2. Capital Budgeting Methods

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Question 1 - CIA 590 IV.49 - Capital Budgeting Methods A firm's optimal capital structure

A. Maximizes the price of the firm's stock. B. Minimizes the firm's tax liability.

C. Maximizes the firm's degree of financial leverage. D. Minimizes the firm's risk.

A. The capital structure that maximizes the share price is the optimal capital structure. If the share price is at its highest, that means that management has properly balanced the risk and returns in its capital structure and investors value this structure the most.

B. The lowest tax liability may not be the best capital structure for the company because the lowest tax rate would be achieved with all debt financing. All debt financing may not provide the lowest cost of capital and it may lead to high levels of risk for the company because of all of the fixed interest payments.

C. The maximization of financial leverage would lead to high levels of risk and would therefore probably not be the best capital structure.

D. The lowest risk may not be the best capital structure for the company because the lowest tax rate would be achieved with all equity financing. All equity financing may not provide the lowest cost of capital and it may lead to investors not wanting to be owners when the ownership share is so diluted from all of the shares that have been issued.

Question 2 - CIA 597 IV.40 - Capital Budgeting Methods

A firm with an 18% cost of capital is considering the following projects (on January 1, year 1):

January 1, Year 1 Cash Outflow (000's Omitted) December 31, Year 5 Cash Inflow (000's Omitted) Year 5 Project Internal Rate of Return Project A $3,500 $7,400 16% Project B 4,000 9,950 ?

Present Value of $1 Due at the End of "N" Periods N 12% 14% 15% 16% 18% 20% 22% 4 .6355 .5921 .5718 .5523 .5158 .4823 .4230 5 .5674 .5194 .4972 .4761 .4371 .4019 .3411 6 .5066 .4556 .4323 .4104 .3704 .3349 .2751

Using the net-present-value (NPV) method, project A's net present value is A. $(265,460)

B. $23,140 C. $316,920 D. $(316,920)

A. There is only one cash inflow to this project, and it occurs 5 years after the initial cash outflow. The firm's cost of capital is 18%. Therefore, the correct Present Value of $1 factor (from the table given) to use in

discounting the cash inflow is .4371. The present value of the cash inflow is .4371 × $7,400,000, or $3,234,540. Subtracting the initial investment of $3,500,000 from the present value of the cash inflow of $3,234,540, we get $(265,460).

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B. An answer of $23,140 results from discounting the cash inflow at the rate of 16%, which is the project's Internal Rate of Return but which is not the appropriate discount rate to use.

C. An answer of $316,920 results from discounting the cash inflow for four years. However, the receipt of the cash occurs five years after the initial investment.

D. An answer of $(316,920) results from two errors. One, the factor for four years was used to discount the cash inflow, which was not correct. And two, the present value of the cash inflow was subtracted from the initial cash outflow. Instead, the initial cash outflow should be subtracted from the present value of the cash inflow.

Question 3 - CIA 597 IV.41 - Capital Budgeting Methods

A firm with an 18% cost of capital is considering the following projects (on January 1, year 1):

January 1, Year 1 Cash Outflow (000's Omitted) December 31, Year 5 Cash Inflow (000's Omitted) Year 5 Project Internal Rate of Return Project A $3,500 $7,400 16% Project B 4,000 9,950 ?

Present Value of $1 Due at the End of "N" Periods N 12% 14% 15% 16% 18% 20% 22% 4 .6355 .5921 .5718 .5523 .5158 .4823 .4230 5 .5674 .5194 .4972 .4761 .4371 .4019 .3411 6 .5066 .4556 .4323 .4104 .3704 .3349 .2751 Project B's internal rate of return is closest to

A. 18% B. 16% C. 15% D. 20%

A. 18% is the company's cost of capital, which is given in the question.

B. 16% is approximately the internal rate of return for project A, but the question asks for the internal rate of return for project B.

C.

The internal rate of return is the discount rate at which the present value of the expected cash inflows from a project equals the present value of the expected cash outflows, or the discount rate at which the net present value is zero. A positive NPV would result from using a discount rate of 15%, so that cannot be the project's IRR.

D.

The internal rate of return is the discount rate at which the present value of the expected cash inflows from a project equals the present value of the expected cash outflows, or the discount rate at which the net present value is zero. To determine the internal rate of return from the information given, we need to first know what discount factor for five years would result in a present value of $9,950 that is equal to $4,000. To arrive at that factor, we divide $4,000 by $9,950, and we get .402. We then look along the line of factors for five years on the

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factor table given to locate a factor close to .402. That is .4019, which is in the 20% column. Thus, the internal rate of return is closest to 20%.

Question 4 - CMA 1278 5.12 - Capital Budgeting Methods

Future, Inc. is in the enviable situation of having unlimited capital funds. The best decision rule, in an economic sense, for it to follow would be to invest in all projects in which the

A. Net present value is greater than zero.

B. Payback reciprocal is greater than the internal rate of return.

C. Accounting rate of return is greater than the earnings as a percent of sales. D. Internal rate of return is greater than zero.

A. If a company has unlimited capital funds, it should invest in all projects in which the net present value is greater than zero, assuming none of the projects are mutually exclusive.

B. The Payback Reciprocal is 1 divided by the payback period. It can be used to give a very rough indication of an internal rate of return, if the cash flows from the project are equal in every period and if the project life is at least twice as long as the payback period. However, comparing the payback reciprocal to the internal rate of return is a meaningless comparison.

C. Earnings as a percent of sales is meaningless in a capital budgeting analysis. So comparing an accounting rate of return to it is also meaningless.

D. If a project's internal rate of return is greater than zero but lower than the company's required rate of return, the project should not be undertaken.

Carco, Inc. wants to use discounted cash flow techniques when analyzing its capital investment projects. The company is aware of the uncertainty involved in estimating future cash flows. A simple method some companies employ to adjust for the uncertainty inherent in their estimates is to

A. Prepare a direct analysis of the probability of outcomes. B. Use accelerated depreciation.

C. Adjust the minimum desired rate of return. D. Increase the estimates of the cash flows.

A. Although the preparation of a direct analysis of the probability of outcomes may be used to address uncertainty, it is not a simple method, and this question asks for a simple method.

B. The use of accelerated depreciation is not a technique used to address uncertainty in capital budgeting.

C. A company adjusts for the uncertainty inherent in its estimates by increasing the required rate of return used to discount the future expected cash flows. A higher discount rate will require higher expected future cash flows in order for the investment to be acceptable. As a result, fewer investments will be acceptable.

D. Increasing estimates of future expected cash flows arbitrarily is not an acceptable method of addressing uncertainty in the capital budgeting process.

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A manager wants to know the effect of a possible change in cash flows on the net present value of a project. The technique used for this purpose is

A. Cost behavior analysis. B. Sensitivity analysis. C. Risk analysis.

D. Return on investment analysis.

A. Cost behavior analysis is not used to determine the effect of a possible change in cash flows on the net present value of a project.

B. Sensitivity analysis is used to determine how an amount will change if factors that were involved in predicting that amount change.

C. Risk analysis is not used to determine the effect of a possible change in cash flows on the net present value of a project.

D. Return on Investment (ROI) is used to analyze the profitability of a company or one of its segments, not for analyzing the effect of a possible change in cash flows on the net present value of a project.

The technique that recognizes the time value of money by discounting the after-tax cash flows for a project over its life to time period zero using the company's minimum desired rate of return is called the

A. Payback method.

B. Net present value method. C. Accounting rate of return method. D. Average rate of return method.

A. The payback method explicitly does not recognize the time value of money.

B. Net present value of a project is calculated by discounting the after-tax expected cash flows for the project over its life to time period zero using the company's minimum required rate of return. The present value of the future expected cash inflows minus the net initial investment equals the net present value.

C. The accounting rate of return is the ratio of the amount of increased book income to the required investment. Since this method uses accrual accounting income, it includes depreciation. However, it does not take into account the time value of money.

D. The average rate of return is not a technique that recognizes the time value of money by discounting the after-tax cash flows for a project.

The technique that reflects the time value of money and is calculated by dividing the present value of the future net after-tax cash inflows that have been discounted at the desired cost of capital by the initial cash outlay for the investment is called the

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A. Profitability index method. B. Capital rationing method.

C. Accounting rate of return method. D. Average rate of return method.

A. The profitability index is a benefit-cost ratio. It is the ratio of the present value of net future expected cash flows, discounted at the required rate of return, to the amount of the initial investment.

B. Capital rationing occurs when the amount of capital funds available to invest is limited.

C. The accounting rate of return is the ratio of the amount of increased book income to the required investment. Since this method uses accrual accounting income, it includes depreciation, and it also does not take into account the time value of money.

D. The average rate of return method is not a technique that reflects the time value of money.

The technique that measures the estimated performance of a capital investment by dividing the project's annual after-tax net income by the average investment cost is called the

A. Internal rate of return method. B. Accounting rate of return method. C. Capital asset pricing model. D. Average rate of return method.

A. The internal rate of return is the discount rate at which the net present value of a capital budgeting project is zero. It does not measure the estimated performance of a capital investment by dividing the project's annual after-tax net income by the average investment cost, however.

B. The accounting rate of return is the ratio of the amount of increased book income to the required investment. Sometimes the average investment figure is used rather than the total initial investment. This is usually

calculated as the initial investment divided by 2. The initial investment is divided by 2 because the investment will have a book value of 0 at the end of the project, and dividing the initial investment by 2 approximates an average of the amount invested over the life of the project.

C. The capital asset pricing model may be used to calculate a company's cost of capital, but it is not used to analyze an individual project's performance.

D. The average rate of return is not a technique that measures the estimated performance of a capital investment by dividing the project's annual after-tax net income by the average investment cost.

The technique that incorporates the time value of money by determining the compound interest rate of an investment such that the present value of the after-tax cash inflows over the life of the investment is equal to the initial investment is called the

A. Accounting rate of return method. B. Internal rate of return method. C. Capital asset pricing model.

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D. Profitability index method.

A. The accounting rate of return is the ratio of the amount of increased book income to the required investment. It does not incorporate the time value of money.

B. The internal rate of return is the discount rate at which the net present value of a project is zero. Therefore, it is also the discount rate at which the present value of the after-tax cash inflows over the life of the investment equal the initial investment, assuming that the future expected cash flows are all positive.

C. The capital asset pricing model may be used to calculate a company's cost of capital. It is not a technique that incorporates the time value of money by determining the compound interest rate of an investment such that the present value of the after-tax cash inflows over the life of the investment is equal to the initial investment.

D. The profitability index is a benefit-cost ratio. It is the ratio of the present value of net future expected cash flows, discounted at the required rate of return, to the amount of the initial investment. It is not an interest rate.

The technique that measures the number of years required for the after-tax cash flows to recover the initial investment in a project is called the

A. Payback method.

B. Net present value method. C. Profitability index method.

D. Accounting rate of return method.

A. The Payback Method is used to determine the number of periods that must pass before the net after-tax cash inflows from the investment will equal (or "pay back") the initial investment cost. If the expected cash inflows are constant over the life of the project, the payback period is the net initial investment divided by the periodic expected cash flow. If the expected cash inflows are not constant over the life of the project, the cash inflows are added to determine on a cumulative basis when the inflows will equal the outflows. The payback method ignores all cash flows beyond the payback period, does not include the time value of money, and does not include any factor for the cost of capital. However, it is widely used because it is simple and it can be useful when a project is judged to be very risky with uncertain cash flows in the later years. In this case, it may be used to determine how quickly the investment will be recouped so that if necessary, the company can abandon the project without too great a loss.

B.

The net present value method does not measure the number of years required for the after-tax cash flows to recover the initial investment in a project. The net present value method is a discounted cash flow method which calculates the value of a project by discounting the after-tax expected cash flows for the project over its life to time period zero using the company's minimum required rate of return. The present value of the future expected cash inflows minus the net initial investment equals the net present value.

C. The profitability index does not measure the number of years required for the after-tax cash flows to recover the initial investment in a project. The profitability index is a ratio of the present value of the net future cash flows to the amount of the initial investment. If a project has a positive net present value, the profitability index will be above 1.00. If it has a negative net present value, it will have a profitability index of less than 1.00.

D. The accounting rate of return does not measure the number of years required for the after-tax cash flows to recover the initial investment in a project. The accounting rate of return is a ratio of the increase in expected annual average after tax accounting net income to the net initial investment. This method uses accrual accounting income, so depreciation is included in the expenses. In addition, it does not take into account the time value of money.

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Yipann Corporation is reviewing an investment proposal. The initial cost as well as other related data for each year are presented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage value of the investment at the end of each year is equal to its net book value, and there will be no salvage value at the end of the investment's life. Investment Proposal Year Initial Cost and Book Value Annual Net After-Tax Cash Flows Annual Net Income 0 $105,000 $ 0 $ 0 1 70,000 50,000 15,000 2 42,000 45,000 17,000 3 21,000 40,000 19,000 4 7,000 35,000 21,000 5 0 30,000 23,000

Yipann uses a 24% after-tax target rate of return for new investment proposals. The discount figures for a 24% rate of return are given.

Year

Present Value of $1 Received at the End of Period

Present Value of Annuity of $1 Received at End of Each Period 1 .81 .81 2 .65 1.46 3 .52 1.98 4 .42 2.40 5 .34 2.74 6 .28 3.02 7 .22 3.24

The traditional payback period for the investment proposal is A. .875 years.

B. 1.833 years. C. Over 5 years. D. 2.250 years.

A. An answer of .875 results from combining the book values and the net after-tax cash flows instead of using the after tax cash flows alone for the years subsequent to year 0.

B. An answer of 1.833 years results from using the yearly book values instead of the after-tax cash flows for the years subsequent to year 0.

C. An answer of "over 5 years" results from using the annual net income amounts instead of the after-tax cash flows for the years subsequent to year 0.

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D.

The cash flow analysis is set up as follows:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Initial Investment in Equipment (105,000)

After-Tax Cash Flow 50,000 45,000 40,000 35,000 30,000 --- --- --- --- --- --- Total After-Tax Cash Flows (105,000) 50,000 45,000 40,000 35,000 30,000 Cumulative Cash Flow (105,000) (55,000) (10,000) 30,000 65,000 95,000

The cumulative cash flow from the project becomes positive during Year 3. Assuming that the cash flows occur evenly throughout the year, the payback period is 2.25 years, calculated as follows:

Number of the project year in the final year when cash flow is negative: 2 Plus: a fraction consisting of

Numerator = the positive value of the negative cumulative inflow amount from the final negative year, which is 10,000

Denominator = cash flow for the following year, which is 40,000 or: 2 + 10,000/40,000 = 2.25

Note that the present value factors given are irrelevant to answering this question, because the payback method is not a discounted cash flow technique.

Crown Corporation has agreed to sell some used computer equipment to Bob Parsons, one of the company's employees, for $5,000. Crown and Parsons have been discussing alternative financing arrangements for the sale. Crown Corporation has offered to accept a $1,000 down payment and set up a note receivable for Bob Parsons that calls for a $1,000 payment at the end of each of the next 4 years. If Crown uses a 6% discount rate, the present value of the note receivable would be

A. $2,940 B. $4,465 C. $3,465 D. $4,212

A. An answer of $2,940 results from discounting the entire amount of the note ($4,000) at 8% for four years. This is incorrect for two reasons: (1) The full principle of the note ($4,000) is assumed to be paid at the maturity date in four years. However, the note calls for annual principle payments of $1,000. (2) The discount rate used is 8%. However, the discount rate to be used is 6%.

B. An answer of $4,465 results from discounting the note receivable using the present value of an annuity of $1,000 and a 6% rate for 4 years and then adding the $1,000 down payment at its undiscounted value of $1,000. However, the question asks only for the present value of the note receivable, not the present value of the entire transaction.

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C. The note calls for four annual payments of $1,000. This is an ordinary annuity, since the payments are due at the end of each period. Therefore, the factor in the present value of an annuity table can be used as it is given, without adjustment. The present value of a four-year ordinary annuity of $1,000, discounted at 6%, is $1,000 × 3.465, or $3,465.

D. An answer of $4,212 results from using the present value of an annuity factor for 6% for 5 years. However, the note is for four years.

Crown Corporation has agreed to sell some used computer equipment to Bob Parsons, one of the company's employees, for $5,000. Crown and Parsons have been discussing alternative financing arrangements for the sale. Crown has offered to accept a $1,000 down payment and to set up a note receivable for Bob Parsons that calls for a $1,000 down payment at the end of this year and the next three years.

Bob Parsons has agreed to the immediate down payment of $1,000 but would like the note for $4,000 to be payable in full at the end of the fourth year. Because of the increased risk associated with the terms of this note, Crown Corporation would apply an 8% discount rate. The present value of this note would be

A. $2,577 B. $2,940 C. $3,940 D. $3,312

A. An answer of $2,577 results from discounting a series of payments of $1,000 at 8% for three years. However, the term of the note is four years, and the note is payable at the end of the term, not in annual payments.

B. Using the Present Value of $1 table, the present value of a single $4,000 payment in 4 years is $4,000 × .735, which equals $2,940.

C. An answer of $3,940 results from discounting the principal repayment of $4,000 at 8% for four years and adding the down payment of $1,000 without discounting it. However, the question asks for the present value of the note, not the present value of the whole transaction.

D. An answer of $3,312 results from discounting a series of payments of $1,000 at 8% for four years. However, the note is payable at the end of the term, not in annual payments.

Yipann Corporation is reviewing an investment proposal. The initial cost as well as other related data for each year are presented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage value of the investment at the end of each year is equal to its net book value, and there will be no salvage value at the end of the investment's life.

Investment Proposal

Year

Initial Cost and Book Value

Annual Net After-Tax Cash Flows Annual Net Income 0 $105,000 $ 0 $ 0

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1 70,000 50,000 15,000 2 42,000 45,000 17,000 3 21,000 40,000 19,000 4 7,000 35,000 21,000 5 0 30,000 23,000

Year

The average annual cash inflow at which Yipann would be indifferent to the investment (rounded to the nearest dollar) is A. $38,321.

B. $40,000. C. $21,000. D. $46,667. A.

The question is asking for an average annual after-tax cash flow amount that will result in a net present value of zero for the project, because that will be the average annual cash flow level at which Yipann will be indifferent to the investment. We need to look at this as a present value of an annuity problem, because since we are looking for an average annual cash flow amount, all the annual cash flow amounts after year 0 will be the same average amount.

The annual cash flows given in the problem are irrelevant, because we are looking for the average annual after-tax cash flow amount that will result in an NPV of zero, given the initial investment in Year 0.

Since the initial investment is $105,000 and the project's life is 5 years, we need to know what annuity amount will produce a present value of $105,000 when discounted at 24% for 5 years. Recall that the present value of an annuity is the annuity amount × PV of an annuity factor. We don't know the annuity amount, but we do know the PV of an annuity factor and the present value amount of $105,000. The PV of an annuity factor for 5 years at 24% is given in the problem: 2.74.

Thus, the formula is: Annuity Amount × 2.74 = $105,000. Therefore, the Annuity Amount = $105,000 ÷ 2.74, which is equal to $38,321.

This means that if the annual after-tax cash flows are all the same and they are $38,321, the NPV will be zero and the company will be indifferent to the investment.

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C. An answer of $21,000 results from dividing the initial cost of the asset by the number of years of the project's life. D. An answer of $46,667 results from dividing the initial investment amount of $105,000 by the payback period.

Yipann Corporation is reviewing an investment proposal. The initial cost as well as other related data for each year are presented in the schedule below. All cash flows are assumed to take place at the end of the year. The salvage value of the investment at the end of each year is equal to its net book value, and there will be no salvage value at the end of the investment's life.

Investment Proposal

Year

Initial Cost and Book Value

Annual Net After-Tax Cash Flows Annual Net Income 0 $105,000 $0 $ 0 1 70,000 50,000 15,000 2 42,000 45,000 17,000 3 21,000 40,000 19,000 4 7,000 35,000 21,000 5 0 30,000 23,000

Year

The accounting rate of return for the investment proposal over its life using the initial value of the investment is A. 38.1%.

B. 28.1%. C. 18.1%. D. 36.2%.

A. An answer of 38.1% results from the average of the after-tax cash flows divided by the net initial investment. However, the after-tax cash flows are not used in calculating the accounting rate of return.

B. An answer of 28.1% results from averaging the annual after-tax cash flows and then averaging the annual net incomes, then taking the average of the two averages and dividing it by the net initial investment. However, the after-tax

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cash flows and annual net incomes should not be averaged together.

C. The accounting rate of return is the average annual after-tax net income attributable to the project divided by the net initial investment. The average of the five annual net income amounts given is $19,000 ([$15,000 + $17,000 + $19,000 + $21,000 + $23,000] / 5 = $19,000.) $19,000 / $105,000 = .18095 or 18.1%. (Note: sometimes the average of the initial investment over the life of the project is used, calculated as the initial investment divided by 2. However, this question specifies to use the initial value of the investment, not the average investment.) D. An answer of 36.2% results from using the average amount of the investment over the life of the project (the net initial investment divided by 2). Sometimes, the accounting rate of return is calculated using the average amount of the investment over the life of the project. However, this question specifies to use the initial value of the investment, not the average investment.

When ranking two mutually exclusive investments with different initial amounts, management should give first priority to the project

A. Whose net after-tax flows equal the initial investment. B. That has the greater accounting rate of return. C. That has the greater profitability index.

D. That generates cash flows for the longer period of time.

A. If the net after-tax flows (discounted, presumably) equal the initial investment, then the net present value of the project will be zero and the investor will be indifferent to the project.

B. The investment that has the greater accounting rate of return may not offer the best return on a discounted cash flow basis.

C. The Profitability Index enables us to compare (or rank) the benefit/cost ratios of different sized investments, since the Profitability Index expresses profitability on a percentage basis rather than a total dollar amount basis. It is very useful when we must compare multiple investments that are of different investment amounts. D. The investment that generates cash flows for the longer period of time may not offer the best return.

The net present value (NPV) method and the internal rate of return (IRR) method are used to analyze capital expenditures. The IRR method, as contrasted with the NPV method,

A. Is considered inferior because it fails to calculate compounded interest rates.

B. Is preferred in practice because it is able to handle multiple desired hurdle rates, which is impossible with the NPV method.

C. Assumes that the rate of return on the reinvestment of the cash proceeds is at the indicated rate of return of the project analyzed rather than at the discount rate used.

D. Incorporates the time value of money whereas the NPV method does not. A. The internal rate of return method does utilize compounded interest rates. B. The internal rate of return method does not handle multiple desired hurdle rates.

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rate of return method assumes that the cash proceeds of the investment will be reinvested at the internal rate of return, which may not be the case.

D. Both the IRR method and the NPV method incorporate the time value of money.

Mercken Industries is contemplating four projects, Project P, Project Q, Project R, and Project S. The capital costs and estimated after-tax net cash flows of each project are listed below. Mercken's desired after-tax opportunity cost is 12%, and the company has a capital budget for the year of $450,000. Idle funds cannot be reinvested at greater than 12%.

Project P Project Q Project R Project S Initial cost $200,000 $235,000 $190,000 $210,000

Annual cash flows

Year 1 $93,000 $90,000 $45,000 $40,000

Year 2 93,000 85,000 55,000 50,000

Year 3 93,000 75,000 65,000 60,000

Year 4 0 55,000 70,000 65,000

Year 5 0 50,000 75,000 75,000

Net present value $23,370 $29,827 $27,333 $(7,854) Internal rate of return 18.7% 17.6% 17.2% 10.6% Excess present value index 1.12 1.13 1.14 0.96 During this year, Mercken will choose

A. Projects P and Q. B. Projects P, Q, and R. C. Projects Q and R. D. Projects P, Q, R, and S.

A. This is a situation where there appears to be a conflict between the NPV results and the IRR results. Projects P and Q have the higher IRRs, whereas Q and R have the higher NPVs. However, the problem also tells us that the cash inflows from the project will be able to be reinvested at a rate no higher than 12%. Thus, the IRRs for these projects are not accurate. Furthermore, Projects P and Q do not have the highest excess present value (profitability) indices.

B. If Mercken chooses Projects P, Q and R, it will exceed its capital budget for the year.

C. Project S is not an acceptable project, because it has a negative NPV. That leaves Projects P, Q and R. However, if all three projects were selected, Mercken would exceed its capital budget of $450,000. Therefore, only two of the three projects can be selected. This is a situation where there appears to be a conflict between the NPV results and the IRR results. Projects P and Q have the higher IRRs, whereas Q and R have the higher NPVs. Remember that the IRR assumes that all cash inflows from the project will be able to be reinvested at the internal rate of return. However, this problem tells us that the cash inflows from the project will be able to be reinvested at a rate no higher than 12%. Thus, the IRRs for these projects are not accurate. Therefore, the projects with the highest NPVs should be selected, and those are Projects Q and R. This is confirmed by looking at the excess present value (profitability) indices. Note that Projects Q and R have the highest profitability indices.

D. First, if all four projects are accepted, Mercken would exceed its capital budget for the year. And second, Project S is completely unacceptable because it has a negative NPV. Therefore, this answer should be rejected.

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Question 20 - CMA 1292 4.11 - Capital Budgeting Methods The bailout payback method

A. Equals the recovery period from normal operations. B. Measures the risk if a project is terminated.

C. Eliminates the disposal value from the payback calculation. D. Incorporates the time value of money.

A. The bailout payback method does not determine the recovery period from normal operations. It determines the recovery period if operations are abnormal.

B. The bailout payback method recognizes the possibility that a project may be ended prematurely and the equipment sold. The after-tax salvage value of the equipment at various dates is included in the cash inflows of the project through the same dates. The use of the bailout payback method gives an indication of the result of terminating the project early.

C. The bailout payback method does not eliminate the disposal value from the payback calculation, but it incorporates it at various points in the calculation.

D. The bailout payback method, like the payback method, does not incorporate the time value of money.

A weakness of the internal rate of return (IRR) approach for determining the acceptability of investments is that it A. Does not consider the time value of money.

B. Implicitly assumes that the firm is able to reinvest project cash flows at the firm's cost of capital.

C. Implicitly assumes that the firm is able to reinvest project cash flows at the project's internal rate of return. D. Is not a straightforward decision criterion.

A. The Internal Rate of Return does consider the time value of money.

B. If the required rate of return used in an NPV calculation is the firm's cost of capital, the calculation of the NPV

assumes that the firm is able to reinvest the project's cash flows at the same rate. However, the IRR is not the firm's cost of capital. The IRR may be higher or lower than the firm's required rate of return.

C. The Internal Rate of Return (IRR) is the discount rate at which the Net Present Value (NPV) of a project is zero. As such, it assumes that the cash flows from the project will be reinvested at the same rate. This is a disadvantage, because the cash flows from the project may not be able to be reinvested at the Internal Rate of Return.

D. The Internal Rate of Return is a straightforward decision criterion. If a project's IRR is greater than the firm's required rate of return, the project is acceptable.

Question 22 - CMA 1292 4.14 - Capital Budgeting Methods The profitability index approach to investment analysis

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A. Always yields the same accept/reject decisions for mutually exclusive projects as the net present value method. B. Fails to consider the timing of project cash flows.

C. Considers only the project's contribution to net income and does not consider cash flow effects.

D. Always yields the same accept/reject decisions for independent projects as the net present value method.

A. If projects are mutually exclusive or are of differing time periods and initial investment amounts, the PI method may result in a different ranking from that of the NPV method.

B. The PI does not fail to consider the timing of project cash flows. On the contrary, it uses the present value of the cash inflows discounted using the firm's required rate of return. Therefore, the timing of the cash flows is included.

C. The calculation of PI is based upon cash flow, not net income.

D. The Profitability Index (PI) is a benefit/cost ratio. It is the present value of the future net cash inflows divided by the initial net cash investment. A ratio of greater than 1 indicates an acceptable project. Therefore, whenever projects are independent (i.e., not mutually exclusive), the PI will yield the same accept/reject decision as the NPV method, because a positive NPV will result in a PI of greater than 1. The PI method is useful for ranking multiple investment opportunities that are of different investment amounts if the projects are not mutually exclusive.

The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the net present value method (NPV) may be different when

A. Multiple projects have unequal lives and the size of the investment for each project is different. B. The lives of the multiple projects are equal and the size of the required investments are equal. C. The required rate of return is higher than the IRR of each project.

D. The required rate of return equals the IRR of each project.

A. When projects have unequal lives and the sizes of the investments are different, it is possible that NPV and IRR will rank the projects in a different order.

B. When the lives of multiple projects are equal and the size the required investments are equal, the IRR method and the NPV method will return the same accept-reject decision.

C. If the required rate of return is higher than the IRR of each project, NPV will be negative and both NPV and IRR will return a decision to reject the project.

D. If the required rate of return equals the IRR of each project, NPV will be zero and the NPV method and the IRR method will rank the investments the same.

When using the net present value method for capital budgeting analysis, the required rate of return is called all of the following except the

A. Discount rate. B. Hurdle rate. C. Cost of capital. D. Risk-free rate.

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A. The required rate of return is the discount rate used in a capital budgeting analysis.

B. The required rate of return may be called the "hurdle rate" because it is the minimum rate of return that is acceptable for an investment. A firm should invest money in a project only if the project provides a higher rate of return than this rate. Investments with a return higher than the hurdle rate will increase the value of the firm and thus stockholders' wealth.

C. The required rate of return may be equal to the firm's cost of capital, if the firm has not seen fit to adjust its cost of capital to reflect higher or lower risk.

D. The required rate of return, which is the rate used to discount future cash flows in a capital budgeting analysis, is not the risk-free rate. There is risk inherent in all capital budgeting projects, and the required rate of return incorporates a risk premium.

The proper discount rate to use in calculating certainty equivalent net present value is the A. Cost of capital.

B. Risk-adjusted discount rate. C. Risk-free rate.

D. Cost of equity capital.

A. The firm's cost of capital is not used in calculating certainty equivalent NPV. B. A risk-adjusted discount rate is not used in calculating certainty equivalent NPV.

C. The goal of the certainty equivalent approach is to find the smallest cash flow in each period that would be acceptable in place of that period's risky cash flow, if that smaller cash flow can be depended upon absolutely. The certainty equivalent approach adjusts risky after-tax cash flows to a level judged by the decision-maker to be certain of attainment, by estimating the minimum cash flow for each year of the project. Then the certainty equivalent cash flows are discounted at the risk-free rate of interest to calculate a Certainty Equivalent NPV. The Certainty Equivalent NPV is then compared with the NPV of the project when its risky cash flows are discounted at the company's required rate of return. If the two NPVs are equivalent, the decision-maker will be indifferent between them and will accept the certain cash flow in place of the risky cash flow.

D. The firm's cost of equity capital is not used in calculating certainty equivalent NPV.

Question 26 - CMA 1293 4.11 - Capital Budgeting Methods If an investment project has a profitability index of 1.15, the A. Project's internal rate of return is 15%.

B. Project's cost of capital is greater than its internal rate of return. C. Project's internal rate of return exceeds its net present value. D. Net present value of the project is positive.

A. The internal rate of return of a project is the discount rate at which a project's net present value is zero. It is not calculated as the profitability index − 1.

B. A positive profitability index indicates that the project's profitability is higher than its cost of capital. Therefore, the internal rate of return of the project must be greater than the cost of capital.

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C. The internal rate of return is the rate at which a project's net present value is zero. Since the IRR is a rate and the NPV is a monetary amount, the two are not comparable.

D. The profitability index for an investment project is its discounted annual net cash inflows divided by its initial cash investment. If a project profitability index is greater than 1.00, we know that its discounted annual net cash inflows are greater than its initial cash investment. Since the net present value is the monetary gain (loss) of the project's cumulative net cash flows, the net present value of a project with a P.I. of greater than 1.00 must be positive.

Question 27 - CMA 1293 4.12 - Capital Budgeting Methods The internal rate of return for a project can be determined

A. If the internal rate of return is greater than the firm's cost of capital. B. Only if the project cash flows are constant.

C. By finding the discount rate that yields a net present value of zero for the project. D. By subtracting the firm's cost of capital from the project's profitability index.

A. The internal rate of return can be determined regardless of whether it is greater, lesser, or the same as the firm's cost of capital.

B. While the internal rate of return is easier to calculate when the project's cash flows are constant each year, it is not impossible to calculate it when the project's cash flows vary. When the project's cash flows vary, the internal rate of return can be found by trial and error.

C. The internal rate of return is the discount rate which, when used to calculate the net present value of a project, yields a net present value of zero.

D. The IRR is not calculated by subtracting the firm's cost of capital from the project's profitability index.

A company has unlimited capital funds to invest. The decision rule for the company to follow in order to maximize shareholders' wealth is to invest in all projects having a(n)

A. Present value greater than zero.

B. Accounting rate of return greater than the hurdle rate used in capital budgeting analyses. C. Net present value greater than zero.

D. Internal rate of return greater than zero.

A. This is not the description of projects that a company with unlimited capital funds to invest would invest in.

B. The accounting rate of return is the ratio of the amount of increased book income to the required investment. Since it uses book income rather than discounted cash flow, it is not comparable to the hurdle rate, which is another term for the firm's required rate of return based on discounted cash flow.

C. The net present value of an investment or project is equal to the difference between the present value of all future cash inflows and the present value of the initial and any future cash outflows, using the required rate of return. Thus, in order to maximize shareholders' wealth, a company with unlimited capital funds to invest will invest in all projects having a net present value greater than zero, unless projects are mutually exclusive.

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D. A company with unlimited capital to invest would not maximize shareholders' wealth by investing in all projects with an internal rate of return greater than zero. Doing so would fail to consider the company's cost of capital.

Question 29 - CMA 1293 4.16 - Capital Budgeting Methods Sensitivity analysis is used in capital budgeting to

A. Simulate probabilistic customer reactions to a new product. B. Estimate a project's internal rate of return.

C. Determine the amount that a variable can change without generating unacceptable results. D. Identify the required market share to make a new product viable and produce acceptable results. A. Sensitivity analysis is not used in simulation.

B. A project's internal rate of return cannot be estimated by using sensitivity analysis.

C. Sensitivity analysis is used to determine how an amount will change if factors that were involved in

predicting that amount change. If a small change in the value of one of the inputs causes a large change in the recommended decision, then we say it is sensitive to that input. If we know that a particular input makes a big difference in the analysis, we can take extra care to make sure the value assigned to that input in the analysis is as accurate as possible. Furthermore, the measure of the sensitivity of a project to a change in one of the variables is also an indication of the risk of the project. The more sensitive the project is to a change in one or more variables, the more risky it is.

D. Sensitivity analysis cannot be used to identify required market share to make a new product viable.

If income tax considerations are ignored, how is depreciation handled by the following capital budgeting techniques? Internal Rate of Return / Accounting Rate of Return / Payback

A. Included / Included / Included B. Excluded / Included /Excluded C. Excluded / Excluded / Included D. Included / Excluded / Included

A. If income tax considerations are ignored, depreciation would be excluded from the internal rate of return and payback calculations, because the IRR and the payback period are based upon cash flows.

B. If income tax considerations are to be ignored, then the depreciation tax shield is ignored. Therefore, the income tax savings from the depreciation are not included in the capital budgeting analyses. If the income tax savings from the depreciation are excluded, then depreciation is ignored in the calculations of internal rate of return and payback. However, depreciation is included in the calculation of the accounting rate of return, because the accounting rate of return is based upon book income, which includes depreciation.

C. If income tax considerations are ignored, depreciation would be included in the accounting rate of return calculation, because the accounting rate of return is based upon book income, which includes depreciation. Furthermore,

depreciation would be excluded from the payback period calculation, because the payback period calculation is based upon cash flows, not book income.

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calculations, because the IRR and the payback period are based upon cash flows. Depreciation would be included in the calculation of the accounting rate of return, because the accounting rate of return is based upon book income, which includes depreciation.

Question 31 - CMA 1293 4.18, adapted - Capital Budgeting Methods

The Keego Company is planning a $200,000 equipment investment which has an estimated 5-year life with no estimated salvage value. The company has projected the following annual cash flows for the investment.

Year Projected Cash Inflows Present Value of $1

1 $120,000 0.91 2 60,000 0.76 3 40,000 0.63 4 40,000 0.53 5 40,000 0.44 Totals $300,000 3.27

Assuming that the estimated cash inflows occur evenly during each year, the payback period for the investment is A. 1.50 years.

B. 1.67 years. C. 2.50 years. D. 3.94 years.

A. 1.5 years results from dividing the total undiscounted cash flows of $300,000 by the initial cash outflow of $200,000. However, this is not the correct way to calculate the payback period.

B. A payback period of 1.67 years would result if the second year's cash flow were the same as the first year's cash flow. However, that is not the case.

C. The payback period is, first, the number of the project year in the final year when cumulative cash flow (including the initial investment) is negative, plus a fraction consisting of the positive value of the negative cumulative cash inflow amount from the final negative year divided by the cash flow for the following year. In this case, the final year in which the cumulative cash flow is zero is Year 2, because $(200,000) + $120,000 + $60,000 = $(20,000). In the third year, the cash flow is $40,000. So $20,000 ÷ $40,000 = .5, and the payback period is 2 + .5, or 2.5 years.

D. This is the discounted payback period, in which all cash flows are discounted and the cumulative discounted cash flow is used to calculate the payback period. Although the discount factors are given in this problem, the problem does not ask for the discounted payback period.

The Keego Company is planning a $200,000 equipment investment which has an estimated 5-year life with no estimated salvage value. The company has projected the following annual cash flows for the investment.

Year Projected Cash Inflows Present Value of $1

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2 60,000 0.76

3 40,000 0.63

4 40,000 0.53

5 40,000 0.44

Totals $300,000 3.27

The net present value for the investment is A. $100,000

B. $18,800 C. $130,800 D. $218,800

A. $100,000 results from subtracting the initial investment of $200,000 from the total of the undiscounted cash flows, which is $300,000. This is not the correct way to calculate NPV.

B. The net present value is the net expected monetary gain or loss from a project when all the expected future cash inflows and outflows are discounted to the point of the investment, using the firm's required rate of return. Discounting the annual cash inflows using the discount factors given results in annual discounted cash inflows of ($120,000 × .91) + ($60,000 × .76) + ($40,000 × .63) + ($40,000 × .53) + ($40,000 × .44) = $218,800. The

discounted total annual cash flows minus the initial investment of $200,000 = $18,800, which is the NPV. C. $130,800 results from discounting the initial investment for 5 years and subtracting the discounted value from the present value of the future cash inflows. However, the initial investment which occurs in Year 0 does not need to be discounted in order to calculate net present value, because it is already expressed at its present value in the analysis. D. $218,800 is the total of the present values of the future cash inflows, but this is not net present value.

When determining net present value in an inflationary environment, adjustments should be made to A. Decrease the estimated cash inflows and increase the discount rate.

B. Increase the estimated cash inflows but not the discount rate. C. Increase the discount rate, only.

D. Increase the estimated cash inflows and increase the discount rate.

A. The estimated future cash inflows need to be increased, not decreased, to reflect the lower value of the dollar in the future as a result of the inflation.

B. The estimated future cash inflows do need to be increased, to reflect the lower value of the dollar in the future as a result of the inflation. However, the discount rate also needs to be increased, because the firm will require a higher rate of return to compensate for the increased inflation.

C. The discount rate does need to be increased, because the firm will require a higher rate of return to compensate for the increased inflation. However, this is not the only adjustment that is necessary to determine net present value in an inflationary environment.

D. In an environment of inflation, both the discount rate used and the future expected cash flows should be increased. The discount rate is increased because the firm will require a higher rate of return to compensate for the increased inflation. The future expected cash flow amounts need to be increased because inflation will cause the dollar to be worth less in the future, and the amounts of cash (both inflows and outflows) will therefore increase in the future.

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The length of time required to recover the initial cash outlay of a capital project is determined by using the A. Payback method.

B. Weighted net present value method. C. Net present value method.

D. Discounted cash flow method. A.

The Payback Method is used to determine the number of periods that must pass before the net after-tax cash inflows from the investment will equal (or "pay back") the initial investment cost. If the incoming cash flows are constant over the life of the project, the payback period may be calculated with a simple division as follows: Initial net investment ÷ Periodic constant expected cash flow.

If the cash flows are not constant over the life of the project, we must add up the cash inflows and determine on a cumulative basis when the inflows equal the outflows.

B. A probability-weighted Net Present Value for a capital project cannot be used to determine the length of time required to recover the initial cash outlay of a capital project.

C. The Net Present Value method of capital budgeting analysis cannot be used to determine the length of time required to recover the initial cash outlay of the capital project.

D.

Methods of capital budgeting analysis that utilize discounted cash flow concepts are Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI).

NPV can be used to determine the difference between the present value of all future cash inflows and the present value of all (the initial as well as all future) cash outflows, using the required rate of return. A project with a positive NPV is acceptable.

The IRR is the discount rate at which the NPV of an investment will be equal to 0, or the discount rate at which the present value of the expected cash inflows from a project equals the present value of the expected cash outflows. If this rate is higher than the required rate of return, the investment is acceptable.

The PI calculation is used to determine the ratio of the PV of net future cash flows (both inflows and outflows) to the amount of the initial investment. It is calculated as follows, using the same information from the NPV calculation: PV of future net cash flows ÷ Net Initial Investment. If a project has a positive net present value, the profitability index will be above 1.00 and it will be an acceptable project.

However, none of these discounted cash flow methods can be used to determine the length of time required to recover the initial cash outlay of a capital project.

In evaluating a capital budget project, the use of the net present value (NPV) model is generally not affected by the A. Initial cost of the project.

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B. Method of funding the project. C. Type of depreciation used.

D. Amount of added working capital needed for operations during the term of the project. A. The initial cost of the project is a component of a net present value capital budgeting analysis.

B. The method of funding the project is separate from the net present value method of capital budgeting analysis.

C. The type of depreciation used for the project's fixed assets is a component of a net present value capital budgeting analysis.

D. Amount of added working capital needed for operations during the term of the project is a component of a net present value capital budgeting analysis.

For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management

A. Believes bank loans are riskier than capital investments. B. Wants to factor risk into its consideration of projects. C. Believes too many proposals are being rejected. D. Wants to use equity funding exclusively.

A. The method of funding a project is a separate decision from the capital budgeting analysis.

B. A company's Weighted Average Cost of Capital (WACC) — which is the rate of return required by investors in the company's securities — is the appropriate discount rate (or hurdle rate) to use in capital budgeting

decisions and NPV calculations as long as the riskiness of the project is the same as the riskiness of the firm's existing business. If management wants to factor the risk of a project into its analysis, it will increase the discount rate used in NPV calculations for more risky, or uncertain, investments. A higher discount rate will require higher expected future cash flows in order for the company to make the investment, thus making fewer investments acceptable.

C. A high hurdle rate of return would require higher future cash inflows from a project in order for the project to be acceptable. Therefore, a high hurdle rate will result in fewer projects being accepted.

D. The method of funding a project is a separate decision from the capital budgeting analysis.

The method that recognizes the time value of money by discounting the after-tax cash flows over the life of a project, using the company's minimum desired rate of return is the

A. Net present value method. B. Internal rate of return method. C. Accounting rate of return method. D. Payback method.

A. The net present value method is used to determine the difference between the present value of all future expected cash inflows and the present value of all (the initial as well as all future) expected cash outflows,

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using the required rate of return. A project with a positive NPV is acceptable.

B. The internal rate of return is the discount rate at which the NPV of an investment will be equal to 0, or the discount rate at which the present value of the expected cash inflows from a project equals the present value of the expected cash outflows. The company's minimum desired rate of return is used only in analyzing the results of the IRR analysis, not in doing the calculation. If the IRR is higher than the company's minimum desired rate of return, the project is acceptable.

C. The accounting rate of return is a ratio of the amount of increased book income to the required investment. It does not recognize the time value of money and it does not include discounting after-tax cash flows over the life of the project. D. The payback method does not recognize the time value of money and does not include discounting after-tax cash flows over the life of the project.

The method that divides a project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment is the

A. Payback method.

B. Accounting rate of return method. C. Internal rate of return method. D. Net present value (NPV) method.

A. The Payback Method is used to determine the number of periods that must pass before the net after-tax cash inflows from the investment will equal (or "pay back") the initial investment cost. If the incoming cash flows are constant over the life of the project, the payback period may be calculated with a simple division as follows: Initial net investment Periodic constant expected cash flow If the cash flows are not constant over the life of the project, the Payback Period is calculated by adding up the cash inflows and determining on a cumulative basis when the inflows equal the outflows. The Payback Method does not utilize a division of the project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment.

B.

The accounting rate of return is a ratio of the amount of increased book income to the required investment. It is calculated as follows: Increase in Expected Annual Average After Tax Accounting Net Income ÷ Net Initial Investment. Sometimes the average investment figure is used rather than the total investment. Since this method uses accrual accounting income, it includes depreciation. However, it does not take into account the time value of money.

C. The internal rate of return is the discount rate at which the NPV of an investment will be equal to 0, or the discount rate at which the present value of the expected cash inflows from a project equals the present value of the expected cash outflows. If the IRR is higher than the company's minimum desired rate of return, the project is acceptable. The IRR does not utilize a division of the project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment.

D. The net present value method is used to determine the difference between the present value of all future cash inflows and the present value of all (the initial as well as all future) cash outflows, using the required rate of return. A project with a positive NPV is acceptable. It does not utilize a division of the project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment.

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The capital budgeting model that is generally considered the best model for long-range decision making is the A. Unadjusted rate of return model.

B. Accounting rate of return model. C. Discounted cash flow model. D. Payback model.

A. The unadjusted rate of return model, or accounting rate of return model, is not generally considered the best model for long-range decision making, because it does not incorporate time value of money concepts.

B. The accounting rate of return model, or unadjusted rate of return model, is not generally considered the best model for long-range decision making, because it does not incorporate time value of money concepts.

C. Discounted cash flow methods of capital budgeting, including net present value, internal rate of return, and profitability index, are generally considered the best model for long-range capital budgeting decision making. D. The payback method is not generally considered the best model for long-range decision making, because it does not incorporate time value of money concepts.

The technique used to evaluate all possible capital projects of different dollar amounts and then rank them according to their desirability is the

A. Discounted cash flow method. B. Payback method.

C. Profitability index method. D. Net present value method.

A. There are three discounted cash flow methods used for capital budgeting. Only one of them can be used to evaluate all possible capital projects of different dollar amounts and rank them according to their desirability.

B. The Payback Method is used to determine the number of periods that must pass before the net after-tax cash inflows from the investment will equal (or "pay back") the initial investment cost. It is not used to evaluate all possible capital projects of different dollar amounts and then rank them according to their desirability.

C. The PI calculation is used to determine the ratio of the PV of net future cash flows (both inflows and

outflows) to the amount of the initial investment. It is calculated as follows, using the same information from the NPV calculation: PV of future net cash flows ÷ Net Initial Investment. If a project has a positive net present value, the profitability index will be above 1.00 and it will be an acceptable project. The profitability index is used to evaluate all possible capital projects of different dollar amounts and then rank them according to their desirability.

D. The net present value method is not used to evaluate all possible capital projects of different dollar amounts and then rank them according to their desirability.

A widely used approach that is used to recognize uncertainty about individual economic variables while obtaining an immediate financial estimate of the consequences of possible prediction errors is

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A. Expected value analysis. B. Sensitivity analysis. C. Learning curve analysis. D. Regression analysis.

A. Expected value is the weighted average of all the possible values of a random variable, with the probabilities of each of the values used as the weights. The expected value is the mean value, also known as the average value. Expected value analysis does not yield an immediate financial estimate of the consequences of possible prediction errors. B. Sensitivity analysis can be used to determine how cash flows can be expected to vary with changes in the underlying assumptions. Using expected cash flows, the NPV, IRR, and PI of the project are determined. Then, the key assumptions that were used in making the original expected cash flow projections are identified. One assumption at a time is then changed, leaving the other assumptions unchanged, and the NPV, IRR and PI are recalculated to determine what effect changing one assumption would have on those measures.

C. Learning curves describe the fact that the more experience people have with something, the more efficient they become in doing that task. Higher costs per unit early in production are part of start-up costs. It is commonly accepted that new products and production processes experience a period of low productivity followed by increased productivity. However, learning curve analysis does not provide an immediate financial estimate of the consequences of possible prediction errors.

D. Regression analysis is a method of forecasting, using trend analysis. However, it does not yield an immediate financial estimate of the consequences of possible prediction errors.

Which one of the following statements about the payback method of investment analysis is correct? The payback method

A. Considers cash flows after the payback has been reached. B. Does not consider the time value of money.

C. Uses discounted cash flow techniques.

D. Generally leads to the same decision as other methods for long-term projects.

A. The payback method does not take into account any cash flows expected to be received after the payback point has been reached.

B. The payback method uses undiscounted cash flows and thus does not incorporate the time value of money in the analysis. That is one of its weaknesses. Another weakness is that it does not take into account any cash flows that are received after the payback point has been reached.

C. The payback method does not use discounted cash flow techniques, and that is one of its weaknesses. D. The payback method does not necessarily lead to the same decision as other methods of analyzing long-term projects do.

Question 43 - CMA 1295 4.12 (adapted) - Capital Budgeting Methods

Willis Inc. has a cost of capital of 15% and is considering the acquisition of a new machine which costs $400,000 and has a useful life of 5 years. Willis projects that earnings and cash flow will increase as follows:

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Net Year

After-Tax

Earnings Cash Flow

1 $100,000 $160,000

2 100,000 140,000

3 100,000 100,000

4 100,000 100,000

5 200,000 100,000

15% Interest Rate factors Period Present Value of $1

Present Value of an Annuity of $1 1 0.87 0.87 2 0.76 1.63 3 0.66 2.29 4 0.57 2.86 5 0.50 3.36

The net present value of this investment is A. Negative, $14,000.

B. Positive, $200,000. C. Negative, $64,000. D. Positive, $18,600.

A. An answer of a negative $14,000 results from using the net earnings amounts instead of the after-tax cash flow amounts in the net present value analysis.

B. An answer of $200,000 results from subtracting the initial investment from the total of the undiscounted cash inflows. C. An answer of a negative $64,000 NPV results from using annual cash flows of $100,000, and forgetting to discount the additional cash flows of $60,000 in Year 1 and $40,000 in Year 2.

D. The net present value is the present value of all cash flows after Year 0 (positive and negative) less the initial investment. To calculate the present value of the cash flows after year 0, you could discount each individual cash flow amount by the appropriate present value of $1 factor. However, that is not the most time-effective way to do it. If you recognize that all the annual cash flow amounts contain an amount such as $100,000 and $100,000 is the exact amount of the cash flow for at least two of the years, you can save time by calculating first the present value of an annuity for the $100,000; then calculating the present value of $1 individually for any amounts over the $100,000 amount. In this case, we have 5 years of $100,000 cash flows, and the discount factor given for the PV of an annuity for 5 years is 3.36. We also have $60,000 to be discounted for one year and $40,000 to be discounted for two years using the appropriate present value of $1 factors. Thus, the present value of the cash inflows is ($100,000 × 3.36) + ($60,000 × .87) + ($40,000 × .76) = $418,600. The net present value is $418,600 less the initial investment of $400,000, or $18,600.

Question 44 - CMA 1295 4.13 (adapted) - Capital Budgeting Methods

Willis Inc. has a cost of capital of 15% and is considering the acquisition of a new machine which costs $400,000 and has a useful life of 5 years. Willis projects that earnings and cash flow will increase as follows: