Basic Concepts Capital Budgeting Defined Agency Problem in Capital Budgeting

MANAGEMENT ADVISORY SERVICES
BASIC CONCEPTS
Capital Budgeting Defined
1
. The capital budget is a(n)
a. Plan to insure that there are sufficient funds available for the operating needs of the
company.
b. Exercise that sets the long-range goals of the company including the consideration of
external influences.
c. Plan that coordinates and communicates a companys plan for the coming year to all
departments and divisions.
d. Plan that assesses the long-term needs of the company for plant and equipment
purchases.
CMA 0695 3-17
2
In planning and controlling capital expenditures, the most logical sequence is to begin with
a. Analyzing capital addition proposals.
b. Making capital and expenditure decisions.
c. Analyzing and evaluating all promising alternatives.
d. Identifying capital addition projects and other capital needs.
CMA 0696 3-11
21. Which of the following involves significant financial investments in projects to develop new
products, expand production capacity, or remodel current production facilities? (E)
a. Capital budgeting
c. Master budgeting
b. Working capital
d. Project-cost budgeting
Horngren
*.
The detailed plan for the acquisition and replacement of major portions of property, plant, and
equipment is known as the
a. capital budget.
c. commitments budget.
b. purchases budget.
d. treasury budget.
Barfield
CAPITAL BUDGETING
D. Capital budgeting is a bottom-up process, while strategic planning is a top-down process
Agency Problem in Capital Budgeting
15. The following are agency problems in capital budgeting except:
A. Reduced effort
C. Empire building
B. Need for good information
D. Perks
B&M

A. Empire building
C. Avoiding risks
B. Entrenching investment
D. Reducing forecast bias
B&M

A. Avoiding risks
B. The free-rider problem
C. Compensation
D. All of the above are agency problems
B&M

A. Monitoring
C. Avoiding risks
B. Compensation
D. Economic value added
B&M
Uses
107.A capital budget is used by management to determine
Barfield
a.
b.
In what to invest
No
No
How much to invest
No
Yes
3
2. _____________ decisions are concerned with the process of planning, setting goals and
priorities, arranging financing, and identifying criteria for making long-term investments.
a. Limited resources
c. Capital investment
b. Sell now or process further
d. Make or buy
H&M
Capital Budgeting vs. Strategic Planning
3. Which of the following statements regarding capital budgeting and strategic planning is true?
A. Capital budgeting and strategic planning are bottom-up processes
B. Capital budgeting and strategic planning are top down processes
B&M
C. Capital budgeting is a top-down process, while strategic planning is a bottom-up process
CMA EXAMINATION QUESTIONS
c.
Yes
No
d.
Yes
Yes
Capital budgeting is concerned with

A. Decisions affecting only capital intensive industries.
B. Analysis of short-range decisions.
C. Analysis of long-range decisions.
D. Scheduling office personnel in office buildings.
Gleim
Capital budgeting is used for the decision analysis of

A. Adding product lines or facilities.
C. Lease-or-buy decisions.
B. Multiple profitable alternatives.
D. All of the answers are correct.
Gleim
Capital budgeting techniques are least likely to be used in evaluating the (E)
Page 1 of 107

a.
b.
c.
d.
Acquisition of new aircraft by a cargo company.

Design and implementation of a major advertising program.
Trade for a star quarterback by a football team.
CMA 0693 4-19
Adoption of a new method of allocating non-traceable costs to product lines.
Application
2. A company can replace the machinery currently used to manufacture its product with more
efficient machinery. The new machinery will reduce labor and also will reduce the percentage
of spoiled units. It is expected to have a useful life of 5 years. The most appropriate technique
for determining whether or not the company should replace its machinery with the new, more
efficient machinery is:
A. cost-volume-profit analysis
C. regression analysis
B. capital-budgeting analysis
D. linear programming
CIA adapted
CAPITAL BUDGETING
a. identification stage.
b. search stage.
c. information-acquisition stage.
d. selection stage.
Horngren
Search Stage
24. The stage of the capital budgeting process which explores alternative capital investments that
will achieve organization objectives is the (E)
b. search stage.
d. selection stage.
Horngren
Selection Stage
26. The stage of the capital budgeting process which chooses projects for implementation is the
(E)
a. selection stage.
c. identification stage.
b. search stage.
d. management-control stage.
Horngren
Not-for-Profit Entities
10. Not-for-profit entities
a. Cannot use capital budgeting techniques because profitability is irrelevant to them.
b. Cannot use discounted cash flow techniques because the time value of money is
irrelevant to them.
c. Might have serious problems in quantifying the benefits expected from an investment.
d. Should use the IRR method to make investment decisions.
L&H
Appropriation Requests
8. Which of the following statements regarding appropriation requests is true?
A. Usually submitted by head office staff
B. Represents the first step in the capital budgeting process
C. Authorization tends to be reserved for senior management
D. None of the above
B&M
Life Cycle Costing

22. The accounting system that corresponds to the project dimension in capital budgeting is the
(E)
a. net present value method.
c. accrual accounting rate of return.
b. internal rate of return.
d. life-cycle costing.
Horngren
9. Which of the following statements regarding appropriation requests is true?

A. Usually submitted by head office staff
B. Usually requires a detailed analysis using more than one investment criterion
C. Usually submitted to a single review at the head office
B&M
Stages
Identification Stage
23. The stage of the capital budgeting process which distinguishes which types of capital
expenditure projects are necessary to accomplish organization objectives is the (E)
b. search stage.
d. selection stage.
Horngren
Implementation & Control Stage

27. The stage of the capital-budgeting process in which projects get underway and performance is
monitored is the (E)
a. implementation and control stage.
c. identification stage.
b. search stage.
d. management-control stage.
Horngren
Information-Acquisition Stage
25. The stage of the capital budgeting process which considers the expected costs and the
expected benefits of alternative capital investments is the (E)
Acquisition Considerations
6. Effective planning and control is important for the effective administration of a capital
expenditure program because:
A. the long-term commitment increases financial risk
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B. the magnitude of expenditures is substantial and the economic penalties for unwise
decisions are usually severe
C. decisions made in this area provide the structure for operation of the firm
D. all of the above
Carter & Usry
7. A company manual used for detailing policies and procedures required for administering the
capital expenditure program should:
A. encourage people to work on and submit new ideas
B. focus attention on useful analytical tasks
C. facilitate rapid project development and expeditious review
D. all of the above
Carter & Usry
14. The normal methods of analyzing investments
a. Cannot be used by not-for-profit entities.
b. Do not apply if the project will not produce revenues.
c. Cannot be used if the company plans to finance the project with funds already available
internally.
d. Require forecasts of cash flows expected from the project.
L&H
6
High-Tech Industries is considering the acquisition of a new state-of-the-art manufacturing

machine to replace a less efficient machine. Hi-Tech has completed a net present value
analysis and found it to be favorable. Which one of the following factors should not be of
concern to Hi-Tech in its acquisition considerations?
A. The availability of any necessary financing.
B. The probability of near-term technological changes to the manufacturing process.
C. The investment tax credit.
CMA 1290 4-18
D. Maintenance requirements, warranties, and availability of service arrangements.
8. A number of evaluations of a single capital expenditure proposal may be necessary because

of:
A. circumstances that change during the time span from the origin of the project idea to its
completion
B. alternative solutions of the problem for which the project is designed
C. assumptions that vary as to the amount and timing of cash flows
D. all of the above
Carter & Usry
23. Which of the following events is most likely to increase the number of investments that meet a
companys acceptance criteria? (M)
CAPITAL BUDGETING
a.
b.
c.
d.
Top management raises the target rate of return.

The interest rate on long-term debt rises.
The income tax rate rises.
The IRS allows companies to expense purchases of fixed assets, instead of depreciating
them over their lives.
L&H
Qualitative Factors
37. Qualitative issues could increase the acceptability of a project under which of the following
conditions?
a. The IRR is less than the companys cutoff rate.
b. The project has a negative NPV.
c. The payback period is longer than the companys cutoff period.
d. All of the above.
L&H
40. Qualitative factors can influence managers to
a. Accept an investment project having a negative NPV.
b. Reject an investment project having an IRR greater than the companys cutoff rate.
c. Raise the ranking of an investment project.
d. Take any of the above courses of action.
L&H
76. Which of the following statements is (are) true about automation?
a. Automation is inexpensive.
b. Automation should be adopted as soon as new technology is available.
c. Automation should be adopted after a company makes the most efficient use of existing
technology.
d. All of the above are true
H&M
Ethical Consideration
4. Common problems related to ethical considerations in the capital budgeting include all of the
following, except:
A. superiors and associates sometimes apply pressure to circumvent the approval process
B. pressure may exist to write-off or devalue assets below their true value to justify
replacement
C. the economic benefit of capital projects may be exaggerated to increase the likelihood of
approval
D. the accountant may mistakenly go to the individuals involved in the ethical conflict first,
rather than first discussing it with the accounting supervisor
E. all of the above are ethical problems related to capital budgeting
AICPA adapted
Page 3 of 107
CAPITAL BUDGETING
Post- Investment Audit

69. Comparison of the actual results for a project to the costs and benefits expected at the time
the project was selected is referred to as (E)
a. the audit trail.
c. a postinvestment audit.
b. management control.
d. a cost-benefit analysis.
Horngren
Expansion Expenditures
10. In which of the following types of capital expenditure decisions does the basis for a decision
most markedly shift from cost savings to increased profits and cash flow?
A. replacement expenditures
C. improvement expenditures
B. expansion expenditures
D. allowance expenditures
Carter & Usry
10. Post audit is conducted:

A. Before starting a project
B. Before authorizing a project
C. Shortly after a project has started operating
D. Long after the project has been completed and the salvage has been realized
B&M
Improvement Expenditures
11. The capital expenditures in which the benefits are most difficult to quantify are:
Carter & Usry
H&M
Not a Capital Expenditure

6. The following capital expenditures may not appear in the capital budget except:
A. Investment in information technology
B. Investment in research and development
C. Investment in training and personal development
D. Investment in a new office building
B&M
7. The following capital expenditures may not appear in the capital budget except:
A. Marketing
B. Training and personnel development
C. Investment in a new machine
D. Investment in research and development
B&M
4. Which of the following capital expenditure may not appear in capital budget?
A. Investment in a new plant
B. Investment in a new machine
C. Investment in information technology
D. All of the above are included in capital budget
B&M
5. Which of the following capital expenditures may not appear in capital budget?
A. Investment in a new building
B. Investment in a new machine
C. Investment in research and development
D. All of the above are included in capital budget
B&M
77. A post audit compares

a. estimated benefits and costs with budgeted benefits and cost
b. estimated benefits with estimated costs
c. actual benefits with actual costs
d. actual benefits and costs with estimated benefits and costs
27 The post-audit is used to(E)

a. Improve cash flow forecasts.
b. Stimulate management to improve operations and bring results into line with forecasts.
c. Eliminate potentially profitable but risky projects.
d. Statements a and b are correct.
e. All of the statements above are correct.
Brigham
11. A post audit will:
A. Identify the problem that needs to be fixed
B. Check the accuracy of the cash flow forecasts
C. Suggest questions that should have been asked before
D. All of the above
B&M
Type of Capital Expenditure

Replacement Expenditures
9. The following capital expenditures that compare the future costs of the old assets with the
future costs of the new assets as a basis for making a decision are:
Carter & Usry
Page 4 of 107
CAPITAL BUDGETING
Types of Projects
Independent Projects
1. ______________ are projects that when accepted or rejected will NOT affect the cash flows of
another project.
a. Independent projects
c. Dependent projects
b. Mutually exclusive projects
d. Both b and c
H&M
a.
b.
c.
d.
7
Mutually Exclusive Projects

4. ______________are projects that when accepted preclude the acceptance of competing
projects.
a. Independent projects
c. Dependent projects
b. Mutually exclusive projects
d. Both b and c
H&M
Inflation Element
*. The inflation element refers to the
a. Impact that future price increases will have on the original cost of a capital expenditure.
b. Fact that the real purchasing power of a monetary unit usually increases over time.
c. Future deterioration of the general purchasing power of the monetary unit.
d. Future increases in the general purchasing power of the monetary unit.
RPCPA 0597
Relevant and Irrelevant Costs
28. Capital budgeting emphasizes two factors (E)
a. qualitative and nonfinancial.
c. quantitative and financial
b. quantitative and nonfinancial.
d. qualitative and financial.
56. The focus in capital budgeting should be on (E)

a. the tax consequences of different investment strategies.
b. the internal rate of return of different strategies.
c. expected future cash flows that differ between alternatives.
d. none of the above.
Horngren
32. The only future costs that are relevant to deciding whether to accept an investment are those
that will
L&H
Which of the following rules are essential to successful cash flow estimates, and ultimately, to
successful capital budgeting? (M)
a. The return on invested capital is the only relevant cash flow.
b. Only incremental cash flows are relevant to the accept/reject decision.
c. Total cash flows are relevant to capital budgeting analysis and the accept/reject decision.
Brigham
Salvage Value
60. The relevant terminal disposal price of a machine equals (M)
a. the difference between the salvage value of the old machine and the ultimate salvage
value of the new machine.
b. the total of the salvage values of the old machine and the new machine.
c. the salvage value of the old machine.
d. the salvage value of the new machine.
Horngren
*.
Karen Company is considering replacing an old machine with a new machine. Which of the
following items is economically relevant to Karens decisions? (M)
RPCPA 0598
a.
b.
c.
d.
Carrying amount of old machine
Yes
Yes
No
No
Disposal value of new machine
Yes
No
Yes
No
*.
You are the treasurer of the Hibang Corp. The company is considering a proposed project
which has an expected economic life of seven years. Net present value is the capital
budgeting technique the president wants you to use. Salvage value of the project would be
(M)
a. Treated as cash inflow at estimated salvage value.
b. Treated as cash flow at its present value.
c. Irrelevant cash flow item.
d. Treated as cash inflow at the future value.
RPCPA 1096
Horngren
29. Which of the following are NOT included in the formal financial analysis of a capital budgeting
program? (E)
a. Quality of the output
c. Cash flow
b. Safety of employees
d. Neither (a) nor (b) are included Horngren
Be different if the project is accepted rather than rejected.

Be saved if the project is accepted rather than rejected.
Be deductible for tax purposes.
Affect net income in the period that they are incurred.
Working Capital
Page 5 of 107

66. In the analysis of a capital budgeting proposal, for which of the following items are there no
after-tax consequences? (E)
a. Cash flow from operations
b. Gain or loss on the disposal of the asset
c. Reduction of working capital balances at the end of the useful life of the capital asset
d. There are no after-tax consequences of any of the above.
Horngren
11. A major difference between an investment in working capital and one in depreciable assets is
that (M)
a. An investment in working capital is never returned, while most depreciable assets have
some residual value.
b. An investment in working capital is returned in full at the end of the projects life, while an
investment in depreciable assets has no residual value.
c. An investment in working capital is not tax-deductible when made, not taxable when
returned, while an investment in depreciable assets does allow tax deductions.
d. Because an investment in working capital is usually returned in full at the end of the
projects life, it is ignored in computing the amount of the investment required for the
project.
L&H
*.
Mahlin Movers, Inc. is planning to purchase equipment to make its operations more efficient.
This equipment has an estimated useful life of six years. As part of this acquisition, a
P150,000 investment in working capital is required. In a discounted cash flow analysis, this
investment in working capital should be (E)
a. Amortized over the useful life of the equipment.
b. Disregarded because no cash is involved.
RPCPA 1095
c. Treated as a recurring annual cash flow that is recovered at the end of six years.
d. Treated as an immediate cash outflow that is recovered at the end of six years.
Fast Freight, Inc. is planning to purchase equipment to make its operations more efficient.
This equipment has an estimated life of 6 years. As part of this acquisition, a $75,000
investment in working capital is anticipated. In a discounted cash flow analysis, the investment
in working capital (E)
a. Should be amortized over the useful life of the equipment.
b. Should be treated as a recurring cash outflow over the life of the equipment.
c. Should be treated as an immediate cash outflow.
CMA 0691 4-20
d. Should be treated as an immediate cash outflow recovered at the end of 6 years.
CAPITAL BUDGETING
32. In connection with a capital budgeting project, an investment in working capital is normally
recovered
a. At the end of the projects life.
c. Evenly through the projects life.
L&H
b. In the first year of the projects life.
d. When the company goes out of business.
12. The proper treatment of an investment in receivables and inventory is to
a. Ignore it.
b. Add it to the required investment in fixed assets.
c. Add it to the required investment in fixed assets and subtract it from the annual cash
flows.
d. Add it to the investment in fixed assets and add the present value of the recovery to the
present value of the annual cash flows.
L&H
34. The cash inflow from the return on an investment in working capital is
a. Adjusted for taxes due.
b. Discounted to present value.
c. Ignored if any depreciable assets also involved in the project have no expected residual
value.
d. Not real.
L & H, RPCPA 1001
29. XYZ Co. is adopting just-in-time principles. When evaluating an investment project that would
reduce inventory, how should XYZ treat the reduction?
a. Ignore it.
b. Decrease the cost of the investment and decrease cash flows at the end of the projects
life.
c. Decrease the cost of the investment.
d. Decrease the cost of the investment and increase the cash flow at the end of the projects
life.
L&H
4. Net Working Capital should be considered in project cash flows because:
A. They are sunk costs
B. Firms must invest cash in short-term assets to produce finished goods
C. Firms need positive NPV projects for investment
B&M
Opportunity Costs
10. The value of a previously purchased machine expected to be used by a proposed project is an
example of:
Page 6 of 107

A. Sunk costs
B. Opportunity costs
CAPITAL BUDGETING
C. Fixed costs
B&M
Cash Outflows
14. All of the following are common cash outflows from capital expenditure programs, except:
A. equipment installation
D. increased working capital requirements
B. employee training
E. salvage value at the end of the project
C. computer programming and fine tuning
Carter & Usry
33. For investments that have only costs (no revenues or cost savings), an appropriate decision
rule is to accept the project that has the
a. Longest payback period.
b. Lower present value of cash outflows.
c. Higher present value of future cash outflows.
d. Lowest internal rate of return.
L&H
Cash Inflows
15. As to a capital investment, net cash inflow is equal to the
a. cost savings resulting from the investment.
b. sum of all future revenues from the investment.
c. net increase in cash receipts over cash payments.
d. net increase in cash payments over cash receipts.
Barfield
8. Which of the following describes the annual returns that are discounted in determining the
NPV of an investment?
a. Net incomes expected to be earned by the project.
b. Pre-tax cash flows expected from the project.
c. After-tax cash flows expected from the project.
d. After-tax cash flows adjusted for the time value of money.
L&H
57. Annual after-tax corporate net income can be converted to annual after-tax cash flow by (E)
a. adding back the depreciation amount.
b. deducting the depreciation amount.
Barfield
c. adding back the quantity (t x depreciation deduction), where t is the corporate tax rate.
d. deducting the quantity [(1- t) x depreciation deduction], where t is the corporate tax rate.
.
To approximate annual cash inflow, depreciation is

a. Added back to net income because it is an inflow of cash.
b. Subtracted from net income because it is an outflow of cash.

c. Subtracted from net income because it is an expense.
d. Added back to net income because it is not an outflow of cash.
RPCPA 1001
59. Depreciation is usually not considered an operating cash flow in capital budgeting because
(E)
a. depreciation is usually a constant amount each year over the life of the capital investment.
b. deducting depreciation from operating cash flows would be counting the lump-sum
amount twice.
c. depreciation usually does not result in an increase in working capital.
d. depreciation usually has no effect on the disposal price of the machine.
Horngren
25. Which of these could occur in practice where the capital expenditure relates to the production
of an established product or service, the demand for which is expected to vary in response to
temporary changes in consumer taste?
A. perfectly correlated cash flows
C. independent cash flows
B. negative cash flows
D. mixed cash flows
Carter & Usry
3. Which of the following is NOT relevant in calculating annual net cash flows for an investment?
a. Interest payments on funds borrowed to finance the project.
b. Depreciation on fixed assets purchased for the project.
c. The income tax rate.
d. Lost contribution margin if sales of the product invested in will reduce sales of other
products.
L&H
39. Which of the following is NOT relevant in calculating net cash flows for Project N?
a. Interest payments on funds that would be borrowed to finance Project N.
b. Depreciation on assets purchased for Project N.
c. The contribution margin the company would lose if sales of the product introduced by
Project N will reduce sales of other products.
d. The income tax rate applicable to the entity.
L&H
13. All of the following are common cash inflows related to capital expenditure proposals, except:
A. additional revenues from increased sales
B. increased working capital requirements
C. reduction in inventory carrying costs
D. salvage value at the end of the project
Carter & Usry
Page 7 of 107
CAPITAL BUDGETING
Tax Shield on Depreciation

8. Which of the following cash flows should be treated as incremental flows when deciding
whether to go ahead with an electric car?
A. The cost of research and development undertaken for developing the electric car in the
past three years
B. The annual depreciation charge
C. The reduction in taxes resulting from the depreciation charges
D. Dividend payments
B&M
Irrelevant Costs
9. Money that a firm has already spent or committed to spend regardless of whether a project is
taken is called:
A. Sunk costs
C. Fixed costs
B. Opportunity costs
B&M
*.
In capital expenditures decisions, the following are relevant in estimating operating costs
except (E)
a. Future costs.
c. Differential costs.
b. Cash costs.
d. Historical costs.
RPCPA 1094
b. When evaluating corporate projects it is important to include all relevant externalities in

the estimated cash flows.
c. Interest expenses should be included in project cash flows.
Brigham
10
. When evaluating potential projects, which of the following factors should be incorporated as
part of a projects estimated cash flows? (E)
a. Any sunk costs that were incurred in the past prior to considering the proposed project.
b. Any opportunity costs that are incurred if the project is undertaken.
c. Any externalities (both positive and negative) that are incurred if the project is undertaken.
d. Statements b and c are correct.
Brigham
11
. Which one of the following statements concerning cash flow determination for capital
budgeting purposes is not correct?
a. Tax depreciation must be considered since it affects cash payments for taxes.
b. Book depreciation is relevant since it affects net income.
d. Net working capital changes should be included in cash flow forecasts.
c. Sunk costs are not incremental flows and should not be included.
CMA 1295 4-11
12
58. An example of a sunk cost in a capital budgeting decision for new equipment is (E)
a. increase in working capital required by a particular investment choice.
b. the book value of the old equipment.
c. the necessary transportation costs on the new equipment.
d. all of the above are examples of sunk costs.
Horngren
7. The following cash flows should be treated as incremental flows when deciding whether to go
ahead with an electric car except: (M)
A. The consequent deduction in sales of the company's existing gasoline models
B. The expenditure on new plants and equipment
C. The value of tools that can be transferred from the company's existing plants
D. Interest payment on debt
B&M
Comprehensive
9
. Which of the following statements is most correct? (E)
a. When evaluating corporate projects it is important to include all sunk costs in the
estimated cash flows.
. A company is considering a new project. The companys CFO plans to calculate the projects
NPV by discounting the relevant cash flows (which include the initial up-front costs, the
operating cash flows, and the terminal cash flows) at the companys cost of capital (WACC).
Which of the following factors should the CFO include when estimating the relevant cash
flows? (E)
a. Any sunk costs associated with the project.
b. Any interest expenses associated with the project.
c. Any opportunity costs associated with the project.
Brigham
13
. Which of the following statements is correct? (M)

a. An asset that is sold for less than book value at the end of a projects life will generate a
loss for the firm and will cause an actual cash outflow attributable to the project.
b. Only incremental cash flows are relevant in project analysis and the proper incremental
cash flows are the reported accounting profits because they form the true basis for
investor and managerial decisions.
c. It is unrealistic to expect that increases in net operating working capital that are required
at the start of an expansion project are simply recovered at the projects completion. Thus,
these cash flows are included only at the start of a project.
Page 8 of 107

d. Equipment sold for more than its book value at the end of a projects life will increase
income and, despite increasing taxes, will generate a greater cash flow than if the same
asset is sold at book value.
Brigham
14

a. The rate of depreciation will often affect operating cash flows, even though depreciation is
not a cash expense.
b. Corporations should fully account for sunk costs when making investment decisions.
c. Corporations should fully account for opportunity costs when making investment
decisions.
d. Statements a and c are correct.
Brigham
CAPITAL BUDGETING
18
. Sanford & Son Inc. is thinking about expanding their business by opening another shop on
property they purchased 10 years ago. Which of the following items should be included in the
analysis of this endeavor? (M)
a. The property was cleared of trees and brush 5 years ago at a cost of $5,000.
b. The new shop is expected to affect the profitability of the existing shop since some current
customers will transfer their business to the new shop. Sanford and Son estimate that
profits at the existing shop will decrease by 10 percent.
c. Sanford & Son can lease the entire property to another company (that wants to grow
flowers on the lot) for $5,000 per year.
d. Both statements b and c should be included in the analysis.
Brigham
19
15
. Which of the following is not a cash flow that results from the decision to accept a project? (E)
a. Changes in net operating working capital. d. Opportunity costs.
b. Shipping and installation costs.
e. Externalities.
c. Sunk costs.
Brigham
16
. Adams Audio is considering whether to make an investment in a new type of technology.

Which of the following factors should the company consider when it decides whether to
undertake the investment? (M)
a. The company has already spent $3 million researching the technology.
b. The new technology will affect the cash flows produced by its other operations.
c. If the investment is not made, then the company will be able to sell one of its laboratories
for $2 million.
d. Statements b and c should be considered.
Brigham
17
. Laurier Inc. is a household products firm that is considering developing a new detergent. In
evaluating whether to go ahead with the new detergent project, which of the following items
should Laurier explicitly include in its cash flow analysis? (M)
a. The company will produce the detergent in a vacant facility that they renovated five years
ago at a cost of $700,000.
b. The company will need to use some equipment that it could have leased to another
company. This equipment lease could have generated $200,000 per year in after-tax
income.
c. The new detergent is likely to significantly reduce the sales of the other detergent
products the company currently sells.
Brigham
. Pickles Corp. is a company that sells bottled iced tea. The company is thinking about
expanding its operations into the bottled lemonade business. Which of the following factors
should the company incorporate into its capital budgeting decision as it decides whether or not
to enter the lemonade business? (M)
a. If the company enters the lemonade business, its iced tea sales are expected to fall 5
percent as some consumers switch from iced tea to lemonade.
b. Two years ago the company spent $3 million to renovate a building for a proposed project
that was never undertaken. If the project is adopted, the plan is to have the lemonade
produced in this building.
c. If the company doesnt produce lemonade, it can lease the building to another company
and receive after-tax cash flows of $500,000 a year.
Brigham
20

a. In a capital budgeting analysis where part of the funds used to finance the project are
raised as debt, failure to include interest expense as a cost in the cash flow statement
when determining the projects cash flows will lead to an upward bias in the NPV.
b. The preceding statement would be true if upward were replaced with downward.
c. The existence of externalities reduces the NPV to a level below the value that would
exist in the absence of externalities.
d. If one of the assets that would be used by a potential project is already owned by the firm,
and if that asset could be leased to another firm if the project is not undertaken, then the
net rent that could be obtained should be charged as a cost to the project under
consideration.
e. The rent referred to in statement d is a sunk cost, and as such it should be ignored.
Brigham
Page 9 of 107
CAPITAL BUDGETING
B. bar graph
C. nonnormal distribution
21
. Which of the following constitutes an example of a cost that is not incremental, and therefore,
not relevant in an accept/reject decision? (M)
a. A firm has a parcel of land that can be used for a new plant site, or alternatively, can be
used to grow watermelons.
b. A firm can produce a new cleaning product that will generate new sales, but some of the
new sales will be from customers who switch from another product the company currently
produces.
c. A firm orders and receives a piece of new equipment that is shipped across the country
and requires $25,000 in installation and set-up costs.
d. Statements a, b, and c are examples of incremental cash flows, and therefore, relevant
cash flows.
Brigham
22
. Which of the following is not considered a relevant concern in determining incremental cash
flows for a new product? (M)
a. The use of factory floor space that is currently unused but available for production of any
product.
b. Revenues from the existing product that would be lost as a result of some customers
switching to the new product.
c. Shipping and installation costs associated with preparing the machine to be used to
produce the new product.
d. The cost of a product analysis completed in the previous tax year and specific to the new
product.
Brigham
Uncertainty
1. Which of the following best identifies the reason for using probabilities in capital budgeting
decisions?
A. uncertainty
C. time value of money
B. cost of capital
D. projects with unequal lives AICPA adapted
*.
Which of the following best identifies the reason for using probabilities in capital budgeting is
(E)
a. Different life of projects.
c. Uncertainty.
RPCPA 0577, 0588, 1093
b. Cost of capital.
d. Time value of money.
Carter & Usry
28. The standard deviation of the expected net present value is determined by summing the
discounted standard deviations for each period over the life of the project when the cash flows
in each of the periods are:
A. independent
D. negative
B. positive
E. perfectly correlated
C. mixed
Carter & Usry
12. Cinzano Inc. wants to use discounted cash flow techniques when analyzing its capital
investment projects. The company is aware of the uncertainty involved in estimating future
cash flows. A simple method some companies employ to adjust for the uncertainty inherent in
their estimates is to:
A. ignore salvage values
B. average the expectations of several different managers
C. use accelerated depreciation
D. adjust the minimum desired rate of return
E. increase the estimates of the cash flows
CMA adapted
Tax Factor
In general
58. Income taxes are levied on
a. net cash flow.
b. income as measured by accounting rules.
c. net cash flow plus depreciation.
d. income as measured by tax rules.
Barfield
18. Which of the following statements is true?

a. All revenue is taxed.
b. All expenses are tax-deductible.
c. Some revenues and expenses have no tax effects.
d. Income taxes are based solely on revenues and expenses.
*.
26. In capital expenditure analysis, which of the following can be constructed to evaluate
alternative levels of investment?
A. normal distribution
D. pie chart
E. payoff table
L&H
In capital budgeting decisions, the following items are considered among others: (M)
1. Cash outflow for the investment.
2. Increase in working capital requirements.
3. Profit on sale of old asset
Page 10 of 107

4. Loss on write-off of old asset.
For which of the above items would taxes be relevant? (D)
a. Items 1 and 3 only.
c. All items.
b. Items 3 and 4 only.
d. Items 1, 3 and 4 only.
CAPITAL BUDGETING
RPCPA 0594
6. The government could encourage increases in investment by

a. Increasing tax rates.
b. Lengthening the MACRS period.
c. Letting a company expense fixed assets in the year acquired instead of through annual
depreciation charges.
d. Taking actions that would increase interest rates.
L&H
61. Which of the following are tax deductible under U.S. tax law? (M)
a. interest payments to bondholders
c. common stock dividends
b. preferred stock dividends
d. all of the above
No Income Tax Situation
21. If there were no income taxes,
a. Depreciation would be ignored in capital budgeting.
b. The NPV method would not work.
c. Income would be discounted instead of cash flow.
d. All potential investments would be desirable.
Barfield
L&H
35. If a company is NOT subject to income tax, which of the following is true of a proposed
investment?
a. The projects IRR equals the entitys cost of capital.
b. The projects NPV is zero.
c. Depreciation on assets required for the project is irrelevant to the evaluation.
d. The expected annual increase in future cash flows equals the investment required to
undertake the project.
L&H
53. The pre-tax and after-tax cash flows would be the same for all of the following items except (D)
a. the liquidation of working capital at the end of a project's life.
b. the initial (outlay) cost of an investment.
c. the sale of an asset at its book value.
d. a cash payment for salaries and wages.
Barfield
Depreciation Tax Shield

*. The accounting area in which the only objective of depreciation accounting relates to the effect
of depreciation charges upon tax payments is (E)
a. Income determination.
c. Cost/volume/profit analysis.
b. Financial reporting.
d. Capital budgeting.
RPCPA 0587
29. Which statement describes the relevance of depreciation in calculating cash flows?
a. Depreciation is relevant only when income taxes exist.
b. Depreciation is always relevant.
c. Depreciation is never relevant.
d. Depreciation is relevant only with discounted cash flow methods.
L&H
56. Multiplying the depreciation deduction by the tax rate yields a measure of the depreciation tax
(D)
a. shield.
c. payable.
b. benefit.
d. loss.
Barfield
3. Depreciation is incorporated explicitly in the cash flow analysis of an investment proposal
because it:
A. is a cost of operations that cannot be avoided
B. results in an annual cash outflow
C. is a cash inflow
D. reduces the cash outlay for income taxes
E. represents the initial cash outflow spread over the life of the investment
CMA adapted
23
. A depreciation tax shield is

a. An after-tax cash outflow.
b. A reduction in income taxes.
c. The cash provided by recording depreciation.
d. The expense caused by depreciation.
CMA 1293 4-14, RPCPA 0596
24
. The annual tax depreciation expense on an asset reduces income taxes by an amount equal
to
a. The firms average tax rate times the depreciation amount.
b. One minus the firms average tax rate times the depreciation amount.
c. The firms marginal tax rate times the depreciation amount.
d. One minus the firms marginal tax rate times the depreciation amount.
CMA 1293 4-20
Page 11 of 107

Accelerated Method vs. Straight-line Method
25
. The use of an accelerated method instead of the straight-line method of depreciation in
computing the net present value of a project has the effect of
a. Raising the hurdle rate necessary to justify the project.
b. Lowering the net present value of the project.
c. Increasing the present value of the depreciation tax shield.
d. Increasing the cash outflows at the initial point of the project.
CMA 0695 4-3
Changes in Tax Rates
*. Your company is purchasing a transport equipment as part of its territorial expansion strategy.
The technical services department indicated that this equipment needs overhauling in year 4
or year 5 of its useful life. The overhauling cost will be expected during the year the
overhauling is done. The finance officer insists that the overhauling be done in year 4, not in
year 5. The most likely reason is (M)
RPCPA 0594
a. There is lower tax rate in year 5.
c. The time value of money is considered.
b. There is higher tax rate in year 5
d. Due statements A and C above.
Optimal Capital Budget
26
. An optimal capital budget is determined by the point where the marginal cost of capital is (D)
A. Minimized.
B. Equal to the average cost of capital.
C. Equal to the rate of return on total assets.
D. Equal to the marginal rate of return on investment.
CIA 1187 IV-43
27
. A firm seeking to optimize its capital budget has calculated its marginal cost of capital and
projected rates of return on several potential projects. The optimal capital budget is determined
by
A. Calculating the point at which marginal cost of capital meets the projected rate of return,
assuming that the most profitable projects are accepted first.
B. Calculating the point at which average marginal cost meets average projected rate of
return, assuming the largest projects are accepted first.
C. Accepting all potential projects with projected rates of return exceeding the lowest
marginal cost of capital.
D. Accepting all potential projects with projected rates of return lower than the highest
marginal cost of capital.
CIA 1191 IV-57
28
. Shanahan Inc. has two divisions: Division A makes up 50 percent of the company, while
Division B makes up the other 50 percent. Shanahans beta is 1.2. Looking at stand-alone
CAPITAL BUDGETING
competitors, Shanahans CFO estimates that Division As beta is 1.5, while Division Bs beta is
0.9. The risk-free rate is 5 percent and the market risk premium is 5 percent. The company is
100 percent equity-financed. (WACC = ks, the cost of equity).
Division B is considering the following projects given below. Each of the projects has the same
risk and all have the same risk as a typical Division B project.
Project
Capital required
IRR
1
$400 million
14.0%
2
300 million
10.7
3
250 million
10.5
4
320 million
10.0
5
230 million
9.0
The company is debating which cost of capital they should use to evaluate Division Bs
projects. John Green argues that Shanahan should use the same cost of capital for each of its
divisions, and believes it should base the cost of equity on Shanahans overall beta. Becky
White argues that the cost of capital should vary for each division, and that Division Bs beta
should be used to estimate the cost of equity for Division Bs projects.
If the company uses Whites approach, how much larger will the capital budget be than if it
uses Greens approach? (E)
a. Capital budget is $320 million larger using Whites approach.
b. Capital budget is $550 million larger using Whites approach.
c. Capital budget is $870 million larger using Whites approach.
d. Capital budget is $1,200 million larger using Whites approach.
e. The capital budget is the same using the two approaches.
Brigham
INVESTMENT OPTIONS
Abandonment option
29
. Which of the following statements best describes the likely impact that an abandonment option
will have on a projects expected cash flow and risk? (E)
a. No impact on expected cash flow, but risk will increase.
b. Expected cash flow increases and risk decreases.
c. Expected cash flow increases and risk increases.
d. Expected cash flow decreases and risk decreases.
e. Expected cash flow decreases and risk increases.
Brigham
Investment timing option
30
. Commodore Corporation is deciding whether it makes sense to invest in a project today, or to
postpone this decision for one year. Which of the following statements best describes the
issues that Commodore faces when considering this investment timing option? (E)
Page 12 of 107
CAPITAL BUDGETING
a. The investment timing option does not affect the expected cash flows and should
therefore have no impact on the projects risk.
b. The more uncertainty about the projects future cash flows the more likely it is that
Commodore will go ahead with the project today.
c. If the project has a positive expected NPV today, this means that its expected NPV will be
even higher if it chooses to wait a year.
d. All of the above statements are correct.
e. None of the above statements is correct.
Brigham
Real options
31
. Which of the following is an example of a flexibility option? (E)
a.
A company has the option to invest in a project today or to wait a year.
b.
A company has the option to back out of a project that turns out to be
unproductive.
c.
A company pays a higher cost today in order to be able to reconfigure the
projects input or outputs at a later date.
d.
A company invests in a project today that may lead to enhanced technological
improvements that allow it to expand into different markets at a later date.
Brigham
4. Which of the following are not real options? (M)
a. The option to expand production if the product is successful.
b. The option to buy additional shares of stock if the stock price goes up.
c. The option to expand into a new geographic region.
d. The option to abandon a project.
e. The option to switch sources of fuel used in an industrial furnace.
5. Which of the following will not increase the value of a real option? (M)
a. An increase in the time remaining until the real option must be exercised.
b. An increase in the volatility of the underlying source of risk.
c. An increase in the risk-free rate.
d. An increase in the cost of exercising the real option.
e. Statements b and d.
Brigham
CAPITAL BUDGET EVALUATION METHODS

In general
*. Net present value is an example of which concept? (E)
a. Capital budgeting.
c. Managerial control.
b. Project feasibility.
d. Management by exception. RPCPA 0580
*.
Net present value is an example of which concept? (E)

a. Capital budgeting
c. Management control
b. Project feasibility
d. Management by objectives RPCPA 0577
*.
All of the following are methods that aid management in analyzing the expected results of
capital budgeting decisions, except (E)
Horngren, RPCPA 1095, 1096
a. Accrual accounting rate of return.
c. Future value cash flow.
b. Payback period.
d. Discounted cash flow rate of return.
1. The following measures are used by firms when making capital budgeting decisions except:
A. Payback period
C. Net present value
B. Internal rate of return
D. P/E ratio
B&M
Brigham
Abandonment and growth options

32
. Clueless Corporation never considers abandonment options or growth options when
estimating its optimal capital budget. What impact does this policy have on the companys
optimal capital budget? (M)
a. Its estimated capital budget is too small because it fails to consider abandonment and
growth options.
b. Its estimated capital budget is too large because it fails to consider abandonment and
growth options.
c. Failing to consider abandonment options makes the optimal capital budget too large, but
failing to consider growth options makes the optimal capital budget too small, so it is
unclear what impact this policy has on the overall capital budget.
d. Failing to consider abandonment options makes the optimal capital budget too small, but
failing to consider growth options makes the optimal capital budget too large, so it is
unclear what impact this policy has on the overall capital budget.
e. Neither abandonment nor growth options should have an effect on the companys optimal
capital budget.
Brigham
Use of Net Income

*. A number of techniques are commonly used in the analysis of capital budgeting decisions.
Each method involves the measurement of cash flows, except the (E)
a. Internal rate of return.
c. Average rate of return method.
b. Payback period method.
d. Net present value.
RPCPA 1097
Page 13 of 107

20. The technique that does NOT use cash flows is
a. Payback.
c. IRR.
b. NPV.
d. Book rate of return.
CAPITAL BUDGETING
a. NPV.
b. Payback.
33
. Which one of the following capital investment evaluation methods does not take the time value
of money into consideration?
a. Net present value.
c. Internal rate of return.
b. Discounted payback.
d. Accounting rate of return. CMA 0696 4-26
Use of Cash Flows

In general
*. In capital budgeting, these techniques are applied: payback (PB) method, net present value
(NPV) method and time-adjusted rate of return (TARR) method. PB method has this in
common with NPV and TARR methods. (M)
a. Use of cash flows.
b. Consideration of the time value of money.
c. Use of discounting.
d. Use of accrual method of accounting.
RPCPA 1094
57. All of the following are major categories of cash flows in capital investment decisions EXCEPT
(E)
a. the initial investment in machines and working capital.
b. recurring operating cash flows.
c. the initial working capital investment
d. depreciation expense reported on the income statement.
Horngren
Without Time Value of Money
1. Which of the following capital budgeting techniques ignores the time value of money?
a. payback period
c. internal rate of return
b. net present value
d. profitability index
Barfield
L&H
L&H
9. Which of the following capital budgeting methods does NOT consider the time value of
money?
a. IRR.
c. Time-adjusted rate of return.
b. Book rate of return.
d. NPV.
L&H
With Time Value of Method

28. Which of the following is a discounted cash flow method?
c. Book rate of return.

8. The method of project selection that considers the time value of money in a capital budgeting
decision computes the:
A. accounting rate of return on average investment
B. internal rate of return
C. payback period
D. return on investment
E. accounting rate of return on initial investment
AICPA adapted
52. Which of the following methods consider the time value of money?
a. payback and accounting rate of return
b. payback and internal rate of return
c. internal rate of return and accounting rate of return
d. internal rate of return and net present value
*.
H&M
Which of the following capital investment rating procedures recognize(s) the time value of
money? (E)
RPCPA 0590
a.
b.
c.
d.
Profitability index
Yes
No
Yes
No
Discounted rate of return
Yes
Yes
No
No
1. Which of the following groups of capital budgeting techniques uses the time value of money?
(E)
a. Book rate of return, payback, and profitability index.
b. IRR, payback, and NPV.
c. IRR, NPV, and profitability index.
d. IRR, book rate of return, and profitability index.
L&H
30. Which of the following combinations of capital budgeting techniques includes only discounted
cash flow techniques?
a. Book rate of return, payback, and profitability index.
b. NPV, IRR and profitability index.
c. IRR, payback, and NPV.
d. Profitability index, NPV, and payback.
L&H
Use of Time Value of Money vs. No Time Value of Money
Page 14 of 107
CAPITAL BUDGETING
27. In contrast to the payback period and book rate of return methods, the NPV and IRR methods
a. Consider the time value of money.
c. Use after-tax cash flows.
b. Ignore depreciation.
L&H
18. The net present value and internal rate of return methods of capital budgeting are superior to
the payback method in that they: (M)
a. are easier to implement.
b. consider the time value of money.
c. require less input.
d. reflect the effects of depreciation and income taxes.
AICPA adapted
ACCOUNTING RATE OF RETURN
Definition
*. A capital budgeting method that provides a rough approximation of an investments profitability
as measured with net income from the income statement is known as: (E)
a. Average rate of return method.
c. Payback period.
RPCPA 1097
b. Net present value method.
d. Internal rate of return method.
A.
B.
C.
D.
Is synonymous with the internal rate of return.

Focuses on income as opposed to cash flows.
Is inconsistent with the divisional performance measure known as return on investment.
Recognizes the time value of money.
CMA 0691 4-18
11. Which of the following methods uses income instead of cash flows?
a. payback
b. accounting rate of return
d. net present value
H&M
37
. The capital budgeting technique known as accounting rate of return uses

a.
b.
c.
Revenue over life of project
No
No
Yes
Depreciation expense
Yes
No
No
d.
Yes
Yes
34
. The technique that measures the estimated performance of a capital investment by dividing
the project's annual after-tax net income by the average investment cost is called the (E)
A. Bail-out payback method.
C. Profitability index method. CMA 0692 4-21
B. Internal rate of return method.
D. Accounting rate of return method.
35
. The technique that measures the estimated performance of a capital investment by dividing
the project's annual after-tax net income by the average investment cost is called the
A. Average rate of return method.
C. Capital asset pricing model. CMA 1290 415
B. Internal rate of return method.
31. The capital budgeting method that divides a project's annual incremental net income by the
initial investment is the: (M)
a. internal rate of return method.
b. the simple ( or accounting) rate of return method.
c. the payback method.
d. the net present value method.
CMA adapted
Characteristics
36
. The accounting rate of return
Page 15 of 107

99. The capital budgeting technique known as accounting rate of return uses (D)
Barfield
a.
b.
c.
Salvage value
No
No
Yes
Time value of money
No
Yes
Yes
CAPITAL BUDGETING
d.
Yes
No
Formula
38
. The method that divides a projects annual after-tax net income by the average investment
cost to measure the estimated performance of a capital investment is the
a. Internal rate of return method.
c. Payback method.
CMA 1294 4-24
b. Accounting rate of return method.
d. Net present value (NPV) method.
100.In computing the accounting rate of return, the ______ level of investment should be used as
the denominator.
a. Average
c. Residual
b. Initial
d. Cumulative
Barfield
16. The accounting rate of return on original investment is calculated as
a. original investment/net income
c. net income/original investment
b. net income/debt
d. assets/debt
H&M
64. The approach to capital budgeting which divides an accounting measure of income by an
accounting measure of investment is (E)
a. net present value.
c. payback method.
Horngren
b. internal rate of return.
d. accrual accounting rate of return.
18. The book rate of return on a project is calculated as:
A. Book Cash Flow/book assets
C. Book assets/book income
B. Book income/book assets
19. The disadvantages of the book rate of return method is/are:

A. It uses net income instead of cash flows
B. The pattern of income has no impact on the book rate of return
C. There is no clear cut decision rule
D. All of the above
PAYBACK PERIOD
Definition
10. The payback period is the
a. length of time over which the investment will provide cash inflows.
b. length of time over which the initial investment is recovered.
c. shortest length of time over which an investment may be depreciated.
d. shortest length of time over which the net present value will be positive.
B&M
Barfield
39
. The length of time required to recover the initial cash outlay of a capital project is determined
by using the
CMA 1294 4-20
a. Discounted cash flow method.
c. Weighted net present value method.
b. Payback method.
d. Net present value method.
*.
B&M
Limitation
*. The following statements refer to the accounting rate of return (ARR)
1. The ARR is based on the accrual basis, not cash basis.
2. The ARR does not consider the time value of money.
3. The profitability of the project is considered.
From the above statements, which are considered limitations of the ARR concept? (M)
a. Statements 2 and 3 only.
c. All the 3 statements.
b. Statements 3 and 1 only.
d. Statements 1 and 2 only.
RPCPA 1094
65. For capital budgeting decisions, the use of the accrual accounting rate of return for evaluating
performance is often a stumbling block to the implementation of the (E)
a. net cash flow.
b. most effective goal-congruence choice.
c. discounted cash flow method for capital budgeting.
d. most effective tax strategy.
Horngren
An investment rating approach which measures the length of time required to recover the initial
outlay for a particular investment proposal is the (E)
a. Accounting rate of return
c. Net present value
b. Payback period
d. Present value index
RPCPA 0590
40
. The technique that measures the number of years required for the after-tax cash flows to
recover the initial investment in a project is called the
A. Net present value method.
B. Payback method.
Page 16 of 107
CAPITAL BUDGETING
*.
The method that measures how quickly investment pesos may be recovered is the (E)
a. Payback method
c. Simple rate of return method
b. Time adjusted rate of return
d. Least squares method RPCPA 1074, 10/77
*.
The payback method measures (E)

a. Profitability of an investment
b. Economic life of the investment
c. Time to recover investment RPCPA 1093

d. Cash flow from an investment
27. The payback method measures: (E)

a. how quickly investment dollars may be recovered.
b. the cash flow from an investment.
c. the economic life of an investment.
d. the profitability of an investment.
2. Which of the following capital budgeting techniques may potentially ignore part of a project's
relevant cash flows? (M)
a. net present value
c. payback period
b. internal rate of return
d. profitability index
Barfield
CMA adapted
61. The method that measures the time it will take to recoup, in the form of future cash inflows, the
total dollars invested in a project is called (E)
a. the accrued accounting rate-of-return method.
b. payback method.
c. internal rate-of-return method.
d. the book-value method.
Horngren
63. The payback method of capital budgeting approach to the investment decision highlights (E)
a. cash flow over the life of the investment.
b. the liquidity of the investment.
c. the tax savings of the depreciation amounts.
d. having as lengthy payback time as possible.
Horngren
Characteristics
19. The technique most concerned with liquidity is (M)
a. Payback.
c. IRR.
b. NPV.
2. The payback criterion for capital investment decisions
a. Is conceptually superior to the IRR criterion.
b. Takes into consideration the time value of money.
c. Gives priority to rapid recovery of cash.
d. Emphasizes the most profitable projects.
8. The payback period rule:

A. Varies the cut-off point with the interest rate
B. Determines a cut-off point so that all projects accepted by the NPV rule will be accepted
by the payback period rule.
C. Requires an arbitrary choice of a cut-off point
D. Both A and C
B&M
L&H
L&H
41
. A characteristic of the payback method (before taxes) is that it (E)

a. Incorporates the time value of money.
b. Neglects total project profitability.
c. Uses accrual accounting inflows in the numerator of the calculation.
CMA 0694 4-17
d. Uses the estimated expected life of the asset in the denominator of the calculation.
4. Which of the following capital budgeting techniques does not routinely rely on the assumption
that all cash flows occur at the end of the period?
a. internal rate of return
c. profitability index
d. payback period
Barfield
7. 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. zero.
Barfield
39. Assuming that a project has already been evaluated using the following techniques, the
evaluation under which technique is least likely to be affected by an increase in the estimated
residual value of the project?
a. Payback period.
c. NPV.
b. IRR.
d. PI.
L&H
30. The evaluation of an investment having uneven cash flows using the payback method: (M)
a. cannot be done.
b. can be done only by matching cash inflows and investment outflows on a year-by-year
basis.
Page 17 of 107
CAPITAL BUDGETING
c. will product essentially the same results as those obtained through the use of discounted
cash flow techniques.
d. requires the use of a sophisticated calculator or computer software.
G & N 9e
10. Which of the following investment rules may not use all possible cash flows in its calculations?
A. Payback period.
C. IRR
B. NPV
D. All of the above
B&M
Advantage
*. An advantage of the payback method is (E)
a. Not based on cash flow data.
b. Insensitive of the life of the project.
*.
c. Precise in estimate of profits.

d. Easy to apply.
RPCPA 1093
An advantage of using the payback method of evaluating capital budgeting alternatives is that
payback is
a. Insensitive to the life of the project considered.
b. Precise estimate of profitability.
c. Based on cash flow data.
d. Easy to apply.
RPCPA 0577, 5/80, 5/98
12. The advantage of the payback rule is:

A. Adjustment for uncertainty of early cash flows
B. It is simple to use
C. Does not discount cash flows
D. Both A and C
B&M
Disadvantage
*. This technique is criticised because it fails to consider investment profitability (E)
a. Time adjusted ROI
c. Average return on investment
b. Payback method
d. Present value method
RPCPA 1093
11. Which of the following capital budgeting techniques has been criticized because it fails to
consider investment profitability? (E)
a. payback method
c. net present value method
d. internal rate of return
Barfield
42
. Which one of the following statements about the payback method of investment analysis is
correct? The payback method
a.
b.
c.
d.
Does not consider the time value of money.

Consider cash flows after the payback has been reached.
Uses discounted cash flow techniques.
CMA 1295 4-1
Generally leads to the same decision as other methods for long-term projects.
34. Which of the following methods FAILS to distinguish between return of investment and return
on investment.
a. NPV.
c. Payback.
b. IRR.
L&H
15. Which of the following is NOT a defect of the payback method?
a. It ignores cash flow because it uses net income.
b. It ignores profitability.
c. It ignores the present values of cash flows.
d. It ignores the pattern of cash flows beyond the payback period.
L&H
14. Deficiencies associated with using the payback method to evaluate investment alternatives
include all of the following, except that:
A. the present value of cash inflows is ignored
B. inflows of different time periods are treated equally
C. it may be used to select those investments yielding a quick return of cash
D. cash flows after the payback period are ignored
CIA adapted
1. A major disadvantage of the payback period method is that it (E)
a. Is useless as a risk indicator.
b. Ignores cash flows beyond the payback period.
c. Does not directly account for the time value of money.
15. The following are disadvantages of using the payback rule except:
A. The payback rule ignores all cash flow after the cutoff date
B. The payback rule does not use the time value of money
C. The payback period is easy to calculate and use
D. The payback rule does not have the value additive property
Brigham
B&M
Formula
. The cash payback formula is:
a. Cost of Capital Investment / Net Income.
Page 18 of 107

b. Average Investment / Net Annual Cash Inflow.
c. Cost of Capital Investment / Net Annual Cash Inflow.
d. Average Investment / Net Income.
CAPITAL BUDGETING
TVM
RPCPA 1001
5. Assume that a project consists of an initial cash outlay of $100,000 followed by equal annual
cash inflows of $40,000 for 4 years. In the formula X = $100,000/$40,000, X represents the (E)
a. payback period for the project.
c. internal rate of return for the project.
b. profitability index of the project.
d. project's discount rate.
Barfield
Decision Criteria
9. The payback period rule accepts all projects for which the payback period is:
A. Greater than the cut-off value
C. Is positive
B. Less than the cut-off value
D. An integer
Payback Reciprocal
43
. The payback reciprocal can be used to approximate a projects
a. Profitability index
b. Net present value.
c. Accounting rate of return if the cash flow pattern is relatively stable.
d. Internal rate of return if the cash flow pattern is relatively stable.
B&M
relevant
irrelevant
Relevant
irrelevant
44
. The capital budgeting technique known as payback period uses

a.
b.
Yes
Yes
Time value of money
Yes
No
c.
No
No
d.
No
Yes
BAILOUT PAYBACK
Definition
*. The bailout payback period is (E)
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. None of the above.
RPCPA 1090
45
CMA 0693 4-27
Relevant Items
1. In order to calculate the payback period for a project, it is necessary to know the:
A. salvage value
D. net present value
B. useful life
E. annual cash flow
C. minimum desired rate of return
Carter & Usry
1. Calculating the payback period for a capital project requires knowing which of the following?
a. Useful life of the project.
b. The companys minimum required rate of return.
c. The projects NPV.
d. The projects annual cash flow.
L&H
. The bailout payback method (E)

A. Is used by firms with federally insured loans.
B. Calculates the payback period using the sum of the net cash flows and the salvage value.
C. Calculates the payback period using the difference between net cash inflow and the
salvage value.
D. Estimates short-term profitability.
Gleim
Use
46
. The bailout payback method
a. Incorporates the time value of money.
b. Equals the recovery period from normal operations.
c. Eliminates the disposal value from the payback calculation.
d. Measures the risk if a project is terminated.
CMA 1292 4-11
Irrelevant Items
*. As a capital budgeting technique, the payback period considers depreciation expenses (DE)
and time value of money (TVM) as follows: (M)
RPCPA 1095
a.
b.
c.
d.
DE
relevant
irrelevant
Irrelevant
relevant
Page 19 of 107
CAPITAL BUDGETING
*.
DISCOUNTED CASH FLOW ANALYSIS

37. The consumption opportunity increases when an investment with positive NPV is available
because:
A. The investment is better than what is available in the market
B. The project rate of return is less than market rate
C. The market is irrelevant to the investment criteria
D. All of the above are reasons for increase in consumption
B&M
Factors
14. When using one of the discounted cash flow methods to evaluate the desirability of a capital
budgeting project, which of the following factors is generally not important? (E)
a. method of financing the project under consideration
b. timing of cash flows relating to the project
c. impact of the project on income taxes to be paid
d. amounts of cash flows relating to the project
Barfield
Assumptions
52. In a typical (conservative assumptions) after-tax discounted cash flow analysis, depreciation
expense is assumed to accrue at
a. the beginning of the period.
b. the middle of the period.
c. the end of the period.
d. irregular intervals over the life of the investment.
Barfield
Time Value Of Money
53. There are two reasons for discounting future cash flow. They are:
A. A dollar today is worth more than a dollar tomorrow
B. A safe dollar is worth more than a risky one
C. The value of a dollar is changing all the time
D. A and B above
B&M
29. The line that connects the maximum that one can consume this year (now) and the maximum
one can consume next year:
A. Has a slope of (1+r)
C. Has a slope of r
B. Has a slope of -(1+r)
D. Has a slope of 1/r
B&M
The method of project selection which considers the time value of money in a capital
budgeting decision is accomplished by computing the (E)
a. Accounting rate of return on initial investment
b. Payback period.
c. Accounting rate of return on average investment.
d. Discounted cash flow.
RPCPA 0598
2. The component of the capital investment decision that would most likely concern an
accountant is the:
A. social responsibility factors
D. imponderables
B. competition
E. legal restrictions
C. time value of money
Carter & Usry
*.
The fact that an amount of money that is to be received in the future is not equivalent to the
same amount of money to be received now is referred to as: (E)
a. Present value of money.
c. Future value of money.
b. Time value of money.
d. Discounted value of money. RPCPA 0587
47
. What is the time value of money?

A. Interest.
B. Present value.
C. Future value.
D. Annuity.
Gleim
12. The time value of money is explicitly recognized through the process of
a. interpolating.
c. annuitizing.
b. discounting.
d. budgeting.
Barfield
13. The time value of money is considered in long-range investment decisions by (M)
a. assuming equal annual cash flow patterns.
b. investing only in short-term projects.
c. assigning greater value to more immediate cash flows.
d. ignoring depreciation and tax implications of the investment.
Barfield
48
. Basic time value of money concepts concern

Gleim
A.
Interest Factors
Yes
Risk
Yes
Cost of Capital
No
B.
Yes
No
Yes
C.
No
Yes
No
D.
No
No
Yes
Page 20 of 107
CAPITAL BUDGETING
49
. The present value may be calculated for discounted cash

Gleim
A.
B.
Inflows
Yes
Yes
Outflows
Yes
No
Annuities
Yes
Yes
C.
No
Yes
No
D.
No
No
Yes
9. The net present value and the internal rate of return methods of decision making in capital
budgeting are superior to the payback method in that they:
A. consider the time value of money
B. are easier to implement
C. consider accrual-based accounting income
D. require less input
E. reflect the effects of depreciation and income taxes
AICPA adapted
Application
11. A company is considering the purchase of a new conveyor belt system for carrying parts and
subassemblies from building to building within its plant complex. It is expected that the system
will have a useful life of at least ten years and that it will substantially reduce labor and waitingtime costs. If the company's average cost of capital is about 15% and if some evaluation must
be made of cost/benefit relationships (including the effects of interest) to determine the
desirability of the purchase, the most relevant quantitative technique for evaluating the
investment is:
A. present value (or internal rate of return) analysis
B. Program Evaluation and Review Technique (PERT)
C. accounting rate of return analysis
D. cost-volume-profit analysis
E. payback analysis
AICPA adapted
2. Discounted cash flow techniques for analyzing capital budgeting decisions are NOT normally
applied to projects
a. Requiring no investment after the first year of life.
b. Having useful lives shorter than one year.
c. That are essential to the business.
d. Involving replacement of existing assets.
L&H
a. Cash flow based payback period.

b. Capital budgeting.
c. Payback method.
RPCPA 0595
*.
The method of project selection which considers the value of money in a capital budgeting
decision is accomplished by computing the
a. Payback period.
b. Accounting rate of return on initial investment.
c. Accounting rate of return on average investment.
RPCPA 0577, 10/79, 10/93
*.
There are several evaluation techniques for determining the acceptability of an investment.
The method that considers the time value of money in an investment budgeting decision is
accomplished by determining the (E)
a. Cash-flow payback method.
c. Average rate of return.
b. Accounting rate of return.
RPCPA 1081
*.
The method of project selection which considers the time value of money in a capital
budgeting decision is accomplished by computing the (E)
a. Accounting rate of return on initial investment.
b. Accounting rate of return on average investment.
c. Discounted cash flow.
d. Payback period.
RPCPA 0580
*.
The modern approach used by decision-makers in evaluating investment opportunities by

comparing the original investment with the cash generation for the entire life of the project to
come up with the rate of return on investment is (E)
a. Discounted cash flow method
d. Profitability index
b. Accounting rate of return approach
e. Cash payoff method
c. Cash flow projections
RPCPA 1077
50
. All of the following items are included in discounted cash flow analysis except
a. Future operating cash savings.
b. The disposal prices of the current assets
c. The future asset depreciation expense.
d. The tax effects of future asset depreciation.
CMA 0694 4-18
Definition of Discounted Cash Flow

*. Which of the following methods measures the cash flows and outflows of a project as if they
occurred at a single point in time? (M)
Page 21 of 107
CAPITAL BUDGETING
51
. The capital budgeting model that is ordinarily considered the best model for long-range
decision making is the
CMA 1294 4-25
a. Payback model.
c. Unadjusted rate of return model.
b. Accounting rate of return model.
d. Discounted cash flow model.
*.
When using one of the discounted-cash-flow methods to evaluate the feasibility of a capital
budgeting project, which of the following factors generally is not important? (M)
a. The method of financing the project under consideration.
b. The impact of the project on income taxes to be paid.
c. The timing of cash flows relating to the project.
d. The amount of cash flows relating to the project.
RPCPA 0598
52
. Discounted cash flow concepts concern

Gleim
a.
Interest Factors
Yes
Risk
Yes
b.
Yes
No
c.
No
Yes
d.
No
No
53
. Depreciation is incorporated explicitly in the discounted cash flow analysis of an investment

proposal because it
A. Is a cost of operations that cannot be avoided.
B. Is a cash inflow.
C. Reduces the cash outlay for income taxes.
D. Represents the initial cash outflow spread over the life of the investment. CMA 1277 5-14
31. Discounted cash flow methods for capital budgeting focus on (E)
a. cash inflows.
c. cash outflows.
b. operating income.
d. both (a) and (c).
Rate of Return
Discount Rate
18. The discount rate for safe projects is the:
A. Market rate of return
B. Risk-free rate
C. Market risk premium

19. The discount rate for a project with a risk the same as the market risk is the:
A. Market rate of return
C. Market risk premium
B. Risk-free rate
Horngren
B&M
B&M
Cost of Capital
27. Hurdle rate for capital budgeting decisions is:
A. The cost of capital
C. The cost of equity
B. The cost of debt
D. All of the above
*.
B&M
In an investment in plant the return that should keep the market price of the firm stock
unchanged is (M)
RPCPA 0577, 1077, 0588, 1093
a. Payback
c. Net present value
b. Discounted rate of return
d. Cost of capital
25. For a project such as plant investment, the return that should leave the market price of the
firm's stock unchanged is known as the
a. cost of capital.
c. payback rate.
b. net present value.
d. internal rate of return.
Barfield
16. A company with cost of capital of 15% plans to finance an investment with debt that bears 10%
interest. The rate it should use to discount the cash flows is
a. 10%.
c. 25%.
b. 15%.
d. Some other rate.
L&H
1. The term cost of capital for a project depends on:
A. The use to which the capital is put, i.e. the project
B. The company's cost of capital
C. The industry cost of capital
D. All of the above
B&M
Weighted-Average Cost of Capital

54
. A company had made the decision to finance next years capital projects through debt rather
than additional equity. The benchmark cost of capital for these projects should be (M)
a. The before-tax cost of new-debt financing.
b. The after-tax cost of new-debt financing.
c. The cost of equity financing.
d. The weighted-average cost of capital.
CIA 0597 IV-42
Opportunity Cost of Capital
32. The ___________________ is the highest rate of return that can be earned from the most
attractive, alternative capital project available to the firm. (D)
a. accounting rate of return
c. hurdle rate
Page 22 of 107

CAPITAL BUDGETING
d. opportunity cost of capital
Barfield
21. The opportunity cost of capital for a risky project is

A. The expected rate of return on a government security having the same maturity as the
project
B. The expected rate of return on a well diversified portfolio of common stocks
C. The expected rate of return on a portfolio of securities of similar risks as the project
B&M
Comprehensive
. All of the following refer to the discount rate used by a firm in capital budgeting except (M)
a. Hurdle rate.
c. Opportunity cost.
b. Required rate of return.
d. Opportunity cost of capital. RPCPA 1096
Present Value Formula
94. If r is the discount rate, the formula [1/(1 + r)] refers to the
a. future value interest factor associated with r for one period.
b. present value of some future cash flow.
c. present value interest factor associated with r for one period.
d. future value interest factor for an annuity with a duration of r periods.
c. present value of X.
d. present value interest factor associated with r.
Barfield
Discounted Cash Flow Methods

*. A mechanized system of handling parts from one assembly line to another is being
contemplated by the Moonbeam Co. The technical evaluation indicated that the system will
reduce labor and waiting time costs substantially. An assessment has to be made of
cost/benefit relationship including the effects of interest. The most relevant quantitative
technique to evaluate the project is (M)
a. Regression analysis.
c. Time adjusted rate of return analysis.
b. PERT-CPM.
d. Payback period analysis.
RPCPA 0594
Barfield
97. Which of the following indicates that the first cash flow is at the end of a period? (M)
Barfield
a.
b.
c.
d.
Ordinary annuity
Yes
Yes
No
No
Annuity due
No
Yes
Yes
No
Future Value Formula
95. Future value is the
a. sum of dollars-in discounted to time zero.
b. sum of dollars-out discounted to time zero.
c. difference of dollars-in and dollars-out.
d. value of dollars-in minus dollars-out for future periods adjusted for any interestcompounding factor.
Barfield
98. Assume that X represents a sum of money that Bill has available to invest in a project that will
yield a return of r. In the formula Y = X(1 + r), Y represents the
a. future value of X in one period.
b. future value interest factor associated with r.
Page 23 of 107

55
. The discount rate (hurdle rate of return) must be determined in advance for the (E)
a. Payback period method.
c. Net present value method.
b. Time adjusted rate of return method.
d. Internal rate of return method.
56
. Amster Corporation has not yet decided on its hurdle rate for use in the evaluation of capital
budgeting projects. This lack of information will prohibit Amster from calculating a projects (M)
CMA 0693 4-20
a.
b.
c.
d.
Accounting Rate of Return
No
Yes
No
No
Net Present Value
No
Yes
Yes
Yes
Internal Rate of Return
No
Yes
Yes
No
30. Which capital budgeting technique(s) measure all expected future cash inflows and outflows
as if they occurred at a single point in time? (E)
a. Net present value
c. Payback
b. Internal rate of return
d. Both (a) and (b).
Horngren
2. Which of the following investment rules does not use the time value of the money concept?
A. The payback period
C. Net present value
D. All of the above use the time value concept
B&M
BREAKEVEN TIME
14. Which of the following statements regarding the discounted payback period rule is true?
A. The discounted payback rule uses the time value of money concept.
B. The discounted payback rule is better than the NPV rule
C. The discounted payback rule considers all cash flows
D. The discounted payback rule exhibits the value additive property
B&M
CAPITAL BUDGETING
3. The profitability index
a. Does not use present values of cash flows.
b. Is generally preferable to any other approach for evaluating mutually exclusive investment
alternatives.
c. Produces the same ranking of investment alternatives as does the IRR criterion.
d. Is a discounted cash flow method.
L&H
*.
Which of the following capital budgeting techniques is computed by dividing present value of
future inflows by the initial investment? (M)
a. Accounting rate of return
c. Payback reciprocal
b. Time-adjusted rate of return
d. Profitability index
RPCPA 0589
41. The profitability index is (E)

a. the ratio of net cash flows to the original investment.
b. the ratio of the present value of cash flows to the original investment.
c. a capital budgeting evaluation technique that doesn't use discounted values.
d. a mandatory technique when capital rationing is used.
Barfield
58
. The technique that reflects the time value of money and is calculated by dividing the present
value of the future net after-tax cash inflows that have been discounted at the desired cost of
capital by the initial cash outlay for the investment is the
a. Capital rationing method.
c. Profitability index method.
b. Average rate of return method.
57
. When evaluating projects, breakeven time is best described as (M)

a. Annual fixed costs monthly contribution margin.
b. Project investment annual net cash inflows.
c. The point at which cumulative cash inflows on a project equal total cash outflows.
d. The point at which discounted cumulative cash inflows on a project equal discounted total
cash outflows.
CMA 0693 4-28
PROFITABILITY INDEX
Definition
Page 24 of 107
CAPITAL BUDGETING
59
. The profitability index (present value index)

a. Represents the ratio of the discounted net cash outflows to cash inflows.
b. Is the relationship between the net discounted cash inflows less the discounted cash
outflows.
c. Is calculated by dividing the discounted profits by the cash outflows.
d. Is the ratio of the discounted net cash inflows to discounted cash outflows. CMA 0695 4-4
19. The profitability index is the ratio of

a. Total cash inflows to the cost of the investment.
b. The present value of cash inflows to the cost of the investment.
c. The NPV of the investment to the cost of the investment.
d. The IRR to the companys cost of capital.
L&H
Assumption
42. Which method of evaluating capital projects assumes that cash inflows can be reinvested at
the discount rate?
a. internal rate of return
c. profitability index
b. payback period
d. accounting rate of return
Barfield
Formula
33. Profitability index is the ratio of:
A. Present value of cash flow to initial investment
B. Net present value cash flow to initial investment
C. Net present value of cash flow to IRR
D. Present value of cash flow to IRR
Benefit Cost Ratio
34. Benefit cost ratio is defined as:
A. Present value of cash flow to initial investment
B. Net present value cash flow to initial investment
C. Net present value of cash flow to IRR
D. Present value of cash flow to IRR
B&M
B&M
NET PRESENT VALUE METHOD

Definition
60
. The method that recognizes the time value of money by discounting the after-tax cash flows
over the life of a project, using the company's minimum desired rate of return is the
A. Accounting rate of return method.
C. Internal rate of return method.
B. Net present value method.
D. Payback method.
CMA 1294 4-23
61
. The technique that recognizes the time value of money by discounting the after-tax cash flows
for a project over its life to time period zero using the companys minimum desired rate of
return is the
CMA 1290 4-13
a. Net present value method.
c. Average rate of return method.
b. Payback method.
d. Accounting rate of return method.
22. Probabilistic estimates are most frequently used with which of the following methods of capital
expenditure evaluation?
A. payback
C. internal rate of return
B. present value
D. accounting rate of return
Carter & Usry
3. The net present value of a proposed project represents the:
A. cash flows less the original investment
B. present value of the cash flows plus the present value of the original investment less the
original investment
C. present value of the cash flows less the original investment
D. present value of the cash flows less the cost of the old machine being replaced
E. cash flows less the present value of the cash flows
Carter & Usry
34. The capital budgeting method which calculates the expected monetary gain or loss from a
project by discounting all expected future cash inflows and outflows to the present point in time
using the required rate of return is the (E)
a. payback method.
b. accrual accounting rate-of-return method.
c. sensitivity method.
d. net present value method.
Horngren
70. A capital budgeting tool management can use to summarize the difference in the future net
cash inflows from an intangible asset at two different points in time is referred to as (E)
a. the accrual accounting rate-of-return method.
b. the net present value method.
c. sensitivity analysis
d. the payback method.
Horngren
Underlying Theory
Page 25 of 107

*.
CAPITAL BUDGETING
The excess present value method is anchored on the theory that the future returns, expressed
in terms of present value, must at least be (E)
a. Equal to the amount of investment
c. More than the amount of investment
b. Less than the amount of investment
RPCPA 1074
62
. If a firm identifies (or creates) an investment opportunity with a present value <List A> its cost,
the value of the firm and the price of its common stock will <List B> (M)
CIA 1195 IV-44
a.
b.
c.
d.
List A
Greater than
Greater than
Equal to
Equal to
List B
Increase
Decrease
Increase
Decrease
Characteristics
35. The net present value method of evaluating proposed investments
a. measures a project's internal rate of return.
b. ignores cash flows beyond the payback period.
c. applies only to mutually exclusive investment proposals.
d. discounts cash flows at a minimum desired rate of return.
C. Uncertain cash flows that extend far into the future

D. All of the above
16. Which of the following capital budgeting methods has the value additive property?
A. NPV
C. Payback period
B. IRR
D. Discounted payback period
Barfield
63
64
. The capital budgeting technique known as net present value uses

AICPA 1180 T-48
a.
b.
Cash flow over life of project
No
No
Time value of money
Yes
No
42. The net present value method focuses on (E)

a. cash inflows.
c. cash outflows.
b. accrual-accounting net income.
41. The net present value rule is valid for:
A. Two period certain cash flows
B. Two period uncertain cash flows
c.
Yes
No
d.
Yes
Yes
Horngren
B&M
Assumption
33. If an analyst desires a conservative net present value estimate, he/she will assume that all
cash inflows occur at (M)
a. mid year.
c. year end.
b. the beginning of the year.
d. irregular intervals.
Barfield
*.
. In evaluating a capital budget project, the use of the net present value (NPV) model is
ordinarily not affected by the (E)
a. Method of funding the project.
b. Initial cost of the project.
c. Amount of added working capital needed for operations during the term of the project.
d. Projects salvage value.
CMA 1294 4-21
e. Amount of the projects associated depreciation tax allowance.
B&M
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 (M)
a. Results in understated estimates of NPV.
b. Is done because present value tables for continuous flows cannot be constructed.
c. Will result in inconsistent errors being made on estimating NPVs such that project cannot
be evaluated reliably.
d. Results in higher estimate for the IRR on the investment.
RPCPA 1095
65
. The accountant of Ronier, Inc. has prepared an analysis of a proposed capital project using
discounted cash flow techniques. One manager has questioned the accuracy of the results
because the discount factors employed in the analysis have assumed the cash flows occurred
at the end of the year when the cash flows actually occurred uniformly throughout each year.
The net present value calculated by the accountant will
A. Not be in error.
B. Be slightly overstated.
C. Be unusable for actual decision making.
D. Be slightly understated but usable.
CMA 1278 5-10
21. The net present value method assumes that all cash inflows can be immediately reinvested at
the
a. cost of capital.
c. internal rate of return.
Barfield
b. discount rate.
d. rate on the corporation's short-term debt.
Page 26 of 107

21. The net present value method of capital budgeting assumes that cash flows are reinvested at:
(E)
a. the internal rate of return on the project.
b. the rate of return on the company's debt.
c. the discount rate used in the analysis.
d. a zero rate of return.
CMA adapted
CAPITAL BUDGETING
A. accounting rate of return
B. net present value
C. internal rate of return
36. The net present value rule assumes that:
A. Borrowing and lending rate are equal
B. Financial markets are well functioning
D. return on investment
E. payback
AICPA adapted
C. Both A and B are true
D. None of the above are true
B&M
66
. The net present value (NPV) method of investment project analysis assumes that the projects
cash flows are reinvested at the
CMA 0692 4-16, RPCPA 0596
a. Computed internal rate of return.
c. Discount rate used in the NPV calculation.
b. Risk-free interest rate.
d. Firms accounting rate of return.
67
. The net present value method of capital budgeting assumes that cash flows are reinvested at
a. The risk-free rate.
c. The internal rate of return of the project.
b. The cost of debt.
d. The discount rate used in the analysis.
CMA 1295 4-9
36. Which of the following statements is true regarding capital budgeting methods? (D)
a. The Fisher rate can never exceed a company's cost of capital.
b. The internal rate of return measure used for capital project evaluation has more
conservative assumptions than the net present value method, especially for projects that
generate a positive net present value.
c. The net present value method of project evaluation will always provide the same ranking
of projects as the profitability index method.
d. The net present value method assumes that all cash inflows can be reinvested at the
project's cost of capital.
Barfield
10. The advantage of the Net Present Value method over the Internal Rate of Return method for
screening investment projects is that it:
a. does not consider the time value of money
b. implicitly assumes that the company is able to reinvest cash flows from the project at the
companys discount rate
c. implicitly assumes that the company is able to reinvest cash flows from the project at the
internal rate of return
d. fails to consider the timing of cash flows
Pol Bobadilla
16. The capital budgeting method that assumes that funds are reinvested at the company's cost of
capital is:
Advantage
68
. 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.
CMA 0695 4-1
b. Can be used when there is no constant rate of return required for each year of the project.
c. Uses a discount rate that equates the discounted cash inflows with the outflows.
d. Uses discounted cash flows whereas the internal rate of return model does not.
28. The net present value capital budgeting technique can be used when cash flows from period to
period are:
AICPA adapted
A.
B.
C.
D.
Uniform
No
No
Yes
Yes
Uneven
Yes
No
No
Yes
53. In situations where the required rate of return is not constant for each year of the project, it is
advantageous to use (E)
a. the adjusted rate-of-return method.
c. the net present value method.
b. the internal rate-of-return method.
d. sensitivity analysis.
Horngren
Disadvantage
69
. A disadvantage of the net present value method of capital expenditure evaluations is that it (M)
a. Is calculated using sensitivity analysis.
b. Computes the true interest rate.
c. Does not provide the true rate of return on investment.
d. Is difficult to apply because it uses a trial-and-error approach.
CMA 1295 4-16 RPCPA
0597
Application
35. NPV is appropriate to use to analyze which decision relating to a joint-products company?
Page 27 of 107
CAPITAL BUDGETING
a. Whether or not to sell facilities now used for additional processing of one of the joint
products.
b. Whether or not to acquire facilities needed for additional processing of one of the joint
products.
c. Whether or not to sell facilities now used to operate the joint process.
L&H
Variables
Required Rate of Return
32. Net present value is calculated using (E)
a. the internal rate of return.
b. the required rate of return.
c. the rate of return required by the investment bankers.
d. none of the above.
13. The rate of return is also called:
A. Discount rate
B. Hurdle rate
C. Opportunity cost of capital

D. All of the above.
Horngren
B&M
Barfield
54. By using the required rate of return of an equivalent security traded in the financial markets as
a discount rate in the NPV calculations, we are:
A. Discounting for time
C. A and B above
B. Discounting for risk
B&M
52. The discount rate is used for calculating the NPV is:
A. Determined by the financial market
B. Found by the government
C. Found by the CEO
. The discount rate ordinarily used in present value calculation is the

a. Federal Reserve rate.
b. Treasury bill rate.
c. Minimum desired rate of return set by the firm.
d. Prime rate.
Gleim
19. A firm's discount rate is typically based on (M)

a. the interest rates related to the firm's bonds.
b. a project's internal rate of return.
c. its cost of capital.
d. the corporate Aa bond yield.
Barfield
20. In capital budgeting, a firm's cost of capital is frequently used as the (M)
a. internal rate of return.
c. discount rate.
b. accounting rate of return.
d. profitability index.
Barfield
71
39. Which of the following is NOT an appropriate term for the required rate of return? (E)
a. Discount rate
c. Cost of capital
Horngren
b. Hurdle rate
d. All of the above are appropriate terms
18. The interest rate used to find the present value of a future cash flow is the
a. prime rate.
c. cutoff rate.
b. discount rate.
70
B&M
. When using the net present value method for capital budgeting analysis, the required rate of
return is called all of the following except the
A. Risk-free rate.
C. Discount rate.
B. Cost of capital.
D. Cutoff rate.
CMA 1292 4-16
72
. All of the following are the rates used in net present value analysis except for the
a. Cost of capital.
c. Discount rate.
b. Hurdle rate.
Net Investment
73
. A projects net present value, ignoring income tax considerations, is normally affected by the
a. Proceeds 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.
AICPA 0593 T-47
d. Amount of annual depreciation on fixed assets used directly on the project.
Working Capital
22. Some investment projects require that a company expand its working capital to service the
greater volume of business that will be generated. Under the net present value method, the
investment of working capital should be treated as: (M)
a. an initial cash outflow for which no discounting is necessary.
b. a future cash inflow for which discounting is necessary.
Page 28 of 107
CAPITAL BUDGETING
c. both an initial cash outflow for which no discounting is necessary and a future cash inflow
for which discounting is necessary.
d. irrelevant to the net present value analysis.
G & N 9e
Salvage Value
31. A proposed project has an expected economic life of eight years. In the calculation of the net
present value (NPV) of the project, salvage value would be:
A. excluded from the calculation of the NPV
B. included as a cash inflow at the estimated salvage value
AICPA adapted
C. included as a cash inflow at the future amount of the estimated salvage value
D. included as a cash inflow at the present value of the estimated salvage value
Comprehensive
19. How are the following used in the calculation of the net present value of a proposed project?
Ignore income tax considerations. (M)
AICPA adapted
A.
B.
C.
D.
Include
Include
Exclude
Exclude
Salvage value
Include
Exclude
Include
Exclude
20. The net present value method takes into account: (M)
AICPA adapted
A.
B.
Cash Flow Over Life of Project
No
No
Time Value of Money
Yes
No
C.
Yes
No
Formula
50. The present value formula for one period cash flow is:
A. PV = C1(1 + r)
C. PV = C1/(1 + r)
B. PV = C1/r
51. The net present value formula for one period is:
A. NPV = PV cash flows - initial investment C. NPV = C0/[C1(1 + r)]
B. NPV = C0/C1
Decision Criteria
43. The managers of a firm can maximize stockholder wealth by:
A. Taking all projects with positive NPVs
B. Taking all projects with NPVs greater than the cost of investment
D.
Yes
Yes
B&M
B&M
C. Taking all projects with NPVs greater than present value of cash flow
D. All of the above
43. If the net present value for a project is zero or positive, this means (E)
a. the project should be accepted.
b. the project should not be accepted.
c. the expected rate of return is below the required rate of return.
B&M
Horngren
32. According to the net present value rule, an investment in a project should be made if the:
A. Net present value is greater than the cost of investment
B. Net present value is greater than the present value of cash flows
C. Net present value is positive
D. Net present value is negative
B&M
35. Which of the following statements regarding the net present value rule and the rate of return
rule is true?
A. Accept a project if the rate of return is positive
B. Accept a project the rate of return on a risky project exceeds the risk-free rate
C. Accept a project if the net present value is positive
D. None of the above statements are true
B&M
38. In using the net present value method, only projects with a zero or positive net present value
are acceptable because (E)
a. the return from these projects equals or exceeds the cost of capital.
b. a positive net present value on a particular project guarantees company profitability.
c. the company will be able to pay the necessary payments on any loans secured to finance
the project.
d. of both (a) and (b).
Horngren
33. Which of the following statements regarding the net present value rule and the rate of return
rule is not true?
A. Accept a project if NPV > cost of investment
B. Accept a project if NPV is positive
C. Accept a project if return on investment exceeds the rate of return on an equivalent
investment in the financial market
D. All of the above statements are true
B&M
Page 29 of 107
CAPITAL BUDGETING
17. The following statements regarding the NPV rule and the rate of return rule are true except:
A. Accept a project if its NPV > 0
B. Reject a project if its NPV < 0
C. Accept a project if its rate of return > 0
D. Accept a project if its rate of return > opportunity cost of capital
B&M
34. According to the rate of return rule an investment in a risky project should be made if:
A. The return on investment exceeds the risk-free rate
B. The return on investment is positive
C. The return on investments exceeds the rate of return on an equivalent investment in the
financial market
B&M
NPV in an Inflationary Environment
13. Which of the following statements is true?
A. Nominal cash flows are discounted using nominal discount rate
B. Nominal cash flows are discounted using the real discount rate
C. Real cash flows are discounted using the nominal discount rate
C. The same as the NPV value obtained by discounting nominal cash flows using the real
discount rate
B&M
INTERNAL RATE OF RETURN
Definition
*. The discount rate that equates the present value of the expected cash flows with the cost of
the investment is the (E)
a. Net present value
c. Accounting rate of return
b. Internal rate of return
d. Payback period
RPCPA 0593
75
. The technique that incorporates the time value of money by determining the compound
interest rate of an investment such that the present value of the after-tax cash inflows over the
life of the investment is equal to the initial investment is called the
A. Internal rate of return method.
B. Capital asset pricing model.
B&M
74
. When determining net present value in an inflationary environment, adjustments should be

made to
a. Increase the discount rate, only.
b. Increase the estimated cash inflows and increase the discount rate.
c. Increase the estimated cash inflows but not the discount rate.
d. Decrease the estimated cash inflows and increase the discount rate.
CMA 1293 4-21
18. Proper treatment of inflation in the NPV calculation involves:

A. Discounting nominal cash flows using the nominal discount rate
B. Discounting real cash flows using the real discount rate
C. Discounting nominal cash flows using the real discount rates
D. A and B
B&M
20. The NPV value obtained by discounting nominal cash flows using the nominal discount rate is:
A. The same as the NPV value obtained by discounting real cash flows using the real
discount rate
B. The same as the NPV value obtained by discounting real cash flows using the nominal
discount rate
Page 30 of 107
CAPITAL BUDGETING
76
. The internal rate of return (IRR) is the

a. Hurdle rate.
b. Rate of interest for which the net present value is greater than 1.0.
c. Rate of interest for which the net present value is equal to zero.
d. Rate of return generated from the operational cash flows. CMA 0694 4-16, RPCPA 1096
24. The IRR is defined as: (E)

A. The discount rate that makes the NPV equal to zero
B. The difference between the cost of capital and the present value of the cash flows
C. The discount rate used in the NPV method
D. The discount rate used in the discounted payback period method
B&M
46. The rate of interest that produces a zero net present value when a project's discounted cash
operating advantage is netted against its discounted net investment is the
a. cost of capital.
c. cutoff rate.
b. discount rate.
Barfield
b. a trial-and-error approach
d. a time line
Barfield
47. The capital budgeting method that calculates the discount rate at which the present value of
expected cash inflows from a project equals the present value of expected cash outflows is the
(E)
a. net present value method.
b. accrual accounting rate-of-return method.
c. payback method.
Horngren
21 The internal rate of return of a capital investment(M)
a. Changes when the cost of capital changes.
b. Is equal to the annual net cash flows divided by one half of the projects cost when the
cash flows are an annuity.
c. Must exceed the cost of capital in order for the firm to accept the investment.
d. Is similar to the yield to maturity on a bond.
e. Statements c and d are correct.
Brigham
77
. The internal rate of return for a project can be determined

A. If the internal rate of return is greater than the firm's cost of capital.
B. Only if the project cash flows are constant.
CMA 1293 4-12
C. By finding the discount rate that yields a net present value of zero for the project.
D. By subtracting the firm's cost of capital from the project's profitability index.
78
. The internal rate of return is

a. The discount rate at which the NPV of the cash flows is zero.
b. The breakeven borrowing rate for the project in question.
c. The yield rate/effective rate of interest quoted on long-term debt and other instruments.
d. All of the answers are correct.
AICPA 1181 I-39
79
. The internal rate of return is

A. The breakeven borrowing rate for the project in question.
B. The yield rate/effective rate of interest quoted on long-term debt and other instruments.
C. Favorable when it exceeds the hurdle rate.
D. All of the answers are correct.
Gleim
17. When a project has uneven projected cash inflows over its life, an analyst may be forced to
use _______________ to find the project's internal rate of return.
a. a screening decision
c. a post investment audit
Variables
*. The capital budgeting technique known as internal rate of return uses (E)
RPCPA 0598
a.
b.
c.
Cash flow over entire life of project
No
Yes
Yes
Time value of money
Yes
Yes
No
d.
No
No
80
. How are the following used in the calculation of the internal rate of return of a proposed
project? Ignore income tax considerations.
a.
b.
c.
d.
Residual sales value of project
Exclude
Include
Exclude
Include
Include
Include
Exclude
Exclude
38. If Co. X wants to use IRR to evaluate long-term decisions and to establish a cutoff rate of
return, X must be sure the cutoff rate is (E)
a. At least equal to its cost of capital.
b. At least equal to the rate used by similar companies.
c. Greater than the IRR on projects accepted in the past.
d. Greater than the current book rate of return.
L&H
Page 31 of 107

Assumption/Disadvantage
48. Which of the following capital expenditure planning and control techniques has been criticized
because it might mistakenly imply that earnings are reinvested at the rate of return earned by
the investment? (M)
a. payback method
c. net present value method
d. internal rate of return
Barfield
81
. The net present value (NPV) method and the internal rate of return (IRR) method are used to
analyze capital expenditures. The IRR method, as contrasted with the NPV method,
A. Is considered inferior because it fails to calculate compounded interest rates.
B. Incorporates the time value of money whereas the NPV method does not.
C. Assumes that the rate of return on the reinvestment of the cash proceeds is at the
indicated rate of return of the project analyzed rather than at the discount rate used.
D. Is preferred in practice because it is able to handle multiple desired hurdle rates, which is
impossible with the NPV method.
CMA 1291 4-7
82
. A weakness of the internal rate of return (IRR) approach for determining the acceptability of
investments is that it (E)
a. Does not consider the time value of money.
b. Is not a straightforward decision criterion.
c. Implicitly assumes that the firm is able to reinvest project cash flows at the firms cost of
capital.
d. Implicitly assumes that the firm is able to reinvest project cash flows at the projects
internal rate of return.
CMA 1292 4-13
25. A weakness of the internal rate of return method for screening investment projects is that it:
(M)
a. does not consider the time value of money.
b. implicitly assumes that the company is able to reinvest cash flows from the project at the
company's discount rate.
c. implicitly assumes that the company is able to reinvest cash flows from the project at the
internal rate of return.
d. does not take into account all of the cash flows from a project.
CMA adapted
10. Which of the following capital expenditure planning and control techniques has been criticized
because it might mistakenly imply that earnings are reinvested at the rate of return earned by
the investment?
A. internal rate of return method
CAPITAL BUDGETING
B.
C.
D.
E.
accounting rate of return on initial investment method

payback method
average return on investment method
present value method
AICPA adapted
25. The following are some of the shortcomings of the IRR method except: (E)
A. IRR is conceptually easy to communicate
B. Projects can have multiple IRRs
B&M
C. IRR method cannot distinguish between a borrowing project and a lending project
D. It is very cumbersome to evaluate mutually exclusive projects using the IRR method
Advantage
83
. Which of the following characteristics represent an advantage of the internal rate of return
techniques over the accounting rate of return technique in evaluating a project? (M)
I Recognition of the projects salvage value.
II Emphasis on cash flows.
III Recognition of the time value of money.
a. I only.
c. II and III.
b. I and II.
d. I, II, and III.
AICPA 1192 T-49
Decision Criteria
48. In capital budgeting, a project is accepted only if the internal rate of return (E)
a. equals or exceeds the required rate of return.
b. equals or is less than the required rate of return.
c. equals or exceeds the net present value.
d. equals or exceeds the accrual accounting rate of return.
Horngren
Comprehensive
23. Your company is comparing internal rate of return to net present value computations as
alternative criteria for evaluating potential capital investments. Which of the following best
describes these computations?
A. The internal rate of return method ignores the initial cost of the investment in its
computations.
B. The net present value method ignores the company's cost of capital.
C. The net present value method is more appropriate to use during periods of inflation.
D. The two methods will give the same rankings because they both consider the time value
of money.
CIA adapted
Page 32 of 107

E. The internal rate of return method assumes that the positive cash flows generated each
year are reinvested at the computed rate of return for the investment being evaluated.
11. A company is considering the purchase of a new conveyor belt system for carrying parts and
subassemblies from building to building within its plant complex. It is expected that the system
will have a useful life of at least ten years and that it will substantially reduce labor and waitingtime costs. If the company's average cost of capital is about 15% and if some evaluation must
be made of cost/benefit relationships (including the effects of interest) to determine the
desirability of the purchase, the most relevant quantitative technique for evaluating the
investment is:
A. present value (or internal rate of return) analysis
B. Program Evaluation and Review Technique (PERT)
C. accounting rate of return analysis
D. cost-volume-profit analysis
E. payback analysis
AICPA adapted
*.
Statement 1 The internal rate of return is the discount rate that equals the amount invested at
a given date with the present value of the expected cash inflows from the
investment.
Statement 2 If the minimum desired rate of return exceeds the internal rate of return expected
from a project, the project should be rejected.
Statement 3 The internal rate of return can be more easily applied to situations with uneven
periodic cash flows than can the net present value. (M)
RPCPA 0592
a.
b.
c.
d.
Statement 1
True
False
True
False
Statement 2
True
False
True
False
Statement 3
True
False
False
True
MODIFIED INTERNAL RATE OF RETURN

22 Which of the following statements is most correct? The modified IRR (MIRR) method: (M)
a. Always leads to the same ranking decision as NPV for independent projects.
b. Overcomes the problem of multiple rates of return.
c. Compounds cash flows at the cost of capital.
d. Overcomes the problems of cash flow timing and project size that lead to criticism of the
regular IRR method.
e. Statements b and c are correct.
Brigham
84
. Which of the following statements is most correct? (M)
CAPITAL BUDGETING
a. The MIRR method will always arrive at the same conclusion as the NPV method.
b. The MIRR method can overcome the multiple IRR problem, while the NPV method
cannot.
c. The MIRR method uses a more reasonable assumption about reinvestment rates than the
IRR method.
Brigham
RELATIONSHIP among Payback, ARR, PI, NPV & IRR
ARR vs. IRR
11. Which of the following is a basic difference between the IRR and the book rate of return (BRR)
criteria for evaluating investments?
a. IRR emphasizes expenses and BRR emphasizes expenditures.
b. IRR emphasizes revenues and BRR emphasizes receipts.
c. IRR is used for internal investments and BRR is used for external investments.
d. IRR concentrates on receipts and expenditures and BRR concentrates on revenues and
expenses.
L&H
Payback & NPV
12. If a project has a payback period shorter than its life,
a. Its NPV may be negative.
b. Its IRR is greater than cost of capital.
c. It will have a positive NPV.
d. Its incremental cash flows may not cover its cost.
L&H
Payback & IRR

5. The relationship between payback period and IRR is that
a. A payback period of less than one-half the life of a project will yield an IRR lower than the
target rate.
b. The payback period is the present value factor for the IRR.
c. A project whose payback period does not meet the companys cutoff rate for payback will
not meet the companys criterion for IRR.
L&H
PI and NPV
31. An investment whose profitability index is 1.00
a. Has an IRR equal tot eh prevailing interest rate.
b. Returns to the company only the cash outlay for the investment.
Page 33 of 107
CAPITAL BUDGETING
c. Has a payback period equal to its useful life.

d. Has an NPV of zero.
L&H
38. If a project generates a net present value of zero, the profitability index for the project will
a. equal zero.
c. equal -1.
b. equal 1.
d. be undefined.
Barfield
40. If a project's profitability index is less than 1, the project's (E)
a. discount rate is above its cost of capital. c. payback period is infinite.
b. internal rate of return is less than zero.
d. net present value is negative.
39. If the profitability index for a project exceeds 1, then the project's
a. net present value is positive.
b. internal rate of return is less than the project's discount rate.
c. payback period is less than 5 years.
d. accounting rate of return is greater than the project's internal rate of return.
15. An investment with a positive NPV also has
a. A positive profitability index.
b. A profitability index of one.
c. A profitability index less than one.
d. A profitability index greater than one.
Barfield
85
PI & IRR
21. If the profitability index is less than one,
a. The IRR is less than cost of capital.
b. The IRR is the same as cost of capital.
CMA 1293 4-11
c. The IRR is greater than cost of capital.

d. None of the above is true.
L&H
48. A project has an IRR less than the cost of capital. The profitability index for this project would
be
a. Less than zero.
b. Between zero and one.
L&H
47. A project has an IRR in excess of the cost of capital. The profitability index for this project
would be (M)
a. Less than zero.
b. Between zero and one.
c. Greater than one.
d. Cannot be determined without more information.
L&H
Barfield
L&H
. If an investment project has a profitability index of 1.15, the

a. Projects internal rate of return is 15%.
b. Projects cost of capital is greater than its internal rate of return.
c. Projects internal rate of return exceeds its net present value.
d. Net present value of the project is positive.
c. Greater than one.

d. Cannot be determined without more information.
NPV and IRR

86
. Polo Co. requires higher rates of return for projects with a life span greater than 5 years.
Projects extending beyond 5 years must earn a higher specified rate of return. Which of the
following capital budgeting techniques can readily accommodate this requirement? (M)
AICPA 0590 T-48
a.
b.
c.
d.
Yes
No
No
Yes
Net Present Value
No
Yes
No
Yes
49. If the discount rate that is used to evaluate a project is equal to the project's internal rate of
return, the project's _________ is zero.
a. profitability index
c. present value of the investment
d. net present value
Barfield
22. If an investment project (normal project) has an IRR equal to the cost of capital, the NPV for
that project is: (E)
A. Positive
C. Zero
B. Negative
D. Unable to be determined
B&M
26. If the net present value of a project is zero based on a discount rate of sixteen percent, then
the time-adjusted rate of return: (M)
a. is equal to sixteen percent.
b. is less than sixteen percent.
c. is greater than sixteen percent.
d. cannot be determined from the information given.
G & N 9e
4. If the present value of the future cash flows for an investment equals the required investment,
the IRR is (D)
a. Equal to the cutoff rate.
Page 34 of 107

b. Equal to the cost of borrowed capital.
c. Equal to zero.
d. Lower than the companys cutoff rate of return.
CAPITAL BUDGETING
89
L&H
87
. If a prospective investment has a positive net present value at a company's cost of capital of
15%, it can be concluded that
A. The accounting rate of return of the project is greater than 15%.
B. The internal rate of return of the project is equal to the accounting rate of return.
C. The payback period of the associated asset is shorter than its life.
D. The internal rate of return of the project is greater than 15%.
CIA 0R98 IV-37
45. If an investment has a positive net present value, the

a. internal rate of return is higher than the discount rate.
b. discount rate is higher than the hurdle rate of return.
c. internal rate of return is lower than the discount rate of return.
d. hurdle rate of return is higher than the discount rate.
7. If an investment has a positive NPV
a. Its IRR is greater than the companys cost of capital.
b. Cost of capital exceeds the cutoff rate of return.
c. Its IRR is less than the companys cutoff rate of return.
d. The cutoff rate of return exceeds cost of capital.
*.
Barfield
L&H
Lenders Inc. is considering an investment that has a positive net present value based on its
16% hurdle rate. The internal rate of return would be (M)
a. More than 16%.
c. 16%.
b. Less than 16%.
d. Zero.
RPCPA 1095
88
. Neu Co. is considering the purchase of an investment that has a positive net present value
based on Neus 12% hurdle rate. The internal rate of return would be
a. 0%.
c. >12%
b. 12%.
d. < 12%
18. An investment has a positive NPV discounting the cash flows at a 14% cost of capital. Which
statement is true?
a. The IRR is lower than 14%.
c. The payback period is less than 14 years.
b. The IRR is higher than 14%.
d. The book rate of return is 14%.
L&H
. The net present value of a proposed investment is negative; therefore, the discount rate used
must be
A. Greater than the project's internal rate of return.
B. Less than the project's internal rate of return.
C. Greater than the firm's cost of equity.
D. Less than the risk-free rate.
CMA 1295 4-14, RPCPA 0596
25. At a company's cost of capital of 15%, a prospective investment has a negative net present
value. Based on this information, it can be concluded that:
A. the internal rate of return is greater than 15%
B. the payback period is shorter than the life of the asset
C. the accounting rate of return is less than 15%
D. the accounting rate of return is greater than 15%
E. the internal rate of return is less than 15%
CIA adapted
90

a. If a projects internal rate of return (IRR) exceeds the cost of capital, then the projects net
present value (NPV) must be positive.
b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
c. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return
equal to the cost of capital.
Brigham
91

a. If a project with normal cash flows has an IRR which exceeds the cost of capital, then the
project must have a positive NPV.
b. If the IRR of Project A exceeds the IRR of Project B, then Project A must also have a
higher NPV.
c. The modified internal rate of return (MIRR) can never exceed the IRR.
Brigham
92
. Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14
percent. Both projects have a cost of capital of 12 percent. Which of the following statements
is most correct? (E)
a. Both projects have a positive net present value (NPV).
b. Project A must have a higher NPV than Project B.
c. If the cost of capital were less than 12 percent, Project B would have a higher IRR than
Project A.
Page 35 of 107

CAPITAL BUDGETING
b. If the multiple IRR problem does not exist, any independent project acceptable by the
NPV method will also be acceptable by the IRR method.
c. If IRR = k (the cost of capital), then NPV = 0.
d. NPV can be negative if the IRR is positive.
e. The NPV method is not affected by the multiple IRR problem.
Brigham
Brigham
93
. Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have
the same risk. Which of the following statements is most correct? (E)
a. If the WACC is 10 percent, both projects will have a positive NPV, and the NPV of Project
B will exceed the NPV of Project A.
b. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A.
c. If the WACC is less than 18 percent, Project B will always have a shorter payback than
Project A.
d. If the WACC is greater than 18 percent, Project B will always have a shorter payback than
Project A.
e. If the WACC increases, the IRR of both projects will decline.
Brigham
94
. Project J has the same internal rate of return as Project K. Which of the following statements
is most correct? (M)
a. If the projects have the same size (scale) they will have the same NPV, even if the two
projects have different levels of risk.
b. If the two projects have the same risk they will have the same NPV, even if the two
projects are of different size.
c. If the two projects have the same size (scale) they will have the same discounted
payback, even if the two projects have different levels of risk.
d. All of the statements above are correct.
e. None of the statements above is correct.
Brigham
NPV, IRR & WACC

95
. Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other
cash flows are positive). Which of the following statements is most correct? (E)
a. All else equal, a projects IRR increases as the cost of capital declines.
b. All else equal, a projects NPV increases as the cost of capital declines.
c. All else equal, a projects MIRR is unaffected by changes in the cost of capital.
Brigham
96
. Which of the following statements is incorrect? (M)

a. Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than
the cost of capital.
97
. A project has an up-front cost of $100,000. The projects WACC is 12 percent and its net
present value is $10,000. Which of the following statements is most correct? (E)
a. The project should be rejected since its return is less than the WACC.
b. The projects internal rate of return is greater than 12 percent.
c. The projects modified internal rate of return is less than 12 percent.
Brigham
NPV, IRR & Payback

37. A project that has a negative NPV.
a. Has a payback period longer than its life.
b. Has a negative profitability index.
c. Must be rejected.
d. Doesnt necessarily fit any of the above descriptions.
98
. Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of
15 percent. Both projects have a positive net present value. Which of the following
statements is most correct? (M)
a. Project X must have a higher net present value than Project Y.
b. If the two projects have the same WACC, Project X must have a higher net present value.
c. Project X must have a shorter payback than Project Y.
Brigham
PI, NPV & IRR

22. Which of the following combinations is possible?
Profitability Index
NPV
a. Greater than 1
Positive
b. Greater than 1
Negative
c. Less than 1
Negative
d. Less than 1
Positive
23. Which of the following combinations is NOT possible? (E)
L&H
L&H
IRR
Equal cost of capital
Less that cost of capital
Less than cost of capital
L&H
Page 36 of 107

a.
b.
c.
d.
Profitability Index
Greater than 1
Equals 1
Less than 1
Less than 1
CAPITAL BUDGETING
NPV
Positive
Zero
Negative
Positive
IRR
More than cost of capital
Equals cost of capital
NPV, IRR, MIRR, and Payback

99
. A proposed project has normal cash flows. In other words, there is an up-front cost followed
over time by a series of positive cash flows. The projects internal rate of return is 12 percent
and its WACC is 10 percent. Which of the following statements is most correct? (E)
a. The projects NPV is positive.
b. The projects MIRR is greater than 10 percent but less than 12 percent.
c. The projects payback period is greater than its discounted payback period.
Brigham
COMPARISION among Payback, ARR, PI, NPV & IRR
NPV vs.IRR
52. An important advantage of the net present value method of capital budgeting over the internal
rate-of-return method is (E)
a. the net present value method is expressed as a percentage.
b. the net present values of individual projects can be added to determine the effects of
accepting a combination of projects.
c. no advantage.
d. both (a) and (b).
Horngren
Depreciation
23. (Ignore income taxes in this
budgeting techniques? (M)
CMA adapted
Simple Rate of Return
Payback
problem.) How is depreciation handled by the following capital

A.
Excluded
Included
Excluded
B.
Included
Excluded
Included
C.
Excluded
Excluded
D.
Included
Included
Excluded
19. If income tax considerations are ignored, how is depreciation expense used in the following
capital budgeting techniques?
AICPA adapted
A.
B.
C.
D.
Excluded
Included
Included
Excluded
Payback
Included
Excluded
Included
Excluded
*.
If income tax considerations are ignored, how is depreciation used in the following capital
budgeting techniques? (E)
RPCPA 0595
a.
b.
c.
d.
Internal rate of return
Included
Excluded
Excluded
Included
Accounting rate of return
Excluded
Included
Excluded
Included
30. If income tax considerations are ignored, how is depreciation expense used in the following
capital budgeting techniques?
AICPA adapted
A.
B.
C.
D.
Excluded
Excluded
Included
Included
Net Present Value
Excluded
Included
Excluded
Included
100
. If income tax considerations

budgeting technique?
CMA 1293 4-17
Payback
are ignored, how is depreciation handled by the following

a.
Excluded
Included
Excluded
b.
Included
Excluded
Included
c.
Excluded
Excluded
Included
d.
Included
Included
Included
Cash Flow
24. Which of the following capital budgeting techniques consider(s) cash flow over the entire life of
the project? (E)
AICPA adapted
A.
B.
C.
D.
Yes
Yes
No
No
Payback
Yes
No
Yes
No
PROJECT SCREENING (Accept/Reject Decision for Independent Project)
59. Which of the following best represents a screening decision?
a. determining which project has the highest net present value
b. determining if a project's internal rate of return exceeds the firm's cost of capital
c. determining which projects are mutually exclusive
d. determining which are the best projects
Barfield
Security Market Line (SML) Concept

. Using the Security Market Line concept in capital budgeting, which of the following is correct?
(M)
Page 37 of 107

a. If the expected rate of return on a given capital project lies above the SML, the project
should be accepted even if its beta is above the beta of the firms average project.
b. If a projects return lies below the SML, it should be rejected if it has a beta greater than
the firms existing beta but accepted if its beta is below the firms beta.
c. If two mutually exclusive projects expected returns are both above the SML, the project
with the lower risk should be accepted.
d. If a projects expected rate of return is greater than the expected rate of return on an
average project, it should be accepted.
Brigham
23. On a graph with common stock returns on the Y axis and market returns on the X-axis, the
slope of the regression line represents the:
A. Alpha
C. R-squared
B. Beta
D. Adjusted beta
B&M
15. The historical returns data for the past three years for Company A's stock is -6.0%, 15%, 15%
and that of the market portfolio is 10%, 10% and 16%. According to the SML, the Stock A is:
A. over priced
C. Correctly priced
B. Under priced
D. Need more information
B&M
22. The historical returns data for the past three years for Stock B and the stock market portfolio
are: Stock B:- 24%, 0%, 24%, Market Portfolios:- 10%, 12%, 20%. According to the SML the
stock B is:
A. Overpriced
C. Correctly priced
B. Underpriced
B&M
Single Project
101
. The profitability index approach to investment analysis (M)
A. Fails to consider the timing of project cash flows.
B. Considers only the project's contribution to net income and does not consider cash flow
effects.
C. Always yields the same accept/reject decisions for independent projects as the net
present value method.
D. Always yields the same accept/reject decisions for mutually exclusive projects as the net
present value method.
CMA 1292 4-14, RPCPA 0596
14. The NPV and IRR methods give
a. The same decision (accept or reject) for any single investment.
b. The same choice from among mutually exclusive investments.
CAPITAL BUDGETING
c. Different rankings of projects with unequal lives.
d. The same rankings of projects with different required investments.
L&H
29. Which of the following is always true of the net present value (NPV) approach?
A. If a project is found to be acceptable under the NPV approach, it would also be acceptable
under the internal rate of return (IRR) approach.
B. The NPV and the IRR approaches will always rank projects in the same order.
C. If a project is found to be acceptable under the NPV approach, it would also be acceptable
under the payback approach.
CIA adapted
D. The NPV and the payback approaches will always rank projects in the same order.
Questions 140 and 141 are based on the following information.
CIA 0594 IV-45 & 46
The financial management team of a company is assessing an investment proposal involving a
$100,000 outlay today. Manager one expects the project to provide cash inflows of $20,000 at the
end of each year for 6 years. She considers the project to be of low risk, requiring only a 10% rate
of return. Manager two expects the project to provide cash inflows of $5,000 at the end of the first
year, followed by $23,000 at the end of each year in years two through six. He considers the
project to be of medium risk, requiring a 14% rate of return. Manager three expects the project to
be of high risk, providing one large cash inflow of $135,000 at the end of the sixth year. She
proposes a 15% rate of return for the project.
Additional Information:
Number
Discount
Present Value of $1 Due at
Annuity of $1 per Period
of Years
Rate (%)
the End of n Periods (PVIF)
for n Periods (PVIFA)
1
10
.9091
.9091
1
14
.8772
.8772
1
15
.8696
.8696
5
10
.6209
3.7908
5
14
.5194
3.4331
5
15
.4972
3.3522
6
10
.5645
4.3553
6
14
.4556
3.8887
6
15
.4323
3.7845
102
. According to the net present value criterion, which of the following is true?
A. Manager one will recommend that the project be accepted.
B. Manager two will recommend that the project be accepted.
C. All three managers will recommend acceptance of the project.
D. All three managers will recommend rejection of the project.
Page 38 of 107

103
. Which manager will assess the project as having the shortest payback period?
A. Manager one.
B. Manager two.
C. Manager three.
D. All three managers will agree on the payback period.
Group Project
6. You are given a job to make a decision on project X, which is composed of three projects A, B,
and C which have NPVs of +$50, -$20 and +$100, respectively. How would you go about
making the decision about whether to accept or reject the project? (M)
A. Accept the firm's joint project as it has a positive NPV
B. Reject the joint project
C. Break up the project into its components: accept A and C and reject B
B&M
Unlimited Capital
104
. A company has unlimited capital funds to invest. The decision rule for the company to follow in
order to maximize shareholders' wealth is to invest in all projects having a(n)
A. Present value greater than zero.
B. Net present value greater than zero.
C. Internal rate of return greater than zero.
CMA 1293 4-15
D. Accounting rate of return greater than the hurdle rate used in capital budgeting analyses.
105
. Future, Inc. is in the enviable situation of having unlimited capital funds. The best decision rule,
in an economic sense, for it to follow would be to invest in all projects in which the
A. Accounting rate of return is greater than the earnings as a percent of sales.
B. Payback reciprocal is greater than the internal rate of return.
C. Internal rate of return is greater than zero.
D. Net present value is greater than zero.
CMA 1278 5-12
CAPITAL BUDGETING
106
. Barker Inc. has no capital rationing constraint and is analyzing many independent investment
alternatives. Barker should accept all investment proposals
a. If debt financing is available for them.
b. That have positive cash flows.
c. That provide returns greater than the after-tax cost of debt.
d. That have a positive net present value.
CMA 1295 4-2
107
. An organization is using capital budgeting techniques to compare two independent projects. It
could accept one, both, or neither of the projects. Which of the following statements is true
about the use of net-present-value (NPV) and internal-rate-of-return (IRR) methods for
evaluating these two projects?
a. NPV and IRR criteria will always lead to the same accept or reject decision for two
independent projects.
b. If the first projects IRR is higher than the organizations cost of capital, the first project will
be accepted but the second project will not.
c. If the NPV criterion leads to accepting or rejecting the first project, one cannot predict
whether the IRR criterion will lead to accepting or rejecting the first project.
d. If the NPV criterion leads to accepting the first project, the IRR criterion will never lead to
accepting the first project.
CIA 0597 IV-43
108
. Which of the following is always true with regard to the net present value (NPV) approach?
A. If a project is found to be acceptable under the NPV approach, it would also be acceptable
under the internal rate of return (IRR) approach.
B. The NPV and the IRR approaches will always rank projects in the same order.
C. If a project is found to be acceptable under the NPV approach, it would also be acceptable
under the payback approach.
CIA 0586 IV-29
D. The NPV and payback approaches will always rank projects in the same order.
PROJECT RANKING METHOD

Capital Rationing
38. Soft rationing is imposed in order to: (E)
A. Control managers' actions
B. Limit runaway growth
C. Cope with market imperfections

D. A and B
B&M
39. Hard rationing is imposed by the: (E)

A. Market
B. Majority stockholder
C. Management
D. Both B and C
B&M
Page 39 of 107
CAPITAL BUDGETING
111
Mutually Inclusive Projects

63. If management judges one project in a mutually inclusive set to be acceptable for investment,
a. all the other projects in the set are rejected.
b. only one other project in the set can be accepted.
c. all other projects in the set are also accepted.
d. only one project in the set will be rejected.
Barfield
Net Present Value (Preferred Method)
7. In choosing from among mutually exclusive investments the manager should normally select
the one with the highest (M)
a. NPV.
c. Profitability index.
b. IRR.
L&H
57. Which of the following capital investment models would be preferred when choosing among
mutually exclusive alternatives? (M)
a. payback period
c. IRR
d. NPV
H&M
Profitability Index
109
. When ranking two mutually exclusive investments with different initial amounts, management
should give first priority to the project
A. That generates cash flows for the longer period of time.
B. Whose net after-tax flows equal the initial investment.
C. That has the greater accounting rate of return.
D. That has the greater profitability index.
CMA 1291 4-6
NPV & IRR
110
. The internal rate of return on an investment
A. Usually coincides with the company's hurdle rate.
B. Disregards discounted cash flows.
C. May produce different rankings from the net present value method on mutually exclusive
projects.
D. Would tend to be reduced if a company used an accelerated method of depreciation for
tax purposes rather than the straight-line method.
CMA 0691 4-19
. The rankings of mutually exclusive investments determined using the internal rate of return
method (IRR) and the net present value method (NPV) may be different when
a. The lives of the multiple projects are equal and the size of the required investments are
equal.
b. The required rate of return equals that IRR of each project.
c. The required rate of return is higher than the IRR of each project.
d. Multiple projects have unequal lives and the size of the investment for each project is
different.
CMA 1292 4-15, RPCPA 1096
50. Why do the NPV method and the IRR method sometimes produce different rankings of
mutually exclusive investment projects?
A. The NPV method does not assume reinvestment of cash flows while the IRR method
assumes the cash flows will be reinvested at the internal rate of return.
B. The NPV method assumes a reinvestment rate equal to the discount rate while the IRR
method assumes a reinvestment rate equal to the internal rate of return.
C. The IRR method does not assume reinvestment of the cash flows while the NPV assumes
the reinvestment rate is equal to the discount rate.
D. The NPV method assumes a reinvestment rate equal to the bank loan interest rate while
the IRR rate method assumes a reinvestment rate equal to the discount rate. Pol Bobadilla
Ranking Decision
112
. Which mutually exclusive project would you select, if both are priced at $1,000 and your
discount rate is 15%; Project A with three annual cash flows of $1,000, or Project B, with 3
years of zero cash flow followed by 3 years of $1,500 annually?
A. Project A.
B. Project B.
C. The IRRs are equal, hence you are indifferent.
D. The NPVs are equal, hence you are indifferent.
Gleim
Definition
*. The kind of investment project which has no direct relationship with other projects and can
therefore be implemented or rejected independently of others (E)
a. Independent investment project
b. Complimentary investment project
c. None of these
RPCPA 0588
Examples
Page 40 of 107
CAPITAL BUDGETING
60. Below are pairs of projects. Which pair best represents independent projects?
a. buy computer; buy software package
b. buy computer #1; buy computer #2
c. buy computer; buy computer security system
d. buy computer; repave parking lot
Profitability Index
35. Profitability index is useful under: (E)
A. Capital rationing
B. Mutually exclusive projects
C. Non-normal projects
40. The profitability index can be used for ranking projects under: (E)
A. Soft capital rationing
C. Capital rationing at t = 0
B. Hard capital rationing
D. Both A and B
*.
Barfield
B&M
B&M
113
. The recommended technique for evaluating projects when capital is rationed and there are no
mutually exclusive projects from which to choose is to rank the projects by
A. Accounting rate of return.
C. Internal rate of return.
B. Payback.
D. Profitability index.
CMA 0692 4-15
114
. The technique used to evaluate all possible capital projects of different dollar amounts and
then rank them according to their desirability is the (M)
a. Profitability index method.
c. Payback method.
CMA 1294 4-26
b. Net present value method.
d. Discounted cash flow method.
Ranking Decision
37. A company is evaluating three possible investments. Information relating to the company and
the investments follow:
Fisher rate for the three projects
7%
Cost of capital
8%
Based on this information, we know that (D)
a. all three projects are acceptable.
b. none of the projects are acceptable.
c. the capital budgeting evaluation techniques profitability index, 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.
Barfield
Several proposed capital projects which are economically acceptable may have to be ranked
due to constraints in financial resources. In ranking these projects, the least pertinent is this
statement. (M)
a. If the internal rate of return method is used in the capital rationing problem, the higher the
rate, the better the project.
b. In selecting the required rate of return, one may either calculate the organizations 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. If the net present value method is used, the profitability index is calculated to rank the
projects. The lower the index, the better the project.
RPCPA 1094
Profitability Index
115
. Capital budgeting methods are often divided into two classifications: project screening and
project ranking. Which one of the following is considered a ranking method rather than a
screening method?
A. Net present value.
C. Profitability index.
B. Time-adjusted rate of return.
D. Accounting rate of return. CMA 0691 4-17
IRR
116
. A company has analyzed seven new projects, each of which has its own internal rate of return.
It should consider each project whose internal rate of return is _____ its marginal cost of
capital and accept those projects in _____ order of their internal rate of return.
A. Below; decreasing.
C. Above; increasing.
B. Above; decreasing.
D. Below; increasing.
CIA 0593 IV-55
Internal Rate of Return & Net Present Value
22. The three frequently used methods for ranking investment proposals are payback, net present
value, and internal rate of return. One of the three is defined as the interest rate that equates
the present value of expected cash flows and the cost of the project. A second method finds
the present value of expected cash flows and subtracts the initial cost of the project. The
following terms that match these respective definitions are:
A. internal rate of return and net present value
B. internal rate of return and payback
C. net present value and internal rate of return
D. net present value and payback
CIA adapted
Page 41 of 107

RISK ANALYSIS
Risk
Risk-free Rate
117
. The proper discount rate to use in calculating certainty equivalent net present value is the (E)
a. Risk-adjusted discount rate.
d. Cost of equity capital.
b. Cost of capital.
c. Risk-free rate.
CMA 1292 4-19
118
. The following data are related to the cash flows of a risky capital-budgeting alternative:
Col. 1
Col. 2
Col. 3
Period
Expected Cash Flows
Certainty Equivalent Factors
1
1,000
.85
2
1,000
.75
3
1,000
.70
The discount rates available for this analysis are: risk-free rate = 5%, cost of capital = 10%,
and risk-adjusted discount rate = 15%. How should these cash flows be discounted using the
certainty-equivalent method (CE) and the risk-adjusted discount rate method (RADR)?
CE
RADR
A.
(Col.2xCol.3) at 10%
(Col.2xCol.3) at 5%
B.
(Col.2xCol.3) at 5%
C.
Col.2 at 15%
D.
(Col.2xCol.3) at 5%
Col.2 at 15%
CIA 0586 IV-32
119
. A firm has negotiated a contract with the government and has locked in the payment it will
receive in each of the future years from this project. However, the firm's costs for this project
are uncertain. How should the certainty-equivalent (CE) approach be applied in this situation?
A. Discount cash inflows using cost of capital and CE values of cost using cost of capital.
B. Discount cash inflows using cost of capital and CE values of cost using risk-free rate.
C. Determine net cash inflows using CE values of cost and discount using cost of capital.
D. Determine net cash inflows using CE values of cost and discount using risk-free rate.
CIA 0586 IV-34
Uncertainties
120
. Carco, Inc. wants to use discounted cash flow techniques when analyzing its capital
investment projects. The company is aware of the uncertainty involved in estimating future
cash flows. A simple method some companies employ to adjust for the uncertainty inherent in
their estimates is to
A. Prepare a direct analysis of the probability of outcomes.
CAPITAL BUDGETING
B. Use accelerated depreciation.
C. Adjust the minimum desired rate of return.
D. Increase the estimates of the cash flows.
CMA 1278 5-8
23. To reflect greater uncertainty (greater risk) about a future cash inflow, an analyst could
a. increase the discount rate for the cash flow.
b. decrease the discounting period for the cash flow.
c. increase the expected value of the future cash flow before it is discounted.
d. extend the acceptable length for the payback period.
Barfield
Risk Factor
121
. For capital budgeting purposes, management would select a high hurdle rate of return for
certain projects because management
a. Wants to use equity funding exclusively.
b. Believes too many proposals are being rejected.
c. Believes bank loans are riskier than capital investments.
d Wants to factor risk into its consideration of projects.
CMA 1294 4-22
16. In a discounted cash flow analysis, which of the following would not be consistent with
adjusting a project's cash flows to account for higher-than-normal risk?
a. increasing the expected amount for cash outflows
b. increasing the discounting period for expected cash inflows
c. increasing the discount rate for cash outflows
d. decreasing the amount for expected cash inflows
Barfield
Different Risk Levels
122
. When the risks of the individual components of a projects cash flows are different, an
acceptable procedure to evaluate these cash flows is to
a. Divide each cash flow by the payback period.
b. Compute the net present value of each cash flow using the firms cost of capital.
c. Compare the internal rate of return from each cash flow to its risk.
CMA 1295 4-6
d. Discount each cash flow using a discount rate that reflects the degree of risk.
Risk-Adjusted Discount Rates
123
. Risk in a revenue-producing project can best be adjusted for by(E)
a. Ignoring it.
b. Adjusting the discount rate upward for increasing risk.
c. Adjusting the discount rate downward for increasing risk.
Page 42 of 107

d. Picking a risk factor equal to the average discount rate.
e. Reducing the NPV by 10 percent for risky projects.
CAPITAL BUDGETING
Risk and Project Selection

. If a company uses the same discount rate for evaluating all projects, which of the following
results is likely? (M)
a. Accepting poor, high-risk projects.
d. Accepting no projects.
b. Rejecting good, low-risk projects.
e. Statements a and b are correct.
c. Accepting only good, low risk projects.
Brigham
.
If a typical U. S. company uses the same discount rate to evaluate all projects, the firm will
most likely become (M)
a. Riskier over time, and its value will decline.
b. Riskier over time, and its value will rise.
c. Less risky over time, and its value will rise.
d. Less risky over time, and its value will decline.
e. There is no reason to expect its risk position or value to change over time as a result of its
use of a single discount rate.
Brigham
124
. A company estimates that an average-risk project has a WACC of 10 percent, a belowaverage risk project has a WACC of 8 percent, and an above-average risk project has a
WACC of 12 percent. Which of the following independent projects should the company
accept? (E)
a. Project A has average risk and an IRR = 9 percent.
b. Project B has below-average risk and an IRR = 8.5 percent.
c. Project C has above-average risk and an IRR = 11 percent.
d. All of the projects above should be accepted.
e. None of the projects above should be accepted.
Brigham
125
. A firm is considering the purchase of an asset whose risk is greater than the current risk of the
firm, based on any method for assessing risk. In evaluating this asset, the decision maker
should(E)
a. Increase the IRR of the asset to reflect the greater risk.
b. Increase the NPV of the asset to reflect the greater risk.
c. Reject the asset, since its acceptance would increase the risk of the firm.
d. Ignore the risk differential if the asset to be accepted would comprise only a small fraction
of the total assets of the firm.
e. Increase the cost of capital used to evaluate the project to reflect the higher risk of the
project.
Brigham
Brigham
126
. Downingtown Industries has an overall (composite) WACC of 10 percent. This cost of capital
reflects the cost of capital for a Downingtown project with average risk; however, there are
large differences among the projects. The company estimates that low-risk projects have a
cost of capital of 8 percent and high-risk projects have a cost of capital of 12 percent. The
company is considering the following projects:
Project
Expected Return
Risk
A
15%
High
B
12
Average
C
11
High
D
9
Low
E
6
Low
Which of the projects will the company select? (E)
a. A and B.
d. A, B, C, and D.
b. A, B, and C.
e. A, B, C, D, and E.
c. A, B, and D.
Brigham
127
. Mega Inc., a large conglomerate with operating divisions in many industries, uses risk-adjusted
discount rates in evaluating capital investment decisions. Consider the following statements
concerning Mega's use of risk-adjusted discount rates.
I. Mega may accept some investments with internal rates of return less than Mega's overall
average cost of capital.
II. Discount rates vary depending on the type of investment.
III. Mega may reject some investments with internal rates of return greater than the cost of
capital.
IV. Discount rates may vary depending on the division.
Which of the above statements are correct?
A. I and III only.
C. II, III, and IV only.
B. II and IV only.
D. I, II, III, and IV.
CMA Samp Q4-5
128
. Kemp Consolidated has two divisions of equal size: a computer division and a restaurant
division. Stand-alone restaurant companies typically have a cost of capital of 8 percent, while
stand-alone computer companies typically have a 12 percent cost of capital. Kemps
restaurant division has the same risk as a typical restaurant company, and its computer
division has the same risk as a typical computer company. Consequently, Kemp estimates that
its composite corporate cost of capital is 10 percent. The companys consultant has suggested
Page 43 of 107

that they use an 8 percent hurdle rate for the restaurant division and a 12 percent hurdle rate
for the computer division. However, Kemp has chosen to ignore its consultant, and instead,
chooses to assign a 10 percent cost of capital to all projects in both divisions. Which of the
following statements is most correct? (M)
a. While Kemps decision to not risk adjust its cost of capital will lead it to accept more
projects in its computer division and fewer projects in its restaurant division, this should
not affect the overall value of the company.
b. Kemps decision to not risk adjust means that it is effectively subsidizing its restaurant
division, which means that its restaurant division is likely to become a larger part of the
overall company over time.
c. Kemps decision to not risk adjust means that the company will accept too many projects
in the computer business and too few projects in the restaurant business. This will lead to
a reduction in the overall value of the company.
Brigham
129
. The Barabas Company has an equal amount of low-risk projects, average-risk projects, and
high-risk projects. Barabas estimates that the overall companys WACC is 12 percent. This is
also the correct cost of capital for the companys average-risk projects. The companys CFO
argues that, even though the companys projects have different risks, the cost of capital for
each project should be the same because the company obtains its capital from the same
sources. If the company follows the CFOs advice, what is likely to happen over time? (M)
a. The company will take on too many low-risk projects and reject too many high-risk
projects.
b. The company will take on too many high-risk projects and reject too many low-risk
projects.
c. Things will generally even out over time, and therefore, the risk of the firm should remain
constant over time.
Brigham
130
. The Oneonta Chemical Company is evaluating two mutually exclusive pollution control
systems. Since the companys revenue stream will not be affected by the choice of control
systems, the projects are being evaluated by finding the PV of each set of costs. The firms
required rate of return is 13 percent, and it adds or subtracts 3 percentage points to adjust for
project risk differences. System A is judged to be a high-risk project (it might end up costing
much more to operate than is expected). System As risk-adjusted cost of capital is(M)
a. 10 percent; this might seem illogical at first, but it correctly adjusts for risk where outflows,
rather than inflows, are being discounted.
CAPITAL BUDGETING
b. 13 percent; the firms cost of capital should not be adjusted when evaluating outflow only
projects.
c. 16 percent; since A is more risky, its cash flows should be discounted at a higher rate,
because this correctly penalizes the project for its high risk.
d. Somewhere between 10 percent and 16 percent, with the answer depending on the
riskiness of the relevant inflows.
e. Indeterminate, or, more accurately, irrelevant, because for such projects we would simply
select the process that meets the requirements with the lowest required investment.
Brigham
Methods of Analyzing Risk
131
. Which of the following is not a method for analyzing risk in capital budgeting? (E)
a. Sensitivity analysis.
b. Beta, or CAPM, analysis.
c. Monte Carlo simulation.
d. Scenario analysis.
e. All of the statements above are methods of analyzing risk in capital budgeting.
Brigham
132

a. Sensitivity analysis is incomplete because it fails to consider the range of likely values of
key variables as reflected in their probability distributions.
b. In comparing two projects using sensitivity analysis, the one with the steeper lines would
be considered less risky, because a small error in estimating a variable, such as unit
sales, would produce only a small error in the projects NPV.
c. The primary advantage of simulation analysis over scenario analysis is that scenario
analysis requires a relatively powerful computer, coupled with an efficient financial
planning software package, whereas simulation analysis can be done using a PC with a
spreadsheet program or even a calculator.
d. Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV
to changes in key variables and the likely range of variable values.
Brigham
Simulation and Sensitivity Analysis

133
. A company is deciding whether to purchase an automated machine to manufacture one of its
products. Expected net cash flows from this decision depend on several factors, interactions
among those factors and the probabilities associated with different levels of those factors. The
method that the company should use to evaluate the distribution of net cash flows from this
decision and changes in net cash flows resulting from changes in levels of various factors is
a. Simulation and sensitivity analysis.
c. Correlation analysis.
Page 44 of 107

b. Linear programming.
CAPITAL BUDGETING
d. Differential analysis.
CIA 1194 III-61
Simulation Analysis
134
. A firm is evaluating a large project. It desires to develop not only the best guess of the
outcome of the project, but also a list (or distribution) of outcomes that might occur. This firm
would best achieve its objective by using
A. The net-present-value (NPV) approach for capital budgeting.
B. The profitability-index approach for capital budgeting.
C. Simulation as applied to capital budgeting.
D. The internal-rate-of-return (IRR) approach for capital budgeting.
CIA 0589 IV-51
135
. A statistical technique used to evaluate possible rates of return for a capital budgeting project
is
A. Regression analysis.
C. Markov chain analysis.
B. Simulation analysis.
D. Gantt charting.
CMA 0689 5-15
A. Sensitivity analysis.
B. Risk analysis.
C. Cost behavior analysis.

CMA 1286 5-4
D. Return on investment analysis.
62. Sensitivity analysis is

a. an appropriate response to uncertainty in cash flow projections.
b. useful in measuring the variance of the Fisher rate.
c. typically conducted in the post investment audit.
d. useful to compare projects requiring vastly different levels of initial investment.
Barfield
139
. Sensitivity analysis is used in capital budgeting to

A. Estimate a project's internal rate of return.
B. Determine the amount that a variable can change without generating unacceptable
results.
C. Simulate probabilistic customer reactions to a new product.
D. Identify the required market share to make a new product viable and produce acceptable
results.
CMA 1293 4-16
136

a. Sensitivity analysis is a good way to measure market risk because it explicitly takes into
account the effects of diversification.
b. One advantage of sensitivity analysis relative to scenario analysis is it explicitly takes into
account the probability of certain effects occurring, whereas scenario analysis does not
take into account probabilities.
c. Simulation analysis is a computerized version of scenario analysis that uses continuous
probability distributions of the input variables.
Brigham
Sensitivity Analysis
137
. Sensitivity analysis, if used with capital projects (M)
a. Is used extensively when cash flows are known with certainty.
b. Measures the change in the discounted cash flows when using the discounted payback
method rather than the net present value method.
c. Is a what-if technique that asks how a given outcome will change if the original estimates
of the capital budgeting model are changed.
d. Is a technique used to rank capital expenditure requests.
CMA 0695 4-2, RPCPA 0596
138
. A manager wants to know the effect of a possible change in cash flows on the net present
value of a project. The technique used for this purpose is
24. In capital budgeting, sensitivity analysis is used

a. To determine whether an investment is profitable.
b. To see how a decision would be affected by changes in variables.
c. To test the relationship of the IRR and NPV.
d. To evaluate mutually exclusive investments.
L&H
17. Which of the following makes investments more desirable than they had been?
a. An increase in income tax rate.
b. An increase in interest rates.
c. An increase in the number of years over which assets must be depreciated.
L&H
28. Which statement could express the results of a sensitivity analysis of an investment decision?
a. The NPV of the project is $50,000.
b. A 5% decline in volume will make the project unprofitable.
c. This project ranks third out of the five available.
d. This project does not meet the cutoff rate of return.
L&H
36. If X Co. expects to get a one-year bank loan to help cover the initial financing of capital project
Q, the analysis of Q should (D)
a. Offset the loan against any investment in inventory or receivables required by the project.
Page 45 of 107

b. Show the loan as an increase in the investment.
c. Show the loan as a cash outflow in the second year of the projects life.
d. Ignore the loan.
CAPITAL BUDGETING
d. increase the project's internal rate of return.
L&H
54. A "what-if" technique that examines how a result will change if the original predicted data are
not achieved or if an underlying assumption changes is called (E)
a. sensitivity analysis.
c. internal rate-of-return analysis. Horngren
b. net present value analysis.
d. adjusted rate-of-return analysis.
Monte Carlo simulation
140
. Monte Carlo simulation(M)
a. Can be useful for estimating a projects stand-alone risk.
b. Is capable of using probability distributions for variables as input data instead of a single
numerical estimate for each variable.
c. Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or
IRR.
Brigham
Net Investment
64. All other factors equal, which of the following would affect a project's internal rate of return, net
present value, and payback period? (M)
a. an increase in the discount rate
c. an increase in the initial cost of the project
b. a decrease in the life of the project
d. all of the above
Barfield
Tax Effect on Transactions
Change in Depreciation Rate
27. If the tax law were changed so that owners of apartment buildings had to depreciate them over
50 years instead of the current 31.5 years,
a. Rents would rise.
b. Rents would fall because annual depreciation charges would fall.
c. Rents would stay about the same.
d. More people would invest in apartment buildings.
L&H
47. For a profitable company, an increase in the rate of depreciation on a specific project could
a. increase the project's profitability index.
b. increase the project's payback period.
c. decrease the project's net present value.
Barfield
Depreciation and Savings on Cash Operating Costs

41. If depreciation of a new asset exceeds its savings in cash operating costs, which of the
following is true?
a. The project is usually unacceptable.
b. The annual after-tax cash flow on the new asset will be greater than the savings in cash
operating costs.
c. The project has a negative NPV.
L&H
Sale of Old Plant Assets
26. Because of idle capacity, a company is considering two assets for sale. They are identical in
all respects except that asset A has a higher tax basis than asset B. Only one need be sold
now and the market price is the same for both assets. Which of the following is true?
a. The cash flow is greater from selling asset A.
b. The cash flow is greater from selling asset B.
c. The cash flow is the same no matter which one is sold.
d. It is not possible to determine how the cash flows from sale of the assets will differ. L & H
Sale of Old Plant Asset at a Loss
51. When a profitable corporation sells an asset at a loss, the after-tax cash flow on the sale will
(D)
a. exceed the pre-tax cash flow on the sale.
b. be less than the pre-tax cash flow on the sale.
c. be the same as the pre-tax cash flow on the sale.
d. increase the corporation's overall tax liability.
Barfield
50. As the marginal tax rate goes up, the benefit from the depreciation tax shield
a. decreases.
b. increases.
c. stays the same.
Barfield
d. can move up or down depending on whether the firm's cost of capital is high or low.
Payback Period
In general
6. All other factors equal, a large number is preferred to a smaller number for all capital project
evaluation measures except (E)
Page 46 of 107

a. net present value.
b. payback period.
CAPITAL BUDGETING
c. internal rate of return.
d. profitability index.
Barfield
26. Risk can be controlled in capital budgeting situations by assuming a:

A. high accounting rate of return
C. high net income
B. large net present value
D. short payback period
CIA adapted
3. In comparing two projects, the _______ is often used to evaluate the relative riskiness of the
projects. (D)
a. payback period
d. discount rate
Barfield
Effect of Cash Flow
28. An investment project that requires a present investment of $210,000 will have cash inflows of
"R" dollars each year for the next five years. The project will terminate in five years. Consider
the following statements (ignore income tax considerations):
I. If "R" is less than $42,000, the payback period exceeds the life of the project.
II. If "R" is greater than $42,000, the payback period exceeds the life of the project.
III. If "R" equals $42,000, the payback period equals the life of the project. (M)
Which statement(s) is (are) true?
a. Only I and II.
c. Only II and III.
b. Only I and III.
d. I, II, and III.
G & N 9e
Relative Profitability
24. Investment A has a payback period of 5.4 years, investment B one of 6.7 years. From this
information we can conclude
a. That investment A has a higher NPV than B.
b. That investment A has a higher IRR than B.
c. That investment As book rate of return is higher than Bs.
L&H
9. If investment A has a payback period of three years and investment B has a payback period of
four years, then
a. A is more profitable than B.
b. A is less profitable than B.
c. A and B are equally profitable.
Barfield
d. the relative profitability of A and B cannot be determined from the information given.

25. Investment A has a book rate of return of 26%, investment B one of 18%. From this
information we can conclude
a. That investment A has a higher NPV than B.
b. That investment A has a higher IRR than B.
c. That investment A has a shorter payback period than B.
L&H
Discount Rate
Effect of Change in Acceptability of Projects
10. All other things being equal, as cost of capital increases
a. More capital projects will probably be acceptable.
b. Fewer capital projects will probably be acceptable.
c. The number of capital projects that are acceptable will change, but the direction of the
change is not determinable just by knowing the direction of the change in cost of capital.
d. The company will probably want to borrow money rather than issue stock.
L&H
Effect on Payback Period, Profitability Index & Accounting Rate of Return
*. Payback period (PP), profitability index (PI), and simple accounting rate of return (SARR) are
some of the capital budgeting techniques. What is the effect of an increase in the cost of
capital on these techniques? (M)
RPCPA 0594
a.
b.
c.
d.
PP
Increase
No change
No change
Decrease
PI
Decrease
Decrease
Increase
No change
SARR
Increase
No change
Decrease
No change
Present Value Factors
Effect of Discount Rate
30. As the discount rate increases
a. Present value factors increase.
b. Present value factors decrease.
c. Present value factors remain constant.
d. It is impossible to tell what happens to present value factors.
L&H
Effect of Length of an Annuity

31. As the length of an annuity increases
a. Present value factors increase.
b. Present value factors decrease.
Page 47 of 107

c. Present value factors remain constant.
d. It is impossible to tell what happen to present value factors.
CAPITAL BUDGETING
L&H
96. All other things being equal, as the time period for receiving an annuity lengthens,
a. the related present value factors increase.
b. the related present value factors decrease.
c. the related present value factors remain constant.
Barfield
d. it is impossible to tell what happens to present value factors from the information given.
Net Present Value
Factors Affecting Net Present Value
54. The after-tax net present value of a project is affected by
a. tax-deductible cash flows.
c. accounting accruals.
b. non-tax-deductible cash flows.
d. all of the above.
Barfield
17. Which of the following events will increase the NPV of an investment involving a new product?
a. An increase in the income tax rate.
b. An increase in the expected per-unit variable cost of the product.
c. An increase in the expected annual unit volume of the product.
d. A decrease in the expected salvage value of equipment.
L&H
55. A project's after-tax net present value is increased by all of the following except
a. revenue accruals.
c. depreciation deductions.
b. cash inflows.
d. expense accruals.
Barfield
Change in Discount Rate

24. A change in the discount rate used to evaluate a specific project will affect the project's
a. life.
c. net present value.
b. payback period.
d. total cash flows.
Barfield
141
. The net present value (NPV) of a project has been calculated to be $215,000. Which one of
the following changes in assumptions would decrease the NPV? (M)
a. Decrease the estimated effective income tax rate.
b. Decrease the initial investment amount.
c. Extend the project life and associated cash inflows.
d. Increase the discount rate.
CMA 1295 4-7
16. An increase in the discount rate: (M)

a.
b.
c.
d.
will increase the present value of future cash flows.

will have no effect on net present value.
will reduce the present value of future cash flows.
is one method of compensating for reduced risk.
G & N 9e
22. Which of the following changes would not decrease the present value of the future
depreciation deductions on a specific depreciable asset? (D)
a. a decrease in the marginal tax rate
b. a decrease in the discount rate
c. a decrease in the rate of depreciation
d. an increase in the life expectancy of the depreciable asset
Barfield
17. Suppose an investment has cash inflows of R dollars at the end of each year for two years.
The present value of these cash inflows using a 12% discount rate will be: (M)
a. greater than under a 10% discount rate.
b. less than under a 10% discount rate.
c. equal to that under a 10% discount rate.
G & N 9e
d. sometimes greater than under a 10% discount rate and sometimes less; it depends on R.
24. A firm is evaluating a project that has a net present value of $0 when a discount rate of 8% is
used. A discount rate of 10% will result in
a. a negative net present value
b. a positive net present value
c. a net present value of $0
d. The question cannot be answered based upon the information provided.
H&M
27. A firm is evaluating a project that has a net present value of $0 when a discount rate of 8% is
used. A discount rate of 6% will result in
a. a negative net present value
b. a positive net present value
c. a net present value of $0
d. The question cannot be answered based upon the information provided.
H&M
12. Which of the following would decrease the net present value of a project?
A. A decrease in the income tax rate.
B. A decrease in the initial investment.
C. An increase in the useful life of the project.
D. An increase in the discount rate.
Pol Bobadilla
Page 48 of 107

142
. Other things held constant, which of the following would increase the NPV of a project being
considered? (E)
a. A shift from MACRS to straight-line depreciation.
b. Making the initial investment in the first year rather than spreading it over the first three
years.
c. A decrease in the discount rate associated with the project.
d. An increase in required net operating working capital.
e. All of the statements above will increase the projects NPV.
Brigham
*.
*.
You have determined the profitability of a planned project by finding the present value of all the
cash flows from that project. Which of the following would cause the project to look less
appealing, that is, have a lower present value? (M)
a. The discount rate increases.
b. The cash flows are extended over a longer period of time.
c. The investment cost decreases without affecting the expected income and life of the
project.
RPCPA 0595
d. The cash flows are accelerated and the project life is correspondingly shortened.
Velasquez & Co. is considering an investment proposal for P10 million yielding a net present
value of P450,000. The project has a life of 7 years with salvage value of P200,000. The
company uses a discount rate of 12%. Which of the following would decrease the net present
value? (M)
a. Extend the project life and associated cash inflows.
b. Increase discount rate to 15%.
c. Decrease the initial investment amount to P9.0 million.
d. Increase the salvage value.
RPCPA 0597
Effect of Salvage Value

34. The salvage value of an old lathe is zero. If instead, the salvage value of the old lathe was
$20,000, what would be the impact on the net present value of the proposal to purchase a new
lathe? (M)
a. It would increase the net present value of the proposal.
b. It would decrease the net present value of the proposal.
c. It would not affect the net present value of the proposal.
d. Potentially it could increase or decrease the net present value of the new lathe. Barfield
Timing of Cash Flow Stream
CAPITAL BUDGETING
22. Two new products, X and Y, are alike in every way except that the sales of X will start low and
rise throughout its life, while those of Y will be the same each year. Total volumes over their
five-year lives will be the same, as will selling prices, unit variable costs, cash fixed costs, and
investment. The NPV of product X
a. Will be less than that of product Y.
c. Will be greater than that of product Y.
b. Will be the same as that of product Y.
L&H
Income Tax Rate
6. Which of the following events is most likely to reduce the expected NPV of an investment?
a. The major competitor for the product to be manufactured with the machinery being
considered for purchase has been rated unsatisfactory by a consumer group.
b. The interest rate on long-term debt declines.
c. The income tax rate is raised by the Congress.
d. Congress approves the use of faster depreciation than was previously available.
L&H
Expected Returns
143
. Stock C has a beta of 1.2, while Stock D has a beta of 1.6. Assume that the stock market is
efficient. Which of the following statements is most correct? (E)
a. The required rates of return of the two stocks should be the same.
b. The expected rates of return of the two stocks should be the same.
c. Each stock should have a required rate of return equal to zero.
d. The NPV of each stock should equal its expected return.
e. The NPV of each stock should equal zero.
Brigham
NPV profiles
144
. If the net present value profiles for two mutually exclusive capital projects are shaped as in the
graph below, which of the following statements is true?
$
NPV Profile
for Project 2
Cost of
Capital %
NPV Profile for Project 1

a. Project 2 has a higher internal rate of return that Project 1.
b. Project 1 has a higher internal rate of return than Project 2.
Page 49 of 107
CAPITAL BUDGETING
c. Project 1 has a higher net present value than Project 2.

d. Project 2 has a higher net present value than Project 1.
43 Projects A and B have the same expected lives and initial cash outflows. However, one
projects cashNPV
flows are larger in the early years, while the other project has larger cash flows
in the later years. The two NPV profiles are given below:
A
Which of the following statements is most correct? (E)

a. Project A has the smaller cash flows in the later years.
b. Project A has the larger cash flows in the later years.
c. We require information on the cost of capital in order to determine which project has larger
early cash flows.
d. The NPV profile graph is inconsistent with the statement made in the problem.
Brigham
145
. Projects A and B both have normal cash flows. In other words, there is an up-front cost
followed over time by a series of positive cash flows. Both projects have the same risk and a
WACC equal to 10 percent. However, Project A has a higher internal rate of return than Project
B. Assume that changes in the WACC have no effect on the projects cash flow levels. Which
of the following statements is most correct? (E)
a. Project A must have a higher net present value than Project B.
b. If Project A has a positive NPV, Project B must also have a positive NPV.
c. If Project As WACC falls, its internal rate of return will increase.
d. If Projects A and B have the same NPV at the current WACC, Project B would have a
higher NPV if the WACC of both projects was lower.
Brigham
146
. Cherry Books is considering two mutually exclusive projects. Project A has an internal rate of
return of 18 percent, while Project B has an internal rate of return of 30 percent. The two
projects have the same risk, the same cost of capital, and the timing of the cash flows is
similar. Each has an up-front cost followed by a series of positive cash flows. One of the
projects, however, is much larger than the other. If the cost of capital is 16 percent, the two
projects have the same net present value (NPV); otherwise, their NPVs are different. Which of
the following statements is most correct? (E)
a. If the cost of capital is 12 percent, Project B will have a higher NPV.
b. If the cost of capital is 17 percent, Project B will have a higher NPV.
c. Project B is larger than Project A.
Brigham
5. Projects L and S each have an initial cost of $10,000, followed by a series of positive cash
inflows. Project L has total, undiscounted cash inflows of $16,000, while S has total
undiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects
have identical NPVs. Which projects NPV will be more sensitive to changes in the discount
rate? (Hint: Projects with steeper NPV profiles are more sensitive to discount rate changes.)
(M)
a. Project S.
b. Project L.
c. Both projects are equally sensitive to changes in the discount rate since their NPVs are
equal at all costs of capital.
d. Neither project is sensitive to changes in the discount rate, since both have NPV profiles
which are horizontal.
e. The solution cannot be determined unless the timing of the cash flows is known. Brigham
6. Two mutually exclusive projects each have a cost of $10,000. The total, undiscounted cash
flows from Project L are $15,000, while the undiscounted cash flows from Project S total
$13,000. Their NPV profiles cross at a discount rate of 10 percent. Which of the following
statements best describes this situation? (M)
a. The NPV and IRR methods will select the same project if the cost of capital is greater
than 10 percent; for example, 18 percent.
b. The NPV and IRR methods will select the same project if the cost of capital is less than 10
percent; for example, 8 percent.
c. To determine if a ranking conflict will occur between the two projects the cost of capital is
needed as well as an additional piece of information.
d. Project L should be selected at any cost of capital, because it has a higher IRR.
e. Project S should be selected at any cost of capital, because it has a higher IRR. Brigham
Page 50 of 107
CAPITAL BUDGETING
However, if they have identical cash flow patterns, then the one with the steeper profile
probably has the lower initial cost.
Brigham
e. If the two projects both have a single outlay at t = 0, followed by a series of positive cash
inflows, and if their NPV profiles cross in the lower left quadrant, then one of the projects
should be accepted, and both would be accepted if they were not mutually exclusive.
147
. A company is comparing two mutually exclusive projects with normal cash flows. Project P
has an IRR of 15 percent, while Project Q has an IRR of 20 percent. If the WACC is 10
percent, the two projects have the same NPV. Which of the following statements is most
correct? (M)
a. If the WACC is 12 percent, both projects would have a positive NPV.
b. If the WACC is 12 percent, Project Q would have a higher NPV than Project P.
c. If the WACC is 8 percent, Project Q would have a lower NPV than Project P.
Brigham
148
. Project C and Project D are two mutually exclusive projects with normal cash flows and the
same risk. If the WACC were equal to 10 percent, the two projects would have the same
positive NPV. However, if the WACC < 10%, Project C has a higher NPV, whereas if the
WACC > 10%, Project D has a higher NPV. On the basis of this information, which of the
a. Project D has a higher IRR, regardless of the cost of capital.
b. If the WACC < 10%, Project C has a higher IRR.
c. If the WACC < 10%, Project Ds MIRR is less than its IRR.
Brigham
7. Your assistant has just completed an analysis of two mutually exclusive projects. You must
now take her report to a board of directors meeting and present the alternatives for the boards
consideration. To help you with your presentation, your assistant also constructed a graph with
NPV profiles for the two projects. However, she forgot to label the profiles, so you do not know
which line applies to which project. Of the following statements regarding the profiles, which
one is most reasonable? (D)
a. If the two projects have the same investment cost, and if their NPV profiles cross once in
the upper right quadrant, at a discount rate of 40 percent, this suggests that a NPV versus
IRR conflict is not likely to exist.
b. If the two projects NPV profiles cross once, in the upper left quadrant, at a discount rate
of minus 10 percent, then there will probably not be a NPV versus IRR conflict,
irrespective of the relative sizes of the two projects, in any meaningful, practical sense
(that is, a conflict which will affect the actual investment decision).
c. If one of the projects has a NPV profile which crosses the X-axis twice, hence the project
appears to have two IRRs, your assistant must have made a mistake.
d. Whenever a conflict between NPV and IRR exist, then, if the two projects have the same
initial cost, the one with the steeper NPV profile probably has less rapid cash flows.
Cross-Over Rate or Fisher Rate

149
. Project A and Project B are mutually exclusive projects with equal risk. Project A has an
internal rate of return of 12 percent, while Project B has an internal rate of return of 15 percent.
The two projects have the same net present value when the cost of capital is 7 percent. (In
other words, the crossover rate is 7 percent.) Which of the following statements is most
correct? (E)
a. If the cost of capital is 10 percent, each project will have a positive net present value.
b. If the cost of capital is 6 percent, Project B has a higher net present value than Project A.
c. If the cost of capital is 13 percent, Project B has a higher net present value than Project A.
e. Statements a and c are correct.
Brigham
150
. Sacramento Paper is considering two mutually exclusive projects. Project A has an internal
rate of return (IRR) of 12 percent, while Project B has an IRR of 14 percent. The two projects
have the same risk, and when the cost of capital is 7 percent the projects have the same net
present value (NPV). Assume each project has an initial cash outflow followed by a series of
inflows. Given this information, which of the following statements is most correct? (E)
a. If the cost of capital is 13 percent, Project Bs NPV will be higher than Project As NPV.
b. If the cost of capital is 9 percent, Project Bs NPV will be higher than Project As NPV.
c. If the cost of capital is 9 percent, Project Bs modified internal rate of return (MIRR) will be
less than its IRR.
Brigham
Profitability Index
*. What is the effect of changes in cash inflows, investment cost and cash outflows on profitability
(present value) index (PI) (M)
a. PI will increase with an increase in cash inflows, a decrease in investment cost, or a
decrease in cash outflows.
b. PI will increase with an increase in cash inflows, an increase in investment cost, or an
increase in cash outflows.
Page 51 of 107
CAPITAL BUDGETING
c. PI will decrease with an increase in cash inflows, a decrease in investment cost, or a

decrease in cash outflows.
d. PI will decrease with an increase in cash outflows, an increase in investment cost, or an
increase in cash inflows.
RPCPA 0594
IRR of Zero
40. If the IRR on an investment is zero,
a. Its NPV is positive.
b. Its annual cash flows equal its required investment.
c. It is generally a wise investment.
d. Its cash flows decrease over its life.
L&H
Timing of Cash Flow Stream

151
. Everything else being equal, the internal rate of return (IRR) of an investment project will be
lower if (M)
a. The investment cost is lower.
b. Cash inflows are received later in the life of the project.
c. Cash inflows are larger.
d. The project has a shorter payback period.
CIA 0595 IV-37
Cash Outflow and Cash Inflow
43. If the total cash inflows associated with a project exceed the total cash outflows associated
with the project, the project's (D)
a. net present value is greater than zero.
b. internal rate of return is greater than zero.
c. profitability index is greater than 1.
d. payback period is acceptable.
Barfield
NPV and IRR
Change in Sales and Cost of Capital
*. You are engaged by the Baquis Co. to evaluate the introduction of a new product line with an
innovative packaging. You computed the net present value (NPV) and internal rate of return
(IRR). If your client would reduce the estimate for its sales of the new product and increase
the projected cost of capital, what would be the impact of these revisions on NPV and IRR?
(M)
RPCPA 1094
a. NPV will increase, IRR will increase.
c. NPV will increase, IRR will decrease.
b. NPV will decrease, IRR will increase.
d. NPV will decrease, IRR will decrease.
36. Which of the following factors increase NPV and IRR?

a. An upward revision in expected annual cash flows.
b. An upward revision of expected life.
c. An upward revision of the residual value of the long-lived assets being acquired for the
project.
L&H
NPV, IRR, and MIRR
17 Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other
cash flows are positive). Which of the following statements is most correct? (M)
a. All else equal, a projects IRR increases as the cost of capital declines.
b. All else equal, a projects NPV increases as the cost of capital declines.
c. All else equal, a projects MIRR is unaffected by changes in the cost of capital.
Brigham
NPV & Market Value of Stocks
152
. If a firm identifies (or creates) an investment opportunity with a present value <List A> its cost,
the value of the firm and the price of its common shares will <List B>.
CIA 1195 IV-44
A.
B.
C.
D.
List A
Greater than
Greater than
Equal to
Equal to
List B
Increase
Decrease
Increase
Decrease
153
. The economic value of the firm will rise following an increase in

A. Net cash flow.
C. Unsystematic risk.
B. Systematic risk.
D. The discount rate.
Comprehensive
33. Which of the following is true of an investment?
a. The lower the cost of capital, the higher the NPV.
b. The lower the cost of capital, the higher the IRR.
c. The longer the projects life, the shorted its payback period.
d. The higher the projects NPV, the shorter its life.
CIA 0591 IV-47
L&H
154
. Lieber Technologies is considering two potential projects, Project X and Project Y. In assessing
the projects risk, the company has estimated the beta of each project and has also conducted
a simulation analysis. Their efforts have produced the following numbers:
Project X
Project Y
Page 52 of 107

Expected NPV
Standard deviation (NPV)
Estimated project beta
Estimated correlation of
projects cash flows with the
cash flows of the Companys
existing projects.
CAPITAL BUDGETING
$350,000
$100,000
1.4
Cash flows are not highly
correlated with the cash
flows of the existing
projects.
$350,000
$150,000
0.8
Cash flows are highly
correlated with the cash
flows of the existing
projects.
Which of the following statements is most correct? (E)

a. Project X has a higher level of stand-alone risk relative to Project Y.
b. Project X has a higher level of corporate risk relative to Project Y.
c. Project X has a higher level of market risk relative to Project Y.
PROJECT EVALUATION & SELECTION
Categories of Projects
5. A firm might categorize its projects into:
A. Cost improvement projects
B. Expansion projects (existing business)
C. New products projects
3. If a firm uses the same company cost of capital for evaluating all projects, which of the
following is likely?
A. Accepting poor low risk projects.
C. Both A and B
B. Rejecting good high risk projects
D. Neither A nor B
B&M
4. Using the company cost of capital to evaluate a project is:
A. Always correct
B. Always incorrect
C. Correct for projects that are about as risky as the average of the firm's other assets
B&M
Brigham
D. Speculative ventures
E. All of the above
B&M
6. Which of the following types of projects have the highest risk?

A. Speculation ventures
C. Expansion of existing business
B&M
B. New products
D. Cost improvement, (known technology)
7. Which of the following type of projects has the lowest risk?
B. New products
D. Cost improvement
B&M
8. Which of the following type of projects has average risk?

B. New products
D. Cost improvement
B&M
Cost of Capital Consideration

2. If a firm uses the same company cost of capital for evaluating all projects, which of the
following is likely?
A. Rejecting good low risk projects
C. Both A and B
B. Accepting poor high risk projects
D. Neither A nor B
B&M
Project Analysis
1. Project analysis includes the following procedures:
A. Sensitivity analysis
C. Monte Carlo simulation
B. Break-even analysis
D. All of the above
B&M
Break-even Analysis
16. Firms often calculate a project's break-even sales using book earnings. Generally, break-even
sales based on NPV is:
A. Higher than the one calculated using book earnings
B. Lower than the one calculated using book earnings
C. Equal to the one calculated using book earnings
B&M
Decision Tree
32. Which of the following statements applied to decision trees?
A. They are simple to construct and analyze
B. They should include all possible future events and decisions
C. They help the financial manager to assess the value of options to abandon or expand the
project
D. All of the above
B&M
Simulation Models
2. Simulation models are useful:
A. To understand the project better
B. To forecast expected cash flows
C. To assess the project risk

D. All of the above
B&M
Page 53 of 107

23. Generally, the simulation models for projects are developed using a:
A. Computer
C. Pair of dice
B. Roulette wheel
D. Pack of cards
28. The hardest and most important part of a simulation is:
A. Simulating the cash flows
B. Specifying the inter-dependencies
C. Specifying probabilities
D. Specifying the numbers on the roulette wheel
CAPITAL BUDGETING
B&M
B&M
20. Which of the following simulation outputs is likely to be most useful and easy to interpret? The
output shows the distribution(s) of the project:
A. Earnings
C. Cash flows
D. Profits
B&M
21. The following statements about simulation models are true except:
A. Simulation models enable the financial manager to analyze risky projects without
estimating the approximate cost of capital
B. Simulation models are complex and expensive to develop
C. Simulation models are specific to the project and every project requires a new simulation
model
D. Simulation models usually ignore opportunities to expand or abandon the project B & M
22. The following statements about simulation models are true except:
A. Simulation models enable the financial manager to analyze what would happen if the
uncertainty about any of the variables were reduced
B. Simulation models take into account the interdependencies between different time periods
C. Simulation models are easy to understand and communicate
D. Simulation models enable the financial manager to visualize how outcomes may be
affected if the project is modified
B&M
Monte Carlo Simulation
19. Monte Carlo simulation is a tool for considering the:
A. Effect of changing one variable on the NPV of the project
B. Effect of changing a limited number of plausible combination of variables on the NPV of
the project
C. Effect of changing all possible combinations of variables on the NPV of the project
B&M
24. Monte Carlo simulation is likely to be most useful:

A. If small amounts of funds are at stake
B. If large amounts of funds are at stake
C. If moderate amounts of funds are at stake
D. Regardless of amount at stake
B&M
25. Monte Carlo simulation is likely to be most useful:

A. For simple problems
B. For problems of moderate complexity
C. For very complex problems
D. Regardless of the problem's complexity
B&M
26. There are three steps involved in Monte Carlo simulations. One of the following is not one of
them:
A. Modeling the project
C. Modeling the strategy
B. Specifying probabilities
D. Simulating the cash flows
B&M
27. The following is not among the steps involved in the Monte Carlo method:
A. Modeling the project
B. Specifying the numbers on the roulette wheel
C. Specifying probabilities
D. Simulating the cash flows
B&M
29. The pharmaceutical companies have used the following method to analyze investments in
R&D (research and development) of new drugs:
A. Monte Carlo Simulation
C. Sensitivity analysis
B. Decision trees
B&M
30. The pharmaceutical companies face three types of uncertainty. They are the following except:
A. Scientific and clinical
C. Bureaucratic
B. Production and distribution
D. Market success
B&M
31. According to the simulation model used by Merck and Company, the following types of
variables are used in their model except:
A. Research and development
B. Manufacturing variables
C. Marketing variables
Page 54 of 107

D. FDA (Food and Drug Administration) variables
CAPITAL BUDGETING
B&M
Basis for Decision

3. After the completion of project analysis, the final decision on the project would be from:
A. Sensitivity analysis
C. Decision trees
B. Break-even analysis
D. NPV
B&M
Page 55 of 107
CAPITAL BUDGETING
Page 56 of 107

155
. Moynihan Motors has a cost of capital of 10.25 percent. The firm has two normal projects of
equal risk. Project A has an internal rate of return of 14 percent, while Project B has an
internal rate of return of 12.25 percent. Which of the following statements is most correct? (E)
a. Both projects have a positive net present value.
b. If the projects are mutually exclusive, the firm should always select Project A.
c. If the crossover rate (that is, the rate at which the Projects NPV profiles intersect) is 8
percent, Project A will have a higher net present value than Project B.
e. Statements a and c are correct.
Brigham
156
. A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of
the following independent projects should the company accept? (M)
a. Project A requires an up-front expenditure of $1,000,000 and generates a net present
value of $3,200.
b. Project B has a modified internal rate of return of 9.5 percent.
c. Project C requires an up-front expenditure of $1,000,000 and generates a positive internal
rate of return of 9.7 percent.
d. Project D has an internal rate of return of 9.5 percent.
Brigham
157
. Project A has an internal rate of return of 18 percent, while Project B has an internal rate of
return of 16 percent. However, if the companys cost of capital (WACC) is 12 percent, Project
B has a higher net present value. Which of the following statements is most correct? (D)
a. The crossover rate for the two projects is less than 12 percent.
b. Assuming the timing of the two projects is the same, Project A is probably of larger scale
than Project B.
c. Assuming that the two projects have the same scale, Project A probably has a faster
payback than Project B.
Brigham

11. Assume that you are comparing two mutually exclusive projects. Which of the following
statements is most correct? (M)
a. The NPV and IRR rules will always lead to the same decision unless one or both of the
projects are non-normal in the sense of having only one change of sign in the cash flow
CAPITAL BUDGETING
stream, that is, one or more initial cash outflows (the investment) followed by a series of
cash inflows.
b. If a conflict exists between the NPV and the IRR, the conflict can always be eliminated by
dropping the IRR and replacing it with the MIRR.
c. There will be a meaningful (as opposed to irrelevant) conflict only if the projects NPV
profiles cross, and even then, only if the cost of capital is to the left of (or lower than) the
discount rate at which the crossover occurs.
Brigham
158
. Jurgensen Medical is considering two mutually exclusive projects with the following
characteristics:
The two projects have the same risk and the same cost of capital.
Both projects have normal cash flows. Specifically, each has an up-front cost followed by
a series of positive cash flows.
If the cost of capital is 12 percent, Project Xs IRR is greater than its MIRR.
If the cost of capital is 12 percent, Project Ys IRR is less than its MIRR.
If the cost of capital is 10 percent, the two Projects have the same NPV.
Which of the following statements is most correct? (M)
a. Project Xs IRR is greater than 12 percent.
b. Project Ys IRR is less than 12 percent.
c. If the cost of capital is 8 percent, Project X has a lower NPV than Project Y.
Brigham
Ranking methods
159
a. Because discounted payback takes account of the cost of capital, a projects discounted
payback is normally shorter than its regular payback.
b. The NPV and IRR methods use the same basic equation, but in the NPV method the
discount rate is specified and the equation is solved for NPV, while in the IRR method the
NPV is set equal to zero and the discount rate is found.
c. If the cost of capital is less than the crossover rate for two mutually exclusive projects
NPV profiles, a NPV/IRR conflict will not occur.
d. If you are choosing between two projects which have the same life, and if their NPV
profiles cross, then the smaller project will probably be the one with the steeper NPV
profile.
e. If the cost of capital is relatively high, this will favor larger, longer-term projects over
smaller, shorter-term alternatives because it is good to earn high rates on larger amounts
Page 57 of 107

over longer periods.
CAPITAL BUDGETING
Brigham
a. There can never be a conflict between NPV and IRR decisions if the decision is related to
a normal, independent project, that is, NPV will never indicate acceptance if IRR indicates
rejection.
b. To find the MIRR, we first compound CFs at the regular IRR to find the TV, and then we
discount the TV at the cost of capital to find the PV.
c. The NPV and IRR methods both assume that cash flows are reinvested at the cost of
capital. However, the MIRR method assumes reinvestment at the MIRR itself.
d. If you are choosing between two projects which have the same cost, and if their NPV
profiles cross, then the project with the higher IRR probably has more of its cash flows
coming in the later years.
Brigham
e. A change in the cost of capital would normally change both a projects NPV and its IRR.
160
. In comparing two mutually exclusive projects of equal size and equal life, which of the
a. The project with the higher NPV may not always be the project with the higher IRR.
b. The project with the higher NPV may not always be the project with the higher MIRR.
c. The project with the higher IRR may not always be the project with the higher MIRR.
Brigham
Ranking conflicts
26 Which of the following statements is most correct? (E)
a. The NPV method assumes that cash flows will be reinvested at the cost of capital while
the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate while the
IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the cost of capital while
the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider the inflation premium.
e. The IRR method does not consider all relevant cash flows, and particularly cash flows
beyond the payback period.
Brigham
Comprehensive
18 Which of the following statements is most correct? (D)
a. When dealing with independent projects, discounted payback (using a payback
requirement of 3 or less years), NPV, IRR, and modified IRR always lead to the same
accept/reject decisions for a given project.
b. When dealing with mutually exclusive projects, the NPV and modified IRR methods
always rank projects the same, but those rankings can conflict with rankings produced by
the discounted payback and the regular IRR methods.
c. Multiple rates of return are possible with the regular IRR method but not with the modified
IRR method, and this fact is one reason given by the textbook for favoring MIRR (or
modified IRR) over IRR.
Brigham
Decision-Making
161
. Which of the following statements is correct? (D)
162
. In an operational audit of the finance department, the auditor observed that the department
always used proper quantitative techniques based on sound economic assumptions to
evaluate proposed alternative capital investments. However, management did not always
choose the investment option with the most favorable quantitative assessment. In fact,
sometimes management opted for what appeared to be the third or fourth most favorable
investment. The chief financial officer indicated that management ultimately makes a
subjective decision as to which investment is best regardless of which investment option looks
best according to the quantitative analysis. Which of the following statements is most
accurate?
A. The approach is justifiable if the economic results of capital investments are highly
uncertain.
B. The approach is an irrational, intuitive decision process.
C. The approach results in the organization not maximizing its profits.
D. The approach is an example of the bounded rationality model of decision making whereby
managers simplify problems.
CIA 1195 II-4
COMPREHENSIVE
*. In capital budgeting decision, the following are relevant statements except: (E)
a. Since resources are scarce, all capital expenditures must be ranked according to priority.
b. The company must be able to define what falls under this category, whether they are for
expansion, for replacements, or for improvements in operations.
c. Capital investments are short-term commitments of resources, and they are decided in the
same process as operating expenses/
d. A careful analysis of the economic and non-economic reasons or justifications for these
investments must be made to arrive at the appropriate decision.
RPCPA 0593
Page 58 of 107

*.
Which of the following statements is correct? (E)

a. One key shortcoming of discounted cash flow method is that they ignore the recovery of
original investment.
b. Although a cash outlay for noncurrent asset such as a machine would be considered in a
capital budgeting analysis, a cash outlay for working capital item such as inventory would
not be considered.
c. To be acceptable, a projects time adjusted rate of return cannot be less than the
companys cost of capital.
d. If the net present value of an investment is zero, then the project should be rejected since
it is not providing any return on investment.
RPCPA 1095
*.
Which of the following statements is False? (M)

a. The net present value (NPV) of a project with cash flows that come in relatively slowly is
more sensitive to changes in the discount rate than is the NPV of a project with cash flows
that come in rapidly.
b. Other things held constant, a decrease in the cost of capital (discount rate) will cause an
increase in a projects internal rate of return.
c. The IRR method can be used in place of the NPV method for all independent projects
because the two methods then result in identical decisions.
d. The NPV method is preferred over the IRR method because the NPV methods
reinvestment rate assumption is the correct assumption.
RPCPA 0595
163
. Which of the following is most correct? (M)

a. The NPV and IRR rules will always lead to the same decision in choosing between
mutually exclusive projects, unless one or both of the projects are non-normal in the
sense of having only one change of sign in the cash flow stream.
b. The Modified Internal Rate of Return (MIRR) compounds cash outflows at the cost of
capital.
c. Conflicts between NPV and IRR rules arise in choosing between two mutually exclusive
projects (that each have normal cash flows) when the cost of capital exceeds the
crossover point (that is, the point at which the NPV profiles cross).
d. The discounted payback method overcomes the problems that the payback method has
with cash flows occurring after the payback period.
Brigham
164
CAPITAL BUDGETING
a. The IRR method is appealing to some managers because it produces a rate of return
upon which to base decisions rather than a dollar amount like the NPV method.
b. The discounted payback method solves all the problems associated with the payback
method.
c. For independent projects, the decision to accept or reject will always be the same using
either the IRR method or the NPV method.
Brigham
165

a. One of the disadvantages of choosing between mutually exclusive projects on the basis of
the discounted payback method is that you might choose the project with the faster
payback period but with the lower total return.
b. Multiple IRRs can occur in cases when project cash flows are normal, but they are more
common in cases where project cash flows are nonnormal.
c. When choosing between mutually exclusive projects, managers should accept all projects
with IRRs greater than the weighted average cost of capital.
Brigham
166
. Normal projects C and D are mutually exclusive. Project C has a higher net present value if
the WACC is less than 12 percent, whereas Project D has a higher net present value if the
WACC exceeds 12 percent. Which of the following statements is most correct? (M)
a. Project D has a higher internal rate of return.
b. Project D is probably larger in scale than Project C.
c. Project C probably has a faster payback.
Brigham
MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)

MACRS accelerated depreciation rates should be given for many of these problems. These rates
are provided in the text in Appendix 12A.
ACRS
15. The system for recovering the cost of capital expenditures through federal income tax
deductions that was required for tangible, depreciable property placed in service after 1980 is
known as:
A. MACRS
C. ACRS
Page 59 of 107

B. 200% declining balance
CAPITAL BUDGETING
D. 150% declining balance
Carter & Usry
MACRS
16. Under the Tax Reform Act of 1986, the system that increased the number of property classes
and lengthened the recovery periods of most kinds of depreciable property is known as:
A. MACRS
C. ACRS
B. 200% declining balance
D. 150% declining balance
Carter & Usry
21. When computing depreciation deductions under the MACRS system, taxpayers must: (M)
a. use the half-year convention under which taxpayers are allowed to take only a half year's
depreciation in the first year of an asset's life.
b. use the half-year convention under which taxpayers are allowed to take only a half year's
depreciation in the last year of an asset's life.
c. use the half-year convention under which taxpayers are allowed to take only a half year's
depreciation in the first and last years of an asset's life.
d. calculate depreciation for partial periods using the exact number of days if the asset is
acquired at some time other than the beginning or end of the fiscal year.
G & N 9e
20. Under MACRS, the depreciation on tangible personal property is computed as if the property
were placed into service at the:
A. beginning of the year
C. midpoint of the year
B. end of the year
D. midpoint of the month
Carter & Usry
21. Under MACRS, the depreciation on real property is computed as if the property were placed
into service at the:
A. beginning of the year
C. midpoint of the year
B. end of the year
D. midpoint of the month
Carter & Usry
16. Classifying an asset in a MACRS life category is based on
a. Useful life estimated by the company.
b. Asset depreciation range (ADR) guidelines.
c. The cost of the asset.
d. Any of the above factors.
17. An example of 5-year property under MACRS is:
A. most manufacturing machinery
C. commercial aircraft
B. railroad cars
D. light trucks
L&H
18. An example of 7-year property under MACRS is:

A. automobiles
C. light trucks
B. most manufacturing machinery
D. small aircraft
Carter & Usry
19. An example of 27.5-year property under MACRS is:

A. residential rental property
C. nonresidential buildings
B. commercial aircraft
D. railroad cars
Carter & Usry
20. With respect to income taxes, the principal advantage of MACRS over straight-line
depreciation is that
a. Total taxes will be lower under MACRS.
b. Taxes will be constant from year to year under MACRS.
c. Taxes will be lower in the earlier years under MACRS.
d. Taxes will decline in future years under MACRS.
L&H
4. Companies using MACRS for tax purposes and straight-line depreciation for financial reporting
purposes usually find that the relationship between the tax basis and book value of their assets
is
a. The tax basis is lower than book value.
b. The tax basis is higher than book value.
c. The tax basis is the same as book value.
L&H
5. A company that wants to use MACRS for tax purposes must
a. Request permission from the IRS.
b. Acquire new assets to or near the middle of the year.
c. Ignore salvage value in calculating depreciation.
d. Do none of the above.
L&H
38. A company evaluates a project using straight-line depreciation over its 10-year estimated
useful life and then reevaluates it using a 7-year MACRS class life. The second analysis will
show
a. A lower IRR for the project.
b. The same NPV and IRR for the project.
c. A higher NPV for the project.
d. Lower total cash flows over the 10 years.
L&H
Carter & Usry

Page 60 of 107

13. If a company uses a five-year MACRS period to depreciate assets instead of a 10-year life
with straight-line depreciation,
a. The NPV of the investment is higher.
b. The IRR of the investment is lower.
c. There is no difference in either NPV or IRR.
d. Total cash flows over the useful life would be lower.
L&H
167
. Flex Corporation is studying a capital acquisition proposal in which newly acquired assets will
be depreciated using the straight-line method. Which one of the following statements about the
proposal would be incorrect if a switch is made to the Modified Accelerated Cost Recovery
System (MACRS)?
CMA 0693 4-29
A. The net present value will increase.
C. The payback period will be shortened.
B. The internal rate of return will increase. D. The profitability index will decrease.
168
. Which of the following statement completions is incorrect? For a profitable firm, when MACRS
accelerated depreciation is compared to straight-line depreciation, MACRS accelerated
allowances produce (M)
a. Higher depreciation charges in the early years of an assets life.
b. Larger cash flows in the earlier years of an assets life.
c. Larger total undiscounted profits from the project over the projects life.
d. Smaller accounting profits in the early years, assuming the company uses the same
depreciation method for tax and book purposes.
e. None of the statements above. (All of the statements above are correct.)
Brigham
Questions 74 and 75 are based on the following information.

CMA 0694 4-13 & 14
The tax impact of equipment depreciation affects capital budgeting decisions. Currently, the
Modified Accelerated Cost Recovery System (MACRS) is used as the depreciation method for
most assets for tax purposes.
169
. The MACRS method of depreciation for assets with 3, 5, 7, and 10-year recovery periods is
most similar to which one of the following depreciation methods used for financial reporting
purposes?
A. Straight-line.
C. Sum-of-the-years'-digits.
B. Units-of-production.
D. 200% declining-balance.
170
. When employing the MACRS method of depreciation in a capital budgeting decision, the use
of MACRS as compared with the straight-line method of depreciation will result in
A. Equal total depreciation for both methods.
CAPITAL BUDGETING
B. MACRS producing less total depreciation than straight line.
C. Equal total tax payments, after discounting for the time value of money.
D. MACRS producing more total depreciation than straight line.
MACRS vs. Optional Straight-line Method
18. In a capital budgeting decision, the use of MACRS tables as compared to the optional straightline method will result in: (M)
a. equal total depreciation for both methods.
b. more total depreciation for the MACRS tables method.
c. more total depreciation for the optional straight-line method.
CMA adapted
d. less depreciation for the MACRS tables method in the early years of asset life.
19. The use of the MACRS tables instead of the optional straight-line method of depreciation has
the effect of: (M)
a. raising the hurdle rate necessary to justify the project.
b. decreasing the net present value of the project.
c. increasing the present value of the depreciation tax shield.
d. increasing the cash outflows at the beginning of the project.
CMA adapted
20. Which of the following is correct? (M)
a. Use of the MACRS tables requires that salvage value be deducted in computing
depreciation deductions.
b. Use of the optional straight-line method requires that salvage value not be considered in
computing depreciation deductions.
c. The use of both MACRS tables and the optional straight-line method requires that salvage
value be deducted in computing depreciation deductions.
d. None of the above are true.
G & N 9e
Taxes on gain on sale
171
. St. Johns Paper is considering purchasing equipment today that has a depreciable cost of $1
million. The equipment will be depreciated on a MACRS 5-year basis, which implies the
following depreciation schedule:
Year
MACRS Depreciation Rate
1
0.20
2
0.32
3
0.19
4
0.12
5
0.11
Page 61 of 107

6
0.06
Assume that the company sells the equipment after three years for $400,000 and the
companys tax rate is 40 percent. What would be the tax consequences resulting from the sale
of the equipment? (E)
a. There are no tax consequences.
b. The company would have to pay $44,000 in taxes.
c. The company would have to pay $160,000 in taxes.
d. The company would receive a tax credit of $124,000.
e. The company would receive a tax credit of $48,000.
Brigham
Risk-adjusted discount rate
172
. Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial
manager is evaluating a project with an IRR of 21 percent, before any risk adjustment. The
risk-free rate is 10 percent, and the required rate of return on the market is 16 percent. The
project being evaluated is riskier than Boes average project, in terms of both beta risk and
total risk. Which of the following statements is most correct? (E)
a. The project should be accepted since its IRR (before risk adjustment) is greater than its
required return.
b. The project should be rejected since its IRR (before risk adjustment) is less than its required return.
c. The accept/reject decision depends on the risk-adjustment policy of the firm. If the firms
policy were to reduce a riskier-than-average projects IRR by 1 percentage point, then the
project should be accepted.
d. Riskier-than-average projects should have their IRRs increased to reflect their added
riskiness. Clearly, this would make the project acceptable regardless of the amount of the
adjustment.
e. Projects should be evaluated on the basis of their total risk alone. Thus, there is
insufficient information in the problem to make an accept/reject decision.
Brigham
173
. The Unlimited, a national retailing chain, is considering an investment in one of two mutually
exclusive projects. The discount rate used for Project A is 12 percent. Further, Project A costs
$15,000, and it would be depreciated using MACRS. It is expected to have an after-tax
salvage value of $5,000 at the end of 6 years and to produce after-tax cash flows (including
depreciation) of $4,000 for each of the 6 years. Project B costs $14,815 and would also be
depreciated using MACRS. B is expected to have a zero salvage value at the end of its 6-year
life and to produce after-tax cash flows (including depreciation) of $5,100 each year for 6
CAPITAL BUDGETING
years. The Unlimiteds marginal tax rate is 40 percent. What risk-adjusted discount rate will
equate the NPV of Project B to that of Project A? (M)
a. 15%
d. 20%
b. 16%
e. 12%
c. 18%
Brigham
174
. California Mining is evaluating the introduction of a new ore production process. Two alternatives are available. Production Process A has an initial cost of $25,000, a 4-year life, and a
$5,000 net salvage value, and the use of Process A will increase net cash flow by $13,000 per
year for each of the 4 years that the equipment is in use. Production Process B also requires
an initial investment of $25,000, will also last 4 years, and its expected net salvage value is
zero, but Process B will increase net cash flow by $15,247 per year. Management believes
that a risk-adjusted discount rate of 12 percent should be used for Process A. If California
Mining is to be indifferent between the two processes, what risk-adjusted discount rate must
be used to evaluate B? (D)
a. 8%
d. 14%
b. 10%
e. 16%
c. 12%
Brigham
New project NPV

175
. Given the following information, calculate the NPV of a proposed project: Cost = $4,000;
estimated life = 3 years; initial decrease in accounts receivable = $1,000, which must be
restored at the end of the projects life; estimated salvage value = $1,000; earnings before
taxes and depreciation = $2,000 per year; method of depreciation = MACRS; tax rate = 40
percent; and cost of capital = 18 percent. (MACRS table required) (M)
a. $1,137
d. $ 804
b. -$ 151
e. $ 544
c. $ 137
Brigham
176
. Mars Inc. is considering the purchase of a new machine that will reduce manufacturing costs
by $5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine,
and it expects to sell the machine at the end of its 5-year operating life for $10,000. The firm
expects to be able to reduce net operating working capital by $15,000 when the machine is
installed, but required net operating working capital will return to the original level when the
machine is sold after 5 years. Mars marginal tax rate is 40 percent, and it uses a 12 percent
cost of capital to evaluate projects of this nature. If the machine costs $60,000, what is the
projects NPV? (MACRS table required) (M)
a. -$15,394
d. -$21,493
Page 62 of 107

b. -$14,093
c. -$58,512
CAPITAL BUDGETING
e. -$46,901
This equipment will be depreciated according to the following depreciation schedule:

Year
1
0.33
2
0.45
3
0.15
4
0.07
The equipment will have no salvage value after four years.
If MacDonald goes ahead with the new business inventories will rise by $500,000 at t = 0,
and its accounts payable will rise by $200,000 at t = 0. This increase in net operating
working capital will be recovered at t = 4.
The new business is expected to have an economic life of four years. The business is
expected to generate sales of $3 million at t = 1, $4 million at t = 2, $5 million at t = 3, and
$2 million at t = 4. Each year, operating costs excluding depreciation are expected to be
75 percent of sales.
The companys tax rate is 40 percent.
The companys weighted average cost of capital is 10 percent.
The company is very profitable, so any accounting losses on this project can be used to
reduce the companys overall tax burden.
What is the expected net present value (NPV) of the new business? (M)
a. $ 740,298
d. -$1,961,833
b. -$1,756,929
e. $5,919,974
c. -$1,833,724
Brigham
Brigham
177
. Stanton Inc. is considering the purchase of a new machine that will reduce manufacturing
costs by $5,000 annually and increase earnings before depreciation and taxes by $6,000
annually. Stanton will use the MACRS method to depreciate the machine, and it expects to sell
the machine at the end of its 5-year operating life for $10,000 before taxes. Stantons marginal
tax rate is 40 percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If
the machines cost is $40,000, what is the projects NPV? (MACRS table required) (M)
a. $1,014
d. $ 817
b. $2,292
e. $5,040
c. $7,550
Brigham
178
. Maple Media is considering a proposal to enter a new line of business. In reviewing the
proposal, the companys CFO is considering the following facts:
The new business will require the company to purchase additional fixed assets that
will cost $600,000 at t = 0. For tax and accounting purposes, these costs will be
depreciated on a straight-line basis over three years. (Annual depreciation will be
$200,000
per
year
at
t = 1, 2, and 3.)
At the end of three years, the company will get out of the business and will sell the
fixed assets at a salvage value of $100,000.
The project will require a $50,000 increase in net operating working capital at t = 0,
which will be recovered at t = 3.
The companys marginal tax rate is 35 percent.
The new business is expected to generate $2 million in sales each year (at t = 1, 2,
and 3). The operating costs excluding deprecia-tion are expected to be $1.4 million per
year.
The projects cost of capital is 12 percent.

What is the projects net present value (NPV)? (M)
a. $536,697
d. $ 56,331
b. $ 86,885
e. $561,609
c. $ 81,243
Brigham
179
. MacDonald Publishing is considering entering a new line of business. In analyzing the

potential business, their financial staff has accumulated the following information:
The new business will require a capital expenditure of $5 million at t = 0. This expenditure
will be used to purchase new equipment.
180
. Rio Grande Bookstores is considering a major expansion of its business. The details of the
proposed expansion project are summarized below:
The company will have to purchase $500,000 in equipment at t = 0. This is the
depreciable cost.
The project has an economic life of four years.
The cost can be depreciated on a MACRS 3-year basis, which implies the following
depreciation schedule:
Year
1
0.33
2
0.45
3
0.15
4
0.07
Page 63 of 107

At t = 0, the project requires that inventories increase by $50,000 and accounts payable
increase by $10,000. The change in net operating working capital is expected to be fully
recovered at t = 4.
The projects salvage value at the end of four years is expected to be $0.
The company forecasts that the project will generate $800,000 in sales the first two years
(t = 1 and 2) and $500,000 in sales during the last two years (t = 3 and 4).
Each year the projects operating costs excluding depreciation are expected to be 60
percent of sales revenue.
The projects cost of capital is 10 percent.
What is the net present value (NPV) of the proposed project? (M)
a. $159,145
d. $150,776
b. $134,288
e. -$257,060
c. $162,817
Brigham
181
. Foxglove Corp. is faced with an investment project. The following information is associated
with this project:
Year
Net Income*
1
$50,000
0.33
2
60,000
0.45
3
70,000
0.15
4
60,000
0.07
*Assume no interest expenses and a zero tax rate.
The project involves an initial investment of $100,000 in equipment that falls in the 3-year
MACRS class and has an estimated salvage value of $15,000. In addition, the company
expects an initial increase in net operating working capital of $5,000 that will be recovered in
Year 4. The cost of capital for the project is 12 percent. What is the projects net present
value? (Round your final answer to the nearest whole dollar.) (D)
a. $153,840
d. $168,604
b. $159,071
e. $182,344
c. $162,409
Brigham
CAPITAL BUDGETING
1
0.33
2
0.45
3
0.15
4
0.07
At the end of four years the company expects to be able to sell the equipment for an after-tax
salvage value of $10,000. The company is in the 40 percent tax bracket. The company has an
after-tax cost of capital of 11 percent. Because there is more uncertainty about the salvage
value, the company has chosen to discount the salvage value at 12 percent. What is the net
present value (NPV) of purchasing the equipment? (D)
a. $ 9,140.78
d. $22,853.90
b. $16,498.72
e. $28.982.64
c. $20,564.23
Brigham
183
. Lugar Industries is considering an investment in a proposed project that requires an initial

expenditure of $100,000 at t = 0. This expenditure can be depreciated at the following annual
rates:
Year
1
0.20
2
0.32
3
0.19
4
0.12
5
0.11
6
0.06
The project has an economic life of six years. The projects revenues are forecasted to be
$90,000 a year. The projects operating costs (not including depreciation) are forecasted to be
$50,000 a year. After six years, the projects estimated salvage value is $10,000. The
companys WACC is 10 percent, and its corporate tax rate is 40 percent. What is the projects
net present value (NPV)? (D)
a. $31,684
d. $38,840
b. $33,843
e. $45,453
c. $34,667
Brigham
184
182
. Pierce Products is deciding whether it makes sense to purchase a new piece of equipment.
The equipment costs $100,000 (payable at t = 0). The equipment will provide before-tax cash
inflows of $45,000 a year at the end of each of the next four years (t = 1, 2, 3, and 4). The
equipment can be depreciated according to the following schedule:
Year
. Mills Mining is considering an expansion project. The proposed project has the following
features:
The project has an initial cost of $500,000. This is also the amount that can be
depreciated using the following depreciation schedule:
Year
1
0.33
Page 64 of 107

0.45
0.15
0.07
If the project is undertaken, at t = 0 the company will need to increase its inventories
by $50,000, and its accounts payable will rise by $10,000. This net operating working
capital will be recovered at the end of the projects life (t = 4).
If the project is undertaken, the company will realize an additional $600,000 in sales
over each of the next four years (t = 1, 2, 3, and 4). The companys operating cost (not
including depreciation) will equal $400,000 a year.
At t = 4, the projects economic life is complete, but it will have a salvage value of
$50,000.
The projects WACC = 10 percent.

What is the projects net present value (NPV)? (D)
a. $11,122.87
d. $68,336.86
b. $50,330.14
e. $80,035.52
c. $54,676.59
Brigham
CAPITAL BUDGETING
2
3
4
Risk-adjusted NPV
185
. Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of capital of 12
percent to evaluate average-risk projects, and it adds or subtracts 2 percentage points to
evaluate projects of more or less risk. Currently, two mutually exclusive projects are under
consideration. Both have a cost of $200,000 and will last 4 years. Project A, a riskier-thanaverage project, will produce annual end-of-year cash flows of $71,104. Project B, a less-thanaverage-risk project, will produce cash flows of $146,411 at the end of Years 3 and 4 only.
Virus Stopper should accept(M)
a. B with a NPV of $10,001.
b. Both A and B because both have NPVs greater than zero.
c. B with a NPV of $8,042.
d. A with a NPV of $7,177.
e. A with a NPV of $15,968.
Brigham
186
. An all-equity firm is analyzing a potential project that will require an initial, after-tax cash outlay
of $50,000 and after-tax cash inflows of $6,000 per year for 10 years. In addition, this project
will have an after-tax salvage value of $10,000 at the end of Year 10. If the risk-free rate is 6
percent, the return on an average stock is 10 percent, and the beta of this project is 1.50, what
is the projects NPV? (M)
a. $13,210
d. -$ 6,158
b.
c.
$ 4,905
$ 7,121
e. -$12,879
Brigham
187
. Real Time Systems Inc. is considering the development of one of two mutually exclusive new
computer models. Each will require a net investment of $5,000. The cash flows for each
project are shown below:
Year
Project A
Project B
1
$2,000
$3,000
2
2,500
2,600
3
2,250
2,900
Model B, which will use a new type of laser disk drive, is considered a high-risk project, while
Model A is an average-risk project. Real Time adds 2 percentage points to arrive at a riskadjusted cost of capital when evaluating high-risk projects. The cost of capital used for
average-risk projects is 12 percent. Which of the following statements regarding the NPVs for
Models A and B is most correct? (M)
a. NPVA = $380; NPVB = $1,815
c. NPVA = $380; NPVB = $1,590
b. NPVA = $197; NPVB = $1,590
d. NPVA = $5,380; NPVB = $6,590 Brigham
NPV and risk-adjusted discount rate

188
. Garcia Paper is deciding whether to build a new plant. The proposed project would have an
up-front cost (at t = 0) of $30 million. The projects cost can be depreciated on a straight-line
basis over three years. Consequently, the depreciation expense will be $10 million in each of
the first three years, t = 1, 2, and 3. Even though the project is depreciated over three years,
the project has an economic life of five years.
The project is expected to increase the companys sales by $20 million. Sales will remain at
this higher level for each year of the project (t = 1, 2, 3, 4, and 5). The operating costs, not
including depreciation, equal 60 percent of the increase in annual sales. The projects interest
expense is $5 million per year and the companys tax rate is 40 percent. The company is very
profitable, so any accounting losses on this project can be used to reduce the companys
overall tax burden. The project does not require any additions to net operating working capital.
The company estimates that the projects after-tax salvage value at t = 5 will be $1.2 million.
The project is of average risk, and, therefore, the CFO has decided to discount the operating
cash flows at the companys overall WACC of 10 percent. However, the salvage value is more
uncertain, so the CFO has decided to discount it at 12 percent. What is the net present value
(NPV) of the proposed project? (D)
a. $11.86 million
d. -$12.55 million
b. $14.39 million
e. -$ 1.18 million
c. -$26.04 million
Brigham
Page 65 of 107
CAPITAL BUDGETING
Discounting risky outflows

189
. Alabama Pulp Company (APC) can control its environmental pollution using either Project Old
Tech or Project New Tech. Both will do the job, but the actual costs involved with Project
New Tech, which uses unproved, new state-of-the-art technology, could be much higher than
the expected cost levels. The cash outflows associated with Project Old Tech, which uses
standard proven technology, are less risky. (They are about as uncertain as the cash flows
associated with an average project.) APCs cost of capital for average-risk projects is normally
set at 12 percent, and the company adds 3 percent for high-risk projects but subtracts 3
percent for low-risk projects. The two projects in question meet the criteria for high and
average risk, but the financial manager is concerned about applying the normal rule to such
cost-only projects. You must decide which project to recommend, and you should recommend
the one with the lower PV of costs. What is the PV of costs of the better project? (M)
Cash Outflows
Years:
0
1
2
3
4
Project New Tech
1,500
315
315
315
315
Project Old Tech
600
600
600
600
600
a. 2,521
d. 2,543
b. 2,399
e. 2,422
c. 2,457
Brigham
Risky projects
190
. Cochran Corporation has a weighted average cost of capital of 11 percent for projects of
average risk. Projects of below-average risk have a cost of capital of 9 percent, while projects
of above-average risk have a cost of capital equal to 13 percent. Projects A and B are mutually
exclusive, whereas all other projects are independent. None of the projects will be repeated.
The following table summarizes the cash flows, internal rate of return (IRR), and risk of each of
the projects.
Year
Project A
Project B
Project C
Project D
Project E
0
-$200,000
-$100,000
-$100,000
-$100,000
-$100,000
1
66,000
30,000
30,000
30,000
40,000
2
66,000
30,000
30,000
30,000
25,000
3
66,000
40,000
30,000
40,000
30,000
4
66,000
40,000
40,000
50,000
35,000
IRR
Project
Risk
12.110%
Below
Average
14.038%
Below
Average
10.848%
Average
16.636%
Above
Average
11.630%
Above
Average
Which projects will the firm select for investment? (M)

a. Projects: A, B, C, D, E
d. Projects: A, D
b. Projects: B, C, D, E
e. Projects: B, C, D
c. Projects: B, D
Brigham
Scenario analysis
191
. Klott Company encounters significant uncertainty with its sales volume and price in its primary
product. The firm uses scenario analysis in order to determine an expected NPV, which it then
uses in its budget. The base-case, best-case, and worst-case scenarios and probabilities are
provided in the table below. What is Klotts expected NPV, standard deviation of NPV, and
coefficient of variation of NPV? (M)
Probability of
Unit Sales
Sales Price
NPV
Outcome
Volume
(In Thousands)
Worst case
0.30
6,000
$3,600
-$6,000
Base case
0.50
10,000
4,200
+13,000
Best case
0.20
13,000
4,400
+28,000
a. Expected NPV = $35,000; NPV = 17,500; CVNPV = 2.00
b. Expected NPV = $35,000; NPV = 11,667; CVNPV = 0.33
c. Expected NPV = $10,300; NPV = 12,083; CVNPV = 1.17
d. Expected NPV = $13,900; NPV = 8,476; CVNPV = 0.61
e. Expected NPV = $10,300; NPV = 13,900; CVNPV = 1.35
Brigham
Questions 50 thru 53 are based on the following information
Brigham
The president of Real Time Inc. has asked you to evaluate the proposed acquisition of a new
computer. The computers price is $40,000, and it falls into the MACRS 3-year class. Purchase of
the computer would require an increase in net operating working capital of $2,000. The computer
would increase the firms before-tax revenues by $20,000 per year but would also increase
operating costs by $5,000 per year. The computer is expected to be used for three years and then
be sold for $25,000. The firms marginal tax rate is 40 percent, and the projects cost of capital is 14
percent. (MACRS table required)
192
. What is the net investment required at t = 0? (E)

a. -$42,000
d. -$37,600
b. -$40,000
e. -$36,600
c. -$38,600
193
. What is the operating cash flow in Year 2? (M)

a. $ 9,000
d. $13,453
Page 66 of 107

b. $10,240
c. $11,687
CAPITAL BUDGETING
e. $16,200
a. -$1,547
b. -$ 562
c. $ 0
d.
e.
$ 562
$1,034
194
. What is the total value of the terminal year non-operating cash flows at the end of Year 3? (M)
a. $18,120
d. $25,000
b. $19,000
e. $27,000
c. $21,000
ANSWER EXPLANATIONS
195
. What is the projects NPV? (M)

a. $2,622
b. $2,803
c. $2,917
d. $5,712
e. $6,438
Questions 54 thru 57 are based on the following information.

Brigham
You have been asked by the president of your company to evaluate the proposed acquisition of a
new special-purpose truck. The trucks basic price is $50,000, and it will cost another $10,000 to
modify it for special use by your firm. The truck falls into the MACRS 3-year class, and it will be
sold after three years for $20,000. Use of the truck will require an increase in net operating working
capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is
expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firms
marginal tax rate is 40 percent. (MACRS table required)
196
. What is the net investment in the truck? (That is, what is the Year 0 net cash flow?) (E)
a. -$50,000
d. -$62,000
b. -$52,600
e. -$65,000
c. -$55,800
197
. What is the operating cash flow in Year 1? (M)

a. $17,820
d. $20,121
b. $18,254
e. $21,737
c. $19,920
198
. What is the total value of the terminal year non-operating cash flows at the end of Year 3? (M)
a. $10,000
d. $16,000
b. $12,000
e. $18,000
c. $15,680
199
. The trucks cost of capital is 10 percent. What is its NPV? (M)
Page 67 of 107
. Answer (D) is correct. Capital budgeting is the process of planning expenditures for long-lived assets. It involves
choosing among investment proposals using a ranking procedure. Evaluations are based on various measures involving
rate of return on investment.
Answer (A) is incorrect because capital budgeting involves long-term investment needs, not immediate operating needs.
Answer (B) is incorrect because strategic planning establishes long-term goals in the context of relevant factors in the
firm's environment. Answer (C) is incorrect because cash budgeting determines operating cash flows. Capital budgeting
evaluates the rate of return on specific investment alternatives.
. Answer (D) is correct. Capital budgeting is a long-term planning process for investments. This process begins with
the identification of capital needs, that is, of projects required to achieve organizational goals. The next step is to search
for specific investments. The third step is to acquire and analyze information about the potential choices. The fourth step
is to select specific investments after considering both qualitative and quantitative factors. The fifth step is to finance the
undertakings. The final step is implementation and monitoring.
Answer (A) is incorrect because analyzing capital addition proposals is a step that is subsequent to identifying capital
addition projects and other capital needs. Answer (B) is incorrect because making expenditure decisions is a step
subsequent to identifying capital addition projects and other capital needs. Answer (C) is incorrect because analyzing
and evaluating all promising alternatives is a step that is subsequent to identifying capital addition projects and other
capital needs.
. Answer (C) is correct. Capital budgeting is concerned with long-range decisions, such as whether to add a product
line, to build new facilities, or to lease or buy equipment. Any decision regarding cash inflows and outflows over a period
of more than 1 year probably needs capital budgeting analysis.
Answer (A) is incorrect because capital budgeting is useful for all long-range decision making. Answer (B) is incorrect
because capital budgeting is not useful for short-range decisions. Answer (D) is incorrect because it is a nonsense
answer.
. Answer (D) is correct. The capital budgeting process is a method of planning the efficient expenditure of the firm's
resources on capital projects. Such planning is essential in view of the rising costs of scarce resources.
Answer (A) is incorrect because capital budgeting may also be used for analysis of multiple profitable alternatives and of
lease-or-buy decisions. Answer (B) is incorrect because capital budgeting permits analysis of adding or discontinuing
product lines or facilities and of lease-or-buy decisions. Answer (C) is incorrect because the lease-or-buy decision is just
one specific example of an appropriate use of capital budgeting techniques.
. Answer (D) is correct. Capital budgeting is the process of planning expenditures for investments on which the
returns are expected to occur over a period of more than 1 year. Thus, capital budgeting concerns the acquisition or
disposal of long-term assets and the financing ramifications of such decisions. The adoption of a new method of
allocating nontraceable costs to product lines has no effect on a company's cash flows, does not concern the acquisition
of long-term assets, and is not concerned with financing. Hence, capital budgeting is irrelevant to such a decision.
Answer (A) is incorrect because a new aircraft represents a long-term investment in a capital good. Answer (B) is
incorrect because a major advertising program is a high cost investment with long-term effects. Answer (C) is incorrect
because a star quarterback is a costly asset who is expected to have a substantial effect on the team's long-term
profitability.
. Answer (C) is correct. The investment tax credit is of no concern because it no longer exists. The 1986 Tax Reform
Act eliminated the investment tax credit.
Answer (A) is incorrect because the availability of any necessary financing should be considered even though the net
present value method indicates that the project is acceptable. Answer (B) is incorrect because the probability of nearterm technological changes to the manufacturing process should be considered even though the net present value
method indicates that the project is acceptable. Answer (D) is incorrect because maintenance requirements, warranties,
and availability of service arrangements should be considered even though the net present value method indicates that
the project is acceptable.
Estimating cash flows
Answer: b Diff: M
. Answer (D) is correct. The investment in a new project includes more than the initial cost of new capital equipment.
In addition, funds must be provided for increases in receivables and inventories. This investment in working capital is
treated as an initial cost of the investment that will be recovered in full at the end of the project's life.
Answer (A) is incorrect because the investment in working capital will be needed throughout the life of the investment.
Answer (B) is incorrect because cash will be needed to fund the investments in receivables and inventory. Answer (C) is
incorrect because the initial investment should be treated as an initial cash outflow, but one that will be recovered at the
end of the project.
10
Relevant cash flows
Answer: b Diff: E N
Sunk costs are never included in project cash flows, so statement a is false.
Externalities are always included, so statement b is true. Since the weighted
average cost of capital includes the cost of debt, and this is the discount
rate used to evaluate project cash flows, interest expense should not be
included in project cash flows. Therefore, statement c is false.
Relevant cash flows
Answer: d Diff: E N
Sunk costs should be ignored, but externalities and opportunity costs should
be included in the project evaluation. Therefore, the correct choice is
statement d.
. Answer (B) is correct. Tax depreciation is relevant to cash flow analysis because it affects the amount of income
taxes that must be paid. However, book depreciation is not relevant because it does not affect the amount of cash
generated by an investment.
Answer (A) is incorrect because it is a true statement relating to capital budgeting. Answer (C) is incorrect because it is
a true statement relating to capital budgeting. Answer (D) is incorrect because it is a true statement relating to capital
budgeting.
11
12
Relevant cash flows

Answer: c Diff: E
The correct answer is c. Sunk costs should be excluded from the analysis, and
interest expense is incorporated in the WACC and not the cash flows.
13
Cash flows and accounting measures

Answer: d Diff: M
Relevant cash flows
Answer:
d Diff: E
Statements a and c are correct; therefore, statement d is the correct answer.
Net cash flow = Net income + depreciation; therefore, depreciation affects
operating cash flows. Sunk costs should be disregarded when making investment
decisions, while opportunity costs should be considered when making
investment decisions, as they represent the best alternative use of an asset.
14.
15
.
16
17
Relevant cash flows

Answer: c Diff: E
Relevant cash flows
Answer: d Diff: M
Statements b and c are correct; therefore, statement d is the correct answer.
The $3 million spent on researching the technology is a sunk cost.
Relevant cash flows
Answer: d Diff: M N
Statement a is a sunk cost and sunk costs are never included in the capital
budgeting analysis. Therefore, statement a is not included. Statement b is an
opportunity cost and should be included in the capital budgeting analysis.
Statement c is the cannibalization of existing products, which will cause the
company to forgo cash flows and profits in another division. Therefore, it is
included in the capital budgeting analysis. Therefore, the correct answer is
statement d.
18
Relevant cash flows
Answer: d Diff: M
Statements b and c are correct; therefore, statement d is the correct answer.

The cost of clearing the land is a sunk cost and should not be considered in
the analysis. The expected impact of the new store on the existing store
should be considered. In addition, the opportunity to lease the land
represents an opportunity cost of opening a new store on the land and should
be considered.
19
Relevant cash flows

Answer: d Diff: M
Statements a and c are correct; therefore, statement d is correct.
Externalities and opportunity costs should be considered, while sunk costs
should not be included in the analysis.
20
Cash flow estimation

Answer: d Diff: M
Statement d is true--the forgone rent is an opportunity cost which should
be charged to the project under consideration. Note that Statements a and b
are both falsethe cash flows should not take account of interest, because
financial costs are dealt with by discounting at the WACC. If interest were
deducted to find cash flows, then this cost would be double counted, and
the NPV would be downward biased. Ignoring interest when determining cash
flows produces no bias in the NPV whatever. Note also that externalities can
be either positive or negativethey tend to be negative if the new project is
a substitute for existing products, but positive if the new project is
complementary to the firms other products.
21
.
.
Incremental cash flows

Incremental cash flows
22
Answer: d Diff: M
Answer: d Diff: M
23
. Answer (B) is correct. A tax shield is something that will protect income against taxation. Thus, a depreciation tax
shield is a reduction in income taxes due to a company's being allowed to deduct depreciation against otherwise taxable
income.
Answer (A) is incorrect because a tax shield is not a cash flow, but a means of reducing outflows for income taxes.
Answer (C) is incorrect because cash is not provided by recording depreciation; the shield is a result of deducting
depreciation from taxable revenues. Answer (D) is incorrect because depreciation is recognized as an expense even if it
has no tax benefit.
24
. Answer (C) is correct. A depreciation deduction will reduce a firm's tax by the amount of the deduction times the
marginal tax rate. A dollar deducted is offset against the firm's last (marginal) dollar of income.
Answer (A) is incorrect because the savings will apply at the marginal rate. Without the deduction, income would be
higher and therefore subject to the marginal tax rate. Answer (B) is incorrect because the marginal rate is relevant to tax
savings from depreciation. Answer (D) is incorrect because one minus the firm's marginal tax rate times the
depreciation amount describes the effect on income, not taxes.
25
. Answer (C) is correct. Accelerated depreciation results in greater depreciation in the early years of an asset's life
compared with the straight-line method. Thus, accelerated depreciation results in lower income tax expense in the early
years of a project and higher income tax expense in the later years. By effectively deferring taxes, the accelerated
method increases the present value of the depreciation tax shield.
Answer (A) is incorrect because the hurdle rate can be reached more easily as a result of the increased present value of
the depreciation tax shield. Answer (B) is incorrect because the greater depreciation tax shield increases the NPV.
Answer (D) is incorrect because greater initial depreciation reduces the cash outflows for the taxes, but has no effect on
the initial cash outflows.
26
. Answer (D) is correct. According to microeconomic theory, a firm should produce until its marginal revenue equals
its marginal cost. In capital budgeting terms, marginal revenue is the marginal rate of return on investment, and marginal
cost is the company's marginal cost of capital (MCC). Hence, the firm should continue to invest until the cost of the last
investment equals the return.
Answer (A) is incorrect because the firm must balance cost and return. Minimizing MCC or average cost of capital (ACC
is minimized when it equals MCC) ignores possible returns. Answer (B) is incorrect because the firm must balance cost
and return. Minimizing MCC or average cost of capital (ACC is minimized when it equals MCC) ignores possible returns.
Answer (C) is incorrect because the rate of return on total assets is an average return. Setting MCC equal to this rate
may result in acceptance of poor investments.
27
. REQUIRED: The determinant of the optimal capital budget.

DISCUSSION: (A) In economics, a basic principle is that a firm should increase output until marginal cost equals
marginal revenue. Similarly, the optimal capital budget is determined by calculating the point at which marginal cost of
capital (which increases as capital requirements increase) and marginal efficiency of investment (which decreases if the
most profitable projects are accepted first) intersect.
Answer (B) is incorrect because the intersection of average marginal cost with average projected rates of return when
the largest (not most profitable) projects are accepted first offers no meaningful capital budgeting conclusion. Answer
(C) is incorrect because the optimal capital budget may exclude profitable projects as lower cost capital goes first to
projects with higher rates of return. Answer (D) is incorrect because accepting projects with rates of return lower than
the cost of capital is not rational.
28
Find the WACCs using both Johns and Beckys methods. (WACC = ks because there is no debt).
Johns WACC for Division B based on overall companys beta:

k = kRF + RPM(b)
k = 5% + 5%(1.2)
k = 5% + 6%
k = 11%.
Therefore, John would only choose Project 1, because it is the only project whose IRR exceeds its cost of capital.
Consequently, the firms capital budget (based on Johns WACC) is only $400 million.
Beckys WACC for Division B:
k = kRF + RPM(b)
k = 5% + 5%(0.9)
k = 5% + 4.5%
k = 9.5%.
Becky would choose projects 1, 2, 3, and 4 because all of these projects have an IRR that exceeds the Divisions 9.5
percent cost of capital. Based on Beckys WACC, the firms capital budget would be $1,270 million ($400 + $300 + $250
+ $320). Therefore, the firms capital budget based on Beckys WACC is $870 million ($1,270 - $400) larger than the one
based on Johns WACC.
29
. The option to abandon will increase expected cash flow and decrease risk. If a firm has the option to
abandon a project, it will choose to do so only when things look bad (negative NPV). Thus, abandoning a
project eliminates the low/negative cash flows. Therefore, statement b is correct.
30
. By having the ability to wait and see you reduce the risk of the project. Therefore, statement a is false. The greater
the uncertainty, the more value there is in waiting for additional information before going on with a project. Therefore,
statement b is false. Statement c is not necessarily true. By waiting to do a project you may lose strategic advantages
associated with being the first competitor to enter a new line of business, which may alter the cash flows. Since
statements a, b, and c are false, the correct choice is statement e.
31
. Statements a, b, c, and d are all examples of different types of real options. A flexibility option permits the firm to
alter operations depending on how conditions change during the life of the project. Typically, either inputs or outputs, or
both, can be changed. Statement a is an example of an investment timing option, while statement b is an example of an
abandonment option. Statement c is an example of a flexibility option, while statement d is an example of a growth
option. Therefore, statement c is the correct choice.

32
. By failing to consider both abandonment and growth options, the firms capital budget would be too small. In both
cases, the firm might reject what might otherwise be profitable projects if these options had been considered. Therefore,
the correct choice is statement a.
33
. Answer (D) is correct. The accounting rate of return (unadjusted rate of return or book value rate of return) equals
accounting net income divided by the required initial or average investment. The accounting rate of return ignores the
time value of money.
Answer (A) is incorrect because the net present value is the sum of the present values of all the cash inflows and
outflows associated with an investment. Answer (B) is incorrect because the discounted payback method calculates the
payback period by determining the present values of the future cash flows. Answer (C) is incorrect because the internal
rate of return is the discount rate at which the NPV is zero.
34
. Answer (D) is correct. The accounting rate of return (also called the unadjusted rate of return or book value rate of
return) measures investment performance by dividing the accounting net income by the average investment in the
project. This method ignores the time value of money.
Answer (A) is incorrect because the bail-out payback method measures the length of the payback period when the
periodic cash inflows are combined with the salvage value. Answer (B) is incorrect because the internal rate of return
method determines the rate at which the NPV is zero. Answer (C) is incorrect because the profitability index is the ratio
of the present value of future net cash inflows to the initial cash investment.
35
. Answer (D) is correct. The accounting rate of return is calculated by dividing the annual after-tax net income from a
project by the book value of the investment in that project. The time value of money is ignored.
Answer (A) is incorrect because the average rate of return method does not divide by the average investment cost.
Answer (B) is incorrect because the internal rate of return incorporates the time value of money into the calculation. The
IRR is the discount rate that results in a net present value of zero. Answer (C) is incorrect because the capital asset
pricing model is a means of determining the cost of capital.
36
. Answer (B) is correct. The accounting rate of return (also called the unadjusted rate of return or book value rate of
return) is calculated by dividing the increase in accounting net income by the required investment. Sometimes the
denominator is the average investment rather than the initial investment. This method ignores the time value of money
and focuses on income as opposed to cash flows.
Answer (A) is incorrect because the IRR is the rate at which the net present value is zero. Thus, it incorporates time
value of money concepts, whereas the accounting rate of return does not. Answer (C) is incorrect because the
accounting rate of return is similar to the divisional performance measure of return on investment. Answer (D) is
incorrect because the accounting rate of return ignores the time value of money.
37
. Answer (D) is correct. The accounting rate of return (ARR) is based on financial statements prepared on the
accrual basis. The formula to compute the ARR is:
ARR =
Expected increase in annual net income

Initial (or average) investment
Both the revenue over life of project and depreciation expense are used in the calculation of the ARR. Depreciation
expense over the projects life and other expenses directly associated with the project under consideration including
income tax effects are subtracted from revenue over life of the project to determine net income over life of project. Net
income over the projects life is then divided by the economic life to determine annual net income, the numerator of the
ARR formula. This is a weakness of the ARR method because it does not consider actual cash flows or the time value
of money.
38
. Answer (B) is correct. The accounting rate of return uses undiscounted net income (not cash flows) to determine a
rate of profitability. Annual after-tax net income is divided by the average book value (or the initial value) of the
investment in assets. Answer (C) is incorrect because the payback period is the time required to complete the return of
the original investment. This method gives no consideration to the time value of money or to returns after the payback
period.
Answer (A) is incorrect because the internal rate of return is the rate at which NPV is zero. The minimum desired rate of
return is not used in the discounting. Answer (D) is incorrect because the NPV method computes the discounted
present value of future cash inflows to determine whether it is greater than the initial cash outflow.
39
. Answer (B) is correct. The payback method measures the number of years required to complete the return of the
original investment. This measure is computed by dividing the net investment by the average expected cash inflows to
be generated, resulting in the number of years required to recover the original investment. The payback method gives
no consideration to the time value of money, and there is no consideration of returns after the payback period.
Answer (A) is incorrect because the discounted cash flow method computes a rate of return. Answer (C) is incorrect
because the net present value method is based on discounted cash flows; the length of time to recover an investment is
not the result. Answer (D) is incorrect because the net present value method is based on discounted cash flows; the
length of time to recover an investment is not the result.
40
. Answer (B) is correct. The usual payback formula divides the initial investment by the constant net annual cash
inflow. The payback method is unsophisticated in that it ignores the time value of money, but it is widely used because of
its simplicity and emphasis on recovery of the initial investment.
Answer (A) is incorrect because the net present value method first discounts the future cash flows to their present value.
Answer (C) is incorrect because the profitability index method divides the present value of the future net cash inflows by
the initial investment. Answer (D) is incorrect because the accounting rate of return divides the annual net income by the
average investment in the project.
41
. Answer (B) is correct. The payback method calculates the number of years required to complete the return of the
original investment. This measure is computed by dividing the net investment required by the average expected cash
flow to be generated, resulting in the number of years required to recover the original investment. Payback is easy to
calculate but has two principal problems: it ignores the time value of money, and it gives no consideration to returns after
the payback period. Thus, it ignores total project profitability.
Answer (A) is incorrect because the payback method does not incorporate the time value of money. Answer (C) is
incorrect because the payback method uses the net investment in the numerator of the calculation. Answer (D) is
incorrect because payback uses the net annual cash inflows in the denominator of the calculation.
42
. Answer (A) is correct. The payback method calculates the amount of time required to complete the return of the
original investment, i.e., the time it takes for a new asset to pay for itself. Although the payback method is easy to
calculate, it has inherent problems. The time value of money and returns after the payback period are not considered.
Answer (B) is incorrect because the payback method ignores cash flows after payback. Answer (C) is incorrect because
the payback method does not use discounted cash flow techniques. Answer (D) is incorrect because the payback
method may lead to different decisions.
43
. Answer (D) is correct. The payback reciprocal (1 payback) has been shown to approximate the internal rate of
return (IRR) when the periodic cash flows are equal and the life of the project is at least twice the payback period.
Answer (A) is incorrect because the payback reciprocal is not related to the profitability index. Answer (B) is incorrect
because the payback reciprocal approximates the IRR, which is the rate at which the NPV is $0. Answer (C) is incorrect
because the accounting rate of return is based on accrual-income based figures, not on discounted cash flows.
44
. Answer (C) is correct. The payback period is computed by dividing the initial investment by the annual net cash
inflow. Depreciation expense is not subtracted from cash inflow; ony the income taxes which are cause by the
depreciation deduction are substracted. One of the weaknesses of the payback period is that is ignores the time value
of time.
45
. Answer (B) is correct. The bailout payback period is the length of time required for the sum of the cumulative net
cash inflow from an investment and its salvage value to equal the original investment. The bailout payback method
measures the risk to the investor if the investment must be abandoned. The shorter the period, the lower the risk.
Answer (A) is incorrect because the use of the bailout payback method is not limited to firms with federally insured
loans. Answer (C) is incorrect because the payback period is calculated by summing the net cash inflow and the
salvage value. Answer (D) is incorrect because the bailout payback method does not estimate short-term profitability.
46
. Answer (D) is correct. The payback period equals the net investment divided by the average expected cash flow,
resulting in the number of years required to recover the original investment. The bailout payback incorporates the
salvage value of the asset into the calculation. It determines the length of the payback period when the periodic cash
inflows are combined with the salvage value. Hence, the method measures risk. The longer the payback period, the
more risky the investment.
Answer (A) is incorrect because the bailout payback method does not consider the time value of money. Answer (B) is
incorrect because the bailout payback includes salvage value as well as cash flow from operations. Answer (C) is
incorrect because the bailout payback incorporates the disposal value in the payback calculation.
47
. Answer (A) is correct. Time value of money means that, because of the interest factor, money held today is worth
more than the same amount of money to be received in the future. Interest is paid for the use of money, i.e., on debts, in
a normal business transaction. This payment compensates the lender for not being able to use the money for current
consumption.
Answer (B) is incorrect because present value is the value today, net of the interest factor, of one or more payments to
be made in the future. Answer (C) is incorrect because future value is the value some time in the future of a deposit
today or of a series of deposits. Answer (D) is incorrect because an annuity is generally a series of equal payments at
equal intervals of time.
48
. Answer (A) is correct. The time value of money is concerned with two issues: (1) the investment value of money,
and (2) the risk (uncertainty) inherent in any executory agreement. Thus, a dollar today is worth more than a dollar in the
future, and the longer one waits for a dollar, the more uncertain the receipt is. The cost of capital involves a specific
application of the time value of money principles. It is not a basic concept thereof.
Answer (B) is incorrect because risk is a basic time value of money concept. Cost of capital is not. Answer (C) is
incorrect because the interest effect is a basic time value of money concept. Answer (D) is incorrect because the interest
effect and risk are basic time value of money concepts. Cost of capital is not.
49
. Answer (A) is correct. The present value concept may be applied both to dollars-in (inflows) and to dollars-out
(outflows). Thus, individual cash inflows and cash outflows or a series thereof (an annuity) may be discounted to time
zero (the present). Net present value is the sum of discounted cash inflows minus any discounted cash outflows. Net
present value may be either positive or negative.
Answer (B) is incorrect because a present value may be calculated for discounted cash outflows. Answer (C) is incorrect
because a present value may be calculated for discounted cash inflows or a series thereof (an annuity). Answer (D) is
incorrect because a present value may be calculated for discounted cash inflows or outflows.
50
. Answer (C) is correct. Discounted cash flow analysis, using either the internal rate of return (IRR) or the net present
value (NPV) method, is based on the time value of cash inflows and outflows. All future operating cash savings are
considered as well as the tax effects on cash flows of future depreciation charges. The cash proceeds of future asset
disposals are likewise a necessary consideration. Depreciation expense is a consideration only to the extent that it
affects the cash flows for taxes. Otherwise, depreciation is excluded from the analysis because it is a noncash expense.
Answer (A) is incorrect because future operating cash savings is a consideration in discounted cash flow analysis.
Answer (B) is incorrect because the current asset disposal price is a consideration in discounted cash flow analysis.
Answer (D) is incorrect because the tax effects of future asset depreciation is a consideration in discounted cash flow
analysis.
51
. Answer (D) is correct. The capital budgeting methods that are generally considered the best for long-range decision
making are the internal rate of return and net present value methods. These are both discounted cash flow methods.
Answer (A) is incorrect because the payback method gives no consideration to the time value of money or to returns
after the payback period. Answer (B) is incorrect because the accounting rate of return does not consider the time value
of money. Answer (C) is incorrect because the unadjusted rate of return does not consider the time value of money.
52
. DISCUSSION: (A) The time value of money is concerned with two issues: (1) the investment value of money, and
(2) the risk (uncertainty) inherent in any executory agreement. Thus, a dollar today is worth more than a dollar in the
future, and the longer one waits for a dollar, the more uncertain the receipt is.
Answers (B), (C) and (D) are incorrect because risk and interest factors are concepts underlying the time value of
money.
53
. Answer (C) is correct. Depreciation is a noncash expense that is deductible for federal income tax purposes. Hence,
it directly reduces the cash outlay for income taxes and is explicitly incorporated in the capital budgeting model.
Answer (A) is incorrect because depreciation is not a cost of operations in the capital budgeting model. Also,
depreciation can be avoided by not making investments. Answer (B) is incorrect because depreciation is an allocation of
historical cost and as such is not a cash inflow, but it may reduce cash outflows for taxes. Answer (D) is incorrect
because periodic depreciation is determined by spreading the depreciation base, i.e., the cost of the asset minus
salvage value, not the initial cash outflow, over the life of the investment.
54
. REQUIRED: The benchmark cost of capital.

DISCUSSION: (D) A weighted average of the costs of all financing sources should be used, with the weights
determined by the usual financing proportions. The terms of any financing raised at the time of initiating a particular
project do not represent the cost of capital for the firm. When a firm achieves its optimal capital structure, the weightedaverage cost of capital is minimized.
Answers (A), (B), and (C) are incorrect because the cost of capital is a composite, or weighted average, of all financing
sources in their usual proportions. The cost of capital should also be calculated on an after-tax basis.
55
. REQUIRED: To determine when the discount rate (hurdle rate) must be determined before a capital budgeting
method can be used.
Answer (C) is correct. The net present value method calculates the expected net monetary gain or loss from a project
by discounting all expected future cash inflows and outflows to the present using some predetermined minimum desired
rate of return (hurdle rate).
Answer (A) is incorrect because the payback method measures the time it will take to recoup, in the form of cash inflows
from operations, the initial dollars invested in a project. The payback period does not consider the time value of money.
Answers (B) and (D) are incorrect. The time adjusted rate of return method is also called the internal rate of return
method. This method computes the rate of interest at which the present value of expected cash inflows from a project
equals the present value of expected cash outflows of the project. Here, the discount rate is not determined in advance
but is the end result of the calculation.
56
. Answer (D) is correct. A hurdle rate is not necessary in calculating the accounting rate of return. That return is
calculated by dividing the net income from a project by the investment in the project. Similarly, a company can calculate
the internal rate of return (IRR) without knowing its hurdle rate. The IRR is the discount rate at which the net present
value is $0. However, the NPV cannot be calculated without knowing the company's hurdle rate. The NPV method
requires that future cash flows be discounted using the hurdle rate.
Answer (A) is incorrect because the accounting rate of return and the IRR but not the NPV can be calculated without
knowing the hurdle rate. Answer (B) is incorrect because the accounting rate of return and the IRR but not the NPV can
be calculated without knowing the hurdle rate. Answer (C) is incorrect because the accounting rate of return and the IRR
but not the NPV can be calculated without knowing the hurdle rate.
57
. Answer (D) is correct. Breakeven time evaluates the rapidity of new product development. The usual calculation
determines the period beginning with project approval that is required for the discounted cumulative cash inflows to
equal the discounted cumulative cash outflows. However, it may also be calculated as the point at which discounted
cumulative cash inflows on a project equal discounted total cash outflows. The concept is similar to the payback period,
but it is more sophisticated because it incorporates the time value of money. It also differs from the payback method
because the period covered begins at the outset of a project, not when the initial cash outflow occurs.
Answer (A) is incorrect because it is related to breakeven point, not breakeven time. Answer (B) is incorrect because the
payback period equals investment divided by annual undiscounted net cash inflows. Answer (C) is incorrect because the
payback period is the period required for total undiscounted cash inflows to equal total undiscounted cash outflows.
58
. Answer (C) is correct. The profitability index is another term for the excess present value index. It measures the
ratio of the present value of future net cash inflows to the original investment. In organizations with unlimited capital
funds, this index will produce no conflicts in the decision process. If capital rationing is necessary, the index will be an
insufficient determinant. The capital available as well as the dollar amount of the net present value must both be
considered.
Answer (A) is incorrect because capital rationing is not a technique but rather a condition that characterizes capital
budgeting when insufficient capital is available to finance all profitable investment opportunities. Answer (B) is incorrect
because the average rate of return method does not divide the future cash flows by the cost of the investment. Answer
(D) is incorrect because the accounting rate of return does not recognize the time value of money.
59
. Answer (D) is correct. The profitability index, also known as the excess present value index, is the ratio of the
present value of future net cash inflows to the initial net cash investment (discounted cash outflows). This tool is a
variation of the NPV method that facilitates comparison of different-sized investments.
Answer (A) is incorrect because the cash inflows are also discounted in the profitability index. Answer (B) is incorrect
because the numerator is the discounted net cash inflows. Answer (C) is incorrect because the profitability index is
based on cash flows, not profits.
60
. Answer (B) is correct. The net present value (NPV) method computes the discounted present value of future cash
inflows to determine whether they are greater than the initial cash outflow. The discount rate (cost of capital or hurdle
rate) must be known to discount the future cash inflows. If the NPV is positive (present value of future cash inflows
exceeds initial cash outflow), the project should be accepted. If the NPV is negative, the project should be rejected.
Answer (A) is incorrect because the accounting rate of return uses net income (not cash flows) to determine a rate of
profitability. Answer (C) is incorrect because the internal rate of return is the rate at which NPV is zero. The minimum
desired rate of return is not used. Answer (D) is incorrect because the payback method measures the time required to
complete the return of the original investment. It gives no consideration to the time value of money or to returns after the
payback period.
61
. Answer (A) is correct. The net present value method discounts future cash flows to the present value using some
arbitrary rate of return, which is presumably the firm's cost of capital. The initial cost of the project is then deducted from
the present value. If the present value of the future cash flows exceeds the cost, the investment is considered to be
acceptable.
Answer (B) is incorrect because the payback method does not recognize the time value of money. Answer (C) is
incorrect because the average rate of return method does not use the firm's cost of capital as a discount rate. Answer
(D) is incorrect because the accounting rate of return method does not recognize the time value of money.
62
. REQUIRED: The effect on the value of the firm and its stock price of investment opportunities.
DISCUSSION: (A) Investments with present values in excess of their costs (positive NPVs) that can be identified or
created by the capital budgeting activities of the firm will have a positive impact on firm value and on the price of the
common stock of the firm. Accordingly, the more effective capital budgeting is, the higher the stock price.
Answer (B) is incorrect because positive NPV investments will increase, not decrease firm value and share price.
Answers (C) and (D) are incorrect because investments with present values equal to their costs have a zero NPV and
neither increase nor decrease firm value and share price.
63
. Answer (A) is correct. The NPV method computes the present value of future cash inflows to determine whether
they are greater than the initial cash outflow. Future cash inflows include any salvage value on facilities. Included in the
initial investment are the cost of new equipment and other facilities, and additional working capital needed for operations
during the term of the project. The discount rate (cost of capital or hurdle rate) must be known to discount the future
cash inflows. If the NPV is positive, the project should be accepted. The method of funding a project is a decision
separate from that of whether to invest.
Answer (B) is incorrect because the initial costs of the project, including additional working capital needs, are necessary
to determine the NPV. Answer (C) is incorrect because the initial costs of the project, including additional working capital
needs, are necessary to determine the NPV. Answer (D) is incorrect because the project's salvage value is a future cash
inflow to be discounted.
64
. REQUIRED: The variable(s) considered in the NPV calculation.

DISCUSSION: (D)The NPV is the difference between the present value of the future cash flows from the project
discounted at an appropriate interest rate and the initial investment. If the NPV is zero or greater, the investment may
be economically rational. The method is a technique for ranking investment proposals. Consequently, the time value of
the cash flows over the life of the project is considered.
Answers (A), (B), and (C) are incorrect because the time value of the cash flows over the life of the project is
considered.
65
. Answer (D) is correct. The effect of assuming cash flows occur at the end of the year simply understates the present
values of the future cash flows; in reality, they probably occur on the average at mid-year.
Answer (A) is incorrect because cash flows in investment decisions do not all occur at the end of each year. Answer (B)
is incorrect because discounting cash flows approximately 6 months longer understates rather than overstates. Answer
(C) is incorrect because the effect of using the year-end assumption produces a slight conservatism in the model but
does not render the results unusable.
66
. Answer (C) is correct. The NPV method is used when the discount rate (cost of capital) is specified. It assumes that
cash flows from the investment can be reinvested at the particular project's cost of capital (the discount rate).
Answer (A) is incorrect because the internal rate of return method assumes that cash flows are reinvested at the internal
rate of return. Answer (B) is incorrect because the NPV method assumes that cash flows are reinvested at the NPV
discount rate. Answer (D) is incorrect because the NPV method assumes that cash flows are reinvested at the NPV
discount rate.
67
. Answer (D) is correct. The NPV method assumes that periodic cash inflows earned over the life of an investment
are reinvested at the company's cost of capital (i.e., the discount rate used in the analysis). This is contrary to the
assumption under the internal rate of return method, which assumes that cash inflows are reinvested at the internal rate
of return. As a result of this difference, the two methods will occasionally give different rankings of investment
alternatives.
Answer (A) is incorrect because the NPV method assumes that cash inflows are reinvested at the discount rate used in
the NPV calculation. Answer (B) is incorrect because the NPV method assumes that cash inflows are reinvested at the
discount rate used in the NPV calculation. Answer (C) is incorrect because the internal rate of return method assumes a
reinvestment rate equal to the rate of return on the project.
68
. Answer (B) is correct. The NPV method calculates the present values of estimated future net cash inflows and
compares the total with the net cost of the investment. The cost of capital must be specified. If the NPV is positive, the
project should be accepted. The IRR method computes the interest rate at which the NPV is zero. The IRR method is
relatively easy to use when cash inflows are the same from one year to the next. However, when cash inflows differ from
year to year, the IRR can be found only through the use of trial and error. In such cases, the NPV method is usually
easier to apply. Also, the NPV method can be used when the rate of return required for each year varies. For example, a
company might want to achieve a higher rate of return in later years when risk might be greater. Only the NPV method
can incorporate varying levels of rates of return.
Answer (A) is incorrect because the IRR method calculates a rate of return. Answer (C) is incorrect because the IRR is
the rate at which NPV is zero. Answer (D) is incorrect because both methods discount cash flows.
69
. Answer (C) is correct. The NPV is broadly defined as the excess of the present value of the estimated net cash
inflows over the net cost of the investment. A discount rate has to be stipulated by the person conducting the analysis. A
disadvantage is that it does not provide the true rate of return for an investment, only that the rate of return is higher than
a stipulated discount rate (which may be the cost of capital).
Answer (A) is incorrect because the ability to perform sensitivity analysis is an advantage of the NPV method. Answer
(B) is incorrect because the NPV method does not compute the true interest rate. Answer (D) is incorrect because the
IRR method, not the NPV method, uses a trial-and-error approach when cash flows are not identical from year to year.
70
. Answer (C) is correct. The discount rate most often used in present value calculations is the minimum desired rate
of return as set by management. The NPV arrived at in this calculation is a first step in the decision process. It indicates
how the project's return compares with the minimum desired rate of return.
Answer (A) is incorrect because the Federal Reserve rate may be considered; however, the firm will set its minimum
desired rate of return in view of its needs. Answer (B) is incorrect because the Treasury bill rate may be considered;
however, the firm will set its minimum desired rate of return in view of its needs. Answer (D) is incorrect because the
prime rate may be considered; however, the firm will set its minimum desired rate of return in view of its needs.
71
. Answer (A) is correct. The rate used to discount future cash flows is sometimes called the cost of capital, the
discount rate, the cutoff rate, or the hurdle rate. A risk-free rate is the rate available on risk-free investments such as
government bonds. The risk-free rate is not equivalent to the cost of capital because the latter must incorporate a risk
premium.
Answer (B) is incorrect because the rate used under the NPV method is the company's cost of capital. Answer (C) is
incorrect because the NPV method discounts future cash flows to their present values. Answer (D) is incorrect because
the cost of capital is often called a cutoff rate. Investments yielding less than the cost of capital should not be made.
72
. Answer (D) is correct. The NPV is the excess of the present values of the estimated cash inflows over the net cost
of the investment. The discount rate used is sometimes the cost of capital or other hurdle rate designated by
management. This rate is also called the required rate of return. The accounting rate of return is never used in NPV
analysis because it ignores the time value of money; it is computed by dividing the accounting net income by the
investment.
Answer (A) is incorrect because cost of capital is a synonym for the rate used in NPV analysis. Answer (B) is incorrect
because hurdle rate is a synonym for the rate used in NPV analysis. Answer (C) is incorrect because discount rate is a
synonym for the rate used in NPV analysis.
73
. REQUIRED: The matter affecting a projects net present value.

DISCUSSION: (A) To compute a projects net present value, the initial investment is subtracted from the present value
of the after-tax cash flows. The proceeds from the sale of the asset to be replaced reduces the initial investment.
Answer (B) is incorrect because the carrying amount of the asset to be replaced affects the gain or loss on the sale.
Answer (C) is incorrect because the amount of annual depreciation on the asset to be replaced affects the carrying
value. Answer (D) is incorrect because annual depreciation of other assets, even if used directly, does not affect the
projects net present value.
74
. Answer (B) is correct. In an inflationary environment, nominal future cash flows should increase to reflect the
decrease in the value of the unit of measure. Also, the investor should increase the discount rate to reflect the increased
inflation premium arising from the additional uncertainty. Lenders will require a higher interest rate in an inflationary
environment.
Answer (A) is incorrect because future cash flows should also increase. Answer (C) is incorrect because the discount
rate should be increased to take into consideration future uncertainty and the risk premium that lenders will require in an
inflationary environment. Answer (D) is incorrect because cash flows should increase in an inflationary environment.
75
. Answer (A) is correct. The internal rate of return (IRR) is the discount rate at which the present value of the cash
inflows equals the present values of the cash outflows (including the original investment). Thus, the NPV of the project is
zero at the IRR. The IRR is also the maximum borrowing cost the firm can afford to pay for a specific project. The IRR is
similar to the yield rate/effective rate quoted in the business media.
Answer (B) is incorrect because the capital asset pricing model is a means of determining the cost of capital. Answer (C)
is incorrect because the profitability index is not an interest rate. Answer (D) is incorrect because the accounting rate of
return is not based on present values.
76
. Answer (C) is correct. The IRR is the interest rate at which the present value of the expected future cash inflows is
equal to the present value of the cash outflows for a project. Thus, the IRR is the interest rate that will produce a net
present value (NPV) equal to zero. The IRR method assumes that the cash flows will be reinvested at the internal rate of
return.
Answer (A) is incorrect because the hurdle rate is a concept used to calculate the NPV of a project; it is determined by
management prior to the analysis. Answer (B) is incorrect because the IRR is the rate of interest at which the NPV is
zero. Answer (D) is incorrect because the IRR is a means of evaluating potential investment projects.
77
. Answer (C) is correct. The IRR is a capital budgeting technique that calculates the interest rate that yields a net
present value equal to $0. It is the interest rate that will discount the future cash flows to an amount equal to the initial
cost of the project. Thus, the higher the IRR, the more favorable the ranking of the project.
Answer (A) is incorrect because the cost of capital is not used in the calculation of the IRR. Answer (B) is incorrect
because the IRR can be determined regardless of the constancy of the cash flows. However, it is more difficult to
calculate when cash flows are not constant because a trial-and-error approach must be used. Answer (D) is incorrect
because there is no relationship between IRR and the profitability index.
78
. REQUIRED: The true statement about internal rate of return.

DISCUSSION: (D) The internal rate of return (IRR) is the discount rate at which the present value of the cash flows
equals the original investment. Thus, the NPV of the project is zero at the IRR. The IRR is also the maximum borrowing
cost the firm could afford to pay for a specific project. The IRR is similar to the yield rate/effective rate quoted in the
business media.
Answers (A), (B), and (C) are incorrect because the IRR is the discount rate at which the NPV of the cash flows is zero,
the breakeven borrowing rate for projects, and the yield rate/effective rate of interest quoted on long-term debt and other
instruments.
79
. Answer (D) is correct. The internal rate of return (IRR) is the discount rate at which the present value of the cash
flows equals the original investment. Thus, the NPV of the project is zero at the IRR. The IRR is also the maximum
borrowing cost the firm could afford to pay for a specific project. The IRR is similar to the yield rate/effective rate quoted
in the business media.
Answer (A) is incorrect because the IRR is the discount rate at which the NPV of the cash flows is zero, the breakeven
borrowing rate for the project in question, the yield rate/effective rate of interest quoted on long-term debt and other
instruments, and favorable when it exceeds the hurdle rate. Answer (B) is incorrect because the IRR is the discount rate
at which the NPV of the cash flows is zero, the breakeven borrowing rate for the project in question, the yield
rate/effective rate of interest quoted on long-term debt and other instruments, and favorable when it exceeds the hurdle
rate. Answer (C) is incorrect because the IRR is the discount rate at which the NPV of the cash flows is zero, the
breakeven borrowing rate for the project in question, the yield rate/effective rate of interest quoted on long-term debt and
other instruments, and favorable when it exceeds the hurdle rate.
80
. Answer (D) is correct. The internal rate of return of a proposed project includes the residual sales value of a project
but not the depreciation expense. This is true because the residual sales value represents a future cash flow whereas
depreciation expense (ignoring income tax considerations) provides no cash inflow or outflow.
Answers (A), (B), and (C) are incorrect because they contain the wrong combination of responses.
81
. Answer (C) is correct. Under the internal rate of return (IRR) method, the interest rate is computed that will exactly
match the present value of the future net inflows with the initial cost of the investment. The IRR method assumes that
cash flows will be reinvested at the IRR. Thus, if the project's funds are not reinvested at the internal rate of return, the
ranking calculations obtained under the IRR method may be in error. The net present value method gives a better grasp
of the problem in many decision situations because the reinvestment is assumed to be at the cost of capital.
Answer (A) is incorrect because the IRR does calculate compounded interest rates. Answer (B) is incorrect because
both methods incorporate the time value of money. Answer (D) is incorrect because sensitivity analysis can be used
with NPV to handle multiple desired hurdle rates.
82
. Answer (D) is correct. The IRR is the rate at which the discounted future cash flows equal the net investment (NPV
= 0). One disadvantage of the method is that inflows from the early years are assumed to be reinvested at the IRR. This
assumption may not be sound. Investments in the future may not earn as high a rate as is currently available.
Answer (A) is incorrect because the IRR method considers the time value of money. Answer (B) is incorrect because the
IRR provides a straightforward decision criterion. Any project with an IRR greater than the cost of capital is acceptable.
Answer (C) is incorrect because the IRR method implicitly assumes reinvestment at the IRR; the NPV method implicitly
assumes reinvestment at the cost of capital.
83
. REQUIRED: Advantage of the IRR over the accounting rate of return.

DISCUSSION: (C) The IRR is the interest rate that equalizes the present value of future cash flows with the initial cost
of the investment. The accounting rate of return is calculated by dividing the increase in accounting net income by the
required investment. However, it ignores the time value of money and does not emphasize cash flows.
Answers (A), (B), and (D) are incorrect because both techniques recognize the projects salvage value.
84
. Statement c is correct; the other statements are false. MIRR and NPV can conflict for mutually exclusive
projects if the projects differ in size. NPV does not suffer from the multiple IRR problem.
85
. Answer (D) is correct. The profitability index is the ratio of the present value of future net cash inflows to the initial
net cash investment. It is a variation of the NPV method that facilitates comparison of different-sized investments. A
profitability index greater than 1.0 indicates a profitable investment, or one that has a positive net present value.
Answer (A) is incorrect because the IRR is the discount rate at which the NPV is $0, which is also the rate at which the
profitability index is 1.0. The IRR cannot be determined solely from the index. Answer (B) is incorrect because, if the
index is 1.15 and the discount rate is the cost of capital, the NPV is positive, and the IRR must be higher than the cost of
capital. Answer (C) is incorrect because the IRR is a discount rate, whereas the NPV is an amount.
86
. (d) The internal rate of return method determines the rate of return at which the present value of the cash flows will
exactly equal the investment outlay. It will indicate the rate of return earned over the life of the project. The net present
value method determines the present vale of all future cash flows at a selected discount rate. If the NPV of the cash
flows is positive, the return earned b the project is higher than the selected rate. Both methods will provide the
information needed to decide if a projects rate of return will meet Polo co.s requirement.
87
. Answer (D) is correct. The IRR is defined as the rate at which the NPV is zero. Accordingly, if the NPV is positive at
a cost of capital of 15%, the rate (the IRR) required to reduce the NPV to zero must exceed 15%.
Answer (A) is incorrect because the accounting rate of return (net income investment) ignores the time value of
money. It is not determinable from the given information. Answer (B) is incorrect because the accounting rate of return
(net income investment) ignores the time value of money. It is not determinable from the given information. Answer (C)
is incorrect because the payback period ignores the time value of money. It is not determinable from the given
information.
88
. Answer (C) is correct. The relationship between the NPV method and the IRR method can be summarized as
follows:
NPVIRRNPV > 0IRR > Discount rateNPV = 0IRR = Discount rateNPV < 0IRR < Discount rateSince the problem states
that Neu Co. has a positive net present value on the investment, then the internal rate of return would be > 12%.
89
. Answer (A) is correct. The higher the discount rate, the lower the NPV. The IRR is the discount rate at which the
NPV is zero. Consequently, if the NPV is negative, the discount rate used must exceed the IRR.
Answer (B) is incorrect because, if the discount rate is less than the IRR, the NPV is positive. Answer (C) is incorrect
because the NPV measures the difference between a company's discount rate and the IRR. Answer (D) is incorrect
because the relationship between the discount rate and the risk-free rate is not a factor in investment analysis under the
NPV method.
90
. Statement a is correct; the other statements are false. If the projects are mutually exclusive, then project B
may have a higher NPV even though Project A has a higher IRR. IRR is calculated assuming cash flows are
reinvested at the IRR, not the cost of capital.
91
. The correct answer is a; the other statements are false. The IRR is the discount rate at which a projects
NPV is zero. If a projects IRR exceeds the firms cost of capital, then its NPV must be positive, since NPV is
calculated using the firms cost of capital to discount project cash flows.
92
.Statement a is true; projects with IRRs greater than the cost of capital will have a positive NPV. Statement b is false
because you know nothing about the relative magnitudes of the projects. Statement c is false because the IRR is
independent of the cost of capital. Therefore, the correct choice is statement a.
93
. The correct statement is b; the other statements are false. Since Project As IRR is 15%, at a WACC of 15% NPVA =
0; however, Project B would still have a positive NPV. Given the information in a, we cant conclude which projects NPV
is going to be greater. Since we are given no details about each projects cash flows we cannot conclude anything about
payback. Finally, IRR is independent of the discount rate, that is, IRR stays the same no matter what the WACC is.
94
. Statement a is false. The projects could easily have different NPVs based on different cash flows and costs of
capital. Statement b is false. NPV is dependent upon the size of the project. Think about the NPV of a $3 project versus
the NPV of a $3 million project. Statement c is false. NPV is dependent on a projects risk. Therefore, the correct choice
is statement e.
95
. A projects NPV increases as the cost of capital declines. A projects IRR is independent of its cost of
capital, while a projects MIRR is dependent on the cost of capital since the terminal value in the MIRR equation
is compounded at the cost of capital.
96
97
. Statement b is correct; the other statements are incorrect. Statement a is incorrect; if the NPV > 0, then the return
must be > 12%. Statement c is incorrect; if NPV > 0, then MIRR > WACC.
98
. Statement e is correct; the other statements are incorrect. Statement a is incorrect; the two projects NPV profiles
could cross, consequently, a higher IRR doesnt guarantee a higher NPV. Statement b is incorrect; it the two projects
NPV profiles cross, Y could have a higher NPV. Statement c is incorrect; we dont have enough information.
99
. Statement a is true because the IRR exceeds the WACC. Statement b is also true because the MIRR assumes that
the inflows are reinvested at the WACC, which is less than the IRR. Statement c is false. For a normal project, the
discounted payback is always longer than the regular payback because it takes longer for the discounted cash flows to
cover the purchase price. So, statement d is the best choice.
100
. Answer (A) is correct. If taxes are ignored, depreciation is not a consideration in any of the methods based on cash
flows because it is a non-cash expense. Thus, the internal rate of return, net present value, and payback methods would
not consider depreciation because these methods are based on cash flows. However, the accounting rate of return is
based on net income as calculated on an income statement. Because depreciation is included in the determination of
accrual accounting net income, it would affect the calculation of the accounting rate of return.
Answer (B) is incorrect because the IRR and the payback period are based on cash flows. Depreciation is not needed in
their calculation. However, the accounting rate of return cannot be calculated without first deducting depreciation.
Answer (C) is incorrect because the IRR and the payback period are based on cash flows. Depreciation is not needed in
Answer (D) is incorrect because the IRR and the payback period are based on cash flows. Depreciation is not needed in
101
. Answer (C) is correct. The profitability index is the ratio of the present value of future net cash inflows to the initial
net cash investment. It is a variation of the net present value (NPV) method and facilitates the comparison of differentsized investments. Because it is based on the NPV method, the profitability index will yield the same decision as the
NPV for independent projects. However, decisions may differ for mutually exclusive projects of different sizes.
Statement a is the incorrect statement. NPV is positive if IRR is greater than the cost of capital.
Answer (A) is incorrect because the profitability index, like the NPV method, discounts cash flows based on the cost of
capital. Answer (B) is incorrect because the profitability index is cash based. Answer (D) is incorrect because the NPV
and the profitability index may yield different decisions if projects are mutually exclusive and of different sizes.
102
. Answer (D) is correct. All three managers will reject the project. Manager one will calculate a NPV of -$12,894 [$100,000 + ($20,000 x 4.3553 PVIFA for six periods at 10%)]. Manager two will calculate a NPV of -$26,349 {- $100,000
+ ($5,000 x .8772 PVIF for one period at 14%) + [($23,000 x 3.4331 PVIFA for five periods at 14%) x .8772 PVIF for one
period at 14%]}. Manager three will calculate a net present value of -$41,640 [-$100,000 + ($135,000 x .4323 PVIF for
six periods at 15%)].
Answer (A) is incorrect because all three managers will calculate a negative NPV, and none will recommend
acceptance. Answer (B) is incorrect because all three managers will calculate a negative NPV, and none will recommend
acceptance. Answer (C) is incorrect because all three managers will calculate a negative NPV, and none will
recommend acceptance.
103
. Answer (A) is correct. The payback period is the number of periods it takes before the cash flows from the project
repay the original investment outlay. This can be expressed as net investment divided by the average expected cash
flow. Manager one expects inflows of $20,000 per year, so it will take exactly 5 years for the project to repay the original
$100,000 invested. Manager two will calculate a payback period of more than 5 years. Only $5,000 is expected at the
end of year one, followed by inflows of $23,000 at the end of each year in years two through six. At the end of year five,
only $97,000 will have been received, based on these expectations. Manager three will calculate a payback period of 6
years. She estimates one inflow of $135,000 at the end of year six.
Answer (B) is incorrect because manager one will calculate a 5-year payback period, which is shorter than the periods
determined by managers two and three. Answer (C) is incorrect because manager one will calculate a 5-year payback
period, which is shorter than the periods determined by managers two and three. Answer (D) is incorrect because all
three managers will derive a different payback period for the project.
104
. Answer (B) is correct. If the net present value (NPV) of an investment is positive, the project should be accepted
(unless projects are mutually exclusive). If the NPV is negative, the investment should be rejected.
Answer (A) is incorrect because the present value of future net cash inflows must be compared with the initial cash
outlay to determine whether a project is acceptable. Answer (C) is incorrect because an IRR may be greater than zero
but less than a firm's cost of capital, in which case the project would not be profitable. Answer (D) is incorrect because
the accounting rate of return is not based on cash flows and is irrelevant to a company's hurdle rate.
105
. Answer (D) is correct. Given unlimited funds, all projects with a net present value greater than zero should be
invested in. Thus, it would be profitable to invest in any company where the rate of return is greater than the cost of
capital.
Answer (A) is incorrect because neither the accounting rate of return nor the earnings as a percent of sales is useful in
capital budgeting. The accounting rate of return is accounting net income over the required investment; it ignores the
time value of money. Earnings as a percent of sales ignores the amount of required investment. Answer (B) is incorrect
because the payback criterion for capital budgeting is not efficient or effective. Answer (C) is incorrect because the
problem states that there are unlimited capital funds but does not indicate what the cost of capital is. Accordingly,
projects can only be invested in when the internal rate of return is greater than cost of capital, i.e., the net present value
is greater than zero.
106
. Answer (D) is correct. A company should accept any investment proposal, unless some are mutually exclusive, that
has a positive net present value or an internal rate of return greater than the company's cost of capital.
Answer (A) is incorrect because the mere availability of financing is not the only consideration; more important is the
cost of the financing, which must be less than the rate of return on the proposed investment. Answer (B) is incorrect
because an investment with positive cash flows may be a bad investment due to the time value of money; cash flows in
later years are not as valuable as those in earlier years. Answer (C) is incorrect because returns should exceed the
weighted-average cost of capital, which includes the cost of equity capital as well as the cost of debt capital.
107
REQUIRED: The true statement about the NPV and IRR methods.
DISCUSSION: (A) The NPV criterion is that the NPV is positive, and the IRR criterion is that the cost of capital is less
than the IRR. When the cost of capital is less than the IRR, the NPV is positive. When it exceeds the IRR, the NPV is
negative. Accordingly, when two projects are independent, the NPV and IRR criteria will always lead to the same accept
or reject decision.
Answer (B) is incorrect because, if the second projects IRR is higher than the first projects, the organization would
accept the second project based on the IRR criterion. Answers (C) and (D) are incorrect because, if the projects are
independent, the NPV and IRR criteria indicates the same decision.
108
. Answer (A) is correct. Although the NPV method and the IRR method may rank projects differently, if a project is
found acceptable under the NPV approach, it will also be acceptable under the internal rate of return approach.
Answer (B) is incorrect because the two approaches may rank projects differently (the IRR assumes that reinvestment
will be at the discount rate, which is frequently not possible). Answer (C) is incorrect because the payback approach
does not consider the time value of money. Therefore, a project may be ranked differently than it would be under the
NPV approach or may be acceptable under the payback approach but not the NPV or IRR approaches. Answer (D) is
incorrect because the payback approach does not consider the time value of money. Therefore, a project may be ranked
differently than it would be under the NPV approach or may be acceptable under the payback approach but not the NPV
or IRR approaches.
109
. Answer (D) is correct. The profitability (excess present value) index facilitates the comparison of investments that
have different initial costs. The profitability index equals the present value of future net cash inflows divided by the initial
cash investment. The investment with the greater profitability index will be the preferred investment. However, if
investments are mutually exclusive, the net present value method may be the better way of ranking projects. The excess
present value index indicates the best return per dollar invested but does not consider the alternative possibilities for
unused funds. Thus, the smaller of the mutually exclusive projects may have the higher index, but the incremental
investment in the larger project may make it the better choice. For example, an $8,000,000 project may be a better use
of funds than a combination of a $6,000,000 project with a higher index and the best alternative use of the remaining
$2,000,000.
Answer (A) is incorrect because the investment generating cash flows the longest may not have the best return. Answer
(B) is incorrect because, given a net present value of zero (a profitability index exactly equal to one), the investor would
be indifferent to the project. Answer (C) is incorrect because the accounting rate of return is not a good measure of
profitability. It ignores the time value of money.
110
. Answer (C) is correct. Investment projects may be mutually exclusive under conditions of capital rationing (limited
capital). In other words, scarcity of resources will prevent an entity from undertaking all available profitable activities.
Under the IRR method, an interest rate is computed such that the present value of the expected future cash flows
equals the cost of the investment (NPV = 0). The IRR method assumes that the cash flows will be reinvested at the IRR.
The NPV is the excess of the present value of the estimated net cash inflows over the net cost of the investment. The
cost of capital must be specified in the NPV method. An assumption of the NPV method is that cash flows from the
investment will be reinvested at the particular project's cost of capital. Because of the difference in the assumptions
regarding the reinvestment of cash flows, the two methods will occasionally give different answers regarding the ranking
of mutually exclusive projects. Moreover, the IRR method may rank several small, short-lived projects ahead of a large
project with a lower rate of return but with a longer life span. However, the large project might return more dollars to the
company because of the larger amount invested and the longer time span over which earnings will accrue. When faced
with capital rationing, an investor will want to invest in projects that generate the most dollars in relation to the limited
resources available and the size and returns from the possible investments. Thus, the NPV method should be used
because it determines the aggregate present value for each feasible combination of projects.
Answer (A) is incorrect because the IRR is a number computed based on the characteristics of a given project. Answer
(B) is incorrect because cash flows are discounted under the IRR method. Answer (D) is incorrect because an
accelerated depreciation method will generate larger net cash inflows in the early years of a project. To equate the
present value of these cash flows with the net investment will therefore require a higher discount rate (IRR).
111
. Answer (D) is correct. The two methods ordinarily yield the same results, but differences can occur when the
duration of the projects and the initial investments differ. The reason is that the IRR method assumes cash inflows from
the early years will be reinvested at the internal rate of return. The NPV method assumes that early cash inflows are
reinvested at the cost of capital.
Answer (A) is incorrect because the two methods will give the same results if the lives and required investments are the
same. Answer (B) is incorrect because if the required rate of return equals the IRR (i.e., the cost of capital is equal to the
IRR), the two methods would yield the same decision. Answer (C) is incorrect because if the required rate of return is
higher than the IRR, both methods would yield a decision not to acquire the investment.
112
Answer (A) is correct. Project A's NPV is calculated as follows:

$1,000 x 2.2832$2,283.20 - Original cost(1,000.00) NPV$1,283.20The second project's NPV is:
$1,500 x (3.7845 - 2.2832) $2,251.95 - Original cost(1,000.00) NPV$1,251.95Since A has a slightly higher NPV, it
should be selected.
Answer (B) is incorrect because Project A has a slightly higher NPV and IRR. Answer (C) is incorrect because Project A
has a slightly higher IRR. Answer (D) is incorrect because Project A has a slightly higher NPV.
113
. Answer (D) is correct. The profitability index (PI) is often used to decide among investment alternatives when more
than one is acceptable. The profitability index is the ratio of the present value of future net cash inflows to the initial net
cash investment. The PI, although a variation of the net present value method, facilitates comparison of different-sized
investments.
Answer (A) is incorrect because the accounting rate of return is a poor technique. It ignores the time value of money.
Answer (B) is incorrect because the payback method ignores the time value of money and long-term profitability.
Answer (C) is incorrect because the internal rate of return is not effective when alternative investments have different
lives.
114
. Answer (A) is correct. The profitability index is the ratio of the present value of future net cash inflows to the initial
cash investment; that is, the figures are those used to calculate the net present value (NPV), but the numbers are
divided rather than subtracted. This variation of the NPV method facilitates comparison of different-sized investments. It
provides an optimal ranking in the absence of capital rationing.
Answer (B) is incorrect because the profitability index method is a discounted cash flow method. Answer (C) is incorrect
because the payback method gives no consideration to the time value of money or to returns after the payback period.
Answer (D) is incorrect because the profitability index method and the NPV method are discounted cash flow methods.
However, the profitability index method is the variant that purports to calculate a return per dollar of investment.
115
. Answer (C) is correct. The profitability index is the ratio of the present value of future net cash inflows to the initial
cash investment. This variation of the net present value method facilitates comparison of different-sized investments.
Were it not for this comparison feature, the profitability index would be no better than the net present value method.
Thus, it is the comparison, or ranking, advantage that makes the profitability index different from the other capital
budgeting tools.
Answer (A) is incorrect because the net present value (NPV > 0) is a capital budgeting tool that screens investments;
i.e., the investment must meet a certain standard to be acceptable. Answer (B) is incorrect because the time-adjusted
rate of return is a capital budgeting tool that screens investments; i.e., the investment must meet a certain standard (rate
of return) to be acceptable. Answer (D) is incorrect because the accounting rate of return is a capital budgeting tool that
screens investments; i.e., the investment must meet a certain standard (rate of return) to be acceptable.
116
. Answer (B) is correct. The IRR is the discount rate at which the net present value of a project is zero. Consequently,
if the IRR exceeds the cost of capital, the NPV calculated at the cost of capital must be positive. Projects with a positive
NPV are expected to be profitable and should be considered. Other factors being equal, projects with higher IRRs
should be accepted before those with lower IRRs.
Answer (A) is incorrect because IRRs should exceed the cost of capital, and projects should be accepted in the
descending order of their IRRs. Answer (C) is incorrect because IRRs should exceed the cost of capital, and projects
should be accepted in the descending order of their IRRs. Answer (D) is incorrect because IRRs should exceed the cost
of capital, and projects should be accepted in the descending order of their IRRs.
117
. Answer (C) is correct. Rational investors choose projects that yield the best return given some level of risk. If an
investor desires no risk, that is, an absolutely certain rate of return, the risk-free rate is used in calculating net present
value. The risk-free rate is the return on a risk-free investment such as government bonds. Certainty equivalent
adjustments involve a technique directly drawn from utility theory. It forces the decision maker to specify at what point
the firm is indifferent to the choice between a sum of money that is certain and the expected value of a risky sum.
Answer (A) is incorrect because a risk-adjusted discount rate does not represent an absolutely certain rate of return. A
discount rate is adjusted upward as the investment becomes riskier. Answer (B) is incorrect because the cost of capital
has nothing to do with certainty equivalence. Answer (D) is incorrect because the cost of equity capital does not equate
to a certainty equivalent rate.
118
. Answer (D) is correct. Under the certainty-equivalent method, expected cash flows are multiplied by a certainty
equivalent factor and discounted at the risk-free rate. Under the risk-adjusted discount rate method, expected cash flows
are discounted at the risk-adjusted discount rate.
Answer (A) is incorrect because the certainty-equivalent method uses the risk-free rate, not the cost of capital. Answer
(B) is incorrect because the risk-adjusted discount rate discounts expected cash flows at the risk-adjusted rate. Answer
(C) is incorrect because the certainty-equivalent method uses the risk-free rate, not the cost of capital.
119
. Answer (D) is correct. Under the certainty-equivalent approach, expected cash flows should be multiplied by
certainty-equivalent factors and discounted at the risk-free rate.
Answer (A) is incorrect because the risk-free rate should be used rather than the cost of capital. Answer (B) is incorrect
because the risk-free rate should be used rather than the cost of capital. Answer (C) is incorrect because the risk-free
rate should be used rather than the cost of capital.
120
. Answer (C) is correct. Uncertainty can be compensated for by adjusting the desired rate of return. If projects have
relatively uncertain returns, a higher rate should be required. A lower rate of return may be acceptable given greater
certainty. The concept is that with increased risk should come increased rewards, i.e., a higher rate of return.
Answer (A) is incorrect because preparing an analysis of probability of outcomes is not a simple method of adjustment.
Answer (B) is incorrect because accelerated depreciation should probably be used for tax purposes in every capital
project to minimize taxes in early years. Answer (D) is incorrect because uniformly increasing the estimated cash flows
and/or ignoring salvage values introduces error into the capital budgeting analysis.
121
. Answer (D) is correct. Risk analysis attempts to measure the likelihood of the variability of future returns from the
proposed investment. Risk can be incorporated into capital budgeting decisions in a number of ways, one of which is to
use a hurdle rate higher than the firm's cost of capital, that is, a risk-adjusted discount rate. This technique adjusts the
interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment
must be relatively larger or the increased discount rate will generate a negative net present value, and the proposed
acquisition will be rejected.
Answer (A) is incorrect because the nature of the funding may not be a sufficient reason to use a risk-adjusted rate. The
type of funding is just one factor affecting the risk of a project. Answer (B) is incorrect because a higher hurdle will result
in rejection of more projects. Answer (C) is incorrect because a risk-adjusted high hurdle rate is used for capital
investments with greater risk.
122
. Answer (D) is correct. Risk-adjusted discount rates can be used to evaluate capital investment options. If risks differ
among various elements of the cash flows, then different discount rates can be used for different flows.
Answer (A) is incorrect because the payback period ignores both the varying risk and the time value of money. Answer
(B) is incorrect because using the cost of capital as the discount rate does not make any adjustment for the risk
differentials among the various cash flows. Answer (C) is incorrect because risk has to be incorporated into the
company's hurdle rate to use the internal rate of return method with risk differentials.
123
.
.
125
.
126
.
124
Risk adjustment Answer: b Diff: E

Risk and project selection Answer: b Diff: E
Accepting risky projects Answer: e Diff: E
Risk and project selection
Answer: c Diff: E N
You have to find out what the required rate of return on each project is. Projects that are of high risk must have a
higher required rate of return than projects that are of low risk. The following table shows the required return for
each project on the basis of its risk level.
Project
A
B
C
D
E
Expected Return
15%
12
11
9
6
Risk
High
Average
High
Low
Low
Required return for

the risk level
12%
10%
12%
8%
8%
The company will accept all projects whose expected return exceeds its required return. Therefore, it will accept
Projects A, B, and D.
127
. Answer (D) is correct. Risk analysis attempts to measure the likelihood of the variability of future returns from the
proposed investment. Risk can be incorporated into capital budgeting decisions in a number of ways, one of which is to
use a hurdle rate higher than the firm's cost of capital, that is, a risk-adjusted discount rate. This technique adjusts the
interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment
must be relatively larger, or the increased discount rate will generate a negative net present value, and the proposed
acquisition will be rejected. Accordingly, the IRR (the rate at which the NPV is zero) for a rejected investment may
exceed the cost of capital when the risk-adjusted rate is higher than the IRR. Conversely, the IRR for an accepted
investment may be less than the cost of capital when the risk-adjusted rate is less than the IRR. In this case, the
investment presumably has very little risk. Furthermore, risk-adjusted rates may also reflect the differing degrees of risk,
not only among investments, but by the same investments undertaken by different organizational subunits.
Answer (A) is incorrect because discount rates may vary with the project or with the subunit of the organization. Answer
(B) is incorrect because the company may accept some projects with IRRs less than the cost of capital, or reject some
project with IRRs greater than the cost of capital. Answer (C) is incorrect because the company may accept some
projects with IRRs less than the cost of capital, or reject some project with IRRs greater than the cost of capital.
128
. By Kemp not making the risk adjustment, it is true that the company will accept more projects in the computer
division, and fewer projects in the restaurant division. However, this will make the company riskier overall, raising its cost
of equity. Investors will discount their cash flows at a higher rate, and the companys value will fall. In addition, some of
the computer projects might not exceed the appropriate risk-adjusted hurdle rate, and will actually be negative NPV
projects, further destroying value. Therefore, statement a is false. Because fewer of the restaurant projects will be
accepted, the restaurant division will become a smaller part of the overall company. Therefore, statement b is false. As
explained above, statement c is true.
129
. By not risk adjusting the cost of capital, the firm will tend to reject low-risk projects since their returns will be lower
than the average cost of capital, and it will take on high-risk projects since their returns will be higher than the average
cost of capital.
130
Risk adjustment Answer: a Diff: M

kA = 13% - 3% = 10%.
If the cash flows are cost only outflows, and the analyst wants to correctly
reflect their risk, the discount rate should be adjusted downward (in this
case by subtracting 3 percentage points) to make the discounted flows
comparatively larger.
131
Risk analysis
Answer: e Diff: E
Methods of analysis
Answer: a Diff: M
.
.
132
133
. REQUIRED: he technique used to evaluate cash flows from the purchase of a machine.
DISCUSSION: (A) Simulation is a technique used to describe the behavior of a real-world system over time. This
technique usually employs a computer program to perform the simulation computations. Sensitivity analysis examines
how outcomes change as the model parameters change.
Answer (B) is incorrect because linear programming is a mathematical technique for optimizing a given objective
function subject to certain constraints. Answer (C) is incorrect because correlation analysis is a statistical procedure for
studying the relation between variables. Answer (D) is incorrect because differential analysis is used for decision
making that compares differences in costs (revenues) of two or more options.
134
. Answer (C) is correct. Capital budgeting is the process of planning expenditures for assets, the returns on which are
expected to continue beyond 1 year. Simulation (Monte Carlo simulation) as applied to capital budgeting is a technique
for experimenting with logical/mathematical models using a computer. The computer is used to generate many
examples of results based upon various assumptions.
Answer (A) is incorrect because this is a method used to rank projects for capital-budgeting decision purposes. Answer
(B) is incorrect because this is a method used to rank projects for capital-budgeting decision purposes. Answer (D) is
incorrect because this is a method used to rank projects for capital-budgeting decision purposes.
135
. Answer (B) is correct. The term "rates of return" suggests the net present value and internal rate of return methods
in this context, but simulation analysis can also be used. Simulation is a mathematical modeling technique for
performing a what-if analysis of estimated data. For instance, it may determine how profitable a company will be if
Machine A is purchased rather than Machine B.
Answer (A) is incorrect because regression analysis is based on past data and is often used to determine trends or
divide costs into their fixed and variable components. Answer (C) is incorrect because Markov chain analysis is used in
decision problems in which the probability of the occurrence of a future state depends only on the current state. A
characteristic of the Markov process is that the initial state matters less and less as times goes on, because the process
will eventually reach its steady state. Answer (D) is incorrect because Gantt charting involves drawing a bar chart
showing the progress of a project.
136
Sensitivity, scenario, and simulation analyses
Answer: c Diff: E N
Statement a is false; sensitivity analysis measures a projects stand-alone risk. Statement b is false; sensitivity
analysis doesnt take into account probabilities, while scenario analysis does. Statement c is correct.
137
. Answer (C) is correct. After a problem has been formulated into any mathematical model, it may be subjected to
sensitivity analysis, which is a trial-and-error method used to determine the sensitivity of the estimates used. For
example, forecasts of many calculated NPVs under various assumptions may be compared to determine how sensitive
the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may
drastically alter the NPV, suggesting that the risk of the investment may be excessive.
Answer (A) is incorrect because sensitivity analysis is useful when cash flows, or other assumptions, are uncertain.
Answer (B) is incorrect because sensitivity analysis can be used with any of the capital budgeting methods. Answer (D)
is incorrect because sensitivity analysis is not a ranking technique; it calculates results under varying assumptions.
138
. Answer (A) is correct. Sensitivity analysis is a technique to evaluate a model in terms of the effect of changing the
values of the parameters. It answers "what if" questions. In capital budgeting models, sensitivity analysis is the
examination of alternative outcomes under different assumptions.
Answer (B) is incorrect because probability (risk) analysis is used to examine the array of possible outcomes given
alternative parameters. Answer (C) is incorrect because cost behavior (variance) analysis concerns historical costs, not
predictions of future cash inflows and outflows. Answer (D) is incorrect because ROI analysis is appropriate for
determining the profitability of a company, segment, etc.
139
. Answer (B) is correct. After a problem has been formulated into any mathematical model, it may be subjected to
sensitivity analysis, which is a trial-and-error method used to determine the sensitivity of the estimates used. For
example, forecasts of many calculated NPVs under various assumptions may be compared to determine how sensitive
the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may
drastically alter the NPV, suggesting that the risk of the investment may be excessive.
Answer (A) is incorrect because sensitivity analysis is a means of making several estimates of inputs into a capital
budgeting decision to determine the effect of changes in assumptions. Answer (C) is incorrect because sensitivity
analysis is not a simulation technique; it is simply a process of making more than one estimate of unknown variables.
Answer (D) is incorrect because sensitivity analysis would not identify the required market share; instead, it would be
used to make several estimates of market share to determine how sensitive the decision is to changes in market share.
140
Monte Carlo simulation
Answer: e Diff: M
. Answer (D) is correct. An increase in the discount rate would lower the net present value, as would a decrease in
cash flows or an increase in the initial investment.
Answer (A) is incorrect because a decrease in the tax rate would decrease tax expense, thus increasing cash flows and
the NPV. Answer (B) is incorrect because a decrease in the initial investment amount would increase the NPV. Answer
(C) is incorrect because an extension of the project life and associated cash inflows would increase the NPV.
141
142
12A-.
NPV and depreciation
Answer: c Diff: E
143
.Statements a, b, c, and d are false. Statement e is correct because you can think of a firm as a big project. If the stock
is correctly priced, i.e., the stock market is efficient, the NPV of this project should be zero.
144
. REQUIRED: The true statement regarding the NPV profiles of two mutually exclusive capital projects.
DISCUSSION: (A) The NPV is the excess of the present value of the estimated cash inflows over the net cost of the
investment. Thus, Project 2 has a higher internal rate of return. The internal rate of return is the cost of capital at which
the NPV is zero, that is, the cost of capital at which the NPV profile crosses the horizontal axis. The NPV profile for
Project 2 intersects the horizontal axis at a higher cost of capital percentage than does that for Project 1.
Answer (B) is incorrect because Project 1 has the lower internal rate of return. Answers (C) and (D) are incorrect
because the profiles of Projects 1 and 2 intersect. Neither project will have a higher NPV at all cost of capital
percentages. To the left of the intersection point, Project 1 has a higher NPV. To the right of the intersection point,
Project 2 has a higher NPV.
145
.You can draw the NPV profiles to get an idea of what is happening. (See the diagram below.) Statement a is false;
Project B could have a higher NPV at some WACC if the NPV profiles cross. Statement b is false; Project B could have
a negative NPV when As NPV is positive. Statement c is false; the IRR is unaffected by the WACC. Statement d is the
correct choice.
NPV
$
k
0
146
10%
IRRB
IRRA
NPV
($)
A
B
Discount rate (%)

0
16% 17%
18%
30%
Draw the NPV profiles using the information given in the problem. It is clear that Project A will have a higher NPV when
the cost of capital is 12 percent. Therefore, statement a is false. At a 17 percent cost of capital, Project B will have a
higher NPV than Project A. Therefore, statement b is true. If the cost of capital were 0, then the NPV of the projects
would be the simple sum of all the cash flows. In order for statement c to be correct, Bs NPV at a 0 cost of capital would
have to be higher than As. From the diagram we see that this is clearly incorrect. So, statement c is false.
.
NPV
147
profiles
Answer: d Diff: M N
NPV
$
P
10%
15%
20%
k
%
The diagram above can be drawn from the statements in this question. From the diagram drawn, statements a, b, and c
are correct; therefore, statement d is the correct choice.
148
.
NPV ($)
C
D
10%
First, draw the NPV profiles as shown above. Make sure the profiles cross at 10 percent because the projects have the
same NPV at a cost of capital of 10 percent. When WACC is less than 10 percent, C has a higher NPV, so Cs NPV
profile is above Ds NPV profile to the left of the crossover point (10%).
Statement a is true. IRR is always independent of the cost of capital, and from the diagram above, we can see that
Ds IRR is to the right of Cs where the two lines cross the X-axis. Statement b is false. IRR is independent of the
cost of capital, and from the diagram Cs IRR is always lower than Ds. Statement c is true. Ds MIRR will be
somewhere between the cost of capital and the IRR. Therefore, the correct choice is statement d.
149
.
NPV
k
0
7%
12%
15%
Since both projects have an IRR greater than the cost of capital, both will have a positive NPV. Therefore, statement a is
true. At 6 percent, the cost of capital is less than the crossover rate and Project A has a higher NPV than B. Therefore,
statement b is false. If the cost of capital is 13 percent, then the cost of capital is greater than the crossover rate and B
would have a higher NPV than A. Therefore, statement c is true. Since statements a and c are both true, the correct
choice is statement e.
150
.
NPV
$
B
k
0
7%
12%
14%
Statement a is correct, because at any point to the right of the crossover point B will have a higher NPV than A.
Statement b is correct for the same reason that statement a is true; at any point to the right of the crossover point, B will
have a higher NPV than A. Statement c is correct. If Bs cost of capital is 9 percent, when MIRR is calculated the cash
flows are being reinvested at 9 percent. When IRR is used, the IRR calculation assumes that cash flows are being
reinvested at the IRR (which is higher than the cost of capital.) Statement e is the correct choice.
151
. REQUIRED: The true statement about the IRR.

DISCUSSION: (B) the IRR is the discount rate at which the net present value is zero. Because the present value of a
dollar is higher the sooner it is received, projects with later cash flows will have lower net present values for any given
discount rate than will projects with earlier cash flows, if other factors are constant. Hence, projects with later cash flows
will have a lower IRR.
Answer (A) is incorrect because the present value of the cash inflows is inversely related to the discount rate, that is, if
the discount rate is higher, the present value of the cash inflows is lower. If the investment cost is lower, a higher
discount rate (the IRR) will be required to set the net present value equal to zero. Answer (C) is incorrect because the
larger the cash inflows, the higher the IRR will be. Higher cash inflows have a higher present value at any given
discount rate. A higher discount rate will be required to set the net present value equal to zero. Answer (D) is incorrect
because projects with shorter payback periods have higher cash inflow early in the life of the project. Projects with
earlier cash inflows have the higher IRRs.
152
. Answer (A) is correct. Investments with present values in excess of their costs (positive NPVs) that can be identified
or created by the capital budgeting activities of the firm will have a positive impact on firm value and on the price of the
common shares of the firm. Accordingly, the more effective capital budgeting is, the higher the share price.
Answer (B) is incorrect because positive NPV investments will increase, not decrease, firm value and share price.
Answer (C) is incorrect because investments with present values equal to their costs have a zero NPV and neither
increase nor decrease firm value and share price. Answer (D) is incorrect because investments with present values
equal to their costs have a zero NPV and neither increase nor decrease firm value and share price.
153
. Answer (A) is correct. The value of the firm is the present value of the expected cash flows, which is given by the
following expression:
n
Sigma CFt
t 1
(1 K) t
If CF is net cash flow, K is the discount rate (cost of capital), and t is time, value will rise as CF increases.
Answer (B) is incorrect because an increase in systematic (market or undiversifiable) risk will increase the overall cost of
capital and thereby increase K, the discount rate. As a result, the value of the firm will fall. Answer (C) is incorrect
because an increase in unsystematic (or firm-specific) risk will have no effect on the value of the firm. The total risk is the
sum of systematic and unsystematic risk. By definition, the latter is the risk that can be eliminated by diversification.
Answer (D) is incorrect because an increase in the discount rate will reduce the value of the firm.
154
Risk analysis
Answer: c Diff: E N
Statement a is false. Stand-alone risk is measured by standard deviation. Therefore, since Ys standard deviation is
higher than Xs, Y has higher stand-alone risk than X. Statement b is false. Corporate risk is measured by the
correlation of project cash flows with other company cash flows. Therefore, since Ys cash flows are highly
correlated with the cash flows of existing projects, while Xs are not, Y has higher corporate risk than X. Market
risk is measured by beta. Therefore, since Xs beta is greater than Ys, statement c is true.
155
. Statement a is correct. The IRRs of both exceed the cost of capital. Statement b is incorrect. We cannot
determine this without knowing the NPVs of the projects. Statement c is correct. To see why draw the NPV
profiles. Statement d is incorrect. Therefore, statement e is the correct answer.
156
157
. Draw out the NPV profiles of these two projects. As Bs NPV declines more rapidly with an increase in
discount rates, this implies that more of the cash flows are coming later on. Therefore, Project A has a faster
payback than Project B.
158
This is the only project with either a positive NPV or an IRR which exceeds the cost of capital.
NPV
$
Y
X
Crossover
k
10%
IRRY 12%
IRRX
If IRRX is greater than MIRRX, then its IRR must be higher than the cost of capital. (Remember that the MIRR will be
somewhere between the cost of capital and the IRR). Therefore, statement a must be true. Similarly, if IRR Y is less than
MIRRY, then its IRR must be lower than the cost of capital. Therefore, statement b must be true. At a cost of capital of 10
percent they have the same NPV, so this is the crossover rate. From statements a and b we know that IRR X must be
greater than IRRY, so to the right of the crossover rate NPV X will be larger than NPVY. Consequently, to the left of the
crossover rate NPVX must be smaller than NPVY. Therefore, statement c is also true. Since statements a, b, and c are all
true, the correct choice is statement d.
159
This statement reflects exactly the difference between the NPV and IRR methods.
160
. Both statements a and c are correct; therefore, statement d is the correct choice. Due to reinvestment rate
assumptions, NPV and IRR can lead to conflicts; however, there will be no conflict between NPV and MIRR if the
projects are equal in size (which is one of the assumptions in this question).
161
. Statement a is true. To see this, sketch out a NPV profile for a normal, independent project, which means
that only one NPV profile will appear on the graph. If WACC < IRR, then IRR says accept. But in that case, NPV >
0, so NPV will also say accept. Statement d is false. Here is the reasoning:
1. For the NPV profiles to cross, then one project must have a higher NPV at k = 0 than the other project, that is, their
vertical axis intercepts will be different.
2. A second condition for NPV profiles to cross is that one have a higher IRR than the other.
3. The third condition necessary for profiles to cross is that the project with the higher NPV at k = 0 will have the lower
IRR.
One can sketch out two NPV profiles on a graph to see that these three conditions are indeed required.
4. The project with the higher NPV at k = 0 must have more cash inflows, because it has the higher NPV when cash
flows are not discounted, which is the situation if k = 0.
5. If the project with more total cash inflows also had its cash flows come in earlier, it would dominate the other
project--its NPV would be higher at all discount rates, and its IRR would also be higher, so the profiles would not
cross. The only way the profiles can cross is for the project with more total cash inflows to get a relatively high
percentage of those inflows in distant years, so that their PVs are low when discounted at high rates. Most students
either grasp this intuitively or else just guess at the question!
162
. Answer (A) is correct. If the economic results of alternative capital investments were known with certainty or with
minimal risk, the quantitative analyses would reveal the absolute best investment options. However, if the economic
results are highly uncertain, using a decision-making process that combines rational analysis with intuition is
appropriate. Moreover, nonquantifiable variables may be involved.
Answer (B) is incorrect because the decision-making process described combines rational quantitative analysis with
intuition. In addition, research has shown that intuition can improve decision making. Answer (C) is incorrect because
knowing with certainty which investment is the most profitable is not possible. Answer (D) is incorrect because the term
bounded rationality refers to the inability to perceive all aspects of a situation and the tendency to simplify, not to intuitive
decision making.
163
. Statement e is correct; the other statements are false. IRR can lead to conflicting decisions with NPV even
with normal cash flows if the projects are mutually exclusive. Cash outflows are discounted at the cost of
capital with the MIRR method, while cash inflows are compounded at the cost of capital. Conflicts between NPV
and IRR arise when the cost of capital is below the crossover point. The discounted payback method does
correct the problem of ignoring the time value of money, but it still does not account for cash flows beyond the
payback period.
164
. Statements a and c are correct; therefore, statement d is the correct choice. The discounted payback
method still ignores cash flows after the payback period.
165
. Statement a is correct; the other statements are false. Multiple IRRs can occur only for projects with
nonnormal cash flows. Mutually exclusive projects imply that only one project should be chosen. The project
with the highest NPV should be chosen.
166
. Statement a is correct; the other statements are false. Sketch the profiles. From the information given, D
has the higher IRR. The projects scale cannot be determined from the information given. As Cs NPV declines
more rapidly with an increase in rates, this implies that more of the cash flows are coming later on. So C would
have a slower payback than D.
167
. Answer (D) is correct. MACRS is an accelerated method of depreciation under which depreciation expense will be
greater during the early years of an asset's life. Thus, the outflows for income taxes will be less in the early years, but
greater in the later years, and the NPV (present value of net cash inflows - investment) will be increased. The profitability
index (present value of net cash inflows the investment) must increase if the NPV increases.
Answer (A) is incorrect because the NPV will increase. The present value of the net inflows will increase with no change
in the investment. Answer (B) is incorrect because the IRR will increase. Deferring expenses to later years increases the
discount rate needed to reduce the NPV to $0. Answer (C) is incorrect because the payback period will be shortened.
Switching to MACRS defers expenses and increases cash flows early in the project's life.
168
12A-.
Depreciation cash flows Answer: c Diff: M
169
. Answer (D) is correct. MACRS for assets with lives of 10 years or less is based on the 200% declining-balance
method of depreciation. Thus, an asset with a 3-year life would have a straight-line rate of 33-1/3%, or a doubledeclining-balance rate of 66-2/3%.
Answer (A) is incorrect because the straight-line method uses the same percentage each year during an asset's life, but
MACRS uses various percentages. Answer (B) is incorrect because MACRS is unrelated to the units-of-production
method. Answer (C) is incorrect because MACRS is unrelated to SYD depreciation.
170
. Answer (A) is correct. For tax purposes, straight-line depreciation is an alternative to the MACRS method. Both
methods will result in the same total depreciation over the life of the asset; however, MACRS will result in greater
depreciation in the early years of the asset's life because it is an accelerated method. Given that MACRS results in
larger depreciation deductions in the early years, taxes will be lower in the early years and higher in the later years.
Because the incremental benefits will be discounted over a shorter period than the incremental depreciation costs,
MACRS is preferable to the straight-line method.
Answer (B) is incorrect because both methods will produce the same total depreciation over the life of the asset. Answer
(C) is incorrect because both methods will produce the same total tax payments (assuming rates do not change).
However, given that the tax payments will be lower in the early years under MACRS, discounting for the time value of
money makes the straight-line alternative less advantageous. Answer (D) is incorrect because both methods will
produce the same total depreciation over the life of the asset.
171
Taxes on gain on sale

Answer: b Diff: E N
When the machine is sold the total accumulated depreciation on it is: (0.2 + 0.32 + 0.19) $1,000,000 = $710,000.
The book value of the equipment is: $1,000,000 - $710,000 = $290,000. The machine is sold for $400,000, so the
gain is $400,000 - $290,000 = $110,000. Taxes are calculated as $110,000 0.4 = $44,000.
172

Answer: c Diff: E
ks = 10% + (16% - 10%)1.5 = 10% + 9% = 19%.
Original IRR = 21%. 21% - Risk adjustment 1% = 20%.
Risk adjusted IRR = 20% > ks = 19%.
173

Time lines:
Project A:
0 k = 12% 1
Answer: b Diff: M
CFsA -15,000 4,000

NPVA = ? = 3,978.60
Project B:
0 k = ?
4,000
4,000
4,000
4,000
Terminal CF =
6
4,000
5,000 Salvage value
9,000
CFsB -14,815
5,100
NPVB = NPVA = 3,978.60
Years
5,100
5,100
0
Salvage value
Terminal CF = 5,100
Tabular solution:
Solve for the NPV of Project A, which is also the NPV of Project B at some k
= ?
NPVA = -$15,000 + $4,000(PVIFA12%,6) + $5,000(PVIF12%,6)
= -$15,000 + $4,000(4.1114) + $5,000(0.5066) = $3,978.60.
Solve for kB
NPVB = $3,978.60 = -$14,815 + $5,100(PVIFAk,6)
$18,793.60 = $5,100(PVIFAk,6)
PVIFAk,6 = 3.68502.
Look across the row for 6 years in the PVIFA table. The factor for 16 percent
is 3.6847; therefore, the risk-adjusted rate for Project B is approximately
16 percent.
174
Financial calculator solution:

A: Inputs: CF0 = -15,000; CF1 = 4,000; Nj = 5; CF2 = 9,000; I = 12.
Output: NPV = $3,978.78.
B: Inputs: CF0 = -18,793.78; CF1 = 5,100; Nj = 6.
Output: IRR = 15.997% 16%.
Answer: e Diff: T
Time lines:
Project A:
0
1
2
3
4 Years
k = 12%
CFsA -25,000
13,000
NPVA = ? = 17,663
Project B:
0
k = ?
CFsB -25,000
15,247
NPVA = NPVB = 17,663
13,000
13,000
13,000
Terminal value = 5,000
CF4 = 18,000
2
Years
15,247
15,247
15,247
Terminal value =
0
CF4 = 15,247
Tabular solution:
NPVA = -$25,000 + $13,000(PVIFA12%,3) + $18,000(PVIF12%,4)
= -$25,000 + $13,000(2.4018) + $18,000(0.6355) = $17,662.40.
NPVB = $17,662.40 = -$25,000 + $15,247(PVIFAk,4)
$42,662.40 = $15,247(PVIFAk,4)
(PVIFAk,4) = 2.79808
k 16%.
A: Inputs: CF0 = -25,000; CF1 = 13,000; Nj = 3; CF2 = 18,000; I = 12.
Output: NPVA = 17,663.13.
B: Inputs: CF0 = -42,663.13; CF1 = 15,247; Nj = 4.
Output: IRR = 16.0% = k.
175
New project NPVAnswer: e Diff: M

Time line:
0 k = 18% 1
2
-3,000
NPV = ?
1,728
1,920
Years
1,152
Project analysis worksheet:

I
Initial outlay
1) Cost
($4,000)
2) Decrease in NOWC
1,000
3) Total net investment
($3,000)
II Operating flows:
Year:
0
4) EBT and depreciation
5) Earnings after taxes
(line 4 0.6)
6) Depreciation (from table)
7) Tax savings from
depreciation (5 0.4)
8) Net operating flows
(line 5 + 7)
III Terminal year cash flows:
9) Estimated salvage value
10) Tax on salvage value
((1,000 - 280) 0.4)
11) Return of NOWC
12) Total termination CFs
IV Net cash flows:
13) Total net cash flows
($3,000)
1
$2,000
2
$2,000
3
$2,000
1,200
1,320
1,200
1,800
1,200
600
528
720
240
$1,728
$1,920
$1,440
$1,000
(288)
(1,000)
($ 288)
$1,728
$1,920
$1,152
Tabular solution:
NPV = -$3,000 + $1,728(PVIF18%,1) + $1,920(PVIF18%,2) + $1,152(PVIF18%,3)
= -$3,000 + $1,728(0.8475) + $1,920(0.7182) + $1,152(0.6086) = $544.53.
Inputs: CF0 = -3000; CF1 = 1728; CF2 = 1920; CF3 = 1152; I = 18.
Output: NPV = $544.46 $544.
176
New project NPV
Answer: d Diff: M
Time line:
0
1
k = 12%
-45,000
NPV = ?
7,800
10,680
Depreciation cash flows:

Year
1
2
3
4
5
6
MACRS
Percent
0.20
0.32
0.19
0.12
0.11
0.06
3
7,560
4
5,880
Depreciable
Basis
$60,000
60,000
60,000
60,000
60,000
60,000
5 Years
-1,920
Annual
Depreciation
$12,000
19,200
11,400
7,200
6,600
3,600
$60,000

I
Initial outlay
1) Machine cost
($60,000)
2) Decrease in NOWC
15,000
3) Total net inv.
($45,000)
II Operating cash flows
Year:
0
1
2
3
4
5
4) Reduction in cost
$ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000
5) After-tax dec. in cost
3,000
3,000
3,000
3,000
3,000
6) Deprec. (from table)
12,000 19,200 11,400
7,200
6,600
7) Tax savings deprec.
(line 6 0.4)
4,800
7,680
4,560
2,880
2,640
8) Net operating CFs
(line 5 + 7)
$ 7,800 $10,680 $ 7,560 $ 5,880 $ 5,640
III Terminal year CFs
$10,000
(10,000 - 3,600)(0.4)
(2,560)
11) Return of NOWC
(15,000)
(7,560)
IV Net CFs
13) Total Net CFs
($45,000) $ 7,800 $10,680 $ 7,560 $ 5,880 ($ 1,920)
Tabular solution:
+ $5,880(PVIF12%,4) - $1,920(PVIF12%,5)
= -$45,000 + $7,800(0.8929) + $10,680(0.7972) + $7,560(0.7118)
+ $5,880(0.6355) - $1,920(0.5674) = -$21,492.74 -$21,493.

Inputs: CF0 = -45,000; CF1 = 7,800; CF2 = 10,680; CF3 = 7,560;
CF4 = 5,880; CF5 = -1,920; I = 12.
Output: NPV = -$21,493.24 $21,493.
177
New project NPVAnswer: b Diff: M

Time line:
0 k = 9%
-40,000
= ?
9,800
11,720
9,640
5 Years
8,520
15,320
NPV
Depreciation cash flows:

Year
1
2
3
4
5
6
MACRS
Percent
0.20
0.32
0.19
0.12
0.11
0.06
Depreciable
Basis
$40,000
40,000
40,000
40,000
40,000
40,000

I
Initial outlay
1) Machine cost
($40,000)
2) Decrease in NOWC
-3) Total net inv. ($40,000)
II Operating cash flows
Year:
0
1
4) Inc. in earnings
before deprec. & tax
$ 6,000
5) After-tax increase in
earnings (line 4 0.6) 3,600
6) Before tax reduction
in cost
5,000
7) After tax reduction
in cost (line 6 0.4)
3,000
8) Deprec. (from table)
8,000
9) Deprec. tax savings
(line 8 0.4)
3,200
_______
(line 5 + 7 + 9)
$ 9,800
III Terminal year CFs
(10,000 - 2,400)(0.4)
13) Return of NOWC
IV Net CFs
15) Total Net CFs ($40,000) $ 9,800
Annual
Depreciation
$ 8,000
12,800
7,600
4,800
4,400
2,400
$40,000
$ 6,000 $ 6,000 $ 6,000 $ 6,000

3,600
3,600
3,600
3,600
5,000
5,000
5,000
5,000
3,000
12,800
3,000
7,600
3,000
4,800
3,000
4,400
5,120
3,040
1,920
1,760
_______ _______ _______ _______
$11,720 $ 9,640 $ 8,520 $ 8,360
$10,000
(3,040)
-6,960
$11,720 $ 9,640 $ 8,520 $15,320
Tabular solution:
+ $8,520(PVIF9%,4) + $15,320(PVIF9%,5)
= -$40,000 + $9,800(0.9174) + $11,720(0.8417) + $9,640(0.7722)
+ $8,520(0.7084) + $15,320(0.6499) = $2,291.29 $2,292.
178

Inputs: CF0 = -40,000; CF1 = 9,800; CF2 = 11,720; CF3 = 9,640;
CF4 = 8,520; CF5 = 15,320; I = 9.
Output: NPV = $2,291.90 $2,292.
New project NPV
Answer: a Diff: M N
0
Equipment purchase
NOWC
Sales increase
Operating costs
Operating income
Depreciation
EBIT
Taxes (35%)
EBIT(1 - T)
+Depreciation
Operating cash flow
Recovery of NOWC
Equipment sale
Taxes on sale
Net CF
-$600,000
-50,000
_________
-$650,000
$2,000,000
1,400,000
$ 600,000
200,000
$ 400,000
140,000
$ 260,000
200,000
$ 460,000
$2,000,000
1,400,000
$ 600,000
200,000
$ 400,000
140,000
$ 260,000
200,000
$ 460,000
__________
$ 460,000
__________
$ 460,000
$2,000,000
1,400,000
$ 600,000
200,000
$ 400,000
140,000
$ 260,000
200,000
$ 460,000
50,000
+100,000
-35,000
$ 575,000
NPV = -$650,000 + $460,000/1.12 + $460,000/(1.12)2 + $575,000/(1.12)3

= -$650,000 + $410,714.29 + $366,709.18 + $409,273.64
= $536,697.11 $536,697.
179
New project NPV

Year
Project cost
NOWC*
Sales
Operating costs (75%)
Operating income before deprec.
Depreciation
EBIT
Taxes (40%)
EBIT(1 - T)
Plus: Depreciation
Operating CF
Recovery of NOWC
Net CF
Answer: b Diff: M N
0
-5,000,000
-300,000
-$5,300,000
$3,000,000
2,250,000
$ 750,000
1,650,000
-$ 900,000
-360,000
-$ 540,000
1,650,000
$1,110,000
$4,000,000
3,000,000
$1,000,000
2,250,000
-$1,250,000
-500,000
-$ 750,000
2,250,000
$1,500,000
$5,000,000
3,750,000
$1,250,000
750,000
$ 500,000
200,000
$ 300,000
750,000
$1,050,000
$1,110,000
$1,500,000
$1,050,000
$2,000,000
1,500,000
$ 500,000
350,000
$ 150,000
60,000
$ 90,000
350,000
$ 440,000
300,000
$ 740,000
*An increase in inventories is a use of funds for the company, and an increase in accounts payable is a source of
funds for the company. Thus, the change in net operating working capital will be $200,000 - $500,000 = -$300,000
at time 0.
NPV = -$5,300,000 + $1,110,000/1.10 + $1,500,000/(1.10)2 + $1,050,000/(1.10)3 + $740,000/(1.10)4
NPV = -$5,300,000 + $1,009,091 + $1,239,669 + $788,881 + $505,430
NPV = -$1,756,929.
180
New project NPV

Answer: a Diff: M N
0
($500,000)
(40,000)
Project cost
NOWC
Sales
Operating costs
Depreciation
EBIT
Taxes (40%)
EBIT(1 - T)
Plus: Depreciation
Recovery of NOWC
Net CF
________
________
($540,000)
$800,000
480,000
165,000
$155,000
62,000
$ 93,000
165,000
________
$258,000
$800,000
480,000
225,000
$ 95,000
38,000
$ 57,000
225,000
________
$282,000
$500,000
300,000
75,000
$125,000
50,000
$ 75,000
75,000
________
$150,000
$500,000
300,000
35,000
$165,000
66,000
$ 99,000
35,000
40,000
$174,000
NPV = -$540,000 + $258,000/1.10 + $282,000/(1.10)2 + $150,000/(1.10)3 + $174,000/(1.10)4

= -$540,000 + $234,545.45 + $233,057.85 + $112,697.22 + $118,844.34
= $159,144.86 $159,145.
181
New project NPVAnswer: d Diff: T

Step 1: Calculate depreciation:
Dep 1 = 100,000(0.33) = 33,000.
Dep 2 = 100,000(0.45) = 45,000.
Dep 3 = 100,000(0.15) = 15,000.
Dep 4 = 100,000(0.07) = 7,000.
Step 2:
Step 3:
182
Calculate cash flows:

CF 0 = -100,000 - 5,000
CF 1 = 50,000 + 33,000
CF 2 = 60,000 + 45,000
CF 3 = 70,000 + 15,000
CF 4 = 60,000 + 7,000 +
= -105,000.
=
83,000.
= 105,000.
=
85,000.
5,000 + 15,000 = 87,000.
Calculate NPV:
Use CF key on calculator. Enter cash flows shown above. Enter I/YR =
12%. Solve for NPV = $168,604.

First, find the after-tax CFs
accomplished by subtracting the
associated with the project.

depreciation expense from the
This is
raw CF,
reducing this net CF by taxes and then adding back the depreciation expense.
For t = 1: ($45,000 - $33,000)(1 - 0.4) + $33,000 = $40,200.
Similarly, the after-tax CFs for t = 2, t = 3, and t = 4 are $45,000,
$33,000, and $29,800, respectively.
Now, enter these CFs along with the cost of the equipment to find the presalvage NPV (note that the salvage value is not yet accounted for in these
CFs). The appropriate discount rate for these CFs is 11 percent. This yields
a pre-salvage NPV of $16,498.72.
Finally, the salvage value must be discounted. The PV of the salvage value
is: N = 4; I = 12; PMT = 0; FV = -10,000; and PV = $6,355.18. Adding the PV
of the salvage amount to the pre-salvage NPV yields the project NPV of
$22,853.90.
183

The cash flows for each of the years are as follows:
0
1
2
3
4
5
6
[90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 [90,000 - 50,000 (10,000)(1 - 0.4)
(100,000)(0.20)](1
(100,000)(0.32)](1
(100,000)(0.19)](1
(100,000)(0.12)](1
(100,000)(0.11)](1
(100,000)(0.06)](1
0.4)
0.4)
0.4)
0.4)
0.4)
0.4)
+
+
+
+
+
+
(100,000)(0.20)
(100,000)(0.32)
(100,000)(0.19)
(100,000)(0.12)
(100,000)(0.11)
(100,000)(0.06)
=
=
=
=
=
+
=
-100,000
32,000
36,800
31,600
28,800
28,400
32,400
Enter the cash flows and solve for the NPV = $38,839.56.
184
New project NPVAnswer: c Diff: T

Get the depreciation using the MACRS table provided in the question.
0
1
2
3
4
Cost
(500,000)
Inventory
( 50,000)
Accounts Payable
10,000
Sales
600,000
600,000
600,000
600,000
Operating Cost
400,000
400,000
400,000
400,000
Depreciation
165,000
225,000
75,000
35,000
EBIT
35,000
( 25,000) 125,000
165,000
Taxes
14,000
( 10,000)
50,000
66,000
EBIT(1 - T)
21,000
( 15,000)
75,000
99,000
After-tax salvage value
30,000
Return of NOWC
40,000
+ Depreciation
________
165,000
225,000
75,000
35,000
Net CF
($540,000)
$186,000
$210,000 $150,000 $204,000
Note in year 4 your $40,000 of net operating working capital is recovered
plus the after tax salvage value of $30,000.
185
Enter the cash flows into the cash flow register and solve for the NPV using
the WACC of 10%. NPV = $54,676.59.
Risk-adjusted NPV
Answer: a Diff: M
Time lines:
Project A:
0 k = 14% 1
2
3
4 Years
CFsA -200,000
NPVA = ?
71,104
71,104
71,104
71,104
Project B:
0
k = 10% 1
CFsB -200,000
NPVB = ?
146,411
Years
146,411
Calculate required returns on A and B:

Project A High risk kRisk adjusted = 12% + 2% = 14%.
Project B Low risk
kRisk adjusted = 12% - 2% = 10%.
Tabular solution:
NPVA = $71,104(PVIFA14%,4) - $200,000
= $71,104(2.9137) - $200,000 = $7,175.72.
NPVB = $146,411(PVIF10%,3) + $146,411(PVIF10%,4) - $200,000
= $146,411(0.7513) + $146,411(0.6830) - $200,000 = $9,997.30.
Project B has the higher NPV.
Since they are mutually exclusive, select
Project B.
186

A Inputs: CF0 = -200,000; CF1 = 71,104; Nj = 4; I = 14.
Output: NPVA = $7,176.60 $7,177.
B Inputs: CF0 = -200,000; CF1 = 0; Nj = 2; CF2 = 146,411; Nj = 2; I = 10.
Output: NPVB = $10,001.43 $10,001.
Note: The difference in the NPVB between the tabular solution and financial
calculator cash flow solution of $4.13 is due to rounding of PVIF factors to
four significant decimals. Greater precision in the PVIF factors produces
identical answers.
Risk-adjusted NPV
Answer: e Diff: M
Time line:
0 k = 12% 1
2
10 Years
-50,000
NPV = ?
6,000
6,000
Salvage value
kProject = 6% + 4%(1.5) = 12%.
6,000
10,000
CF10 =
16,000
Tabular solution:
NPV = -$50,000 + $6,000(PVIFA12%,10) + $10,000(PVIF12%,10)
= -$50,000 + $6,000(5.6502) + $10,000(0.3220)
= -$12,878.80 -$12,879.
Inputs: CF0 = -50,000; CF1 = 6,000; Nj = 9; CF10 = 16,000; I = 12%.
Output: NPV = -$12,878.93 -$12,879.
187
Risk-adjusted NPV
Answer: c Diff: M
Time lines:
Project A:
0
1
k = 12%
CFsA -5,000
= ?
Project B:
0
k = 14%
CFsB -5,000
= ?
2,000
1
3,000
2
2,500
2
2,600
Periods
2,250
NPVA
Periods
2,900
NPVB
Project A:
Project B:
kAverage risk = 12%.

kHigh risk = 12% + 2% = 14%.
Tabular solution:
NPVA = $2,000(PVIF12%,1) + $2,500(PVIF12%,2) + $2,250(PVIF12%,3)
= $2,000(0.8929) + $2,500(0.7972) + $2,250(0.7118) = $380.35 $380.
NPVB = $3,000(PVIF14%,1) + $2,600(PVIF14%,2) + $2,900(PVIF14%,3)
= $3,000(0.8772) + $2,600(0.7695) + $2,900(0.6750) = $1,589.80 $1,590.
- $5,000
$5,000
- $5,000
$5,000

A: Inputs: CF0 = -5,000; CF1 = 2,000; CF2 = 2,500; CF3 = 2,250; I% = 12.
Output: NPV = $380.20 $380.
B: Inputs: CF0 = -5,000; CF1 = 3,000; CF2 = 2,600; CF3 = 2,900; I% = 14.
Output: NPV = $1,589.61 $1,590.
188
NPV and risk-adjusted discount rate
Answer: e Diff: T N
The following table shows the cash flows:

Initial invest. outlay
Sales
Oper. cost
Deprec.
EBIT
Less: Taxes
EBIT(1 - T)
Add back: Deprec.
NCF
Step 1:
0
-$30.0
-$30.0
Determine the NPV of net cash flows:
1
$20.0
12.0
10.0
-$ 2.0
-0.8
-$ 1.2
10.0
$ 8.8
2
$20.0
12.0
10.0
-$ 2.0
-0.8
-$ 1.2
10.0
$ 8.8
3
$20.0
12.0
10.0
-$ 2.0
-0.8
-$ 1.2
10.0
$ 8.8
4
$20.0
12.0
0.0
$ 8.0
3.2
$ 4.8
0.0
$ 4.8
5
$20.0
12.0
0.0
$ 8.0
3.2
$ 4.8
0.0
$ 4.8
NPV = -$30 + $8.8/1.10 + $8.8/(1.10)2 + $8.8/(1.10)3 + $4.8/(1.10)4 + $4.8/(1.10)5

= -$30 + $8 + $7.2727 + $6.6116 + $3.2785 + $2.9804
= -$1.8568 million.
Step 2:
Determine the NPV of the projects AT salvage value:

$1.2/(1.12)5 = $0.6809 million.
Step 3:
Determine the projects NPV:

Add the PV of the salvage value to the NPV of the cash flows to get the projects NPV.
NPV = -$1.8568 + $0.6809 = -$1.1759 million -$1.18 million.

Step 1:
Determine the NPV of net cash flows:
Enter the following inputs in the calculator:
CF0 = -30, CF1-3 = 8.8, CF4-5 = 4.8, I = 10, and then solve for NPV = -$1.8568 million.
Step 2:
Determine the NPV of the projects AT salvage value:

Enter the following inputs in the calculator:
CF0 = 0, CF1-4 = 0, CF5 = 1.2, I = 12, and then solve for NPV = $0.6809 million.
Step 3:
Determine the projects NPV:

Add the PV of the salvage value to the NPV of the cash flows to get the projects NPV.
-$1.8568 + $0.6809 = -$1.1759 million $-1.18 million.
189
Discounting risky outflows

Time line:
0
|
CFsNew Tech -1,500
NPVNew Tech = ?
CFsOld Tech
-600
NPVOld Tech = ?
Answer: e Diff: M
1
|
-315
-600
2
|
-315
-600
3
|
-315
-600
4
|
-315
-600
Recognize that (1) risk outflows must be discounted at lower rates, and (2)
since Project New Tech is risky, it must be discounted at a rate of 12% - 3%
= 9%. Project Old Tech must be discounted at 12%.
Tabular solution:
PVNew Tech = -$1,500 - $315(PVIFA9%,4) = -$1,500 - $315(3.2397)
= -$2,520.51.
PVOld Tech = -$600 - $600(PVIFA12%,4) = -$600 - $600(3.0373) = -$2,422.38.
PVOld Tech is a smaller outflow than NPVNew Tech, thus, Project Old Tech is the
better project.
Project New Tech: Inputs: CF0
Output: NPV
Project Old Tech: Inputs: CF0
Output: NPV
=
=
=
=
-1,500; CF1 = -315; Nj = 4; I = 9.

-$2,520.51.
-600; CF1 = -600; Nj = 4; I = 12.
-$2,422.41.
190
Risky Projects Answer: d Diff: M

Look at the NPV, IRR, and hurdle rate for each project:
Project
A
B
C
D
E
Hurdle
9.00%
9.00%
11.00% 13.00% 13.00%
NPV
$13,822
$11,998
IRR
12.11%
14.04%
10.85% 16.64% 11.63%
Projects A and B are mutually exclusive, so we pick project A because it has
the largest NPV. Projects C, D, and E are independent so we pick the ones
whose IRR exceeds the cost of capital, in this case, just D. Therefore, the
projects undertaken are A and D.
191
Scenario analysis Answer: c Diff: M

Calculate expected value of NPV:
Probability of
Outcome, Pi
Worst case
0.30
Base case
0.50
Best case
0.20
Unit Sales Sales

NPV
Volume
Price (In 1000s)
6,000
$3,600
-$6,000
10,000
4,200
13,000
13,000
4,400
28,000
Pi(x)
0.3(-6,000)
0.5(13,000)
0.2(28,000)
Expected NPV
Calculate standard deviation of NPV (in thousands):

Pi(x - x )2
(x - x )2
Pi(x - x )2
_____________________________________
Worst case
Base case
Best case
0.3(-6 - 10.3)
0.5(13 - 10.3)2
0.2(28 - 10.3)2
____________________
265.69
7.29
313.29
_________________________
79.707
3.645
62.658
Sum 146.01
(146.01) = 12,083 thousand.

Calculate coefficient of variation (CV) of NPV:
CVNPV = NPV/E(NPV) = $12,083/$10,300 = 1.17.
= -1,800
=
6,500
=
5,600
= $10,300
192
New project investment Answer: a Diff: E

Initial investment:
Cost
($40,000)
Change in NOWC
(2,000)
($42,000)
193
Operating cash flow

Answer: e Diff: M
Depreciation schedule:
Depreciable basis = $40,000.
MACRS
Depreciation
Year
Rate
1
0.33
2
0.45
3
0.15
4
0.07
Operating cash flows:
Year
1) Increase in revenues
2) Increase in costs
3) Before-tax change in
earnings
4) After-tax change in
earnings (line 3 0.60)
5) Depreciation
6) Tax savings deprec.
(line 6 0.40)
(line 4 + 6)
194
Non-operating cash flows Answer: a Diff: M

Additional Year 3 cash flows:
Salvage value
Tax on Salvage value
Recovery of NOWC
Depreciable
Basis
$40,000
40,000
40,000
40,000
Annual
Depreciation
$13,200
18,000
6,000
2,800
$40,000
1
$20,000
(5,000)
2
$20,000
(5,000)
3
$20,000
(5,000)
15,000
15,000
15,000
9,000
13,200
9,000
18,000
9,000
6,000
5,280
7,200
2,400
$14,280
$16,200
$11,400
3
$25,000
(8,880)*
2,000
$18,120
*(Market value - Book value)(Tax rate)

($25,000 - $2,800)(0.40) = $8,880.
195
New project NPVAnswer: c Diff: M

Time line:
0 k = 14% 1
-42,000
14,280
2
16,200
3 Years
11,400
TV = 18,120
29,520
Tabular solution:
NPVk = 14% = -$42,000 + $14,280(PVIF14%,1)
+ $16,200(PVIF14%,2) + $29,520(PVIF14%,3)
= -$42,000 + $14,280(0.8772) + $16,200(0.7695)
+ $29,520(0.6750) = $2,918.32.

Inputs: CF0 = -42,000; CF1 = 14,280; CF2 = 16,200; CF3 = 29,520; I = 14.
Output: NPV = $2,916.85 $2,917.
Note:
Tabular solution differs from calculator solution due to interest

factor rounding.
196
New project investment Answer: d Diff: E

Initial investment:
Cost
($50,000)
Modification
(10,000)
Change in NOWC
(2,000)
Total net investment = ($62,000)
197
Operating cash flow

Answer: c Diff: M
Depreciation schedule:
Depreciable basis = $60,000.
MACRS
Depreciation
Year
Rate
1
0.33
2
0.45
3
0.15
4
0.07
Operating cash flows:
Year
1) Before-tax cost reduction
2) After-tax cost reduction
(line 1 0.6)
3) Depreciation
4) Tax savings from deprec.
(line 3 0.4)
198
Depreciable
Basis
$60,000
60,000
60,000
60,000
Annual
Depreciation
$19,800
27,000
9,000
4,200
$60,000
1
$20,000
2
$20,000
3
$20,000
12,000
19,800
12,000
27,000
12,000
9,000
7,920
$19,920
10,800
$22,800
3,600
$15,600
Non-operating cash flows Answer: c Diff: M

Additional Year 3 cash flows:
Salvage value
Tax on salvage value
Recovery of NOWC
Total terminal year CF
3
$20,000
(6,320)*
2,000
$15,680
*(Market value - Book value)(Tax rate)

($20,000 - $4,200)(0.40) = $6,320.
199
New project NPVAnswer: a Diff: M

Time line:
0
k = 10% 1
-62,000
19,920
2
22,800
3 Years
15,600
TV = 15,680
31,280
Tabular solution:
NPVk = 10% = -$62,000 + $19,920(PVIF10%,1) + $22,800(PVIF10%,2)
+ $31,280(PVIF10%,3)
= -$62,000 + $19,920(0.9091) + $22,800(0.8264)
+ $31,280(0.7513) = -$1,548.14.
Inputs: CF0 = -62,000; CF1 = 19,920; CF2 = 22,800; CF3 = 31,280; I = 10.
Output: NPV = -$1,546.81 -$1,547.
Note:
Tabular solution differs from calculator solution due to interest

factor rounding.

Basic Concepts Capital Budgeting Defined Agency Problem in Capital Budgeting

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What are some techniques used in capital budgeting?

What are some techniques used in capital budgeting?

What are some agency problems that can occur in capital budgeting?

What are some agency problems that can occur in capital budgeting?

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16. The following are agency problems in capital budgeting except:

17. The following are agency problems in capital budgeting except:

18. The following are agency problems in capital budgeting except:

Capital budgeting is concerned with

Capital budgeting is used for the decision analysis of

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Acquisition of new aircraft by a cargo company.

Life Cycle Costing

9. Which of the following statements regarding appropriation requests is true?

Implementation & Control Stage

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Not a Capital Expenditure

77. A post audit compares

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Be different if the project is accepted rather than rejected.

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CMA EXAMINATION QUESTIONS

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To approximate annual cash inflow, depreciation is

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b. Subtracted from net income because it is an outflow of cash.

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Tax Shield on Depreciation

b. When evaluating corporate projects it is important to include all relevant externalities in

. Which of the following statements is correct? (M)

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. Which of the following statements is most correct? (E)

. Adams Audio is considering whether to make an investment in a new type of technology.

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. Which of the following statements is correct? (M)

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Carter & Usry

18. Which of the following statements is true?

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6. The government could encourage increases in investment by

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Depreciation Tax Shield

. A depreciation tax shield is

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