Deck 13: Capital Investment Decisions: Appraisal Methods

Question 1

Firms may select projects with short paybacks because

A)projects with longer paybacks may be riskier.
B)shorter paybacks may help reduce liquidity problems.
C)if the risk of obsolescence is high, the firm may want to recover the funds rapidly.
D)All of the above are correct.

Answer 1

D

Question 2

Why would a company use the accounting rate of return?

A)to ensure that a new investment will not adversely affect accounting income
B)because it does not consider the time value of money
C)because it is a measure of liquidity
D)all of the above

Answer 2

A

Question 3

A firm is considering two projects with the following cash flows: $\begin{array}{rrr} & \text { Project A } & \text { Project B } \\\text { Year 1 } & £ 40,000 & £ 140,000 \\\text { Year 2 } & 60,000 & 60,000 \\\text { Year 3 } & 140,000 & 40,000\end{array}$ Each project requires an investment of £120,000. Which project will have the higher net present value?

A)Project A
B)Project B
C)Project A and Project B will have the same net present value.
D)The question cannot be answered from the information provided.

Answer 3

Project B

Question 4

If a project has a net present value of £0 when a discount rate of 10 per cent is used, what can be concluded about the rate of return of the project?

A)The rate of return is greater than 10 per cent.
B)The rate of return is less than 10 per cent.
C)The rate of return equals 10 per cent.
D)The rate of return is 0.

Question 5

If the annual cash flows are an annuity (equal each period), payback is calculated as

A)Annual net cash inflows/Capital investment.
B)Capital investment/Annual net cash inflows.
C)Annual net cash inflows/Present value factor.
D)(Annual net cash inflows - Annual depreciation)/Capital investment.

Question 6

A firm is evaluating a project that has a net present value of £0 when a discount rate of 8 per cent is used. A discount rate of 6 per cent will result in

A)a negative net present value.
B)a positive net present value.
C)a net present value of £0.
D)The question cannot be answered based upon the information provided.

Question 7

What is a weakness of the payback method?

A)It emphasizes projects with possible liquidity problems.
B)It ignores the profitability of investments beyond the payback period.
C)It can be used in conjunction with discounted cash flow methods.
D)both a and b above

Question 8

The time required for a project to return its investment is the

A)accounting rate of return.
B)interest.
C)net present value.
D)payback period.

Question 9

Future cash flows expressed in present value terms are

A)compounded cash flows.
B)extended cash flows.
C)budgeted cash flows.
D)discounted cash flows.

Question 10

A firm is evaluating a project that has a net present value of £0 when a discount rate of 8 per cent is used. A discount rate of 10 per cent will result in

A)a negative net present value.
B)a positive net present value.
C)a net present value of £0.
D)The question cannot be answered based upon the information provided.

Question 11

The accounting rate of return is calculated as

A)Investment/Income.
B)Income/Debt.
C)Income/Investment.
D)Assets/Debt.

Question 12

Which of the following methods consider the time value of money?

A)payback and accounting rate of return
B)payback and internal rate of return
C)internal rate of return and accounting rate of return
D)internal rate of return and net present value

Question 13

____ are capital budgeting models that identify criteria for accepting or rejecting projects without considering the time value of money.

A)Net present value models
B)Nondiscounting models
C)Discounting models
D)Capital return models

Question 14

Which of the following methods assumes a reinvestment rate equal to the discount rate?

A)payback
B)accounting rate of return
C)net present value
D)internal rate of return

Question 15

Projects that, if accepted, preclude the acceptance of competing projects are

A)priority projects.
B)mutually exclusive projects.
C)independent projects.
D)equity projects.

Question 16

If the investment's internal rate of return is more than the required rate of return, the investment should be

A)accepted.
B)rejected.
C)put on hold.
D)None of the above are correct.

Question 17

When the discount rate is decreased,

A)the present value of future cash flows increases.
B)the present value of future cash flows decreases.
C)there is no change in the present value.
D)net present value would equal zero.

Question 18

Which of the following methods uses income instead of cash flows?

A)payback
B)accounting rate of return
C)internal rate of return
D)net present value

Question 19

If the annual cash flows are not an annuity (equal each period), payback is calculated by

A)dividing the investment required by the average annual cash inflow.
B)dividing the average annual cash inflow by the investment required.
C)accumulating the net cash flows until they equal the initial investment.
D)Payback cannot be calculated for a project with unequal cash flows.

Question 20

The internal rate of return is the

A)rate of return that sets the project's net present value equal to zero.
B)hurdle rate.
C)cost of capital.
D)required rate of return.

Question 21

Matusadona Company plans to invest £450,000 in a new factory. With a discount rate of 14 per cent, the present value from the factory is £483,000. To yield a 14 per cent internal rate of return, the actual investment cost cannot exceed the £450,000 estimate by more than

A)£63,000.
B)£33,000.
C)£16,500.
D)This cannot be determined from the information given.

Question 22

The present value of £10,000 to be received five years from now and earning a 12 per cent return is

A)£2,774.
B)£5,670.
C)£17,637.
D)£36,050.

Question 23

The Bradshaw Company is considering purchasing equipment for £78,000. This equipment will save the company £22,000 in operating costs annually. The payback period for this equipment is

A)3.5 years.
B)4 years.
C)2.2 years.
D)0.3 years.

Question 24

Lake Kariba Company is considering buying a new boat that would cost £120,000. The accountant determined that the boat promises an internal rate of return of 10 per cent and has a life of four years. The accountant resigned and the president wanted to check her calculations. What were the approximate annual net cash inflows from the project?

A)£20,490
B)£30,000
C)£37,855
D)Net cash inflows cannot be determined from the information given.

Question 25

The present value of £8,000 to be received each year for ten years and earning a 16 per cent return is

A)£1,655.
B)£1,816.
C)£35,242.
D)£38,664.

Question 26

A firm is considering a project with annual cash flows of £75,000. The project would have a 7-year life, and the company uses a discount rate of 10 per cent. What is the maximum amount the company could invest in the project and the project still be acceptable?

A)£525,000
B)£365,100
C)£269,325
D)none of the above

Question 27

If NPV and IRR produce different rankings, which method should be used in choosing investment projects?

A)payback
B)accounting rate of return
C)net present value
D)internal rate of return

Question 28

Kaylin Company purchased a piece of equipment for £100,000 that had a useful life of 5 years. The equipment had no salvage value. It saves the company £40,000 a year and costs the company £5,000 a year to operate. What is the accounting rate of return on the equipment?

A)30%
B)15%
C)40%
D)35%

Question 29

How is working capital needed in the operations of investments treated in discounted cash flow analysis?

A)added to cost of the investment
B)added to cash inflows when recovery occurs
C)both a and b
D)none of the above

Question 30

A firm is considering a project with annual cash flows of £120,000. The project would have an 8-year life, and the company uses a discount rate of 12 per cent. What is the maximum amount the company could invest in the project and the project still be acceptable?

A)£488,740
B)£562,614
C)£580,291
D)£596,160

Question 31

Brooks Company invested in a project that is expected to have an annual cash flow of £10,000. The project's life is five years and has an IRR of 14 per cent. How much was the initial investment in the project?

A)£34,330
B)£50,000
C)£36,050
D)£29,140

Question 32

A firm is considering a project requiring an investment of £14,150. The project would generate annual cash inflows of £3,300 per year for the next seven years. The approximate internal rate of return for the project is

A)6%.
B)8%.
C)12%.
D)14%.

Question 33

Ducky Pizza Restaurant purchases a van to deliver pizzas to their customers. The van costs £28,000 and is projected to increase revenues by £10,000 a year and to increase costs by £4,500. The payback period for this van is

A)2.8 years.
B)6.2 years.
C)5.1 years.
D)0.4 years.

Question 34

The present value of £2,000 to be received three years from now and earning a 12 per cent return is

A)£1,424.
B)£1,760.
C)£2,440.
D)£2,720.

Question 35

Lewis Manufacturing Company is planning to invest in equipment costing £240,000. The estimated cash flows from this equipment are expected to be as follows: $\begin{array}{cr}\text { Year } & \text { Cash Inflows } \\1 & £ 100,000 \\2 & 75,000 \\3 & 55,000 \\4 & 40,000 \\5 & 50,000 \\\text { Total } & £ 320,000 \end{array}$ Assume that the cash inflows occur evenly over the year. The payback period for this investment is

A)3.75 years.
B)3.25 years.
C)2.4 years.
D)1.3 years.

Question 36

Why do the NPV method and the IRR method sometimes produce different rankings of mutually exclusive investment projects?

A)The NPV method does not assume reinvestment of cash flows, while the IRR method assumes the cash flows will be reinvested at the internal rate of return.
B)The NPV method assumes a reinvestment rate equal to the discount rate, while the IRR method assumes a reinvestment rate equal to the internal rate of return.
C)The IRR method does not assume reinvestment of the cash flows, while the NPV method assumes the reinvestment rate is equal to the discount rate.
D)The NPV method assumes a reinvestment rate equal to the bank loan interest rate, while the IRR method assumes a reinvestment rate equal to the discount rate.

Question 37

A firm is considering a project with annual cash flows of £40,000. The project would have a 10-year life, and the company uses a discount rate of 8 per cent. What is the maximum amount the company could invest in the project and the project still be acceptable?

A)£400,000
B)£268,400
C)£203,200
D)£363,600

Question 38

A firm is considering a project requiring an investment of £100,000. The project would generate annual cash inflows of £26,380 per year for the next five years. The approximate internal rate of return for the project is

A)8%.
B)10%.
C)12%.
D)16%.

Question 39

The present value of £2,000 to be received each year for three years and earning a 10 per cent return is

A)£5,560.
B)£4,974.
C)£4,922.
D)£4,600.

Question 40

Which of the following is NOT included in the calculation of net present value of a proposed project? (Ignore income taxes.)

A)salvage value
B)working capital
C)discount rate
D)depreciation expense

Question 41

In computing the net present value of a project, a manager uses a cost of capital number that is too low. This error causes the manager to compute a net present value that:

A)is lower that what it in fact should be.
B)is higher that what it in fact should be.
C)has no effect on the net present value computation.
D)is undefined in mathematical terms.

Question 42

A firm is considering a project with an annual cash flow of £200,000. The project would have a 7-year life, and the company uses a discount rate of 10 per cent. Ignoring income taxes, what is the maximum amount the company could invest in the project and have the project still be acceptable?

A)£718,200
B)£1,400,000
C)£973,600
D)£200,000

Question 43

A capital investment project requires an investment of £350,000. It has an expected life of ten years with annual cash flows of £50,000 received at the end of each year.
a.Compute payback for the project.
b.Determine the accounting rate of return for the project, based on the initial capital investment.
c.Compute the internal rate of return for the project.
d.Compute the net present value of the project using a 14 per cent discount rate.
e.Would you recommend this project be accepted? Why or why not?

Question 44

A capital investment project requires an investment of £75,000 and has an expected life of four years. Annual cash flows at the end of each year are expected to be as follows: $$\begin{array} { c c } \text { Year } & \text { Amount } \\1 & £ 40,000 \\2 & £ 30,000 \\3 & £ 10,000 \\4 & £ 35,000\end{array}$$
a.Compute payback assuming that the cash flows occur evenly throughout the year.
b.Compute the net present value of the project using a 12 per cent discount rate.

Question 45

Maxim, Inc., is considering two mutually exclusive projects. Project 1 requires an investment of £40,000, while Project 2 requires an investment of £30,000. Cash revenues and cash costs for each project are shown below. $\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\text { PROJECT } 1$
$\begin{array}{lrrrr}\text { YEAR }&1&2&3&4\\\text { Revenues } & £ 13,000 & £ 18,000 & £ 35,000 & £ 25,000 \\\text { Variable costs } & 7,000 & 9,000 & 12,000 & 12,000 \\\text { Fixed costs } & 1,000 & 2,000 & 3,000 & 1,000\end{array}$


$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\text { PROJECT } 2$
$\begin{array}{lrrrr}\text { YEAR }&1&2&3&4\\\text { Revenues } & £ 22,000 & £ 38,000 & £ 16,000 & £ 9,000 \\\text { Variable costs } & 12,000 & 21,000 &8,000 &5,000 \\\text { Fixed costs } &4,000 & 3,000 & 2,000 & 1,000\end{array}$
The company estimates that at the end of the fourth year Project 1 would have a salvage value of £3,000 and Project 2 would have a salvage value of £1,000.
a.Determine the net present value of EACH project using a 16 per cent discount rate.
b.Prepare a memorandum for management stating your recommendation. Include supporting calculations in good form.

Question 46

Mitchell, Inc., is considering two mutually exclusive projects. Project 1 requires an investment of £80,000, while Project 2 requires an investment of £90,000.
Cash revenues and cash costs for each project are shown below: $\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\text { PROJECT } 1$
$\begin{array}{lrrrr}\text { YEAR }&1&2&3&4\\\text { Revenues } & £ 30,000 & £ 50,000 & £ 70,000 & £ 90,000 \\\text { Variable costs } & 8,000 & 12,000 & 20,000 & 25,000 \\\text { Fixed costs } & 12,000 & 10,000 & 10,000 & 10,000\end{array}$


$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\text { PROJECT } 2$
$\begin{array}{lrrrr}\text { YEAR }&1&2&3&4\\\text { Revenues } & £ 65,000 & £ 80,000 & £ 60,000 & £ 40,000 \\\text { Variable costs } & 15,000 & 30,000 & 14,000 & 12,000 \\\text { Fixed costs } & 5,000 & 20,000 & 10,000 & 8,000\end{array}$ The company estimates that at the end of the fourth year Project 1 would have a salvage value of £10,000 and Project 2 would have a salvage value of £5,000.
a.Determine the net present value of EACH project using an 8 per cent discount rate.
b.Prepare a memorandum for management stating your recommendation. Include supporting calculations in good form.

Question 47

Van Dyke Company is evaluating a capital expenditure proposal that has the following predicted cash flows: $\begin{array}{ll}\text { Original investment }&£ 45,000\\\\\text { Year 1 } & £ 17,500 \\\text { Year 2 } & 25,000 \\\text { Year 3 } & 15,000\\\\\text { Salvage value}&-0-\\\\\text { Discount rate}&14\%\end{array}$
a.Net present value of the investment
b.Proposal's internal rate of return
c.Payback period

Question 48

A firm is considering a project with an annual cash flow of £240,000. The project would have an 8-year life, and the company uses a discount rate of 12 per cent. Ignoring income taxes, what is the maximum amount the company could invest in the project and have the project still be acceptable (rounded)?

A)£977,480
B)£1,125,228
C)£1,160,582
D)£1,192,320

Question 49

The problem with the accounting rate of return is that it fails to consider the:

A)profitability of the project.
B)life of the project.
C)timing of cash flows.
D)effect on net income.

Question 50

A capital investment project requires an investment of £450,000. It has an expected life of six years with an annual cash flow of £90,000 received at the end of each year. The company uses the straight-line method of depreciation. Ignore income taxes.
a.Compute payback for the project.
b.Compute the net present value of the project using a 12 per cent discount rate.
c.Would you recommend this project be accepted? Why or why not?

Question 51

Fill in the lettered blanks in the following table: $\begin{array}{lccc}&\text { Investment A}& \text { Investment B}& \text { Investment C }\\ \text { Amount of investment } & £ 40,000 & \text { (a) } & £ 20,000 \\ \text { Economic life in years } & 10 & 5 & 8 \\ \text { Annual cash flow } & £ 5,000 & \text { (b) } & £ 2,500 \\\text { Payback period in years } & \text { (c) } & 4 & \text { (d) } \\\text { Present value of cash flows } & (\mathrm{e}) & £ 33,000 & \text { (f) } \\\text { Net present value } & £ 5,500 & £ 3,000 & (£ 1,000)\end{array}$

Question 52

Which of the following is a capital investment criterion, but NOT captured in any of the basic capital budgeting models examined in the text?

A)the period of time required to recoup an initial investment
B)various non-quantitative factors
C)the time value of money
D)the company's discount rate

Question 53

The internal rate of return model assumes that all net cash inflows are reinvested at the:

A)project's internal rate of return.
B)discount rate.
C)prime rate.
D)none of the above.

Question 54

Five mutually exclusive projects had the following information: $\begin{array}{lccccc} & \text { A } & \text { B } & \text { C } & \text { D } & \text { E } \\\text { NPV } & £ 200 & £400 & £ 2,000 & £ 1,000 & £(400) \\\text { IRR } & 11 \% & 13 \% & 10 \% & 12 \% & 8 \%\end{array}$ Which project is preferred?

A)Project A
B)Project B
C)Project C
D)Project D

Question 55

A capital investment project requires an investment of £145,000 and has an expected life of four years. Annual cash flows at the end of each year are expected to be as follows: $$\begin{array} { c c } \text { Year } & \text { Amount } \\1 & £ 35,000 \\2 & £ 45,000 \\3 & £ 55,000 \\4 & £ 50,000\end{array}$$
a.Compute payback assuming that the cash flows occur evenly throughout the year.
b.Compute the net present value of the project using an 8 per cent discount rate.

Question 56

Which of the following capital investment models would be preferred when choosing among mutually exclusive alternatives?

A)payback period
B)accounting rate of return
C)IRR
D)NPV

Question 57

A company invests in a project that realizes an internal rate of return equal to its cost of capital. This project should:

A)increase the value of the company.
B)have little or no effect on the value of the company.
C)decrease the value of the company.
D)cause the company to realize an infinite net present value.

Question 58

Dale Davis Company is evaluating a proposal to purchase a new machine that would cost £100,000 and have a salvage value of £10,000 in four years. It would provide annual operating cash savings of £10,000, as follows: $\begin{array}{lrr}&\text { Old Machine }&\text { New Machine }\\\text { Salaries } & £ 40,000 & £ 36,000 \\\text { Supplies } & 7,000 & 5,000 \\\text { Maintenance } &\underline{9,000} & \underline{5,000} \\\text { Total } & £ 56,000 & £ 46,000\end{array}$
If the new machine is purchased, the old machine will be sold for its current salvage value of £20,000. If the new machine is not purchased, the old machine will be disposed of in four years at a predicted salvage value of £2,000. The old machine's present book value is £40,000. If kept, in one year the old machine will require repairs predicted to cost £35,000.
Dale Davis's cost of capital is 14 per cent.

Question 59

A capital investment project requires an investment of £1,000,000. It has an expected life of five years with annual cash flows of £240,000 received at the end of each year.
a.Compute payback for the project.
b.Compute the internal rate of return for the project.
c.Compute the net present value of the project using a 12 per cent discount rate. Ignore income taxes.
d.Would you recommend this project be accepted? Why or why not?

Question 60

(Memorandum required)
Simon Enterprises is considering the purchase of a flexible manufacturing system. The savings associated with the system are estimated to be as follows: $\begin{array}{lr}\text { Increased quality } & £ 75,000 \\\text { Decrease in operating costs } & 20,000 \\\text { Increase in on-time deliveries } & 5,000\end{array}$ The system will cost £400,000 and will last ten years. The system would have a salvage value of £30,000 at the end of ten years. The company's cost of capital is 8 per cent.