Deck 15: Long-Run Investment Decisions: Capital Budgeting

Question 1

Which of the following is an appropriate way to measure cash flows?

A) Treat depreciation as a negative cash flow
B) Consider only pretax cash flows
C) Consider only incremental costs and revenues
D) None of the above is an appropriate way to measure cash flows.

Answer 1

Consider only incremental costs and revenues

Question 2

The net present value of a project is equal to

A) total revenue from all time periods minus total cost from all time periods.
B) the discounted present value of all future total revenue.
C) the discounted present value of all future total revenue minus the discounted present value of all future total cost.
D) None of the above is correct.

Answer 2

the discounted present value of all future total revenue minus the discounted present value of all future total cost.

Question 3

A firm can borrow at an interest rate of 5 percent. Its marginal tax rate is 40 percent. What is its cost of debt?

A) 9 percent
B) 5 percent
C) 3 percent
D) 1 percent

Answer 3

3 percent

Question 4

The method of raising funds for capital investment that involves the least amount of risk to the firm is

A) issuing common stock.
B) borrowing by selling bonds.
C) relying on retained earnings.
D) borrowing directly from a bank.

Question 5

If the beta coefficient for a firm's stock is negative, then

A) a decrease in the average price of all stocks is likely to be associated with a decrease in the price of the firm's stock.
B) an increase in the average price of all stocks is likely to be associated with a decrease in the price of the firm's stock.
C) a change in the average price of all stocks is likely to have little or no effect on the price of the firm's stock.
D) a calculation error must have been made, because beta cannot be negative.

Question 6

A firm is likely to select a higher debt-to-equity ratio if

A) interest rates are unusually high.
B) both corporate and individual income taxes are expected to increase in the near future.
C) the firm is very risk averse.
D) All of the above would be likely to increase the debt-to-equity ratio.

Question 7

Which of the following is one of the categories used by firms to classify investment projects?

A) Replacement
B) Cost reduction
C) Government regulation
D) All of the above are categories used to classify investment projects.

Question 8

A firm has found that the net present value of a project is equal to zero. The net present value was calculated using the firm's risk-adjusted discount rate of 15 percent. Based on this information, your conclusion is

A) the internal rate of return on the project is greater than 15 percent.
B) the internal rate of return on the project is equal to 15 percent.
C) the internal rate of return on the project is less than 15 percent.
D) the internal rate of return on the project may be greater than, equal to, or less than 15 percent depending on which method was used to adjust the firm's discount rate for risk.

Question 9

If the net present value (NPV) method and the internal rate of return (IRR) method are both applied to the comparison of two mutually exclusive projects,

A) both can be expected to yield the same conclusion.
B) if they yield conflicting conclusions, then the conclusion implied by the NPV method should be followed.
C) if they yield conflicting conclusions, then the conclusion implied by the IRR method should be followed.
D) if they yield conflicting conclusions, then a third method should be used to resolve the conflict.

Question 10

Which of the following could be expected to increase the calculated net present value (NPV) of a project that is being considered by a firm?

A) An increase in the firm's aversion to risk
B) A decrease in the cost of capital
C) An increase in the initial cost of the project
D) All of the above would increase the NPV.

Question 11

A firm that is considering one independent project should accept it if

A) the internal rate of return on the project exceeds the firm's cost of capital.
B) the net present value of the project is less than zero.
C) the firm's cost of capital exceeds the internal rate of return.
D) None of the above is correct.

Question 12

The profitability index for a project that has an initial cost of $500 is equal to one when the firm's risk-adjusted discount rate is equal to 11 percent,

A) so the project's internal rate of return is greater than 11 percent.
B) so the project's net present value is equal to zero.
C) so the project's net present value is equal to $500.
D) None of the above is correct.

Question 13

The internal rate of return on a project with an initial cost of $500 is 7.5 percent, so at a discount rate of 7.5 percent

A) the profitability index will be equal to one.
B) the net present value of the project will be equal to zero.
C) the present value of future net revenue will be equal to $500.
D) All of the above are correct.

Question 14

A firm that uses a discount rate of 11 percent calculated the net present value of a project and found it to be $123, so

A) the internal rate of return must be less than 11 percent.
B) the profitability index must be between zero and one.
C) the firm should implement the project.
D) All of the above are correct.

Question 15

A firm that must raise all of the funds required for a project by borrowing at an interest rate of 12 percent has a marginal tax rate of 50 percent. Which of the following independent projects should the firm undertake?

A) A project with an internal rate of return of 19 percent
B) A project with an internal rate of return of 13 percent.
C) A project with an internal rate of return of 8 percent.
D) All of the above should be undertaken.

Question 16

A firm plans to raise $4 million by borrowing at an interest rate of 16 percent and to raise $1 million by issuing common stock. The firm's stock has a beta coefficient of 2, the risk-free interest rate is 6 percent, the average rate of return on stocks is 9 percent, and the marginal tax rate is 25 percent. What is the firm's composite cost of capital?

A) 9 percent
B) 12 percent
C) 15 percent
D) 18 percent

Question 17

A firm plans to raise $4 million by borrowing at an interest rate of 16 percent and to raise $1 million by issuing common stock. The firm's stock has a beta coefficient of 2, the risk-free interest rate is 6 percent, the average rate of return on stocks is 9 percent, and the marginal tax rate is 25 percent. What is the firm's cost of equity capital?

A) 9 percent
B) 12 percent
C) 15 percent
D) 18 percent

Question 18

A firm plans to raise $4 million by issuing common stock. The firm's stock has a beta coefficient of 1.5, the risk-free interest rate is 8 percent, the average rate of return on stocks is 10 percent, and the marginal tax rate is 40 percent. What is the firm's cost of equity capital?

A) 6 percent
B) 9 percent
C) 11 percent
D) None of the above is correct.

Question 19

A firm plans to raise $4 million by issuing bonds and $1 million by issuing stock. The firm's cost of debt is 5 percent and its cost of equity is 10 percent. What is its composite cost of capital?

A) 6 percent
B) 7.5 percent
C) 9 percent
D) None of the above is correct.

Question 20

The stock of a firm that pays an annual dividend of $10 and has a marginal tax rate of 40 percent is selling for $100. What is the firm's cost of equity capital?

A) 6 percent
B) 10 percent
C) 14 percent
D) None of the above is correct.

Question 21

The process of planning expenditures that will influence the operation of a firm over a number of years is called

A) investment.
B) capital budgeting.
C) net present valuation.
D) dividend valuation.

Question 22

Which of the following is not an example of a capital investment project?

A) Replacement of worn-out equipment
B) Expansion of production facilities
C) Development of employee training programs
D) All of the above are examples of capital investment projects.

Question 23

A firm is considering three investment projects, which we will refer to as A, B, and C. Each project has an initial cost of $10 million. Investment A offers an expected rate of return of 16 percent, B of 8 percent, and C of 12 percent. The firm's cost of capital is 6 percent if it borrows $10 million, 10 percent if it borrows $20 million, and 15 percent if it borrows $30 million. Which project(s) should the firm invest in?

A) Just A, because it offers the highest rate of return and is the only investment that has a rate of return higher than 15 percent
B) All three should be undertaken, because the rate of return on B is above 6 percent, on C is above 10 percent, and on A is above 15 percent
C) Only A and C should be undertaken because both have rates of return that are greater than 10 percent
D) None of the above is correct.

Question 24

Which of the following is not an appropriate way to measure cash flows?

A) Treat depreciation as a negative cash flow
B) Consider only incremental costs and revenues
C) Consider only after-tax cash flows
D) All of the above are appropriate ways to measure cash flows.

Question 25

The net present value of a project is equal to

A) the present value of all net cash flows that result from the project.
B) the present value of all revenues minus the present value of all costs that result from the project.
C) the present value of all future net cash flows that result from the project minus the initial investment required to start the project.
D) All of the above are correct.

Question 26

The net present value method and the internal rate of return method will always yield the same decision when

A) a single project is evaluated.
B) mutually exclusive projects are evaluated.
C) a limited number of projects must be selected from a large number of opportunities.
D) All of the above are correct.

Question 27

Which of the following is not a form of capital as the term is used in economics?

A) Houses owned by individuals
B) Factories owned by businesses
C) Education
D) Money

Question 28

In cases where capital must be rationed, a firm should rank projects according to their

A) net present values.
B) internal rates of return.
C) profitability indexes.
D) external rates of return.

Question 29

Which of the following is an internal source of investment funding?

A) Issuing bonds
B) Sale of stocks
C) Undistributed profits
D) All of the above are internal sources.

Question 30

A firm can borrow at an interest rate of 10 percent. Its marginal tax rate is 40 percent. What is its cost of debt?

A) 10 percent
B) 14 percent
C) 6 percent
D) None of the above is correct.

Question 31

The method of raising funds for capital investment that involves the greatest risk to the firm is

A) borrowing by selling bonds.
B) relying on retained profits.
C) issuing common stock.
D) raising the dividend rate.

Question 32

Which of the following sources of funds for capital investment involves a tax adjustment to determine the cost of capital?

A) Retained profits
B) Issuing debt
C) Issuing common stock
D) All of the above involve a tax adjustment.

Question 33

Assume that the risk-free interest rate is 6 percent and that a firm can issue bonds at an interest rate of 9 percent. Assume further that the difference between the average yield on stocks and the average yield on corporate bonds is 4 percent. What is the risk premium associated with the firm's cost of equity capital?

A) 15 percent
B) 13 percent
C) 7 percent
D) 4 percent

Question 34

Assume that investors require a rate of return of 10 percent to invest in a firm that pays a dividend of $2 per year. The price of the firm's stock is currently based on the assumption that the firm's dividend will remain constant. By how much will the price of the firm's stock increase if the firm begins to grow at a rate of 2 percent per year and is expected to continue to do so indefinitely?

A) $25
B) $20
C) $10
D) $5

Question 35

The beta coefficient is associated with

A) the capital asset pricing model.
B) the dividend valuation model.
C) the risk-free rate plus premium model.
D) the tax-adjusted cost of debt.

Question 36

Assume that the risk-free rate is 5 percent and that the rate of return on a balanced portfolio of common stocks is 9 percent. If a firm has a beta coefficient of 2, then its risk premium is

A) 18 percent.
B) 10 percent.
C) 8 percent.
D) 4 percent.

Question 37

A firm must raise $10 million dollars in funding for a capital investment project. Two million dollars will be raised by issuing debt with an interest rate of 10 percent, while the remainder will be raised by issuing stocks that will yield a return of 12 percent. The firm's marginal tax rate is 30 percent. What is the firm's composite cost of capital?

A) 15 percent
B) 12 percent
C) 11 percent
D) 10 percent

Question 38

The debt-to-equity ratio that is selected by a firm depends on

A) the attitude of the firm toward risk.
B) the cost of debt and the cost of equity capital.
C) the nature of the firm's business.
D) All of the above are correct.

Question 39

The review of projects after they have been implemented is called

A) capital budgeting.
B) a postaudit.
C) blame spreading.
D) context correlation.

Question 40

According to the Gitman and Forrester study published in 1977, the two most commonly used capital budgeting techniques are

A) net present value and profitability index.
B) internal rate of return and payback period.
C) net present value and average rate of return.
D) profitability index and average rate of return.

Question 41

Assume that each of the following projects have the same costs (1,000). The discount rate is 3%. The payoffs from the projects are presented in the table below:
Based on this information, which project would you recommend?
$$\begin{array} {| l c c c | } \hline& { \text { Project } } \\\text { at the end of year 1 } & 500 & \text { B } & \text { C } \\\text { at the end of year 2 } & 500 & 250 & 500 \\\text { at the end of year 3 } & 500 & 250 & 1000 \\\hline\end{array}$$

A) A
B) B
C) C
D) None

Question 42

Consider three stocks (A, B, and C) with three different beta coefficients. Beta A is 0.9, beta B is 0.7, and beta C is -0.5. If an investor holds shares of A and wishes to diversify their portfolio and limit the risk from a decline in the overall stock market, they should add to their portfolio

A) More shares of A
B) Shares of B
C) Shares of C
D) None of the above as the position is already diversified

Question 43

What is the firms cost of debt if the firm can borrow at 7 percent and its marginal tax rate is 25 percent?

A) 3.25 percent
B) 5.25 percent
C) 18 percent
D) 32 percent

Question 44

A firm that uses a discount rate of 10 percent calculated the internal rate of return of a project to be 11% so

A) the net present value of the project is negative.
B) the profitability index is between 0 and 1.
C) the present value of the future net revenue is less than the initial investment.
D) the net present value is positive.

Question 45

If the firm uses a discount rate of 10%, which of the following projects would increase the firm's value assuming the projects are not mutually exclusive?
$$\begin{array} { | l | l | l | l | l | } \hline \text { Project } & \text { A } & \text { B } & \text { C } & \text { D } \\\hline \text { IRR } & 5 \% & 14 \% & 7 \% & 11 \% \\\hline\end{array}$$

A) A and C
B) B and D
C) B, C and D
D) A, B, C and D

Question 46

The firm is considering a project which has an initial cost of $1,000,000 and will have a single return of 1,100,000 in one year. If the risk-adjusted discount rate is 9 percent, should the firm invest to this project?

A) It should not because NPV is negative.
B) It should not because IRR is greater than the discount rate.
C) It should because NPV is positive.
D) It should because IRR is less than the discount rate.

Question 47

The firm has computed the net present value of the two-period project to be negative. What does this mean about the internal rate of return?

A) Internal rate of return is smaller than the discount rate.
B) Internal rate of return is greater than the discount rate.
C) Internal rate of return equals the discount rate.
D) Not enough information to say anything about IRR.

Question 48

The firm is considering two investment projects, A and B. If the firm is able to compute only the net present value or the internal rate of return. Which of the two measures is more reliable?

A) The internal rate of return.
B) Net present value.
C) Both always give the same recommendation.
D) Not enough information.

Question 49

If the firm projects next year's sales to be $1,000,000, variable costs to be $250,000, fixed costs to be $250,000, depreciation to be $100,000 and income taxes to be $100,00, what is the firm's profit before taxes?

A) $300,000
B) $400,000
C) $500,000
D) $750,000

Question 50

If the firm projects next year's sales to be $1,000,000, variable costs to be $250,000, fixed costs to be $250,000, depreciation to be $100,000 and income taxes to be $100,00, what is the firm's profit after taxes?

A) $300,000
B) $400,000
C) $500,000
D) $750,000

Question 51

If a firm projects next year's sales to be $1,000,000, variable costs to be $250,000, fixed costs to be $250,000, depreciation to be $100,000 and income taxes to be $100,00, what is the firm's net cash flow?

A) $300,000
B) $400,000
C) $500,000
D) $750,000

Question 52

A firm estimates the two cash flows of the project in the next two years to be $100,00 and $200,000, consecutively. If the initial investment is $200,000 and the risk-adjusted discount rate is 10%, what is the approximate net present value of the project?

A) $0
B) $24,000
C) $56,000
D) $91,000

Question 53

A firm has an opportunity to invest in the project with only one positive future cash flow of $150,000. What is the internal rate of return of the project if the initial cost is $125,000?

A) -17.67 percent
B) 0 percent
C) 17.67 percent
D) 20 percent

Question 54

A firm has an opportunity to invest in the project with only one positive future cash flow of $150,000. What is the internal rate of return of the project if the initial cost is $150,000?

A) -10 percent
B) 0 percent
C) 10 percent
D) 100 percent

Question 55

A firm, which uses a discount rate of 10 percent, has an opportunity to invest in the project with only one positive future cash flow of $150,000. Approximately, what is the profitability index of the project if the initial cost is $125,000?

A) -1.1
B) 0.1
C) 1.1
D) None of the above.

Question 56

A firm, which uses a discount rate of 10 percent, has an opportunity to invest in the project with only one positive future cash flow of $150,000. Approximately, what is the profitability index of the project if the initial cost is $150,000?

A) -0.9
B) 0.9
C) 1.1
D) None of the above

Question 57

What should the price of a share of common stock be according to dividend valuation model if the dividends are expected to stay at $1 per share indefinitely and the investors' discount rate is 5 percent?

A) 1.05
B) 5
C) 10
D) 20

Question 58

What should the price of a share of common stock be according to dividend valuation model if the dividends are expected to stay at $1 per share indefinitely and the investors' discount rate is 10 percent?

A) 1.05
B) 5
C) 10
D) 20

Question 59

What should the price of a share of common stock be according to dividend valuation model if the dividends are expected to grow 2 percent per year, the next dividend is $2.00 and the investors' discount rate is 7 percent?

A) 10
B) 20
C) 30
D) 40

Question 60

A dividend is growing 5 percent per year and the upcoming dividend is $5. If s share of stock is selling for $100, what is the investors' required rate of return?

A) 0 percent
B) 5 percent
C) 10 percent
D) 20 percent

Question 61

What is the weighted cost of capital if the firm's capital structure is 40 percent debt, the cost of debt is 10 percent, the cost of equity is 12 percent and the marginal tax rate is 30 percent?

A) 2.8 percent
B) 7.2 percent
C) 10 percent
D) 15 percent

Question 62

What is the weighted cost of capital if the firm's capital structure is 40 percent capital, the cost of debt is 10 percent, the cost of equity is 12 percent and the marginal tax rate is 30 percent?

A) 4.2 percent
B) 4.8 percent
C) 7 percent
D) 9 percent

Question 63

Investment decisions involve costs and revenues that extend over a number of years.

Question 64

One of the reasons that capital budgeting is so important is that major capital investment projects are generally irreversible.

Question 65

A firm should continue to increase its level of capital investment so long as the rate of return on the least profitable investment project that the firm undertakes is less than the marginal cost of capital.

Question 66

In calculating net cash flows, depreciation is treated as a cost.

Question 67

In general, a firm should undertake a project only if the net present value is positive.

Question 68

In general, a firm should undertake any project that has an internal rate of return that is positive.

Question 69

If the internal rate of return is used to discount all cash flows associated with a project, the net present value of the project will be equal to zero.

Question 70

Calculation of the internal rate of return incorporates the implicit assumption that net cash flows from a project can be reinvested at the internal rate of return.

Question 71

If the net present value method and the internal rate of return method yield contradictory results, the latter should be followed rather than the former.

Question 72

A house that is owned by an individual is referred to as human capital, whereas a house that is owned by a corporation is referred to as nonhuman capital.

Question 73

The profitability per dollar invested is referred to as the profitability index.

Question 74

One problem with the profitability index is that it ignores the time value of money.

Question 75

In the absence of capital rationing, a firm should undertake all projects with a profitability index greater than zero.

Question 76

One advantage of using internal funding to support investment projects is that the firm experiences no economic cost of capital for internal funding.

Question 77

The cost of debt should generally be figured on an after-tax basis.

Question 78

The difference between the external and internal cost of raising equity capital is due to flotation costs.

Question 79

The cost of raising equity capital should generally be figured on an after-tax basis.

Question 80

The rate of return that stockholders require to invest in a firm is the cost of equity capital.