Chap010 - Making Capital Investment Decisions
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Chapter 10 - Making Capital Investment Decisions
Chapter 10
Making Capital Investment Decisions
Multiple Choice Questions
1. The difference between a firm's future cash flows if it accepts a project and the firm's future
cash flows if it does not accept the project is referred to as the project's:
A. incremental cash flows.
B. internal cash flows.
C. external cash flows.
D. erosion effects.
E. financing cash flows.
2. The fact that a proposed project is analyzed based on the project's incremental cash flows is
the assumption behind which one of the following principles?
A. underlying value principle
B. stand-alone principle
C. equivalent cost principle
D. salvage principle
E. fundamental principle
3. Which one of the following costs was incurred in the past and cannot be recouped?
A. incremental
B. side
C. sunk
D. opportunity
E. erosion
4. The option that is foregone so that an asset can be utilized by a specific project is referred to as which one of the following?
A. salvage value
B. wasted value
C. sunk cost
D. opportunity cost
E. erosion
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Chapter 10 - Making Capital Investment Decisions
5. Which one of the following best describes the concept of erosion?
A. expenses that have already been incurred and cannot be recovered
B. change in net working capital related to implementing a new project
C. the cash flows of a new project that come at the expense of a firm's existing cash flows
D. the alternative that is forfeited when a fixed asset is utilized by a project
E. the differences in a firm's cash flows with and without a particular project
6. Which one of the following best describes pro forma financial statements?
A. financial statements expressed in a foreign currency
B. financial statements where the assets are expressed as a percentage of total assets and costs are expressed as a percentage of sales
C. financial statements showing projected values for future time periods
D. financial statements expressed in real dollars, given a stated base year
E. financial statements where all accounts are expressed as a percentage of last year's values
7. Which one of the following is the depreciation method which allows accelerated write-offs of property under various lifetime classifications?
A. IRR
B. ACRS
C. AAR
D. straight-line to zero
E. straight-line with salvage
8. The depreciation tax shield is best defined as the:
A. amount of tax that is saved when an asset is purchased.
B. tax that is avoided when an asset is sold as salvage.
C. amount of tax that is due when an asset is sold.
D. amount of tax that is saved because of the depreciation expense.
E. amount by which the aftertax depreciation expense lowers net income.
10-2
Chapter 10 - Making Capital Investment Decisions
9. The annual annuity stream of payments that has the same present value as a project's costs is referred to as which one of the following?
A. yearly incremental costs
B. sunk costs
C. opportunity costs
D. erosion cost
E. equivalent annual cost
10. Kelley's Baskets makes handmade baskets for distribution to upscale retail outlets. The firm is currently considering making handmade wreaths as well. Which one of the following is the best example of an incremental operating cash flow related to the wreath project?
A. storing supplies in the same space currently used for materials storage
B. utilizing the basket manager to oversee wreath production
C. hiring additional employees to handle the increased workload should the firm accept the wreath project
D. researching the market to determine if wreath sales might be profitable before deciding to proceed
E. planning on lower interest expense by assuming the proceeds of the wreath sales will be used to reduce the firm's currently outstanding debt
11. Danielle's is a furniture store that is considering adding appliances to its offerings. Which of the following should be considered incremental cash flows of this project?
I. utilizing the credit offered by a supplier to purchase the appliance inventory
II. benefiting from increased furniture sales to appliance customers
III. borrowing money from a bank to fund the appliance project
IV. purchasing parts for inventory to handle any appliance repairs that might be necessary
A. I and II only
B. III and IV only
C. I, II, and IV only
D. II, III, and IV only
E. I, II, III, and IV
10-3
Chapter 10 - Making Capital Investment Decisions
12. The stand-alone principle advocates that project analysis should be based solely on which one of the following costs?
A. sunk
B. total
C. variable
D. incremental
E. fixed
13. Which one of the following is an example of a sunk cost?
A. $1,500 of lost sales because an item was out of stock
B. $1,200 paid to repair a machine last year
C. $20,000 project that must be forfeited if another project is accepted
D. $4,500 reduction in current shoe sales if a store commences selling sandals
E. $1,800 increase in comic book sales if a store commences selling puzzles
14. G & L Plastic Molders spent $1,200 last week repairing a machine. This week the company is trying to decide if the machine could be better utilized if they assigned it a proposed project. When analyzing the proposed project, the $1,200 should be treated as which
type of cost?
A. opportunity
B. fixed
C. incremental
D. erosion
E. sunk
15. Which one of the following best illustrates erosion as it relates to a hot dog stand located on the beach?
A. providing both ketchup and mustard for its customer's use
B. repairing the roof of the hot dog stand because of water damage
C. selling fewer hot dogs because hamburgers were added to the menu
D. offering French fries but not onion rings
E. losing sales due to bad weather
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Chapter 10 - Making Capital Investment Decisions
16. Which of the following should be included in the analysis of a new product?
I. money already spent for research and development of the new product
II. reduction in sales for a current product once the new product is introduced
III. increase in accounts receivable needed to finance sales of the new product
IV. market value of a machine owned by the firm which will be used to produce the new product
A. I and III only
B. II and IV only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV
17. You are considering the purchase of a new machine. Your analysis includes the evaluation
of two machines which have differing initial and ongoing costs and differing lives. Whichever
machine is purchased will be replaced at the end of its useful life. You should select the machine which has the:
A. longest life.
B. highest annual operating cost.
C. lowest annual operating cost.
D. highest equivalent annual cost.
E. lowest equivalent annual cost.
18. The bid price is:
A. an aftertax price.
B. the aftertax contribution margin.
C. the highest price you should charge if you want the project.
D. the only price you can bid if the project is to be profitable.
E. the minimum price you should charge if you want to financially breakeven.
19. Which one of the following will increase a bid price?
A. a decrease in the fixed costs
B. a reduction in the net working capital requirement
C. a reduction in the firm's tax rate
D. an increase in the salvage value
E. an increase in the required rate of return
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Chapter 10 - Making Capital Investment Decisions
20. All of the following are related to a proposed project. Which of these should be included in the cash flow at time zero?
I. purchase of $1,400 of parts inventory needed to support the project
II. loan of $125,000 used to finance the project
III. depreciation tax shield of $1,100
IV. $6,500 of equipment needed to commence the project
A. I and II only
B. I and IV only
C. II and IV only
D. I, II, and IV only
E. I, II, III, and IV
21. Changes in the net working capital requirements:
A. can affect the cash flows of a project every year of the project's life.
B. only affect the initial cash flows of a project.
C. only affect the cash flow at time zero and the final year of a project.
D. are generally excluded from project analysis due to their irrelevance to the total project.
E. reflect only the changes in the current asset accounts.
22. Which one of the following is a project cash inflow? Ignore any tax effects.
A. decrease in accounts payable
B. increase in inventory
C. decrease in accounts receivable
D. depreciation expense based on MACRS
E. equipment acquisition
23. Net working capital:
A. can be ignored in project analysis because any expenditure is normally recouped at the end of the project.
B. requirements, such as an increase in accounts receivable, create a cash inflow at the beginning of a project.
C. is rarely affected when a new product is introduced.
D. can create either a cash inflow or a cash outflow at time zero of a project.
E. is the only expenditure where at least a partial recovery can be made at the end of a project.
10-6
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Related Questions
Chapter 11 Homework Questions
1.
Why are capital projects critical?
2.
What are the critical steps involved in the capital budgeting process?
3.
Why is capital cost allowance used instead of depreciation expense in capital
budgeting?
4.
What do we mean by the economic life of a project?
5.
Differentiate between a capital investment and an expense investment.
6.
Why is working capital part of cash payouts in a capital investment, and what is
its makeup?
arrow_forward
1. The payback criterion for capital investment decisionsa. is conceptually superior to the IRR criterion
b. takes into consideration the time value of money
c. gives priority to rapid recovery of cash
d. emphasizes the most profitable projects
arrow_forward
Which decision rule assumes that project cash flows are reinvested at the firm's weighted average cost of capital (WACC)?
Question 8 options:
NPV
IRR
PB
arrow_forward
Which of the following should you focus when assessing the NPV of a project for a MNC?
I. variability of the project's cash flow.
II. correlation of the project's cash flow relative to the prevailing cash flows of the MNC.
III. interest rate
IV. capital structure
A.
II, III
B.
I, III
C.
III, IV
D.
I, II
arrow_forward
Which methods of evaluating a capital investment project ignore the time value of money?
Multiple Choice
Net present volue and accounting rate of retum,
Accounting rate of return and internal rate of return.
Internal rate of return and payback perlod.
arrow_forward
Answer the following:
1. Calculating the payback period for a capital project requires knowing which of the following?
a. Useful life of the project
b. The company's minimum required rate of return
c. The project's NPV
d. The project's annual cash flow
2. The payback criterion for capital investment decisionsa. is conceptually superior to the IRR criterion
b. takes into consideration the time value of money
c. gives priority to rapid recovery of cash
d. emphasizes the most profitable projects
3. What is an investor’s objective in financial statement analysis?a. To determine if the firm is risky
b. To determine the stability of earnings.
c. To determine changes necessary to improve future performance
d. To determine whether or not an investment is warranted by estimating a company’s future earnings stream
4. The current ratio isa. calculated by dividing current liabilities by current assets.…
arrow_forward
Which of the following methods for evaluating capital investment proposals reduces the expected future net cash flows originating from the proposals to their present values and computes a net present value?
a. average rate of return
b. net present value
c. internal rate of return
d. cash payback
arrow_forward
Question Content Area
Which of the following is a method of analyzing capital investment proposals that ignores present value?
a. average rate of return
b. net present value
c. discounted cash flow
d. internal rate of return
arrow_forward
Internal Rate of Return Method
The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows. This method, sometimes called the time-adjusted rate of return method,
starts with the proposal's net cash flows and works backward to estimate the proposal's expected rate of return.
Let's look at an example of internal rate of return calculation with even cash flows.
A company has a project with a 4-year life, requiring an initial investment of $189,700, and is expected to yield annual cash flows of $56,000. What is the internal rate of return?
IRR
Investmentb
Factor
Annual cash
flows
PIRR Factor: This is the factor which Investment: This is the present
you'll use on the table for the
value of cash outflows associated
CAnnual Cash Flows:
present value of an annuity of $1
with a project. If all of the
This is the amount of
dollar in order to find the
investment is up front at the
cash…
arrow_forward
15
The time value of money concept is given consideration in long-range investment decisions by
Group of answer choices
assuming equal annual cash flow patterns
weighting cash flows with subjective probabilities
assigning greater value to more immediate cash flows
investing only in short-term projects
arrow_forward
The cost of capital for a new project:
Multiple Choice
1.) is determined by the overall risk level of the firm.
2.) is dependent upon the source of the funds obtained to fund that project.
3.) is dependent upon the firm's overall capital structure.
4.) should be applied as the discount rate for all other projects considered by the firm.
5.) depends upon how the funds raised for that project are going to be spent.
arrow_forward
In considering the payback period, ____.
a.
it considers the time value of money in determining the maximum allowable time period
b.
it is based on cash flows both during and after the payback period
c.
it gives some indication of a project’s desirability from a liquidity viewpoint
d.
the maximum period allowed by a firm is a specific time period based on objective criteria
arrow_forward
1. Concepts used in cash flow estimation and risk analysis
You can come across different situations in your life where the concepts from capital budgeting will help you in evaluating the situation and making
calculated decisions. Consider the following situation:
The following table contains five definitions or concepts. Identify the term that best corresponds to the concept or definition given.
Concept or Definition
An example of externality that can have a negative effect on a firm
The cash flow at the end of the life of the project
The risk of a project without factoring in the impact of diversification
A risk analysis technique that measures changes in the internal rate of return (IRR) and
net present value (NPV) as individual variables are changed
Newcastle Coal Co. owns a warehouse that it is not currently using. It could sell the warehouse for $300,000 or use the warehouse in a new project.
Should Newcastle Coal Co. include the value of the warehouse as part of the initial…
arrow_forward
Select all that are true with respect to the Cost of Capital.
Group of answer choices
The cost of capital is the discount rate to use when evaluating investment opportunities
There is one cost of capital for every firm, and that one rate should be used for evaluating all investment opportunities
The cost of capital for an asset is driven by an asset's riskiness
The cost of capital is driven by how we raise funds to pay for an investment opportunity
The cost of capital for a project is driven by the systematic risk of that project
When estimating the cost of capital for a project, it is the total risk of that project that matters
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1. Define and identify the components of:a. Operating cycleb. Cash conversion cycle2. What is the impact of longer cash conversion cycles on a firm’s working capital needs?3. Explain the profitability-risk trade-off of alternative levels of working capital balances.4. Explain the profitability-risk trade-off of alternative methods of financing a given working capital investment.5. Why does the typical firm need to make investments in working capital?6. Discuss the profitability versus risk trade-offs associated with alternative levels of working capital investment.7. A. which of the following working capital financing policies subjects the firm to a greater risk?i. Financing permanent current assets with short-term debtii. Financing fluctuating current assets with long-term debt
B. Which policy will produce the higher expected profitability?
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now estimation
Capital budgeting analysis not only requires the evaluation of cash flows but also requires the understanding of the origin of those cash flows. Based
on your understanding of cash flows in a firm, answer the following questions:
The present value of
v can be used to determine the basis of a firm's value.
Ideally, capital budgeting analysis should take cash flows into account
Understanding the nature of projects
Capital budgeting analysis often involves decisions related to expansion projects and/or replacement projects. Based on your understanding of
expansion and replacement projects, answer the following:
If a clothing store opens a second retail location on the other side of town, this project would be considered
project.
What are sunk costs?
Alexander Industries owns a warehouse that it is not currently using. It could sell the warehouse for $300,000 or use the warehouse in a new project.
Should Alexander Industries include the value of the warehouse as part of the…
arrow_forward
iw) What does it mean for projects to be mutually exclusive? How should managers rank mutually
exclusive projects?
B. What are the strength and weaknesses of each of the following capital budgeting technique below?
i.
Payback
i.
ARR
i.
Profitability Index
iv.
IRR
arrow_forward
Net Present Value Method
Net present value (NPV) is one method that can be used to evaluate the financial viability of potential projects. It determines the present value of all future cash flows associated with potential projects and measures this against the cost of the
project. To use net present value, a required rate of return must be defined. The required rate of return is the minimum
-v acceptable rate of return that an investment must yield for it to make sense economically. Managers often choose
a required rate of return above their cost of capital to ensure that the inherent uncertainties surrounding future cash flows is addressed. This can be risky, however, as it biases the process toward short-term projects. If the NPV is positive, then
the project should be accepted
- V ; if it is negative, then the project should be rejected
V.
Let's look at a net present value example using the present value of an ordinary annuity table.
The company has a project with a 5-year life that…
arrow_forward
22. If a capital budgeting project’s cash flows are not normal, the internal rate of return (IRR) method should be used to make the investment decision.
Group of answer choices
True
False
arrow_forward
29. Which one of the following statements is correct regarding capital Investment appraisal methods?a) The Payback period takes into account all the cash flows accruing to the projectb) The Net Present value method does not take the time value of money into accountc) The Accounting Rate of Return takes the time value of cash flows into consideration and is the one most often used in practice by business organisationsd) The Internal Rate of Return is the discount rate at which the net present value is zero
arrow_forward
The duration of time within which the
investment made for the project will be
recovered by the net returns of the project is
known as
а.
Accounting rate of return method
b.
Payback period
С.
Net present value method
d.
Period of return
Capital budgeting is the process of evaluating
and selecting short-term investments that are
consistent with the firm's goal of maximizing
owners' wealth.
Select one:
True
False
arrow_forward
Question Content Area
Which of the following methods of evaluating capital investment proposals uses present value concepts to compute the rate of return from the net cash flows?
a. average rate of return method
b. internal rate of return method
c. cash payback method
d. net present value method
arrow_forward
What refers to the interest rate at which the present work of the cash flow on a project is zero of
the interest earned by an investment?
Select one:
a. Return of investment
b. Yield
c. Rate of return
d. Economic return
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1] What are three concerns the financial manager should be aware of when analyzing a balance sheet, & income statement? Why do we need a statement of cash flows? How does a statement of cash flow differ from balance sheet and income statement?
2] Net Present Value Suppose a project has conventional cash flows and a positive NPV. What do you know about its payback? Its discounted payback? Its profitability index? Its IRR? Explain.
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Defining capital investments and the capital budgeting process
Match each definition with its capital budgeting method.
Methods
Accounting rate of return
Internal rate of return
Net present value
Payback
Definitions
It is only concerned with the time it takes to get cash outflows returned.
It considers operating income but not the time value of money in its analyses.
Compares the present value of cash outflows to the present value of cash inflows to determine investment worthiness.
The true rate of return an investment earns.
arrow_forward
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- Chapter 11 Homework Questions 1. Why are capital projects critical? 2. What are the critical steps involved in the capital budgeting process? 3. Why is capital cost allowance used instead of depreciation expense in capital budgeting? 4. What do we mean by the economic life of a project? 5. Differentiate between a capital investment and an expense investment. 6. Why is working capital part of cash payouts in a capital investment, and what is its makeup?arrow_forward1. The payback criterion for capital investment decisionsa. is conceptually superior to the IRR criterion b. takes into consideration the time value of money c. gives priority to rapid recovery of cash d. emphasizes the most profitable projectsarrow_forwardWhich decision rule assumes that project cash flows are reinvested at the firm's weighted average cost of capital (WACC)? Question 8 options: NPV IRR PBarrow_forward
- Which of the following should you focus when assessing the NPV of a project for a MNC? I. variability of the project's cash flow. II. correlation of the project's cash flow relative to the prevailing cash flows of the MNC. III. interest rate IV. capital structure A. II, III B. I, III C. III, IV D. I, IIarrow_forwardWhich methods of evaluating a capital investment project ignore the time value of money? Multiple Choice Net present volue and accounting rate of retum, Accounting rate of return and internal rate of return. Internal rate of return and payback perlod.arrow_forwardAnswer the following: 1. Calculating the payback period for a capital project requires knowing which of the following? a. Useful life of the project b. The company's minimum required rate of return c. The project's NPV d. The project's annual cash flow 2. The payback criterion for capital investment decisionsa. is conceptually superior to the IRR criterion b. takes into consideration the time value of money c. gives priority to rapid recovery of cash d. emphasizes the most profitable projects 3. What is an investor’s objective in financial statement analysis?a. To determine if the firm is risky b. To determine the stability of earnings. c. To determine changes necessary to improve future performance d. To determine whether or not an investment is warranted by estimating a company’s future earnings stream 4. The current ratio isa. calculated by dividing current liabilities by current assets.…arrow_forward
- Which of the following methods for evaluating capital investment proposals reduces the expected future net cash flows originating from the proposals to their present values and computes a net present value? a. average rate of return b. net present value c. internal rate of return d. cash paybackarrow_forwardQuestion Content Area Which of the following is a method of analyzing capital investment proposals that ignores present value? a. average rate of return b. net present value c. discounted cash flow d. internal rate of returnarrow_forwardInternal Rate of Return Method The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows. This method, sometimes called the time-adjusted rate of return method, starts with the proposal's net cash flows and works backward to estimate the proposal's expected rate of return. Let's look at an example of internal rate of return calculation with even cash flows. A company has a project with a 4-year life, requiring an initial investment of $189,700, and is expected to yield annual cash flows of $56,000. What is the internal rate of return? IRR Investmentb Factor Annual cash flows PIRR Factor: This is the factor which Investment: This is the present you'll use on the table for the value of cash outflows associated CAnnual Cash Flows: present value of an annuity of $1 with a project. If all of the This is the amount of dollar in order to find the investment is up front at the cash…arrow_forward
- 15 The time value of money concept is given consideration in long-range investment decisions by Group of answer choices assuming equal annual cash flow patterns weighting cash flows with subjective probabilities assigning greater value to more immediate cash flows investing only in short-term projectsarrow_forwardThe cost of capital for a new project: Multiple Choice 1.) is determined by the overall risk level of the firm. 2.) is dependent upon the source of the funds obtained to fund that project. 3.) is dependent upon the firm's overall capital structure. 4.) should be applied as the discount rate for all other projects considered by the firm. 5.) depends upon how the funds raised for that project are going to be spent.arrow_forwardIn considering the payback period, ____. a. it considers the time value of money in determining the maximum allowable time period b. it is based on cash flows both during and after the payback period c. it gives some indication of a project’s desirability from a liquidity viewpoint d. the maximum period allowed by a firm is a specific time period based on objective criteriaarrow_forward
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