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MANAGEMENT ADVISORY SERVICES

CAPITAL BUDGETING
THEORY
1. Capital budgeting techniques are least likely to be used in evaluating the
a. Acquisition of new aircraft by a cargo company.
b. Design and implementation of a major advertising program.
c. Trade for a star quarterback by a football team.
d. Adoption of a new method of allocating nontraceable costs to product lines.
!. The "inflation element# refers to the
a. $mpact that future price increases will have on the original cost of a capital e%penditure.
b. &act that the real purchasing power of a monetary unit usually increases over time.
c. &uture deterioration of the general purchasing power of the monetary unit.
d. &uture increases in the general purchasing power of the monetary unit.
'. (ahlin (overs) $nc. is planning to purchase equipment to make its operations more efficient.
This equipment has an estimated useful life of si% years. As part of this acquisition) a
*1+,),,, investment in working capital is required. $n a discounted cash flow analysis) this
investment in working capital should be
a. Amorti-ed over the useful life of the equipment.
b. Disregarded because no cash is involved.
c. Treated as a recurring annual cash flow that is recovered at the end of si% years.
d. Treated as an immediate cash outflow that is recovered at the end of si% years.
.. To appro%imate annual cash inflow) depreciation is
a. Added back to net income because it is an inflow of cash.
b. /ubtracted from net income because it is an outflow of cash.
c. /ubtracted from net income because it is an e%pense.
d. Added back to net income because it is not an outflow of cash.
+. $n capital e%penditures decisions) the following are relevant in estimating operating costs
e%cept
a. &uture costs. b. Cash costs. c. Differential costs. d. 0istorical costs.
1. 2hich of the following best identifies the reason for using probabilities in capital budgeting
is
a. Different life of projects. c. 3ncertainty.
b. Cost of capital. d. Time value of money.
4. $n capital budgeting decisions) the following items are considered among others5
1. Cash outflow for the investment.
!. $ncrease in working capital requirements.
'. *rofit on sale of old asset
.. 6oss on writeoff of old asset.
&or which of the above items would ta%es be relevant7
a. $tems 1 and ' only. c. All items.
b. $tems ' and . only. d. $tems 1) ' and . only.
8. 9our company is purchasing a transport equipment as part of its territorial e%pansion strategy.
The technical services department indicated that this equipment needs overhauling in year .
or year + of its useful life. The overhauling cost will be e%pected during the year the
overhauling is done. The finance officer insists that the overhauling be done in year .) not in
year +. The most likely reason is
a. There is lower ta% rate in year +. c. The time value of money is considered.
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b. There is higher ta% rate in year + d. Due statements A and C above.
:. An optimal capital budget is determined by the point where the marginal cost of capital is
A. (inimi-ed.
;. <qual to the average cost of capital.
C. <qual to the rate of return on total assets.
D. <qual to the marginal rate of return on investment.
1,. The following statements refer to the accounting rate of return =A>>?
1. The A>> is based on the accrual basis) not cash basis.
!. The A>> does not consider the time value of money.
'. The profitability of the project is considered.
&rom the above statements) which are considered limitations of the A>> concept7
a. /tatements ! and ' only. c. All the ' statements.
b. /tatements ' and 1 only. d. /tatements 1 and ! only.
11. The payback method assumes that all cash inflows are reinvested to yield a return equal to
a. the discount rate. c. the internal rate of return.
b. the hurdle rate. d. -ero.
1!. As a capital budgeting technique) the payback period considers depreciation e%penses =D<?
and time value of money =T@(? as follows5
a. b. c. d.
D< relevant irrelevant $rrelevant relevant
T@( relevant irrelevant >elevant irrelevant
1'. The bailout payback period is
a. The payback period used by firms with government insured loans.
b. The length of time for payback using cash flows plus the salvage value to recover the
original investment
c. =a? and =b?
d. Aone of the above.
1.. 2hich of the following methods measures the cash flows and outflows of a project as if they
occurred at a single point in time7
a. Cash flow based payback period. c. *ayback method.
b. Capital budgeting. d. Discounted cash flow.
1+. 2hen using one of the discountedcashflow methods to evaluate the feasibility of a capital
budgeting project) which of the following factors generally is not important7
a. The method of financing the project under consideration.
b. The impact of the project on income ta%es to be paid.
c. The timing of cash flows relating to the project.
d. The amount of cash flows relating to the project.
11. $n an investment in plant the return that should keep the market price of the firm stock
unchanged is
a. *ayback c. Aet present value
b. Discounted rate of return d. Cost of capital
14. The e%cess present value method is anchored on the theory that the future returns) e%pressed
in terms of present value) must at least be
a. <qual to the amount of investment c. (ore than the amount of investment
b. 6ess than the amount of investment d. Cannot be determined
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18. A company had made the decision to finance ne%t yearBs capital projects through debt rather
than additional equity. The benchmark cost of capital for these projects should be
a. The beforeta% cost of newdebt financing. c. The cost of equity financing.
b. The afterta% cost of newdebt financing. d. The weightedaverage cost of capital.
1:. All of the following refer to the discount rate used by a firm in capital budgeting e%cept
a. 0urdle rate. c. Cpportunity cost.
b. >equired rate of return. d. Cpportunity cost of capital.
!,. $f a firm identifies =or creates? an investment opportunity with a present value D6ist AE its
cost) the value of the firm and the price of its common stock will D6ist ;E
a. b. c. d.
6ist A Freater than Freater than <qual to <qual to
6ist ; $ncrease Decrease $ncrease Decrease
!1. The common assumption in capital budgeting analysis is that cash inflows occur in lump
sums at the end of individual years during the life of an investment project when in fact they
flow more or less continuously during those years
a. >esults in understated estimates of A*@.
b. $s done because present value tables for continuous flows cannot be constructed.
c. 2ill result in inconsistent errors being made on estimating A*@s such that project cannot
be evaluated reliably.
d. >esults in higher estimate for the $>> on the investment.
!!. An advantage of the net present value method over the internal rate of return model in
discounted cash flow analysis is that the net present value method
a. Computes a desired rate of return for capital projects.
b. Can be used when there is no constant rate of return required for each year of the project.
c. 3ses a discount rate that equates the discounted cash inflows with the outflows.
d. 3ses discounted cash flows whereas the internal rate of return model does not.
!'. 2hen using the net present value method for capital budgeting analysis) the required rate of
return is called all of the following e%cept the
A. >iskfree rate. ;. Cost of capital. C. Discount rate. D. Cutoff rate.
!.. A projectBs net present value) ignoring income ta% considerations) is normally affected by the
a. *roceeds from the sale of the asset to be replaced.
b. Carrying amount of the asset to be replaced by the project.
c. Amount of annual depreciation on the asset to be replaced.
d. Amount of annual depreciation on fi%ed assets used directly on the project.
!+. 9ou have determined the profitability of a planned project by finding the present value of all
the cash flows from that project. 2hich of the following would cause the project to look less
appealing) that is) have a lower present value7
a. The discount rate increases.
b. The cash flows are e%tended over a longer period of time.
c. The investment cost decreases without affecting the e%pected income and life of the
project.
d. The cash flows are accelerated and the project life is correspondingly shortened.
!1. 0ow are the following used in the calculation of the internal rate of return of a proposed
project7 $gnore income ta% considerations.
a. b. c. d.
>esidual sales value of project <%clude $nclude <%clude $nclude
Depreciation e%pense $nclude $nclude <%clude <%clude
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!4. The discount rate that equates the present value of the e%pected cash flows with the cost of
the investment is the
a. Aet present value c. Accounting rate of return
b. $nternal rate of return d. *ayback period.
!8. 2hich of the following characteristics represent an advantage of the internal rate of return
techniques over the accounting rate of return technique in evaluating a project7
$ >ecognition of the projectBs salvage value.
$$ <mphasis on cash flows.
$$$ >ecognition of the time value of money.
a. $ only. b. $ and $$. c. $$ and $$$. d. $) $$) and $$$.
!:. *olo Co. requires higher rates of return for projects with a life span greater than + years.
*rojects e%tending beyond + years must earn a higher specified rate of return. 2hich of the
following capital budgeting techniques can readily accommodate this requirement7
a. b. c. d.
$nternal >ate of >eturn 9es Ao Ao 9es
Aet *resent @alue Ao 9es Ao 9es
',. 2hich of the following combinations is ACT possible7
*rofitability $nde% A*@ $>>
a. Freater than 1 *ositive (ore than cost of capital
b. <quals 1 Gero <quals cost of capital
c. 6ess than 1 Aegative 6ess than cost of capital
d. 6ess than 1 *ositive 6ess than cost of capital
'1. 2hich of the following is always true with regard to the net present value =A*@? approach7
A. $f a project is found to be acceptable under the A*@ approach) it would also be
acceptable under the internal rate of return =$>>? approach.
;. The A*@ and the $>> approaches will always rank projects in the same order.
C. $f a project is found to be acceptable under the A*@ approach) it would also be
acceptable under the payback approach.
D. The A*@ and payback approaches will always rank projects in the same order.
'!. 2hen ranking two mutually e%clusive investments with different initial amounts)
management should give first priority to the project
A. That generates cash flows for the longer period of time.
;. 2hose net afterta% flows equal the initial investment.
C. That has the greater accounting rate of return.
D. That has the greater profitability inde%.
''. 2hich mutually e%clusive project would you select) if both are priced at H1),,, and your
discount rate is 1+IJ *roject A with three annual cash flows of H1),,,) or *roject ;) with '
years of -ero cash flow followed by ' years of H1)+,, annually7
A. *roject A.
;. *roject ;.
C. The $>>s are equal) hence you are indifferent.
D. The A*@s are equal) hence you are indifferent.
'.. *ayback period =**?) profitability inde% =*$?) and simple accounting rate of return =/A>>?
are some of the capital budgeting techniques. 2hat is the effect of an increase in the cost of
capital on these techniques7
a. b. c. d.
** $ncrease Ao change Ao change Decrease
*$ Decrease Decrease $ncrease Ao change
/A>> $ncrease Ao change Decrease Ao change
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'+. A company is evaluating three possible investments. $nformation relating to the company and
the investments follow5
&isher rate for the three projects 4I
Cost of capital 8I
;ased on this information) we know that
a. all three projects are acceptable.
b. none of the projects are acceptable.
c. the capital budgeting evaluation techniques profitability inde%) net present value) and
internal rate of return will provide a consistent ranking of the projects.
d. the net present value method will provide a ranking of the projects that is superior to the
ranking obtained using the internal rate of return method.
'1. /everal proposed capital projects which are economically acceptable may have to be ranked
due to constraints in financial resources. $n ranking these projects) the least pertinent is this
statement.
a. $f the internal rate of return method is used in the capital rationing problem) the higher
the rate) the better the project.
b. $n selecting the required rate of return) one may either calculate the organi-ationBs cost of
capital or use a rate generally acceptable in the industry.
c. A ranking procedure on the basis of quantitative criteria may be established by specifying
a minimum desired rate of return) which rate is used in calculating the net present value
of each project.
d. $f the net present value method is used) the profitability inde% is calculated to rank the
projects. The lower the inde%) the better the project.
'4. Capital budgeting methods are often divided into two classifications5 project screening and
project ranking. 2hich one of the following is considered a ranking method rather than a
screening method7
A. Aet present value. C. *rofitability inde%.
;. Timeadjusted rate of return. D. Accounting rate of return.
'8. A company has analy-ed seven new projects) each of which has its own internal rate of
return. $t should consider each project whose internal rate of return is KKKKK its marginal cost
of capital and accept those projects in KKKKK order of their internal rate of return.
A. ;elowJ decreasing. C. AboveJ increasing.
;. AboveJ decreasing. D. ;elowJ increasing.
':. @elasque- L Co. is considering an investment proposal for *1, million yielding a net present
value of *.+,),,,. The project has a life of 4 years with salvage value of *!,,),,,. The
company uses a discount rate of 1!I. 2hich of the following would decrease the net present
value7
a. <%tend the project life and associated cash inflows.
b. $ncrease discount rate to 1+I.
c. Decrease the initial investment amount to *:., million.
d. $ncrease the salvage value.
.,. 2hat is the effect of changes in cash inflows) investment cost and cash outflows on
profitability =present value? inde% =*$?
a. *$ will increase with an increase in cash inflows) a decrease in investment cost) or a
decrease in cash outflows.
b. *$ will increase with an increase in cash inflows) an increase in investment cost) or an
increase in cash outflows.
c. *$ will decrease with an increase in cash inflows) a decrease in investment cost) or a
decrease in cash outflows.
d. *$ will decrease with an increase in cash outflows) an increase in investment cost) or an
increase in cash inflows.
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PROBLEMS
1. Acme is considering the sale of a machine with a book value of H8,),,, and ' years
remaining in its useful life. /traightline depreciation of H!+),,, annually is available. The
machine has a current market value of H1,,),,,. 2hat is the cash flow from selling the
machine if the ta% rate .,I.
a. H!+),,, b. H8,),,, c. H:!),,, d. H1,,),,,
! 0atchet Company is considering replacing a machine with a book value of H.,,),,,) a
remaining useful life of + years) and annual straightline depreciation of H8,),,,. The
e%isting machine has a current market value of H.,,),,,. The replacement machine would
cost H++,),,,) have a +year life) and save H4+),,, per year in cash operating costs. $f the
replacement machine would be depreciated using the straightline method and the ta% rate is
.,I) what would be the net investment required to replace the e%isting machine7
a. H:,),,,. b. H1+,),,, c. H'',),,, d. H++,),,,
'. Diliman >epublic *ublishers) $nc. is considering replacing an old press that cost *8,,),,, si%
years ago with a new one that would cost *!)!+,),,,. /hipping and installation would cost
an additional *!,,),,,. The old press has a book value of *1+,),,, and could be sold
currently for *+,),,,. The increased production of the new press would increase inventories
by *.,),,,) accounts receivable by *11,),,, and accounts payable by *1.,),,,. Diliman
>epublicBs net initial investment for analy-ing the acquisition of the new press assuming a
'+I income ta% rate would be
a. *!).+,),,, b. *!).!+),,, c. *!)1,,),,, d. *!)!+,),,,
.. Mey Corp. plans to replace a production machine that was acquired several years ago.
Acquisition cost is *.+,),,, with salvage value of *+,),,,. The machine being considered
is worth *8,,),,, and the supplier is willing to accept the old machine at a tradein value of
*1,),,,. /hould the company decide not to acquire the new machine) it needs to repair the
old one at a cost of *!,,),,,. Ta%wise) the tradein transaction will not have any
implication but the cost to repair is ta%deductible. The effective corporate ta% rate is '+I of
net income subject to ta%. &or purposes of capital budgeting) the net investment in the new
machine is
a. *+.,),,, b. *11,),,, c. *11,),,, d. *8,,),,,
+. Freat @alue Company is planning to purchase a new machine costing *+,),,, with freight
and installation costs amounting to *1)+,,. The old unit is to be tradedin will be given a
tradein allowance of *4)+,,. Cther assets that are to be retired as a result of the acquisition
of the new machine can be salvaged and sold for *'),,,. The loss on retirement of these
other assets is *1),,, which will reduce income ta%es of *.,,. $f the new equipment is not
purchased) repair of the old unit will have to be made at an estimated cost of *.),,,. This
cost can be avoided by purchasing the new equipment. Additional gross working capital of
*1!),,, will be needed to support operation planned with the new equipment.
The net investment assigned to the new machine for decision analysis is
a. *+,)!,, b. *+!)1,, c. *+')1,, d. *+4)1,,
1. 0ooker Cak &urniture Company is considering the purchase of wood cutting equipment.
Data on the equipment are as follows5
Criginal investment H',),,,
Aet annual cash inflow H1!),,,
<%pected economic life in years +
/alvage value at the end of five years H'),,,
The company uses the straightline method of depreciation with no midyear convention.
2hat is the accounting rate of return on original investment rounded off to the nearest
percent) assuming no ta%es are paid7
a. .,.,I b. !,.,I c. !..,I d. !!.,I
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4. A company is considering putting up *+,),,, in a threeyear project. The companyBs
e%pected rate of return is 1!I. The present value of *1.,, at 1!I for one year is ,.8:') for
two years is ,.4:4) and for three years is ,.41!. The cash flow) net of income ta%es will be
*18),,, =present value of *11),4.? for the first year and *!!),,, =present value of *14)+'.?
for the second year. Assuming that the rate of return is e%actly 1!I) the cash flow) net of
income ta%es) for the third year would be
a. *4)1!, b. *1,),,, c. *11)':! d. *!'),!!
8. 6or $ndustries is analy-ing a capital investment proposal for new machinery to produce a
new product over the ne%t ten years. At the end of the ten years) the machinery must be
disposed of with a -ero net book value but with a scrap salvage value of *!,),,,. $t will
require some *',),,, to remove the machinery. The applicable ta% rate is '+I. The
appropriate "endoflife# cash flow based on the foregoing information is
a. $nflow of *',),,,. c. Cutflow of *1,),,,.
b. Cutflow of *1)+,,. d. Cutflow of *14),,,.
:. C Corp. faces a marginal ta% rate of '+ percent. Cne project that is currently under evaluation
has a cash flow in the fourth year of its life that has a present value of H1,),,, =afterta%?. C
Corp. assumes that all cash flows occur at the end of the year and the company uses 11
percent as its discount rate. 2hat is the preta% amount of the cash flow in year .7 =>ound to
the nearest dollar.?
a. H1+)181 b. H!')'+1 c. H:)818 d. H.')'4+
1,. (a%well Company has an opportunity to acquire a new machine to replace one of its present
machines. The new machine would cost H:,),,,) have a +year life) and no estimated
salvage value. @ariable operating costs would be H1,,),,, per year. The present machine
has a book value of H+,),,, and a remaining life of + years. $ts disposal value now is
H+),,,) but it would be -ero after + years. @ariable operating costs would be H1!+),,, per
year. $gnore income ta%es. Considering the + years in total) what would be the difference in
profit before income ta%es by acquiring the new machine as opposed to retaining the present
one7
A. H1,),,, decrease ;. H1+),,, decrease C. H'+),,, increase D. H.,),,, increase
11. A project under consideration by the 2hite Corp. would require a working capital investment
of H!,,),,,. The working capital would be liquidated at the end of the projectNs 1,year life.
$f 2hite Corp. has an afterta% cost of capital of 1, percent and a marginal ta% rate of ',
percent) what is the present value of the working capital cash flow e%pected to be received in
year 1,7
a. H'1)818 b. H44)1,, c. H+'):4, d. H!')1',
1!. 6yben $nc. is planning to produce a new product. To do this) it is necessary to acquire a new
equipment that will cost the company *1,,),,,. The estimated life of the new equipment is
five years with no salvage value. The estimated income and costs based on e%pected sales of
*1,),,, units per year are5
/ales O *1,.,, per unit *1,,),,,
Costs O *8.,, per unit 8,),,,
Aet income * !,),,,
The accounting rate of return based on initial investment is !,I
2hat will be the accounting rate of return based on initial investment of *1,,),,, if
management decrease its selling price of the new product by 1,I7
a. +I b. 1,I c. 1+I d. !,I
1'. (6& Corporation is evaluating the purchase of a *+,,),,, die attach machine. The cash
inflows e%pected from the investment is *1.+),,, per year for five years with no equipment
salvage value. The cost of capital is 1!I. The net present value factor for five =+? years at
1!I is '.1,.8 and at 1.I is '..''1. The internal rate of return for this investment is
a. '..+I b. !.,.I c. 1'.8I d. 1+..8I
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1.. A*P) $nc. is planning to purchase a new machine that will take si% years to recover the cost.
The new machine is e%pected to produce cash flow from operations) net of income ta%es) of
*.)+,, a year for the first three years of the payback period and *')+,, a year of the last
three years of the payback period. Depreciation of *'),,, a year shall be charged to income
of the si% years of the payback period. 0ow much shall the machine cost7
a. *1!),,, b. *18),,, c. *!.),,, d. *'1),,,
1+. /weets) <tc.) $nc. plans to undertake a capital e%penditure requiring *! million cash outlay.
;elow are the projected afterta% cash inflow for the five year period covering the useful life.
The companyBs ta% rate is '+I.
9ear 1 ! ' . +
*B,,, 1,, 4,, .8, .,, .,,
The founder and president of the candy company believes that the best gauge for capital
e%penditure is cash payback period and that the recovery period should not be more than
4+I of the useful life of the project or the asset. /hould the company undertake the project7
a. Ao) since the payback period is . years or 8,I of the useful life of the project.
b. 9es) since the payback period is '.++ years or 41I of the useful life of the project.
c. Ao) since the payback period e%tends beyond the life of the project.
d. 9es) since the payback period is . years and still shorter than the useful life of the project.
11. 2omark Company purchased a new machine on Panuary 1 of this year for H:,),,,) with an
estimated useful life of + years and a salvage value of H1,),,,. The machine will be
depreciated using the straightline method. The machine is e%pected to produce cash flow
from operations) net of income ta%es) of H'1),,, a year in each of the ne%t + years. The new
machineBs salvage value is H!,),,, in years 1 and !) and H1+),,,, in years ' and .. 2hat
will be the bailout period =rounded? for the new machine7
a. 1.. years. b. !.! years. c. 1.: years. d. '.. years.
14. $t is the start of the year and /t. Trope- Co. plans to replace its old singalong equipment.
These information are available5
Cld Aew
<quipment cost *4,),,, *1!,),,,
Current salvage value 1,),,,
/alvage value) end of useful life !),,, 11),,,
Annual operating costs +1),,, '8),,,
Accumulated depreciation ++)',,
<stimated useful life 1, years 1, years
The companyBs income ta% rate is '+I and its cost of capital is 1!I. 2hat is the present
value of all the relevant cash flows at time -ero7
a. =*+.),,,? b. (P110,000) c. =*1!,),,,? d. (P124,700)
18. Cramden Armored Car Co. is considering the acquisition of a new armored truck. The truck
is e%pected to cost H',,),,,. The companyNs discount rate is 1! percent. The firm has
determined that the truck generates a positive net present value of H14),!!. 0owever) the
firm is uncertain as to whether it has determined a reasonable estimate of the salvage value of
the truck. $n computing the net present value) the company assumed that the truck would be
salvaged at the end of the fifth year for H1,),,,. 2hat e%pected salvage value for the truck
would cause the investment to generate a net present value of H,7 $gnore ta%es.
a. H',),,, b. H, c. H++)!48 d. H.!):48
1:. ;ooker /teel $nc. is considering an investment that would require an initial cash outlay of
H.,,),,, and would have no salvage value. The project would generate annual cash inflows
of H4+),,,. The firmNs discount rate is 8 percent. 0ow many years must the annual cash
flows be generated for the project to generate a net present value of H,7
a. between + and 1 years c. between 4 and 8 years
b. between 1 and 4 years d. between 8 and : years
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!,. /alvage Co. is considering the purchase of a new oceangoing vessel that could potentially
reduce labor costs of its operation by a considerable margin. The new ship would cost
H+,,),,, and would be fully depreciated by the straightline method over 1, years. At the
end of 1, years) the ship will have no value and will be sunk in some already polluted harbor.
The /alvage Co.Ns cost of capital is 1! percent) and its marginal ta% rate is ., percent. $f the
ship produces equal annual labor cost savings over its 1,year life) how much do the annual
savings in labor costs need to be to generate a net present value of H, on the project7 =>ound
to the nearest dollar.?
a. H18).:! b. H11.)1+. c. H88).:! d. H1.4).84
!1. The (cAally Co. is considering an investment in a project that generates a profitability inde%
of 1.'. The present value of the cash inflows on the project is H..),,,. 2hat is the net
present value of this project7
a. H1,)1+. b. H1')!,, c. H+4)!,, d. H'')8.1
!!. The Geron Corporation wants to purchase a new machine for its factory operations at a cost
of H:+,),,,. The investment is e%pected to generate H'+,),,, in annual cash flows for a
period of four years. The required rate of return is 1.I. The old machine can be sold for
H+,),,,. The machine is e%pected to have -ero value at the end of the fouryear period. 2hat
is the net present value of the investment7 2ould the company want to purchase the new
machine7 $ncome ta%es are not considered.
a. H11:)++,J yes b. H1:)++,J no c. H1),1:)++,J yes d. H'!1)4+,J no
!'. Drillers $nc. is evaluating a project to produce a hightech deepsea oil e%ploration device.
The investment required is H8, million for a plant with a capacity of 1+),,, units a year for +
years. The device will be sold for a price of H1!),,, per unit. /ales are e%pected to be 1!),,,
units per year. The variable cost is H4),,, and fi%ed costs) e%cluding depreciation) are H!+
million per year. Assume Drillers employs straightline depreciation on all depreciable assets)
and assume that they are ta%ed at a rate of '1I. $f the required rate of return is 1!I) what is
the appro%imate A*@ of the project7
A. H14)!!+),,, ;. H!1)+11),,, C. H!1)48,),,, D. H+1)114),,,
!.. PP Corp. is considering the purchase of a new machine that will cost *'!,),,,. $t has an
estimated useful life of ' years. Assume that ',I of the depreciable base will be depreciated
in the first year) .,I in the second year) and ',I in the third year. $t has a resale value of
*!,),,, at the end of its economic life. /avings are e%pected from the use of machine
estimated at *14,),,, annually. The company has an effective ta% rate of .,I. $t uses 11I
as hurdle rate in evaluating capital projects. /hould the company proceed with the *'!,),,,
capital investment7
9ear *resent @alue of *1 *resent @alue of an Crdinary Annuity of *1
1 ,.81! ,.81!
! ,.4.' 1.1,+
' ,.1.1 !.!.1
a. 9es) due to A*@ of *1)++1. c. 9es) due to A*@ of *11)8!,.
b. 9es) due to A*@ of *11)18.. d. Ao) due to negative A*@ of *1)1'1
!+. A companyNs marginal cost of new capital =(CC? is 1,I up to H1,,),,,. (CC increases .
+I for the ne%t H.,,),,, and another .+I thereafter. /everal proposed capital projects are
under consideration) with projected cost and internal rates of return =$>>? as follows5
*roject Cost $>>
A H1,,),,, 1,.+I
; H',,),,, 1..,I
C H.+,),,, 1,.8I
D H'+,),,, 1'.+I
< H.,,),,, 1!.,I
2hat should the companyNs capital budget be7
A. H, ;. H1),+,),,, C. H1)+,,),,, D. H1)1,,),,,
MSQ-08
*age :
!1. The following forecasts have been prepared for a new investment by C%ford $ndustries of
H!, million with an 8year life5
*essimistic <%pected Cptimistic
(arket si-e 1,),,, :,),,, 1.,),,,
(arket share) I !+ ', '+
3nit price H4+, H8,, H84+
3nit variable cost H+,, H.,, H'+,
&i%ed cost) millions H4 H. H'.+
Assume that C%ford employs straightline depreciation) and that they are ta%ed at '+I.
Assuming an opportunity cost of capital of 1.I) what is the A*@ of this project) based on
e%pected outcomes7
A. H!)1!1).1+ ;. H.)+1')+,+ C. H1)4!!)1,: D. H8),++)4!!
!4. The following data pertain to /unlight Corp.) whose management is planning to purchase an
automated tanning equipment.
1. <conomic life of equipment Q 8 years.
!. Disposal value after 8 years Q nil.
'. <stimated net annual cash inflows for each of the 8 years Q *81),,,.
.. Timeadjusted internal rate of return Q 1.I
+. Cost of capital of /unlight Corp Q 11I
1. The table of present values of *1 received annually for 8 years has these factors5 at
1.I R ..1':) at 11I R ..'..
4. Depreciation is appro%imately *.1):4, annually.
&ind the required increase in annual cash inflows in order to have the timeadjusted rate of
return appro%imately equal the cost of capital.
a. *+)+,1 b. *1)+,1 c. *.)'.. d. *+)841
!8. *ayback Company is considering the purchase of a copier machine for *.!)8!+. The
copier machine will be e%pected to be economically productive for . years. The salvage
value at the end of . years is negligible. The machine is e%pected to provide 1+I internal
rate of return. The company is subject to .,I income ta% rate. The present value of an
ordinary annuity of 1 for . periods is !.8+.:8. $n order to reali-e the $>> of 1+I) how much
is the estimated beforeta% cash inflow to be provided by the machine7
A. *14)81, ;. *1+),,, C. *!+),,, D.
*'+)4,,
!:. *ara Co. is reviewing the following data relating to an energy saving investment proposal5
Cost H+,),,,
>esidual value at the end of + years 1,),,,
*resent value of an annuity of 1 at 1!I for + years '.1,
*resent value of 1 due in + years at 1!I ,.+4
2hat would be the annual savings needed to make the investment reali-e a 1!I yield7
a. H8)18: b. H11)111 c. H1!)',1 d. H1')88:
',. /moot Automotive has implemented a new project that has an initial cost) and then generates
inflows of H1,),,, a year for the ne%t seven =4? years. The project has a payback period of
.., years. 2hat is the projectNs internal rate of return =$>>?7
A. 1..4:I ;. 11.''I C. 18.+.I D. 1+.11I
'1. ;erry *roducts is considering two pieces of machinery. The first machine costs *+,),,,
more than the second machine. During the twoyear life of these two alternatives) the first
machine has *1++),,, more cash flow in year one and a *11,),,, less cash flow in year two
than the second machine. All cash flows occur at yearend. The present value of 1 at 1+I
end of 1 period and ! periods are ,.81:+4 and ,.4+11.) respectively. The present value of 1
at 8I end of period 1 is ,.:!+:' and period ! is ,.8+4'..
At what discount rate would (achine 1 equally acceptable as machine !7
A. :I ;. 1,I C. 11I D. 1!I
MSQ-08
*age 1,
'!. The Geron Corporation recently purchased a new machine for its factory operations at a cost
of H:!1)!+,. The investment is e%pected to generate H!+,),,, in annual cash flows for a
period of si% years. The required rate of return is 1.I. The old machine has a remaining life
of si% years. The new machine is e%pected to have -ero value at the end of the si%year
period. The disposal value of the old machine at the time of replacement is -ero. 2hat is the
internal rate of return7
a. 1+I b. 11I c. 14I d. 18I
''. >ohan Transport is considering two alternative buses to transport people between cities that
are in the /outheastern 3./.) such as ;aton >ouge and Fainesville. A gaspowered bus has a
cost of H++),,,) and will produce endofyear net cash flows of H!!),,, per year for . years.
A new electric bus will cost H:,),,,) and will produce cash flows of H!8),,, per year for 8
years. The company must provide bus service for 8 years) after which it plans to give up its
franchise and to cease operating the route. $nflation is not e%pected to affect either costs or
revenues during the ne%t 8 years. $f >ohan TransportNs cost of capital is 14 percent) by what
amount will the better project increase the companyNs value7
A. H+)'+, ;. H14)..1 C. H1,)4,1 D. H!4)8,1
'.. 3nion <lectric Company must clean up the water released from its generating plant. The
companyNs cost of capital is 11 percent for average projects) and that rate is normally adjusted
up or down by ! percentage points for high and lowrisk projects. Clean3p *lan A) which is
of average risk) has an initial cost of H1, million) and its operating cost will be H1 million per
year for its 1,year life. *lan ;) which is a highrisk project) has an initial cost of H+ million)
and its annual operating cost over 9ears 1 to 1, will be H! million. 2hat is the appro%imate
*@ of costs for the better project7 =@D?
A. H+.: million. ;. H1+.: million. C. H11.8 million. D. H14.8 million.
'+. (ulva $nc. is considering the following five independent projects5
*roject >equired Amount of Capital $>>
A H',,),,, !+.'+I
; +,,),,, !'.!!I
C .,,),,, 1:.1,I
D ++,),,, :.!+I
< 1+,),,, 8.+,I
The company has a target capital structure which is ., percent debt and 1, percent equity.
The company can issue bonds with a yield to maturity of 1, percent. The company has
H:,,),,, in retained earnings) and the current stock price is H., per share. The flotation costs
associated with issuing new equity are H! per share. (ulvaNs earnings are e%pected to
continue to grow at + percent per year. Ae%t yearNs dividend =D1? is forecasted to be H!.+,.
The firm faces a ., percent ta% rate. 2hat is the si-e of (ulvaNs capital budget7
A. H1)!,,),,, ;. H1)4+,),,, C. H!).,,),,, D. H8,,),,,
'1. A ta%e%empt foundation) /incerely &oundation) $nc. intends to invest *1 million in a five
year project. The foundation estimates that the annual savings from the project will amount
to *'!+),,,. The *1 million asset is depreciable over five =+? years on a straightline basis.
The foundationBs hurdle rate is 1!I and as a consultant of the foundation) you are asked to
determine the internal rate of return and advise if the project should be pursued.
To facilitate computations) below are present value factors5
AR+ 1!I 1.I 11I
*resent value of *1 ,.+4 ,.+! ,..8
*resent value of an annuity of *1 '.1, '.., '.',
9our advice is
a. To proceed due to an estimated $>> of less than 1.I but not more than 1!I.
b. To proceed due to an estimated $>> of less than 11I but not more than 1.I.
c. Aot to proceed due to an estimated $>> of less than 1!I.
d. To proceed due to an estimated $>> of more than 11I.
MSQ-08
*age 11
'4. The following data relate to two capitalbudgeting projects of equal risk5
*resent @alue of Cash &lows
*eriod *roject A *roject ;
, H=1,),,,? H=',),,,?
1 .)++, 1')1+,
! .)1+, 1!).+,
' ')4+, 11)!+,
2hich of the projects will be selected using the profitability inde% =*$? approach and the
A*@ approach7
a. b. c. d.
*$ ; <ither <ither ;
A*@ A ; A ;
'8. &ive mutually e%clusive projects had the following information5
A ; C D
A*@ H+,, H=!,,? H!,, H1),,,
$>> 1!I 8I 1'I 1,I
2hich project is preferred7
a. A c. C
b. ; d. D
':. The Aativity Corporation has the following investment opportunities5
*roposal *rofitability $nde% $nitial Cash Cutlay
1 1.1+ *!,,),,,
! 1.1' 1!+),,,
' 1.11 14+),,,
. 1.,8 1+,),,,
The firm has a budget constraint of *',,),,,.
2hat proposal=s? should be accepted7
a. *roposal 1 because it has the highest profitability inde%.
b. *roposal . because it has the lowest profitability inde%.
c. *roposals ! and ' because their total net present values are the highest among all possible
proposal combinations.
d. *roposals 1 and ! because their total net present values are the highest among all possible
proposal combinations.
.,. $nformation on three ='? investment projects is given below5
*roject $nvestment >equired Aet *resent @alue
S *1+,),,, *'.),,+
F 1,,),,, !!)14,
2 1,),,, 1')1,!
>ank the projects in terms of preference5
a. 1st 2J !nd FJ 'rd S. c. 1st SJ !nd FJ 'rd 2.
b. 1st FJ !nd 2J 'rd S. d. The ranking is the same.
*roblem .1 and .! are based on the following information.
DanecheBs) a ta%e%empt entity) plans to purchase a new machine which they project to
depreciate over a tenyear period without salvage value. The new machine will cost *!,,),,,
and is e%pected to generate cash savings of *1,),,, per year in operating costs. DanecheNs cost
of capital is 1!I.
&or ten periods at 1!I) the present value of *1 is *,.'!!,) while the present value of an ordinary
annuity of *1 is *+.1+,.
.1. 2hat is the net present value of the proposed investment) assuming Daneche uses a 1!I
discount rate7
a. *18+)1., b. *1:):8, c. *1':),,, d. Aone of the above.
MSQ-08
*age 1!
.!. 2ith the companyBs initial investment on the new machine) the accounting rate of return is
a. 1+I b. !,I c. !+I d. Aone of the above.
Tuestions .' and .. are based on the following information.
The construction of a waste treatment plant was arrived at after a careful costbenefit analysis.
During the construction period a status report was presented for your review5
completed cost as originally estimated) *+ million
I of actual completion to date) 1+I
actual cost to date) *'.4+ million
.'. Assuming cost is evenly distributed throughout the construction period) how much will the
completion cost be most likely7
a. The original cost estimate of *+ million.
b. *+ million plus a cost overrun of about *41:),,,
c. *+,,),,, less than the original cost at completion.
d. About *1,,),,, above the original cost at completion.
... 2hat would be an appropriate action to take considering the situation in number !87
a. Ao need to take any action.
b. $mmediately stop further work on the project.
c. >ecommend immediate review with the project implementation team to determine the
cause of overrun and the corrective actions to be taken.
d. 2ait for the ne%t quarterly status report on the project.
Tuestions .+ and .1 are based on the following information.
;eta Company plans to replace its company car with a new one. The new car costs *1!,),,,
and its estimated useful life is five years without scrap value. The old car has a book value of
*1+),,, and can be sold at *1!),,,. The acquisition of the new car will yield annual cash
savings of *!,),,, before income ta%. $ncome ta% rate is !+I. =(?
.+. The net investment of the new car is
a. *1,8),,, b. *1,8)4+, c. *1,4)!+, d. *1,4),,,
.1. The payback period of the investment is =(?
a. +.1. years b. +.18 years c. +.11 years d. +.,:+ years
.4. Telephone Corp. is contemplating four projects5 6) () A) and C. The capital costs for the
initiation of each mutuallye%clusive project and its estimated afterta%) net cash flow are
listed below. The companyBs desired afterta% opportunity costs is 1!I. $t has *:,,),,,
capital budget for the year. $dle funds cannot be reinvested at greater than 1!I.
$n Thousand *esos
6 ( A C
$nitial cost .,, .4, '8, .!,
Annual cash flows
9ear 1 11' 18, :, 8,
! 11' 14, 11, 1,,
' 11' 1+, 1', 1!,
. 11' 11, 1., 1',
+ 11' 1,, 1+, 1+,
Aet present value *4)+., *+:)1+. *+.)111 *=1+)4,8?
$nternal rate of return 1!.4I 14.1I 14.!I 1,.1I
<%cess present value inde% 1.,! 1.1' 1.1. ,.:1
The company will choose
a. *rojects M & N. b. *rojects 6 L A. c. Projects L & M. d. *rojects () A L C.
MSQ-08
*age 1'
Tuestions .8 through ++ are based on the following information.
The ;urgos Corporation is considering investing in a project. $t requires an immediate cash
outlay of *1,,),,,. $t has a life of four years and will be depreciated on a straightline basis =no
salvage value?. The firmBs ta% rate is !+I and requires a return of 1,I. $ncome before
depreciation is projected to be5
9<A> 1 ! ' .
$ncome before depreciation *',),,, *',),,, *.,),,, *.,),,,
The present value factors for *1 at 1,I is
9ear 1 ! ' .
*resent @alue &actor ,.:,: ,.8!1 ,.4+1 ,.18'
.8. The net cash flow for year 1 is
a. *!+)8+, b. *!8)4+, c. *'1)!+, d. *'.).+,
.:. The net cash flow for year . is
a. *'+)8+, b. *'+):+, c. *',)1+, d. *'1)!+,
+,. The payback period for the project is
a. ' years b. '.14 years c. '.+ years d. . years.
+1. The accounting rate of return of the project is
a. 4I b. :I c. 1!I d. 1+I
+!. The present value of year twoBs cash flow is
a. *!')4.4.+, b. *!+)8+1.!+ c. *!1)1,,.4+ d. *!:)4+,.4+
+'. The present value of the projectBs net cash flow is
a. *:+)1+,.1+ b. *:8)1+1.!+ c. *1,1)81'.4+ d. *1,.)4+,.!+
+.. The profitability inde% of the project =rounded to the nearest hundredth? is
a. ,.:1 b. ,.:8 c. 1.,! d. 1.,+
++. The project would be accepted on the basis of the
a. *ayback and present value results.
b. Accounting rate of return and profitability inde% results.
c. *ayback results only
d. a and b combined
MSQ-08
*age 1.
Answer Sheet
Theor Pro!"e#
1. D !1. A 1. C !1. A .1. C
!. C !!. ; !. ; !!. A .!. ;
'. D !'. A '. ; !'. ; .'. ;
.. D !.. A .. ; !.. ; ... C
+. D !+. A +. A !+. ; .+. C
1. C !1. D 1. D !1. ; .1. C
4. ; !4. ; 4. D !4. A .4. A
8. A !8. C 8. ; !8. A .8. ;
:. D !:. D :. ; !:. C .:. D
1,. D ',. D 1,. D ',. ; +,. ;
11. D '1. A 11. ; '1. ; +1. D
1!. ; '!. D 1!. ; '!. ; +!. A
1'. ; ''. A 1'. C ''. D +'. C
1.. D '.. ; 1.. C '.. ; +.. C
1+. A '+. C 1+. ; '+. ; ++. D
11. D '1. D 11. C '1. D
14. A '4. C 14. ; '4. ;
18. D '8. ; 18. A '8. D
1:. C ':. ; 1:. C ':. C
!,. A .,. A !,. ; .,. D
MSQ-08
*age 1+