Statement 1: Capital budgeting refers to a group of methods used by a company to

analyze possible capital projects to invest in.

Statement 2: “capital budgeting” is called as such because capital—whether debt,
equity, or retained earnings—is a limited resource.
Response: Only statement 1 is correct.
Feedback: Since management is faced with limited sources of capital, management
needs a means of carefully deciding whether a particular project under consideration is
one that will contribute to profits and thus to the value or wealth of the firm and its
owners, the stockholders. If more than one project is under consideration, management
needs to be able to identify the projects that will contribute the most to profits and value.
Capital budgeting makes it possible to evaluate the different investment opportunities
that are available to a company and decide which opportunities should be pursued.

Thus, capital budgeting is used to make long-term planning decisions for investments in
projects. These projects could be the purchase of fixed assets or any other purchases
or investments that will provide benefit for a period of time greater than one year into the
future. These are long-term decisions, and they usually involve large amounts of
money. Once a company has made a decision, it is generally committed to it for a great
deal of time. Therefore, it is critical to the company’s success that its management
makes correct decisions that will be profitable and beneficial in the long run.
Correct answer: Both statements are correct.
Score: 0 out of 1 No

Question 2
 Statement 1: The firm’s objective in using capital budgeting to select projects is to
maximize the value of its equity and thus maximize shareholder wealth.
Statement 2: In evaluating a potential investment, capital budgeting focuses on the
entire life of the project.
Response: Both statements are correct.
Feedback: In evaluating a potential investment, capital budgeting focuses on the entire
life of the project. It considers all expected cash inflows (including expected cash
savings) as well as all expected cash outflows that should result from investing in the
project. Therefore, capital budgeting is not concerned with only one year’s or one
accounting period’s expected results from an investment in a project. Instead, capital
budgeting is a “life-cycle” or “cradle-to-grave” approach to selecting, implementing and
monitoring the results of long-term investments.

The life-cycle approach accumulates all revenues and all costs for a particular project
throughout the years that the project is expected to have revenues and costs. All the
revenues expected to be received during the life of the project are included. Costs
include everything from the initial investment to research and development,
manufacturing, and even anticipated after-sale costs, such as customer service costs
and warranty costs—for as long as the project is ongoing.
When used in capital budgeting, the life-cycle approach accumulates all expected
revenues, all expected costs and all the expected cost savings related to the project
over its entire planned life. If a decision must be made whether or not to embark upon a
project, the expected revenues, costs and cost savings are determined using the
incremental approach. In the incremental approach, the only cash flows relevant to the
analysis are cash flows that would be additional as a result of the activity. On the other
hand, if the decision calls for a choice between two or more alternatives, the differential
approach is used, in which the only cash flows relevant to the analysis are those that
would differ between or among the alternatives. The terms “incremental” and
“differential” are often used interchangeably. However, they are not the same.

For instance, when using a “life-cycle” capital budgeting approach to determine whether
to produce a new product, a company will first use life-cycle costing and various
projected alternative selling price/sales quantity combinations to determine the best
price to charge for the product. The selected price will be expected to maximize life-
cycle operating income. Once a pricing policy is determined, the company will turn to
capital budgeting techniques to determine whether the return on the project will be
sufficient to make it an attractive investment.
Correct answer: Both statements are correct.
Score: 1 out of 1 Yes

Question 3
 Statement 1: Capital budgeting is a decision-making tool.
Statement 2: In the capital budgeting phase, all the cash inflows, outflows and savings
(such as tax savings resulting from the depreciation of the purchased assets) are
evaluated.
Response: Both statements are correct.
Feedback: Capital budgeting is a decision-making tool. In the capital budgeting phase,
all the cash inflows, outflows and savings (such as tax savings resulting from the
depreciation of the purchased assets) are evaluated. Four major capital budgeting
techniques are used. The four methods offer four different ways to look at a project. All
have their places in capital budgeting analysis, and we will discuss each of them in
detail.

The time value of money is used in two of the methods, Net Present Value and Internal
Rate of Return, recognizing the fact that a $1,000,000 net cash inflow received next
year is worth more than a $1,000,000 net cash inflow received five years from now.
Therefore, to make the analysis meaningful, the expected net cash flows for each of the
years over the entire life of the project are discounted to their present values at the
beginning of the project’s life using the firm’s required rate of return.

In a third method, the Payback Method, the future net cash inflows are compared with
the net initial investment (outflow) to determine the time it will take to recoup the net
 initial investment, without taking the time value of money into consideration. The final
method, the Accrual Accounting Rate of Return Method, divides an accounting measure
of net income for the project (rather than cash flow) by an accounting measure of
investment to calculate an annual average accounting rate of return on the investment.
Correct answer: Both statements are correct.
Score: 1 out of 1 Yes

Question 4
 This is a stage in capital budgeting process. This stage indicates which types of capital
expenditure projects are necessary for the company to accomplish its organizational
objectives.
Response: Selection Stage
Feedback:
The Stages in Capital Budgeting
There are six stages that need to be followed in the process of making capital
investment decisions. They are:
1.  Identification Stage – This stage indicates which types of capital expenditure
projects are necessary for the company to accomplish its organizational objectives. For
instance, if the company needs to reduce expenses, it would identify projects to improve
productivity and efficiency. If the company needs to increase revenues, it would look for
projects to develop new markets or increase existing markets.
2. Search Stage – During this stage, the company explores alternative capital
investments that will
achieve the organizational objectives. Various technologies and other alternatives are
researched.
3. Information-Acquisition Stage – The company then must consider the expected
costs and benefits (quantitative and qualitative) of alternative capital investments. There
are four main steps in this
stage for determining net cash flows for each potential project it has identified:
o Determine the net investment and initial-cost cash outflow, which are the
net cash outflows associated with the increase in long-term assets needed for the
project(s) under consideration, as well as the initial cash outflows for things such as
advertising, employee training, and research
and development.
o Determine additional net working capital requirements, which is the
increase in net current assets (current assets minus current liabilities) that will result
from the investment decision. In the information-acquisition stage, the additional net
working capital that is required must be treated as an investment because it represents
short-term assets that are not available for other purposes for the company.
o Determine the estimated subsequent net operating cash flows for each
future period that will result from using the assets that are acquired. To do this, we need
to have reliable estimates of revenues and expenses and tax savings.
o  Determine the net cash flows at the end of the project relating to disposal
of the long-term assets and release of working capital.

 Note: All amounts gathered for inclusion during the
Information-Acquisition Stage are net amounts, that is, cash inflows minus
cash outflows.
4. Selection Stage – At this stage the company chooses projects for implementation
on the basis of financial analysis and non-financial considerations.
5. Financing Stage – The company obtains the necessary project funding.
6. Implementation and Control Stage – This is the final stage in which the project is
implemented and monitored over time.
 
Note: A post-completion audit or post-audit of a capital budgeting project involves
comparing the actual costs and benefits of the project with the original estimates. Post-
completion audits should be done for all large projects and for all strategically important
projects, regardless of size. They should also be done for a sample of smaller projects.
A post-audit lets management know how close the actual results of the project came to
its original estimates. The feedback received from a post-audit helps management to
learn where their forecasts may have been off and to understand what important factors
they may have omitted in their capital budgeting analysis. This information can help to
improve future capital budgeting analyses.
 
In this chapter we are interested largely in only the third and fourth steps from the
above list. We will look at potential investments from a  purely financial
viewpoint. However, in real-world analysis of a potential project, it is important to
realize that there may be  non-financial considerations that will cause the company
to select an investment that is not the most “profitable” (financially).  Such factors
can include the role of a business in a local community, media coverage and reaction to
a decision that is made or not made, or other similar items.
Correct answer: Identification Stage
Score: 0 out of 1 No

Question 5
 This is a stage in the capital budgeting process where a company  must consider the
expected costs and benefits (quantitative and qualitative) of alternative capital
investments. There are four main steps in this
stage for determining net cash flows for each potential project it has identified.
 Response: Identification Stage
Feedback:
The Stages in Capital Budgeting
There are six stages that need to be followed in the process of making capital
investment decisions. They are:
1.  Identification Stage – This stage indicates which types of capital expenditure
projects are necessary for the company to accomplish its organizational objectives. For
instance, if the company needs to reduce expenses, it would identify projects to improve
productivity and efficiency. If the company needs to increase revenues, it would look for
projects to develop new markets or increase existing markets.
2. Search Stage – During this stage, the company explores alternative capital
investments that will
achieve the organizational objectives. Various technologies and other alternatives are
researched.
3. Information-Acquisition Stage – The company then must consider the expected
costs and benefits (quantitative and qualitative) of alternative capital investments. There
are four main steps in this
stage for determining net cash flows for each potential project it has identified:
o Determine the net investment and initial-cost cash outflow, which are the
net cash outflows associated with the increase in long-term assets needed for the
project(s) under consideration, as well as the initial cash outflows for things such as
advertising, employee training, and research
and development.
o Determine additional net working capital requirements, which is the
increase in net current assets (current assets minus current liabilities) that will result
from the investment decision. In the information-acquisition stage, the additional net
working capital that is required must be treated as an investment because it represents
short-term assets that are not available for other purposes for the company.
o Determine the estimated subsequent net operating cash flows for each
future period that will result from using the assets that are acquired. To do this, we need
to have reliable estimates of revenues and expenses and tax savings.
o  Determine the net cash flows at the end of the project relating to disposal
of the long-term assets and release of working capital.

 Note: All amounts gathered for inclusion during the
Information-Acquisition Stage are net amounts, that is, cash inflows minus
cash outflows.
4. Selection Stage – At this stage the company chooses projects for implementation
on the basis of financial analysis and non-financial considerations.
5. Financing Stage – The company obtains the necessary project funding.
6. Implementation and Control Stage – This is the final stage in which the project is
implemented and monitored over time.
 
Note: A post-completion audit or post-audit of a capital budgeting project involves
comparing the actual costs and benefits of the project with the original estimates. Post-
completion audits should be done for all large projects and for all strategically important
projects, regardless of size. They should also be done for a sample of smaller projects.
A post-audit lets management know how close the actual results of the project came to
its original estimates. The feedback received from a post-audit helps management to
learn where their forecasts may have been off and to understand what important factors
they may have omitted in their capital budgeting analysis. This information can help to
improve future capital budgeting analyses.
 
In this chapter we are interested largely in only the third and fourth steps from the
above list. We will look at potential investments from a  purely financial
viewpoint. However, in real-world analysis of a potential project, it is important to
realize that there may be  non-financial considerations that will cause the company
to select an investment that is not the most “profitable” (financially).  Such factors
can include the role of a business in a local community, media coverage and reaction to
a decision that is made or not made, or other similar items.
Correct answer: Information-Acquisition Stage
Score: 0 out of 1 No

Question 6
 Which one of the following procedures would most likely help managers identify errors
in their capital budgeting decisions?
Response: Post-audits
Correct answer: Post-audits
Score: 1 out of 1 Yes

Question 7
 A cost that is shared by all of the available options or all divisions. Because it is the
same for all options, it is not relevant and should not be taken into account in making a
decision between any two different options.
Response: Opportunity Cost
Feedback:
Terms Used in Capital Budgeting
In the process of capital budgeting there are a number of different types of cash flows,
revenues and costs with which we need to be familiar, either to make sure that they are
taken into account in, or excluded from, the decision-making process.
1. Avoidable Cost.  An avoidable cost is one that can be avoided or eliminated by
making a decision not to invest, or to cease investing. Because these costs may be
different among options, they will be relevant costs that will need to be addressed if the
costs are different among the options.
2. Committed Cost. The company has already agreed to and committed itself to a
committed cost, even if the invoicing or delivery of the product or service has not taken
place. A long-term contract (for rent, for example) is an example of a committed cost.
This is similar to a sunk cost in that it cannot be changed, but it is different because the
money has not yet been spent. However, because the company is committed to the
cost, it will have a future impact and therefore it needs to be recognized as a cost that
needs to be covered. But if the committed cost cannot be changed by any current
decision, it is not relevant to a process of deciding among alternatives currently,
because it will be the same no matter which alternative is selected.
3. Common Cost. A common cost is shared by all of the available options or all
divisions. Because it is the same for all options, it is not relevant and should not be
taken into account in making a decision between any two different options.
4. Cost of Capital.The cost of capital is the weighted average cost of interest on
debt (net of tax) and the implicit and explicit cost of equity capital. The cost of capital is
the minimum required rate of return for a project in order to not dilute (reduce)
shareholders’ interest. The cost of capital is often used as the discount rate in net
present value calculations.
5. Deferrable Cost, or Discretionary Cost. A deferrable cost is one that can
be deferred to future periods without creating a significant impact in the current period.
Marketing and training are often considered deferrable costs.
6. Differential Revenue, Cost, or Cash Flow .A differential revenue or differential
cost or differential cash flow is the difference in revenue, cost, or cash flow between two
alternatives. A differential revenue, cost or cash flow results from choosing one option
over another option, and these are the important factors to consider when deciding
between two options. Differential revenues, costs and cash flows are different from
incremental revenues, costs and cash flows (see below).
7. Fixed Cost. A fixed cost remains constant over the specified level of activity (the
relevant range).
8. Opportunity Cost .An opportunity cost is a forgone alternative that had to be
dismissed in order to achieve a goal. Opportunity cost is the cost of the “next best
alternative” or the “next highest valued alternative.” It is the price of not only some other
alternative that should be considered, but also the highest other opportunity that must
be given up in order to achieve one project.
9. Imputed Cost.An imputed cost is an opportunity cost. An imputed, or opportunity,
cost is the benefit that is given up as a result of using the company’s resources
elsewhere. It is the benefit of the next best option. Another definition of an imputed cost
is one that is not stated and must be calculated in some way. 
10. Incremental Revenue, Cost, or Cash Flow. An incremental revenue or
incremental cost or incremental cash flow is the additional revenue, cost or cash flow
from choosing an activity over not choosing any activity, and these are the important
factors that need to be taken into account when deciding whether to embark upon a
project.
11. Relevant Revenues, Costs or Cash Flows .Relevant revenues, costs, or cash
flows vary with one course of action over another, and they are the important factors in
a decision, because all other revenues, costs and cash flows are the same for all
options. Relevant revenues, costs, or cash flows may be either incremental or
differential.
12. Sunk Costs. A sunk cost is one that has already been incurred and therefore
is not a relevant cost. Sunk costs are not taken into account in decision-
making because the money has already been spent, and any new decision will not
change those costs.
Correct answer: Common Cost
Score: 0 out of 1 No

Question 8
 Is one that can be avoided or eliminated by making a decision not to invest, or to cease
investing. Because these costs may be different among options, they will be relevant
costs that will need to be addressed if the costs are different
among the options.
Response: Sunk Costs
Feedback:
Terms Used in Capital Budgeting
In the process of capital budgeting there are a number of different types of cash flows,
revenues and costs with which we need to be familiar, either to make sure that they are
taken into account in, or excluded from, the decision-making process.
1. Avoidable Cost.  An avoidable cost is one that can be avoided or eliminated by
making a decision not to invest, or to cease investing. Because these costs may be
different among options, they will be relevant costs that will need to be addressed if the
costs are different among the options.
2. Committed Cost. The company has already agreed to and committed itself to a
committed cost, even if the invoicing or delivery of the product or service has not taken
place. A long-term contract (for rent, for example) is an example of a committed cost.
This is similar to a sunk cost in that it cannot be changed, but it is different because the
money has not yet been spent. However, because the company is committed to the
cost, it will have a future impact and therefore it needs to be recognized as a cost that
needs to be covered. But if the committed cost cannot be changed by any current
decision, it is not relevant to a process of deciding among alternatives currently,
because it will be the same no matter which alternative is selected.
3. Common Cost. A common cost is shared by all of the available options or all
divisions. Because it is the same for all options, it is not relevant and should not be
taken into account in making a decision between any two different options.
4. Cost of Capital.The cost of capital is the weighted average cost of interest on
debt (net of tax) and the implicit and explicit cost of equity capital. The cost of capital is
the minimum required rate of return for a project in order to not dilute (reduce)
 shareholders’ interest. The cost of capital is often used as the discount rate in net
present value calculations.
5. Deferrable Cost, or Discretionary Cost. A deferrable cost is one that can
be deferred to future periods without creating a significant impact in the current period.
Marketing and training are often considered deferrable costs.
6. Differential Revenue, Cost, or Cash Flow .A differential revenue or differential
cost or differential cash flow is the difference in revenue, cost, or cash flow between two
alternatives. A differential revenue, cost or cash flow results from choosing one option
over another option, and these are the important factors to consider when deciding
between two options. Differential revenues, costs and cash flows are different from
incremental revenues, costs and cash flows (see below).
7. Fixed Cost. A fixed cost remains constant over the specified level of activity (the
relevant range).
8. Opportunity Cost .An opportunity cost is a forgone alternative that had to be
dismissed in order to achieve a goal. Opportunity cost is the cost of the “next best
alternative” or the “next highest valued alternative.” It is the price of not only some other
alternative that should be considered, but also the highest other opportunity that must
be given up in order to achieve one project.
9. Imputed Cost.An imputed cost is an opportunity cost. An imputed, or opportunity,
cost is the benefit that is given up as a result of using the company’s resources
elsewhere. It is the benefit of the next best option. Another definition of an imputed cost
is one that is not stated and must be calculated in some way. 
10. Incremental Revenue, Cost, or Cash Flow. An incremental revenue or
incremental cost or incremental cash flow is the additional revenue, cost or cash flow
from choosing an activity over not choosing any activity, and these are the important
factors that need to be taken into account when deciding whether to embark upon a
project.
11. Relevant Revenues, Costs or Cash Flows .Relevant revenues, costs, or cash
flows vary with one course of action over another, and they are the important factors in
a decision, because all other revenues, costs and cash flows are the same for all
options. Relevant revenues, costs, or cash flows may be either incremental or
differential.
12. Sunk Costs. A sunk cost is one that has already been incurred and therefore
is not a relevant cost. Sunk costs are not taken into account in decision-
making because the money has already been spent, and any new decision will not
change those costs.
Correct answer: Avoidable Cost
Score: 0 out of 1 No

Question 9
Statement 1: Three of the four capital budgeting screening methods (Net Present Value,
Internal Rate of Return and Payback Method) rely on the relevant expected cash inflows
and outflows, whereas one (the Accrual Accounting Rate of Return Method) utilizes
relevant accounting incomes and expenses.
 Statement 2: All expected cash flows in a capital budgeting analysis are treated as
though they are received at the end of the year to which they are assigned, even though
in actuality, they will be received throughout the year.
Response: Both statements are incorrect.
Feedback:
Expected Cash Flows at the Beginning of the Project (Year 0)
The expected cash flows at the beginning of the project are the cash outflows and
inflows that are expected to occur at Day Zero or shortly thereafter, when a new project
is first implemented. They relate to the net initial investment. In capital budgeting
analysis, the date of the initial investment may be referred to as either “Year 0” or “Time
0.” We have chosen to use “Year 0” but whichever way they are referred to, cash flows
that occur at the beginning of a project take place one year before the end of Year 1.
Cash flows at the beginning of the project that relate to the net initial investment consist
of three components:
1. Initial investment. The initial investment is the cash outflow that is used
to purchase the new machinery or make the initial investment into the project. The initial
investment includes any setup, testing or other related costs. Essentially, all of the costs
necessary to get the project operating are included as the initial investment.
o
 Tax Effect: There is no immediate tax effect in respect to the initial
investment. Any tax benefits that may arise will occur over the life of the project as the
machinery or equipment is depreciated.
2. Initial working capital investment. “Working capital” (also called “net working
capital”) is defined as total current assets minus total current liabilities. When speaking
of an expected increase in working capital, it means that we expect accounts receivable
and inventory to increase because of the project under consideration. Raw materials
inventory may need to be purchased. Accounts receivable will increase as soon as
sales are made. We also expect that accounts payable related to the purchased
inventory will increase. However, the increase in accounts payable will not be as large
as the increases in accounts receivable and inventory. Thus, working capital will
increase incrementally by the amount of the increase in current assets (accounts
receivable and inventory) minus the amount of increase in current liabilities (accounts
payable).
This incremental increase in working capital requires cash, needed to purchase
inventory. The increase in accounts receivable represents goods supplied or services
rendered for which the company has incurred expenses but for which it has not yet
received payment.
This increase in working capital is a cash outflow at the beginning of the
project. Remember that if a new machine is replacing an old one, the initial working
capital investment will be the difference between the working capital investment
required to operate the new machine and the working capital investment that was
required to operate the old machine. In the case of a new machine replacing an old one,
the initial working capital investment would be an incremental amount.
o
 Tax Effect: There is no tax effect related to working capital.
Therefore, the amount that needs to be included in the capital budgeting analysis is the
actual amount of the increase in working capital that the company expects to occur.
3. Cash received from the disposal of the old machine if there is an old machine to be
disposed of. Cash received from the disposal of the old machine is a cash inflow and
therefore reduces the initial investment for the new machine.

o
 Tax Effect: When the old machine is sold, there will be a tax
effect related to the gain or loss on the sale. The amount of the gain or loss is
calculated as the difference between the tax basis (the asset’s book value for tax
purposes) of the asset and the cash received from the sale of the asset. If there is a
gain, this gain will be taxed. The effect of this tax is a reduction of the cash inflow by
the amount of taxes paid on the gain. If there is a loss, this loss will be a reduction of
net taxable income because the loss will be deducted. The effect of this deductible loss
is that the company pays less in taxes in total, which saves them money. Therefore, the
loss on the disposal of the old equipment creates a cash “inflow” in the form of lower
taxes. It is considered a cash inflow because it is a decrease in cash outflow. The
amount of this tax savings is a cash inflow that increases the cash received from
the sale of the asset for the capital budgeting calculation.
 
Ongoing Annual Net Cash Flows from Operations
After the project has started, the company will have cash flows that occur on an annual
basis. The annual cash flows used may be the same each year during the project, or
they may be different.
A. The operating cash inflows may result from one or both of two sources:
1.
1. Increased sales. As a result of having made this investment, the company
should experience an increase in sales, which will lead to an increase in profits. The
cash inflow for capital budgeting purposes is the amount of the increased operating
cash flows (cash inflows minus cash outflows) that result each year from this
investment.
2. Decreased operating expenses. While decreased operating expenses will
also lead to increased profits, it comes about from the other side of the process. The
new equipment may be more efficient than the old equipment, leading to lower
operating costs. The amount of the decreased operating expenses that result from the
investment are a cash inflow for capital budgeting purposes.

 Tax Effect: The company will need to pay taxes as a result
of either increased sales and profits or decreased operating costs. Therefore, the cash
flows related to these items need to be reduced for the taxes that will be paid as a
result.
      B. Additionally, the company may have cash outflows in years after the initial
investment is made. There are two potential sources of cash outflows in the following
years:
1.
1. Another cash investment. It is possible that a follow-up investment must
be made after some period of time, or that there will be a capital investment that needs
to be made with the equipment to maintain it after a certain number of years. These
would both be treated as cash outflows for the amount that is paid in the year it is to be
paid.

 Tax Effect: The tax effect of additional investments will be
treated in the same manner as the
original investment. The tax savings will be received (and the cash inflow received)
when the asset is depreciated.
2. Further working capital investment. The company may need another
increase in its working capital later in the project’s life. This additional increase is treated
in the same manner is the increase in working capital at the start of the project, except it
occurs in a later year.

 Tax Effect: As was the case with the original investment in
working capital, any increase in working capital in subsequent periods also does
not have a tax effect.
 
Depreciation Tax Shield –  A Cash Inflow
The most difficult recurring cash flow over the life of the asset is the cash flow that
arises from the depreciation tax shield. As we have already discussed in respect to the
tax effect of the initial investment in the assets, the tax effect of the asset is received as
the asset is depreciated. Depreciation is an expense, so it increases expenses and
decreases net taxable income on the firm’s tax return. The tax benefit is received in the
form of reduced taxes due to the decreased taxable income.

o
 The calculated amount of tax-deductible depreciation will be a
reduction of the company’s taxable income, because depreciation expense is a tax-
deductible expense. The amount of tax-deductible depreciation will cause an equal
reduction in the company’s taxable income. That will, in turn, cause a reduction in the
amount of tax that will be due. This tax reduction will not represent an actual cash
inflow, but it reduces the cash outflow of the company for taxes. Therefore, the amount
of tax savings that occurs as a result of the depreciation expense is treated as a cash
inflow for capital budgeting purposes. The amount of tax savings that results from the
depreciation is called the depreciation tax shield.
 The depreciation tax shield is calculated as follows for each year of
an asset’s life:
 = Annual Depreciation as Calculated × Tax rate
Or to put it another way:
=Full Cost of Asset × Annual Depreciation Rate × Tax Rate
 
Cash Flows at the Disposal or Completion of the Project
When the project is terminated, there are number of potential cash flows related to this
event. These potential cash flows are:
1. Cash received from the disposal of equipment. The cash received from the sale
of any assets (equipment, machines or the investment project itself) is a cash inflow in
the final year of the project.
o
 Tax Effect: If the sale of the assets results in a gain or loss, there
will be a tax effect from this gain or loss. The gain or loss is calculated by comparing
the tax basis (or book value, if the tax basis is not given) with the cash received.
Remember that the tax basis is the full cost of the asset minus accumulated
depreciation on the sale date. If there is a gain, the cash inflow will be reduced by the
taxes paid on the gain. If there is a loss, the loss will be tax deductible and the resulting
tax savings will be added to the cash received from the sale to calculate the cash
inflow. This tax treatment is the same as the treatment of the gain or loss on the sale of
the old equipment at the start of the project.
2. Recovery of working capital. The initial incremental investment in working capital
and any subsequent investments in working capital are usually fully recouped at the end
of the project. The final accounts receivable will be collected and not replaced with other
accounts receivable (for this project), the inventory associated with the project will have
been sold, and all the related accounts payable paid. It is also possible for an
investment in working capital to be recovered before the end of the project. Whenever
working capital is recovered, it is a cash inflow in that year with no tax effect.
 
Correct answer: Both statements are correct.
Score: 0 out of 1 No

Question 10
 Garfield, Inc. is considering a 10-year capital investment project with forecasted
revenues of $40,000 per year and forecasted cash operating expenses of $29,000 per
year. The initial cost of the equipment for the project is $23,000, and Garfield expects to
sell the equipment for $9,000 at the end of the 10th year. The equipment depreciates
over 7 years. The project requires a working capital investment of $7,000 at its inception
and another $5,000 at the end of year 5. Assuming a 40% marginal tax rate, the
expected net cash flow from the project in the 10th year is:
Response: $24,000
Feedback: This question gives a lot of information that is not relevant to the question
that is asked, which is simply what the cash flows in the final year of this project will be.
There will be $11,000 of cash inflows that are a result of profits ($40,000 − $29,000). In
addition, the equipment will be sold for $9,000. There is also a total of $12,000 of
working capital invested in the project that will be released in Year 10. In addition to
these items, we need to take into account taxes and the fact that taxes will need to be
paid on the profits. The equipment is fully depreciated, so the full $9,000 proceeds from
the sale will be taxable gain. Income tax will be paid on that $9,000 and on the
operating income of $11,000, for a taxable income of $20,000. The freeing up of
working capital is not a taxable event.

Therefore, taxes will be $8,000 ($20,000 × 40%).

This makes the Year 10 cash flows a total of $24,000 ($11,000 operating income +
$9,000 received from the sale of the equipment + $12,000 working capital released −
$8,000 income tax).
Correct answer: $24,000
Score: 1 out of 1 Yes

Question 11
 Kore Industries is analyzing a capital investment proposal for new equipment to
produce a product over the next 8 years. The analyst is attempting to determine the
appropriate "end-of-life" cash flows for the analysis. At the end of 8 years, the
equipment must be removed from the plant and will have a net book value of zero, a tax
basis of $75,000, a cost to remove of $40,000, and scrap salvage value of $10,000.
Kore's effective tax rate is 40%. What is the appropriate "end-of-life" cash flow related to
these items that should be used in the analysis?
Response: $(18,000)
Feedback: This question is asking for the cash flows related to ending the project. The
cash flows are: (1)
$10,000 cash received from the salvage value of the project, (2) $40,000 spent on
removing the equipment,
and (3) the tax savings, or cash inflow, related to the capital loss from the disposal of
the equipment. The
capital loss from the disposal of the equipment is calculated as the $10,000 cash
received from the sale of the
equipment minus the $75,000 tax basis (“tax basis” is book value for tax purposes)
minus the $40,000
disposal cost. This $105,000 capital loss leads to a tax savings, or cash inflow, of
$42,000 ($105,000 × 40%).
Thus the net cash flows related to the end of the project are $10,000 − $40,000 +
$42,000 = $12,000.
Correct answer: $12,000
Score: 0 out of 1 
 Statement 1: The book value of an existing equipment is not relevant for capital
budgeting decision. Statement 2: Overhead costs allocated to a branch and the capital
budgeting project under consideration would cause an increase in the overhead costs to
be allocated to that branch are also irrelevant costs.
Response: Only statement 2 is correct.
Feedback:
Irrelevant Cash Flows
 When determining relevant cash flows, remember that sunk costs, such as
the book value of existing equipment, are not relevant, because they will not change as
a result of any capital budgeting project under
consideration.
 Also, there may be overhead costs allocated to a branch, for instance, and the
capital budgeting project under consideration would cause an increase in the overhead
costs to be allocated to that branch. However, that is also not relevant unless the total
overhead costs for the company as a whole will actually change as a result
of the project. If the total overhead costs do change, the only relevant cash flows are
the increase in total overhead costs as a result of the project. If the total overhead costs
do not change
but are simply allocated differently as a result of the project and this branch gets more,
then other branches will get less. As long as the total overhead costs incurred will not
change as a result of the project, there is no relevant increase in costs.
 Financing cash flows are also irrelevant. Cash flows associated with financing of
the project—principal and interest payments on debt or dividends on stock issued—are
not a part of any capital budgeting analysis. The cost of the financing is captured in the
discount rate, or hurdle rate*** that is used to discount the future cash flows for
discounted cash flow methods.  Including the cash flows for financing in the analysis
would be double counting them. If financing can ultimately be obtained on a more
favorable basis than anticipated, it can add value to the actual project. But the financing
cash flows are never included in the capital budgeting analysis that is used to make a
decision about whether or not to embark upon a capital budgeting project.
***The hurdle rate is the minimum rate of return on a project or investment required by
company management or an investor. The company’s cost of capital is usually the
hurdle rate for a capital budgeting project. However, if management perceives unusual
risk in an investment, it should set the hurdle rate higher than the cost of capital to
compensate for the additional risk it is taking.
Correct answer: Both statements are correct.
Score: 0 out of 1 No

Question 2
 eGoods is an online retailer. The management of eGoods is interested in purchasing
and installing a new server for a total cost of $150,000. The controller of eGoods has
asked an accountant at eGoods to determine the incremental yearly tax savings should
the new server be acquired. The server has an estimated useable life of approximately
four years and no salvage value. eGoods currently uses straight-line depreciation and is
assessed an effective income tax rate of 40%. The accountant calculated the
incremental yearly tax savings to be
Response: $22,500.
Feedback: This question is just asking for the annual depreciation tax shield. Even
though it asks for incremental
cash flow and the new server is replacing an old server, no information is given
regarding the cash flow
related to the old server to be replaced. Therefore, we must treat this as a purchase that
is not replacing an
old piece of equipment. The initial investment is $150,000 and the useful life of the
asset is 4 years. Since the
problem tells us the company uses straight-line depreciation, the annual depreciation
expensed will be
$150,000 ÷ 4, or $37,500. Since the company’s tax rate is 40%, the annual depreciation
tax shield (tax
savings) will be $37,500 × 0.40, or $15,000.
Correct answer: $15,000.
Score: 0 out of 1 No

Question 3
 Statement 1: Payback Method does not incorporate the time value of money.
Statement 2: Payback Method ignores the cost of capital.
Response: Both statements are correct.
Feedback:
Payback Period or Payback Method
 Companies use the Payback Method to determine the number of periods that
must pass before the net aftertax cash inflows from the investment will equal (or “pay
back”) the initial investment cost.
 In using the Payback Method, a company usually chooses a period of time in
which it wants its investments to “pay back” their initial investments.
 Projects with payback periods of less than that amount of time are candidates for
further analysis, while projects with payback periods in excess of that amount of time
are rejected without further consideration.
 If the incoming cash flows are constant over the life of the project, the payback
period is calculated with a simple division as follows:
=Initial net investment / Periodic constant expected cash flow
 If the cash flows are not constant over the life of the project, we must sum the
cash inflows and determine—on a cumulative basis—when the inflows will equal the
outflows.
 
Advantages and Disadvantages of the Payback Method
Advantages
 It is simple and easy to understand.
 It can be useful for preliminary screening when there are many proposals.
 It can be useful when expected cash flows in later years of the project
are uncertain. Cash flow predictions for periods far in the future are less certain than
predictions for 3 - 5 years ahead.
 It is helpful for evaluating an investment when the company desires to recoup its
initial investment quickly.
 
Disadvantages
 It ignores all cash flows beyond the payback period. Therefore, a project that has
large expected cash flows in the latter years of its life could be rejected in favor of a less
profitable project that has a larger portion of its cash flows in its early years.
 It does not incorporate the time value of money. Therefore, interest lost while the
company waits to receive money is not considered at all.
 It ignores the cost of capital, so the company could accept a project for which it
will pay more for its capital than the project can return.
 
Discounted Payback Period or Method (Breakeven Time)
 The Discounted Payback Method (also called the breakeven time) is an attempt
to deal with the Payback Method’s weakness of not considering time value of
money concepts.
 The Discounted Payback Method uses the present value of cash flows instead of
undiscounted cash flows to calculate the payback period.
 Each year’s cash flow is discounted using an appropriate interest rate, usually
the company’s cost of capital, and then those discounted cash flows are used to
calculate the payback period.
Correct answer: Both statements are correct.
Score: 1 out of 1 Yes

Question 4
 A proposed capital budgeting project has a discounted payback period of 5 years when
a 10% cost of capital is used. The project has cash flows that will be positive for years 1
through 7. The undiscounted payback period of the project is
Response: between 5 and 7 years.
Feedback: The payback period will always be longer under the discounted payback
method than it is under the
undiscounted payback method. So if the payback period is 5 years, the undiscounted
payback period must be
less than 5 years. That is the only thing we can know for sure from the information
given.
Correct answer: less than 5 years.
Score: 0 out of 1 No

Question 5
 Fitzgerald Company is planning to acquire a $250,000 machine that will provide
increased efficiencies, thereby reducing annual operating costs by $80,000. The
machine will be depreciated by the straight-line method over a 5-year life with no
salvage value at the end of 5 years. Assuming a 40% income tax rate, the machine's
payback period is:
Response: 3.21 years
Feedback: The payback period is calculated by determining how many years it will take
for the net after-tax cash
inflows to equal the initial investment. The yearly cash flow includes the $80,000 in cost
reductions, which is a
cash inflow. The cash inflows will be reduced by the payment of taxes on the increased
income. However, in
the calculation of taxes, we need to include the depreciation expense that will be
recognized. This will be
$50,000 per year and this makes the taxable income only $30,000 per year (the
$80,000 savings minus the
$50,000 depreciation expense). The taxes on this amount are $12,000 ($30,000 ×
0.40). This makes the
total cash flows per year $80,000 − $12,000, or $68,000. (Remember that the
depreciation expense is a noncash expenditure.) Given a $250,000 initial investment
and a net cash inflow of $68,000 per year, the
payback period is 3.68 years ($250,000 ÷ $68,000).
Correct answer: 3.68 years
Score: 0 out of 1 No

Question 6
 Jasper 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. Jasper 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:
Response: $60,000
Feedback: We need to calculate the amount that needs to be saved in before-tax
operating cash flow (not
including the depreciation tax shield) in order for the project to have a payback period of
3 years. The
equipment will cost $450,000, so the after-tax net cash flow needs to be $150,000 per
year ($450,000 ÷ 3).
We need to find the before-tax operating cash flow that will be necessary in order to
give the company this
after-tax net cash flow of $150,000 per year. The company will have two cash inflows:
after-tax operating
cash flow and the depreciation tax shield. Therefore, our basic formula is:
After-tax operating cash flow + Depreciation tax shield = $150,000
The depreciation tax shield equals ($450,000 ÷ 5) × 0.40, which is $36,000.
The after-tax operating cash flow equals the before-tax operating cash flow multiplied by
(1 – the tax rate), or
0.60. Letting BTOCF stand for the before-tax operating cash flow that we are looking
for, our formula will be:
(BTOCF × 0.6) + 36,000 = 150,000
To solve for BTOCF:
Subtract 36,000 from both sides of the equation:
BTOCF × 0.6 = 114,000
Divide both sides of the equation by 0.6:
BTOCF = 190,000
Correct answer: $190,000
Score: 0 out of 1 No
Question 7
 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
Response: between 3 and 4 years.
Feedback:
The discounted cumulative cash flows until the initial investment is recovered are as
follows:
Year      Annual Cash Flow × Discount Factor @ 20%      Discounted Cash Flow     
Cumulative Discounted Cash Flow
0                                  $(95,000) × 1.000                                       $(95,000)                   
$(95,000)
1                                  $40,000 × .833                                                33,320                   
(61,680)
2                                  $40,000 × .694                                              27,760                     
(33,920)
3                                  $40,000 × .579                                              23,160                     
(10,760)
4                                  $40,000 × .482                                             19,280                       
8,520
 
There is no need to carry the calculations beyond Year 4, because the project’s
cumulative cash flow becomes positive at some point during Year 4. Thus the correct
answer is “between 3 and 4 years.”
Correct answer: between 3 and 4 years.
Score: 1 out of 1 Yes

Question 8
 Testra Foods is considering opening a new restaurant. The expected purchase price is
$270,000, expected annual revenues are $150,000, and expected annual costs are
$90,000, including $22,500 of depreciation. The investment has a payback period of
approximately
Response: 3.0 years.
Feedback: When the incoming cash flows for an investment are the same each year for
the life of the project, the
payback period is the initial investment divided by the annual cash inflow. In this
question, we are not given
enough information to calculate the tax shield related to the depreciation, so the only
thing we can do is
subtract cash costs (excluding the depreciation) from revenues to determine annual net
operating cash flow.
Total annual costs are $90,000, including $22,500 of depreciation (a non-cash
expense), so cash costs
excluding the depreciation are $67,500. Thus net cash flow is $150,000 minus $67,500,
or $82,500 per year.
The initial investment of $270,000 divided by $82,500 equals 3.27, or 3.3 years to pay
back the initial
investment.
Correct answer: 3.3 years.
Score: 0 out of 1 

It measures all of the expected future cash inflows and outflows of a project using time
value of money concepts, which is that money received today is worth more than money
received in any future period.
Response: Net Present Value Method
Feedback: Discounted cash flow (DCF) methods measure all of the expected future
cash inflows and outflows of a project using time value of money concepts, which is that
money received today is worth more than money received in any future period. In a
discounted cash flow analysis, the earlier that a project is able to generate cash inflows,
the better, because cash flows received earlier in a project’s life are worth more than
cash flows received later.

Discounted cash flow methods focus on the actual cash inflows and outflows from the
project rather than using income as the measurement basis, as in accrual accounting.
Cash flow is used because we are most interested in the cash return that we can obtain
in the future for a cash outlay now.

When we are using discounted cash flow analysis, unless we are told differently, we
always assume that all cash flows occur at the end of the year. In some instances, a
problem may say that a particular cash flow occurs at the beginning of the year. If that
happens, we treat the cash flow occurring at the beginning of the year as though it
occurs at the end of the previous year. Though this assumption about cash flows
occurring only at the end of a year is not in line with reality, it is a necessary assumption
in order to be able to use discounted cash flow techniques to determine the present
value of the future cash flows. The inaccuracy introduced by this assumption is not
material to the analysis being done.

The two main DCF methods that we will look at in more detail below are the Net Present
Value method and the Internal Rate of Return method.
The NET PRESENT VALUE (NPV) method calculates the present value of 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. A project’s NPV is
the present value of the project’s future expected cash flows minus the proposal’s initial
cash outflow.

The present value of the expected future cash flows is calculated by using a discount
rate that is the company’s required rate of return (RRR). The required rate of return is
either:
1) The return the organization could expect to receive in the market for an investment of
comparable risk, or
2) The minimum rate of return that the project must earn in order to justify investment of
the resources.

This required rate of return is also called the discount rate, hurdle rate, or opportunity
cost of capital.
Generally the company’s cost of capital is used as the discount rate.
• When a project has a positive NPV, the project will be profitable because it will earn
more than it will cost the company, so it will increase the wealth of shareholders.
• When a project has a zero NPV, the value of its expected future cash inflows is exactly
equal to the amount of the initial investment, so the project will neither increase nor
decrease shareholder wealth.
• When a project has a negative NPV, the project will be unprofitable because it will cost
the company more than it will earn for the company.

Only projects with at least a zero NPV but more probably a positive NPV are acceptable
to a company from a financial standpoint. If a project has a negative NPV, the project
should not be undertaken. If the project has a zero NPV, it is questionable. Technically,
the company would not lose money on the project, but it would not earn anything on the
project either.

The required rate of return chosen to discount the cash flows and compute the NPV
must be appropriate to the risk of the project. Adjustment of the required rate of return to
reflect risk will be discussed in more detail later.

The INTERNAL RATE OF RETURN (IRR) method calculates the interest rate (in other
words, the discount rate) at which the present value of expected cash inflows from a
project equals the present value of expected cash outflows. In other words, in the
calculation of IRR we are calculating the interest (discount) rate at which the NPV is
equal to zero. When evaluating the results of an IRR calculation, the IRR that is
determined for the project being analyzed is compared with the required rate of return
(RRR) for the purpose of deciding whether the project is profitable enough to undertake.
Correct answer: Discounted Cash Flow Method
Score: 0 out of 1 No
Question 2
 The Keego Company is planning a $200,000 investment that has an estimated 5-year
life and no salvage value. The company has projected the following cash flows for the
investment:
Year      Projected Cash Inflows      Present Value of $1
1                   $120,000                                    .91
2                      60,000                                     .76
3                      40,000                                     .63
4                      40,000                                    .53
5                      40,000                                    .44
The net present value of the investment is:

Response: $196,200
Feedback:
To calculate the NPV of the investment, we simply need to multiply each year’s cash
inflow by the
given present value of $1 factor for the appropriate time period, add these numbers
together and then
subtract the cash investment of $200,000 from the total. The calculations are as follows:
            Cash Inflow     Factor PV of $1
Year 1 $120,000                 × .91              = $109,200
Year 2     60,000                 × .76              =     45,600
Year 3     40,000                 × .63              =     25,200
Year 4     40,000                 × .53              =     21,200
Year 5     40,000                 × .44              =     17,600
PV of Cash Inflows                                  = $218,800
Given that there was a cash investment of $200,000, the NPV of the project is $18,800.
Correct answer: $18,800
Score: 0 out of 1 No

Question 3
McLean is considering the purchase of a new machine that will cost $160,000. The
machine has an estimated useful life of 3 years. Assume that 30% of the depreciable
base will depreciate in the first year, 40% in the second year and 30% in the third year.
The new machine will have a $10,000 resale value, which is equal to residual value at
the end of its useful life. The machine is expected to save the company $85,000 in
operating expenses each year. McLean uses a 40% estimated tax rate and a 16%
hurdle rate to evaluate capital projects.
The discount rates for 16% are as follows:
             PV of $1        PV of a $1 Annuity
Year 1    .862                     .862
Year 2    .743                   1.605
Year 3    .641                   2.246
What is the net present value of this project?

Response: $6,270
Feedback:
The cash flows are as follows:
                                                                    Year 0              Year 1            Year 2         
Year 3
Initial Investment                                  (160,000)
Depreciation                                                                       48,000         64,000           
48,000
Depreciation Tax Shield (Depr. × 0.40)                           19,200         25,600           
19,200
After-tax cash from disposition ($10,000 × 0.60)                                                       
6,000
Operating cash flows before tax                                    85,000           85,000         
85,000
Tax on operating cash flow at 40%                              (34,000)        (34,000)       
(34,000)
Net after-tax cash flow                                                     70,200          76,600           
76,200
Discount factor @ 16%                                                      .0862             0.743             
0.641
Discounted Cash Flow                       (160,000)             60,512          56,914           
48,844

The net present value is $(160,000) + $60,512 + $56,914 + $48,844 = $6,270

Correct answer: $6,270
Score: 1 out of 1 Yes

Question 4
 Doria Chung, controller of Nanjing Manufacturing, is evaluating two projects and wishes
to do a cash flow analysis of each of the projects. Both projects have positive cash
inflows starting in year 1 and have similar initial investments. The cost of capital is
expected to fluctuate during the life of the projects, and Chung has selected the net
present value method for her analysis. Did Chung select the most appropriate method
for her analysis?
Response: Yes, she should have selected the net present value method because it can
properly consider the fluctuating cost of capital.
Feedback: When NPV is being used to evaluate a project, it is not necessary to use the
same discount rate for
every year of the project’s life. If the required rate of return is expected to fluctuate
throughout the life of the
project, a different discount rate can be used to discount each year’s cash flow, and
each year’s cash flow can
be discounted individually. Net Present Value is the only capital budgeting method that
can incorporate a
fluctuating required rate of return/cost of capital.
Correct answer: Yes, she should have selected the net present value method because it
can properly consider the fluctuating cost of capital.
Score: 1 out of 1 Yes

Question 5
 If an investment project has a negative net present value (NPV), which one of the
following statements about the internal rate of return (IRRT) of this project must be true?
Response: The IRR is equal to zero.
Feedback: If the IRR is higher than the required rate of return, or hurdle rate,
established by the firm for the project, the project is acceptable. If the IRR is lower than
the required rate of return, the project is not acceptable and should not be considered
further. A negative NPV would indicate an unacceptable project because a negative
NPV would result from expected returns lower than the required rate of return. An IRR
that is lower than the required rate of return would also result if expected returns were
lower than the required rate of return. If the weighted average cost of capital is being
used as the required rate of return, an IRR that is lower than the weighted average cost
of capital would also result from expected returns that are lower than the weighted
average cost of capital.
Correct answer: The IRR is less than the company’s weighted average cost of capital.
Score: 0 out of 1 No

Question 6
A firm with an 18% cost of capital is considering the following projects (on January 1,
Year 1):

                   January 1, Year 1      December 31, Year 5      Project Internal

                      Cash Outflow                  Cash Inflow               Rate of Return
Project A       $3,500,000                      $7,400,000                        16%
Project B       $4,000,000                      $9,950,000                          ?
Present Value of $1 Due at the End of "N" Periods
         N       12%        14%       15%          16%         18%        20%         22%
         4     0.6355   0.5921   0.5718    0.5523    0.5158    0.4823    0.4230
         5     0.5674   0.5194   0.4972    0.4761    0.4371    0.4019    0.3411
         6      0.5066  0.4556   0.4323    0.4104     0.3704   0.3349    0.2751
Using the net-present-value (NPV) method, project A's net present value is:

Response: $23,140
Feedback:
In contrast to the usual way of referring to the date of the initial cash outflow, this
problem gives the initial cash outflow as occurring on January 1, Year 1. January 1,
Year 1 is essentially the same as December 31, Year 0.
Therefore, the cash flows should be discounted for 5 years. To calculate the NPV of
Project A we simply need to calculate the present value of the cash inflow at the end of
the 5th year and subtract the initial cash outflow. The cash inflow is $7,400,000 and
given an 18% cost of capital, the present value of $1 factor for 5 years is 0.4371.
$7,400,000 × 0.4371 = $3,234,540.
Given an initial investment of $3,500,000 this project has a negative NPV of $(265,460).
Correct answer: $(265,460)
Score: 0 out of 1 No

Question 7
A firm with an 18% cost of capital is considering the following projects (on January 1,
Year 1):

                   January 1, Year 1      December 31, Year 5      Project Internal

                      Cash Outflow                  Cash Inflow               Rate of Return
Project A       $3,500,000                      $7,400,000                        16%
Project B       $4,000,000                      $9,950,000                          ?
Present Value of $1 Due at the End of "N" Periods
         N       12%        14%       15%          16%         18%        20%         22%
         4     0.6355   0.5921   0.5718    0.5523    0.5158    0.4823    0.4230
         5     0.5674   0.5194   0.4972    0.4761    0.4371    0.4019    0.3411
         6      0.5066  0.4556   0.4323    0.4104     0.3704   0.3349    0.2751
Project B’s internal rate of return is closest to:

Response: 15%
Feedback:
The IRR is the rate at which the NPV is equal to $0. Since in this problem we have only
one annual cash flow, we use the PV of $1 table to find the rate for a 5-year period that
will make the following equation true:
9,950,000X = 4,000,000
Where X is the factor.
Solving for X:
X = 4,000,000 ÷ 9,950,000
X = 0.402.
We then look for a factor close to 0.402 on the PV of $1 table on the line for 5 years. We
find 0.4019 under the rate of 20%.
Thus, the IRR is closest to 20%.

Correct answer: 20%

Score: 0 out of 1 No

Question 8
 The net present value (NPV) and the internal rate of return (IRR) capital budgeting
methods make assumptions about the reinvestment rate of cash inflows over the life of
the project. Which one of the following statements is correct with respect to this
reinvestment rate of cash inflows?
Response: Under NPV and IRR the reinvestment rates are the cost of capital rate and
the risk-free rate of return, respectively.
Feedback: The assumption when NPV is used is that the cash inflows from the project
will be reinvested at the
discount rate used to calculate the net present value of the project, which is usually the
firm’s cost of capital.
The assumption when IRR is used is that the cash inflows from the project will be
reinvested at the internal
rate of return.
Correct answer: Under NPV and IRR the reinvestment rates are the cost of capital rate
and the internal rate of return, respectively.
Score: 0 out of 1 No

Question 9
Gro-well Inc., which has a cost of capital of 12%, invested in a project with an internal
rate of return of 14%. The project is expected to have a useful life of four years and will
produce net cash inflows as follows.

Year     Net Cash Inflows

1                 $10,000
2                   20,000
3                   40,000
4                   40,000

The initial investment in this project was

Response: $74,830.
Feedback:
A project’s IRR is the discount rate at which the NPV of the project is zero. The net
present value of a project is the present value of the cash inflows minus the initial
investment. In order for the net present value of the project to be zero, the initial
investment must be equal to the present value of the net cash inflows.
Therefore, the initial investment in the project is equal to the sum of the present values
of the annual future net cash inflows of the project, discounted at the 14% IRR, as
follows:

              Net Cash                    PV of $1            Present

                 Inflow                 Factor @ 14%         Value
Year 1   $10,000                         .877                $ 8,770
Year 2     20,000                         .769                 15,380
Year 3     40,000                         .675                 27,000
Year 4     40,000                         .592                23,680
Present value of net cash inflows                 $74,830
The present value of the net cash inflows ($74,830) minus the initial investment
($74,830) equals zero.
Correct answer: $74,830.
Score: 1 out of 1 Yes

Question 10
 Which one of the following statements is correct regarding the Net Present Value
(NPV) and the Internal Rate of Return (IRR) approaches to capital budgeting?
Response: If the IRR of a project is equal to the company's cost of capital, the NPV of
the project must be 0.
Feedback: The NPV of a project is equal to the sum of the present values of the future
net cash inflows minus the initial investment. A project’s IRR is the discount rate at
which the NPV of the project is zero. If the IRR is equal to the discount rate used to
calculate the NPV, and if that discount rate is assumed to be the company’s cost of
capital, then the NPV of the project must be zero.
Correct answer: If the IRR of a project is equal to the company's cost of capital, the NPV
of the project must be 0.
Score: 1 out of 1 
The Moore Corporation is considering the acquisition of a new machine. The machine
can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and
$9,000 to install. It is estimated that the machine will last 10 years, and it is expected to
have an estimated salvage value of $5,000. Over its 10-year life, the machine is
expected to produce 2,000 units per year with a selling price of $500 and combined
material and labor costs of $450 per unit. Federal tax regulations permit machines of
this type to be depreciated using the straight-line method over 5 years with no estimated
salvage value. Moore has a marginal tax rate of 40%.

What is the net cash outflow at the beginning of the first year that Moore Corporation
should use in a capital budgeting analysis?
Response: $(85,000)
Feedback: The net cash outflow, or net investment, includes not only the cost of the
machine itself, but also the costs of shipping and installation. The purchase price of the
machine is $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to
install, for a total of $105,000.
Correct answer: $(105,000)
Score: 0 out of 1 No

Question 2
 The Moore Corporation is considering the acquisition of a new machine. The machine
can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and
$9,000 to install. It is estimated that the machine will last 10 years, and it is expected to
have an estimated salvage value of $5,000. Over its 10-year life, the machine is
expected to produce 2,000 units per year with a selling price of $500 and combined
material and labor costs of $450 per unit. Federal tax regulations permit machines of
this type to be depreciated using the straight-line method over 5 years with no estimated
salvage value. Moore has a marginal tax rate of 40%.

What is the net cash flow for the third year that Moore Corporation should use in a
capital budgeting analysis?
Response: $79,000
Feedback: In the third year the unit will produce 2,000 units (as it does in each year).
The profit from these units will be $100,000 ($50 profit per unit). In addition, there will be
depreciation of $21,000 per year for the first 5 years, resulting in a taxable income of
$79,000 in Year 3. Given a tax rate of 40%, the company will need to pay $31,600 in
taxes in Year 3. This reduces their cash flows to $68,400 ($100,000 − $31,600).
Correct answer: $68,400
Score: 0 out of 1 No

Question 3
 The Moore Corporation is considering the acquisition of a new machine. The machine
can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and
$9,000 to install. It is estimated that the machine will last 10 years, and it is expected to
have an estimated salvage value of $5,000. Over its 10-year life, the machine is
expected to produce 2,000 units per year with a selling price of $500 and combined
material and labor costs of $450 per unit. Federal tax regulations permit machines of
this type to be depreciated using the straight-line method over 5 years with no estimated
salvage value. Moore has a marginal tax rate of 40%.

What is the net cash flow for the tenth year of the project that Moore Corporation should
use in a capital budgeting analysis?
Response: $63,000
Feedback: In the tenth year the profit will still be $100,000, but there will be no
depreciation. Also, there will be $5,000 gain on the sale of the equipment. The sale will
increase the cash received to $105,000, but it will also increase the taxable income.
Given a 40% tax rate, they will pay $42,000 in taxes during Year 10, which will reduce
their net cash inflows to $63,000 ($105,000 − $42,000).
Correct answer: $63,000
Score: 1 out of 1 Yes

Question 4
Yipann Corporation is reviewing an investment proposal. The initial cost and other
relevant data for each year are presented in the schedule below. All cash flows are
assumed to take place at the end of the year. The salvage value of the investment at
the end of each year is equal to its net book value, and there will be no salvage value at
the end of the investment's life.

                Initial Cost         Annual Net After-Tax        Annual

Year    and Book Value             Cash Flows           Net Income
0             $105,000                            $ 0                          $ 0
1                  70,000                        50,000                  15,000
2                  42,000                        45,000                  17,000
3                  21,000                        40,000                  19,000
4                    7,000                        35,000                   21,000
5                           0                         30,000                   23,000
Yipann uses a 24% after-tax target rate of return for new investment proposals. The
discount factors for a 24% rate of return are given below.

                      Present Value of                     Present Value of an Annuity

                    $1.00 Received at                   of $1.00 Received at the End
Year             the End of Period                             of Each Period
1                           0.81                                                      0.81
2                           0.65                                                      1.46
3                           0.52                                                      1.98
4                          0.42                                                       2.40
5                          0.34                                                       2.74
6                          0.28                                                       3.02
7                          0.22                                                       3.24
The average annual cash inflow at which Yipann would be indifferent to the investment
(rounded to the nearest dollar) is:

Response: $46,667
Feedback:
This question is asking for an average annual after-tax cash flow amount that will result
in a net present value of zero for the project, because that will be the average annual
cash flow at which Yipann will be indifferent to the investment. This is a present value of
an annuity problem, because since we are looking for an average annual cash flow
amount, all the annual cash flow amounts after Year 0 must be the same average
amount. The annual cash flows given in the problem are irrelevant to calculating the
answer to this
question.
Since the initial investment is $105,000 and the project’s life is 5 years, we need to
know what annuity amount will produce a present value of $105,000 when discounted at
24% for 5 years. The present value of an annuity is the annuity amount multiplied by the
PV of an annuity factor. The PV of an annuity factor for 24% for 5 years is given in the
question: 2.74. The present value needed is the amount of the initial investment, which
is $105,000. Using the present value and the present value factor, we can calculate the
annuity amount. The annuity amount is $105,000 ÷ 2.74, which is equal to $38,321.
Therefore, if the 5 annual after-tax cash flows are all the same and they are each
$38,321, the NPV of the investment will be zero and Yipann will be indifferent to
whether or not it makes the investment. If it makes the investment, the investment will
provide no additional value to the shareholders and the shareholders will gain nothing. If
Yipann does not make the investment, the shareholders will lose nothing.
Correct answer: $38,321
Score: 0 out of 1 No

Question 5
Yipann Corporation is reviewing an investment proposal. The initial cost and other
relevant data for each year are presented in the schedule below. All cash flows are
assumed to take place at the end of the year. The salvage value of the investment at
the end of each year is equal to its net book value, and there will be no salvage value at
the end of the investment's life.

                Initial Cost         Annual Net After-Tax        Annual

Year    and Book Value             Cash Flows           Net Income
0             $105,000                            $ 0                          $ 0
1                  70,000                        50,000                  15,000
2                  42,000                        45,000                  17,000
3                  21,000                        40,000                  19,000
4                    7,000                        35,000                   21,000
5                           0                         30,000                   23,000
Yipann uses a 24% after-tax target rate of return for new investment proposals. The
discount factors for a 24% rate of return are given below.

                      Present Value of                     Present Value of an Annuity

                    $1.00 Received at                   of $1.00 Received at the End
Year             the End of Period                             of Each Period
1                           0.81                                                      0.81
2                           0.65                                                      1.46
3                           0.52                                                      1.98
4                          0.42                                                       2.40
5                          0.34                                                       2.74
6                          0.28                                                       3.02
7                          0.22                                                       3.24
 The accounting rate of return for the investment proposal over its life using the initial
value of the investment is:

Response: 28.1%
Feedback: The accounting rate of return is the average annual after-tax net income
attributable to the project divided by the net initial investment. The average of the five
annual net income amounts given is $19,000 ([$15,000 + $17,000 + $19,000 + $21,000
+ $23,000] ÷ 5 = $19,000.) $19,000 ÷ $105,000 = 0.18095 or 18.1%. (Note: sometimes
the average of the initial investment over the life of the project is used to calculate the
accounting rate of return. The average of the initial investment over the life of the project
is calculated as the initial investment divided by 2. However, this question specifies to
use the initial value of the investment, not the average investment.)
Correct answer: 18.1%
Score: 0 out of 1 No

Question 6
Yipann Corporation is reviewing an investment proposal. The initial cost and other
relevant data for each year are presented in the schedule below. All cash flows are
assumed to take place at the end of the year. The salvage value of the investment at
the end of each year is equal to its net book value, and there will be no salvage value at
the end of the investment's life.

                Initial Cost         Annual Net After-Tax        Annual

Year    and Book Value             Cash Flows           Net Income
0             $105,000                            $ 0                          $ 0
1                  70,000                        50,000                  15,000
2                  42,000                        45,000                  17,000
3                  21,000                        40,000                  19,000
4                    7,000                        35,000                   21,000
5                           0                         30,000                   23,000
Yipann uses a 24% after-tax target rate of return for new investment proposals. The
discount factors for a 24% rate of return are given below.

                      Present Value of                     Present Value of an Annuity

                    $1.00 Received at                   of $1.00 Received at the End
Year             the End of Period                             of Each Period
1                           0.81                                                      0.81
2                           0.65                                                      1.46
3                           0.52                                                      1.98
4                          0.42                                                       2.40
5                          0.34                                                       2.74
6                          0.28                                                       3.02
7                          0.22                                                       3.24
The traditional payback period for the investment proposal is:

Response: 0.875 years

Feedback:
The cash flow analysis is as follows:
                                                          Year 0         Year 1      Year 2      Year 3      Year 4 
Year 5
Initial Investment in Equipment(105,000)
After-Tax Cash Flow                                        50,000      45,000       40,000     35,000   
 30,000
Total After-Tax Cash Flows       (105,000)    50,000      45,000       40,000     35,000   
30,000
Cumulative Cash Flow               (105,000)   (55,000)   (10,000)      30,000     65,000   
95,000
The cumulative cash flow from the project becomes positive during Year 3. Assuming
that the cash flows occur evenly throughout the year, the payback period is 2.25 years,
calculated as follows:
Number of the project year in the final year when cash flow is negative: 2
Plus: a fraction consisting of
 Numerator = the positive value of the negative cumulative inflow amount from the
final negative year,
which is 10,000
 Denominator = cash flow for the following year, which is 40,000
or: 2 + (10,000 ÷ 40,000) = 2.25
Note that the present value factors given are irrelevant to answering this question,
because the payback method is not a discounted cash flow technique.
Correct answer: 2.250 years
Score: 0 out of 1 No

Question 7
Yipann Corporation is reviewing an investment proposal. The initial cost and other
relevant data for each year are presented in the schedule below. All cash flows are
assumed to take place at the end of the year. The salvage value of the investment at
the end of each year is equal to its net book value, and there will be no salvage value at
the end of the investment's life.

                Initial Cost         Annual Net After-Tax        Annual

Year    and Book Value             Cash Flows           Net Income
0             $105,000                            $ 0                          $ 0
1                  70,000                        50,000                  15,000
2                  42,000                        45,000                  17,000
3                  21,000                        40,000                  19,000
4                    7,000                        35,000                   21,000
5                           0                         30,000                   23,000
Yipann uses a 24% after-tax target rate of return for new investment proposals. The
discount factors for a 24% rate of return are given below.

                      Present Value of                     Present Value of an Annuity

                    $1.00 Received at                   of $1.00 Received at the End
Year             the End of Period                             of Each Period
1                           0.81                                                      0.81
2                           0.65                                                      1.46
3                           0.52                                                      1.98
4                          0.42                                                       2.40
5                          0.34                                                       2.74
6                          0.28                                                       3.02
7                          0.22                                                       3.24
The net present value of the investment proposal is:

Response: $10,450
Feedback:
To calculate the NPV, we simply need to multiply each annual after tax cash flow
amount by the appropriate present value of $1 factor, sum them, and subtract the initial
investment. All of these amounts are given to us, which means that our work is simply
mathematical.
   
               Cash Inflow    PV of $1 factor
Year 1    $50,000               × .81          = $ 40,500
Year 2     45,000                 × .65          = 29,250
Year 3    40,000                 × .52          = 20,800
Year 4    35,000                 × .42          = 14,700
Year 5    30,000                 × .34          = 10,200
PV of Cash Inflows                        = $115,450

The NPV is $115,450 − the initial investment of $105,000, or $10,450.

Correct answer: $10,450
Score: 1 out of 1 Yes

Question 8
Capital Invest Inc. uses a 12% hurdle rate for all capital expenditures and has done the
following analysis for 4 projects for the upcoming year.

                                                  Project 1      Project 2      Project 3      Project 4

Initial capital outlay                $200,000      $298,000     $248,000     $272,000
Annual net cash inflows
Year 1                                       $ 65,000       $100,000      $ 80,000       $ 95,000
Year 2                                          70,000          135,000         95,000        125,000
Year 3                                          80,000            90,000         90,000           90,000
Year 4                                          40,000            65,000         80,000           60,000
Net present value                      (3,798)              4,276         14,064          14,662
Internal rate of return                  11%                   13%           14%                15%
Which project(s) should Capital Invest Inc. undertake during the upcoming year
assuming it has no budget restrictions?

Response: Projects 2, 3 and 4

Feedback: If there are no budget restrictions, Capital should invest in every project that
has a positive NPV. This is Projects 2, 3 and 4.
Correct answer: Projects 2, 3 and 4
Score: 1 out of 1 Yes

Question 9
A company is considering two investments. Both have an estimated useful life of 5
years and require an initial cash outflow of $15,000. The cash inflow for each project is
shown below.

              Project A      Project Z

Year 1    $7,000                 $ 0
Year 2    $8,000          $ 5,000
Year 3    $9,000          $ 5,000
Year 4          $ 0          $ 5,000
Year 5          $ 0         $25,000
The company requires an 8% rate of return and uses straight-line depreciation.
Present value factors at a rate of 8% are as follows:
                PV of $1      PV of Annuity
1 year        0.926              0.926
2 years      0.857              1.783
3 years      0.794              2.577
4 years     0.735               3.312
5 years     0.681               3.993
Which one of the following capital budgeting evaluation methods would result in an
initial recommendation of the less profitable project as the better choice?

Response: Payback period.

Feedback:
Project A’s cash flows are all received in the first three years of the project, whereas
Project Z’s cash flows are received in Years 2 through 5, with its largest cash flow not
received until Year 5.
The Payback Period for Project A is 2 years ($7,000 + $8,000 = $15,000, the amount of
the investment).
The Payback Period for Project Z is 4 years ($0 + $5,000 + $5,000 + 5,000 = $15,000).
Therefore, according to the Payback Period, Project A is the better project to invest in.
 
The NPVs of both projects are as follows:
Project A: ($7,000 × 0.926) + ($8,000 × 0.857) + ($9,000 × 0.794) − $15,000 = $5,484
Project Z: ($5,000 × 0.857) + ($5,000 × 0.794) + ($5,000 × 0.735) + ($25,000 × 0.681) −
$15,000 = $13,955.
Therefore, the NPV of Project Z is higher than the NPV of Project A, so Project A is less
profitable than Project Z.
 
(Note: The problem says that the company uses straight line depreciation but it does not
give the company’s tax rate. Therefore, it is not possible to calculate the depreciation
tax shields for these projects. However, because the initial investments and the length
of the projects are the same, the depreciation and thus the depreciation tax shield will
be the same for both projects and so it is not relevant to a comparison of which NPV is
higher.)
Correct answer: Payback period.