Chapter 14Capital Budgeting

TRUE/FALSE

1. A decrease in interest rates decreases the net present value of an investment.

ANS: F PTS: 1

2. A decrease in investors' required rate of return will increase an investment's net present value.

ANS: T PTS: 1

3. A decrease in the cost of an investment will increase its net present value.

ANS: T PTS: 1

4. The internal rate of return equates the present value of an investment's cash inflows and its cost
(outflows).

ANS: T PTS: 1

5. If the cost of capital exceeds the internal rate of return, the firm should not make the investment.

ANS: T PTS: 1

6. If an investment requires the firm to carry more current assets, that increases the investment's net
present value.

ANS: F PTS: 1

7. For a given set of cash inflows, the more an investment costs, the smaller will be its NPV.

ANS: T PTS: 1

8. A major difference between the net present value and internal rate of return is the interest factor.

ANS: T PTS: 1

9. The internal rate of return assumes that cash inflows are reinvested at the firm's cost of capital.

ANS: F PTS: 1

10. If two investments are mutually exclusive, the firm cannot make both investments.

ANS: T PTS: 1

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 11. The net present value assumes that cash inflows are reinvested at the net present value.

ANS: F PTS: 1

12. A high cost of capital favors investments with large initial cash inflows.

ANS: T PTS: 1

13. If a firm switches from straight-line to accelerated depreciation, an investment's internal rate of return
declines.

ANS: F PTS: 1

14. An increase in interest rates increases the net present value of an investment.

ANS: F PTS: 1

15. An increase in investors' required return decreases an investment's internal rate of return.

ANS: F PTS: 1

16. An increase in the cost of an investment decreases the investment's cash flows.

ANS: F PTS: 1

17. An increase in an investment's cash inflows that is not the result of an increase in earnings has no
effect on the net present value of an investment.

ANS: F PTS: 1

18. The internal rate of return equates the net present value and the cost of an investment.

ANS: F PTS: 1

19. The net present value of an investment cannot be negative.

ANS: F PTS: 1

20. The internal rate of return method of capital budgeting permits a ranking of investment proposals.

ANS: T PTS: 1

21. If two investments are not mutually exclusive, the firm can make only one of them.

ANS: F PTS: 1

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 22. If the cost of capital rises, an investment's internal rate of return falls.

ANS: F PTS: 1

23. The net present value of an investment is independent of the firm's cost of capital.

ANS: F PTS: 1

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 24. The internal rate of return of an investment is independent of the firm's cost of capital.

ANS: T PTS: 1

25. A higher cost of capital reduces an investment's internal rate of return.

ANS: F PTS: 1

26. Risk adjustments favor the use of net present value over the internal rate of return.

ANS: F PTS: 1

27. Analyzing an investment from a stand-alone perspective avoids considering portfolio effects.

ANS: T PTS: 1

28. For an investment to diversify a portfolio, its returns must be positively correlated with other returns.

ANS: F PTS: 1

29. Low correlation among cash inflows is associated with lower net present values.

ANS: F PTS: 1

30. One type of risk adjustment alters the firm's cost of capital for the probability of occurrence.

ANS: F PTS: 1

31. A higher standard deviation for an investment's cash inflows is associated with greater risk.

ANS: T PTS: 1

32. Certainty equivalents adjust an investment's cash outflows in terms of a risk-free return.

ANS: F PTS: 1

33. The coefficient of variation divides an investment's standard deviation by the internal rate of return.

ANS: F PTS: 1

34. Greater risk is associated with larger beta coefficients.

ANS: T PTS: 1

35. Lower beta coefficients imply the investment may be analyzed on a stand-alone basis.

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 ANS: F PTS: 1

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 36. If the probability of an investment's cash inflows is decreased, the firm's cost of capital should be
increased.

ANS: T PTS: 1

37. If an investment is riskier, using a higher beta coefficient to analyze the alternative reduces the
investment's internal rate of return.

ANS: F PTS: 1

MULTIPLE CHOICE

1. The net present value method considers

1. the timing of the cash inflows from an investment
2. the cost of an investment
3. the firm's cost of capital

a. 1 and 2
b. 1 and 3
c. 2 and 3
d. 1, 2, and 3
ANS: D PTS: 1

2. The internal rate of return will be higher if

a. the cost of capital is lower
b. the cost of capital is higher
c. the cost of the investment is lower
d. the cost of the investment is higher
ANS: C PTS: 1

3. The net present value will be larger if

a. the cost of capital is higher
b. there is no salvage value
c. the cost of the investment is lower
d. the firm uses straight-line depreciation
ANS: C PTS: 1

4. A firm should not make an investment if

1. its net present value is positive
2. its net present value is negative
3. the internal rate of return exceeds the cost of capital
4. the internal rate of return is less than the cost of capital

a. 1 and 3
b. 1 and 4

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 c. 2 and 3
d. 2 and 4
ANS: D PTS: 1

5. An increase in the cost of capital will

a. increase an investment's internal rate of return
b. decrease an investment's internal rate of return
c. increase an investment's net present value
d. decrease an investment's net present value
ANS: D PTS: 1

6. If the internal rates of return of two mutually exclusive investments exceed the firm's cost of capital,
the firm should
a. make both investments
b. make neither investment
c. make the investment with the lower internal rate of return
d. make the investment with the higher internal rate of return
ANS: D PTS: 1

7. The internal rate of return and net present value methods of capital budgeting assume the cash flows
are reinvested at
a. the cost of capital
b. the internal rate of return
c. the cost of capital for IRR and the internal rate of return for NPV
d. the cost of capital for NPV and the internal rate of return for IRR
ANS: D PTS: 1

8. NPV may be preferred to IRR because

a. IRR makes the more conservative assumption concerning reinvestment
b. NPV makes the more conservative assumption concerning reinvestment
c. IRR excludes salvage value
d. NPV includes salvage value
ANS: B PTS: 1

9. Risk may be incorporated into capital budgeting by

1. increasing an investment's internal rate of return by a risk premium
2. adjusting the cash flows by the probability of occurrence
3. increasing the cost of capital by a risk premium

a. 1 and 2
b. 1 and 3
c. 2 and 3
d. 1, 2, and 3
ANS: C PTS: 1

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 10. According to net present value, the reinvestment rate is
a. the net present value
b. the internal rate of return
c. the cost of capital
d. the cost of equity
ANS: C PTS: 1

11. If the net present value is positive,

1. the internal rate of return exceeds the firm's cost of capital
2. the internal rate of return is less than the firm's cost of capital
3. the present value of cash inflows exceeds the present cost of an investment
4. the present value of cash inflows is less than the present cost of an investment

a. 1 and 3
b. 1 and 4
c. 2 and 3
d. 2 and 4
ANS: A PTS: 1

12. Risk analysis may be introduced by

a. estimating an investment's beta
b. using the firm's cost of capital
c. reducing an investment's expected life
d. using accelerated depreciation
ANS: A PTS: 1

13. The internal rate of return will be higher if

a. the cost of capital is lower
b. the cost of the investment is higher
c. the cost of the investment is lower
d. the cost of capital is higher
ANS: C PTS: 1

14. A firm should make an investment if the present value of the cash inflows is
a. less than zero
b. greater than zero
c. less than the cost of the investment
d. greater than the cost of the investment
ANS: D PTS: 1

15. A firm should not make an investment if the internal rate of return is
a. greater than the cost of capital
b. less than the cost of capital
c. greater than the interest rate
d. less than the interest rate
ANS: B PTS: 1

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 16. If an investment's net present value is negative,
1. the firm should not make the investment
2. the costs exceed the present value of the cash inflows
3. the investment will increase the value of the firm

a. 1 and 2
b. 1 and 3
c. 2 and 3
d. 1, 2, and 3
ANS: A PTS: 1

17. If the net present value of two mutually exclusive investments is positive, the firm should
a. make both investments
b. make neither investment
c. make the investment with the higher present value
d. make the investment with the higher net present value
ANS: D PTS: 1

18. If the internal rate of return of two mutually exclusive investments is less than the firm's cost of
capital, the firm should make
a. both investments
b. neither investment
c. the investment with the higher internal rate of return
d. the investment with the lower net present value
ANS: B PTS: 1

19. According to the risk-adjusted net present value, an investment should be made if
a. the net present value is positive
b. the internal rate of return is positive
c. the cost of capital is positive
d. the cost of equity is positive
ANS: A PTS: 1

20. If the risk-adjusted net present value is positive,

1. the internal rate of return exceeds the firm's cost of capital
2. the internal rate of return is less than the firm's cost of capital
3. the present value of cash inflows exceeds the present cost of an investment
4. the present value of cash inflows is less than the present cost of an investment

a. 1 and 3
b. 1 and 4
c. 2 and 3
d. 2 and 4
ANS: A PTS: 1

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 21. A stand-alone perspective for capital budgeting suggests
a. an investment has no risk
b. cash flows are independent of the firm's other investments
c. portfolio effects are ignored
d. the investment has a low beta
ANS: C PTS: 1

22. The lack of correlation between an investment's return and the firm's other investments suggests
a. the investment has little risk
b. portfolio effects may exist
c. the investment's beta coefficient is low
d. the investment's net present value is negative
ANS: B PTS: 1

23. Small standard deviations for cash inflows

a. reduces an investment's net present value
b. increases an investment's internal rate of return
c. increases the firm's cost of capital
d. implies more certainty
ANS: D PTS: 1

24. The use of certainty equivalents means

a. the investment's cash inflows are certain
b. an investment's cash inflows are expressed as if they were certain
c. the cost of capital is known
d. the probability of occurrence is certain
ANS: B PTS: 1

PROBLEM

1. An investment costs $10,000 and will generate annual cash inflows of $1,770 for ten years. According
to the net present value and internal rate of return methods of capital budgeting, should the firm make
this investment if its cost of capital is (a) 10% or (b) 14%?

ANS:
Internal rate of return:
$10,000 = (PVAIF %, 10y)$1,770
$10,000 = $1,770X
X = $10,000 / $1,770 = 5.650
r = 12%

(PV = -10000; N= 10; I = ?; PMT = 1770, and FV = 0. I = 12.)

Net present value at 10%:

NPV = $1,770(PVAIF 10%, 10y)
= $1,770(6.145) - $10,000 = $10,876.65 - $10,000

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 = $876.65

(PV = ?; N = 10; I = 10; PMT = 1770, and FV = 0. PV = -10876.)

Net present value at 14%:

NPV = $1,770(PVAIF 14%, 10y)
= $1,770(5.216) - $10,000 = ($767.68)

(PV = ?; N = 14; I = 10; PMT = 1770, and FV = 0. PV = -9233.)

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 At k = 10% the firm should make the investment. (NPV is positive and IRR exceeds the firm's cost of
capital.) At k = 14% the firm should not make the investment. (NPV is negative and IRR is less than
the firm's cost of capital.)

PTS: 1

2. A firm with the following investment opportunities has a capital budget of $10,000. According to the
net present value technique, which investment(s) should the firm make if the firm's cost of capital is
10%?

Investment
A B C
Cost $10,000 $7,000 $3,000
Cash inflow $12,000 $8,600 $4,000

ANS:
The firm should select that combination of investments which uses the available funds and maximizes
the combined net present value.
NPVA = $12,000(PVIF 10%, 1y) - $10,000
= $12,000 / (1 + .1) - 10,000
= $12,000(.909) - $10,000 = $908

NPVB = $8,600 / (1 + .1) - $7,000

= $8,600(.909) - $7,000 = $817

NPVC = $4,000 / (1 + .1) - $3,000

= $4,000(.909) - $3,000 = $636

NPVA is less than NPVB + NPVC. Therefore, select B + C over A even though A has the highest
individual NPV.

PTS: 1

3. Two mutually exclusive investments cost $10,000 each and have the following cash inflows. The
firm's cost of capital is 12%.

Investment
Cash inflow: A B
Year
1 $12,407 --
2 -- --
3 -- --
4 -- $19,390

a. What is the net present value of each investment?

b. What is the internal rate of return of each investment?
c. Which investment(s) should the firm make?
d. Would your answers be different to c if the funds received in year 1 for investment A

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 could be reinvested at 12%, 16%, or 20%?

ANS:
a. NPVA = $12,407 / (1 + .12) - $10,000
= $12,407(.893) - $10,000 = $1,079

NPVB = 19,390 / (1 + .12)4 - $10,000

= $19,390(.636) - $10,000 = $2,332

b. $10,000 = $12,407 / (1 + r)
(1 + r) = $12,407 / $10,000 = .806
r = 24%

$10,000 = $19,390 / (1 + r)4

(1 + r)4 = $19,390 / $10,000 = .516
r = 18%

c. Since the investments are mutually exclusive, the firm can only make one. The NPV B
exceeds the NPVA; therefore, B is to be preferred. However, the IRR of A exceeds the IRR
of B, which argues for A.

d. Reconciliation of the conflict may be achieved by considering the reinvestment rate of the
funds earned in year 1 by investment A.

At 12%: $12,407(1 + .12)3 = $12,407(1.405) = $17,432

At 16%: $12,407(1 + .16)3 = $12,407(1.561) = $19,367

At 20%: $12,407(1 + .20)3 = $12,407(1.728) = $21,439

At both 12% and 16%, B is preferred because it produces the higher terminal value.
However, at 20%, A is now preferred because it produces the higher terminal value.

The break-even point between A and B is

$12,407(1 + r)3 = $19,390.
(1 + r)3 = $19,390 / $12,407 = 1.5628
r = 16.05%

Below a reinvestment rate of 16.05%, B is always the preferred investment.

PTS: 1

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 4. A firm has two $1,000, mutually exclusive investment alternatives with the following cash inflows.
The cost of capital is 6 percent.

Year Cash Inflow

A B
1 $175 $1,100
2 175 -
3 175 -
4 175 -
5 175 -
6 175 -
7 175 -
8 175 -

a. What is the internal rate of return on each investment? Which investment should the firm
make?
b. What is the net present value of each investment? Which investment should the firm
make?
c. If the cash inflows can be reinvested at 8 percent, which investment should be made?

ANS:
a. Determination of the internal rates of return:
A: $175(PVAIF %, 8y) = $1,000
Interest factor = $1,000 / $175 = 5.174
rA = approximately 8%

(PV = -1000; N = 8; I = ?; PMT = 175, and FV = 0. I = 8.15.)

B: $1,100 / (1 + rB) = $1,000

Interest factor = $1,000 / $1,100 = .909
rB = 10%

Since the investments are mutually exclusive, the firm should select B because it has the
higher internal rate of return.

b. Determination of the net present values:

A: Net present value A:
$175(PVAIF 6%, 8y) - $1,000 = $175(6.210) - $1,000 = $87

B: Net present value B:

$1,100 / (1 + .06) - $1,000 = $1,100(.943) - $1,000 = $37

Since the investments are mutually exclusive, the firm should select A because it has the
higher net present value.(This contradicts part a, which selected investment B.)

c. If the firm is able to reinvest the annual payments of $175, the terminal value of A is
$175(10.637) = $1,861.48 (10.637 is the interest factor for the future value of an ordinary
annuity at 8% for eight years.)

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 If the firm selects B, it receives $1,100 in year one, which is reinvested at 8% for seven
years. The terminal value is $1,100(1.714) = $1,885.40. This is higher than the terminal
value for A, so the firm should make investment B.

PTS: 1

5. A firm has the following investment alternatives:

Cash Inflows
Year A B C
1 $400 $ --- $ ---
2 400 400 ---
3 400 800 ---
4 400 800 1,800

Each investment costs $1,400 and the firm's cost of capital is 10 percent.
a. What is each investment's internal rate of return?
b. Should the firm make any of these investments?
c. What is each investment's net present value?
d. Should the firm make any of these investments?

ANS:
a. Determination of the internal rates of return:
Investment A:
$400(PVAIF %, 4y) = $1,400
Interest factor = $1,400 / $400 = 3.5
rA = approximately 5.6%

(PV = -1400; N = 4; I = ?; PMT = 400, and FV = 0. I = 5.56.)

Investment B:
$1,400 = $400 / (1 + rB)2 + $800 / (1 + rB)3 + $800 / (1 + rB)4

Use 12%:
$400(.780) + $800(.712) + $800(.634) = $1,389
rB = approximately 12% (11.9%)

Investment C:
$1,400 = $1,800 / (1 + rC)4
Interest factor = $1,400 / $1,800 = .778
rC = approximately 7% (6.5%)

b. The firm should make only investment B.

c. Determination of the net present values:

Investment A:
$400(PVAIF 10%, 4y) $1,400 = $400(3.170) - $1,400 = ($132)

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 Investment B:
$400 / (1 + .1)2 + $800 / (1 + .1)3 + $800 / (1 + .1)4 - 1,400
= $400(.826) + $800(.751) + $800(.683) - $1,400
= $1,477.60 - $1,400 = $77.60

Investment C:
$1,800 / (1 + .1)4 - $1,400 = $1,800(.683) - $1,400 = ($170.60)

d. According to the net present value, only investment B should be made. (This confirms the
answer to part b.)

PTS: 1

6. A firm has three investment opportunities. Each costs $1,000, and the firm's cost of capital is 10
percent. The cash inflow of each investment is as follows:

cash inflow A B C
year
1 $300 500 100
2 300 400 200
3 300 200 400
4 300 100 500

a. If the net present value method is used, which investment(s) should the firm make?
b. What is the internal rate of return of investment A? The internal rate of return of
investment B is 10.22% and 6.15% for investment C. Which investment(s) should the firm
make?
c. What is the payback period for each investment?

ANS:
a. Discount the cash inflows by the cost of capital. For each investment, that is

A B
$300 .909 = $272.70 $500 .909 = $ 454.50
300 .826 = 247.80 400 .826 = 330.40
300 .751 = 225.30 200 .751 = 150.20
300 .683 = 204.90 100 .683 = 68.30
$950.70 $1,003.40

C
$100 .909 = $ 90.90
200 .826 = 165.20
400 .751 = 300.40
500 .683 = 341.50
$898.00

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 Since investment A is an annuity, the present value could be determined by using the
interest table for the present value of an annuity. That is, $300 3.170 = $951, which is
essentially the same answer except for rounding.

Next subtract the cost from the present value to determine the net present value:
A: $950.70 - $1,000 = ($49.30)
B: $1,003.40 - $1,000 = $3.40
C: $898.00 - $1,000 = ($102.00).

Since only B has a net present value that is positive, it is the only investment that covers
the firm's cost of capital and hence is the only one that should be selected.

b. Internal rate of return for A:

Since investment A is an annuity, the annuity table for the present value of an annuity may
be used to solve the problem. Restated the equation is
$1,000 = $300X
X = $1,000 / $300 = 3.33.

3.33 is the interest factor for the present value of an annuity for four years. Find this
interest factor in the table to determine the internal rate of return. In this case the internal
rate of return is approximately 8 percent, which is less than the firm's cost of capital. (The
IRR is 7.7 percent using a financial calculator.) Therefore, the investment should not be
made. (This answer is consistent with the answer given by the net present value in the
previous question.) The internal rates of return for investments B and C were given. Only
the internal rate of return of B exceeds the cost of capital; thus it is the only investment the
firm should make.

c. The payback periods for the investments are

A three and one-third years
B two and one-half years
C three and two-thirds years.

Notice that in this case the payback method gives the same ranking of investments as the
net present value. However, the payback method does not tell if any of the investments
should be made.

PTS: 1

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 7. Investments A and B are mutually exclusive and cost $2,000 each. The firm's cost of capital is 9%, and
the investments' estimated cash inflows are

cash inflow A B
year
1 $2,320 ---
2 --- ---
3 --- $2,810

a. What investment(s) should the firm make according to net present value?
b. What investment(s) should the firm make according to internal rate of return?
c. If the firm can reinvest funds earned in year 1 at 10%, which investment(s) should the
firm make?

ANS:
a. Net present value of A: $2,320 / (1 + .09) - 2,000 = $128

Net present value of B: $2,810 / (1 + .09)3 - 2,000 = $170

Since the investments are mutually exclusive, the firm cannot make both and will select B
since it has the higher NPV.

b. Internal rate of return of A: $2,000 = $2,320 / (1 + r)

PVIF = .862
r = 16%

Internal rate of return of B: $2,000 = $2810 / (1 + r)3

PVIF = .712
r = 12%

Since the investments are mutually exclusive, the firm cannot make both and will select A
since it has the higher IRR.

c. There is an obvious conflict in the rankings. The purpose of this question is to help
reconcile the conflict. If the $2,320 grow annually at 10 percent, then the future value is
$2,320(1 + .1)2 = $2,320(1.210) = $2,807.20.

Investment B is now clearly preferred to A because the terminal value of S is $2,807.20,

which is less than $2810.

PTS: 1

8. A risky $500,000 investment is expected to generate the following cash flows:

Year 1 2 3
$250,000 $266,667 $285,715

The probability of receiving each cash inflow is 80, 75, and 70 percent, respectively. If the firm's cost
of capital is 10 percent, should the investment be made?

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 ANS:
The risk-adjusted cash inflows are
(0.80)($250,000) = $200,000
(0.75)($266,667) = 200,000
(0.70)($285,715) = 200,000

The present value of the cash inflows is

$200,000(PVAIF, 10I, 3N) = $200,000(2.487) = $497,400

(FV = 0; PMT = 200000, I = 10; N = 3; PV = ?. PV = -497370.)

Since the net present value is negative [$497,400 - 500,000 = ($2,600)], the investment should not be
made.

PTS: 1

9. A firm has the following investment alternatives. Each cost $10,000 and has the following cash
inflows.

Cash flow Year

1 2 3 4
Investment A $4,000 4,000 4,000 4,000
B $3,600 3,800 4,200 4,600

Investment A is considered to be typical of the firm's investments, but investment B's cash flows are
less certain. The firm's cost of capital is 8 percent, but the financial manager uses a hurdle rate of 6
percent for less risky projects and 10 percent for riskier projects.
a. Based on the cost of capital, which investment(s) should be made?
b. If the financial manager uses the risk-adjusted cost of capital, which investment(s) should
be made?
c. Would the answers to (a) and (b) be different if the two investments were not mutually
exclusive?

ANS:
a. NPV calculations using the firm's 8 percent cost of capital:

A: $4,000(PVAIF 8I, 4N) - $10,000 =

$4,000(3.170) - $10,000 = $3,248

B: $3,700(0.926) + $3,800(0.857) + $4,200(0.794)

+ $4,600(0.735) - $103,000 = $3,398

Using the firm's 8 percent cost of capital, A and B have positive net present values. Since
the investments are mutual exclusive, select B.

b. NPV calculations using the risk-adjusted cost of capital:

A: at 8%:

2012 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S.
Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.
 $4,000(PVAIF 8I, 4N) - $10,000 =
$4,000(3.312) - $10,000 = $3,248

B: at 10%:
$3,700(0.893) + $3,800(0.797) + $4,200(0.712)
+ $4,600(0.636) - $10,000 = $2,249

Using the risk-adjusted costs of capital, A and B have positive net present values. Since
they are mutual exclusive, select A.

c. If the alternatives were not mutually exclusive, you accept every investment with a
positive NPV. Since both have positive net present values, make both investments.

PTS: 1

10. A risky $1,000 investment is expected to generate the following cash flows:

Year 1 2 3
$600 $600 $600

a. If the firm's cost of capital is 10 percent, should the investment be made?

b. An alternative use for the $1,000 is a three-year U.S. Treasury note that pays $50 annually
and repays the $1,000 at maturity for an annual risk-free return of 5 percent. Management
believes that the cash inflows from the risky investment are only equivalent to 70 percent
of the certain investment. Does this information alter the decision in (a)?

ANS:
a. The net present values if the firm's cost of capital is 10 percent:
$600(PVAIF 10I, 3N) - $1,000 =
$600(2.487) - $1,000 = $492.20.

The net present value is positive. The investment should be made.

b. If the cash flows are considered to be only 70 percent certain and the risk-free, certain
discount rate is 5 percent, the net present value is
(0.7)$600(PVAIF 5I, 3N) - $1,000 =
$420(2.723) - $1,000 = $143.66.

The adjusted net present value remains positive, so the investment should be made.

PTS: 1

2012 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S.
Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.