Principles of Managerial Finance, 13e, Global Edition (Gitman) Chapter 10 Capital Budgeting Te Techniques chniques
10.1 Understand the key elements of the capital budgeting process. 1) In capital budgeting, the preferred p referred approaches in assessing whether a project is acceptable are those that integrate time value procedures, risk and return considerations, and valuation concepts. nswer! "#U$ "opic! "o pic! %apital &udgeting "echni'ues "echni'ues (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills +) In capital budgeting, the preferred p referred approaches in assessing whether a project is acceptable integrate time value procedures, risk and return considerations, valuation concepts, and the re'uired payback period. nswer! -$ "opic! "o pic! %apital &udgeting "echni'ues "echni'ues (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills ) %apital budgeting techni'ues are used to evaluate the firm/s fied asset investments which provide the basis for the firm/s earning power and value. nswer! "#U$ "opic! "o pic! %oncept of %apital &udgeting (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills ) "he purchase of additional physical facilities, such as additional property o r a new factory, is an eample of a capital ependiture. nswer! "#U$ "opic! "o pic! %apital &udgeting "erminology "erminology (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills 2) %apital budgeting is the process of evaluating and selecting short3term investments consistent with the firm/s goal of owner wealth maimi4ation. nswer! -$ "opic! "o pic! %oncept of %apital &udgeting (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills 5) 650,000 outlay for a new n ew machine with a usable life of 12 years is an operating ependiture that would appear as a current asset on the firm/s balance sheet. nswer! -$ "opic! "o pic! %apital &udgeting "erminology "erminology (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills 1 %opyright 7 +01+ 8earson $ducation
9) capital ependiture is an outlay of funds invested only in fied assets that is epected to produce benefits over a period of time less than one year. nswer! -$ "opic! "o pic! %apital &udgeting "erminology "erminology (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills :) n outlay for advertising and management consulting is considered to be a fied asset ependiture. nswer! -$ "opic! "o pic! %apital &udgeting "erminology "erminology (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills ;) %apital ependiture proposals are reviewed to assess their appropriateness in light of the firm/s overall objectives and plans, and to evaluate their economic validity. nswer! "#U$ "opic! "o pic! %oncept of %apital &udgeting (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills 10) "he basic motives for capital ependitures are to epand, replace, or renew fied assets or to obtain some other, less tangible benefit over a long period. nswer! "#U$ "opic! "o pic!
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1) "he capital budgeting process consists of four distinct but interrelated steps! proposal generation, review and analysis, decision making, and termination. nswer! -$ "opic! "o pic! teps in %apital %apital &udgeting 8rocess (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills 12) Independent projects are projects that compete with one another for the firm/s resources, so that the acceptance of one o ne eliminates the others from further consideration. nswer! -$ "opic! "o pic! Independent 8rojects (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills 15) non3conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by a series of inflows. nswer! -$ "opic! "o pic! %onventional versus =onconventional %ash lows lows (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills 19) If a firm has unlimited funds to invest in in capital assets, all independent projects that meet its minimum investment criteria should be implemented. nswer! "#U$ "opic! "o pic! %oncept of %apital &udgeting (uestion tatus! #evised %& *uidelines! *uidelines! #eflective thinking thinking skills skills 1:) "he following three projects would seem to compete with one another form the firm/s resources and therefore would be eamples of o f mutually eclusive projects. >1) installin installing g air conditioning conditioning in the plant >+) ac'uiring ac'uiring a small small supplie supplier r >) purchasing purchasing a new computer computer system system nswer! -$ "opic! "o pic!
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+5) If a firm is subject to capital rationing, it is able to accept all independent projects that provide an acceptable return. nswer! -$ "opic! %apital #ationing (uestion tatus! #evised %& *uidelines! #eflective thinking skills +9) If a firm has unlimited funds, it is able to accept all independent projects that provide an acceptable return. nswer! "#U$ "opic! %apital #ationing (uestion tatus! #evised %& *uidelines! #eflective thinking skills +:) If a firm is subject to capital rationing, it has only a fied number of dollars available for capital ependitures, and numerous projects compete for these dollars. nswer! "#U$ "opic! %apital #ationing (uestion tatus! #evised %& *uidelines! #eflective thinking skills +;) "he ranking approach involves the ranking of capital ependiture projects on the basis of some predetermined measure such as the rate of return. nswer! "#U$ "opic! ccept3#eject versus #anking pproaches (uestion tatus! #evised %& *uidelines! #eflective thinking skills 0) "he accept3reject approach involves the ranking of capital ependiture projects on the basis of some predetermined measure such as the rate of return. nswer! -$ "opic! ccept3#eject versus #anking pproaches (uestion tatus! #evised %& *uidelines! #eflective thinking skills 1) conventional cash flow pattern is one in which an initial outflow is followed only by a series of inflows. nswer! "#U$ "opic! %onventional versus =onconventional %ash lows (uestion tatus! #evised %& *uidelines! #eflective thinking skills +) nonconventional cash flow pattern is one in which an initial outflow is followed only by a series of inflows. nswer! -$ "opic! %onventional versus =onconventional %ash lows (uestion tatus! #evised %& *uidelines! #eflective thinking skills 2 %opyright 7 +01+ 8earson $ducation
) nonconventional cash flow pattern is one in which an initial outflow is followed by a series of both inflows and outflows. nswer! "#U$ "opic! %onventional versus =onconventional %ash lows (uestion tatus! #evised %& *uidelines! #eflective thinking skills ) @@@@@@@@ is the process of evaluating and selecting long3term investments consistent with the firm/s goal of owner wealth maimi4ation. ) #ecapitali4ing assets &) %apital budgeting %) #atio analysis A) #estructuring debt nswer! & "opic! %oncept of %apital &udgeting (uestion tatus! #evised %& *uidelines! #eflective thinking skills 2) ied assets that provide the basis for the firm/s profit and va lue are often called ) tangible assets. &) non3current assets. %) earning assets. A) book assets. nswer! % "opic! %apital &udgeting "erminology (uestion tatus! #evised %& *uidelines! #eflective thinking skills 5) "he most common motive for adding fied assets to the firm is ) epansion. &) replacement. %) renewal. A) transformation. nswer! "opic!
:) "he first step in the capital budgeting process is ) review and analysis. &) implementation. %) decision3making. A) proposal generation. nswer! A "opic! teps in %apital &udgeting 8rocess (uestion tatus! #evised %& *uidelines! #eflective thinking skills ;) 650,000 outlay for a new machine with a usable life of 12 years is called ) capital ependiture. &) operating ependiture. %) replacement ependiture. A) none of the above. nswer! "opic! %apital &udgeting "erminology (uestion tatus! #evised %& *uidelines! #eflective thinking skills 0) capital ependiture is all of the following $B%$8" ) an outlay made for the earning assets of the firm. &) epected to produce benefits over a period of time greater than one year. %) an outlay for current asset epansion. A) commonly used to epand the level of operations. nswer! % "opic! %oncept of %apital &udgeting (uestion tatus! #evised %& *uidelines! #eflective thinking skills 1) ll of the following are motives for capital budgeting ependitures $B%$8" ) epansion. &) replacement. %) renewal. A) invention. nswer! A "opic!
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+) ll of the following are steps in the capital budgeting process $B%$8" ) implementation. &) follow3up. %) transformation. A) decision3making. nswer! % "opic! teps in %apital &udgeting 8rocess (uestion tatus! #evised %& *uidelines! #eflective thinking skills ) @@@@@@@@ projects do not compete with each other? the acceptance of one @@@@@@@@ the others from consideration. ) %apital? eliminates &) Independent? does not eliminate %)
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5) conventional cash flow pattern associated with capital investment projects consists of an initial ) outflow followed by a broken cash series. &) inflow followed by a broken series. %) outflow followed by a series of inflows. A) inflow followed by a series of outflows. nswer! % "opic! %onventional versus =onconventional %ash lows (uestion tatus! #evised %& *uidelines! #eflective thinking skills 9) non3conventional cash flow pattern associated with capital investment projects consists of an initial ) outflow followed by a series of both cash inflows and outflows. &) inflow followed by a series of both cash inflows and outflows. %) outflow followed by a series of inflows. A) inflow followed by a series of outflows. nswer! "opic! %onventional versus =onconventional %ash lows (uestion tatus! #evised %& *uidelines! #eflective thinking skills :) @@@@@@@@ is a series of e'ual annual cash flows. ) mied stream &) conventional %) non3conventional A) n annuity nswer! A "opic! nnuity %ash lows (uestion tatus! #evised %& *uidelines! #eflective thinking skills ;) "he cash flows of any project having a conventional pattern include all of the basic components $B%$8" ) initial investment. &) operating cash outflows. %) operating cash inflows. A) terminal cash flow. nswer! & "opic! %onventional versus =onconventional %ash lows (uestion tatus! #evised %& *uidelines! #eflective thinking skills
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20) 8rojects that compete with one another, so that the acceptance of one eliminates the others from further consideration are called ) independent projects. &) mutually eclusive projects. %) replacement projects. A) none of the above. nswer! & "opic!
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Table 10.1
2) "he cash flow pattern depicted is associated with a capital investment and may be characteri4ed as @@@@@@@@. >ee "able 10.1) ) an annuity and conventional cash flow &) a mied stream and non3conventional cash flow %) an annuity and non3conventional cash flow A) a mied stream and conventional cash flow nswer! "opic! %onventional versus =onconventional %ash lows (uestion tatus! #evised %& *uidelines! #eflective thinking skills Table 10.2
2) "he cash flow pattern depicted is associated with a capital investment and may be characteri4ed as @@@@@@@@. >ee "able 10.+) ) an annuity and conventional cash flow &) a mied stream and non3conventional cash flow %) an annuity and non3conventional cash flow A) a mied stream and conventional cash flow nswer! A "opic! %onventional versus =onconventional %ash lows (uestion tatus! #evised %& *uidelines! #eflective thinking skills
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10.+ %alculate, interpret, and evaluate the payback period. 1) In the case of annuity cash inflows, the payback period can be found by dividing the initial investment by the annual cash inflow. nswer! "#U$ "opic! 8ayback
though not eplicit) consideration to the timing of cash flows and therefore to the time value of money. nswer! "#U$ "opic! 8ayback
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9) project must be rejected if its payback period is less than the maimum acceptable payback period. nswer! -$ "opic! 8ayback
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1) If a project/s payback period is greater than the maimum acceptable payback period, we would reject it. nswer! "#U$ "opic! 8ayback
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1;) $amples of sophisticated capital budgeting techni'ues include all of the following $B%$8" ) internal rate of return. &) payback period. %) annuali4ed net present value. A) net present value. nswer! & "opic! %apital &udgeting "echni'ues (uestion tatus! #evised %& *uidelines! #eflective thinking skills +0) "he @@@@@@@@ measures the amount of time it takes the firm to recover its initial investment. ) average rate of return &) internal rate of return %) net present value A) payback period nswer! A "opic! 8ayback
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+9) firm is evaluating a proposal which has an initial investment of 620,000 and has cash flows of 612,000 per year for five years. "he payback period of the project is ) 1.2 years. &) + years. %) . years. A) years. nswer! % "opic! 8ayback
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1) hould "angshan
8roject 310,000 ,000 ,000 ,000 0
8roject & 310,000 ,000 ,000 +,000 1,000,000
) 8roject can be accepted because the payback period is +.2 years but 8roject & can not be accepted because it/s payback period is longer than years. &) 8roject & should be accepted because even thought the payback period is +.2 years for project and .001 project &, there is a 61,000,000 payoff in the th year in 8roject &. %) 8roject & should be accepted because you get more money paid back in the long run. A) &oth projects can be accepted because the payback is less than years. nswer! "opic! 8ayback
10. %alculate, interpret, and evaluate the net present value >=8G) and economic value added >$G). 1) =et present value is considered a sophisticated capital budgeting techni'ue since it gives eplicit consideration to the time value of money. nswer! "#U$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! #eflective thinking skills +) "he discount rate >which is also known as the re'uired return, cost of capital, or opportunity cost) is the minimum return that must be earned on a project to leave the firm/s market value unchanged. nswer! "#U$ "opic! 8roject #e'uired #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills ) If net present value of a project is greater than 4ero, the firm will earn a return greater than its cost of capital. "he acceptance of such a project would enhance the wealth of the firm/s owners. nswer! "#U$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! #eflective thinking skills ) "he net present value is found by subtracting a project/s initial investment from the present value of its cash inflows discounted at a rate e'ual to the project/s internal rate of return. nswer! -$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! #eflective thinking skills 2) sophisticated capital budgeting techni'ue that can be computed by subtracting a project/s initial investment from the present value of its cash inflows discounted at a rate e'ual to the firm/s cost of capital is called net present value. nswer! "#U$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! #eflective thinking skills 5) sophisticated capital budgeting techni'ue that can be computed by subtracting a project/s initial investment from the present value of its cash inflows discounted at a rate e'ual to the firm/s cost of capital is called internal rate of return. nswer! -$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! #eflective thinking skills 1; %opyright 7 +01+ 8earson $ducation
9) If the =8G is greater than the cost of capital, a project should be accepted. nswer! -$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! #eflective thinking skills :) If the =8G is greater than the initial investment, a project sho uld be accepted. nswer! -$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! #eflective thinking skills ;) If the =8G is greater than 60.00, a project should be accepted. nswer! "#U$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! #eflective thinking skills 10) "he =8G of an project with an initial investment of 61,0 00 that provides after3ta operating cash flows of 600 per year for four years where the firm/s cost of capital is 12 percent is 6:25.;. nswer! -$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills 11) "he =8G of an project with an initial investment of 61,000 that provides after3ta operating cash flows of 600 per year for four years where the firm/s cost of capital is 12 percent is 61.21. nswer! -$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills 1+) "he =8G of an project with an initial investment of 61,0 00 that provides after3ta operating cash flows of 600 per year for four years where the firm/s cost of capital is 12 percent is 3 61.21. nswer! "#U$ "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills
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1) $conomic value added is the difference between an investment/s net operating profit after taes and the cost of funds used to finance the investment, which is found by multiplying the dollar amount of the funds used to finance the investment by the firm/s weighted average cost of capital. nswer! "#U$ "opic! $conomic Galue dded (uestion tatus! #evised %& *uidelines! #eflective thinking skills 1) "he investment operating schedule is the difference between an investment/s net operating profit after taes and the cost of funds used to finance the investment, which is found by multiplying the dollar amount of the funds used to finance the investment by the firm/s weighted average cost of capital. nswer! -$ "opic! $conomic Galue dded (uestion tatus! #evised %& *uidelines! #eflective thinking skills 12) firm is evaluating three capital projects. "he net present values for the projects are as follows!
"he firm should ) accept 8rojects 1 and + and reject 8roject . &) accept 8rojects 1 and and reject 8roject +. %) accept 8roject 1 and reject 8rojects + and . A) reject all projects. nswer! "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills 15) ophisticated capital budgeting techni'ues do not ) eamine the si4e of the initial outlay. &) use net profits as a measure of return. %) eplicitly consider the time value of money. A) take into account an unconventional cash flow pattern. nswer! & "opic! %apital &udgeting "echni'ues (uestion tatus! #evised %& *uidelines! #eflective thinking skills
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19) "he minimum return that must be earned on a project in order to leave the firm/s value unchanged is ) the internal rate of return. &) the interest rate. %) the cost of capital. A) the compound rate. nswer! % "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills 1:) firm would accept a project with a net present value of 4ero because ) the project would maintain the wealth of the firm/s owners. &) the project would enhance the wealth of the firm/s owners. %) the return on the project would be positive. A) the return on the project would be 4ero. nswer! "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! #eflective thinking skills 1;) firm is evaluating an investment proposal which has an initial investment of 62,000 and cash flows presently valued at 6,000. "he net present value of the investment is @@@@@@@@. ) 361,000 &) 60 %) 61,000 A) 61.+2 nswer! "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills +0) Chat is the =8G for the following project if its cost of capital is 12 p ercent and its initial after ta cost is 62,000,000 and it is epected to provide after3ta operating cash inflows of 61,:00,000 in year 1, 61,;00,000 in year +, 61,900,000 in year and 61,00,000 in year D ) 61,900,000 &) 691,95 %) >619,02) A) =one of the above nswer! % "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills
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+1) Chat is the =8G for the following project if its cost of capital is 0 percent and its initial after ta cost is 62,000,000 and it is epected to provide after3ta operating cash inflows of 61,:00,000 in year 1, 61,;00,000 in year +, 61,900,000 in year and 61,00,000 in year D ) 61,900,000 &) 691,95 %) 619,02 A) =one of the above nswer! "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills ++) Chat is the =8G for the following project if its cost of capital is 1+ p ercent and its initial after ta cost is 62,000,000 and it is epected to provide after3ta operating cash flows of 61,:00,000 in year 1, 61,;00,000 in year +, 61,900,000 in year and >61,00,000) in year D ) 6>1,;,5) &) 61,;,5 %) 612:,011 A) "wo of the above nswer! "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills Table 10.1
+) *iven the information in "able 10.1 and 12 percent cost of capital, >a) compute the net present value. >b) should the project be acceptedD nswer! >a) =8G H >1,000.12)J131>1.12)2K 3 +,200 H 1,000 >.2+) 3 +,200 H 6:2+ >b) ince =8G L 0, the project should be accepted. "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills
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Table 10.2
+) *iven the information in "able 10.+ and 12 percent cost of capital, >a) compute the net present value. >b) should the project be acceptedD nswer! >a)
=8G H ;:,:+0 3 100,000 H 361,1:0 M 0 >b) ince =8G M 0, the project should be rejected. "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills 10. %alculate, interpret, and evaluate the internal rate of return >I##). 1) "he internal rate of return >I##) is defined as the discount rate that e'uates the net present value with the initial investment associated with a project. nswer! -$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills +) "he I## is the discount rate that e'uates the =8G of an investment opportunity with 60. nswer! "#U$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills
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) "he I## is the compound annual rate of return that the firm will earn if it invests in a project and receives the estimated cash inflows. nswer! "#U$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills ) n internal rate of return greater than the cost of capital guarantees that the firm earns at least its re'uired return. Investing in such an project would enhance the market value of the firm and therefore the wealth of its owners. nswer! "#U$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills 2) sophisticated capital budgeting techni'ue that can be computed by solving for the discount rate that e'uates the present value of a projects inflows with the present value of its outflows is called net present value. nswer! -$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills 5) sophisticated capital budgeting techni'ue that can be computed by solving for the discount rate that e'uates the present value of a projects inflows with the present value of its outflows is called internal rate of return. nswer! "#U$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills 9) If its I## is greater than 60.00, a project should be accepted. nswer! -$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills :) If its I## is greater than 0 percent, a project should be accepted. nswer! -$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills ;) If its I## is greater than the cost of capital, a project should be accepted. nswer! "#U$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills +2 %opyright 7 +01+ 8earson $ducation
10) Chat is the I## for the following project if its initial after ta cost is 62,000,000 and it is epected to provide after3ta operating cash inflows of 61,:00,000 in year 1, 61,;00,000 in year +, 61,900,000 in year and 61,00,000 in year D ) 12.29N &) 0.00N %) 1.29N A) =one of the above nswer! % "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! nalytic skills 11) Chat is the I## for the following project if its initial after ta cost is 62,000,000 and it is epected to provide after3ta operating cash flows of >61,:00,000) in year 1, 6+,;00,000 in year +, 6+,900,000 in year and 6+,00,000 in year D ) 2.:N &) ;.59N %) 11.N A) =one of the above nswer! "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! nalytic skills 10.2 Use net present value profiles to compare =8G and I## techni'ues. 1) or conventional projects, both =8G and I## techni'ues will always generate the same accept3reject decision, but differences in their underlying assumptions can cause them to rank mutually eclusive projects differently. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills +) "he I## method assumes the cash flows are reinvested at the internal rate of return rather than the re'uired rate of return nswer! "#U$ "opic! Internal #ate of #eturn (uestion tatus! =ew %& *uidelines! #eflective thinking skills ) project/s net present value profile is a graph that plots a project/s =8G for various discount rates. nswer! "#U$ "opic! =et 8resent Galue 8rofile (uestion tatus! #evised %& *uidelines! #eflective thinking skills +5 %opyright 7 +01+ 8earson $ducation
) project/s net present value profile is a graph that plots a project/s I## for various discount rates. nswer! -$ "opic! =et 8resent Galue 8rofile (uestion tatus! #evised %& *uidelines! #eflective thinking skills 2) =et present value profiles are most useful when selecting among independent projects. nswer! -$ "opic! =et 8resent Galue 8rofile (uestion tatus! #evised %& *uidelines! #eflective thinking skills 5) =et present value profiles are most useful when selecting among mutually eclusive projects. nswer! "#U$ "opic! =et 8resent Galue 8rofile (uestion tatus! #evised %& *uidelines! #eflective thinking skills 9) "here is sometimes a ranking problem among =8G and I## when selecting among mutually eclusive investments. "his ranking problem only occurs when ) the =8G is greater than the crossover point. &) the =8G is less than the crossover point. %) the cost of capital is to the right of the crossover point. A) the cost of capital is to the left of the crossover point. nswer! A "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills :) %onsider the following projects, B and F, where the firm can only choose one. 8roject B costs 6500 and has cash flows of 600 in each of the net + years. 8roject F also costs 6500, and generates cash flows of 6200 and 6+92 for the net + years, respectively. Chich investment should the firm choose if the cost of capital is 10 percentD ) 8roject B. &) 8roject F. %) =either. A) =ot enough information to tell. nswer! "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! nalytic skills
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;) %onsider the following projects, B and F where the firm can only choose on e. 8roject B costs 6500 and has cash flows of 600 in each of the net + years. 8roject & also costs 6500, and generates cash flows of 6200 and 6+92 for the net + years, respectively. Chich investment should the firm choose if the cost of capital is +2 percentD ) 8roject B. &) 8roject F. %) =either. A) =ot enough information to tell. nswer! % "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! nalytic skills 10) "angshan 61,00,000) in year D >a) %alculate the project/s =8G. >b) %alculate the project/s I##. >c) hould the firm make the investmentD nswer!
=o the firm should not accept the project. "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! nalytic skills 10.5 Aiscuss =8G and I## in terms of conflicting rankings and the theoretical and practical strengths of each approach. 1) %onflicting rankings in the case of mutually eclusive projects using =8G and I## often results from differences in the magnitude andor timing of cash flows. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills
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+) 8rojects having higher cash inflows in the early years tend to be less sensitive to changes in the cost of capital and are therefore often acceptable at higher discount rates compared to projects with higher cash inflows that occur in the later years. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills ) En a purely theoretical basis, =8G is a better approach to capital budgeting than I## because =8G implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firm/s cost of capital. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills ) En a purely theoretical basis, =8G is the better approach to capital budgeting than I## because I## implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firm/s cost of capital. nswer! -$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills 2) %ertain mathematical properties may cause a project with a nonconventional cash flow pattern to have multiple I##s? this problem does not occur with the =8G approach. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills 5) =et present value >=8G) assumes that intermediate cash inflows are reinvested at the cost of capital, whereas internal rate of return >I##) assumes that intermediate cash inflows can be reinvested at a rate e'ual to the project/s I##. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills 9) ince the cost of capital tends to be a reasonable estimate of the rate at which the firm could actually reinvest intermediate cash inflows, the use of =8G is in theory preferable to I##. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills
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:) In general, projects with similar3si4ed investments and lower early3year cash inflows >lower cash inflows in the early years) tend to be preferred at higher discount rates. nswer! -$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills ;) In general, the greater the difference between the magnitude andor timing of cash inflows, the greater the likelihood of conflicting ranking between =8G and I##. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills 10) "he internal rate of return assumes that a project/s intermediate cash inflows are reinvested at a rate e'ual to the firm/s cost of capital. nswer! -$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills 11) lthough differences in the magnitude and timing of cash flows eplain conflicting rankings under the =8G and I## techni'ues, the underlying cause is the implicit assumption concerning the reinvestment of intermediate cash inflows cash inflows received prior to the termination of a project. nswer! "#U$ "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills
1+) En a purely theoretical basis, =8G is a better approach when selecting among two mutually eclusive projects. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills 1) En a purely theoretical basis, I## is a better approach when selecting among two mutually eclusive projects. nswer! -$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills
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1) In spite of the theoretical superiority of =8G, financial managers prefer to use I##. nswer! "#U$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills 12) In spite of the theoretical superiority of I##, financial managers prefer to use =8G. nswer! -$ "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills 15) "he @@@@@@@@ is the discount rate that e'uates the present value of the cash inflows with the initial investment. ) payback period &) average rate of return %) cost of capital A) internal rate of return nswer! A "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills 19) "he @@@@@@@@ is the compound annual rate of return that the firm will earn if it invests in the project and receives the given cash inflows. ) discount rate &) internal rate of return %) opportunity cost A) cost of capital nswer! & "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills
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1:) firm with a cost of capital of 1 percent is evaluating three capital projects. "he internal rates of return are as follows!
"he firm should ) accept 8roject + and reject 8rojects 1 and . &) accept 8rojects + and and reject 8roject 1. %) accept 8roject 1 and reject 8rojects + and . A) accept 8roject and reject 8rojects 1 and +. nswer! & "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! nalytic skills Table 10.3
firm is evaluating two projects that are mutually eclusive with initial investments and cash flows as follows!
1;) If the firm in "able 10. has a re'uired payback of two >+) years, it should ) accept projects and &. &) accept project and reject &. %) reject project and accept &. A) reject both. nswer! & "opic! 8ayback
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+0) "he new financial analyst does not like the payback approach >"able 10.) and determines that the firm/s re'uired rate of return is 12 percent. Ois recommendation would be to ) accept projects and &. &) accept project and reject &. %) reject project and accept &. A) reject both. nswer! % "opic! =et 8resent Galue (uestion tatus! #evised %& *uidelines! nalytic skills Table 10.4
firm must choose from si capital budgeting proposals outlined below. "he firm is subject to capital rationing and has a capital budget of 61,000,000? the firm/s cost of capital is 12 percent.
+1) Using the internal rate of return approach to ranking projects, which projects should the firm acceptD >ee "able 10.) ) 1, +, , , and 2 &) 1, +, , and 2 %) +, , , and 5 A) 1, , , and 5 nswer! & "opic! I## and %apital #ationing (uestion tatus! #evised %& *uidelines! nalytic skills ++) Using the net present value approach to ranking projects, which projects should the firm acceptD >ee "able 10.) ) 1, +, , , and 2 &) 1, +, , 2, and 5 %) +, , , and 2 A) 1, , 2, and 5 nswer! A "opic! =8G and %apital #ationing (uestion tatus! #evised %& *uidelines! nalytic skills
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+) Chen the net present value is negative, the internal rate of return is @@@@@@@@ the cost of capital. ) greater than &) greater than or e'ual to %) less than A) e'ual to nswer! % "opic! =8G and I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills +) firm is evaluating two independent projects utili4ing the internal rate of return techni'ue. 8roject B has an initial investment of 6:0,000 and cash inflows at the end of each of the net five years of 6+2,000. 8roject P has a initial investment of 61+0,000 and cash inflows at the end of each of the net four years of 60,000. "he firm should ) accept both if the cost of capital is at most 12 percent. &) accept only P if the cost of capital is at most 12 percent. %) accept only B if the cost of capital is at most 12 percent. A) none of the above nswer! % "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! nalytic skills +2) "he underlying cause of conflicts in ranking for projects by internal rate of return and net present value methods is ) the reinvestment rate assumption regarding intermediate cash flows. &) that neither method eplicitly considers the time value of money. %) the assumption made by the I## method that intermediate cash flows are reinvested at the cost of capital. A) the assumption made by the =8G method that intermediate cash flows are reinvested at the internal rate of return. nswer! "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills +5) En a purely theoretical basis, the =8G is the better approach to capital budgeting due to all the following reasons $B%$8" ) that it measures the benefits relative to the amount invested. &) for the reasonableness of the reinvestment rate assumption. %) that there may be multiple solutions for an I## computation. A) that it maimi4es shareholder wealth. nswer! "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills %opyright 7 +01+ 8earson $ducation
+9) %omparing net present value and internal rate of return ) always results in the same ranking of projects. &) always results in the same acceptreject decision. %) may give different acceptreject decisions. A) is only necessary on mutually eclusive projects. nswer! & "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills +:) In comparing the internal rate of return and net present value methods of evaluation, ) internal rate of return is theoretically superior, but financial managers prefer net present value. &) net present value is theoretically superior, but financial managers prefer to use internal rate of return. %) financial managers prefer net present value, because it is presented as a rate of return. A) financial managers prefer net present value, because it measures benefits relative to the amount invested. nswer! & "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills +;) Unlike the net present value criteria, the internal rate of return approach assumes an interest rate e'ual to ) the relevant cost of capital. &) the project/s internal rate of return. %) the project/s opportunity cost. A) the market/s interest rate. nswer! & "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! #eflective thinking skills 0) Chen evaluating projects using internal rate of return, ) projects having lower early3year cash flows tend to be preferred at higher discount rates. &) projects having higher early3year cash flows tend to be preferred at higher discount rates. %) projects having higher early3year cash flows tend to be preferred at lower discount rates. A) the discount rate and magnitude of cash flows do not affect internal rate of return. nswer! & "opic! Internal #ate of #eturn (uestion tatus! #evised %& *uidelines! #eflective thinking skills
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1) Chich capital budgeting method is most useful for evaluating the following projectD "he project has an initial after ta cost of 62,000,000 and it is epected to provide after3ta operating cash flows of 61,:00,000 in year 1, >6+,;00,000) in year +, 6+,900,000 in year and 6+,00,000 in year D ) =8G. &) I##. %) 8ayback. A) "wo of the above. nswer! "opic! =8G versus I## (uestion tatus! #evised %& *uidelines! nalytic skills Table 10.5
*alay atellite %o. is attempting to select the best group of independent projects competing for the firm/s fied capital budget of 610,000,000. ny unused portion of this budget will earn less than its +0 percent cost of capital. summary of key data about the proposed projects follows.
+) Use the =8G approach to select the best group of projects. >ee "able 10.2) nswer! %hoose 8rojects % and A, since this combination maimi4es =8G at 610,000 and only re'uires 6:,000,000 initial investment. "opic! =8G and %apital #ationing (uestion tatus! #evised %& *uidelines! nalytic skills ) Use the I## approach to select the best group of projects. >ee "able 10.2) nswer! !! "ppr#ach
%hoose 8rojects & and %, resulting in a =8G of 6:0,000. "opic! I## and %apital #ationing (uestion tatus! #evised %& *uidelines! nalytic skills
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