Module 3—THE BASICS OF CAPITAL BUDGETING

Multiple Choice Questions Assignment

Instruction: Select the best answer by marking or writing the letter of the best choice.
Point/s per correct answer: 1 for theoretical question and 2 for problem solving.

1. 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? Why?
a. All else equal, a project's IRR increases as the cost of capital declines.
b. All else equal, a project's NPV increases as the cost of capital declines.
c. All else equal, a project's MIRR is unaffected by changes in the cost of capital.
d. Statements a and b are correct.
e. Statements b and c are correct.

2. Which of the following statements is most correct? Why?

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, particularly, cash flows beyond
the payback period.

3. A major disadvantage of the payback period is that it

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.
d. Statements b and c are correct.
e. All of the statements above are correct.

4. 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? Why?
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 A's 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.
e. Statements b and c are correct.

5. 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.) Assume each project has an initial cash outflow followed by a series of inflows.
Which of the following statements is most correct? Why?
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.
d. Statements a and b are correct.
e. Statements a and c are correct.

6. O'Leary Lumber Company is considering two mutually exclusive projects, Project X and Project Y.
The two projects have normal cash flows (an up-front cost followed by a series of positive cash flows),
the same risk, and the same 10 percent WACC. However, Project X has an IRR of 16 percent, while
Project Y has an IRR of 14 percent. Which of the following statements is most correct? Why?
1

a. Project X's NPV must be positive.

Page

b. Project X's NPV must be higher than Project Y's NPV.

 c. If Project X has a lower NPV than Project Y, then this means that Project X must be a
larger project.
d. Statements a and c are correct.
e. All of the statements above are correct.

7. Project X's IRR is 19 percent. Project Y's IRR is 17 percent. Both projects have the same risk, and both
projects have normal cash flows (an up-front cost followed by a series of positive cash flows). If the
cost of capital is 10 percent, Project Y has a higher NPV than Project X. Given this information, which
of the following statements is most correct? Why?
a. The crossover rate between the two projects (that is, the point where the two projects have
the same NPV) is greater than 10 percent.
b. If the cost of capital is 8 percent, Project X will have a higher NPV than Project Y.
c. If the cost of capital is 10 percent, Project X's MIRR is greater than 19 percent.
d. Statements a and b are correct.
e. All of the statements above are correct.

8. Which of the following statements is most correct? Why?

a. If a project's internal rate of return (IRR) exceeds the cost of capital, then the project's 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.
d. Statements a and c are correct.
e. None of the statements above is correct.

9. 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? Why?
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.
d. Statements a and c are correct.
e. All of the statements above are correct.

10. A project has an up-front cost of P100,000. The project's WACC is 12 percent and its net present value
is P10,000. Which of the following statements is most correct? Why?
a. The project should be rejected since its return is less than the WACC.
b. The project's internal rate of return is greater than 12 percent.
c. The project's modified internal rate of return is less than 12 percent.
d. All of the statements above are correct.
e. None of the statements above is correct.

11. 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 project's internal rate of return is 12 percent and its WACC is 10
percent. Which of the following statements is most correct? Why?
a. The project's NPV is positive.
b. The project's MIRR is greater than 10 percent but less than 12 percent.
c. The project's payback period is greater than its discounted payback period.
d. Statements a and b are correct.
e. All of the statements above are correct.

12. 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? Why?
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.

13. Moynihan Motors has a cost of capital of 10.25 percent. The firm has two normal projects of equal
2

risk. Project A has an internal rate of return of 14 percent, while Project B has an internal rate of return
Page

of 12.25 percent. Which of the following statements is most correct? Why?

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 Project's NPV profiles intersect) is 8
percent, Project A will have a higher net present value than Project B.
d. Statements a and b are correct.
e. Statements a and c are correct.

14. 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? Why?
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.

15. Assume that you are comparing two mutually exclusive projects. Which of the following statements is
most correct? Why?
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
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.
d. All of the statements above are correct.
e. None of the statements above is correct.

16. Which of the following statements is incorrect? Why?

a. Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than
the cost of capital.
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.

17. Project J has the same internal rate of return as Project K. Which of the following statements is most
correct? Why?
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.

18. Which of the following statements is most correct? Why?

a. If a project with normal cash flows has an IRR that 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.
d. Statements a and c are correct.
e. None of the statements above is correct.

19. Which of the following statements is most correct? Why?

3
Page

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.
d. Statements a and c are correct.
e. All of the statements above are correct.

20. 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 X's IRR is greater than its MIRR.
· If the cost of capital is 12 percent, Project Y's IRR is less than its MIRR.
· If the cost of capital is 10 percent, the two Project's have the same NPV.

Which of the following statements is most correct? Why?

a. Project X's IRR is greater than 12 percent.
b. Project Y's IRR is less than 12 percent.
c. If the cost of capital is 8 percent, Project X has a lower NPV than Project Y.
d. All of the statements above are correct.
e. None of the statements above is correct.

21. If income tax considerations are ignored, how is depreciation expense used in the following capital budgeting
techniques?
Internal rate of return Payback
a. Excluded Excluded
b. Excluded Included
c. Included Excluded
d. Included Included

22. A proposed project has an expected economic life of eight years. In the calculation of the net present value of
the proposed project, salvage value would be
a. Excluded from the calculation of the net present value.
b. Included in a cash inflow at the estimated salvage value.
c. Included as a cash inflow at the present value of the estimated salvage value.
d. Included as a cash inflow at the future amount of the estimated salvage value. (aicpa)
23. It is assumed that cash flows are reinvested at the rate earned by the investment in which of the following capital
budgeting techniques?

Internal rate of return Net present value

a. Yes Yes
b. Yes No
c. No No
d. No Yes

24. 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:
a. There is lower tax rate in year 5.
b. There is higher tax rate in the year 5.
c. The time value of money is considered.
d. Due to statements A and C above.
25. Several proposed capital projects, which are economically acceptable, may have to be ranked due to constraints
in financial resources. In ranking those projects, the least pertinent is this statement.
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 organization’s 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
4

project.
Page

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.

26. The “inflation element” refers to the

a. Impact that future price increases will have on the original cost of 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.
27. All of the following refer to the discount rate used by a firm in capital budgeting except
a. Hurdle rate.
b. Required rate of return.
c. Opportunity cost.
d. Opportunity cost of capital.
28. You are the treasurer of Mayaman Corporation. 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.
a. Treated as cash inflow at estimated salvage value.
b. Treated as cash inflow at its present value.
c. Irrelevant cash flow item.
d. Treated as cash inflow at the future value.
29. Depreciation tax shield is
a. The expense caused by depreciation.
b. The cash provided by recording depreciation.
c. A reduction in income tax.
d. A after-tax cash flow.
30. Sensitivity analysis, if applied in capital budgeting evaluation,
a. Is used extensively when cash flows are known with certainty.
b. Is “what if” techniques that ask how a given outcome will change if the original estimates of the
capital budgeting model are changed.
c. Measures the amount of time it will take for a project to recover its initial capital outflow.
d. Is a technique used to rank capital expenditures request?
31. You just passed the CPA licensure examination and took your oath. As you started your practice, Kon Fuse Inc.
came you for help in establishing a minimum desired rate of return to be used in the evaluation of a capital
project with a five-year life. The following data were provided:
Inflation rate for the past 5 years 13%
Expected inflation rate for the next 5 years 9%
“Risk-free” element 5%
“Risk” premium demanded for the project 7%
You will advise the client to consider a minimum desired rate of return of (2 points):
a. 20%
b. 21%
c. 16%
d. 25%
32. The common assumption in capital budgeting analysis that cash inflows occur in lump sums at the end of
individuals years during the life of an investment project when in fact they flow more or less continuously during
those years
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 NPV’s such that project cannot be
evaluated reliably.
d. Results in higher estimates for the IRR on the investment.
33. You have determined the profitability of a planned project by finding the present value of all cash flows from
that project. Which of the following would cause the project to look less appealing, that is, have a lower present
value?
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.
d. The cash flows are accelerated and the project life is correspondingly shortened.
5
Page
34. Anton Corporation is planning to buy a new machine with the expectation that this investment should earn a
discounted rate of return of at least 15%. This machine, which costs P150,000, would yield an estimated net
cash flow of P30,000 a year for 10 years, after income taxes. In order to determine the net present value of
buying the new machine, Anton should first multiply the P30,000 by what amount of the following factors (2
points)?

a. 20.304 (Future amount of an ordinary annuity of P1).

b. 5.019 (Present value of an ordinary annuity of P1).
c. 4.046 (Future amount of P1).
d. 0.247 (Present value of P1).

35. Essex Corporation is evaluating a lease that takes effect on March 1, 2018. The Company must make eight equal
payments, with the first payment due on March 1, 2018. The concept most relevant to the evaluation of the lease
is
a. The present value of an annuity due.
b. The present value of an ordinary annuity.
c. The future value of an annuity due.
d. The future value of an ordinary annuity.
36. An actuary has determined that a company should have P90 million accumulated in its pension fund 20 years
from now for the fund to be able to meet its obligations. An interest rate of 8% is considered appropriate for all
pensions fund calculations. The company wishes to know how much it should contribute to the pension fund at
the end of each of the next 20 years. Which set of instructions correctly describes the procedures necessary to
compute the annual contribution (2 points)?
a. Divide P90,000,000 by the factor for present value of an ordinary annuity.
b. Multiply P90,000,000 by the factor for present value of a n ordinary annuity.
c. Divide P90,000,000 by the factor for future value of an ordinary annuity.
d. Multiply P90,000,000 by the factor for future value of an ordinary annuity.

37. Tranx Corporations has offered to accept a P1,000 down payment and set up a note receivable for R. Santos that
calls for a P1,000 payment at the end of each of the next 4 years. If Tranx uses a 6% discount rate, the present
value of the note receivable would be (2 points):
a. P2,940
b. P4,465
c. P4,212
d. P3465
38. Rod Santos has agreed to the immediate down payment of P1,000 but would like the note for P4,000 to be
payable in full at the end of the fourth year. Because of the increased risk associated with the terms of this note,
Tranx Corporation would apply an 8% discount rate. The present value of this note would be (2 points)
a. P2,940
b. P3,312
c. P3,940
d. P2,557
39. If Rod Santos borrowed the P5,000 at 8% interest for 4 years from his bank and paid Tranx Corporation the full
price of the equipment immediately, Tranx could invest the P5,000 for 3 years at 7%. The future value of this
investment (rounded) would be (2 points)
a. P6,297
b. P6,127
c. P6,553
d. P6,803
40. Snow Company plans to invest P2,000 at the end of the next ten years. Assume that Snow will earn interest at an
annual rate of 6% compounded annually. The future amount of an ordinary annuity of P1 for 10 periods at 6% is
13.181. The present value of P1 for ten periods at 6% is 0.558. The present value of an ordinary annuity of P1
for ten periods at 6% is 7.360. The investment after the end of ten years would be (2 points):
a. P26,362
b. P21,200
c. P14,720
d. P27,478
41. Girl Casual Wear has P75,000 in a bank account as of December 31, 2017. If the company plans on depositing
P4,000 in the account at the end of each of the next 3 years (2018 ,2019, and 2020) and all amounts in the
account balance earn 8% per year, what will the account balance be at December 31, 2020? Ignore the effect of
6

income taxes (2 points).

Page
 8% Interest Rate Factors
Future value Future value of
Period of P1 an annuity of P
1 1.08 1.00
2 1.17 2.08
3 1.26 3.25
4 1.36 4.51
a. P87,000
b. P88,000
c. P96,070
d. P107,500
42. 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>.
List A List B
a. Greater than Increase
b. Greater than Decrease
c. Equal to Increase
d. Equal to Decrease
43. The proper discount rate to use in calculating certainty equivalent net present value is the
a. Risk-adjusted discount rate.
b. Risk-free rate.
c. Cost of equity capital
d. Cost of debt
44. A project’s net present value, ignoring income tax considerations, is normally affected by the
a. Proceeds from the sale of the assets to be replaced.
b. Carrying amount of the assets to be replaced by the project.
c. Amount of annual depreciation on the asset to be replaced.
d. Amount of annual depreciation on fixed assets used directly on the project.
45. The discount (hurdle) rate of return must be determined in advance for the
a. Internal rate of return method.
b. Net present value method.
c. Payback period method.
d. Time adjusted rate of return method.
46. The net present value capital budgeting technique can be used when cash flows from period to period are
Uniform Uneven
a. No Yes
b. No No
c. Yes No
d. Yes Yes
47. Velasquez & Company 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?
a. Extend the project life and associated cash inflows.
b. Increase the discount rate to 15%.
c. Decrease the initial investment amount to P9.0 million.
d. Increase the salvage value.
48. A disadvantage of the net present value method of capital expenditure evaluation is that it
a. Is difficult to apply because it uses a trial-and-error approach.
b. Does not provide the true rate of return on investment.
c. Is calculated using sensitivity analysis.
d. Computes the true rate of return.
49. Garfield Company purchased a machine, which will be depreciated on the straight-line basis over an estimated
useful life of seven years and no salvage value. This machine is expected to generate cash flow from operations,
net of income taxes, of P80,000 in each of the seven years. Garfield’s expected rate of return is 12%.
Information on present value factors is as follows:
Present value of P1 at 12% for seven periods 0.452
Present value of an ordinary annuity of P1 at 12% for 7 periods 4.564
Assuming a positive net present value of P12,720, what was the cost of the machine?
a. P240,000
b. P253,120
7

c. P352,400
Page

d. P377,840
 Apex Corporation is planning to buy production machinery costing P100,000. The machinery’s expected useful
life is five years, with no residual value. Apex required a rate of return of 20%, and has calculated the following
data pertaining to the purchase and operation of this machinery.
Estimated
Annual Present value
Year Cash Inflow of P1 at 20%
1 P 60,000 .91
2 30,000 .76
3 20,000 .63
4 20,000 .53
5 20,000 .44
Total P150,000 3.27
Assuming that the cash inflow was received evenly during the year.

50. The payback period is

a. 2.50 years
b. 2.75 years
c. 3.00 years
d. 5.00 years

PART 2: PROBLEM SOLVING (Correct answer 2 points; computation in good form-3 points)
Instructions:
1. Solve the following problems.
2. Double rule your final answer and submit supporting computations in good form (not in excel,
pdf or jpeg or any equivalent file);
3. Submit answers through BigSky Dropbox only.

1. Genuine Products Inc. requires a new machine. Two companies have submitted bids, and you have
been assigned the task of choosing one of the machines. Cash flow analysis indicates the following:

Year Machine A Cash Flow Machine B Cash Flow

0 -P2,000 -P2,000
1 0 832
2 0 832
3 0 832
4 3,877 832

What is the internal rate of return for each machine?

2. A project has the following net cash flows:

Year Project Cash Flow

0 -P X
1 150
2 200
3 250
4 400
5 100

At the project's WACC of 10 percent, the project has an NPV of P124.78. What is the project's internal
rate of return (round to 4 decimal places)?

3. Project C has the following net cash flows:

Year Project C Cash Flow

0 -P500
1 200
2 -X
3 300
4 500

Note, that the cash flow, X, at t = 2 is an outflow (that is, X < 0). Project C has a 10 percent cost of
capital and a 12 percent modified internal rate of return (MIRR). What is the project's cash outflow at t
8

= 2?
Page
 Company A
Company A is considering a project with the following cash flows:

Year Project Cash Flow

0 -P5,000
1 5,000
2 3,000
3 -1,000
The project has a cost of capital of 10 percent.

4. Refer to Company A. What is the project's net present value (NPV)?

9
Page