Financial Management (Chapter 11: Investment Decision Criteria)
11.1 An Overview of Capital Budgeting
1) Which of the following are typical consequences of good capital budgeting
decisions?
A) The firm increases in value.
B) The firm gains knowledge and experience that may be useful in future decisions.
C) Good capital budgeting decisions help a company define its core competencies.
D) All of the above.
2) Errors in capital budgeting decisions
A) tend to average out over time.
B) decrease the firm's value.
C) are diminished because the time value of money makes future cash flows less
important.
D) are easily reversed.
3) Which of the following factors is least important to capital budgeting decisions?
A) The time value of money
B) The risk-return tradeoff
C) Net income based on accrual accounting principles
D) Cash flows directly resulting from the decision
4) Which of the following would be considered a capital budgeting decision?
A) Walmart purchases inventory for resale to customers.
B) Apple sells bonds and uses the proceeds to repurchase stock.
C) Goldman Sachs obtains short-term loans to finance day to day operations.
D) Pfizer develops a new therapy and brings it to market.
5) Which of the following is a typical capital budgeting decision?
A) Purchase of office supplies
B) Granting credit to a new customer
C) Replacement of manufacturing equipment with more modern and efficient
equipment
D) Financing the firm with more long-term debt and less equity
6) Good capital investment opportunities are most likely to exist when
A) many firms compete to sell similar products.
B) interest rates are high and rising.
C) goods and services can be produced cheaply using readily available tools and
technologies.
D) a line of business is expensive to enter and uses proprietary technology.
7) Errors resulting from a capital budgeting decision are not considered major since
the consequences of such errors average out over the life of the investment.
Answer: FALSE
8) Competitive market forces make it imperative for a firm to have a systematic
strategy for generating capital-budgeting projects.
Answer: TRUE
,9) The size of capital investments and the difficulty in reversing them once they are
made make capital-budgeting decisions very important to the firm.
Answer: TRUE
10) Capital budgeting is the decision-making process with respect to investment in
working capital.
Answer: FALSE
11) Some capital budgeting decisions may be mandated by government regulations.
Answer: TRUE
12) The primary objective of all capital budgeting decisions is to increase the size of
the firm.
Answer: FALSE
13) Why are capital budgeting decisions among the most important decisions made
by any company? Give a few examples from recent business developments.
Answer: The main objective of financial management is to maximize the value of the
firm. The main source of value is the company's cash flows discounted at rates that
reflect their risk. Both the firm's cash flows and their level of risk are determined by
the projects the company chooses to undertake. Recent examples include Apples
string of "I" products (pod, phones, pad), and Amazon's Kindle which have added
tremendous value to those companies. Students may cite examples from the text
such as Kimberly-Clark's Huggies or Walmart's use of central distribution centers.
Examples of less than successful decisions, at least so far, might include the Segue
or the Gap's ephemeral redesigned logo. (Students' answers will vary their
experience and recent events.)
14) Distinguish between revenue enhancement investments, cost-reduction
investments, and mandated investments.
Answer: Revenue enhancements investments may include new product lines such
as Amazon's Kindle or GM's Chevy Volt undertaken, obviously, to increase cash
flows by increasing sales. Companies such as Walmart may expand internationally or
enter new businesses such as groceries for the same reason. Cost reduction
investments such as improved distribution, energy saving equipment or loss
prevention systems may not increase sales, but increase cash flows by reducing
costs. Mandated investments may include such issues as access for the
handicapped, pollution abatement, or employee safety. They are unavoidable
because required by federal, state, or local laws. In these cases, companies will seek
the least expensive way to comply.
15) Why is it so difficult for firms to find good investment ideas?
Answer: All firms are competing to maximize their value, so if an idea is obvious,
many companies will pursue it at the same time. The Blackberry, for example, soon
faced intense competition from any number of smart phones. Companies often find
the best opportunities in areas where they have some protection from competition
because they possess proprietary technology (Pfizer, Merck), strong brand loyalty
(Coca Cola), or because the business is very expensive to enter (Toyota, Disney).
11.2 Net Present Value
,1) Project Sigma requires an investment of $1 million and has a NPV of $10. Project
Delta requires an investment of $500,000 and has a NPV of $150,000. The projects
involve unrelated new product lines.
A) Both projects should be accepted because they have positive NPV's.
B) Neither project should be accepted because they might compete with one another.
C) Only project Delta should be accepted. Alpha's NPV is too low for the investment.
D) The company should look at other investment criteria, not just NPV.
Answer: A
2) ABC Service can purchase a new assembler for $15,052 that will provide an
annual net cash flow of $6,000 per year for five years. Calculate the NPV of the
assembler if the required rate of return is 12%. (Round your answer to the nearest
$1.)
A) $1,056
B) $4,568
C) $7,621
D) $6,577
3) Central Mass Ambulance Service can purchase a new ambulance for $200,000
that will provide an annual net cash flow of $50,000 per year for five years. Calculate
the NPV of the ambulance if the required rate of return is 9%. (Round your answer to
the nearest $1.)
A) $50,000
B) $(5,061)
C) $(5,517)
D) $5,517
4) Central Mass Ambulance Service can purchase a new ambulance for $200,000
that will provide an annual net cash flow of $50,000 per year for five years. The
salvage value of the ambulance will be $25,000. Assume the ambulance is sold at
the end of year 5. Calculate the NPV of the ambulance if the required rate of return is
9%. (Round your answer to the nearest $1.)
A) $(10,731)
B) $10,731
C) $(5,517)
D) $5,517
5) Fitchminster Armored Car can purchase a new vehicle for $200,000 that will
provide annual net cash flow over the next five years of $40,000, $45,000, $50,000,
$55,000, $60,000. The salvage value of the vehicle will be $25,000. Assume that the
vehicle is sold at the end of year 5. Calculate the NPV of the ambulance if the
required rate of return is 9%. (Round your answer to the nearest $1.)
A) $7,390
B) $6,048
C) $6,780
D) $19,483
6) Project H requires an initial investment of $100,000 and the produces annual cash
flows of $50,000, $40,000, and $30,000. Project T requires an initial investment of
$100,000 and the produces annual cash flows of $30,000, $40,000, and $50,000. If
the required rate of return is greater than 0% and the projects are mutually exclusive
A) H will always be preferable to T.
B) T will always be preferable to H.
C) H and T are equally attractive.
, D) The project rankings will change with different discount rates.
7) Project H requires an initial investment of $100,000 and the produces annual cash
flows of $45,000 per year for each of the next 3 years. Project T also requires an
initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000
in year 2, and $70,000 in year 3. If the discount rate is 10% and the projects are
mutually exclusive
A) Project H should be chosen.
B) Project T should be chosen.
C) H and T are equally attractive.
D) Both projects should be chosen.
8) Project H requires an initial investment of $100,000 and the produces annual cash
flows of $45,000 per year for each of the next 3 years. Project T also requires an
initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000
in year 2, and $70,000 in year 3. If the discount rate is 10% and the projects are not
mutually exclusive
A) Project H should be chosen.
B) Project T should be chosen.
C) H and T are equally attractive.
D) Both projects should be accepted.
9) Project H requires an initial investment of $100,000 and the produces annual cash
flows of $45,000 per year for each of the next 3 years. Project T also requires an
initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000
in year 2, and $70,000 in year 3. If the discount rate increases from 10% to 16%
A) Project T should be chosen.
B) Both projects should be rejected.
C) H and T are equally attractive.
D) The project rankings will change.
10) A machine costs $1,000, has a three-year life, and has an estimated salvage
value of $100. It will generate after-tax annual cash flows (ACF) of $600 a year,
starting next year. If your required rate of return for the project is 10%, what is the
NPV of this investment? (Round your answer to the nearest $10.)
A) $490
B) $570
C) $900
D) -$150
11) Suppose you determine that the NPV of a project is $1,525,855. What does that
mean?
A) In all cases, investing in this project would be better than investing in a project that
has an NPV of $850,000.
B) The project would add value to the firm.
C) Under all conditions, the project's payback would be less than the profitability
index.
D) Other investment criteria might need to be considered.
12) Project January has a NPV of $50,000, project December has a NPV of $40,000.
Which of the following circumstances could make it possible to choose December
over January?
A) January has a shorter payback period.
B) The projects are mutually exclusive.
C) The projects have unequal lives.
11.1 An Overview of Capital Budgeting
1) Which of the following are typical consequences of good capital budgeting
decisions?
A) The firm increases in value.
B) The firm gains knowledge and experience that may be useful in future decisions.
C) Good capital budgeting decisions help a company define its core competencies.
D) All of the above.
2) Errors in capital budgeting decisions
A) tend to average out over time.
B) decrease the firm's value.
C) are diminished because the time value of money makes future cash flows less
important.
D) are easily reversed.
3) Which of the following factors is least important to capital budgeting decisions?
A) The time value of money
B) The risk-return tradeoff
C) Net income based on accrual accounting principles
D) Cash flows directly resulting from the decision
4) Which of the following would be considered a capital budgeting decision?
A) Walmart purchases inventory for resale to customers.
B) Apple sells bonds and uses the proceeds to repurchase stock.
C) Goldman Sachs obtains short-term loans to finance day to day operations.
D) Pfizer develops a new therapy and brings it to market.
5) Which of the following is a typical capital budgeting decision?
A) Purchase of office supplies
B) Granting credit to a new customer
C) Replacement of manufacturing equipment with more modern and efficient
equipment
D) Financing the firm with more long-term debt and less equity
6) Good capital investment opportunities are most likely to exist when
A) many firms compete to sell similar products.
B) interest rates are high and rising.
C) goods and services can be produced cheaply using readily available tools and
technologies.
D) a line of business is expensive to enter and uses proprietary technology.
7) Errors resulting from a capital budgeting decision are not considered major since
the consequences of such errors average out over the life of the investment.
Answer: FALSE
8) Competitive market forces make it imperative for a firm to have a systematic
strategy for generating capital-budgeting projects.
Answer: TRUE
,9) The size of capital investments and the difficulty in reversing them once they are
made make capital-budgeting decisions very important to the firm.
Answer: TRUE
10) Capital budgeting is the decision-making process with respect to investment in
working capital.
Answer: FALSE
11) Some capital budgeting decisions may be mandated by government regulations.
Answer: TRUE
12) The primary objective of all capital budgeting decisions is to increase the size of
the firm.
Answer: FALSE
13) Why are capital budgeting decisions among the most important decisions made
by any company? Give a few examples from recent business developments.
Answer: The main objective of financial management is to maximize the value of the
firm. The main source of value is the company's cash flows discounted at rates that
reflect their risk. Both the firm's cash flows and their level of risk are determined by
the projects the company chooses to undertake. Recent examples include Apples
string of "I" products (pod, phones, pad), and Amazon's Kindle which have added
tremendous value to those companies. Students may cite examples from the text
such as Kimberly-Clark's Huggies or Walmart's use of central distribution centers.
Examples of less than successful decisions, at least so far, might include the Segue
or the Gap's ephemeral redesigned logo. (Students' answers will vary their
experience and recent events.)
14) Distinguish between revenue enhancement investments, cost-reduction
investments, and mandated investments.
Answer: Revenue enhancements investments may include new product lines such
as Amazon's Kindle or GM's Chevy Volt undertaken, obviously, to increase cash
flows by increasing sales. Companies such as Walmart may expand internationally or
enter new businesses such as groceries for the same reason. Cost reduction
investments such as improved distribution, energy saving equipment or loss
prevention systems may not increase sales, but increase cash flows by reducing
costs. Mandated investments may include such issues as access for the
handicapped, pollution abatement, or employee safety. They are unavoidable
because required by federal, state, or local laws. In these cases, companies will seek
the least expensive way to comply.
15) Why is it so difficult for firms to find good investment ideas?
Answer: All firms are competing to maximize their value, so if an idea is obvious,
many companies will pursue it at the same time. The Blackberry, for example, soon
faced intense competition from any number of smart phones. Companies often find
the best opportunities in areas where they have some protection from competition
because they possess proprietary technology (Pfizer, Merck), strong brand loyalty
(Coca Cola), or because the business is very expensive to enter (Toyota, Disney).
11.2 Net Present Value
,1) Project Sigma requires an investment of $1 million and has a NPV of $10. Project
Delta requires an investment of $500,000 and has a NPV of $150,000. The projects
involve unrelated new product lines.
A) Both projects should be accepted because they have positive NPV's.
B) Neither project should be accepted because they might compete with one another.
C) Only project Delta should be accepted. Alpha's NPV is too low for the investment.
D) The company should look at other investment criteria, not just NPV.
Answer: A
2) ABC Service can purchase a new assembler for $15,052 that will provide an
annual net cash flow of $6,000 per year for five years. Calculate the NPV of the
assembler if the required rate of return is 12%. (Round your answer to the nearest
$1.)
A) $1,056
B) $4,568
C) $7,621
D) $6,577
3) Central Mass Ambulance Service can purchase a new ambulance for $200,000
that will provide an annual net cash flow of $50,000 per year for five years. Calculate
the NPV of the ambulance if the required rate of return is 9%. (Round your answer to
the nearest $1.)
A) $50,000
B) $(5,061)
C) $(5,517)
D) $5,517
4) Central Mass Ambulance Service can purchase a new ambulance for $200,000
that will provide an annual net cash flow of $50,000 per year for five years. The
salvage value of the ambulance will be $25,000. Assume the ambulance is sold at
the end of year 5. Calculate the NPV of the ambulance if the required rate of return is
9%. (Round your answer to the nearest $1.)
A) $(10,731)
B) $10,731
C) $(5,517)
D) $5,517
5) Fitchminster Armored Car can purchase a new vehicle for $200,000 that will
provide annual net cash flow over the next five years of $40,000, $45,000, $50,000,
$55,000, $60,000. The salvage value of the vehicle will be $25,000. Assume that the
vehicle is sold at the end of year 5. Calculate the NPV of the ambulance if the
required rate of return is 9%. (Round your answer to the nearest $1.)
A) $7,390
B) $6,048
C) $6,780
D) $19,483
6) Project H requires an initial investment of $100,000 and the produces annual cash
flows of $50,000, $40,000, and $30,000. Project T requires an initial investment of
$100,000 and the produces annual cash flows of $30,000, $40,000, and $50,000. If
the required rate of return is greater than 0% and the projects are mutually exclusive
A) H will always be preferable to T.
B) T will always be preferable to H.
C) H and T are equally attractive.
, D) The project rankings will change with different discount rates.
7) Project H requires an initial investment of $100,000 and the produces annual cash
flows of $45,000 per year for each of the next 3 years. Project T also requires an
initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000
in year 2, and $70,000 in year 3. If the discount rate is 10% and the projects are
mutually exclusive
A) Project H should be chosen.
B) Project T should be chosen.
C) H and T are equally attractive.
D) Both projects should be chosen.
8) Project H requires an initial investment of $100,000 and the produces annual cash
flows of $45,000 per year for each of the next 3 years. Project T also requires an
initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000
in year 2, and $70,000 in year 3. If the discount rate is 10% and the projects are not
mutually exclusive
A) Project H should be chosen.
B) Project T should be chosen.
C) H and T are equally attractive.
D) Both projects should be accepted.
9) Project H requires an initial investment of $100,000 and the produces annual cash
flows of $45,000 per year for each of the next 3 years. Project T also requires an
initial investment of $100,000 and produces cash flows of $30,000 in year 1, $40,000
in year 2, and $70,000 in year 3. If the discount rate increases from 10% to 16%
A) Project T should be chosen.
B) Both projects should be rejected.
C) H and T are equally attractive.
D) The project rankings will change.
10) A machine costs $1,000, has a three-year life, and has an estimated salvage
value of $100. It will generate after-tax annual cash flows (ACF) of $600 a year,
starting next year. If your required rate of return for the project is 10%, what is the
NPV of this investment? (Round your answer to the nearest $10.)
A) $490
B) $570
C) $900
D) -$150
11) Suppose you determine that the NPV of a project is $1,525,855. What does that
mean?
A) In all cases, investing in this project would be better than investing in a project that
has an NPV of $850,000.
B) The project would add value to the firm.
C) Under all conditions, the project's payback would be less than the profitability
index.
D) Other investment criteria might need to be considered.
12) Project January has a NPV of $50,000, project December has a NPV of $40,000.
Which of the following circumstances could make it possible to choose December
over January?
A) January has a shorter payback period.
B) The projects are mutually exclusive.
C) The projects have unequal lives.
