INVESTMENT DECISIONS

INVESTMENT DECISIONS

1. 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.

2. Which one of the following statements concerning cash flow determination for capital
budgeting purposes is not correct?
A. Tax depreciation must be considered because it affects cash payments for taxes.
B. Book depreciation is relevant because it affects net income.
C. Sunk costs are not incremental flows and should not be included.
D. Net working capital changes should be included in cash flow forecasts.

3. When calculating the certainty equivalent cash flow of a project, the discount rate used
should be:
A. the company's weighted average cost of capital.
B. a risk-adjusted discount rate.
C. the risk premium.
D. the risk-free rate of return.

4. Purchasing a house is a somewhat complicated process. Typically, if the buyer's offer is

accepted by the seller, the transaction will not be completed or “closed” for several
weeks. During this time the buyer may gather more information about the house or
research other houses in the area. Some home purchase contracts include an option fee.
The buyer may pay the seller a few hundred dollars for the right to walk away from the
contract prior to closing for any reason. This real option is best described as:
A. an option to delay investment.
B. an option to expand.
C. an option to abandon.
D. an option to scale back.

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5. 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.

6. Buttermere Company has just produced its first online game, Ponder's Quest. The
company is evaluating different hosting platforms to provide the bandwidth and technical
support necessary to put the game online. Buttermere Company knows that online games
are the most popular in the first six months after introduction, and paid subscribers
decrease over time. Three companies are offering the bandwidth and technical support.
Companies A and B are large and have plenty of bandwidth available but charge a fixed
fee per month for the service. Company C is smaller and can handle the anticipated
number of subscribers, but not very much more. Company C charges a small flat rate and
a rate per subscriber. As opposed to the offers from Companies A and B, Company C's
offer contains a real option to:
A. scale back.
B. abandon.
C. delay.
D. expand.

7. Which of the following most concisely describes the Monte Carlo Simulation technique?
A. Allows for the testing of a capital investment project using hypothetical variables to
approximate cash flow.
B. A separation of the timing of cash flows from their risk to evaluate a project's
success.
C. It uses repeated random sampling and computational algorithms to calculate a range
of most likely outcomes for a project.
D. A what-if technique for evaluating how NPV, IRR, and other indicators of the
profitability of a project change if some given variable varies from one case to
another.

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8. Virtu Associates is considering a one-year project. The investment costs $3,000,000.

There is a 10% probability that the project will yield a cash flow of $2,500,000 at the end
of the first year, and a 90% probability that the project will yield a cash flow of
$6,000,000 at the end of the first year. Virtu calculates the risk-adjusted rate of return for
this project as 8%, and the risk-free rate is 2%. Calculate the expected cash flow from the
project.
A. $4,250,000
B. $5,650,000
C. $5,700,000
D. $4,500,000

9. A company is considering an equipment upgrade. The company uses discounted cash

flow (DCF) analysis in evaluating capital investments and has an effective tax rate of
40%. Selected data developed by the company is as follows:

Based on this information, what is the initial investment for a DCF analysis of this proposed
upgrade?

A. $92,400

B. $92,800

C. $95,800

D. $96,200

10. A firm is considering a $1 million investment in stamping equipment to produce a new

product. The equipment is expected to last 9 years, produce revenue of $700,000 per
year, and have related cash expenses of $450,000 per year. At the end of the ninth year,
the equipment is expected to have a salvage value of $100,000 and cost $50,000 to
remove. The IRS categorizes this as 5-year Modified Accelerated Cost Recovery System
(MACRS) property subject to the following depreciation rates.

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The firm’s effective income tax rate is 40%, and the firm expects to continue to be
profitable and have significant taxable income. If the firm uses the net present value
method to analyze investments, what is the expected net tax impact on cash flow in Year
2 before discounting?

A. Positive $28,000 impact.

B. $0 impact.
C. Negative $100,000 impact.
D. Negative $128,000 impact.

11. Which of the following is a qualitative factor in capital budgeting?

A. The sale price of the old machinery.
B. The hurdle rate of return.
C. The incremental operating cash flows.
D. Environmental impact.

12. The modeling technique that should be used in a complex situation involving uncertainty
is a(n):
A. Monte Carlo simulation.
B. program evaluation review technique.
C. Markov process.
D. expected value analysis.

13. The modeling technique that should be used in a complex situation involving uncertainty
is a(n):
A. Monte Carlo simulation.
B. program evaluation review technique.
C. Markov process.
D. expected value analysis.

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14. Why is net present value (NPV) the preferable method to use when comparing
investment projects when the timing and amount of cash flows differ over the life of a
capital investment project?
A. The initial investment amount has no effect—the scale of the investment is ignored.
B. NPV assumes that all of a project's net cash inflows earn the same rate of return once
reaching the payback period.
C. NPV more readily identifies when proceeds from project termination might be better
applied to new projects.
D. NPV assumes that all net cash flows earn the same rate as the discount rate used in
the NPV calculation.

15. JM Manufacturing is evaluating two alternatives for a capital investment. The

information gathered for the two options is as follows:

Which of the two investment opportunities should JM Manufacturing pursue based on net
present value (NPV) and why?

A. Investment R, as its NPV is higher than Investment T's NPV

B. Investment T, as its NPV is positive while Investment R's NPV is negative
C. Investment R, as its NPV is positive while Investment T's NPV is negative
D. Neither investment should be made.

16. All of the following are an established method to solve the multiple IRR problem except:
A. use net present value to evaluate projects as opposed to internal rate of return.
B. use an average of the two different returns generated by the internal rate of return
formula.
C. use modified internal rate of return instead of internal rate of return.
D. give greater weight to the qualitative aspects of the project.

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17. Two mutually exclusive capital expenditure projects have the following characteristics.

All cash flows are received at the end of the year. Based on this information, which one
of the following statements is not correct?

A. The net present value of Project B at a cost of capital of 12% is $19,950.

B. The profitability index of Project B is greater than the profitability index of Project A.
C. The net present value of Project A at a cost of capital of 10% is $22,720.
D. The payback years for Project A is greater than the payback years for Project B.

18. When evaluating capital projects, the decisions reached from using the net present value
(NPV) method and the internal rate of return (IRR) method will agree if:
A. the projects are independent.
B. the cash flow pattern is conventional.
C. the projects are mutually exclusive.
D. the projects are independent and the cash flows are conventional.

19. Which of the following projects would be considered mutually exclusive, assuming the
company has adequate capital?
A. A project to purchase new computers for the manufacturing floor and a project to
upgrade the marketing department's software.
B. A project to purchase a new fleet of delivery vehicles and a project to develop an
unused piece of land into a new warehouse.
C. A project to increase quality control on the manufacturing floor and a project to
adequately train new employees.
D. A project to upgrade the current manufacturing facilities and a project to convert the
current manufacturing facilities to manufacture a new product line.

20. Under which one of the following conditions is the internal rate of return (IRR) method
less reliable than the net present value technique?
A. when the net present value of the project is equal to zero.

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B. when both benefits and costs are included, but each is separately discounted to the
present.
C. when income taxes are considered in the analysis.
D. when there are several alternating periods of net cash inflows and net cash outflows.
21. Which of the following is an example of a traditional cash flow pattern?
A. A cash outlay followed by multiple cash receipts.
B. Multiple cash receipts with no cash outlay.
C. Multiple cash payments with no cash receipt.
D. Multiple cash payments and multiple cash receipts.

22. Maloney Company uses a 12% hurdle rate for all capital expenditures and has done the
following analysis for four projects for the upcoming year:

Which project(s) should Maloney undertake during the upcoming year assuming it has
no budget restrictions?

A. All of the projects.

B. Projects 1, 2, and 3.

C. Projects 1, 2, and 4.

D. Projects 1 and 2.

23. 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 called the
A. Capital rationing method.
B. Average rate of return method.
C. Profitability index method.
D. Accounting rate of return method.

24. A transit company is considering two alternative buses to transport people between cities
that are in the same region. A gas-powered bus has a cost of $55,000, and will produce
end-of-year net cash flows of $22,000 per year for 4 years. A new electric bus will cost

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$90,000, and will produce cash flows of $28,000 per year for 8 years. The company must
provide bus service for 8 years, after which it plans to give up its franchise and to cease
operating the route. Inflation is not expected to affect either costs or revenues during the
next 8 years. If the cost of capital is 16%, by what amount will the better project increase
the company’s value?
A. $6,556
B. $(14,432)
C. $13,112
D. $31,632

25. A 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)?
A. The net present value will increase.
B. The internal rate of return will increase.
C. The payback period will be shortened.
D. The profitability index will decrease.

26. A construction firm is evaluating two value-adding projects. The first project deals with
building access roads to a new terminal at the local airport. The second project is to build
a parking garage on a piece of land that the firm owns adjacent to the airport. If both
projects are positive-NPV projects and there are no capital constraints, the firm should:

A. select the higher NPV project because the projects are mutually exclusive.
B. accept both projects because they are independent projects.
C. accept both projects because they are contingent projects.
D. Not enough information is given to make a decision.

27. The following methods are used to evaluate capital investment projects.

— Internal rate of return

— Average rate of return
— Payback
— Net present value (NPV)

Which one of the following correctly identifies the methods that utilize discounted cash-
flow (DCF) techniques?

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A. IRR: Yes; Average Rate of Return: No; Payback Method: No; NPV: Yes.
B. IRR: Yes; Average Rate of Return: Yes; Payback Method: No; NPV: No.
C. IRR: Yes; Average Rate of Return: No; Payback Method: Yes; NPV: No.
D. IRR: No; Average Rate of Return: No; Payback Method: Yes; NPV: Yes.

28. The economic breakeven point is the number of units that must be sold each year over
the life of a project for the NPV of that project to equal:
A. $1.
B. the present value of cash inflows.
C. the present value of the initial investment.
D. $0.

29. Which of the following statements is true with respect to the present value of a future
amount?
A. The higher the discount rate, the higher the present value of a single sum for a given
time period.
B. The relation between present value and time is exponential.
C. The greater the time period, the higher the present value of a single sum for a given
interest rate.
D. The lower the discount rate, the lower the present value of a single sum for a given
time period.

30. A corporation is subject to a 30% effective income tax rate and uses the net present value
method to evaluate capital budgeting proposals. The capital budget manager desires to
improve the appeal of a marginally attractive proposal. To accomplish his goal, which
one of the following actions should be recommended?
A. Postpone a fully deductible major overhaul from Year 4 to Year 5.
B. Decrease the project’s estimated terminal salvage value.
C. Immediately pay the proposal’s marketing program in its entirety rather than pay in
five equal installments.
D. Adjust the project’s discount rate to reflect movement of the project from a low risk
category to an average risk category.

31. A transit company is considering two alternative buses to transport people between cities
that are in the same region. A gas-powered bus has a cost of $55,000, and will produce
end-of-year net cash flows of $22,000 per year for 4 years. A new electric bus will cost
$90,000, and will produce cash flows of $28,000 per year for 8 years. The company must
provide bus service for 8 years, after which it plans to give up its franchise and to cease
operating the route. Inflation is not expected to affect either costs or revenues during the

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next 8 years. If the cost of capital is 16%, by what amount will the better project increase
the company’s value?
A. $6,556
B. $(14,432)
C. $13,112
D. $31,632
32. If a project with positive after-tax cash flows for 8 years has a discounted payback period
of 5 years when the cost of capital is 10%, the project has a(n)

A. Undiscounted payback period greater than 6 years.

B. Internal rate of return that is less than 10%.

C. Positive net present value.

D. Profitability index that is less than one.

33. Lunar Inc. is considering the purchase of a machine for $500,000 which will last 5 years.
A financial analysis is being developed using the following information.

The machine will be depreciated over 5 years on a straight-line basis for tax purposes and
Lunar is subject to a 40% effective income tax rate. Assuming Lunar will have significant
taxable income from other lines of business, and using a 20% discount rate, the net
present value of the project would be:

A. $280,000.
B. $161,550.
C. $480,000.
D. $16,530.

34. Henderson, Inc., has purchased a new fleet of trucks to deliver its merchandise. The
trucks have a useful life of 8 years and cost a total of $500,000. Henderson expects its net
increase in after-tax cash flow to be $150,000 in Year 1, $175,000 in Year 2, $125,000 in
Year 3, and $100,000 in each of the remaining years.

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Ignoring the time value of money, how long will it take Henderson to recover the amount
of investment?
A. 3.5 years.
B. 4.0 years.
C. 4.2 years.
D. 5 years.

35. A company has a payback goal of 3 years on new equipment acquisitions. A new sorter
is being evaluated that costs $450,000 and has a 5-year life. Straight-line depreciation
will be used; no salvage is anticipated. The company is subject to a 40% income tax rate.
To meet the company’s payback goal, the sorter must generate reductions in annual cash
operating costs of
A. $60,000
B. $100,000
C. $150,000
D. $190,000

36. A characteristic of the payback method (before taxes) is that it

A. Incorporates the time value of money.

B. Neglects total project profitability.

C. Uses accrual accounting inflows in the numerator of the calculation.

D. Uses the estimated expected life of the asset in the denominator of the calculation.

37. Whenever a project has a negative impact on an existing project's cash flows, that effect
should:
A. be included as a cash outflow on the new project's cash flow analysis.
B. be ignored if the project is evaluated using the correct cost of capital.
C. be included if the impact is limited to noncash expenditures.
D. be ignored.

38. The owner of Woofie's Video Rental cannot decide how to project the real costs of
opening a rental store in a new shopping mall. The owner knows the capital investment
required but is not sure of the returns from a store in a new mall. Historically, the video
rental industry has had an inflation rate equal to the economic norm. The owner requires
a real internal rate of return of 10%. Inflation is expected to be 3% during the next few
years. The industry expects a new store to show a growth rate, without inflation, of 8%.
First year revenues at the new store are expected to be $400,000.

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The revenues for the second year, using both the real rate approach and the nominal rate
approach, respectively, would be:

A. $440,000 real and $453,200 nominal.

B. $432,000 real and $452,000 nominal.
C. $440,000 real and $452,000 nominal.
D. $432,000 real and $444,960 nominal.
39. Investment Project B will require an initial investment of $430,000 and is expected to
generate after-tax net cash inflows of $113,500 each year over the project's five-year life.
Management has established a hurdle rate of 12% on similar investments. What is the
investment's expected internal rate of return and should the company invest in the
project?
A. Less than the 12% hurdle; reject the project
B. Equal to the 12% hurdle; indifferent about investing in the project
C. Greater than the 12% hurdle; invest in the project
D. Unable to determine the internal rate of return with the information provided

40. Foster Manufacturing is analyzing a capital investment project that is forecasted to

produce the following cash flows and net income.

If Foster's cost of capital is 12%, the internal rate of return (IRR) (rounded to the nearest
whole percentage) is:

A. 13%.
B. 15%.
C. 12%.
D. 14%.

41. Despite its shortcomings, the traditional payback period continues to be a popular
method to evaluate investments because, in part, it

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A. Provides some insight into the risk associated with a project.

B. Ignores the time value of money.

C. Focuses on income rather than cash flow.

D. Furnishes information about an investment’s lifetime performance.

42. A proposed capital budgeting project requires an initial investment of $95,000. The
subsequent annual cash flows from the project of $40,000 are expected to last for 7 years
and be received at the end of each year. If the cost of capital is 20%, the discounted
payback period of the project is

A. Less than 2 years.

B. Between 2 and 3 years.

C. Between 3 and 4 years.

D. Between 4 and 5 years.

43. Don Adams Breweries is considering an expansion project with an investment of

$1,500,000. The equipment will be depreciated to zero salvage value on a straight-line
basis over 5 years. The expansion will produce incremental operating revenue of
$400,000 annually for 5 years. The company’s opportunity cost of capital is 12%. Ignore
taxes.

What is the NPV of the investment?

A. $0
B. $(58,000)
C. $(116,000)
D. $1,442,000

44. Martinez Ltd. is considering investing in a new project that will cost $750,000, with an
estimated useful life of 10 years and no salvage value. Projections indicate that the
investment will result in before-tax net cash inflows of $158,000 (not including
depreciation). Assuming straight-line deprecation and an effective tax rate of 30%, what
is the project's internal rate of return?

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Management has set a hurdle rate of 10% on similar investments.

A. Less than the 10% hurdle rate

B. Equal to the 10% hurdle rate
C. Greater than the 10% hurdle rate.
D. Unable to determine with the information provided

45. Logan Enterprises is at a critical decision point and must decide whether to go out of
business or continue to operate for five more years. Logan has a labor contract with five
years remaining which calls for $1.5 million in severance pay if Logan's plant shuts
down. The firm also has a contract to supply 150,000 units per year, at a price of $100
each, to Dill Inc. for the next five years. Dill is Logan's only remaining customer. Logan
must pay Dill $500,000 immediately if it defaults on the contract. The plant has a net
book value of $600,000, and appraisers estimate the facility would sell for $750,000
today but would have no market value if operated for another five years. Logan's fixed
costs are $4 million per year, and variable costs are $75 per unit. Logan's appropriate
discount rate is 12%. Ignoring taxes, the optimal decision is to:
A. shut down since the breakeven point is 160,000 units while annual sales are 150,000
units.
B. keep operating to avoid the severance pay of $1,500,000.
C. keep operating since the incremental net present value (NPV) is approximately
$350,000.
D. shut down because the annual cash flow is negative $250,000 per year.

46. FB Inc. is considering an investment project. The company has calculated its weighted-
average cost of capital (WACC) as 9.1%. In the decision of which discount rate is
appropriate to use in calculating net present value (NPV) on a project, which of the
following is true?
A. The weighted-average cost of capital represents the appropriate discount rate for all
NPV calculations.
B. If the investment project is perceived as high risk, the WACC would be adjusted to a
discount rate lower than 9.1% to ensure that sufficient profits are earned.
C. The discount rate used for this investment opportunity should be the same as other
projects considered by JFB.

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D. The weighted-average cost of capital would be the minimum required return on the
investment assuming an average level of risk is anticipated with the investment
opportunity.

47. Webster Products is performing a capital budgeting analysis on a new product it is

considering. Annual sales are expected to be 50,000 units in the first year, 100,000 units
in the second year, and 125,000 units the year thereafter. Selling price will be $80 in the
first year and is expected to decrease by 5% per year. Annual costs are forecasted as
follows.

The investment of $2 million will be depreciated on a straight-line basis over 4 years for
financial reporting and tax purposes. Webster's effective tax rate is 40%. When
calculating net present value (NPV), the net cash flow for year 3 would be:

A. $858,750.
B. $1,431,250.
C. $1,058,750.
D. $558,750.

48. As used in capital budgeting analysis, the internal rate of return (IRR) uses which of the
following items in its computation?
A. net incremental investment-yes; incremental average operating income-no; net annual
cash flows-yes.
B. net incremental investment-yes; incremental average operating income-yes; net
annual cash flows-yes.
C. net incremental investment-no; incremental average operating income-yes; net annual
cash flows-yes.
D. net incremental investment-yes; incremental average operating income-yes; net
annual cash flows-no.

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49. Mangione Company is selling an existing machine that is being replaced with new
equipment. The existing machine originally cost $50,000, with an estimated useful life of
four years and a salvage value of $1,000 when it was initially placed in service years ago.
Mangione, in seeking to dispose of the existing machine, has found a scrapyard that is
offering $1,500. What is the present value effect related to the sale of the existing
machine?

Assume a 30% income tax rate and an 8% hurdle rate.

A. $368
B. $1,050
C. $1,250
D. $1,350

50. An investment decision is acceptable if the:

A. present value of cash outflows is greater than or equal to $0.
B. present value of cash inflows is greater than or equal to $0.
C. present value of cash inflows is less than the present value of cash outflows.
D. net present value (NPV) is greater than or equal to $0.

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