Deck 10: Capital Budgeting

Question 1

What are the two primary drawbacks to the payback period method?

A) Difficult to calculate; ignores time value of money
B) Difficult to calculate; only works for long projects (e.g., 5 years or more)
C) Ignores time value of money; ignores cash flows after payback is reached
D) Only works for long projects; ignores cash flows after payback is reached
E) Difficult to calculate; ignores cash flows after payback is reached

Answer 1

C

Question 2

If a project's NPV is negative:

A) the project earns less than the cost of capital.
B) the investment will not add value or contribute to shareholder wealth.
C) the present value of expected cash outflows is greater than the present value of expected cash inflows.
D) All of the above

Answer 2

D

Question 3

Which of the following is most correct?

A) Stand-alone projects with positive NPV's should always be accepted.
B) Mutually exclusive projects with positive NPV's should always be accepted.
C) Projects can be mutually exclusive even if they address totally different business issues.
D) Both a. and c. are correct.
E) All of the above are correct.

Answer 3

D

Question 4

Although quick and easy to apply, the payback method is deficient. In that it:

A) disregards the time value of money.
B) it assumes that inflows are reinvested at the internal rate of return until the end of the project's life.
C) disregards cash flows after the payback period.
D) a and c

Question 5

Mutually exclusive projects:

A) are usually different alternatives to meeting the same need.
B) occur where the acceptance or rejection of one alternative project has no bearing on the acceptance or rejection of other projects.
C) are best analyzed by the profitability index.
D) None of the above

Question 6

Which of the following best describes the reinvestment assumptions implicit in the internal rate of return (IRR) method and the net present value (NPV) method?

A) Both NPV and IRR assume cash flows are reinvested at the cost of capital.
B) NPV assumes cash flows are reinvested at the cost of capital, while IRR assumes reinvestment at the IRR.
C) IRR assumes cash flows are reinvested at the cost of capital, while NPV assumes reinvestment at the IRR.
D) Both NPV and IRR assume cash flows are reinvested at the IRR.
E) None of the above describes the reinvestment assumptions used by NPV and IRR.

Question 7

The first step in the capital budgeting process is the identification of the project's:

A) cost of capital.
B) incremental cash flows.
C) investment requirement.
D) overall cash flows.

Question 8

The internal rate of return is the rate of interest that makes the present value of a project's cash inflows:

A) greater than the present value of its cash outflows.
B) less than the present value of its cash outflows.
C) equal to the present value of its cash outflows.
D) None of the above

Question 9

Rank order the following capital project types according to level of risk, from highest risk to lowest risk.

A) Expansion, New Venture, Replacement
B) Replacement, Expansion, New Venture
C) New Venture, Replacement, Expansion
D) Expansion, Replacement, New Venture
E) New Venture, Expansion, Replacement

Question 10

Capital projects are said to be mutually exclusive when:

A) the financial viability of a single project is being evaluated.
B) two or more projects are being evaluated and doing one precludes doing another.
C) one project is much easier to do than another.
D) b and c

Question 11

Capital budgeting involves how companies spend:

A) day to day resources.
B) money raised in capital markets.
C) expenses only.
D) large sums on infrequent projects.

Question 12

Project A has a payback period of 8 years, while Project B has a payback period of 7 years. The payback policy maximum is 6 years. Which project should be accepted?

A) Project A, if they are mutually exclusive
B) Project B, if they are mutually exclusive
C) Both Project A and Project B
D) Neither Project A or Project B

Question 13

The internal rate of return (IRR) is simply the return on a project viewed as an investment. Therefore any project whose IRR exceeds the cost of capital:

A) should be undertaken if the company has the resources to do it.
B) contributes to wealth because it earns more than the cost of the money used to do it.
C) should not be undertaken because IRR isn't as good as NPV.
D) a and b

Question 14

Which of the following is most correct?

A) A project can have more than one internal rate of return.
B) If a project has more than one internal rate of return, it cannot be accurately evaluated using the IRR method.
C) Multiple IRR's arise because nth-order equations have "n" solutions, even if some of them are imaginary.
D) Both a. and c. are correct.
E) All of the above are correct.

Question 15

Risk varies with project type, and the least risky of the capital projects, in terms of the probability of making less than management's expectations is:

A) inventory management.
B) equipment replacement.
C) new business ventures.
D) expansion.

Question 16

IRR does not include the following in its analysis:

A) the time value of money.
B) all of the project's cash flows.
C) a measure of the change in shareholders wealth.
D) a clearly defined, objective decision criteria.
E) All of the above

Question 17

When using the net present value technique to evaluate the quality of an investment, if the resulting NPV is positive, the cost of capital will generally be:

A) less than the internal rate of return.
B) greater than the internal rate of return.
C) equal to the internal rate of return.
D) None of the above

Question 18

The money needed to get a project started is generally referred to as the initial outlay. It includes all cash outflows:

A) before the start of the project and in its first year.
B) throughout the life of the project.
C) before or at the start of the project, generally referred to as at time zero.
D) already spent.

Question 19

Incremental cash flows associated with capital budgeting projects can include:

A) reductions in labor costs.
B) reductions in fuel and maintenance costs.
C) increased profitability.
D) All of the above

Question 20

Payback does not include the following in its analysis:

A) the time value of money.
B) all of the project's cash flows.
C) a measure of the change in shareholders wealth.
D) All of the above

Question 21

Gamma Inc. is considering two mutually exclusive projects with the following cash flows. Based on their approximate MIRRs, which project should the company accept? Gamma's cost of capital is 8%. $\begin{array}{lll}\text { Years } & \text { Project A } & \text { Project B } \\& (\$ \text { in millions) } & (\$ \text { in millions) } \\0 & (100) & (85) \\1 & 65 & 44 \\2 & (8) & (5) \\3 & 48 & 55\end{array}$

A) Project A, as it has an MIRR of 8%
B) Project B, as it has an MIRR of 5%
C) Project A, as it has an MIRR of 6%
D) Project B, as it has an MIRR of 6%

Question 22

The payback period of a project is defined as:

A) the number of years required for cumulative profits from a project to equal the initial outlay.
B) the number of years required for the cumulative cash flows from a project to equal the initial outlay.
C) the number of years required for the cumulative cash flows from a project to equal the average investment in the project.
D) a period of time sufficient to earn a rate of return equal to the firm's cost of capital.

Question 23

The NPV and IRR techniques can give conflicting results:

A) in standalone cases where the project's NPV profile is downward sloping.
B) in mutually exclusive decisions in which the NPV profiles do not cross.
C) in mutually exclusive situations in which the NPV profiles cross anywhere.
D) in mutually exclusive decisions in which the NPV profiles cross in the first quadrant.

Question 24

A stand-alone project should be undertaken only if:

A) the cost of capital is greater than the project's IRR.
B) the cost of capital is equal to the project's IRR.
C) the cost of capital is less than the project's IRR.
D) the NPV of the project is zero.

Question 25

Technical problems associated with the internal rate of return include:

A) the possibility of multiple IRRs, which rarely present practical difficulties.
B) the assumption that all cash flows are reinvested at the IRR.
C) Neither of the above
D) Both of the above

Question 26

A project's NPV profile will cross the horizontal axis at:

A) the cost of debt.
B) the cost of capital.
C) the internal rate of return.
D) zero.

Question 27

When the NPV and IRR rules produce conflicting investment decisions, then the:

A) NPV rule is superior.
B) IRR rule is superior.
C) firm should be indifferent between the IRR rule and NPV rule.
D) payback period rule should be used.
E) a and d

Question 28

The MIRR is an interest rate that:

A) equates the present value of outflows with the present value of the future value of all inflows of a project.
B) equates the present value of all cash inflows with the cost of capital of a project.
C) is used to determine the rate of reinvestment of a project with multiple cash outflows.
D) is used to determine the net present value of a project.

Question 29

Swift Limited is considering a project with the following cash flows. Calculate the approximate MIRR of the project. The cost of capital is 10 percent. $\begin{array}{ll}\text { Year } & \text { CF } \\ & (\$) \\0 & (15,000) \\1 & 1,000 \\2 & 2,500 \\3 & (2,000) \\4 & 12,000 \\5 & 14,000\end{array}$

A) 15%
B) 25%
C) 13%
D) 14%

Question 30

One of the steps involved in calculating the MIRR is to:

A) calculate the future value of all cash outflows.
B) determine the present values of all cash outflows at the cost of capital.
C) determine the present value of cash inflows at the cost of capital.
D) subtract cash outflows from cash inflows before calculating the future value.

Question 31

The profitability index (PI) is particularly useful in comparing mutually exclusive projects:

A) with different IRR's.
B) of different lengths.
C) of different sizes.
D) where the IRR and NPV select different projects.
E) in all of the above situations.

Question 32

The most difficult part of the capital budgeting process is:

A) choosing which method to use.
B) doing the correct calculations.
C) many parts are equally important and difficult.
D) estimating the cash flows involved.

Question 33

IRR is:

A) guaranteed to give the right answer.
B) not as good as the Payback method because it's tedious and involved to calculate.
C) conceptually and mathematically very closely tied to NPV.
D) not involved in an "NPV Profile."

Question 34

Consider a project with an initial investment and positive future cash flows. As the cost of capital is increased, the:

A) IRR remains constant while NPV increases.
B) IRR decreases while NPV remains constant.
C) IRR remains constant while NPV decreases.
D) IRR increases while NPV remains constant.
E) IRR decreases while NPV decreases.

Question 35

The modified internal rate (MIRR) of return eliminates the:

A) average return problem of IRR.
B) negative cost of capital under the NPV method.
C) the reinvestment and multiple solutions problems of IRR.
D) present value problem of the payback period method.

Question 36

Which of the following statement(s) is(are) true for the application of the IRR in a capital budgeting decision?

A) The IRR must exceed the cost of capital to warrant undertaking the project.
B) The project's IRR is dependent on the project's cost of capital.
C) The IRR is similar to a bond's yield in that both generate a zero NPV.
D) a and c

Question 37

How is the MIRR better than the IRR method of capital budgeting?

A) Present and future values are calculated using the cost of capital rather than the IRR.
B) The cash inflows are projected at the beginning of the project.
C) Present value of all cash flows are considered to calculate the rate of return.
D) Cash flows are projected to the end of the project using the IRR.

Question 38

One weakness of the internal rate of return approach is that:

A) it does not directly consider the timing of the cash flows from a project.
B) it fails to provide a straightforward decision rule.
C) it implicitly assumes that the firm is able to reinvest the interim cash flows from a project at the firm's cost of capital.
D) None of the above

Question 39

The relationship between NPV and IRR is such that:

A) both approaches always provide the same ranking of alternative investment projects.
B) the IRR of a project is equal to the firm's cost of capital if the NPV of a project is $0.
C) if the NPV of a project is negative, the IRR must be greater than the cost of capital.
D) None of the above

Question 40

The main criticism of the Payback method is:

A) it doesn't use time value.
B) it ignores cash flows after the payback is reached.
C) it assumes that inflows can be reinvested at the internal rate of return.
D) a and b

Question 41

A firm's financial managers have been asked to evaluate the following investment proposals: 1. a new mainframe computer to replace an existing computer for administrative processing
2) a new assembly line to expand production capacity
3) new kitchen equipment for an existing cafeteria kitchen
4) new food vending machines to replace the existing cafeteria kitchen
Which of the above proposals are mutually exclusive?

A) 1 and 2
B) 3 and 4
C) 1, 2, and 3
D) 1, 2, 3, and 4

Question 42

A decrease in the cost of capital will cause the ____ to decrease.

A) NPV
B) IRR
C) payback period
D) None of the above

Question 43

The net present value (NPV) method assumes that cash flows are reinvested at the:

A) IRR.
B) cost of capital.
C) average rate it pays investors.
D) Both b & c

Question 44

An investment has a payback period of 5 years and a useful life of 10 years. If all other variables are held constant, which of the following changes would reduce the payback period?

A) An increase in the investment's cost
B) An increase in the investment's useful life
C) An increase in the cash inflows in years 1 and 2
D) An increase in the cash inflows in years 9 and 10
E) None of above

Question 45

Which of the following is the most difficult step in the capital budgeting process?

A) Estimating cash flows
B) Applying the capital budgeting techniques
C) Interpreting the results
D) Determining how to finance the project

Question 46

If a proposed investment's payback period is 3 years, its initial cost is $50,000, and its useful life is 10 years, which of the following must be true?

A) Cash inflows over the investment's useful life total $150,000.
B) Cash inflows over the first three years total $50,000.
C) The accounting profits generated by the investment over the first three years total $50,000.
D) None of the above

Question 47

Although the payback method suffers from several deficiencies, it is widely used because it:

A) is quick.
B) is easy to apply and understand.
C) provides a rough screening device to eliminate poor projects.
D) All of the above

Question 48

A firm's cost of capital is:

A) the time value of money calculated on the capital owned by a business.
B) the average return it pays to investors for the use of their money.
C) the cost a firm incurs while operating a business.
D) None of the above

Question 49

Which of the following techniques ignores the time value of money?

A) NPV
B) IRR
C) Payback
D) All of the above consider the time value of money.

Question 50

If a net present value analysis for a normal project gives an NPV greater than zero, an internal rate of return calculation on the same project would yield an internal rate of return ____ the firm's cost of capital.

A) greater than
B) less than
C) equal to
D) Cannot be determined from the information given

Question 51

The net present value method assumes that the cash flows over the life of the project are reinvested at:

A) the project's internal rate of return.
B) the risk-free rate.
C) the market capitalization rate.
D) the firm's cost of capital.

Question 52

The profitability index is a variation of the ____ method.

A) NPV
B) IRR
C) payback
D) Both a & c

Question 53

If the net present value of a project is positive then the:

A) project would be unacceptable under the internal rate of return method.
B) project would be acceptable under the payback method.
C) project's rate of return is greater than the firm's cost of capital.
D) All of the above are correct.

Question 54

Which of the following is NOT true regarding an NPV profile?

A) It slopes downward and to the right.
B) They slope upward and to the left.
C) It graphs NPV versus IRR.
D) It crosses the horizontal axis at IRR.

Question 55

Although NPV is the best capital budgeting technique, most executives prefer to use:

A) payback because the calculations are easy.
B) profitability index because they are familiar with ratios.
C) IRR because people are more comfortable with rates of return than with the somewhat abstract notion of a present valued dollar.
D) NPV adjusted for inflation because it overcomes the difficulties they have with the method.

Question 56

A project's ____ is the sum of the present values of all cash inflows and outflows discounted at the cost of capital.

A) NPV
B) IRR
C) payback period
D) All of the above

Question 57

The internal rate of return method assumes that the cash flows over the life of the project are reinvested at:

A) the risk-free rate.
B) the firm's cost of capital.
C) the computed internal rate of return.
D) the market capitalization rate.

Question 58

A larger interest rate will reduce all of the following, except the:

A) initial cash flow.
B) net present value.
C) present value of future cash outlays.
D) profitability index.

Question 59

Which of the following capital budgeting techniques does NOT take into account the cost of capital?

A) Payback Period
B) Net Present Value
C) Internal Rate of Return
D) Profitability Index
E) All of the above take into account the cost of capital.

Question 60

A negative NPV indicates that a project:

A) has an IRR that exceeds the cost of capital.
B) is overpriced.
C) will reduce the value of a firm if accepted.
D) b and c
E) None of the above

Question 61

A project is acceptable under the profitability index technique if its:

A) PI is less than one.
B) PI is greater than one.
C) PI is greater than zero.
D) PI is greater than the initial outlay.

Question 62

A project has the following cash flows: $\begin{array}{llllll}\text { Year } & 0 & 1 &2& 3 & 4 \\\text { Cash flow } & (\$ 240,000) & \$ 60,000 & \$ 100,000 & \$ 60,000 & \$ 80,000\end{array}$ The project's payback period is:

A) four years.
B) three and one-half years.
C) three and one-quarter years.
D) None of the above

Question 63

You are evaluating two projects with unequal lives. Purchase of a high-quality machine will result in positive cash flows for nine years, while purchase of a medium-quality machine will result in positive cash flows for six years. At the end of each respective time period, the machine is expected to be worthless. How many times will the medium-quality machine project have to be linked in order to come up with a common time period?

A) Twice
B) Three times
C) Four times
D) Nine times

Question 64

Capital rationing may:

A) require omitting projects with higher IRRs while undertaking some with lower IRRs because they fit into the budget constraint better.
B) be necessary because there is a budgetary limit on capital spending.
C) in practice be done intuitively for reasons that are not entirely financial.
D) All of the above

Question 65

Assume the following facts about a firm's financing in the next year: $\begin{array}{l}\text { Proportion of capital projects funded by debt}&=45 \% \\\text {Proportion of capital projects funded by equity }&=55 \% \\\text {Return re ceived by bondholders }&=8.0 \% \\\text {Return received by stockholders }&=14.0 \%\end{array}$ The weighted cost of capital of this project is:

A) 11.0%.
B) $113,000.
C) 11.3%.
D) 10.7%.

Question 66

Capital rationing:

A) is a technique for allocating scarce financial resources among viable projects.
B) determines which projects pass the NPV and/or IRR tests.
C) implies that all projects with positive NPVs should be undertaken.
D) generally gives terrible results when done intuitively.

Question 67

According to one study done some time ago, most small firms use the _____ method to evaluate capital projects.

A) NPV
B) IRR
C) payback
D) PI

Question 68

The future cash flows of a stand-alone capital project follow: $\begin{array}{lllll}\text { Year } &0&1&2&3\\\text { Cash flow }&(\$5,000)&\$2,500&\$2,500&\$2,500\end{array}$ If the company's cost of capital is 14%, what is the approximate NPV of the project?

A) $5,804
B) $1,217
C) $6,217
D) $804

Question 69

A project has the following cash flows: $\begin{array}{lr}0&1&2&3\\()\$500&\$100&\$200&\$250\end{array}$
What is the project's NPV if the interest rate is $6%?

A) ($17.76)
B) $482.24
C) ($537.78)
D) $22.44

Question 70

The easiest way to compare projects with unequal lives is by using:

A) IRR.
B) the replacement chain method.
C) the equivalent annual annuity method.
D) Either b or c

Question 71

The objective in solving capital rationing problems is to:

A) accept all projects with a PI greater than 1.1.
B) maximize the average IRR of the projects that are accepted.
C) maximize the total NPV of the projects that are accepted.
D) minimize the firm's cost of capital.

Question 72

Atlantis Inc. is considering two mutually exclusive projects with the following cash flows: $\begin{array}{llllll}\text { Year } & 0 & 1 & 2 & 3 & 4 \\\text { Project A } & (\$ 120,000) & \$ 60,000 & \$ 40,000 & \$ 60,000 & \$ 80,000 \\\text { Project B } & (\$ 100,000) & \$ 60,000 & \$ 50,000 & \$ 0 & \$ 0\end{array}$ If Atlantis accepts projects that pay back in two years or less, which should be undertaken?

A) Project A
B) Project B
C) Both projects
D) Neither project

Question 73

A firm has the following investment opportunities: $\begin{array}{llll}&\text { Investment }&\text { NFV }& \text { IRR } \\\text { Project A } & \$ 150,000 & \$ 30,000 & 14 \% \\\text { Project B } & \$ 125,000 & \$ 20,000 & 11 \% \\\text { Project C } & \$ 100,000 & \$ 25,000 & 13 \%\end{array}$ If the cost of capital is 10% and the capital budget is limited to $280,000, which project(s) should the firm undertake?

A) Project A and project B
B) Project A and project C
C) Project B and project C
D) Project A

Question 74

____ involves selecting projects subject to a funding limitation.

A) Capital Budgeting
B) Capital Rationing
C) Cost of Capital
D) Capital Financing

Question 75

Capital rationing requires that companies:

A) always select the projects with the highest IRR's.
B) always select projects that fit within their capital constraints.
C) may reject some projects that have an IRR higher than the cost of capital.
D) Both b. and c. are correct.
E) All of the above are correct.

Question 76

Capital rationing may involve:

A) accepting projects with negative NPVs.
B) rejecting projects with positive NPVs.
C) limitations on the number of project proposals that are submitted for evaluation.
D) allocating available capital among all project proposals with positive NPVs.

Question 77

Sentry Oil Inc. is considering two mutually exclusive projects as follows: $\begin{array}{llllll}\text { Year } & 0 &1&2&3&4\\\text { Cash flow A } & (\$ 185,000) & \$ 60,000 & \$ 75,000 & \$ 70,000 & \$ 70,000 \\\text { Cashflow B } & (\$ 125,000) & (\$ 60,000) & \$ 95,000 & \$ 90,000 & \$ 95,000\end{array}$ Sentry's a cost of capital is 14%. It can spend no more than $350,000 on capital projects this year, which of the following statements is applicable when evaluating the projects by the NPV method?

A) Both projects add shareholder wealth and should be undertaken.
B) Project B appears to add more shareholder wealth than project A and should be done.
C) Project A appears to add more shareholder wealth than project B and should be done.
D) Project B should be undertaken because it requires a smaller investment.

Question 78

A firm has the following investment opportunities: $\begin{array}{llll}&\text { Investment }&\text { NFV }& \text { IRR } \\\text { Project A } & \$ 150,000 & \$ 30,000 & 14 \% \\\text { Project B } & \$ 120,000 & \$ 20,000 & 13 \% \\\text { Project C } & \$ 100,000 & \$ 25,000 & 12 \% \\\text { Project D } & \$ 10,000 & \$ 6,000 & 11 \%\end{array}$ If the cost of capital is 10% and the capital budget is limited to $280,000, which project(s) should the firm undertake?

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

Question 79

Which of the following can be used to make a comparison of projects with unequal lives?

A) Replacement Chain Method
B) Equivalent Annual Annuity Approach
C) Profitability Index
D) Both a & b
E) All of the above

Question 80

Which of the following best describes the appropriate way to evaluate mutually exclusive projects with unequal lives?

A) NPV is the appropriate method because NPV is always the method of choice.
B) IRR is the appropriate method because IRR adjusts for the fact that the projects are not of the same length.
C) Replacement chain is the appropriate method because it equalizes the length of the unequal projects.
D) Equivalent annual annuity is the appropriate method because it adjusts for the fact that the projects are not of the same length.
E) Both c. and d. are correct.