
A. When capital is limited, the decision as to which project should receive money first is made using the Profitability
Indices of the different proposed projects. (Note that this is not an absolute rule, and there are some exceptions.
However, this is not one of the exceptions.) Project 3 and Project 4 will use $520,000 of capital, which is within the
$600,000 maximum. Their Profitability Indices are the highest, at 106% and 105%, respectively. In addition, their
NPVs and IRRs are the highest

Question 78
Same 76
Which project(s) should Capital Invest Inc. undertake during the upcoming year if it has only $300,000 of capital
funds available?
A. Project 3.
B. Project 1.
C. Projects 3 and 4.
D. Projects 2, 3, and 4.
A. The Profitability Index represents the ratio of the benefits (net cash inflows) to the costs (net initial investment).
Thus, it can identify the project with the greatest return per dollar of investment. The Profitability Index enables us
to rank different sized investments, since the Profitability Index expresses profitability on a percentage basis rather
than a total dollar amount basis. It is very useful for comparing multiple investments that are of different investment
amounts. In this case, we can accept only one project because of the limitation in capital. The project with the
highest Profitability Index is Project 3, even though it does not have the highest NPV or IRR. Although its NPV is lower
than the NPV of Project 4, Project 3 requires only $248,000 of capital outlay compared with $272,000 required for
Project 4

Question 79
Jorelle Company's financial staff has been requested to review a proposed investment in new capital
equipment. Applicable financial data is presented below. There will be no salvage value at the end of the
investment's life and, due to realistic depreciation practices, it is estimated that the salvage value and net book value
are equal at the end of each year. All cash flows are assumed to take place at the end of each year. For investment
proposals, Jorelle uses a 12% after-tax target rate of return

The accounting rate of return on the average investment proposal is

A. 17.2%
B. 12.0%
C. 28.0%
D. 34.4%
D. The accounting rate of return on an investment, using the average investment amount as instructed in the
question, is the increase in the expected annual average after-tax accounting net income divided by the average
investment. Since the initial investment is $250,000, the average investment is $250,000 / 2, or $125,000. The
average after-tax accounting net income attributable to the investment is ($35,000 + $39,000 + $43,000 + $47,000 +
$51,000) / 5, or $43,000. $43,000 / $125,000 = .344 or 34.4%

Question 80
Same 78
The net present value for the investment proposal is
A. $(97,970)
B. $106,160
C. $96,560
D. $356,160
B. The NPV is the present value of the future cash inflows less the initial investment, when the future cash flows are
discounted using the discount rate determined by management. In this case, the discount rate chosen by
management is 12%. Using the present value of $1 factors, the present value of the future cash flows is ($120,000 ×
.89) + ($108,000 × .80) + ($96,000 × .71) + ($84,000 × .64) + ($72,000 ×.57) = $356,160. Subtracting the

initial investment of $250,000 from the present value of the future cash flows of $356,160 gives us an NPV of
$106,160.

Question 81
Same 79
The traditional payback period for the investment proposal is
A. Over 5 years.
B. 2.83 years.
C. 2.23 years.
D. 1.65 years
C. When cash flows are not constant over the life of the project, we must add up the cash inflows in order to
determine when the inflows will equal the outflows. The cash flows are as follows: Year 0 Year 1 Year 2 Year 3 Year 4
Year 5 Net initial investment(250,000) After-tax cash flows from operations 120,000 108,000
96,00084,00072,000Cumulative cash flows(250,000)(130,000)(22,000)74,000158,000230,000The cumulative cash
flow from the project becomes positive sometime during year 3. If the cash flows are assumed to occur evenly
throughout the year, the exact payback period is 2.23 years, calculated as follows: Number of the project year in the
final year when cash flow is negative: 2 Plus: a fraction consisting of Numerator = the positive value of the negative
cumulative inflow amount from the final negative year: 22,000 Denominator = cash flow for the following year:
96,000 OR: 2 + (22,000/96,000) = 2.23 The initial investment will be recouped after 2.23 years.
Question 82
Which one of the following capital investment evaluation methods does not take the time value of money into
consideration?
A. Internal rate of return.
B. Discounted payback.
C. Net present value.
D. Accounting rate of return

D. The accounting rate of return is the average annual increased accounting net income after tax attributable to the
investment divided by the net initial investment, or sometimes divided by the average investment over the life of the
project (i.e., the initial investment amount divided by 2). The accounting rate of return does not take into consideration
the time value of money

Question 83

Jackson Corporation uses net present value techniques in evaluating its capital investment projects. The company is
considering a new equipment acquisition that will cost $100,000, fully installed, and have a zero salvage value at the
end of its five-year productive life. Jackson will depreciate the equipment on a straight-line basis for both financial
and tax purposes. Jackson estimates $70,000 in annual recurring operating cash income and $20,000 in annual
recurring operating cash expenses. Jackson's cost of capital is 12% and its effective income tax rate is 40%. What is
the net present value of this investment on an after-tax basis?

A. $80,250

B. $8,150

C. $36,990

D. $28,840

C. Annual after-tax cash flows will be *($70,000 − $20,000) × (1 − .40)+, which equals $30,000. The annual
depreciation tax shield is ($100,000 / 5) × .40, which is $8,000. Therefore, the total annual after-tax cash flow is
$38,000. The present value of these net inflows for a 5-year period is $136,990 ($38,000 x 3.605 present value of an
ordinary annuity for 5 years at 12%), and the NPV of the investment is $36,990 ($136,990 − $100,000 initial
investment)

Question 84

Mega Inc., a large conglomerate with operating divisions in many industries, uses risk-adjusted discount rates in
evaluating capital investment decisions. Consider the following statements concerning Mega's use of risk-adjusted
discount rates.I. Mega may accept some investments with internal rates of return less than Mega's overall average
cost of capital.II. Discount rates vary depending on the type of investment.III. Mega may reject some investments
with internal rates of return greater than the cost of capital.IV. Discount rates may vary depending on the
division.Which of the above statements are correct?

A. II and IV only.

B. I and III only.

C. I, II, III, and IV.

D. II, III, and IV only.

C- All of the statements are correct. When we analyze risk, we are measuring the amount of variability that could
take place in the future returns from the investment being considered. One way of accounting for the anticipated
amount of risk in a capital budgeting analysis is to use a required rate of return to discount the cash flows that is
either higher or lower than the company's cost of capital. If the project is considered to be riskier than the firm's
existing business (there is more variability in the possible future cash flows), a higher required rate of return is used
to discount the future cash flows. If the project is considered to be less risky than the firm's existing business, a lower
required rate of return is used to discount the future cash flows. This is called a "risk-adjusted rate of return." Mega
may accept some investments with internal rates of return less than Mega's overall average cost of capital because
the investment may be considered to be less risky than the firm's other business, and thus a lower required rate of
return (i.e., hurdle rate) was used to discount its expected future cash flows.Discount rates vary depending on the
type of investment because a higher discount rate would be used to discount a riskier investment and a lower
discount rate would be used to discount a less risky investment. Mega may reject some investments with internal
rates of return greater than the cost of capital because those investments were judged to be riskier than the firm's
existing business and therefore the expected future cash flows have been discounted at a rate higher than the firm's
cost of capital. For a riskier investment using a risk-adjusted discount rate, the expected cash flow from the
investment will need to be relatively larger, or the increased discount rate will generate a negative net present
value. So even though the investments' IRRs are greater than the cost of capital, if they are not greater than the
higher required rate of return, the investments will be rejected.Discount rates may vary depending on the division
because the same investments undertaken by different organizational subunits may carry different levels of risk due
to risk factors that could be specific to one unit and not to another unit

Question 85

The following methods are used to evaluate capital investment projects.

• Internal rate of return (IRR)

• Average rate of return (ARR)

• Payback

• Net present value (NPV)

Which one of the following correctly identifies the methods that utilize discounted cash-flow (DCF) techniques?

A. IRR and NPV.

B. IRR and ARR only.

C. IRR and Payback only.

D. Payback and NPV only

A. Both the IRR and NPV use discounted cash-flow techniques

Question 86

Which one of the following methods for evaluating capital projects is the least useful from an investment analysis
point of view?

A. Net present value.

B. Payback.

C. Internal rate of return.

D. Accounting rate of return

D. Accounting rate of return uses accounting profit in its analysis instead of cash flows. This makes this the least
useful of the methods listed for investment analysis.