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Exam 12: The Capital Budgeting Decision

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Question 21

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Capital budgeting decisions involve a minimum time horizon of five years. Project expenditures are planned for at least one year.

A) True
B) False

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Question 22

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Which of the following is not a step in creating the net present value profile?

A) Determine the net present value at a zero discount rate.
B) Determine the net present value at a normal discount rate.
C) Determine the project's internal rate of return.
D) Determine the payback for the project.

E) A) and D)
F) A) and B)

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Question 23

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The longer the life of an investment

In a replacement decision, if an old asset sells below book value, from a tax standpoint

A firm is selling an old asset below book value in a replacement decision. As the firm's tax rate is raised, the net cash outflow (purchase price less proceeds from the sale of the old asset) would

The selection of a mutually exclusive project means that all other projects with a positive net present value may also be selected. By definition, mutually exclusive means that the selection of one project precludes the selection of any other alternative.

A good capital budgeting program requires that a number of steps be taken in the decision-making process. The first step is the explanation of data. The first step involves searching for investment opportunities.

The reinvestment assumption is a downside of the IRR method of analysis because it assumes that cash flows are reinvested at the cost of capital. It actually assumes that cash flows are reinvested at the IRR rate, which can sometimes be excessively high, rendering this assumption unrealistic.

Assume a project has earnings before depreciation and taxes of $15,000, depreciation of $25,000, and that the firm has a 30% tax bracket. What are the after-tax cash flows for the project?

The net present value profile

The payback method considers all cash inflows. The payback method does not consider any cash flows that occur after the point of payback has been reached.

For acceptable investments, the reinvestment assumption under the internal rate of return is generally

The Taylor Corporation is using a machine that originally cost $88,000. The machine is being depreciated by the straight-line method over eight years ($11,000 per year) and has four years of depreciation remaining. The machine has a book value of $44,000 and a current market value of $40,000. Jacqueline Elliott, the Chief Financial Officer of Taylor, is considering replacing this machine with a newer model costing $75,000. The new machine will save $5,000 in after-tax earnings each year for the next six years. The new machine is in the 5-year MACRS category. Taylor Corporation is in the 34% tax bracket and has a 10% cost of capital. a) Calculate the cash inflows from the sale of the old machine. b) Calculate the net cost of the new machine. c) Calculate the incremental depreciation on the new versus the old machine. d) Determine the net present value of the new machine. Should they purchase the new machine?

The Dammon Corp. has the following investment opportunities: $\begin{array}{lccc}\text { Machine A }&\text { Machine B }&\text { Machine C }\\\text { (\$ 10.000) }&\text {(\$ 22.500) }&\text { (\$ 35.500) }\\\text { Inflows }&\text { Inflows }&\text { Inflows }\\\text { year 1 }\quad \$ 6,000 &\text { year } 1 \quad \$ 12,000 &\text { year 1 } \quad-0-\\\text { year 2 }\quad 3,000& \text { year } 2 \quad7,500 &\text { year 2 }\quad 30,000\\\text { year } 3 \quad 3,000 & \text { year } 3 \quad 1,500& \text { year 3 }\quad 5,000\\\text { year } 4 \quad-0- &\text { year } 4\quad 1,500&\text { year 4 }\quad 20,000\end{array}$ Under the payback method and assuming these machines are mutually exclusive, which machine(s) would Dammon Corp. choose?

A&B Enterprises is trying to select the best investment from among four alternatives. Each alternative involves an initial outlay of $100,000. Their cash flows follow: $\begin{array}{crrrrr}\text { Year } & {\mathrm{A}} & {\mathrm{B}} & \mathrm{C} & {\mathrm{D}} \\1 & \$ 10,000 & \$ 50,000 & \$ 25,000 & \$ 0 \\2 & 20,000 & 40,000 & 25,000 & \$ 0 \\3 & 30,000 & 30,000 & 25,000 & 45,000 \\4 & 40,000 & 0 & 25,000 & 55,000 \\5 & 50,000 & 0 & 25,000 & 60,000\end{array}$ Evaluate and rank each alternative based on a) payback period, b) net present value (use a 10% discount rate), and c) internal rate of return. For the internal rate of return, please use Excel's "IRR" function as described in the text.

The payback method has several disadvantages, among them:

The modified internal rate of return assumes that

For a small business, it is possible for the purchase price of an asset to be expensed rather than depreciated.

Assume a $6,500 investment and the following cash flows for two alternatives. $\begin{array} { l l l } \text { Year } & \text { Investment } \mathbf { X } & \text { Investment Y } \\1 & \$ 1,000 & \$ 1,300 \\2 & 1,800 & 2,000 \\3 & 1,700 & 1,100 \\4 & 2,000 & 1,500 \\5 & & 600\end{array}$ Under the payback method, which of the following could be concluded?

The net present value method is a more conservative technique for selecting investment projects than the internal rate of return method because the NPV method