CAPITAL BUDGETING

Part 1: Multiple Choice. b. increase the estimated cash inflows and increase the
discount rate.
1. The relevance of a particular cost to a decision is c. increase the estimated cash inflows but not the discount
determined by rate.
a. riskiness of the decision. d. decrease the estimated cash inflows and increase the
b. number of decision variables. discount rate.
c. amount of the cost. 9. The capital budgeting model that is ordinarily considered
d. potential effect on the decision. the best model for long-range decision-making is the
2. The term that refers to costs incurred in the past and are not a. payback model.
relevant to a future decision is b. accounting rate of return model.
a. discretionary cost. c. unadjusted rate of return model.
b. full absorption cost. d. discounted cash flow model.
c. under-allocated indirect cost. 10. A company has no capital rationing constraint and is
d. sunk cost. analyzing many independent investment alternatives. It
3. A depreciation tax shield is should accept all investment proposals
a. an after-tax cash flow. a. if debt financing is available for them.
b. a reduction in income outflow. b. that has positive cash flows.
c. the cash provided by recording depreciation. c. that provide returns greater than the before-tax cost of
d. the expense caused by depreciation. debt.
4. The length of time required to recover the initial cash outlay d. that has a positive net present value.
of a capital project is determined by using the 11. The internal rate of return is the
a. discounted cash flow method. a. hurdle rate.
b. payback method. b. rate of interest for which the NPV is greater than 1.0.
c. weighted net present value method. c. rate of interest for which the NPV is equal to zero.
d. net present value method. d. rate of return generated from the operational cash flows.
5. The payback reciprocal can be used to approximate a 12. The profitability index approach to investment analysis
project’s a. fails to consider the timing of project cash flows.
a. profitability index. b. considers only the project’s contribution to net income
b. net present value. and does not consider cash flow effects.
c. accounting rate of return if the cash flow pattern is c. always yields the same accept/reject decisions for
relatively stable. independent projects as the NPV method.
d. internal rate of return If the cash flow pattern is d. always yields the same accept/reject decisions for
relatively stable. mutually exclusive projects as the NPV method.
6. The net present value (NPV) method of investment project 13. A company is studying a capital acquisition proposal in
analysis assumes that the project’s cash flows are reinvested which newly acquired assets will be depreciated using the
at the straight-line method. Which of the following statements
a. computed internal rate of return. about the proposal would be incorrect if a switch is made to
b. risk-free interest rate. the Modified Accelerated Cost Recovery System
c. discount rate used in the NPV calculation. (MACRS)?
d. firm’s accounting rate of return. a. The net present value will increase.
7. The proper discount rate to use in calculating with certainty b. The internal rate of return will increase.
equivalent net present value is c. The payback period will be shortened.
a. risk-adjusted discount rate. d. The profitability index will decrease.
b. cost of capital. 14. The profitability index (present value index)
c. risk-free rate. a. represents the ratio of the discounted net cash outflows to
d. cost of equity capital. cash inflows.
8. When determining net present values in an inflationary
environment, adjustments should be made to
a. increase the discount rate only.
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 b. is the relationship between the net discounted cash a. IRR method.
inflows less the discounted cash outflows divided by the b. ARR method.
discounted cash outflows c. payback method.
d. NPV method.
c. is calculated by dividing the discounted profits by the 16. Which one of the following capital investment evaluation
cash outflows. methods does not take the time value of money into
d. is the ratio of the discounted net cash inflows to consideration?
discounted cash outflows. a. NPV. c. IRR
15. The method that divides a project’s annual after tax net b. discounted payback. d. ARR
income by the average investment cost to measure the
estimated performance of a capital investment is the

depreciated over 7 years and requires a working capital

17. A company has P75,000 in a bank account as of Dec. 31, investment of P7,000 at its inception and another P5,000 at
2011. If it plans on depositing P4,000 in the account at the the end of year 5. Assuming a 40% marginal tax rate, the
end of each of the next 3 years (2012,2013,2014) and all expected net cash flow from the project in the tenth year is
amount in the account earn 8% per year, what will the a. P32,000 b. P24,000 c. P20,000 d. P11,000
account balance be at Dec. 31, 2014? Ignore the effect on 22. A company is expanding its manufacturing plant, which
income taxes. requires an investment of P4 million in new equipment and
a. P 87,000 c. P 96,070 plant modifications. Its sales are expected to increase by P3
b. P 88,000 d. P 107,500 million per year as a result of the expansion. Cash
investment in current assets averages 30% of sales;
Questions 18 through 20 are based on the following accounts payable and other current liabilities are 10% of
information. sales. What is the estimated total investment for this
expansion?
A company has purchased a new fleet of trucks to a. P3.4 million b. P4.3 million c. P4.6 million d. P4.9
deliver its merchandise. The trucks have a useful life of 8 years million
and cost a total of P500,000. The company expects its net
increase in after-tax cash flow to be P150,000 in Year 1, Questions 23 through 25 are based on the following
P175,000 in Year 2, P125,000 in Year 3, and P100,000 in each information.
of the remaining years. A company has a cost of capital of 15% and is
considering the acquisition of a new machine that costs
18. Ignoring the time value of money, how long will it take the P800,000 and has a useful life of 5 years. The company projects
company to recover the amount of investment? that earnings and cash flow will increase as follows:
a. 3.5 years c. 4.2 years
b. 4 years d. 5 years Year Net Earnings After-tax Cash
19. What is the payback reciprocal for the fleet of trucks? Flow
1 P200,000 P320,000
a. 29% b. 25% c. 24 d. 20%
2 P200,000 P280,000
20. Assume the net cash flow to be P130,000 a year. What is
3 P200,000 P200,000
the payback tie for the fleet of trucks? 4 P200,000 P200,000
a. 3 years b. 3.15 years c. 3.85 years d. 4 years 5 P200,000 P200,000
21. A company is considering a 10-year capital investment
project with forecasted revenues of P40,000 per year and 23. The net present value of this investment is
forecasted cash operating expenses of P29,000 per year. a. (128,000) c. P 37,200
The initial cost of the equipment for the project is P23,000, b. P200,000 d. P 400,000
and the company expects to sell the equipment for P9,000 24. What is the profitability index for the investment?
at the end of the 10th year. The equipment will be a. 0.05 b. 0.96 c. 1.05 d. 1.25
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25. What is the payback period for this investment? 15. _____ A term that cannot mean cost of capital is
a. 1.5 years b. 3.0 years c. 3.3 years d. 4.0 years standard rate.
16. _____ The length of time required to recover the initial
cash outlay for a project is determined by using the net
present value method.
Part 2: True or false. Write T. or F only. Show solution for 17. _____ The net operating income is necessary in order
problem-solving items. to calculate the payback period of a project.
18. _____ A company is considering a certain project with
1. _____ Capital budgeting is concerned with decisions the following projected cash income after taxes for 4
affecting only capital-intensive industries. years, the life of the project: end of year 1, P11,000;
2. _____ Only the annual returns and cost of capital are year 2, P9,000; year 3, P8,000; year 4, P7,000. If the
the factors to be considered when evaluation a project requires an investment of P25,000 with a
proposed capital investment. salvage value of P5,000, the payback period is 2.265
3. _____ A company is considering the sale of a machine years.
with a book value of P80,000 and 3 years remaining in 19. _____ When computing for the accounting rate of
its useful life. Straight-line depreciation of P25,000 is return, the income before depreciation and taxes is
available. The machine has a current market value of used.
P100,000. The cash flow from selling the machine if 20. _____ A company purchased a new machine for
the tax rate is 40% is P80,000. P60,000 on January 1, The machine is being
4. _____ A company is considering replacing a machine depreciated on the straight-line basis over 5 years with
with one that will save P50,000 per year in cash no salvage value. The simple rate of return is expected
operating costs and have P20,000 more depreciation to be 15% on the initial investment. Assuming a
expense per year than the existing machine. The tax uniform cash flow, this investment is expected to
rate is 40%. Buying the new machine will increase provide annual cash flow from operations of P12,000.
annual net cash flows of the company by P18,000. 21. _____ The internal rate of return is the cash flow
5. _____ The most convenient way to handle proceeds method of evaluating capital investment that ignores
from the disposal of an old asset is to treat it as a cash the time value of money.
flow. 22. _____ A peso now is worth more than a peso to be
6. _____ In deciding whether to replace a machine, the received in the future because of inflation.
depreciated cost of the existing machine is not a sunk 23. _____ In computing the present value of future cash
cost. inflows that are uniform, reference will be made to a
7. _____ To approximate annual cash inflow, table that shows present value of P1.
depreciation is added back to net income because it is 24. _____ A company purchased a machine, which will be
an inflow of cash. depreciated on the straight-line basis over an estimated
8. _____ Annual cash inflow from the capital projects are useful life of 7 years with no salvage value. The
measured in terms of net income before depreciation machine is expected to generate cash flows from
and taxes. operations, net of income taxes of P80,000 in each of
9. _____ A company’s depreciation deduction last year the 7 years. The company’s expected rate of return is
was P50,000 and its tax rate was 30%. The company’s 12%. Information on present value factors is as
tax savings from the depreciation tax shield for the year follows:
was P50,000. PV of P1 at 12% for 7 periods = 0.452
10. _____ Cost of capital is the amount the company must PV of an ordinary annuity of P1 at 12% for 7
pay for its plant assets. periods = 4.564
11. _____ For a certain project, the return that investors Assuming a positive net present value of
demand for investing in a firm is known as net present P12,720, the cost of the machine is P253,120.
value. 25. _____ An investment opportunity costing P110,000 is
12. _____ A company has 5% preferred stock with a par expected to yield net cash flows of P28,000 annually
value of P100. Selling price is P123.50 per share and for 6 years. The NPV of the investment at a cutoff rate
flotation costs are P0.50 per share. The company’s tax of 12% would be (round off PV factors based on 3
rate is 20%. The cost of preferred stock is 4.03%. decimal places) P(5,108).
13. _____ The weighted average cost of capital approach
to decision making is not directly affected by the value 26. _____ A decrease in the discount rate will reduce
of common stock. present values of future cash flow.
14. _____ A company with cost of capital of 15% plans to 27. _____ The present value of P50,000 due in five years
finance an investment with debt that bears 10% would be highest if discounted at a rate of 10%.
interest. The rate it should use to discount the cash
flows is 25%.

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28. _____ A project requires an investment of P40,000 and
has a net present value of P10,000. The project’s
profitability index would be 4.0.
29. _____ The internal rate of return is the rate of return
for which the net present value is greater than 1.0.
30. _____ The discount rate that equates the PV of
expected cash flows with the cost of investments is the
net present value.

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