Question 1:
L1CF-TBP104-1504 - hard
Lesson 1: Capital Budgeting
Dursley Inc. considered a prospective investment in a business one month ago,
but it could not proceed due to insufficient funds. Now, it is again presented with
an opportunity to make the same investment. The net present value (NPV) of the
project is less than earlier, despite no change in its cash flows. Based solely on
the information, which of the following statements is the most likely conclusion?
The unsystematic risk of the investment has decreased. (not cover yet)
The corporate bond prices have dropped.
The interest offered on Treasury bills has decreased.
Question 2:
L1R35TB-AC002-1605 - medium
Lesson 1: Capital Budgeting
A corporation purchased land in a downtown location for $120,000 five years
ago. If the land were to be sold today, the corporation expects it would receive
net after-tax proceeds of $90,000. Currently, the corporation is considering a
project to pave the land and make it a parking lot that charges people to park
their cars on it. With respect to the land, when completing its capital budgeting
assessment of the parking lot project, the cash flows being used most
likely should reflect a cost of:
$0
$90,000
$120,000 (historical cost)
Question 3:
L1FR-PQ3501-1410 - medium
Lesson 1: Capital Budgeting
Which of the following types of capital budgeting projects is least likely to directly
generate revenue?
New product development
Regulatory projects (even NPV<0, we still have to do it. e.g. Clean the
water)
Replacement projects
Question 4:
L1R35TB-BW001-1612 - easy
Lesson 1: Capital Budgeting
What is the correct sequence of activities in the capital budgeting process?
1. Preparation of capital budget for the entity.
2. Analysis of each project proposal.
3. Conducting a review of the performance of the project.
4. Gathering of ideas for projects.
1-4-3-2
4-2-1-3
1-4-2-3
Question 5:
L1R35TB-BW006-1612 - medium
Lesson 1: Capital Budgeting
The axes of the NPV profile of a project are:
x-axis: different discount rates; y-axis: NPV
x-axis: different NPVs; y-axis: discount rate
x-axis: different discount rates; y-axis: profitability index
Question 6:
L1FR-PQ3506-1410 - medium
Lesson 1: Capital Budgeting
A firm is considering investing in the following two mutually exclusive projects:
NPV
IRR
Project $5,000 20%
1
Project $6,000 10%
2
Which of the following statements is correct?
The firm should invest in Project 1.
The firm should invest in both projects.
The firm should invest in Project 2.
Question 7:
L1R35TB-AC026-1605 - medium
Lesson 1: Capital Budgeting
Jurer Industries is considering expanding its products to include a new product.
The cost of the expansion is 150 million yen. The expansion will cause after-tax
cash flows to rise by 28 million yen for the next 10 years. The required rate of
return is 7 percent. What is the project's NPV and IRR?
NPV (in IRR
million
yen)
A. 37.8
10.5%
B. 46.7
13.3%
C. 60.4
17.6%
Row A
Row B
Row C
Question 8:
L1R35TB-AC011-1605 - medium
Lesson 1: Capital Budgeting
A project with conventional cash flows has an internal rate of return of 12.4
percent. If the project's required rate of return is 14.0 percent, then the project's
profitability index is most likely:
less than 0.0.
greater than 1.0.
between 0.0 and 1.0.
Question 9:
L1R35TB-AC018-1605 - medium
Lesson 1: Capital Budgeting
In discussing NPV and IRR rankings for two projects being compared, an analyst
has made the following statements:
i.
IRR and NPV will always rank two projects differently if they vary in size.
ii.
IRR and NPV may rank two projects with unconventional cash flows
differently because IRR assumes that cash flows can be reinvested at the
IRR rate.
The analyst is most likely correct in stating:
Statement (i) only.
Statement (ii) only.
Neither statement (i) nor (ii).
Question 10:
L1R35TB-AC004-1605 - medium
Lesson 1: Capital Budgeting
Three projects—A, B, and C—are being considered by a company. Projects A
and B are mutually exclusive, while project C is independent of both A and B.
The NPVs for each project is as follows:
Project Net Present Value
A
£570,000
B
£450,000
C
£140,000
The company most likely should fund:
Projects A and B only.
Projects A and C only.
Projects A, B, and C.
Question 11:
L1FR-PQ3513-1410 - medium
Lesson 1: Capital Budgeting
Consider the following statements:
Statement 1: Lower-level managers have discretion to make decisions that
exceed a given capital budget.
Statement 2: The benefits from the improved decision-making should exceed the
costs of the capital budgeting efforts.
Which of the following is most likely?
Only Statement 1 is incorrect.
Only Statement 2 is incorrect.
Both statements are correct.
Question 12:
L1R35TB-AC019-1605 - medium
Lesson 1: Capital Budgeting
An analyst using capital budgeting has determined that a project has no IRR.
The analyst is most likely correct in stating that:
the project should not be funded.
there is no discount rate that will result in a zero NPV.
the project has no payback period or discounted payback period.
Question 13:
L1CFR35-LIC006-1510 - medium
Lesson 1: Capital Budgeting
The average accounting rate of return (AAR) is least likely to be criticized as a
method for evaluating projects because the AAR does not:
Incorporate the time value of money.
Incorporate the required rate of return.
Consider the income over the complete life of a project.
Question 14:
L1FR-PQ3529-1410 - medium
Lesson 1: Capital Budgeting
QM Motors invests $40 million in a new project which is expected to generate the
following cash flows:
Years
1 2 3 4
Cash
10 10 15 15
flows ($
millions)
Given that the company’s required rate of return is 12%, the project’s profitability
index is closest to:
0.93
1.25
0.82
Question 15:
L1R35TB-AC010-1605 - medium
Lesson 1: Capital Budgeting
An analyst is discussing the relative merits of payback period and discounted
payback period. He mentions that both have two common weaknesses they
share, which are:
i.
Cash flows occurring after the payback and discounted payback periods are
ignored.
ii.
For projects with unconventional cash flows, each approach always
generates two answers.
Which of the following is most likely correct with respect to the analyst's
statements?
Only statement (i) is correct.
Only statement (ii) is correct.
Both statements are correct.
Question 16:
L1R35TB-BW002-1612 - easy
Lesson 1: Capital Budgeting
The five key principles in capital budgeting contemplate the following except:
Cash flows are relevant only before tax is applied.
Capital budgeting cash flows are not accounting net income.
Opportunity costs are included in the analysis.
Question 17:
L1R35TB-AC030-1605 - medium
Lesson 1: Capital Budgeting
A corporation is examining an investment that costs $2.5 million. Given its
riskiness, the investment's required rate of return is 22 percent. If the investment
returns $1.5 million in one year and $1.9 million in two years, what is the
investment's internal rate of return and should the investment be funded?
The investment's IRR is 22.2 percent and it should be funded.
The investment's IRR is 22.2 percent and it should not be funded.
The investment's IRR is 13.1 percent and it should not be funded.
Question 18:
L1R35TB-AC020-1605 - medium
Lesson 1: Capital Budgeting
A project being considered has an initial cost of 200 million pesos and will
generate after-tax cash flows of 35 million pesos per year for six years. In
addition, the project's assets can be sold at the end of year 6 and the after-tax
proceeds will be 120 million. The required rate of return for the project is 6.0
percent. The project's profitability index (PI) is closest to:
0.86
1.25
1.28
Question 19:
L1CFR35-LIC008-1510 - medium
Lesson 1: Capital Budgeting
A company is offered two projects, with the net cash flows (in $ million) from
each project as shown below. The cost of project A is $2 million, and the cost of
project B is $10 million. The cost of capital for project A is 10% and for project B
is 12%. Which of the projects should be accepted for inclusion in the capital
budget?
End Project Project B
of
A
Year
1
1.1
2.0
2
0.8
4.0
3
0.4
7.0
Both projects should be rejected.
Both projects should be accepted.
A should be accepted and B rejected.
Question 20:
L1CFR35-LIC002-1510 - medium
Lesson 1: Capital Budgeting
When calculating cash flows for capital budgeting cash flow analysis, which of
the following statements is most accurate?
Interest payments should not be included since the cost of capital includes
the cost of debt.
Gross interest payments should be included since the cost of capital
includes the cost of debt.
Interest payments reflecting long-term debt should be included since the
cost of capital includes the cost of debt.
Answers
Question 1:
L1CF-TBP104-1504 - hard
Lesson 1: Capital Budgeting
Dursley Inc. considered a prospective investment in a business one month ago,
but it could not proceed due to insufficient funds. Now, it is again presented with
an opportunity to make the same investment. The net present value (NPV) of the
project is less than earlier, despite no change in its cash flows. Based solely on
the information, which of the following statements is the most likely conclusion?
The unsystematic risk of the investment has decreased.
The corporate bond prices have dropped.
The interest offered on Treasury bills has decreased.
Rationale
Rationale
A decrease in the corporate bond prices indicates an increase in the interest
rates in the economy. An increase in the interest rates will result in an increase in
the opportunity cost for Dursley, thus leading to an increase in the discount rate
for the investment, in turn reducing the NPV of the investment.
Question 2:
L1R35TB-AC002-1605 - medium
Lesson 1: Capital Budgeting
A corporation purchased land in a downtown location for $120,000 five years
ago. If the land were to be sold today, the corporation expects it would receive
net after-tax proceeds of $90,000. Currently, the corporation is considering a
project to pave the land and make it a parking lot that charges people to park
their cars on it. With respect to the land, when completing its capital budgeting
assessment of the parking lot project, the cash flows being used most
likely should reflect a cost of:
$0
$90,000
$120,000
Rationale
$0
If sold, the corporation would receive a net of $90,000 today. This $90,000 net
value of the land represents an opportunity cost and it should be considered a
cost to the parking lot project. Opportunity costs are always included in a
project's cost and in this case, the $90,000 would be treated as a cash outflow at
year 0.
Rationale
$90,000
If sold, the corporation would receive a net of $90,000 today. This $90,000 net
value of the land represents an opportunity cost and it should be considered a
cost to the parking lot project. Opportunity costs are always included in a
project's cost and in this case, the $90,000 would be treated as a cash outflow at
year 0.
Rationale
$120,000
If sold, the corporation would receive a net of $90,000 today. This $90,000 net
value of the land represents an opportunity cost and it should be considered a
cost to the parking lot project. Opportunity costs are always included in a
project's cost and in this case, the $90,000 would be treated as a cash outflow at
year 0.
Question 3:
L1FR-PQ3501-1410 - medium
Lesson 1: Capital Budgeting
Which of the following types of capital budgeting projects is least likely to directly
generate revenue?
New product development
Regulatory projects
Replacement projects
Rationale
Rationale
Regulatory projects are forced upon companies by the government and do not
directly generate any revenue.
Question 4:
L1R35TB-BW001-1612 - easy
Lesson 1: Capital Budgeting
What is the correct sequence of activities in the capital budgeting process?
1. Preparation of capital budget for the entity.
2. Analysis of each project proposal.
3. Conducting a review of the performance of the project.
4. Gathering of ideas for projects.
1-4-3-2
4-2-1-3
1-4-2-3
Rationale
1-4-3-2
The first choice is incorrect. The capital budgeting process starts from the project
ideas produced by the company (4), followed by the review of each of the project
proposals received (2). The analysis will be the basis for preparing a firmwide
capital budget (1) and as the projects progress and end, monitoring and postaudit procedures are conducted (3).
Rationale
4-2-1-3
The second choice is correct. The capital budgeting process starts from the
project ideas produced by the company (4), followed by the review of each of the
project proposals received (2). The analysis will be the basis for preparing a
firmwide capital budget (1) and as the projects progress and end, monitoring and
post-audit procedures are conducted (3).
Rationale
1-4-2-3
The third choice is incorrect. The capital budgeting process starts from the
project ideas produced by the company (4), followed by the review of each of the
project proposals received (2). The analysis will be the basis for preparing a
firmwide capital budget (1) and as the projects progress and end, monitoring and
post-audit procedures are conducted (3).
Question 5:
L1R35TB-BW006-1612 - medium
Lesson 1: Capital Budgeting
The axes of the NPV profile of a project are:
x-axis: different discount rates; y-axis: NPV
x-axis: different NPVs; y-axis: discount rate
x-axis: different discount rates; y-axis: profitability index
Rationale
x-axis: different discount rates; y-axis: NPV
The first choice is correct. This statement is true.
Rationale
x-axis: different NPVs; y-axis: discount rate
The second choice is incorrect.
Rationale
x-axis: different discount rates; y-axis: profitability index
The third choice is incorrect.
Question 6:
L1FR-PQ3506-1410 - medium
Lesson 1: Capital Budgeting
A firm is considering investing in the following two mutually exclusive projects:
NPV
IRR
Project $5,000 20%
1
Project $6,000 10%
2
Which of the following statements is correct?
The firm should invest in Project 1.
The firm should invest in both projects.
The firm should invest in Project 2.
Rationale
Rationale
When considering mutually exclusive projects, a company should invest in the
project with the highest positive NPV.
Question 7:
L1R35TB-AC026-1605 - medium
Lesson 1: Capital Budgeting
Jurer Industries is considering expanding its products to include a new product.
The cost of the expansion is 150 million yen. The expansion will cause after-tax
cash flows to rise by 28 million yen for the next 10 years. The required rate of
return is 7 percent. What is the project's NPV and IRR?
NPV (in IRR
million
yen)
A. 37.8
10.5%
B. 46.7
13.3%
C. 60.4
17.6%
Row A
Row B
Row C
Rationale
Row A
The NPV is calculated using your financial calculator:
TI BAII+: CF 150 +/- ENTER, ↓28 ENTER, ↓10 ENTER, NPV 7 ENTER ↓CPT =
46.66
HP12C: 150 CHS g CF0, 28 g CFj, 10 g Nj, 7 i, f NPV = 46.66
These show that the approximate NPV is 46.7 million yen.
Next, we find the IRR using our calculators again:
TI BAII+: CF 150 +/- ENTER, ↓28 ENTER, ↓10 ENTER, IRR CPT = 13.32
HP12C: 150 CHS g CF0, 28 g CFj, 10 g Nj, f IRR = 13.32
The IRR is approximately 13.3 percent.
Rationale
Row B
The NPV is calculated using your financial calculator:
TI BAII+: CF 150 +/- ENTER, ↓28 ENTER, ↓10 ENTER, NPV 7 ENTER ↓CPT =
46.66
HP12C: 150 CHS g CF0, 28 g CFj, 10 g Nj, 7 i, f NPV = 46.66
These show that the approximate NPV is 46.7 million yen.
Next, we find the IRR using our calculators again:
TI BAII+: CF 150 +/- ENTER, ↓28 ENTER, ↓10 ENTER, IRR CPT = 13.32
HP12C: 150 CHS g CF0, 28 g CFj, 10 g Nj, f IRR = 13.32
The IRR is approximately 13.3 percent.
Rationale
Row C
The NPV is calculated using your financial calculator:
TI BAII+: CF 150 +/- ENTER, ↓28 ENTER, ↓10 ENTER, NPV 7 ENTER ↓CPT =
46.66
HP12C: 150 CHS g CF0, 28 g CFj, 10 g Nj, 7 i, f NPV = 46.66
These show that the approximate NPV is 46.7 million yen.
Next, we find the IRR using our calculators again:
TI BAII+: CF 150 +/- ENTER, ↓28 ENTER, ↓10 ENTER, IRR CPT = 13.32
HP12C: 150 CHS g CF0, 28 g CFj, 10 g Nj, f IRR = 13.32
The IRR is approximately 13.3 percent.
Question 8:
L1R35TB-AC011-1605 - medium
Lesson 1: Capital Budgeting
A project with conventional cash flows has an internal rate of return of 12.4
percent. If the project's required rate of return is 14.0 percent, then the project's
profitability index is most likely:
less than 0.0.
greater than 1.0.
between 0.0 and 1.0.
Rationale
less than 0.0.
If the project has conventional cash flows and its IRR is less than its required
rate of return, then the project's NPV must be negative. A negative NPV occurs
when the initial outlay exceeds the present value of the cash flows. Given that
the profitability index (PI) is the PV of the cash flows divided by the initial outlay,
it will be less than 1.0 when the initial outlay exceeds the PV of the cash flows.
Given that the project has a positive IRR, its PI must be greater than 0.
Therefore, the PI is between 0.0 and 1.0.
Rationale
greater than 1.0.
If the project has conventional cash flows and its IRR is less than its required
rate of return, then the project's NPV must be negative. A negative NPV occurs
when the initial outlay exceeds the present value of the cash flows. Given that
the profitability index (PI) is the PV of the cash flows divided by the initial outlay,
it will be less than 1.0 when the initial outlay exceeds the PV of the cash flows.
Given that the project has a positive IRR, its PI must be greater than 0.
Therefore, the PI is between 0.0 and 1.0.
Rationale
between 0.0 and 1.0.
If the project has conventional cash flows and its IRR is less than its required
rate of return, then the project's NPV must be negative. A negative NPV occurs
when the initial outlay exceeds the present value of the cash flows. Given that
the profitability index (PI) is the PV of the cash flows divided by the initial outlay,
it will be less than 1.0 when the initial outlay exceeds the PV of the cash flows.
Given that the project has a positive IRR, its PI must be greater than 0.
Therefore, the PI is between 0.0 and 1.0.
Question 9:
L1R35TB-AC018-1605 - medium
Lesson 1: Capital Budgeting
In discussing NPV and IRR rankings for two projects being compared, an analyst
has made the following statements:
i.
IRR and NPV will always rank two projects differently if they vary in size.
ii.
IRR and NPV may rank two projects with unconventional cash flows
differently because IRR assumes that cash flows can be reinvested at the
IRR rate.
The analyst is most likely correct in stating:
Statement (i) only.
Statement (ii) only.
Neither statement (i) nor (ii).
Rationale
Statement (i) only.
Both statements are incorrect. Statement (i) is incorrect in stating that projects of
differing sizes will always be ranked differently. It is possible that they will be
ranked differently, but it also possible that they will have the same ranking order.
Statement (ii) is incorrect in that it is mixing two different concepts. A project with
unconventional cash flows will have either two IRRs or no IRR at all. This means
that IRR will be unable to rank the projects. This inability to rank is being caused
by the unconventional cash flows and not the assumption that cash flows are
reinvested at the IRR rate.
Rationale
Statement (ii) only.
Both statements are incorrect. Statement (i) is incorrect in stating that projects of
differing sizes will always be ranked differently. It is possible that they will be
ranked differently, but it also possible that they will have the same ranking order.
Statement (ii) is incorrect in that it is mixing two different concepts. A project with
unconventional cash flows will have either two IRRs or no IRR at all. This means
that IRR will be unable to rank the projects. This inability to rank is being caused
by the unconventional cash flows and not the assumption that cash flows are
reinvested at the IRR rate.
Rationale
Neither statement (i) nor (ii).
Both statements are incorrect. Statement (i) is incorrect in stating that projects of
differing sizes will always be ranked differently. It is possible that they will be
ranked differently, but it also possible that they will have the same ranking order.
Statement (ii) is incorrect in that it is mixing two different concepts. A project with
unconventional cash flows will have either two IRRs or no IRR at all. This means
that IRR will be unable to rank the projects. This inability to rank is being caused
by the unconventional cash flows and not the assumption that cash flows are
reinvested at the IRR rate.
Question 10:
L1R35TB-AC004-1605 - medium
Lesson 1: Capital Budgeting
Three projects—A, B, and C—are being considered by a company. Projects A
and B are mutually exclusive, while project C is independent of both A and B.
The NPVs for each project is as follows:
Project Net Present Value
A
£570,000
B
£450,000
C
£140,000
The company most likely should fund:
Projects A and B only.
Projects A and C only.
Projects A, B, and C.
Rationale
Projects A and B only.
If all three projects were independent, then all would be funded. But Projects A
and B are mutually exclusive, which means that only one of these two can be
undertaken. Therefore, the project of the two that has the highest NPV should be
selected, and that is Project A. Project C is independent of both A and B and has
a positive NPV, which means it should also be funded regardless of whether
Project A or B is selected.
Rationale
Projects A and C only.
If all three projects were independent, then all would be funded. But Projects A
and B are mutually exclusive, which means that only one of these two can be
undertaken. Therefore, the project of the two that has the highest NPV should be
selected, and that is Project A. Project C is independent of both A and B and has
a positive NPV, which means it should also be funded regardless of whether
Project A or B is selected.
Rationale
Projects A, B, and C.
If all three projects were independent, then all would be funded. But Projects A
and B are mutually exclusive, which means that only one of these two can be
undertaken. Therefore, the project of the two that has the highest NPV should be
selected, and that is Project A. Project C is independent of both A and B and has
a positive NPV, which means it should also be funded regardless of whether
Project A or B is selected.
Question 11:
L1FR-PQ3513-1410 - medium
Lesson 1: Capital Budgeting
Consider the following statements:
Statement 1: Lower-level managers have discretion to make decisions that
exceed a given capital budget.
Statement 2: The benefits from the improved decision-making should exceed the
costs of the capital budgeting efforts.
Which of the following is most likely?
Only Statement 1 is incorrect.
Only Statement 2 is incorrect.
Both statements are correct.
Rationale
Rationale
Lower-level managers may have discretion to make decisions that do not exceed
a given capital budget.
Question 12:
L1R35TB-AC019-1605 - medium
Lesson 1: Capital Budgeting
An analyst using capital budgeting has determined that a project has no IRR.
The analyst is most likely correct in stating that:
the project should not be funded.
there is no discount rate that will result in a zero NPV.
the project has no payback period or discounted payback period.
Rationale
the project should not be funded.
When a project has a cash flow pattern that results in no IRR, then it means that
there is no discount rate that results in a zero NPV. Remember, the IRR is the
rate that equates the discounted cash inflows and outflows. So if these flows
cannot be made to equal each other, then there is no way to get a NPV of zero
no matter what discount rate is used.
Rationale
there is no discount rate that will result in a zero NPV.
When a project has a cash flow pattern that results in no IRR, then it means that
there is no discount rate that results in a zero NPV. Remember, the IRR is the
rate that equates the discounted cash inflows and outflows. So if these flows
cannot be made to equal each other, then there is no way to get a NPV of zero
no matter what discount rate is used.
Rationale
the project has no payback period or discounted payback period.
When a project has a cash flow pattern that results in no IRR, then it means that
there is no discount rate that results in a zero NPV. Remember, the IRR is the
rate that equates the discounted cash inflows and outflows. So if these flows
cannot be made to equal each other, then there is no way to get a NPV of zero
no matter what discount rate is used.
Question 13:
L1CFR35-LIC006-1510 - medium
Lesson 1: Capital Budgeting
The average accounting rate of return (AAR) is least likely to be criticized as a
method for evaluating projects because the AAR does not:
Incorporate the time value of money.
Incorporate the required rate of return.
Consider the income over the complete life of a project.
Rationale
Rationale
Criticisms of the AAR include the following:
 It is based on net income rather than cash flows.
 It does not look at the timing of income.
 It does not distinguish between profitable and unprofitable projects (relative to
a required return).
It does, however, look at the average income over the life of a project, so the
correct answer is the third choice.
Question 14:
L1FR-PQ3529-1410 - medium
Lesson 1: Capital Budgeting
QM Motors invests $40 million in a new project which is expected to generate the
following cash flows:
Years
1 2 3 4
Cash
10 10 15 15
flows ($
millions)
Given that the company’s required rate of return is 12%, the project’s profitability
index is closest to:
0.93
1.25
0.82
Rationale
Rationale
Present value of future cash flows:
[CF] [2ND] [FV] [2ND] [CE|C]
0 [ENTER] [↓]
10 [ENTER] [↓] [↓]
10 [ENTER] [↓] [↓]
15 [ENTER] [↓] [↓]
15 [ENTER]
[NPV] 12 [ENTER] [↓] [CPT]
NPV = 37.11 million
Initial cost = $40 million
Profitability index = PV of future cash flows / Initial investment
Profitability index = 37.11 / 40 = 0.93
Question 15:
L1R35TB-AC010-1605 - medium
Lesson 1: Capital Budgeting
An analyst is discussing the relative merits of payback period and discounted
payback period. He mentions that both have two common weaknesses they
share, which are:
i.
Cash flows occurring after the payback and discounted payback periods are
ignored.
ii.
For projects with unconventional cash flows, each approach always
generates two answers.
Which of the following is most likely correct with respect to the analyst's
statements?
Only statement (i) is correct.
Only statement (ii) is correct.
Both statements are correct.
Rationale
Only statement (i) is correct.
The first statement is correct in that both approaches ignore any cash flows that
occur after the payback period has been reached. Statement (ii) is incorrect, as it
does not apply to the payback period and discounted payback period
approaches. It is IRR that has the potential to generate two answers when cash
flows are unconventional.
Rationale
Only statement (ii) is correct.
The first statement is correct in that both approaches ignore any cash flows that
occur after the payback period has been reached. Statement (ii) is incorrect, as it
does not apply to the payback period and discounted payback period
approaches. It is IRR that has the potential to generate two answers when cash
flows are unconventional.
Rationale
Both statements are correct.
The first statement is correct in that both approaches ignore any cash flows that
occur after the payback period has been reached. Statement (ii) is incorrect, as it
does not apply to the payback period and discounted payback period
approaches. It is IRR that has the potential to generate two answers when cash
flows are unconventional.
Question 16:
L1R35TB-BW002-1612 - easy
Lesson 1: Capital Budgeting
The five key principles in capital budgeting contemplate the following except:
Cash flows are relevant only before tax is applied.
Capital budgeting cash flows are not accounting net income.
Opportunity costs are included in the analysis.
Rationale
Cash flows are relevant only before tax is applied.
The first choice is correct. Taxes have an effect on the cash flows of an entity. It
is relevant in capital budgeting decisions.
Rationale
Capital budgeting cash flows are not accounting net income.
The second choice is incorrect. Accounting income includes noncash expenses.
If included, accounting income is inconsistent with the principle of a cash-flowbased decision in capital budgeting.
Rationale
Opportunity costs are included in the analysis.
The third choice is incorrect. Incremental cash flows that occur with an
investment as compared to what they would have been without the project are
relevant and are included in the analysis.
Question 17:
L1R35TB-AC030-1605 - medium
Lesson 1: Capital Budgeting
A corporation is examining an investment that costs $2.5 million. Given its
riskiness, the investment's required rate of return is 22 percent. If the investment
returns $1.5 million in one year and $1.9 million in two years, what is the
investment's internal rate of return and should the investment be funded?
The investment's IRR is 22.2 percent and it should be funded.
The investment's IRR is 22.2 percent and it should not be funded.
The investment's IRR is 13.1 percent and it should not be funded.
Rationale
The investment's IRR is 22.2 percent and it should be funded.
The IRR is calculated using your financial calculator:
TI BAII+: CF 2.5 +/− ENTER, ↓1.5 ENTER, ↓↓1.9 ENTER, IRR CPT = 22.2
HP12C: 2.5 CHS g CF0, 1.5 g CFj, 1.9 g CFj, f IRR = 22.2
The IRR of 22.2 percent is above the 22 percent required return. Thus, the
project should be funded.
Rationale
The investment's IRR is 22.2 percent and it should not be funded.
The IRR is calculated using your financial calculator:
TI BAII+: CF 2.5 +/− ENTER, ↓1.5 ENTER, ↓↓1.9 ENTER, IRR CPT = 22.2
HP12C: 2.5 CHS g CF0, 1.5 g CFj, 1.9 g CFj, f IRR = 22.2
The IRR of 22.2 percent is above the 22 percent required return. Thus, the
project should be funded.
Rationale
The investment's IRR is 13.1 percent and it should not be funded.
The IRR is calculated using your financial calculator:
TI BAII+: CF 2.5 +/− ENTER, ↓1.5 ENTER, ↓↓1.9 ENTER, IRR CPT = 22.2
HP12C: 2.5 CHS g CF0, 1.5 g CFj, 1.9 g CFj, f IRR = 22.2
The IRR of 22.2 percent is above the 22 percent required return. Thus, the
project should be funded.
Question 18:
L1R35TB-AC020-1605 - medium
Lesson 1: Capital Budgeting
A project being considered has an initial cost of 200 million pesos and will
generate after-tax cash flows of 35 million pesos per year for six years. In
addition, the project's assets can be sold at the end of year 6 and the after-tax
proceeds will be 120 million. The required rate of return for the project is 6.0
percent. The project's profitability index (PI) is closest to:
0.86
1.25
1.28
Rationale
0.86
It is critical to be sure to account for the extra cash flow in year 6, which results in
total year 6 cash flows of 155 million pesos. As this extra cash flow occurs at the
end of year 6, it is discounted for six periods—the same as we use for the other
35 million pesos received in year 6. The present value of the cash inflows for the
project can be found using your financial calculator:
TI BAII+: CF 0 ENTER, ↓35 ENTER, ↓5 ENTER, ↓155 ENTER, NPV 6 ENTER
↓CPT = 256.7
HP12C: 0 g CF0, 35 g CFj, 5 g Nj, 155 g CFj, 6 i, f NPV = 256.7
Note: We used a 0 for our initial investment, as we need the PV and not the
NPV. With a zero initial investment, when we solve for NPV on the calculator we
get the PV. The amount of 0 is not really needed to be entered as long as the
calculator was cleared before doing the calculation.
Using this PV and the initial investment cost of 200 million pesos, we can
calculate the profitability index (PI):
Rationale
1.25
It is critical to be sure to account for the extra cash flow in year 6, which results in
total year 6 cash flows of 155 million pesos. As this extra cash flow occurs at the
end of year 6, it is discounted for six periods—the same as we use for the other
35 million pesos received in year 6. The present value of the cash inflows for the
project can be found using your financial calculator:
TI BAII+: CF 0 ENTER, ↓35 ENTER, ↓5 ENTER, ↓155 ENTER, NPV 6 ENTER
↓CPT = 256.7
HP12C: 0 g CF0, 35 g CFj, 5 g Nj, 155 g CFj, 6 i, f NPV = 256.7
Note: We used a 0 for our initial investment, as we need the PV and not the
NPV. With a zero initial investment, when we solve for NPV on the calculator we
get the PV. The amount of 0 is not really needed to be entered as long as the
calculator was cleared before doing the calculation.
Using this PV and the initial investment cost of 200 million pesos, we can
calculate the profitability index (PI):
Rationale
1.28
It is critical to be sure to account for the extra cash flow in year 6, which results in
total year 6 cash flows of 155 million pesos. As this extra cash flow occurs at the
end of year 6, it is discounted for six periods—the same as we use for the other
35 million pesos received in year 6. The present value of the cash inflows for the
project can be found using your financial calculator:
TI BAII+: CF 0 ENTER, ↓35 ENTER, ↓5 ENTER, ↓155 ENTER, NPV 6 ENTER
↓CPT = 256.7
HP12C: 0 g CF0, 35 g CFj, 5 g Nj, 155 g CFj, 6 i, f NPV = 256.7
Note: We used a 0 for our initial investment, as we need the PV and not the
NPV. With a zero initial investment, when we solve for NPV on the calculator we
get the PV. The amount of 0 is not really needed to be entered as long as the
calculator was cleared before doing the calculation.
Using this PV and the initial investment cost of 200 million pesos, we can
calculate the profitability index (PI):
Question 19:
L1CFR35-LIC008-1510 - medium
Lesson 1: Capital Budgeting
A company is offered two projects, with the net cash flows (in $ million) from
each project as shown below. The cost of project A is $2 million, and the cost of
project B is $10 million. The cost of capital for project A is 10% and for project B
is 12%. Which of the projects should be accepted for inclusion in the capital
budget?
End Project Project B
of
A
Year
1
1.1
2.0
2
0.8
4.0
3
0.4
7.0
Both projects should be rejected.
Both projects should be accepted.
A should be accepted and B rejected.
Rationale
Rationale
The present value of the cash flows for project A, discounted at 10%, is $1.96
million (1.00 + 0.66 + 0.30), which is less than the cost; therefore, the project
should be rejected.
The present value of the cash flows for project B, discounted at 12%, is $9.96
million (1.79 + 3.19 + 4.98), which is less than the cost; therefore, the project
should be rejected.
Question 20:
L1CFR35-LIC002-1510 - medium
Lesson 1: Capital Budgeting
When calculating cash flows for capital budgeting cash flow analysis, which of
the following statements is most accurate?
Interest payments should not be included since the cost of capital includes
the cost of debt.
Gross interest payments should be included since the cost of capital
includes the cost of debt.
Interest payments reflecting long-term debt should be included since the
cost of capital includes the cost of debt.
Rationale
Rationale
The weighted cost of capital includes the cost of debt, so the cash flow available
for bond and equity holders should be used, that is, before interest payments.