Deck 18: Capital Investment Decisions

Question 1

The accounting rate of return (ARR) is a traditional method of project evaluation, which involves dividing either the average net profit by the average book value of the investment, or the average net profit by the total initial investment value.

Answer 1

True

Question 2

In which of the following situations would it not be useful to apply the concepts and techniques used in capital investment decisions?

A) A company is considering the purchase of a new machine that would reduce the cost of direct labour in the production process.
B) A company is comparing the profitability and capital investments of two district offices to determine which one has the best current return on investment.
C) A company is reviewing the past performance of two investment projects to determine which project had the best five-year return on the investment made.
D) A company is evaluating the potential investment in research and development expenses to develop a new product line.

Answer 2

B

Question 3

An entity is contemplating investing in a long-term project. A comparison of two mutually exclusive projects reveals that Project A involves an initial outlay of $6000 with cash inflows of $2600 for years 1-5, whereas Project B requires a cash outlay of $4500 with cash inflows of $1300 for years 1-5. Based on this information, the IRR for Project A is higher than the IRR for Project

Answer 3

True

Question 4

The payback period provides some assessment of risk, with a longer payback period indicating a lower risk for the project.

Question 5

Which of the following does not affect a capital investment decision?

A) Cash flows
B) Accrual-basis net profit
C) Risk
D) All of the above affect capital investment decisions

Question 6

Capital investment decisions include mutually exclusive projects where the acceptance of one project results in the rejection of another project or projects.

Question 7

The accounting rate of return does not consider:

A) cost of investment.
B) profitability.
C) the time value of money.
D) depreciation.

Question 8

An alternative approach to using the algebraic equation for calculating the internal rate of return is to use trial and error.

Question 9

For mutually exclusive projects, the IRR and NPV can give different rankings, but for independent conventional cash flow projects the rankings will be the same.

Question 10

What is the average annual accounting rate of return based on the average book value of the investment?

A) 40%
B) 60%
C) 100%
D) 120%

Question 11

What is the average annual accounting rate of return on the initial total investment?

A) 10%
B) 20%
C) 60%
D) 70%

Question 12

A problem with calculating the internal rate of return is that it relies on the estimation of future cash flows, which can be inaccurate, thus making the IRR less reliable.

Question 13

A common characteristic of the internal rate of return and the accounting rate of return is that both use the concept of a rate of return.

Question 14

The payback period is a method used to assist in making decisions about capital investments, and looks at the time required to recover the initial investment.

Question 15

For a project that has an initial outflow of $10 000 and equal inflows of $3400 for four years, the NPV at a minimum rate of return of 20% will be ($1198) and should not be accepted.

Question 16

What is a disadvantage of using the accounting rate of return?

A) It links long-term decision making to profit as the measure of success.
B) It is easy to understand.
C) It uses accounting measures of profit rather than cash flows.
D) None of the above.

Question 17

Which of the following is not an advantage of the accounting rate of return method?

A) It is easy to understand.
B) It includes the time value of money.
C) It is simple to calculate.
D) The profit ratio is familiar to managers.

Question 18

Where two projects have the same investment outlays and project lives but different net cash inflows, the IRR and NPV may give different rankings.

Question 19

Guerdon Ltd is reviewing a project that has an initial outlay of $3m. The project will generate a cash inflow of $2m per annum. The project is expected to have a useful life of six years and a zero salvage value. This company uses straight-line depreciation. What is the average annual accounting rate of return on the initial total investment?

A) 15%
B) 20%
C) 33%
D) 50%

Question 20

The internal rate of return is the rate of return that discounts the cash flows of a project so that the present value of cash inflows equals the present value of expected profits.

Question 21

Which of the following statements is true concerning the future value of an investment?

A) The difference between the future and present values of an investment is the annuity.
B) The future value of an investment is expected to be larger than its present value.
C) The future value of an investment is expected to be smaller than its present value.
D) The future value of an investment is always smaller than its present value.

Question 22

Using the tables provided, calculate the IRR of two investments and select the best combination of answers. Present value of $1 to be received after N periods:
IRR Project A
IRR Project B

A) 9%
12%
B) 9%
7%
C) 9%
14%
D) 10%
12%

Question 23

The Sparks Sailboat Company has just acquired new manufacturing equipment. No down payment was made, but four year-end payments of $2400 will be required to pay for the machine. If 8% is the appropriate rate, at what amount should Sparks Sailboat Company record the new equipment on its books? (PV annuity at 8% for four years is 3.312, five years is 3.993)

A) $7056
B) $7949
C) $9581
D) $13 060

Question 24

Based on the following information, what is the payback period for the two investment projects? Select the best combination.

A) 6.4 years 5.6 years
B) 5.4 years 4.6 years
C) 6.5 years 5.5 years
D) 5.4 years 5.6 years

Question 25

Net present value (NPV) is an important concept used to analyse capital investment projects. NPV can best be described as:

A) the amount that should be used to discount the future cash flows to the present, and then compared with the current investment.
B) the amount that must be invested now to earn a particular future value.
C) the difference between the future cash inflows and the discounted cost of the investment.
D) the difference between the discounted future cash inflows and the cost of the investment.

Question 26

The difference between future value and present value is:

A) cost.
B) annuity.
C) apportionment.
D) interest.

Question 27

Which of the following is not an advantage of IRR?

A) It uses the concept of a rate of return, which is familiar to many managers.
B) It incorporates the time value of money by not treating cash received in different years as equal.
C) There is only one IRR for every investment.
D) It uses cash flows and not profits, and the payment of cash outflows is more closely aligned with cash inflows than profits would be.

Question 28

The ____ value of an amount is the value of that amount at a later date.

A) Present
B) Fair
C) Future
D) Prospective

Question 29

Phil's Fish Shack Ltd wants to purchase machinery costing $20 000. The machinery is expected to have a life of two years and a zero residual value at the end of that time. The company uses a discount rate of 10%. The net cash inflows for each year are forecast to be: Year 1 $12 000
Year 2 $16 000
What is the approximate net present value of the investment to the nearest whole dollar?

A) $4131
B) $5452
C) $8000
D) $20 000

Question 30

Using the tables provided, calculate or estimate the internal rates of return (IRR) that are the closest to those listed for the two projects. Present value of $1 to be received after N periods:
IRR IRR
Project A Project B

A) 10.0% 11.5%
B) 11.5% 12.0%
C) 10.0% 12.0%
D) 11.0% 13.5%

Question 31

What is an advantage of the payback method of reviewing capital investments?

A) It is based on accounting information.
B) It considers the timing of all cash flows.
C) It is based on non-cash flow information.
D) It provides some assessment of risk.

Question 32

A positive net present value indicates that:

A) the IRR is less than the discount rate.
B) the cost of capital is greater than the present value of the future cash inflows.
C) the projected return on the investment is expected to exceed the cost of capital plus the cost of the initial investment.
D) the IRR is less than the cost of capital.

Question 33

What is the internal rate of return for a project that has an initial outlay of $65 000 and expected cash inflows of $9456 per year for eight years?

A) 3%
B) 3.5%
C) 4%
D) 6.8%

Question 34

The payback period is:

A) the length of time required for cash inflows from the project to recover the initial investment.
B) the length of time required for profits from the project to equal the original cash outlay.
C) the length of time required for the cash flows from the project to be expressed as a percentage of the original capital.
D) none of the above.

Question 35

Which of the following statements is true concerning the present value of an investment?

A) The difference between the future and present values of an investment is the annuity.
B) The present value of an investment is expected to be larger than its future value.
C) The present value of an investment is expected to be smaller than its future value.
D) The present value of an investment is always larger than its future value.

Question 36

Ridge NL is considering investing in a new project. Given the following information, which project would Ridge choose if a maximum payback period of 5.8 years is set?

A) Project B, as the payback period is less than 5.8 years.
B) Both projects, as the payback periods are less than 5.8 years.
C) Project A, as the payback period is less than 5.8 years.
D) Neither project, as both payback periods exceed 5.8 years.

Question 37

Guerdon Ltd is reviewing a project that has an initial outlay of $3m. The project will generate a cash inflow of $2m per annum. The project is expected to have a useful life of six years and a zero salvage value. This company uses straight-line depreciation. What is the payback period?

A) 0.67 years
B) 1.5 years
C) 2.0 years
D) 6 years

Question 38

The Orgonne Milling Company is contemplating the purchase of new equipment. The machinery is expected to generate increased sales of $50 000 per year over its five-year life. Excluding the cost of the machinery, additional costs are expected to be $15 000 per year. If the firm requires a minimum 12% return on its investment, what is the maximum price the company can pay for this equipment? (PV annuity at 12% for five years is 3.604)

A) $180 200
B) $175 000
C) $126 140
D) $54 072

Question 39

Which of the methods of evaluating capital investment projects does not consider all of the future cash flows related to a project?

A) Net present value (NPV)
B) Internal rate of return (IRR)
C) Payback method
D) All are correct

Question 40

Companies evaluating capital investment projects frequently use net present value analysis to make decisions about which projects are likely to be the most profitable. Cash flows are projected for future periods and then discounted to the present. A common rate to use when discounting these cash flows is the:

A) internal rate of return.
B) weighted cost of capital.
C) prime rate of interest.
D) accounting rate of return.

Question 41

A business is for sale at $100 000. Discounting the expected cash inflows and expected cash outflows (except the purchase price) at 12% yields an amount of $94 741. Based on this information:

A) the minimum price you should pay for the business is $94 741.
B) at a purchase price of $100 000, the business is projected to earn just a little more than 12%.
C) a higher discount rate would make this business opportunity more attractive.
D) the investment opportunity should be rejected if a 12% return is required.

Question 42

The Tearess Company can accept either Proposal A or Proposal B (but not both), or it can reject both investment proposals. Proposal A requires an investment of $7000 and promises increased net cash inflows of $2600 for five years. Proposal B requires an investment of $7000 and promises increased net cash inflows of $3000 in each of the first three years, $2000 in the fourth year and $2200 in the fifth year. The company's minimum acceptable rate of return is 20%.
Prepare an analysis to determine which (if either) of the proposals should be selected for investment.
Discount factors for 20%:

Question 43

You have an opportunity to purchase the Kuppajo Cafe, a busy shop near your office. The owner is asking $49 000. After satisfying yourself as to the accuracy of the firm's past financial statements, you note that it generated $12 000 per year in net cash flow. You believe you could operate the business for four years and sell it for $30 000. What is the maximum amount you would be willing to pay for the business if you wished to earn at least a 10% return on your investment?

A) $33 467
B) $58 528
C) $68 690
D) $95 096

Question 44

Describe the accounting rate of return (ARR) and payback period methods of evaluating capital projects, including the formula and decision criterion associated with each method.

Question 45

Earning interest in one period on interest earned in an earlier period is known as:

A) simple interest.
B) compound interest.
C) combined interest.
D) composite interest.

Question 46

Which of the following combinations of interest rate and number of periods is needed for calculation of the present value of an investment that involves an annual interest rate of 12% for three years with monthly compounding? Number of periods Interest rate

A) 3 12%
B) 6 6%
C) 12 3%
D) 36 1%

Question 47

If you placed $1000 in a savings account today, how much would you have one year from now if the bank paid 8% interest?

A) $1800
B) $1080
C) $1008
D) $1000

Question 48

An annuity is a series of:

A) equal amounts paid or received over a specified number of unequal time periods.
B) unequal amounts paid or received over a specified number of equal time periods.
C) equal amounts paid or received over an unspecified number of equal time periods.
D) equal amounts paid or received over a specified number of equal time periods.

Question 49

The Bee Family Fun Centre is for sale at an asking price of $400 000. The audited financial statements show that the business generates approximately $43 000 per year in net cash flow. You believe you could operate the business for three years and sell it for $500 000. What is the maximum amount you would be willing to pay for the business if you wished to earn at least a 10% return on your investment?

A) $629 000
B) $500 000
C) $482 582
D) $375 655

Question 50

Which of the following will increase future value relative to present value?

A) A higher interest rate
B) A shorter period
C) More safety
D) Less risk

Question 51

Describe the major disadvantages of using the accounting rate of return (ARR) and payback period methods as bases for evaluating capital projects.

Question 52

Harglo Construction is considering purchasing a radio antenna for broadcasting to service trucks over the airwaves, rather than using telephone lines. The antenna is expected to reduce cash operating costs by $2000 the first year, $2500 the second year, and $3000 the third year. The antenna will cost $6000, will last three years (due to technological advances), and will have no residual value at the end of its life. Harglo's minimum acceptable rate of return is 8%.

Question 53

An entity is contemplating investing in a long-term project. A comparison of two mutually exclusive projects reveals that Project A has an initial outlay of $10 000 with cash inflows of $3400 for years 1-5; Project B has a cash outlay of $4500 with cash inflows of $1400 for years 1-5. If the minimum rate of return is 20%, which of the following statements is incorrect?

A) The internal rate of return suggests that Project A would be accepted and Project B would not.
B) The net present value suggests that Project A would be accepted and Project B would not.
C) The net present value for Project B is a negative amount.
D) If the projects were not mutually exclusive, the net present values would suggest that both projects should be selected.

Question 54

Which of the following formulas would you use to correctly calculate the future amount of an investment of $600 that was earning interest at 8% annually for three years?

A) $600 * 1.08 * 1.08 * 1.08
B) $600 * 1.08 * 3
C) 3 * $600 * 0.08
D) (1.08 * 3) * $600

Question 55

First Time Cinema, Inc. is a small company that produces movies for artists who have little prior experience in the film industry. Because of the high risk associated with these projects, the company will not accept projects that have a payback period of more than three years. The company is considering three projects and requests your assistance in evaluating their potential given their projected cash flows.

Question 56

The ____ value of an amount is the value of that amount on a particular date prior to the time the amount is paid or received.

A) present
B) current
C) contemporary
D) coetaneous

Question 57

A series of equal amounts received or paid over a specified number of equal time periods is known as an:

A) allotment.
B) apportionment.
C) annuity.
D) allowance.

Question 58

Which of the following best expresses the concept of compound interest?

A) Calculating interest on an annuity
B) Earning interest on interest already earned
C) Making complicated interest calculations
D) Making more than one interest payment

Question 59

Using the tables provided, calculate the net present value (NPV) of each of the following projects and select the best answer from the choices given. The applicable discount rate is 11%. Present value of $1 to be received after N periods:
NPV
Project A
NPV
Project B

A) $24 820
$93 072
B) ($180)
$93 072
C) ($180)
$13 072
D) $24 820
$13 072

Question 60

The Sloppy Jeans Company is considering the purchase of a machine that would increase the company's cash inflows by $12 000 per year for six years. Operation of the machine would increase the company's cash payments by $400 in each of the first three years, $800 the fourth year, and $1000 in the fifth and sixth years. The machine costs $50 000 and would have a residual value of $2000 at the end of the sixth year.

Question 61

Second Time Cinema, Inc., is a small company which produces movies for artists who have some prior experience in the film industry. Because of the high risk associated with these projects, the company will not accept projects that have an average Accounting Rate of Return of less than 25%. The company is considering three projects and requests your assistance in evaluating their potential given their projected cash flows. All of the initial investments are assets which have an estimated life of five years and will be depreciated on a straight-line basis.

Question 62

A company is considering two projects with the following cash flows: (Albright, 12, p.4)
Present value of $1 to be received after N periods:
Present value of an annuity of $1 for N periods: