Chapter 9: Capital Budgeting Techniques

126GitmanPrinciplesofFinance,EleventhEdition
Chapter9
CapitalBudgetingTechniques
.1
Learning Goals
1.
Understandtheroleofcapitalbudgetingtechniquesinthecapitalbudgetingprocess.
2.
Calculate,interpret,andevaluatethepaybackperiod.
3.
Calculate,interpret,andevaluatethenetpresentvalue(NPV).
4.
Calculate,interpret,andevaluatetheinternalrateofreturn(IRR).
5.
UsenetpresentvalueprofilestocompareNPVandIRRtechniques.
6.
DiscussNPVandIRRintermsofconflictingrankingsandthetheoreticalandpracticalstrengthsof
eachapproach.
.2
True/False
1.
Incapitalbudgeting,thepreferredapproachesinassessingwhetheraprojectisacceptablearethose
thatintegratetimevalueprocedures,riskandreturnconsiderations,andvaluationconcepts.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:CapitalBudgetingTechniques
2.
Inthecaseofannuitycashinflows,thepaybackperiodcanbefoundbydividingtheinitial
investmentbytheannualcashinflow.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:PaybackMethod
3.
Thepaybackperiodistheexactamountoftimerequiredforthefirmtorecovertheinstalledcostof
anewasset.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:PaybackMethod
4.
Thepaybackperiodisgenerallyviewedasanunsophisticatedcapitalbudgetingtechnique,because
itdoesnotexplicitlyconsiderthetimevalueofmoneybydiscountingcashflowstofindpresent
value.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
5.
Bymeasuringhowquicklythefirmrecoversitsinitialinvestment,paybackperiodgivessome
implicitconsiderationtothetimingofcashflowsandthereforetothetimevalueofmoney.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
6.
Onestrengthofpaybackperiodisthatittakesfullyintoaccountthetimefactorinthevalueof
money.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
7.
Oneweaknessofpaybackisitsfailuretorecognizecashflowsthatoccurafterthepaybackperiod.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
8.
Aprojectmustberejectedifitspaybackperiodislessthanthemaximumacceptablepayback
period.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
9.
Sincethepaybackperiodcanbeviewedasameasureofriskexposure,manyfirmsuseitasa
decisioncriterionorasasupplementtosophisticateddecisiontechniques.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
10.
Themajorweaknessofpaybackperiodinevaluatingprojectsisthatitcannotspecifytheappropriate
paybackperiodinlightofthewealthmaximizationgoal.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
Chapter9CapitalBudgetingTechniques128
11.
Netpresentvalueisconsideredasophisticatedcapitalbudgetingtechniquesinceitgivesexplicit
considerationtothetimevalueofmoney.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:NetPresentValue
12.
Thediscountrate,requiredreturn,costofcapital,oropportunitycostistheminimumreturnthat
mustbeearnedonaprojecttoleavethefirmsmarketvalueunchanged.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:ProjectRequiredReturn
13.
Ifnetpresentvalueofaprojectisgreaterthanzero,thefirmwillearnareturngreaterthanitscostof
capital.Suchaprojectshouldenhancethewealthofthefirmsowners.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
14.
Thenetpresentvalueisfoundbysubtractingaprojectsinitialinvestmentfromthepresentvalueof
itscashinflowsdiscountedatarateequaltotheprojectsinternalrateofreturn.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
15.
Theinternalrateofreturn(IRR)isdefinedasthediscountratethatequatesthenetpresentvalue
withtheinitialinvestmentassociatedwithaproject.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:4
Topic:InternalRateofReturn
16.
TheIRRisthediscountratethatequatestheNPVofaninvestmentopportunitywith$0.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
17.
TheIRRisthecompoundannualrateofreturnthatthefirmwillearnifitinvestsintheprojectand
receivesthegivencashinflows.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
18.
Aninternalrateofreturngreaterthanthecostofcapitalguaranteesthatthefirmearnsatleastits
requiredreturn.Suchanoutcomeshouldenhancethemarketvalueofthefirmandthereforethe
wealthofitsowners.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
19.
Forconventionalprojects,bothNPVandIRRtechniqueswillalwaysgeneratethesameaccept
rejectdecision,butdifferencesintheirunderlyingassumptionscancausethemtorankprojects
differently.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:NPVversusIRR
20.
ConflictingrankingsusingNPVandIRRresultfromdifferencesinthemagnitudeandtimingof
cashflows.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:6
Topic:NPVversusIRR
21.
Projectshavinghighercashinflowsintheearlyyearstendtobepreferredathigherdiscountrates.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
22.
Onapurelytheoreticalbasis,NPVisthebetterapproachtocapitalbudgetingthanIRRbecause
NPVimplicitlyassumesthatanyintermediatecashinflowsgeneratedbyaninvestmentare
reinvestedatthefirmscostofcapital.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
23.
Onapurelytheoreticalbasis,NPVisthebetterapproachtocapitalbudgetingthanIRRbecauseIRR
implicitlyassumesthatanyintermediatecashinflowsgeneratedbyaninvestmentarereinvestedat
thefirmscostofcapital.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
24.
Certainmathematicalpropertiesmaycauseaprojectwithanonconventionalcashflowpatternto
havezeroormorethanoneIRR;thisproblemdoesnotoccurwiththeNPVapproach.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
25.
Netpresentvalue(NPV)assumesthatintermediatecashinflowsarereinvestedatthecostofcapital,
whereasinternalrateofreturn(IRR)assumesthatintermediatecashinflowscanbereinvestedata
rateequaltotheprojectsIRR.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
26.
Sincethecostofcapitaltendstobeareasonableestimateoftherateatwhichthefirmcouldactually
reinvestintermediatecashinflows,theuseofNPVisintheorypreferabletoIRR.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
27.
Ingeneral,projectswithsimilarsizedinvestmentsandlowerearlyyearcashinflows(lowercash
inflowsintheearlyyears)tendtobepreferredathigherdiscountrates.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:6
Topic:NPVversusIRR
28.
Ingeneral,thegreaterthedifferencebetweenthemagnitudeandtimingofcashinflows,thegreater
thelikelihoodofconflictingrankingbetweenNPVandIRR.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:6
Topic:NPVversusIRR
29.
Theinternalrateofreturnassumesthatintermediatecashinflowsareinvestedatarateequaltothe
firmscostofcapital.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:6
30.
Althoughdifferencesinthemagnitudeandtimingofcashflowsexplainconflictingrankingsunder
theNPVandIRRtechniques,theunderlyingcauseistheimplicitassumptionconcerningthe
reinvestmentofintermediatecashinflowscashinflowsreceivedpriortotheterminationofa
project.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:6
31.
Incapitalbudgeting,thepreferredapproachesinassessingwhetheraprojectisacceptableintegrate
timevalueprocedures,riskandreturnconsiderations,valuationconcepts,andtherequiredpayback
period.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
32.
Ifthepaybackperiodislessthanthemaximumacceptablepaybackperiod,wewouldrejecta
project.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
33.
Ifthepaybackperiodislessthanthemaximumacceptablepaybackperiod,wewouldaccepta
project.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
34.
Ifthepaybackperiodisgreaterthanthemaximumacceptablepaybackperiod,wewouldrejecta
project.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
35.
Ifthepaybackperiodisgreaterthanthemaximumacceptablepaybackperiod,wewouldaccepta
project.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
36.
Thepaybackperiodofaprojectthatcosts$1,000initiallyandpromisesaftertaxcashinflowsof
$300forthenextthreeyearsis3.33years.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
37.
$300forthenextthreeyearsis0.333years.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
38.
$3,000forthenextthreeyearsis0.333years.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
39.
$3,000forthenextthreeyearsis3.33years.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
40.
Asophisticatedcapitalbudgetingtechniquethatcanbecomputedbysubtractingaprojectsinitial
investmentfromthepresentvalueofitscashinflowsdiscountedatarateequaltothefirmscostof
capitaliscallednetpresentvalue.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
41.
Asophisticatedcapitalbudgetingtechniquethatcanbecomputedbysubtractingaprojectsinitial
investmentfromthepresentvalueofitscashinflowsdiscountedatarateequaltothefirmscostof
capitaliscalledinternalrateofreturn.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
42.
IftheNPVisgreaterthanthecostofcapital,aprojectshouldbeaccepted.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
43.
IftheNPVisgreaterthantheinitialinvestment,aprojectshouldbeaccepted.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
44.
IftheNPVisgreaterthan$0.00,aprojectshouldbeaccepted.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
45.
TheNPVofanprojectwithaninitialinvestmentof$1,000thatprovidesaftertaxoperatingcash
flowsof$300peryearforfouryearswherethefirmscostofcapitalis15percentis$856.49.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:NetPresentValue(Equation9.1andEquation9.1a)
46.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
47.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
48.
Asophisticatedcapitalbudgetingtechniquethatcanbecomputedbysolvingforthediscountrate
thatequatesthepresentvalueofaprojectsinflowswiththepresentvalueofitsoutflowsiscallednet
presentvalue.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
49.
Asophisticatedcapitalbudgetingtechniquethatcanbecomputedbysolvingforthediscountrate
thatequatesthepresentvalueofaprojectsinflowswiththepresentvalueofitsoutflowsiscalled
internalrateofreturn.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
50.
IfitsIRRisgreaterthan$0.00,aprojectshouldbeaccepted.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
51.
IfitsIRRisgreaterthan0percent,aprojectshouldbeaccepted.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
52.
IfitsIRRisgreaterthanthecostofcapital,aprojectshouldbeaccepted.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
53.
AprojectsnetpresentvalueprofileisagraphthatplotsaprojectsNPVforvariousdiscountrates.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:NetPresentValueProfile
54.
AprojectsnetpresentvalueprofileisagraphthatplotsaprojectsIRRforvariousdiscountrates.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:5
55.
Netpresentvalueprofilesaremostusefulwhenselectingamongindependentprojects.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:5
56.
Netpresentvalueprofilesaremostusefulwhenselectingamongmutuallyexclusiveprojects.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
57.
Onapurelytheoreticalbasis,NPVisabetterapproachwhenselectingamongtwomutually
exclusiveprojects.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
58.
Onapurelytheoreticalbasis,IRRisabetterapproachwhenselectingamongtwomutually
exclusiveprojects.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
59.
InspiteofthetheoreticalsuperiorityofNPV,financialmanagersprefertouseIRR.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
60.
InspiteofthetheoreticalsuperiorityofIRR,financialmanagersprefertouseNPV.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
.3
Multiple Choice Questions
1.
ExamplesofsophisticatedcapitalbudgetingtechniquesincludeallofthefollowingEXCEPT
(a) internalrateofreturn.
(b) paybackperiod.
(c) annualizednetpresentvalue.
(d) netpresentvalue.
Answer: B
LevelofDifficulty:1
LearningGoal:2
2.
The_________istheexactamountoftimeittakesthefirmtorecoveritsinitialinvestment.
(a) averagerateofreturn
(b) internalrateofreturn
(c) netpresentvalue
(d) paybackperiod
Answer: D
LevelofDifficulty:1
LearningGoal:2
Topic:PaybackMethod
3.
Unsophisticatedcapitalbudgetingtechniquesdonot
(a) examinethesizeoftheinitialoutlay.
(b) usenetprofitsasameasureofreturn.
(c) explicitlyconsiderthetimevalueofmoney.
(d) takeintoaccountanunconventionalcashflowpattern.
Answer: C
LevelofDifficulty:2
LearningGoal:2
4.
AllofthefollowingareweaknessesofthepaybackperiodEXCEPT
(a) adisregardforcashflowsafterthepaybackperiod.
(b) onlyanimplicitconsiderationofthetimingofcashflows.
(c) thedifficultyofspecifyingtheappropriatepaybackperiod.
(d) itusescashflows,notaccountingprofits.
Answer: D
LevelofDifficulty:2
LearningGoal:2
Topic:PaybackMethod
5.
Amongthereasonsmanyfirmsuse,thepaybackperiodasaguidelineincapitalinvestment
decisionsareallofthefollowingEXCEPT
(a) itgivesanimplicitconsiderationtothetimingofcashflows.
(b) itrecognizescashflowswhichoccurafterthepaybackperiod.
(c) itisameasureofriskexposure.
(d) itiseasytocalculate.
Answer: B
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
6.
Paybackisconsideredanunsophisticatedcapitalbudgetingtechnique,andassuch
(a) givesnoconsiderationtothetimingofcashflowsandthereforethetimevalueofmoney.
(b) givesnoconsiderationtoriskexposure.
(c) doesconsiderthetimingofcashflowsandthereforegivesexplicitconsiderationtothetime
valueofmoney.
(d) givessomeimplicitconsiderationtothetimingofcashflowsandthereforethetimevalueof
money.
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
7.
Somefirmsusethepaybackperiodasadecisioncriterionorasasupplementtosophisticated
decisiontechniques,because
(a) itexplicitlyconsidersthetimevalueofmoney.
(b) itcanbeviewedasameasureofriskexposure.
(c) thedeterminationofpaybackisanobjectivelydeterminedcriteria.
(d) itcantaketheplaceofthenetpresentvalueapproach.
Answer: B
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
8.
Afirmisevaluatingaproposalwhichhasaninitialinvestmentof$35,000andhascashflowsof
$10,000inyear1,$20,000inyear2,and$10,000inyear3.Thepaybackperiodoftheprojectis
(a) 1year.
(b) 2years.
(c) between1and2years.
(d) between2and3years.
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
9.
Afirmisevaluatingaproposalwhichhasaninitialinvestmentof$50,000andhascashflowsof
$15,000peryearforfiveyears.Thepaybackperiodoftheprojectis
(a) 1.5years.
(b) 2years.
(c) 3.3years.
(d) 4years.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
10.
Afirmisevaluatingthreecapitalprojects.Thenetpresentvaluesfortheprojectsareasfollows:
Project
1
2
3
NPV
$100
$0
$100
Thefirmshould
(a) acceptProjects1and2andrejectProject3.
(b) acceptProjects1and3andrejectProject2.
(c) acceptProject1andrejectProjects2and3.
(d) rejectallprojects.
Answer: A
LevelofDifficulty:2
LearningGoal:3
11.
Sophisticatedcapitalbudgetingtechniquesdonot
(a) examinethesizeoftheinitialoutlay.
(b) usenetprofitsasameasureofreturn.
(c) explicitlyconsiderthetimevalueofmoney.
(d) takeintoaccountanunconventionalcashflowpattern.
Answer: B
LevelofDifficulty:2
LearningGoal:3
12.
Theminimumreturnthatmustbeearnedonaprojectinordertoleavethefirmsvalueunchangedis
(a) theinternalrateofreturn.
(b) theinterestrate.
(c) thediscountrate.
(d) thecompoundrate.
Answer: C
LevelofDifficulty:2
LearningGoal:3
13.
Afirmwouldacceptaprojectwithanetpresentvalueofzerobecause
(a) theprojectwouldmaintainthewealthofthefirmsowners.
(b) theprojectwouldenhancethewealthofthefirmsowners.
(c) thereturnontheprojectwouldbepositive.
(d) thereturnontheprojectwouldbezero.
Answer: A
LevelofDifficulty:2
LearningGoal:3
14.
Afirmisevaluatinganinvestmentproposalwhichhasaninitialinvestmentof$5,000andcash
flowspresentlyvaluedat$4,000.Thenetpresentvalueoftheinvestmentis_________.
(a) $1,000
(b) $0
(c) $1,000
(d) $1.25
Answer: A
LevelofDifficulty:2
LearningGoal:3
15.
The_________isthediscountratethatequatesthepresentvalueofthecashinflowswiththeinitial
investment.
(a) paybackperiod
(b) averagerateofreturn
(c) costofcapital
(d) internalrateofreturn
Answer: D
LevelofDifficulty:1
LearningGoal:4
16.
The_________isthecompoundannualrateofreturnthatthefirmwillearnifitinvestsinthe
projectandreceivesthegivencashinflows.
(a) discountrate
(b) internalrateofreturn
(c) opportunitycost
(d) costofcapital
Answer: B
LevelofDifficulty:2
LearningGoal:4
17.
Afirmwithacostofcapitalof13percentisevaluatingthreecapitalprojects.Theinternalratesof
returnareasfollows:
Project
1
2
3
InternalRate
ofReturn
12%
15
13
Thefirmshould
(a) acceptProject2andrejectProjects1and3.
(b) acceptProjects2and3andrejectProject1.
(c) acceptProject1andrejectProjects2and3.
(d) acceptProject3andrejectProjects1and2.
Answer: B
LevelofDifficulty:2
LearningGoal:4
Topic:InternalRateofReturn(Equation9.2andEquation9.2a)
Afirmisevaluatingtwoprojectsthataremutuallyexclusivewithinitialinvestmentsandcashflowsas
follows:
Table9.1
ProjectA
Initial
EndofYear
Investment
CashFlows
$40,000
$20,000
20,000
20,000
ProjectB
Initial
EndofYear
Investment
CashFlows
$90,000
$40,000
40,000
80,000
18.
IfthefirminTable9.1hasarequiredpaybackoftwo(2)years,theyshould
(a) acceptprojectsAandB.
(b) acceptprojectAandrejectB.
(c) rejectprojectAandacceptB.
(d) rejectboth.
Answer: B
LevelofDifficulty:3
LearningGoal:4
Topic:PaybackMethod
19.
Thenewfinancialanalystdoesnotlikethepaybackapproach(Table9.1)anddeterminesthatthe
firmsrequiredrateofreturnis15percent.Hisrecommendationwouldbeto
(a) acceptprojectsAandB.
(b) acceptprojectAandrejectB.
(c) rejectprojectAandacceptB.
(d) rejectboth.
Answer: C
LevelofDifficulty:3
LearningGoal:4
Afirmmustchoosefromsixcapitalbudgetingproposalsoutlinedbelow.Thefirmissubjecttocapital
rationingandhasacapitalbudgetof$1,000,000;thefirmscostofcapitalis15percent.
Table9.2
Project
1
2
3
4
5
6
20.
InitialInvestment
$200,000
400,000
250,000
200,000
150,000
400,000
IRR
19%
17
16
12
20
15
NPV
$100,000
20,000
60,000
5,000
50,000
150,000
Usingtheinternalrateofreturnapproachtorankingprojects,whichprojectsshouldthefirmaccept?
(SeeTable9.2)
(a) 1,2,3,4,and5
(b) 1,2,3,and5
(c) 2,3,4,and6
(d) 1,3,4,and6
Answer: B
LevelofDifficulty:3
LearningGoal:4
Topic:IRRandCapitalRationing
21.
Usingthenetpresentvalueapproachtorankingprojects,whichprojectsshouldthefirmaccept?
(SeeTable9.2)
(a) 1,2,3,4,and5
(b) 1,2,3,5,and6
(c) 2,3,4,and5
(d) 1,3,5,and6
Answer: D
LevelofDifficulty:3
LearningGoal:4
Topic:NPVandCapitalRationing
22.
Whenthenetpresentvalueisnegative,theinternalrateofreturnis_________thecostofcapital.
(a) greaterthan
(b) greaterthanorequalto
(c) lessthan
(d) equalto
Answer: C
LevelofDifficulty:3
LearningGoal:4
Topic:NPVandIRR
23.
Afirmisevaluatingtwoindependentprojectsutilizingtheinternalrateofreturntechnique.Project
Xhasaninitialinvestmentof$80,000andcashinflowsattheendofeachofthenextfiveyearsof
$25,000.ProjectZhasainitialinvestmentof$120,000andcashinflowsattheendofeachofthe
nextfouryearsof$40,000.Thefirmshould
(a) acceptbothiftheircostofcapitalis15percentatthemaximum.
(b) acceptonlyZiftheircostofcapitalis15percentatthemaximum.
(c) acceptonlyXiftheircostofcapitalis15percentatthemaximum.
(d) rejectbothiftheircostofcapitalis12percentatthemaximum.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Table9.3
NuffFoldingBoxCompany,Inc.isconsideringpurchasinganewgluingmachine.Thegluing
machinecosts$50,000andrequiresinstallationcostsof$2,500.Thisoutlaywouldbepartially
offsetbythesaleofanexistinggluer.Theexistingglueroriginallycost$10,000andisfouryears
old.ItisbeingdepreciatedunderMACRSusingafiveyearrecoveryscheduleandcancurrentlybe
soldfor$15,000.Theexistinggluerhasaremainingusefullifeoffiveyears.Ifhelduntilyear5,
theexistingmachinesmarketvaluewouldbezero.Overitsfiveyearlife,thenewmachineshould
reduceoperatingcosts(excludingdepreciation)by$17,000peryear.Trainingcostsofemployees
whowilloperatethenewmachinewillbeaonetimecostof$5,000whichshouldbeincludedin
theinitialoutlay.ThenewmachinewillbedepreciatedunderMACRSusingafiveyearrecovery
period.Thefirmhasa12percentcostofcapitalanda40percenttaxonordinaryincomeand
capitalgains.
24.
Thepaybackperiodfortheprojectis(SeeTable9.3)
(a) 2years.
(b) 3years.
(c) between3and4years.
(d) between4and5years.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:Payback
25.
Thetaxeffectofthesaleoftheexistingassetis(SeeTable9.3)
(a) ataxliabilityof$2,340.
(b) ataxbenefitof$1,500.
(c) ataxliabilityof$3,320.
(d) ataxliabilityof$5,320.
Answer: D
LevelofDifficulty:4
LearningGoal:4
Topic:DepreciationandTaxes
26.
Theinitialoutlayforthisprojectis(SeeTable9.3)
(a) $42,820.
(b) $40,320.
(c) $47,820.
(d) $35,140.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:InitialOutlay
27.
Thepresentvalueoftheprojectsannualcashflowsis(SeeTable9.3)
(a) $47,820.
(b) $42,820.
(c) $51,694.
(d) $100,563.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:PresentValueofOperatingCashFlows
28.
Thenetpresentvalueoftheprojectis(SeeTable9.3)
(a) $3,874.
(b) $2,445.
(c) $5,614.
(d) $7,500.
Answer: A
LevelofDifficulty:4
LearningGoal:4
29.
Theinternalrateofreturnfortheprojectis(SeeTable9.3)
(a) between7and8percent.
(b) between9and10percent.
(c) greaterthan12percent.
(d) between10and11percent.
Answer: C
LevelofDifficulty:4
LearningGoal:4
30.
Theunderlyingcauseofconflictsinrankingforprojectsbyinternalrateofreturnandnetpresent
valuemethodsis
(a) thereinvestmentrateassumptionregardingintermediatecashflows.
(b) thatneithermethodexplicitlyconsidersthetimevalueofmoney.
(c) theassumptionmadebytheIRRmethodthatintermediatecashflowsarereinvestedatthecost
ofcapital.
(d) theassumptionmadebytheNPVmethodthatintermediatecashflowsarereinvestedatthe
internalrateofreturn.
Answer: A
LevelofDifficulty:3
LearningGoal:6
Topic:NPVversusIRR
31.
Onapurelytheoreticalbasis,theNPVisthebetterapproachtocapitalbudgetingduetoallthe
followingreasonsEXCEPT
(a) thatitmeasuresthebenefitsrelativetotheamountinvested.
(b) forthereasonablenessofthereinvestmentrateassumption.
(c) thattheremaybemultiplesolutionsforanIRRcomputation.
(d) thatitmaximizesshareholderwealth.
Answer: A
LevelofDifficulty:3
LearningGoal:6
Topic:NPVversusIRR
32.
Comparingnetpresentvalueandinternalrateofreturnanalysis
(a) alwaysresultsinthesamerankingofprojects.
(b) alwaysresultsinthesameaccept/rejectdecision.
(c) maygivedifferentaccept/rejectdecisions.
(d) isonlynecessaryonmutuallyexclusiveprojects.
Answer: B
LevelofDifficulty:3
LearningGoal:6
Topic:NPVversusIRR
33.
Incomparingtheinternalrateofreturnandnetpresentvaluemethodsofevaluation,
(a) internalrateofreturnistheoreticallysuperior,butfinancialmanagersprefernetpresentvalue.
(b) netpresentvalueistheoreticallysuperior,butfinancialmanagersprefertouseinternalrateof
return.
(c) financialmanagersprefernetpresentvalue,becauseitispresentedasarateofreturn.
(d) financialmanagersprefernetpresentvalue,becauseitmeasuresbenefitsrelativetotheamount
invested.
Answer: B
LevelofDifficulty:3
LearningGoal:6
Topic:NPVversusIRR
34.
Unlikethenetpresentvaluecriteria,theinternalrateofreturnapproachassumesaninterestrate
equalto
(a) therelevantcostofcapital.
(b) theprojectsinternalrateofreturn.
(c) theprojectsopportunitycost.
(d) themarketsinterestrate.
Answer: B
LevelofDifficulty:3
LearningGoal:6
Topic:NPVversusIRR
35.
Whenevaluatingprojectsusinginternalrateofreturn,
(a) projectshavinglowerearlyyearcashflowstendtobepreferredathigherdiscountrates.
(b) projectshavinghigherearlyyearcashflowstendtobepreferredathigherdiscountrates.
(c) projectshavinghigherearlyyearcashflowstendtobepreferredatlowerdiscountrates.
(d) thediscountrateandmagnitudeofcashflowsdonotaffectinternalrateofreturn.
Answer: B
LevelofDifficulty:4
LearningGoal:6
36.
Whichofthefollowingcapitalbudgetingtechniquesignoresthetimevalueofmoney?
(a) Payback.
(b) Netpresentvalue.
(c) Internalrateofreturn.
(d) Twooftheabove.
Answer: A
LevelofDifficulty:2
LearningGoal:1
37.
Whichofthefollowingstatementsisfalse?
(a) Ifthepaybackperiodislessthanthemaximumacceptablepaybackperiod,accepttheproject.
(b) Ifthepaybackperiodisgreaterthanthemaximumacceptablepaybackperiod,rejecttheproject.
(c) Ifthepaybackperiodislessthanthemaximumacceptablepaybackperiod,rejecttheproject
(d) Twooftheabove.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
38.
Whichofthefollowingstatementsisfalse?
(a) Ifthepaybackperiodisgreaterthanthemaximumacceptablepaybackperiod,acceptthe
project.
(b) Ifthepaybackperiodislessthanthemaximumacceptablepaybackperiod,rejecttheproject.
(c) Ifthepaybackperiodisgreaterthanthemaximumacceptablepaybackperiod,rejecttheproject.
(d) Twooftheabove.
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
39.
WhatisthepaybackperiodforTangshanMiningcompanysnewprojectifitsinitialaftertaxcostis
$5,000,000anditisexpectedtoprovideaftertaxoperatingcashinflowsof$1,800,000inyear1,
$1,900,000inyear2,$700,000inyear3and$1,800,000inyear4?
(a) 4.33years.
(b) 3.33years.
(c) 2.33years.
(d) Noneoftheabove.
Answer: B
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
40.
ShouldTangshanMiningcompanyacceptanewprojectifitsmaximumpaybackis3.5yearsandits
initialaftertaxcostis$5,000,000anditisexpectedtoprovideaftertaxoperatingcashinflowsof
$1,800,000inyear1,$1,900,000inyear2,$700,000inyear3and$1,800,000inyear4?
(a) Yes.
(b) No.
(c) Itdepends.
(d) Noneoftheabove.
Answer: A
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
41.
ShouldTangshanMiningcompanyacceptanewprojectifitsmaximumpaybackis3.25yearsand
itsinitialaftertaxcostis$5,000,000anditisexpectedtoprovideaftertaxoperatingcashinflowsof
$1,800,000inyear1,$1,900,000inyear2,$700,000inyear3and$1,800,000inyear4?
(a) Yes.
(b) No.
(c) Itdepends
(d) Noneoftheabove
Answer: B
LevelofDifficulty:3
LearningGoal:2
Topic:PaybackMethod
42.
WhatistheNPVforthefollowingprojectifitscostofcapitalis15percentanditsinitialaftertax
costis$5,000,000anditisexpectedtoprovideaftertaxoperatingcashinflowsof$1,800,000in
year1,$1,900,000inyear2,$1,700,000inyear3and$1,300,000inyear4?
(a) $1,700,000
(b) $371,764
(c) ($137,053)
(d) Noneoftheabove
Answer: C
LevelofDifficulty:3
LearningGoal:3
43.
costis$5,000,000anditisexpectedtoprovideaftertaxoperatingcashinflowsof$1,800,000in
year1,$1,900,000inyear2,$1,700,000inyear3and$1,300,000inyear4?
(a) $1,700,000.
(b) $371,764.
(c) $137,053.
(d) Noneoftheabove.
Answer: A
LevelofDifficulty:3
LearningGoal:3
44.
costis$5,000,000anditisexpectedtoprovideaftertaxoperatingcashflowsof$1,800,000inyear
1,$1,900,000inyear2,$1,700,000inyear3and($1,300,000)inyear4?
(a) $(1,494,336).
(b) $1,494,336.
(c) Greaterthanzero.
(d) Twooftheabove.
Answer: A
LevelofDifficulty:4
LearningGoal:3
45.
WhatistheIRRforthefollowingprojectifitsinitialaftertaxcostis$5,000,000anditisexpected
toprovideaftertaxoperatingcashinflowsof$1,800,000inyear1,$1,900,000inyear2,$1,700,000
inyear3and$1,300,000inyear4?
(a) 15.57%.
(b) 0.00%.
(c) 13.57%.
(d) Noneoftheabove.
Answer: C
LevelofDifficulty:3
LearningGoal:4
46.
WhatistheIRRforthefollowingprojectifitsinitialaftertaxcostis$5,000,000anditisexpected
toprovideaftertaxoperatingcashflowsof($1,800,000)inyear1,$2,900,000inyear2,$2,700,000
inyear3and$2,300,000inyear4?
(a) 5.83%.
(b) 9.67%.
(c) 11.44%.
(d) Noneoftheabove.
Answer: A
LevelofDifficulty:3
LearningGoal:4
47.
Whichcapitalbudgetingmethodismostusefulforevaluatingthefollowingproject?Theprojecthas
aninitialaftertaxcostof$5,000,000anditisexpectedtoprovideaftertaxoperatingcashflowsof
$1,800,000inyear1,($2,900,000)inyear2,$2,700,000inyear3and$2,300,000inyear4?
(a) NPV.
(b) IRR.
(c) Payback.
(d) Twooftheabove.
Answer: A
LevelofDifficulty:2
LearningGoal:6
Topic:NPVversusIRR
48.
ThereissometimesarankingproblemamongNPVandIRRwhenselectingamongmutually
exclusiveinvestments.Thisrankingproblemonlyoccurswhen
(a) theNPVisgreaterthanthecrossoverpoint.
(b) theNPVislessthanthecrossoverpoint.
(c) thecostofcapitalistotherightofthecrossoverpoint.
(d) thecostofcapitalistotheleftofthecrossoverpoint.
Answer: D
LevelofDifficulty:3
LearningGoal:5
Topic:NPVversusIRR
49.
Considerthefollowingprojects,XandY,wherethefirmcanonlychooseone.ProjectXcosts$600
andhascashflowsof$400ineachofthenext2years.ProjectBalsocosts$600,andgeneratescash
flowsof$500and$275forthenext2years,respectively.Whichinvestmentshouldthefirmchoose
ifthecostofcapitalis10percent?
(a) ProjectX.
(b) ProjectY.
(c) Neither.
(d) Notenoughinformationtotell.
Answer: A
LevelofDifficulty:3
LearningGoal:5
Topic:NPVversusIRR(Equation9.1,Equation9.1a,Equation9.2andEquation9.2a)
50.
Considerthefollowingprojects,XandYwherethefirmcanonlychooseone.ProjectXcosts$600
flowsof$500and$275forthenext2years,respectively.Whichinvestmentshouldthefirmchoose
ifthecostofcapitalis25percent?
(a) ProjectX.
(b) ProjectY.
(c) Neither.
(d) Notenoughinformationtotell.
Answer: C
LevelofDifficulty:3
LearningGoal:5
Topic:NPVversusIRR(Equation9.1,Equation9.1a,Equation9.2andEquation9.2a)
.4
Essay Questions
Table9.4
$1,000
OperatingCashInflows
$1,000
$1,000
$1,000
$1,000
$2,500
(Initialoutlay)
1.
GiventheinformationinTable9.4and15percentcostofcapital,
(a) computethenetpresentvalue.
(b) shouldtheprojectbeaccepted?
Answers:
(a) NPV1,000(PVIFA15%,5)2,500
1,000(3.352)2,500$852
(b) SinceNPV>0,theprojectshouldbeaccepted.
LevelofDifficulty:3
LearningGoal:3
Table9.5
OperatingCashInflows
$25,000
$10,000
$50,000
$10,000
$10,000
$100,000
(Initialoutlay)
2.
(b) shouldtheprojectbeaccepted?
Answers:
(a)
Year
1
2
3
4
5
6
CF
$25,000
10,000
50,000
10,000
10,000
60,000
PVIF15%,t
0.870
0.756
0.658
0.572
0.497
0.432
NPV98,820100,000$1,180<0
(b) SinceNPV<0,theprojectshouldberejected.
LevelofDifficulty:3
LearningGoal:3
PV
$21,750
7,560
32,900
5,720
4,970
25,920
$98,820
$60,000
DegnanDanceCompany,Inc.,amanufacturerofdanceandexerciseapparel,isconsideringreplacingan
existingpieceofequipmentwithamoresophisticatedmachine.Thefollowinginformationisgiven.
Table9.6
Facts
ExistingMachine
Cost$100,00
Purchased2yearsago
DepreciationusingMACRSover
a5yearrecoverschedule
Currentmarketvalue$105,000
Fiveyearusableliferemaining
ProposedMachine
Cost$150,000
Installation$20,000
DepreciationtheMACRS
5yearrecoveryschedulewillbeused
Fiveyearusablelifeexpected
EarningsbeforeDepreciationandTaxes
ExistingMachine
ProposedMachine
Year 1
$160,000
Year 1
$170,000
2
150,000
2
170,000
3
140,000
3
170,000
4
140,000
4
170,000
5
140,000
5
170,000
The firm pays 40 percent taxes on ordinary income and capital gains.
3.
GiventheinformationinTable9.6,computetheinitialinvestment.
Answer:
Costofnewequipment
Installationcost
Proceedsfromsaleofexistingequip.
Taxeffectonsaleofexistingequip.
InitialInvestment
LevelofDifficulty:4
LearningGoal:3
Topic:InitialInvestment
$150,000
20,000
105,000
22,800
$87,800
4.
GiventheinformationinTable9.6,computetheincrementalannualcashflows.
Answer:
Profitsbefore
Depreciation
Year
andTaxes
ExistingMachine
1
$160,000
2
150,000
3
140,000
4
140,000
5
140,000
6
0
ProposedMachine
1
$170,000
2
170,000
3
170,000
4
170,000
5
170,000
6
0
Year
1
2
3
4
5
6
CalculationofOperatingCashFlows
NetProfits
before
Depreciation
Taxes
Taxes
NetProfits
afterTaxes
Cash
Flow
$19,000
12,000
12,000
5,000
0
0
$141,000
138,000
128,000
135,000
140,000
0
$56,400
55,200
51,200
54,000
56,000
0
$84,600
82,800
76,800
81,000
84,000
0
$103,600
94,800
88,800
86,000
84,000
0
$34,000
54,400
32,300
20,400
20,400
8,500
$136,000
115,600
137,700
149,600
149,600
8,500
$54,400
46,240
55,080
59,840
59,840
3,400
$81,600
69,360
82,620
89,760
89,760
5,100
$115,600
123,760
114,920
110,160
110,160
3,400
CalculationofIncrementalCashFlows
ProposedMachine ExistingMachine IncrementalCashFlows
$115,600
$103,600
$12,000
123,760
94,800
28,960
114,920
88,800
26,120
110,160
86,000
24,160
110,160
84,000
26,160
3,400
0
3,400
LevelofDifficulty:4
LearningGoal:3
Topic:IncrementalOperatingCashFlows
5.
GiventheinformationinTable9.6,computethepaybackperiod.
Answer:
Year
IncrementalCashFlows CumulativeCashFlow
1
$12,000
$12,000
2
28,960
40,960
3
26,120
67,080
4
24,160
91,240
5
26,160
115,400
6
3,400
118,800
PP3[(87,80067,080)/24,160]3.86years.
LevelofDifficulty:4
LearningGoal:3
Topic:PaybackMethod
6.
(b) Shouldtheprojectbeaccepted?
Answers:
(a)
Year
1
2
3
4
5
6
ICF
$12,000
28,960
26,120
24,160
26,160
3,400
PVIF15%,t
0.870
0.756
0.658
0.572
0.497
0.432
PV
$10,440
21,894
17,187
13,820
13,002
1.469
$77,812
NPV77,81287,800$9,988
(b) SinceNPV<0,theprojectshouldberejected.
LevelofDifficulty:4
LearningGoal:3
GalaxySatelliteCo.isattemptingtoselectthebestgroupofindependentprojectscompetingforthefirms
fixedcapitalbudgetof$10,000,000.Anyunusedportionofthisbudgetwillearnlessthanits20percent
costofcapital.Asummaryofkeydataabouttheproposedprojectsfollows.
Table9.7
Projec
t
A
B
C
D
7.
InitialInvestment
$3,000,000
9,000,000
1,000,000
7,000,000
IRR
21%
25
24
23
PVofInflows
at20%
$3,050,000
9,320,000
1,060,000
7,350,000
UsetheNPVapproachtoselectthebestgroupofprojects.(SeeTable9.7)
Answer: ChooseProjectsCandD,sincethiscombinationmaximizesNPVat$410,000andonly
requires$8,000,000initialinvestment.
LevelofDifficulty:3
LearningGoal:6
Topic:NPVandCapitalRationing
8.
UsetheIRRapproachtoselectthebestgroupofprojects.(SeeTable9.7)
Answer:
IRRApproach
Project
IRR InitialInvestment
NPV
B
25%
$9,000,000
$320,000
C
24
1,000,000
60,000
D
23
7,000,000
350,000
A
21
3,000,000
50,000
ChooseProjectsBandC,resultinginaNPVof$380,000.
LevelofDifficulty:3
LearningGoal:6
Topic:IRRandCapitalRationing
9.
Whichprojectsshouldthefirmimplement?(SeeTable9.7)
Answer: ProjectsCandD
LevelofDifficulty:3
LearningGoal:6
Topic:NPVversusIRRandCapitalRationing
10.
Considerthefollowingprojects,XandYwherethefirmcanonlychooseone.ProjectXcosts$600
flowsof$500and$275forthenext2years,respectively.Sketchanetpresentvalueprofileforeach
oftheseprojects.Whichprojectshouldthefirmchooseifthecostofcapitalis10percent?Whatif
thecostofcapitalis25percent?Showallwork.
Answer:
Cost
ofCapital
0%
5%
10%
15%
20%
25%
ProjectX
$200
$144
$94
$50
$11
$(24)
ProjectY
$175
$126
$86
$43
$8
$(24)
Atacostofcapitalof10percent,thefirmwouldchooseProjectX.Atacostofcapitalof
25percent,thefirmwouldchooseneither.
LevelofDifficulty:3
LearningGoal:6
Topic:NetPresentValueProfiles(Equation9.1andEquation9.1a)
11.
TangshanMiningCompanyisconsideringinvestinginanewminingproject.Thefirmscostof
capitalis12percentandtheprojectisexpectedtohaveaninitialaftertaxcostof$5,000,000.
Furthermore,theprojectisexpectedtoprovideaftertaxoperatingcashflowsof$2,500,000in
year1,$2,300,000inyear2,$2,200,000inyear3and($1,300,000)inyear4?
(a) CalculatetheprojectsNPV.
(b) CalculatetheprojectsIRR.
(c) Shouldthefirmmaketheinvestment?
Answer:
Time
0
1
2
3
4
CashFlow
$(5,000,000)
$2,500,000
$2,300,000
$2,000,000
$(1,300,000)
PVIF(12%)
1.0000
0.8929
0.7972
0.7118
0.6355
NPV
IRR
PVofCF
$(5,000,000)
$2,232,143
$1,833,546
$1,423,560
$(826,174)
$(336,924)
6.80%
Nothefirmshouldnotaccepttheproject.
LevelofDifficulty:3
LearningGoal:5
Topic:NPVandIRR(Equation9.1,Equation9.1a,Equation9.2andEquation9.2a)

Chapter 9: Capital Budgeting Techniques

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126GitmanPrinciplesofFinance,EleventhEdition

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