PLANNING FOR CAPITAL INVESTMENTS

MULTIPLE CHOICE QUESTIONS

5. The cash payback

a) technique is a quick way to calculate a project's net present value.
b) period is calculated by dividing the annual cash inflow by the cost of the capital investment.
c) method is frequently used as a screening tool but it does not take into consideration the long-
term profitability of a project.
d) the longer the payback period the more attractive the investment.

6. The capital budget for the year is approved by a company's

a) board of directors.
b) capital budgeting committee.
c) officers.
d) shareholders.

7. Which of the following describes the capital budgeting evaluation process?

a) The capital budget committee submits its proposals to the officers of the company who
choose which projects will be forwarded to the shareholders for ultimate approval.
b) The officers of the company submit their proposals to the capital budget committee who
choose which projects will be forwarded to the shareholders for ultimate approval.
c) The officers of the company submit their proposals to the capital budget committee who
choose which projects will be forwarded to the board of directors for ultimate approval.
d) The capital budget committee submits its proposal to the officers of the company who choose
which projects will be forwarded to the board of directors for ultimate approval.

8. Which of the following represents a cash inflow?

a) the initial investment
b) sale of old equipment
c) repairs and maintenance
d) increased operating costs

9. Which of the following represents a cash outflow?

a) overhaul of equipment
b) increased cash received from customers
c) reduced cash flows for operating costs
d) salvage value of equipment when project is completed

10. The capital budgeting decision depends in part on the

a) availability of funds.
b) relationships among proposed projects.
c) risk associated with a particular project.
d) all of these.

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is prohibited
11. Capital budgeting is the process
a) used in sell or process further decisions.
b) of determining how many common shares to issue.
c) of making capital expenditure decisions.
d) of eliminating unprofitable product lines.

12. If an asset costs $60,000 and is expected to have a $5,000 salvage value at the end of its
nine-year life, and generates annual net cash inflows of $10,000 each year, the cash payback
period is
a) 6.5 years.
b) 6 years.
c) 5.5 years.
d) 9 years.
Solution: $60,000 / $10,000 = 6 years

13. If a payback period for a project is greater than its expected useful life, the
a) project will always be profitable.
b) entire initial investment will not be recovered.
c) project would only be acceptable if the company's cost of capital was low.
d) project's return will always exceed the company's cost of capital.

14. The cash payback technique

a) should be used as a final screening tool.
b) can be the only basis for the capital budgeting decision.
c) is relatively easy to calculate and understand.
d) considers the expected profitability of a project.

15. The cash payback period is calculated by dividing the cost of the capital investment by the
a) annual net income.
b) net annual cash inflow.
c) present value of the cash inflow.
d) present value of the net income.

16. When using the cash payback technique, the payback period is expressed in terms of
a) a percent.
b) dollars.
c) years.
d) months.

17. A disadvantage of the cash payback technique is that it

a) ignores obsolescence factors.
b) ignores the cost of an investment.
c) is complicated to use.
 Planning for Capital Investments 13 - 3

d) ignores the time value of money.

18. Bark Company is considering buying a machine for $120,000 with an estimated life of ten
years and no salvage value. The straight-line method of depreciation will be used. The machine
is expected to generate net income of $8,000 each year. The cash payback period on this
investment is
a) 15 years.
b) 10 years.
c) 6 years.
d) 3 years.
Solution: $120,000 / $8,000 + ($120,000 / 10) = 6 years

19. Carr Company is considering two capital investment proposals. Estimates regarding each
project are provided below:
Project Soup Project Nuts
Initial investment $270,000 $600,000
Annual net income 27,000 45,000
Net annual cash inflow 90,000 142,000
Estimated useful life 5 years 6 years
Salvage value -0- -0-
The cash payback period for Project Soup is
a) 13.5 years.
b) 5 years.
c) 3.9 years.
d) 3 years.
Solution: $270,000 / $90,000 = 3 years

20. A company is considering purchasing factory equipment that costs $400,000 and is
estimated to have no salvage value at the end of its 5-year useful life. If the equipment is
purchased, annual revenues are expected to be $150,000 and annual operating expenses
exclusive of depreciation expense are expected to be $25,000. The straight-line method of
depreciation would be used. The cash payback period on the equipment is
a) 8.89 years.
b) 5.0 years.
c) 3.2 years.
d) 2.67 years.
Solution: $400,000 / ($150,000 - $25,000) = 3.2 years.

Use the following information for questions 21–22.

A company projects an increase in net income of $40,000 each year for the next five years if it
invests $500,000 in new equipment. The equipment has a five-year life and an estimated
salvage value of $50,000. The company uses the straight-line method of depreciation.

21. What is the net annual cash flow?

a) $40,000
b) $90,000
c) $130,000
d) $140,000
Solution: $40,000 + ($500,000 – $50,000) / 5 years = $130,000

22. What is the cash payback period?

a) 12.5 years
b) 5.56 years
c) 3.85 years
d) 3.57 years
Solution: $500,000 / ($500,000 – $50,000) / 5 years] = 3.85 years

23. Doris Co. is considering purchasing a new machine which will cost $200,000, but which will
decrease costs each year by $50,000. The useful life of the machine is 10 years. The machine
would be depreciated straight-line with no residual value over its useful life at the rate of
$20,000/year. The payback period is
a) 5.0 years.
b) 4.5 years.
c) 4.0 years.
d) 10.0 years.
Solution: $200,000 / $50,000= 4 years

24. Mystery Co. is considering purchasing a new piece of equipment that will cost $600,000.
The equipment has an estimated useful life of 8 years and no salvage value. The equipment will
produce cash inflows of $215,000 per year and net income of $90,000 per year. Mystery
requires a 10% rate of return. What is the payback period for this equipment?
a) 8.0 years
b) 3.75 years
c) 2.79 years
d) 6.67 years
Solution: $600,000 / $215,000 = 2.79 years

25. Capital budgeting relies on cash inflows and outflows as preferred inputs for calculations
because
a) managers prefer to use cash figures rather than accounting figures.
b) GAAP does not apply to capital budgeting decisions.
c) projects require cash paid out and firms want to know when cash will be returned.
d) cash figures are easier to calculate than accounting figures.

26. Which of the following would not be considered as an input into a capital budgeting
decision?
a) scrap value of equipment sold at the end of a project
b) labour savings as a result of mechanization of a process
c) cost outlays many years after the project has started
d) amortization on a straight-line basis

27. The cash payback method is useful because

 Planning for Capital Investments 13 - 5

a) it gives a broad indication when outlays will be recovered by the firm.

b) it gives a specific date as to when outlays will be recovered by the firm.
c) it avoids using complicated accounting data in capital budgeting decisions.
d) it is easy to communicate the relation between cash received and ultimate profitability of a
project to everyone in the organization.

28. The major difficulty of the cash payback method is

a) it includes salvage values at the end of a project.
b) it ignores net income in its calculation.
c) it ignores the overall cash flow of the project.
d) it ignores the overall profitability of the project.

29. When using the net present value method

a) a net present value of zero indicates that the project would be acceptable.
b) the expected cash flows from a project must be an equal amount each year.
c) net cashflows are discounted to their future value.
d) a proposal is only acceptable when the rate of return on the investment exceeds the required
rate of return.

30. The discount rate is referred to by all of the following alternative names except the
a) maximum return rate.
b) cutoff rate.
c) hurdle rate.
d) required rate of return.

31. The rate that a company must pay to obtain funds from creditors and shareholders s known
as the
a) hurdle rate.
b) cost of capital.
c) cutoff rate.
d) all of these.

32. The higher the risk element in a project, the

a) more attractive the investment.
b) higher the net present value.
c) higher the cost of capital.
d) higher the discount rate.

33. If a company's required rate of return is 10% and, in using the net present value method, a
project's net present value is zero, this indicates that the
a) project's rate of return exceeds 10%.
b) project's rate of return is less than the minimum rate required.
c) project earns a rate of return of 10%.
d) project earns a rate of return of 0%.
34. Which of the following assumptions is made in order to simplify the net present value
method?
a) All cash flows come at the end of the year.
b) All cash flows are immediately reinvested at the best rate available at the time.
c) All cash flows come at the beginning of the year.
d) All cash flows are not reinvested.

35. When the annual cash flows from an investment are unequal, the appropriate table to use is
in the calculation of net present value is the
a) future value of 1 table.
b) future value of annuity table.
c) present value of 1 table.
d) present value of annuity table.

36. If a company uses a 12% discount rate with the net present value method, and then does
the same analysis, but with a 15% discount rate, which of the following is likely to occur?
a) The 12% rate will show the project is more profitable than the 15% rate.
b) The 15% rate will show the project is more profitable than the 12% rate.
c) Both rates will produce the same net present value.
d) The relative profitability of the two studies depends only on the timing of the cash flows, not
on the discount rate.

37. Present Value of an Annuity of 1

Periods 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487
A company has a minimum required rate of return of 9% and is considering investing in a
project that costs $50,000 and is expected to generate cash inflows of $30,000 at the end of
each year for two years. The net present value of this project is
a) $20,000.
b) $10,000.
c) $6,920.
d) $2,770.
Solution: ($30,000 x 1.759) – $50,000 = $2,770

38. Present Value of an Annuity of 1

Periods 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487
A company has a minimum required rate of return of 10% and is considering investing in a
project that requires an investment of $68,000 and is expected to generate cash inflows of
$30,000 at the end of each year for 3 years. The present value of future cash inflows for this
project is
a) $68,000.
 Planning for Capital Investments 13 - 7

b) $74,610.
c) $7,930.
d) $6,610.
Solution: ($30,000 x 2.487) = $74,610

39. Carr Company is considering two capital investment proposals. Estimates regarding each
project are provided below:
Project Soup Project Nuts
Initial investment $270,000 $600,000
Annual net income 27,000 45,000
Net annual cash inflow 90,000 142,000
Estimated useful life 5 years 6 years
Salvage value -0- -0-
The company requires a 10% rate of return on all new investments.
Present Value of an Annuity of 1
Periods 9% 10% 11% 12%
5 3.890 3.791 3.696 3.605
6 4.486 4.355 4.231 4.111
The net present value for Project Nuts is
a) $618,410.
b) $182,912.
c) $100,000.
d) $18,410.
Solution: ($142,000 x 4.355) – $600,000 = $18,410

40. Vault Company wants to purchase an asset with a 3-year useful life, which is expected to
produce cash inflows of $10,000 each year for two years, and $15,000 in year 3. Vault has a
14% cost of capital, and uses the following factors. What is the present value of these future
cash flows?
Present Value of 1
Period 14%
1 .88
2 .77
3 .67
a) $30,800
b) $30,400
c) $26,550
d) $17,750
Solution: ($10,000 x.88) + ($10,000 x.77) + ($15,000 x.67) = $26,550

41. Tammy Co. is considering purchasing a machine that will produce annual savings of
$22,000 at the end of the year. Tammy requires a 12% rate of return and the asset has a 5-year
useful life. What is the maximum Tammy would be willing to pay for this machine?
Present Value of Annuity of 1 Present Value of 1
Period 12% Period 12%
5 3.605 5 .567
a) $43,386
b) $79,310
c) $110,000
d) $62,370
Solution: ($22,000 x 3.605) = $79,310

42. Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful life.
The equipment will provide cost savings of $7,300 and will be depreciated straight-line over its
useful life with no salvage value. Cleaners, Inc. requires a 10% rate of return. What is the
approximate net present value of this investment?
Present Value of an Annuity of 1_
Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784
a) $13,800
b) $1,792
c) $886
d) $2,748
Solution: ($7,300 x 4.355) - $30,000 = $1,792

43. When evaluating a project, companies should always use

a) the Bank of Canada rate of interest.
b) the rate that is currently charged at its bank.
c) the current corporate borrowing rate.
d) the corporate borrowing rate adjusted for any perceived risk of the project.

44. Using a number of outcome estimates to get a sense of the variability among potential
returns is
a) financial analysis.
b) post-audit analysis.
c) sensitivity analysis.
d) outcome analysis.

45. An approach that uses a number of outcome estimates to get a sense of the variability
among potential returns is
a) the discounted cash flow technique.
b) the net present value method.
c) risk analysis.
d) sensitivity analysis.

46. A thorough evaluation of how well a project's actual performance matches the projections
made when the project was proposed is called a
a) pre-audit.
b) post-audit.
c) risk analysis.
d) sensitivity analysis.

47. Sensitivity analysis on a potential project

a) is only useful to perform when there are firm calculations on the project available.
 Planning for Capital Investments 13 - 9

b) is useful to perform when uncertainty exists and calculations are based on estimates.
c) is designed to ensure that management is aware of all possible outcomes of the project.
d) is designed to provide an escape-hatch for management should the project not succeed.

48. Peanut Co. is planning on investing in a new 2-year project, Project Jelly. Project Jelly is
expected to produce cash flows of $100,000 and $120,000 in year 1 and year 2, respectively.
Peanut requires an internal rate of return of 15%. What is the maximum amount that Peanut
should invest immediately in Project Jelly?
Present Value of 1 Future Value of 1
Period 15% Period 15%
1 .870 1 1.150
2 .756 2 1.323
a) $191.400
b) $177,720
c) $220,000
d) $273,760
Solution: ($100,000 x.870) + ($120,000 x.756) = $177,720

49. The major difference between the net present value method and the annual rate of return
method in evaluating a capital project is
a) the ARR method is easier for accountants to justify than the NPV method.
b) the NPV method is easier for managers to justify than the ARR method.
c) the ARR method focuses on overall profitability of a project.
d) the NPV method focuses on the overall profitability of a project.

50. Which of the following statements is false?

a) By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate
projects that could be beneficial to the company.
b) To avoid accepting projects that actually should be rejected, a company should ignore
intangible benefits in calculating net present value.
c) One way of incorporating intangible benefits into the capital budgeting decision is to project
conservative estimates of the value of the intangible benefits and include them in the NPV
calculation.
d) Intangible benefits include increased quality, improved safety or greater employment loyalty.

51. A post-audit
a) should be performed as an evaluation of an organization’s investment projects before their
completion.
b) creates an incentive for managers to make lower estimates, since managers know that their
results will be evaluated.
c) is an evaluation of how well a project's actual performance matches the projections made
when the project was proposed.
d) provides an informal mechanism for deciding whether existing projects should be supported
or terminated.

52. Using the profitability index method, the present value of cash inflows for Project Flower is
$88,000 and the present value of cash inflows of Project Plant is $48,000. If Project Flower and
Project Plant require initial investments of $90,000 and $40,000, respectively, and have the
same useful life, the project that should be accepted is
a) Project Flower.
b) Project Plant.
c) Either project may be accepted.
d) Neither project should be accepted.

53. Intangible benefits in capital budgeting would include all of the following except increased
a) product quality.
b) employee loyalty.
c) salvage value.
d) product safety.

54. Intangible benefits in capital budgeting

a) should be ignored because they are difficult to determine.
b) include increased quality or employee loyalty.
c) are not considered because they are usually not relevant to the decision.
d) have a rate of return in excess of the company’s cost of capital.

55. To avoid rejecting projects that actually should be accepted,

1. intangible benefits should be ignored.
2. conservative estimates of the intangible benefits' value should be incorporated into the
NPV calculation.
3. calculate net present value ignoring intangible benefits and then, if the NPV is negative,
estimate whether the intangible benefits are worth at least the amount of the negative
NPV.
a) 1
b) 2
c) 3
d) both 2 and 3 are correct.

56. All of the following statements about intangible benefits in capital budgeting are correct
except that they
a) include increased quality and employee loyalty.
b) are difficult to quantify.
c) are often ignored in capital budgeting decisions.
d) cannot be incorporated into the NPV calculation.

57. In evaluating high-tech projects

a) only tangible benefits should be considered.
b) only intangible benefits should be considered.
c) both tangible and intangible benefits should be considered.
d) neither tangible nor intangible benefits should be considered.
 Planning for Capital Investments 13 - 11

58. If a company's required rate of return is 9%, and in using the profitability index method, a
project's index is greater than 1, this indicates that the project's rate of return is
a) equal to 9%.
b) greater than 9%.
c) less than 9%.
d) unacceptable for investment purposes.

59. The profitability index is calculated by dividing the

a) total cash flows by the initial investment.
b) present value of cash flows by the initial investment.
c) initial investment by the total cash flows.
d) initial investment by the present value of cash flows.

60. The capital budgeting method that takes into account both the size of the original investment
and the discounted cash flows is the
a) cash payback method.
b) internal rate of return method.
c) net present value method.
d) profitability index.

61. The profitability index

a) does not take into account the discounted cash flows.
b) is calculated by dividing total cash flows by the initial investment.
c) allows comparison of the relative desirability of projects that require differing initial
investments.
d) will never be greater than 1.

62. The capital budgeting method that allows comparison of the relative desirability of projects
that require differing initial investments is the
a) cash payback method.
b) internal rate of return method.
c) net present value method.
d) profitability index.

63. The following information is available for a potential investment for Panda Company:
Initial investment $40,000
Net annual cash inflow 10,000
Net present value 18,112
Salvage value 5,000
Useful life 10 yrs.
The potential investment’s profitability index is
a) 4.00.
b) 2.85.
c) 2.50.
d) 1.45.
Solution: ($18,112 + $40,000) / $40,000 = 1.45
64. Post-audits of capital projects
a) are usually foolproof.
b) are done using different evaluation techniques than were used in making the original capital
budgeting decision.
c) provide a formal mechanism by which the company can determine whether existing projects
should be supported or terminated.
d) all of these.

65. A post-audit should be performed using

a) a different evaluation technique than that used in making the original decision.
b) the same evaluation technique used in making the original decision.
c) estimated amounts instead of actual figures.
d) an independent advisor.

66. Performing a post-audit is important because

a) managers will be more likely to submit reasonable data when they make investment
proposals if they know their estimates will be compared to actual results.
b) it provides a formal mechanism by which the company can determine whether existing
projects should be terminated.
c) it improves the development of future investment proposals because managers improve their
estimation techniques by evaluating their past successes and failures.
d) all of these.

67. Present Value of an Annuity of 1

Periods 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487
A company has a minimum required rate of return of 9% and is considering investing in a
project that costs $50,000 and is expected to generate cash inflows of $20,000 at the end of
each year for three years. The profitability index for this project is
a).99.
b) 1.00.
c) 1.01.
d) 1.20.
Solution: ($20,000 x 2.531) / $50,000 = 1.01

68. Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful life.
The equipment will provide cost savings of $7,300 and will be amortized using the straight-line
method over its useful life with no salvage value. Cleaners, Inc. requires a 10% rate of return.
What is the approximate profitability index associated with this equipment?
Present Value of an Annuity of 1_
Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784
a) 1.23
 Planning for Capital Investments 13 - 13

b) 1.03
c) 1.06
d) 73
Solution: ($7,300 x 4.355) / $30,000 = 1.06

69. An intangible benefit of a project would best be described as

a) goodwill will be increased on the balance sheet as a result of the project.
b) the company’s bankers may offer a lower rate of interest for certain projects.
c) the company’s presence in its market is enhanced by the project which may result in
additional sales of the company’s other product lines.
d) the company may be allowed deferred income tax payment terms as a result of the project.

70. When accepting large capital projects, a company should

a) pay strict attention to what the numbers indicate and accept or reject a project accordingly.
b) pay close attention to trends in the marketplace before accepting or rejecting a project.
c) assess the numbers on the project and then go with management’s best judgment.
d) assess the numbers on the project then review the intangible benefits before accepting or
rejecting a project.

71. The internal rate of return method

a) is, like the NPV method, a discounted cash flow technique.
b) will reject a project when the internal rate of return is greater than or equal to the required
rate of return.
c) finds the rate that results in a positive net present value.
d) does not recognize the time value of money.

72. A capital budgeting method that takes into consideration the time value of money is the
a) annual rate of return method.
b) return on shareholders' equity method.
c) cash payback technique.
d) internal rate of return method.

73. The internal rate of return is the interest rate that results in a
a) positive NPV.
b) negative NPV.
c) zero NPV.
d) positive or negative NPV.

74. In using the internal rate of return method, the internal rate of return factor was 4.0 and the
equal annual cash inflows were $16,000. The initial investment in the project must have been
a) $8,000.
b) $16,000.
c) $64,000.
d) $32,000.
Solution: $16,000 x 4 = $64,000
75. The capital budgeting technique that finds the interest yield of the potential investment is the
a) annual rate of return method.
b) internal rate of return method.
c) net present value method.
d) profitability index method.

76. All of the following statements about the internal rate of return method are correct except
that it
a) recognizes the time value of money.
b) is widely used in practice.
c) is easy to interpret.
d) can be used only when the cash inflows are equal.

77. Present Value of an Annuity of 1

Periods 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487
A company has a minimum required rate of return of 8% and is considering investing in a
project that costs $67,145 and is expected to generate cash inflows of $27,000 each year for
three years. The approximate internal rate of return on this project is
a) 8%.
b) 10%.
c) 9%.
d) less than the required 8%.
Solution: $67,145 / $27,000 = 2.487 factor for 3 periods at 10%

78. Carr Company is considering two capital investment proposals. Estimates regarding each
project are provided below:
Project Soup Project Nuts
Initial investment $270,000 $600,000
Annual net income 27,000 45,000
Net annual cash inflow 90,000 142,000
Estimated useful life 5 years 6 years
Salvage value -0- -0-
The company requires a 10% rate of return on all new investments.
Present Value of an Annuity of 1
Periods 9% 10% 11% 12%
5 3.890 3.791 3.696 3.605
6 4.486 4.355 4.231 4.111
The internal rate of return for Project Nuts is approximately
a) 10%.
b) 11%.
c) 12%.
d) 9%.
Solution: $600,000 / $142,000 = 4.23 factor for 6 periods at 11%
 Planning for Capital Investments 13 - 15

79. Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful life.
The equipment will provide cost savings of $7,300 and will be depreciated straight-line over its
useful life with no salvage value. Cleaners, Inc. requires a 10% rate of return. What is the
approximate internal rate of return for this investment?
Present Value of an Annuity of 1_
Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784
a) 9%
b) 10%
c) 11%
d) 12%
Solution: $30,000 / $7,300 = 4.11 factor for 6 periods at 12%

80. In using the internal rate of return method

a) management can ignore the cost of capital for the project.
b) management must understand its own required rate of return for projects.
c) the net present value method can be ignored in assessing the project.
d) both the net present value and Cash Payback methods can be ignored in assessing the
project.

81. Using the annual rate of return method,

a) a project is acceptable if its rate of return is greater than management's minimum rate of
return.
b) requires dividing a project's annual cash inflows by the economic life of the project.
c) is advantageous as it considers the time value of money.
d) is advantageous as it relies on accrual accounting numbers rather than actual cash flows.

82. Carr Company is considering two capital investment proposals. Estimates regarding each
project are provided below:
Project Soup Project Nuts
Initial investment $270,000 $600,000
Annual net income 27,000 45,000
Net annual cash inflow 90,000 142,000
Estimated useful life 5 years 6 years
Salvage value -0- -0-
The company requires a 10% rate of return on all new investments.
Present Value of an Annuity of 1
Periods 9% 10% 11% 12%
5 3.890 3.791 3.696 3.605
6 4.486 4.355 4.231 4.111
The annual rate of return for Project Soup is
a) 13.3%.
b) 20%.
c) 33.3%.
d) 30%.
Solution: $27,000 / ($270,000 / 2) = 20%
83. A company is considering purchasing factory equipment that costs $400,000 and is
estimated to have no salvage value at the end of its 5-year useful life. If the equipment is
purchased, annual revenues are expected to be $150,000 and annual operating expenses
exclusive of depreciation expense are expected to be $25,000. The straight-line method of
depreciation would be used. If the equipment is purchased, the annual rate of return expected
on this equipment is
a) 37.5%.
b) 31.25%.
c) 22.5%.
d) 6.25%.
Solution: [$150,000 – $25,000 – ($400,000 / 5 years)] /( $400,000 / 2) = 22.5%

84. The annual rate of return method is also referred to as

a) simple rate of return method.
b) accounting rate of return method.
c) unadjusted rate of return method.
d) all of the above

85. The annual rate of return method is based on

a) accounting data.
b) the time value of money data.
c) market values.
d) cash flow data.

86. What is the main disadvantage of the annual rate of return method?
a) It is only valid for investments with a one year time perspective.
b) It incorporates depreciation into the calculations, which increases the uncertainty of the
calculations associated with estimating the life and salvage value of the investment.
c) No consideration is given as to when the cash inflows occur.
d) It does not consider the time value of money.

87. A company projects an increase in net income of $40,000 each year for the next five years if
it invests $500,000 in new equipment. The equipment has a five-year life and an estimated
salvage value of $50,000. The company uses the straight-line method of depreciation. What is
the annual rate of return?
a) 8%
b) 14.5%
c) 18%
d) 26.7%
Solution: $40,000 / ($500,000 + $50,000) / 2 = 14.5%

88. All of the following statements about the annual rate of return method are correct except
that it
a) indicates the profitability of a capital expenditure.
 Planning for Capital Investments 13 - 17

b) ignores the salvage value of an investment.

c) does not consider the time value of money.
d) compares the annual rate of return to management’s minimum rate of return.
 ANSWERS TO MULTIPLE CHOICE QUESTIONS
Item Ans. Item Ans. Item Ans. Item Ans. Item Ans.
5. c 22. c 39. d 56. d 73. c
6. a 23. c 40. c 57. c 74. c
7. d 24. c 41. b 58. b 75. b
8. b 25. c 42. b 59. b 76. d
9. a 26. d 43. d 60. d 77. b
10. d 27. a 44. c 61. c 78. b
11. c 28. d 45. d 62. d 79. d
12. b 29. a 46. b 63. d 80. b
13. b 30. a 47. b 64. c 81. a
14. c 31. b 48. b 65. b 82. b
15. b 32. d 49. c 66. d 83. c
16. c 33. c 50. b 67. c 84. d
17. d 34. a 51. c 68. c 85. a
18. c 35. c 52. b 69. c 86. d
19. d 36. a 53. c 70. d 87. b
20. c 37. d 54. b 71. a 88. b
21. c 38. b 55. d 72. d
 Planning for Capital Investments 13 - 19

BRIEF EXERCISES

Brief Exercise 89
Diamond Co. is considering investing in new equipment that will cost $800,000 with an 8-year
useful life. The new equipment is expected to produce annual net income of $25,000 over its
useful life. Depreciation expense, using the straight-line rate, is $100,000 per year.

Instructions
Calculate the payback period.

Solution 89 (5 min.)
$800,000 ÷ ($25,000 + $100,000) = 6.4 years

Brief Exercise 90
Johnstown Ltd. wants to buy a new machine for its main product line. It costs $60,000 and will
save the company $9,000 per year for the next ten years.
Calculate the payback for the company on this machine.

Solution 90 (5 min.)
$60,000 ÷ $9,000 = 6.67 years

Brief Exercise 91
Madeline Company is proposing to spend $170,000 to purchase a machine that will provide
annual cash flows of $37,000. The appropriate present value factor for 8 periods is 6.73.

Instructions
Calculate the proposed investment’s net present value, and indicate whether the investment
should be made by Madeline Company.

Solution 91 (5 min.)
Present Value
Cash inflows—$37,000 x 6.73 $ 249,010
Cash outflow—investment $170,000 x 1.00 (170,000)
Net present value $ 79,010

The investment should be made because the net present value is positive.

Brief Exercise 92
LeMo Co. is considering investing in a cottage that will cost $310,000. The company expects to
rent the cottage for 7 years, after which it will be sold for $400,000 at that time. LeMo anticipates
cash flows of $60,000 resulting from the cottage and the company’s borrowing rate is 9%, while
its cost of capital is 12%.

Instructions
Calculate the net present value of the cottage and indicate whether LeMo should make the
investment.
 Present Value of an Annuity of 1
Period 9% 12%
7 5.03295 4.56376

Present Value of 1
Period 9% 12%
7 0.54703 0.45235

Solution 92 (5 min.)
Cash 12% Discount Present
Flows x Factor = Value
Present value of annual cash flows $60,000 x 4.56376 = $273,826
Present value of salvage value 400,000 x 0.45235 = 180,940
454,766
Capital investment (310,000)
Net present value $144,766

Since the net present value is positive, LeMo should accept the project.

Brief Exercise 93
LakeFront Company is considering investing in a new dock that will cost $560,000. The
company expects to use the dock for 5 years, after which it will be sold for $300,000. LakeFront
anticipates annual cash flows of $110,000 resulting from the new dock. The company’s
borrowing rate is 8%, while its cost of capital is 10%.

Instructions
Calculate the net present value of the dock and indicate whether LakeFront should make the
investment.

Present Value of an Annuity of 1

Period 8% 10%
5 3.99271 3.79079

Present Value of 1
Period 8% 10%
5 0.68058 0.62092

Solution 93 (5 min.)
Cash Flows × 10% Discount Factor = Present Value
Present value of annual cash flows $110,000 × 3.79079 = $416,987
Present value of salvage value 300,000 × .62092 = 186,276
Present Value 603,263
Capital investment 560,000
Net present value $ 43,263

Since the net present value is positive, LakeFront should accept the project. Present value-
investment=NPV/(NPV)

Brief Exercise 94
 Planning for Capital Investments 13 - 21

EKPN Co. has hired a consultant to propose a way to increase the company’s revenues. The
consultant has evaluated two mutually exclusive projects with the following information provided
for each project:

Project Chicken Project Rooster

Capital investment $810,000 $200,000
Annual cash flows 210,000 60,000
Estimated useful life 5 years 5 years
Estimated salvage value $130,000 $50,000

EKPN Co. uses a discount rate of 8% to evaluate both projects.

Present Value of an Annuity of 1

Period 8%
5 3.99271

Present Value of 1
Period 8%
5 0.68058

Instructions
a) Calculate the net present value of both projects.
b) Calculate the profitability index for each project.
c) Which project should EKPN accept?

Solution 94 (10–15 min.)

Project Chicken
Cash 8% Discount Present
Flows x Factor = Value
Present value of annual cash flows $210,000 x 3.99271 = $838,469
Present value of salvage value 130,000 x 0.68058 = 88,475
926,944
Capital investment (810,000)
Net present value $116,944

Profitability index = $926,944 / $810,000 = 1.144

Project Rooster
Cash 9% Discount Present
Flows x Factor = Value
Present value of annual cash flows $60,000 x 3.99271 = $239,563
Present value of salvage value 50,000 x 0.68058 = 34,029
273,592
Capital investment (200,000)
Net present value $ 73,592

Profitability index = $273,592 / $200,000 = 1.368

Project Rooster has a lower net present value than Project Chicken, but because of its lower
capital investment, it has a higher profitability index. Based on its profitability index, Project
Rooster should be accepted.

Brief Exercise 95
The manager of Induction Ltd. wants to evaluate the profitability of four potential new projects
and has provided you with the following information:
Project Investment Net Present Value
1 $150,000 $25,000
2 140,000 25,000
3 130,000 35,000
4 60,000 15,000

Instructions
Using the profitability index approach, rank the four projects

Solution 95 (5 min.)
3 4 2 1
165÷130 = 1.27 75÷60 = 1.25 165÷140 = 1.18 175÷150 = 1.17

Brief Exercise 96
An investment costing $72,000 is being contemplated by Mint Co. The investment will have a
life of 5 years with no salvage value and will produce annual cash flows of $19,481.

Instructions
What is the approximate internal rate of return associated with this investment?

Solution 96 (5 min.)
When net annual cash inflows are expected to be equal, the internal rate of return can be
approximated by dividing the capital investment by the net annual cash inflows to determine the
discount factor, and then locating this discount factor on the present value of an annuity table.

$72,000 / $19,481 = 3.69591

By tracing across on the 5-year row we see that the discount factor for 11% is 3.69590. Thus,
the internal rate of return on this project is approximately 11%.

Brief Exercise 97
Mint Company is contemplating an investment costing $135,000. The investment will have a life
of 8 years with no salvage value and will produce annual cash flows of $25,305.

Instructions
What is the approximate internal rate of return associated with this investment?

Solution 97 (5 min.)
When net annual cash inflows are expected to be equal, the internal rate of return can be
approximated by dividing the capital investment by the net annual cash inflows to determine the
discount factor and then locating this discount factor on the present value of an annuity table.
$135,000 ÷ $25,305 = 5.33
 Planning for Capital Investments 13 - 23

By tracing across on the 8-year row, we see that the discount factor of 10% is 5.33493. Thus
the internal rate of return on this project is approximately 10%.

Brief Exercise 98
Salt Co. is considering investing in a new facility to extract and produce salt. The facility will
increase revenues by $170,000, but will also increase annual expenses by $50,000 including
depreciation. The facility will cost $720,000 to build, but will have a $30,000 salvage value at the
end of its 15-year useful life.

Instructions
Calculate the annual rate of return on this facility.

Solution 98 (5 min.)
The annual rate of return is calculated by dividing expected annual income by the average
investment. The company’s expected annual income is:
$170,000 – $50,000 = $120,000

Its average investment is:

$720,000 + $30,000
= $375,000
2

Therefore, its annual rate of return is:

$120,000 / $375,000 = 32%

Brief Exercise 99
Stanton Company is performing a post-audit of a project completed one year ago. The initial
estimates were that the project would cost $490,000, would have a useful life of 9 years, zero
salvage value, and would result in net annual cash flows of $90,000 per year. Now that the
investment has been in operation for 1 year, revised figures indicate that it actually cost
$510,000, will have a useful life of 11 years, and will produce net annual cash flows of $77,000
per year with zero salvage value. Evaluate the success of the project. Assume a discount rate of
10%. The PV of an annuity for 11 years at 10% is 6.49506 and the PV of $1 for 11 years at 10%
is 0.42410. Calculate the post-audit NPV

Solution 99 (5 min.)
Cash Flows × 10% Discount Factor = Present Value
Present value of net annual
cash flows $77,000 × 6.49506 = 500,120
Capital investment 510,000
Net present value $ 9,880