CHAPTER 7: CAPITAL BUDGETING DECISIONS PART I

Multiple Choice

a. Useful life of the project. b. The company's minimum required rate of return. c. The project's NPV. d. The project's annual cash flow.

a. is conceptually superior to the IRR criterion. b. ta es into consideration the time value of money. c. gives priority to rapid recovery of cash. d. emphasizes the most profitable projects.

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

a 4. If the present value of the future cash flows for an investment equals the required investment, the IRR is

c 2. The paybac

criterion for capital investment decisions

d 1. Calculating the paybac which of the following?

period for a capital project requires nowing

a. equal to the cutoff rate. b. equal to the cost of borrowed capital. c. equal to zero. d. lower than the company's cutoff rate of return.

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

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

a 7. If an investment has a positive NPV, a. its IRR is greater than the company's cost of capital. b. cost of capital exceeds the cutoff rate of return. c. its IRR is less than the company's cutoff rate of return. d. the cutoff rate of return exceeds cost of capital.

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

b 9. Which of the following capital budgeting methods does NOT consider the time value of money? a. IRR.

c. Time-adjusted rate of return. d. NPV.

b 10. All other things being equal, as cost of capital increases a. more capital projects will probably be acceptable. b. fewer capital projects will probably be acceptable. c. the number of capital projects that are acceptable will change, but the direction of the change is not determinable just by nowing the direction of the change in cost of capital. d. the company will probably want to borrow money rather than issue stoc .

d 11. Which of the following is a basic difference between the IRR and the boo rate of return (BRR) criteria for evaluating investments? a. IRR emphasizes expenses and BRR emphasizes expenditures. b. IRR emphasizes revenues and BRR emphasizes receipts.

b. Boo

rate of return.

c. IRR is used for internal investments and BRR is used for external investments. d. IRR concentrates on receipts and expenditures and BRR concentrates on revenues and expenses.

a. its NPV may be negative. b. its IRR is greater than cost of capital. c. it will have a positive NPV. d. its incremental cash flows may not cover its cost.

c 13. Cost of capital is a. the amount the company must pay for its plant assets. b. the dividends a company must pay on its equity securities. c. the cost the company must incur to obtain its capital resources. d. the cost the company is charged by investment ban ers who handle the issuance of equity or long-term debt securities.

d 14. The normal methods of analyzing investments a. cannot be used by not-for-profit entities. b. do not apply if the project will not produce revenues. c. cannot be used if the company plans to finance the project with funds already available internally. d. require forecasts of cash flows expected from the project.

a 12. If a project has a paybac

period shorter than its life,

a 15. Which of the following is NOT a defect of the paybac method? a. It ignores cash flows because it uses net income. b. It ignores profitability. c. It ignores the present values of cash flows. d. It ignores the pattern of cash flows beyond the paybac period.

b 16. A company with cost of capital of 15% plans to finance an investment with debt that bears 10% interest. The rate it should use to discount the cash flows is a. 10%. b. 15%. c. 25%. d. some other rate.

c 17. Which of the following events will increase the NPV of an investment involving a new product? a. An increase in the income tax rate. b. An increase in the expected per-unit variable cost of the product. c. An increase in the expected annual unit volume of the product. d. A decrease in the expected salvage value of equipment.

b 18. An investment has a positive NPV discounting the cash flows at a 14% cost of capital. Which statement is true? a. The IRR is lower than 14%. b. The IRR is higher than 14%. c. The paybac period is less than 14 years.

a 19. The technique most concerned with liquidity is a. paybac . b. NPV.

d. The boo

rate of return is 14%.

c. IRR.

d 20. The technique that does NOT use cash flows is a. paybac . b. NPV. c. IRR.

a 21. If there were no income taxes, a. depreciation would be ignored in capital budgeting. b. the NPV method would not wor . c. income would be discounted instead of cash flow. d. all potential investments would be desirable.

a 22. Two new products, X and Y, are ali e in every way except that the sales of X will start low and rise throughout its life, while those of Y will be the same each year. Total volumes over their five-year lives will be the same, as will selling prices, unit variable costs, cash fixed costs, and investment. The NPV of product X a. will be less than that of product Y. b. will be the same as that of product Y. c. will be greater than that of product Y. d. none of the above.

d. boo

rate of return.

d. boo

rate of return.

d 23. Which of the following events is most li ely to increase the number of investments that meet a company's acceptance criteria? a. Top management raises the target rate of return. b. The interest rate on long-term debt rises. c. The income tax rate rises. d. The IRS allows companies to expense purchases of fixed assets, instead of depreciating them over their lives.

d 24. Investment A has a paybac period of 5.4 years, investment B one of 6.7 years. From this information we can conclude a. that investment A has a higher NPV than B. b. that investment A has a higher IRR than B. c. that investment A's boo rate of return is higher than B's. d. none of the above.

d 25. Investment A has a boo rate of return of 26%, investment B one of 18%. From this information we can conclude a. that investment A has a higher NPV than B. b. that investment A has a higher IRR than B.

d. none of the above.

c 26. A dollar now is worth more than a dollar to be received in the future because of a. inflation. b. uncertainty. c. the opportunity cost of waiting. d. none of the above.

a. consider the time value of money. b. ignore depreciation.

a 27. In contrast to the paybac IRR methods

and boo rate of return methods, the NPV and

c. that investment A has a shorter paybac

period than B.

c. use after-tax cash flows. d. all of the above.

a 28. Which of the following is a discounted cash flow method? a. NPV. b. Paybac .

d. All of the above.

a 29. Which statement describes the relevance of depreciation in calculating cash flows? a. Depreciation is relevant only when income taxes exist. b. Depreciation is always relevant. c. Depreciation is never relevant. d. Depreciation is relevant only with discounted cash flow methods.

b 30. As the discount rate increases a. present value factors increase. b. present value factors decrease. c. present value factors remain constant. d. it is impossible to tell what happens to the factors.

c. Boo

rate of return.

a 31. As the length of an annuity increases a. present value factors increase. b. present value factors decrease. c. present value factors remain constant. d. it is impossible to tell what happens to present value factors.

a 32. The only future costs that are relevant to deciding whether to accept an investment are those that will a. be different if the project is accepted rather than rejected. b. be saved if the project is accepted rather than rejected. c. be deductible for tax purposes. d. affect net income in the period that they are incurred.

a 33. Which of the following is true of an investment? a. The lower the cost of capital, the higher the NPV. b. The lower the cost of capital, the higher the IRR.

d. The higher the project's NPV, the shorter its life.

c 34. Which of the following methods FAILS to distinguish between return of investment and return on investment? a. NPV. b. IRR. c. Paybac .

c 35. If a company is NOT subject to income tax, which of the following is true of a proposed investment? a. The project's IRR equals the entity's cost of capital. b. The project's NPV is zero. c. Depreciation on assets required for the project is irrelevant to the evaluation.

d. Boo

rate of return.

c. The longer the project's life, the shorter its paybac

period.

d. The expected annual increase in future cash flows equals the investment required to underta e the project.

d 36. Which of the following increases NPV and IRR? a. An upward revision in expected annual net cash flows. b. An upward revision of expected life. c. An upward revision of the residual value of the long-lived assets being acquired for the project. d. All of the above.

d 37. Qualitative issues could increase the acceptability of a project under which of the following conditions? a. The IRR is less than the company's cutoff rate. b. The project has a negative NPV. c. The paybac period is longer than the company's cutoff period. d. All of the above.

a 38. If Co. X wants to use IRR to evaluate long-term decisions and to establish a cutoff rate of return, X must be sure the cutoff rate is a. at least equal to its cost of capital. b. at least equal to the rate used by similar companies. c. greater than the IRR on projects accepted in the past.

d. greater than the current boo

rate of return.

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

b 40. If the IRR on an investment is zero, a. its NPV is positive. b. its annual cash flows equal its required investment. c. it is generally a wise investment. d. its cash flows decrease over its life.

d 41. If depreciation on a new asset exceeds its savings in cash operating costs, which of the following is true? a. The project is usually unacceptable. b. The annual after-tax cash flow on the new asset will be greater than the savings in cash operating costs. c. The project has a negative NPV. d. All of the above.

d 42. Cost of capital is a. the interest rate an entity must pay to borrow money. b. the return an entity's stoc holders expect on their investment. c. the rate of return the entity can earn from investing available cash. d. a concept of managerial finance incorporating all of the above ideas.

b 43. An investment opportunity costing $75,000 is expected to yield net cash flows of $23,000 annually for five years. The NPV of the investment at a cutoff rate of 14% would be

a. $(3,959). b. $3,959. c. $75,000. d. $78,959.

b 44. An investment opportunity costing $55,000 is expected to yield net cash flows of $22,000 annually for five years. The paybac period of the investment is a. 0.4 years. b. 2.5 years. c. $33,000. d. some other number.

c 45. An investment opportunity costing $180,000 is expected to yield net cash flows of $53,000 annually for five years. The IRR of the investment is between a. 10 and 12%. b. 12 and 14%. c. 14 and 16%. d. 16 and 18%.

b 46. An investment opportunity costing $150,000 is expected to yield net cash flows of $45,000 annually for five years. The cost of capital is 10%. The boo rate of return would be a. 10%. b. 20%. c. 30%. d. 33.3%.

a 47. An investment opportunity costing $150,000 is expected to yield net cash flows of $36,000 annually for six years. The NPV of the investment at a cutoff rate of 12% would be a. $(2,004). b. $2,004. c. $150,000. d. $147,996.

c 48. An investment opportunity costing $100,000 is expected to yield net cash flows of $22,000 annually for seven years. The paybac period of the investment is a. 0.22 years. b. 3.08 years. c. 4.55 years. d. some other number.

a 49. An investment opportunity costing $200,000 is expected to yield net cash flows of $39,000 annually for eight years. The IRR of the investment is between a. 10 and 12%. b. 12 and 14%. c. 14 and 16%. d. 16 and 18%.

b 50. An investment opportunity costing $80,000 is expected to yield net cash flows of $25,000 annually for four years. The cost of capital is 10%. The boo rate of return would be

a. 10.0%. b. 12.5%. c. 21.3%. d. 32.0%.

True-False

T 1. Paybac period is the length of time it will ta e a company to recoup its outlay for an investment.

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

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

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

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

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

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

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

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

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

Problems

1. An investment opportunity costing $180,000 is expected to yield net cash flows of $60,000 annually for five years.

a. Find the NPV of the investment at a cutoff rate of 12%.

c. Find the IRR on the investment.

SOLUTION:

a. NPV: $36,300 [(3.605 x $60,000) - $180,000]

b. Paybac period: 3 years ($180,000/$60,000)

b. Find the paybac

period of the investment.

c. IRR: between 18 % and 20% (3.0 is between 3.127 and 2.991)

2. Tofte is considering the purchase of a machine. Data are as follows:

Cost $100,000 Useful life 10 years Annual straight-line depreciation $ 10,000 Expected annual savings in cash operation costs $ 18,000

Tofte's cutoff rate is 12% and its tax rate is 40%.

a. Compute the annual net cash flows for the investment.

b. Compute the NPV of the project.

SOLUTION:

a. Annual net cash flows: $14,800 [$18,000 pretax - 40% x ($18,000 $10,000 depreciation)]

b. NPV: Negative $16,380 [($14,800 x 5.650) - $100,000]

3. Willow Company is considering the purchase of a machine with the following characteristics.

Cost $150,000 Estimated useful life 10 years Expected annual cash cost savings $35,000

Marquette's tax rate is 40%, its cost of capital is 12%, and it will use straight-line depreciation for the new machine.

a. Compute the annual after-tax cash flows for this project.

SOLUTION:

a. Annual cash flows: $27,000 [$35,000 - 40% x ($35,000 - $15,000)]

b. Paybac period: 5.56 years ($150,000/$27,000)

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

a. Find the increase in annual after-tax cash flows for this opportunity.

b. Find the paybac period on this project.

b. Find the paybac

period for this project.

c. Find the NPV for this project.

SOLUTION:

a. Increase in annual cash flows: $1,700,000

Income before taxes, 250,000 x ($60 - $40) - $3,000,000 - $5,000,000/4 $ 750,000 Income tax (300,000) ---------Net income $ 450,000 Plus depreciation 1,250,000 ---------Net cash flow $1,700,000 ==========

c. NPV: $389,000 [($1,700,000 x 3.170) - $5,000,000]

b. Paybac

period: 2.94 years ($5,000,000/$1,700,000)

5. An investment opportunity costing $600,000 is expected to yield net cash flows of $120,000 annually for ten years.

a. Find the NPV of the investment at a cutoff rate of 12%.

c. Find the IRR on the investment.

SOLUTION:

a. NPV: $78,000 [(5.650 x $120,000) - $600,000]

b. Paybac period: 5 years ($600,000/$120,000)

c. IRR: 15% (5.0 is about halfway between 5.216 and 4.833)

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

Year One $75,000 Year Two $90,000 Year Three $115,000 Year Four $130,000 Year Five $100,000 Year Six $90,000

a. Find the paybac period of the investment.

b. Find the paybac

period of the investment.

b. Find the boo rate of return of the investment.

c. Find the NPV of the investment at a cutoff rate of 10%.

SOLUTION:

b. Boo rate of return: 33.3%

Average return: $100,000 ($600,000 total / 6 years) Depreciation: 50,000 ($30,000 / 6 years) ------Average income $50,000

Average investment: $300,000 / 2 = $150,000

Boo rate of return = $50,000 / 150,000 = 33.3%

c. NPV: $130,530

Cash Factor PV ------ ------ -----1 75,000 .909 68,175 2 90,000 .826 74,340

a. Paybac

period: 3.15 years (75,000 + 90,000 + 115,000 + .15 x 130,000)

3 115,000 .751 86,365 4 130,000 .683 88,790 5 100,000 .621 62,100 6 90,000 .564 50,760 ------430,530 Investment 300,000 ------NPV 130,530 ======

7. Acme is considering the purchase of a machine. Data are as follows:

Cost $160,000 Useful life 10 years Annual straight-line depreciation $ ??? Expected annual savings in cash operation costs $ 33,000

Acme's cutoff rate is 12% and its tax rate is 40%.

a. Compute the annual net cash flows for the investment.

b. Compute the NPV of the project.

c. Compute the IRR of the project.

SOLUTION:

a. Annual net cash flows: $26,200 [$33,000 pretax - 40% x ($33,000 $16,000 depreciation)]

b. NPV: Negative $11,970 [($26,200 x 5.650) - $160,000]

c. IRR: between 10% and 12% [factor of 6.107 (160,000/26,200) is between 6.145 and 5.650]

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

Year One $ 30,000 Year Two $ 60,000 Year Three $ 90,000 Year Four $ 60,000 Year Five $ 30,000

b. Find the boo rate of return of the investment.

c. Find the NPV of the investment at a cutoff rate of 12%.

SOLUTION:

a. Find the paybac

period of the investment.

b. Boo rate of return: 20%

Average return: $54,000 ($270,000 total / 5 years) Depreciation: 36,000 ($180,000 / 5 years) -----Average income $18,000

Average investment: $180,000 / 2 = $90,000

Boo rate of return = $18,000 / $90,000 = 20%

c. NPV: $6,930

Cash Factor PV ------ ------ -----1 30,000 .893 26,790 2 60,000 .797 47,820 3 90,000 .712 64,080 4 60,000 .636 38,160 5 30,000 .567 17,010 ------193,860 Investment 180,000 ------NPV 13,860 ======

a. Paybac

period: 3.0 years (30,000 + 60,000 + 90,000)

9. Reno Company is considering the purchase of a machine with the following characteristics.

Cost $160,000 Estimated useful life 5 years Expected annual cash cost savings $56,000 Expected salvage value none

Reno's tax rate is 40%, its cost of capital is 12%, and it will use straight-line depreciation for the new machine.

a. Compute the annual after-tax cash flows for this project.

c. Compute the NPV for this project.

SOLUTION:

a. Annual cash flows: $46,400 [$56,000 - 40% x ($56,000 - 32,000)]

b. Paybac period: 3.45 years ($160,000/$46,400)

c. NPV: $7,272 [($46,400 x 3.605) - $160,000]

b. Find the paybac

period for this project.

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

a. Find the increase in annual after-tax cash flows for this opportunity.

c. Find the NPV for this project.

SOLUTION:

a. Increase in annual cash flows: $1,100,000

Income before taxes, [200,000 x ($40 - $27) - $1,500,000 - $3,500,000/4] $ 225,000 Income tax ( 90,000) ---------Net income $ 135,000 Plus depreciation 875,000 ---------Net cash flow $1,010,000 ==========

b. Paybac period: 3.47 years ($3,500,000/$1,010,000)

c. NPV: negative $298,300 [($1,010,000 x 3.170) - $3,500,000]

b. Find the paybac

period on this project.