Financial Management

Investment Decision Criteria

1. An Overview of Capital Budgeting

1) Which of the following are typical consequences of good capital budgeting decisions?

1. The firm increases in value.
2. The firm gains knowledge and experience that may be useful in future decisions.
3. Good capital budgeting decisions help a company define its core competencies.
4. All of the above.

Answer: D

2) Errors in capital budgeting decisions

1. tend to average out over time.
2. decrease the firm's value.
3. are diminished because the time value of money makes future cash flows less important.
4. are easily reversed.

Answer: B

3) Which of the following factors is least important to capital budgeting decisions?

1. The time value of money
2. The risk-return tradeoff
3. Net income based on accrual accounting principles
4. Cash flows directly resulting from the decision

Answer: C

4) Which of the following would be considered a capital budgeting decision?

1. Walmart purchases inventory for resale to customers.
2. Apple sells bonds and uses the proceeds to repurchase stock.
3. Goldman Sachs obtains short-term loans to finance day to day operations.
4. Pfizer develops a new therapy and brings it to market.

Answer: D

5) Which of the following is a typical capital budgeting decision?

1. Purchase of office supplies
2. Granting credit to a new customer
3. Replacement of manufacturing equipment with more modern and efficient equipment
4. Financing the firm with more long-term debt and less equity

Answer: C

6) Good capital investment opportunities are most likely to exist when

1. many firms compete to sell similar products.
2. interest rates are high and rising.
3. goods and services can be produced cheaply using readily available tools and technologies.
4. a line of business is expensive to enter and uses proprietary technology.

Answer: D

7) Errors resulting from a capital budgeting decision are not considered major since the consequences of such errors average out over the life of the investment.

Answer: FALSE

8) Competitive market forces make it imperative for a firm to have a systematic strategy for generating capital-budgeting projects.

Answer: TRUE

9) The size of capital investments and the difficulty in reversing them once they are made make capital-budgeting decisions very important to the firm.

Answer: TRUE

10) Capital budgeting is the decision-making process with respect to investment in working capital.

Answer: FALSE

11) Some capital budgeting decisions may be mandated by government regulations.

Answer: TRUE

12) The primary objective of all capital budgeting decisions is to increase the size of the firm.

Answer: FALSE

13) Why are capital budgeting decisions among the most important decisions made by any company? Give a few examples from recent business developments.

Answer: The main objective of financial management is to maximize the value of the firm. The main source of value is the company's cash flows discounted at rates that reflect their risk. Both the firm's cash flows and their level of risk are determined by the projects the company chooses to undertake. Recent examples include Apples string of "I" products (pod, phones, pad), and Amazon's Kindle which have added tremendous value to those companies. Students may cite examples from the text such as Kimberly-Clark's Huggies or Walmart's use of central distribution centers. Examples of less than successful decisions, at least so far, might include the Segue or the Gap's ephemeral redesigned logo. (Students' answers will vary their experience and recent events.)

14) Distinguish between revenue enhancement investments, cost-reduction investments, and mandated investments.

Answer: Revenue enhancements investments may include new product lines such as Amazon's Kindle or GM's Chevy Volt undertaken, obviously, to increase cash flows by increasing sales. Companies such as Walmart may expand internationally or enter new businesses such as groceries for the same reason. Cost reduction investments such as improved distribution, energy saving equipment or loss prevention systems may not increase sales, but increase cash flows by reducing costs. Mandated investments may include such issues as access for the handicapped, pollution abatement, or employee safety. They are unavoidable because required by federal, state, or local laws. In these cases, companies will seek the least expensive way to comply.

15) Why is it so difficult for firms to find good investment ideas?

Answer: All firms are competing to maximize their value, so if an idea is obvious, many companies will pursue it at the same time. The Blackberry, for example, soon faced intense competition from any number of smart phones. Companies often find the best opportunities in areas where they have some protection from competition because they possess proprietary technology (Pfizer, Merck), strong brand loyalty (Coca Cola), or because the business is very expensive to enter (Toyota, Disney).

2. Net Present Value

1) Project Sigma requires an investment of $1 million and has a NPV of $10. Project Delta requires an investment of $500,000 and has a NPV of $150,000. The projects involve unrelated new product lines.

1. Both projects should be accepted because they have positive NPV's.
2. Neither project should be accepted because they might compete with one another.
3. Only project Delta should be accepted. Alpha's NPV is too low for the investment.
4. The company should look at other investment criteria, not just NPV.

Answer: A

2) ABC Service can purchase a new assembler for $15,052 that will provide an annual net cash flow of $6,000 per year for five years. Calculate the NPV of the assembler if the required rate of return is 12%. (Round your answer to the nearest $1.)

1. $1,056
2. $4,568
3. $7,621
4. $6,577

Answer: D

3) Central Mass Ambulance Service can purchase a new ambulance for $200,000 that will provide an annual net cash flow of $50,000 per year for five years. Calculate the NPV of the ambulance if the required rate of return is 9%. (Round your answer to the nearest $1.)

1. $50,000
2. $(5,061)
3. $(5,517)
4. $5,517

Answer: C

4) Central Mass Ambulance Service can purchase a new ambulance for $200,000 that will provide an annual net cash flow of $50,000 per year for five years. The salvage value of the ambulance will be $25,000. Assume the ambulance is sold at the end of year 5. Calculate the NPV of the ambulance if the required rate of return is 9%. (Round your answer to the nearest $1.)

1. $(10,731)
2. $10,731
3. $(5,517)
4. $5,517

Answer: B

5) Fitchminster Armored Car can purchase a new vehicle for $200,000 that will provide annual net cash flow over the next five years of $40,000, $45,000, $50,000, $55,000, $60,000. The salvage value of the vehicle will be $25,000. Assume that the vehicle is sold at the end of year 5. Calculate the NPV of the ambulance if the required rate of return is 9%. (Round your answer to the nearest $1.)

1. $7,390
2. $6,048
3. $6,780
4. $19,483

Answer: A

6) Project H requires an initial investment of $100,000 and the produces annual cash flows of $50,000, $40,000, and $30,000. Project T requires an initial investment of $100,000 and the produces annual cash flows of $30,000, $40,000, and $50,000. If the required rate of return is greater than 0% and the projects are mutually exclusive

1. H will always be preferable to T.
2. T will always be preferable to H.
3. H and T are equally attractive.
4. The project rankings will change with different discount rates.

Answer: A

7) Project H requires an initial investment of $100,000 and the produces annual cash flows of $45,000 per year for each of the next 3 years. Project T also requires an initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000 in year 2, and $70,000 in year 3. If the discount rate is 10% and the projects are mutually exclusive

1. Project H should be chosen.
2. Project T should be chosen.
3. H and T are equally attractive.
4. Both projects should be chosen.

Answer: B

8) Project H requires an initial investment of $100,000 and the produces annual cash flows of $45,000 per year for each of the next 3 years. Project T also requires an initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000 in year 2, and $70,000 in year 3. If the discount rate is 10% and the projects are not mutually exclusive

1. Project H should be chosen.
2. Project T should be chosen.
3. H and T are equally attractive.
4. Both projects should be accepted.

Answer: D

9) Project H requires an initial investment of $100,000 and the produces annual cash flows of $45,000 per year for each of the next 3 years. Project T also requires an initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000 in year 2, and $70,000 in year 3. If the discount rate increases from 10% to 16%

1. Project T should be chosen.
2. Both projects should be rejected.
3. H and T are equally attractive.
4. The project rankings will change.

Answer: D

10) A machine costs $1,000, has a three-year life, and has an estimated salvage value of $100. It will generate after-tax annual cash flows (ACF) of $600 a year, starting next year. If your required rate of return for the project is 10%, what is the NPV of this investment? (Round your answer to the nearest $10.)

1. $490
2. $570
3. $900
4. -$150

Answer: B

11) Suppose you determine that the NPV of a project is $1,525,855. What does that mean?

1. In all cases, investing in this project would be better than investing in a project that has an NPV of $850,000.
2. The project would add value to the firm.
3. Under all conditions, the project's payback would be less than the profitability index.
4. Other investment criteria might need to be considered.

Answer: B

12) Project January has a NPV of $50,000, project December has a NPV of $40,000. Which of the following circumstances could make it possible to choose December over January?

1. January has a shorter payback period.
2. The projects are mutually exclusive.
3. The projects have unequal lives.
4. The projects are mandated.

Answer: C

13) The present value of the total costs over a five year period for Project April is $50,000. The net present value of total costs over a 4 year period for Project October is $40,000. The company uses a discount rate of 9%. Which project should it choose and why?

1. April because it has a higher net present value (NPV).
2. April because is has a higher equivalent annual cost (EAC).
3. October because it has a shorter life.
4. October because it has a lower equivalent annual cost (EAC).

Answer: D

14) Warchester Inc. is considering the purchase of copying equipment that will require an initial investment of $15,000 and $4,000 per year in annual operating costs over the equipment's estimated useful life of 5 years. The company will use a discount rate of 8.5%. What is the equivalent annual cost?

1. $4,000
2. $7,000
3. $6,152.51
4. $7,806.49

Answer: D

15) Artie's Soccer Ball Company is considering a project with the following cash flows:

Initial outlay = $750,000

Incremental after-tax cash flows from operations Years 1-4 = $250,000 per year

Compute the NPV of this project if the company's discount rate is 12%.

1. $9,337
2. $7,758
3. $4,337
4. $2,534

Answer: A

The information below describes a project with an initial cash outlay of $10,000 and a required return of 12%.

After-tax cash inflow

Year 1 $6,000

Year 2 $2,000

Year 3 $2,000

Year 4 $2,000

16) Which of the following statements is correct?

1. The project should be accepted since its NPV is $353.87.
2. The project should be rejected since its NPV is -$353.87.
3. The project should be accepted since it has a payback of less than four years.
4. The project should be rejected since its NPV is -$23.91.

Answer: B

17) You have been asked to analyze a capital investment proposal. The project's cost is $2,775,000. Cash inflows are projected to be $925,000 in Year 1; $1,000,000 in Year 2; $1,000,000 in Year 3; $1,000,000 in Year 4; and $1,225,000 in Year 5. Assume that your firm discounts capital projects at 15.5%. What is the project's NPV?

1. $101,247
2. $285,106
3. $473,904
4. $582,380

Answer: D

18) Which of the following is a correct equation to solve for the NPV of the project that has an initial outlay of $30,000, followed by incremental cash inflows in the next 3 years of $15,000, $20,000, and $30,000? Assume a discount rate of 10%.

1. NPV = - $30,000 + $15,000(1.10)1+ $20,000(1.10)2+ $30,000(1.10)3
2. NPV = - $30,000 + $15,000/(1.10)1+ $20,000/(1.10)2+ $30,000/(1.10)3
3. NPV = - $30,000 + $15,000/(1.01).10+ $20,000/(1.02).10 + $30,000/(1.03).10
4. NPV = - $30,000 + $15,000/(1.1).10+ $20,000(1.2).10+ $30,000(1.3).10

Answer: B

19) Project EH! requires an initial investment of $50,000, and has a net present value of $12,000. Project BE requires an initial investment of $100,000, and has a net present value of $13,000. The projects are mutually exclusive. The firm should accept

1. project EH!.
2. project BE.
3. both projects.
4. neither project.

Answer: B

20) Project Eh! requires an initial investment of $50,000, and has a net present value of $12,000. Project B requires an initial investment of $100,000, and has a net present value of $13,000. The projects are proposals for increasing revenue and are not mutually exclusive. The firm should accept

1. project Eh!.
2. project B.
3. both projects.
4. neither project.

Answer: C

21) A machine has a cost of $5,375,000. It will produce cash inflows of $1,825,000 (Year 1); $1,775,000 (Year 2); $1,630,000 (Year 3); $1,585,000 (Year 4); and $1,650,000 (Year 5). At a discount rate of 16.25%, what is the NPV?

1. $81,724
2. $257,106
3. $416,912
4. $190,939

Answer: D

22) A machine has a cost of $5,575,000. It will produce cash inflows of $1,825,000 (Year 1); $1,775,000 (Year 2); $1,630,000 (Year 3); $1,585,000 (Year 4); and $1,650,000 (Year 5). At a discount rate of 16.25%, the project should be

1. accepted.
2. rejected.
3. discounted at a lower rate.
4. abandoned after the first year.

Answer: B

23) Which of the following is the correct equation to solve for the NPV of the project that has an initial outlay of $30,000, followed by three years of $20,000 in incremental cash inflow? Assume a discount rate of 10%.

1. NPV = -30,000 + (3 × 20,000)/(1.10)3
2. NPV = -$30,000 + $20,000/(1.10)1+ $20,000/(1.10)2+ $20,000/(1.10)3
3. NPV = -$30,000 + $20,000/(1.01).10+ $20,000/(1.02).10 + $20,000/(1.03).10
4. NPV = -$30,000 + $20,000/(1.1).10+ $20,000(1.2).10+ $20,000(1.3).10

Answer: B

24) Project Full Moon has an initial outlay of $30,000, followed by positive cash flows of $10,000 in year 1, $15,000 in year 2, and $15,000 in year 3. The project should be accepted if the required rate of return is

1. greater than 0.
2. less than 14.6%.
3. less than 16.25%.
4. greater than 12%.

Answer: B

25) Which of the following is a correct EXCEL formula to solve for the net present value of a project.

1. =NPV (k,CF1,CF2,...CFn)+CF0
2. =NPV (k,CF0,CF1,CF2,...CFn)
3. =NPV (CF0,CF1,CF2,...CFn)
4. =NPV (CF1,CF2,...CFn)+CF0

Answer: A

26) WSU Inc. has various options for replacing a piece of manufacturing equipment. The present value of costs for option Ell is $84,000. Option Ell has a useful life of 5 years; annual operating costs were discounted at 9%. What is the equivalent annual cost?

1. $16,800
2. $21,595.77
3. $14,035.77
4. $18,312

Answer: B

27) The equivalent annual cost (EAC) method is appropriate for evaluating accessibility projects mandated by the Americans With Disabilities Act.

Answer: TRUE

28) The required rate of return represents the cost of capital for a project.

Answer: TRUE

29) The higher the discount rate, the greater the importance of the early cash flows.

Answer: TRUE

30) The equivalent annual cost (EAC) method is helpful for mutually exclusive projects with unequal economic lives.

Answer: TRUE

31) What is the NPV of a $45,000 project that is expected to have an after-tax cash flow of $14,000 for the first two years, $10,000 for the next two years, and $8,000 for the fifth year? Use a 10% discount rate. Would you accept the project?

Answer:

32) Dieyard Battery Recyclers is considering a project with the following cash flows:

Initial outlay = $13,000

Cash flows: Year 1 = $5,000

Cash flows: Year 2 = $3,000

Cash flows: Year 3 = $9,000

If the appropriate discount rate is 15%, compute the NPV of this project.

Answer: NPV=13,000 + 5,000/(1.15) + 3,000/(1.15)2 + 9,000/(1.15)3

33) Two projects are under consideration by the same company at the same time. Project Alpha has a NPV of $20 million and an estimated useful life of 10 years. Project Beta has a NPV of $12 million and also an estimated useful life of 10 years. What should the company's decision be

1. if the project's involve unrelated expansion decisions or
2. if the project's are mutually exclusive because they would have to occupy the same space?

Answer: If the projects involve unrelated expansion decisions, they should both be accepted because they both add significant value to the firm. If they are mutually exclusive, they cannot both be accepted so the company should accept project Alpha because it has the higher NPV and reject project Beta.

34) Dudster Manufacturing has 2 options for installing legally required safety equipment. Option Ex has an initial cost of $25,000 and annual operating costs over 3 years of $5,000, $5,250, $5,600. Option WYE has an initial cost of $40,000 and annual operating costs of $4,000, $4,200, $4,450, $4,750, $5,100. Whether Dudster chooses Ex or Wye, the equipment is always needed and must be replaced at the end of its useful life. Which choice is least expensive over the long run? Use a discount rate of 9%.

Answer:

NPV Project X = -$25,000 - $5,000/(1.09)1 - $5,250/(1.09)2 - $5,600/(1.09)3 =-$38,330.20

NPV = -$40,000 - $4,000/(1.09)1 - $4,200/(1.09)2 - $4,450/(1.09)3 - $4,750/(1.09)4 - $5,100/(1.09)5 = -$57,320.67. Using a financial calculator, the EAC for project Ex is N = 3, i = 9,PV = -38,330.20, PMT = 15,138.57, FV = 0. For Project Wye N = 5, i = 9,PV = -57,320.67, PMT = 14,736.71, FV = 0. Project Wye has the lower EAC (PMT) and should be selected.

35) What is the NPV of a $45,000 project that is expected to have an after-tax cash flow of $14,000 for the first two years, $10,000 for the next two years, and $8,000 for the fifth year? Use a discount rate of 8%. Would you accept or reject the investment?

Answer:

3. Other Investment Criteria

1) Webley Corp. is considering two expansion options, but does not have enough capital to undertake both, Project W requires an investment of $100,000 and has an NPV of $10,000. Project D requires an investment of $80,000 and has an NPV of $8,200. If Webley uses the profitability index to decide, it would

1. choose D because it has a higher profitability index.
2. choose W because it has a higher profitability index.
3. choose D because it has a lower profitability index.
4. choose W because it has a lower profitability index.

Answer: A

2) If a project has a profitability index greater than 1

1. the npv will also be positive.
2. the irr will be higher than the required rate of return.
3. the present value of future cash flows will exceed the amount invested in the project.
4. all of the above.

Answer: D

3) A project has an initial outlay of $4,000. It has a single payoff at the end of Year 4 of $6,996.46. What is the IRR for the project (round to the nearest percent)?

1. 16%
2. 13%
3. 21%
4. 15%

Answer: D

4) Given the following annual net cash flows, determine the IRR to the nearest whole percent of a project with an initial outlay of $1,800.

1. 14%
2. 12%
3. 8%
4. 25%

Answer: A

5) Initial Outlay Cash Flow in Period

1 2 3 4

-$4,000 $1,546.17 $1,546.17 $1,546.17 $1,546.17

The IRR (to the nearest whole percent) is

1. 10%.
2. 18%.
3. 20%.
4. 16%.

Answer: C

6) Your company is considering a project with the following cash flows:

Initial outlay = $1,748.80

Cash flows Years 1-6 = $500

Compute the IRR on the project.

1. 9%
2. 11%
3. 18%
4. 24%

Answer: C

7) Project Black Swan requires an initial investment of $115,000. It has positive cash flows of $140,000 for each of the next two years. Because of major demolition and environmental clean-up costs, cash flow for the third and final year of the project is $(170,000). If the company 's required rate of return is 12%, the project should be

1. rejected because the IRR is less than 12%.
2. accepted because the NPV is positive at 12%.
3. the project is unacceptable at any discount rate.
4. rejected because there may be more than one IRR.

Answer: B

8) Project Black Swan requires an initial investment of $115,000. It has positive cash flows of $140,000 for each of the next two years. Because of major demolition and environmental clean-up costs, cash flow for the third and final year of the project is $(170,000).

1. All possible IRR's for this project are negative.
2. It is not possible to compute an IRR for this project.
3. The project is unacceptable at any required rate of return.
4. This project might have more than one IRR.

Answer: D

9) Compute the payback period for a project with the following cash flows, if the company's discount rate is 12%.

Initial outlay = $450

Cash flows: Year 1 = $325

Cash flows: Year 2 = $65

Cash flows: Year 3 = $100

1. 3.43 years
2. 3.17 years
3. 2.88 years
4. 2.6 years

Answer: D

10) Project Black Swan requires an initial investment of $115,000. It has positive cash flows of $140,000 for each of the next two years. Because of major demolition and environmental clean-up costs, cash flow for the third and final year of the project is $(170,000).

1. All possible IRR's for this project are negative.
2. It is not possible to compute an IRR for this project.
3. This project might have more than one IRR, but only one MIRR.
4. The project is unacceptable at any required rate of return. This project might have more than one IRR.

Answer: C

11) Project Black Swan requires an initial investment of $115,000. It has positive cash flows of $140,000 for each of the next two years. Because of major demolition and environmental clean-up costs, cash flow for the third and final year of the project is $(170,000). The company accepts all projects with a payback period of 2 years or less.

1. The payback rule would reject this project because of its risks are too high.
2. The payback rule would reject this project because all negative cash flows are added together.
3. If strictly applied, the payback rule would reject this project.
4. If strictly applied, the payback rule would accept this project.

Answer: D

12) Consider a project with the following cash flows:

Initial outlay = $1,500

Terminal cash flow = 0

Compute the profitability index if the company's discount rate is 10%.

1. 15.8
2. 1.61
3. 1.81
4. 0.62

Answer: B

13) Manheim Candles is considering a project with the following incremental cash flows. Assume a discount rate of 10%.

Calculate the project's MIRR. (Round to the nearest whole percentage.)

1. 31%
2. 47%
3. 53%
4. 61%

Answer: B

14) Project H requires an initial investment of $100,000 and produces annual cash flows of $50,000, $40,000, and $30,000. Project T requires an initial investment of $100,000 and the produces annual cash flows of $30,000, $40,000, and $50,000. The projects are mutually exclusive. The company accepts projects with payback periods of 3 years or less.

1. Project H will be accepted.
2. Project T will be accepted.
3. H and T will both be accepted.
4. Neither projected will be accepted.

Answer: A

15) A new forklift under consideration by Home Warehouse requires an initial investment of $100,000 and produces annual cash flows of $50,000, $40,000, and $30,000. Which of the following will not change if the required rate of return is increased from 10% to 12%.

1. The net present value.
2. The internal rate of return.
3. The profitability index.
4. The modified internal rate of return.

Answer: B

16) Project Ell requires an initial investment of $50,000 and the produces annual cash flows of $30,000, $25,000, and $15,000. Project Ess requires an initial investment of $60,000 and then produces annual cash flows of $25,000 per year for the next ten years. The company ranks projects by their payback periods.

1. Projects with unequal lives cannot be ranked using the payback method.
2. Ess will be ranked higher than Ell.
3. Ell and Ess will be ranked equally.
4. Ell will be ranked higher than Ess.

Answer: D

17) Which of the following series of cash flows could have more than one IRR? (Negative cash flows are in parentheses.)

1. $(XX,XXX), $X,XXX , $X,XXX, $X,XXX
2. $(XX,XXX), $X,XXX , $X,XXX, $X,XXX, $(XX,XXX)
3. $X,XXX, $X,XXX , $X,XXX, $X,XXX, $(XX,XXX)
4. $XX,XXX, $X,XXX , $X,XXX, $X,XXX

Answer: B

Below are the expected after-tax cash flows for Projects Y and Z. Both projects have an initial cash outlay of $20,000 and a required rate of return of 17%.

18) Payback for Project Y is

1. two years.
2. one year.
3. three years.
4. four years.

Answer: A

19) What is payback for Project Z?

1. Two years
2. One year
3. Zero years
4. Project Z does not payback the original investment.

Answer: A

20) MacHinery Manufacturing Company is considering a three-year project that has a cost of $75,000. The project will generate after-tax cash flows of $33,100 in Year 1, $31,500 in Year 2, and $31,200 in Year 3. Assume that the firm's proper rate of discount is 10% and that the firm's tax rate is 40%. What is the project's payback?

1. 0.33 years
2. 1.22 years
3. 2.33 years
4. Three years

Answer: C

21) MacHinery Manufacturing Company is considering a three-year project that has a cost of $75,000. The project will generate after-tax cash flows of $33,100 in Year 1, $31,500 in Year 2, and $31,200 in Year 3. Assume that the appropriate discount rate is 10% and that the firm's tax rate is 40%. What is the project's discounted payback period?

1. 2.81 years
2. 2.33 years
3. 1.22 years
4. The project never reaches payback.

Answer: A

22) Analysis of a machine indicates that it has a cost of $5,375,000. The machine is expected to produce cash inflows of $1,825,000 in Year 1; $1,775,000 in Year 2; $1,630,000 in Year 3; $1,585,000 in Year 4; and $1,650,000 in Year 5. What is the machine's IRR?

1. 12.16%
2. 17.81%
3. 23.00%
4. 11.11%

Answer: B

Below are the expected after-tax cash flows for Projects Y and Z. Both projects have an initial cash outlay of $20,000 and a required rate of return of 17%.

23) Discounted payback periods for projects Y and Z are

1. 1.64 and 1.71 years.
2. 3.14 years and never.
3. 2 years and 2 years.
4. 5 years and never.

Answer: B

24) You are considering investing in a project with the following year-end after-tax cash flows:

Year 1: $5,000

Year 2: $3,200

Year 3: $7,800

If the initial outlay for the project is $12,113, compute the project's IRR.

1. 14%
2. 10%
3. 32%
4. 24%

Answer: A

25) WKW, Inc. is analyzing a project that requires an initial investment of $10,000, followed by cash inflows of $1,000 in Year 1, $4,000 in Year 2, and $15,000 in Year 3. The cost of capital is 10%. What is the profitability index of the project?

1. 1.04
2. 1.55
3. 1.78
4. 1.97

Answer: B

26) Frazier Fudge has a project with an initial outlay of $40,000, followed by three years of annual incremental cash flows of $35,000. At the end of the third year, equipment will be sold producing additional cash flow of $10,000. Assuming a cost of capital of 10%, calculate the MIRR of the project.

1. 46.5%
2. 51.3%
3. 62.9%
4. 74.7%

Answer: A

27) Frazier Fudge has a project with an initial outlay of $40,000, followed by three years of annual incremental cash flows of $35,000. At the end of the third year, equipment will be sold producing additional cash flow of $10,000. Assuming a discount rate of 10%, which of the following is the correct equation to solve for the IRR of the project?

1. $40,000 = $35,000(1.12)1+ $35,000(1.12)2+ $45,000(1.12)3
2. $40,000 = $35,000(1 + IRR)1+ $35,000(1 + IRR)2+ $45,000(1 + IRR)3
3. $40,000 = $35,000/(1.12)IRR+ $35,000/(1.12)IRR+ $45,000/(1.12)IRR
4. $40,000 = $35,000/(1 + IRR) + $35,000/(1.IRR) + $45,000/(1 + IRR)

Answer: D

28) The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $100,000 today, and the firm's cost of capital is 10%. Assume cash flows occur evenly during the year.

1. 5.23 years
2. 4.26 years
3. 4.35 years
4. 3.72 years

Answer: B

29) The director of capital budgeting of South Park Development Corporation is evaluating a project that will cost $200,000; it is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm's cost of capital is 14% and its tax rate is 40%, what is the project's IRR?

1. 8%
2. 14%
3. 18%
4. -5%

Answer: C

30) The owner of a small construction business has asked you to evaluate the purchase of a new front end loader. You have determined that this investment has a large, positive, NPV, but are afraid that your client will not understand the method. A good alternative method in this circumstance might be

1. the payback method.
2. the profitability index.
3. the internal rate of return.
4. the modified internal rate of return.

Answer: A

31) Whenever the IRR on a project equals that project's required rate of return

1. the NPV equals 0.
2. The NPV equals the initial investment.
3. The profitability index equals 0.
4. The NPV equals 1.

Answer: A

32) Aroma Candles, Inc. is evaluating a project with the following cash flows. Calculate the IRR of the project. (Round to the nearest whole percentage.)

1. 18%
2. 23%
3. 28%
4. 33%

Answer: B

33) Aroma Candles, Inc. is evaluating a project with the following cash flows. The project involves a new product that will not affect the sales of any other project. Which two methods would always lead to the same accept/reject decision for this project, regardless of the discount rate.

1. Payback and Discounted Payback
2. NPV and Payback
3. NPV and IRR
4. Discounted Payback and IRR

Answer: C

34) Which of the following is considered to be a deficiency of the IRR?

1. It fails to properly rank capital projects.
2. It could produce more than one rate of return.
3. It fails to utilize the time value of money.
4. It is not useful in accounting for risk in capital budgeting.

Answer: B

35) You have been asked to analyze a capital investment proposal. The project's cost is $2,775,000. Cash inflows are projected to be $925,000 in Year 1; $1,000,000 in Year 2; $1,000,000 in Year 3; $1,000,000 in Year 4; and $1,225,000 in Year 5. Assume that your firm discounts capital projects at 15.5%. What is the project's MIRR?

1. 12.62%
2. 10.44%
3. 16.73%
4. 19.99%

Answer: D

36) Dizzyland Enterprises has been presented with an investment opportunity which will yield end-of-year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10%. What is the profitability index for this investment?

1. 1.34
2. 0.87
3. 1.85
4. 0.21

Answer: A

37) We compute the profitability index of a capital-budgeting proposal by

1. multiplying the IRR by the cost of capital.
2. dividing the present value of the annual after-tax cash flows by the cost of capital.
3. dividing the present value of the annual after-tax cash flows by the cost of the project.
4. multiplying the cash inflow by the IRR.

Answer: C

38) What is the payback period for a $20,000 project that is expected to return $6,000 for the first two years and $3,000 for Years 3 through 5?

1. 3 1/2
2. 4 1/2
3. 4 2/3
4. 5

Answer: C

39) The payback method focuses primarily on the length of time required to recover the cost of the investment rather than estimating the total value the project will add to the firm.

Answer: TRUE

40) One advantage of the payback method is that it can be readily understood by people with no special training in finance.

Answer: TRUE

41) When several sign reversals in the cash flow stream occur, the IRR equation can have more than one positive IRR.

Answer: TRUE

42) If the project's internal rate of return is greater than or equal to zero, the project should always be accepted.

Answer: FALSE

43) The profitability index provides the same accept/reject decision result as the net present value (NPV) method but would not necessarily rank mutually exclusive projects the same way.

Answer: TRUE

44) The internal rate of return (IRR) will increase as the required rate of return of a project is increased.

Answer: FALSE

45) The IRR assumes that cash flows are reinvested at the cost of capital.

Answer: FALSE

46) If the NPV of a project is zero, then the profitability index should equal one.

Answer: TRUE

47) Unlike the basic IRR method, the MIRR method allows the analyst to specify a reinvestment rate for positive cash flows.

Answer: TRUE

48) According to the modified internal rate of return (MIRR) technique, when a project's MIRR is greater than its cost of capital, the project should be accepted.

Answer: TRUE

49) The IRR is the discount rate that equates the present value of the project's future net cash flows with the project's initial outlay.

Answer: TRUE

50) Determine the IRR on the following projects:

1. Initial outlay of $35,000 with an after-tax cash flow at the end of the year of $5,836 for seven years
2. Initial outlay of $350,000 with an after-tax cash flow at the end of the year of $70,000 for seven years
3. Initial outlay of $3,500 with an after-tax cash flow at the end of the year of $1,500 for three years

Answer:

Using a financial calculator

1. N=7, PV=-35,000, PMT=5,836, FV= 0, solve for i=4.02%
2. N=7, PV=-350,000, PMT=70,000, solve for i=9.2%
3. N=7, PV=-3,500, PMT=1,500, FV= 0, solve for i=13.7%

51) Discuss the merits and shortcomings of using the payback period for capital budgeting decisions.

Answer: The payback period is intuitive and easily understood even by those with no training in finance. It also provides a quick assessment of a project's risk because cash flow forecasts are likely to be more accurate for the near-term.

On the other hand, there is no clear-cut decision rule associated with this method; it does not specifically take the time value of money into account, and it ignores cash flows that occur after the payback period.

52) Project November requires an initial investment of $500,000. The present value of operating cash flows is $550,000. Project December requires an initial investment of $750,000. The present value of operating cash flows is $810,000.

1. Compute the profitability index for each project.
2. If the projects are mutually exclusive, does the profitability index rank them correctly?

Answer:

1. The PI for November is 550,000/500,000 = 1.1. The PI for December is 810,000/750,000 = 1.08.
2. The PI criterion would select project November because it has the higher PI. December, however, has the higher NPV ($60,000 v. $50,000) and should be selected, so the method does not rank the projects correctly.

53) Black Friday Inc. has estimated the following cash flows for a project it is considering:

1. What is the payback period for this project?
2. What is the obvious problem with using the payback method in this case?

Answer: The payback period is exactly 2 years (70,000+80,000) = 150,000. However, the project obviously has a negative NPV at any discount rate. One major problem with the payback method is that it ignores cash flows occurring after the payback period.

54) Tinker Tools, Inc. is considering a project with the following cash flows. Calculate the MIRR of the project assuming a reinvestment rate of 8%.

Answer:

PV Cash Outflows

Year 0 = -$70,000

Year 1: Calculator Steps' → N=1, i=8, FV=-55,000, solve for PV = -$50,926

PV Outflows = -$70,000 - $50,926 = -$120,926

FV of Cash Inflows

N=2, i=8, PV=40000, PMT =0, solve for FV = $46,656

N=1, i=8, PV=60000, PMT =0, solve for FV = $64,800

FV of Inflows = $46,656 +$64,800 + $100,000 = $211,456

MIRR: N=4, PV=-$120,926,FV= $211,456 solve for i=15%

11. A Glance at Actual Capital-Budgeting Practices

1) Recent surveys of the CFOs of large U.S. companies rank the popularity of major capital budgeting methods in which order?

1. IRR, NPV, Payback, Discounted Payback, Profitability Index
2. Payback, Discounted Payback, Profitability Index, IRR, NPV
3. NPV, IRR, Profitability Index, Discounted Payback, Payback
4. NPV, IRR, Payback, Discounted Payback, Profitability Index

Answer: A

2) Which of the following best explains the continuing popularity of the payback method?

1. Mathematical simplicity and some insight into the riskiness of cash flows.
2. Uses all cash flows and takes into account the time value of money.
3. Reliably selects the projects that add most value to the firm.
4. It provides objective selection criteria and is taught as the primary method in most business schools.

Answer: A

3) With respect to the capital budgeting practices of large U. S. corporations

1. the profitability index has been gaining in popularity.
2. IRR and NPV have been gaining in popularity.
3. payback and discounted payback have been gaining in popularity.
4. IRR and NPV have declined in popularity.

Answer: B

4) Which of the following techniques will always produce a single rate of return estimate?

1. IRR
2. MIRR
3. PI
4. Discounted payback

Answer: B

5) Which of the following techniques might be useful in situations where the economic life of a project is highly uncertain?

1. IRR
2. MIRR
3. PI
4. Discounted payback

Answer: D

6) Which of the following techniques might be useful in situations where mutually exclusive projects have unequal lives?

1. IRR
2. Equivalent annual cost (EAC).
3. PI
4. Discounted payback

Answer: B

7) When various capital budgeting techniques rank mutually exclusive projects differently, which of the following is theoretically most reliable?

1. IRR
2. Equivalent annual cost (EAC).
3. NPV
4. Discounted payback

Answer: C

8) Many firms today continue to use the payback method but employ the NPV or IRR methods as secondary decision methods of control for risk.

Answer: FALSE

9) Currently, most firms use NPV and IRR as their primary capital-budgeting technique.

Answer: TRUE

10) Most firms use the payback period as a secondary capital-budgeting technique, which in a sense allows them to control for risk.

Answer: TRUE

11) Although discounted cash flow decision techniques have become widely accepted, their use depends to some degree on the size of the project and where within the firm the decision is being made.

Answer: TRUE

12) Briefly describe the actual capital budgeting methods of large U.S. corporations.

Answer: According to recent surveys of CFOs, the most common methods are IRR and NPV used by more than 70% of large corporations. The payback method remains popular and is used as a primary or secondary method by almost 60% of those surveyed, perhaps because of its simplicity and for a quick calculation of risk.