# Capital Budgeting Questions and Answers

1. The managers of Central Concrete Incorporated are evaluating 5 potential projects (A, B, C, D, and E).  Based on the information presented in the 2 tables, what is the maximum amount of value that the managers can create for the firm if they can choose to undertake none, one, some, or all of the 5 potential projects?

 Project Initial investment (in \$ millions) Net present value (in \$ millions) Payback period (in years) Discounted payback period (in years) Internal rate of return (in %) Average accounting return       (in %) A 1.4 3.1 3.6 4.5 6.3 -5.1 B 3.2 -2.3 2.1 ∞ 21.5 23.4 C 4.5 9.7 0.8 4.6 3.9 14.5

 Expected cash flows (number of years from today) in millions of dollars Project Cost of capital 0 1 2 3 4 D 12.0% -1.1 9.0 7.0 -7.0 -9.0 E 14.0% -8.1 1.0 2.0 3.0 4.0

A. An amount equal to or greater than \$8 million but less than \$10 million

B.   An amount equal to or greater than \$10 million but less than \$12 million

C.   An amount equal to or greater than \$12 million but less than \$14 million

D. An amount less than \$6 million or an amount that is equal to or greater than \$14 million

E.   The question can not be answered for one or more of the following reasons: at least one of the projects has non-conventional cash flows; the cost of capital is not known for all projects; and the payback and discounted paybackthresholds are not known.

(Spring 2010, quiz 4, question 1)         (Fall 2010, quiz 3, question 7)

(Fall 2011, final, question 11)             (Spring 2012, quiz 3, question 7)

(Fall 2013, quiz 3, question 7)

2. Area Forests is evaluating a project that would cost \$1,500,000 today.  The project is expected to produce annual cash flows of \$135,000 forever with the first annual cash flow expected in 1 year.  The cost of capital associated with the project is 8.40 percent and the project’s internal rate of return is 9.00 percent.  What is the net present value (NPV) of the project?

3. Wooden Forests is evaluating a project that would require an initial investment of \$900,000 today.  The project is then expected to produce annual cash flows that grow by 1.80 percent per year forever.  The first annual cash flow is expected in 1 year and is expected to be \$65,000.  The project’s internal rate of return is 9.02 percent and its cost of capital is 9.32 percent.  What is the net present value (NPV) of the project?

(Fall 2012, quiz 3, question 7)

4. Karim’s Kabobs is evaluating a project that would last for 3 years.  The project’s cost of capital is 10.0 percent; its NPV is \$10,000; and the expected cash flows are presented in the table.  What is X?

 Years from today 0 1 2 3 Expected cash flow (in \$) -65,000 50,000 -10,000 X

A. An amount equal to or greater than \$28,000 but less than \$36,000

B. An amount equal to or greater than \$36,000 but less than \$44,000

C. An amount equal to or greater than \$44,000 but less than \$52,000

D. An amount less than \$36,000 or an amount equal to or greater than \$52,000

E.   The amount can not be determined or does not exist because the cash flows are not conventional

(Spring 2011, quiz 3, question 7)

(Fall 2011, quiz 3, question 8)

(Fall 2012, final, question 13)

(Spring 2013, quiz 3, question 7)

(Spring 2014, quiz 3, question 7)

5. Pallone Rackets is considering a project that is expected to cost \$6,200 today; produce a cash flow of \$7,100 in 1 year, and have an NPV of -\$300.  What is the cost of capital for the project?

6. Graphco Rackets is considering a project that is expected to cost \$5,800 today; produce a cash flow of \$8,900 in 4 years, and have an NPV of \$300.  What is the cost of capital for the project?

7. VinyJungles is evaluating a project that would cost \$1,500,000 today.  The project is expected to produce annual cash flows of \$135,000 forever with the first annual cash flow expected in 1 year.  The NPV of the project is \$107,143.  What is the cost of capital of the project?

8. Buggy Jungles is evaluating a project that would cost \$900,000 today.  The project is expected to produce annual cash flows that grow by 1.80 percent per year forever.  The first annual cash flow is expected in 1 year and is expected to be \$65,000.  The NPV of the project is \$33,333.  What is the cost of capital of the project?

9. Indicate whether the following assertion is true or false: if we define a “good” project as creating value, a “bad” project as destroying value, the “right” decision as accepting a “good” project or rejecting a “bad” project, and the “wrong” decision as rejecting a “good” project or accepting a “bad” project, then using net present value and the NPV rule always leads to the “right” decision for both “good” and “bad” projects when projects have conventional cash flows.

10. Indicate whether the following assertion is true or false: if we define a “good” project as creating value, a “bad” project as destroying value, the “right” decision as accepting a “good” project or rejecting a “bad” project, and the “wrong” decision as rejecting a “good” project or accepting a “bad” project, then Using net present value and the NPV rule always leads to the “right” decision for both “good” and “bad” projects when projects do not have conventional cash flows.

11. Based on the information presented in the table, which statement about the projects’ internal rates of return (IRR) is true?

 Expected cash flows (number of years from today) Project 0 1 2 3 Cost of capital NPV A -75 30 25 40 10.40% 2.41 B -150 60 50 80 12.60% -1.24 C -225 90 75 120 10.40% 7.24

A. The IRR of project A is equal to the IRR of project B and the IRR of project A is equal to the IRR of project C

B. The IRR of project A is equal to the IRR of project B and the IRR of project A is not equal to the IRR of project C

C. The IRR of project A is not equal to the IRR of project B and the IRR of project A is equal to the IRR of project C

D. The IRR of project A is not equal to the IRR of project B and the IRR of project A is not equal to the IRR of project C

12. Based on the information presented in the table, which statement about the projects’ internal rates of return (IRR) is true?

 Expected cash flows (number of years from today) Project 0 1 2 Cost of capital NPV A -18.25 10.45 18.15 10.00% 6.25 B -43.25 32.45 24.20 10.00% 6.25 C -23.25 21.45 12.10 10.00% 6.25

A. The IRR of project A is equal to the IRR of project B and the IRR of project A is equal to the IRR of project C

B. The IRR of project A is equal to the IRR of project B and the IRR of project A is not equal to the IRR of project C

C. The IRR of project A is not equal to the IRR of project B and the IRR of project A is equal to the IRR of project C

D. The IRR of project A is not equal to the IRR of project B and the IRR of project A is not equal to the IRR of project C

13. Based on the information presented in the table, which statement about the projects’ internal rates of returns (IRRs) is true?

 Expected cash flows (number of years from today) Project 0 1 2 3 Cost of capital NPV A -96.0 56.8 32.4 38.4 12.42% 7.19 B -48.0 28.4 16.2 19.2 8.26% 7.19 C -85.0 47.5 34.2 32.5 12.42% 7.19

A. The IRR of project A is equal to the IRR of project B and the IRR of project A is equal to the IRR of project C

B. The IRR of project A is equal to the IRR of project B and the IRR of project A is not equal to the IRR of project C

C. The IRR of project A is not equal to the IRR of project B and the IRR of project A is equal to the IRR of project C

D. The IRR of project A is not equal to the IRR of project B and the IRR of project A is not equal to the IRR of project C

(Spring 2013, quiz 3, question 8)

14. What is the internal rate of return for a project that is expected to cost \$1,410 today; produce a cash flow of \$1,620 in 1 year; and have a net present value of \$100?

(Spring 2014, quiz 3, question 8)

15. What is the internal rate of return for a project that is expected to cost \$1,410 today; produce a cash flow of \$1,620 in 3 years; and have a net present value of \$100?

16. Wooden Forests is evaluating a project that would require an initial investment of \$540,000 today.  The project is expected to produce annual cash flows of \$62,000each year forever with the first annual cash flow expected in 1 year.  The NPV of the project is \$40,000.  What is the IRR of the project?

(Fall 2013, quiz 3, question 9)

17. Dark Forests is evaluating a project that would cost \$900,000 today.  The project is expected to produce annual cash flows that grow by 1.82 percent per year forever.  The first annual cash flow is expected in 1 year and is expected to be \$67,000.  The NPV of the project is \$33,333.  What is the IRR of the project?

18. Which of the following assertions is true if we define a “good” project as creating value, a “bad” project as destroying value, the “right” decision as accepting a “good” project or rejecting a “bad” project, and the “wrong” decision as rejecting a “good” project or accepting a “bad” project?

A. Using internal rate of return (IRR) always leads to the “right” decision for “good” projects when projects have conventional cash flows and using IRR always leads to the “right” decision for “bad” projects when projects have conventional cash flows

B. Using internal rate of return (IRR) always leads to the “right” decision for “good” projects when projects have conventional cash flows and using IRR can lead to the “wrong” decision for “bad” projects when projects have conventional cash flows

C. Using internal rate of return (IRR) can lead to the “wrong” decision for “good” projects when projects have conventional cash flows and using IRR always leads to the “right” decision for “bad” projects when projects have conventional cash flows

D. Using internal rate of return (IRR) can lead to the “wrong” decision for “good” projects when projects have conventional cash flows and using IRR can lead to the “wrong” decision for “bad” projects when projects have conventional cash flows

(Fall 2010, quiz 3, question 8)

19. Which of the following assertions is true if we define a “good” project as creating value, a “bad” project as destroying value, the “right” decision as accepting a “good” project or rejecting a “bad” project, and the “wrong” decision as rejecting a “good” project or accepting a “bad” project?

A. Using internal rate of return (IRR) always leads to the “right” decision for “good” projects when projects do not have conventional cash flows and using IRR always leads to the “right” decision for “bad” projects when projects do not have conventional cash flows

B. Using internal rate of return (IRR) always leads to the “right” decision for “good” projects when projects do not have conventional cash flows and using IRR can lead to the “wrong” decision for “bad” projects when projects do not have conventional cash flows

C. Using internal rate of return (IRR) can lead to the “wrong” decision for “good” projects when projects do not have conventional cash flows and using IRR always leads to the “right” decision for “bad” projects when projects do not have conventional cash flows

D. Using internal rate of return (IRR) can lead to the “wrong” decision for “good” projects when projects do not have conventional cash flows and using IRR can lead to the “wrong” decision for “bad” projects when projects do not have conventional cash flows

20. Which of the following assertions is true if we define a “good” project as creating value, a “bad” project as destroying value, the “right” decision as accepting a “good” project or rejecting a “bad” project, and the “wrong” decision as rejecting a “good” project or accepting a “bad” project?

A. Using internal rate of return (IRR) and the IRR rule always leads to the “right” decision when projects have conventional cash flows and using IRR always leads to the “right” decision when projects have non-conventional cash flows

B. Using internal rate of return (IRR) and the IRR rule always leads to the “right” decision when projects have conventional cash flows and using IRR can lead to the “wrong” decision when projects have non-conventional cash flows

C. Using internal rate of return (IRR) and the IRR rule can lead to the “wrong” decision when projects have conventional cash flows and using IRR always leads to the “right” decision when projects have non-conventional cash flows

D. Using internal rate of return (IRR) and the IRR rule can lead to the “wrong” decision when projects have conventional cash flows and using IRR can lead to the “wrong” decision when projects have non-conventional cash flows

(Fall 2013, quiz 3, question 8)

21. Mulberry Incorporated is analyzing a project with conventional cash flows that is expected to last for 3 years.  The cost of capital for the project is 5.8 percent.  The internal rate of return (IRR) of the project is between 7.1 percent and 7.5 percent.  The initial investment today is \$10,000; the expected cash flow in 1 year is \$4,000; the expected cash flow in 2 yearsis \$4,000; and the expected cash flow in 3 years is X.  Which of the following statements is true?

A.  The NPV of the project is a positive number

B.  The NPV of the project is equal to zero

C.  The NPV of the project is negative number

D.  Without knowing the value of X, it is not clear whether the NPV of the project is a positive number, zero, or a negative number

(Spring 2011, quiz 3, question 8)

22. Yumberry Incorporated is analyzing a project with conventional cash flows that is expected to last for 3 years.  The cost of capital for the project is 5.8 percent.  The internal rate of return (IRR) of the project is between 4.1 percent and 4.5 percent.  The initial investment today is \$10,000; the expected cash flow in 1 year is \$4,000; the expected cash flow in 2 years is \$4,000; and the expected cash flow in 3 years is X.  Which of the following statements is true?

A.  The NPV of the project is a positive number

B.  The NPV of the project is equal to zero

C.  The NPV of the project is negative number

D.  Without knowing the value of X, it is not clear whether the NPV of the project is a positive number, zero, or a negative number

23. Which one of the assertions about statement 1 and statement 2 is true?  Statement 1: It is appropriate to use the internal rate of return (IRR) rule to analyze 4 or fewer (in other words, 0, 1, 2, 3, or 4) of the 6 projects described in the table.  Therefore, it is not appropriate to use the IRR rule to analyze 2 or more (in other words, 2, 3, 4, 5, or 6) of the 6 projects described in the table.  Note that this statement is addressing the appropriateness or inappropriateness of using the IRR rule to evaluate projects, where appropriateness refers to whether the IRR rule would always result in the selection of positive NPV projects and rejection of negative NPV projects.  Suggestion: identify which (if any) projects are appropriate for IRR analysis and which (if any) projects are inappropriate for IRR analysis and then count.  Statement 2: The internal rate of return (IRR) of project A is equal to the internal rate of return (IRR) of project B.

 Expected cash flows (number of years from today) Project 0 1 2 3 Cost of capital A -34 13 13 13 6% B -34 13 13 13 9% C -29 3 3 41 4% D 41 19 19 -4 5% E -51 35 35 -12 8% F -64 64 0 0 7%

A. Statement 1 is true and statement 2 is true

B. Statement 1 is true and statement 2 is false

C. Statement 1 is false and statement 2 is true

D. Statement 1 is false and statement 2 is false

(Fall 2012, quiz 3, question 8)

(Fall 2013, final, question 12)

24. The following table presents information on a potential project currently being evaluated by Erie Shipping.  Which assertion about statement 1 and statement 2 is true?

 Expected cash flows (number of years from today) Cost of capital 0 1 2 3 4 -76,000 38,000 29,000 19,000 6,000 13.2%

Statement 1:Erie Shipping would accept the project based on the project’s net present value (NPV) and the NPV rule

Statement 2: Erie Shipping would accept the project based on the project’s payback period and the payback rule if the payback threshold is 2.55 years

A. Statement 1 is true and statement 2 is true

B. Statement 1 is true and statement 2 is false

C. Statement 1 is false and statement 2 is true

D. Statement 1 is false and statement 2 is false

(Spring 2012, final, question 12)

25. The following table presents information on a potential project currently being evaluated by Macklemore Thrift Shops.  Which of the assertions about statement 1 and statement 2 is true?

 Expected cash flows (number of years from today) Cost of capital 0 1 2 3 4 -\$98,000 \$56,000 \$25,000 \$27,000 \$3,000 7.20%

Statement 1: Macklemore Thrift Shops would accept the project based on the project’s internal rate of return (IRR) and the IRR rule

Statement 2: Macklemore Thrift Shops would accept the project based on the project’s payback period and the payback rule if the payback threshold is 2.50 years

A.              Statement 1 is true and statement 2 is true

B.              Statement 1 is true and statement 2 is false

C.              Statement 1 is false and statement 2 is true

D.              Statement 1 is false and statement 2 is false

(Spring 2013, final, question 13)

(Spring 2014, quiz 3, question 9)

26. Dinner JacketInc. is evaluating a project with conventional cash flows that would last for 3 years.  The project would require an initial investment of \$85,000 and produce expected cash flows of \$43,000 in year 1, \$25,000 in year 2, and X in year 3.  The cost of capital for the project is 10.0 percent.  If the project has a payback period of 2.65 years, then what is X, the expected cash flow for this project in year 3?

A. An amount less than \$10,000

B. An amount equal to or greater than \$10,000 but less than \$25,000

C. An amount equal to or greater than \$25,000 but less than \$30,000

D. An amount equal to or greater than \$30,000 but less than \$35,000

E.   An amount equal to or greater than \$35,000

(Fall 2010, quiz 3, question 10)

27. The following table presents information on a potential project currently being evaluated by Book Jacket Corp.  Which one of the assertions about statement 1 and statement 2 is true?

 Expected cash flows (number of years from today) Cost of capital 0 1 2 3 4 -90,000 44,000 50,000 18,000 5,000 10.0%

Statement 1:Book Jacket would accept the project based on the project’s net present value (NPV) and the NPV rule

Statement 2: Book Jacket would accept the project based on the project’s discounted payback period and the discounted payback rule if the discounted payback threshold is 2.50 years

A. Statement 1 is true and statement 2 is true

B. Statement 1 is true and statement 2 is false

C. Statement 1 is false and statement 2 is true

D. Statement 1 is false and statement 2 is false

(Fall 2010, quiz 3, question 9)

28. The following table presents information on a potential project currently being evaluated by Kasual KatInc.Which one of the assertions about statement 1 and statement 2 is true?

 Expected cash flows (number of years from today) Cost of capital 0 1 2 3 4 -95,000 11,160 84,000 34,000 1,000 11.6%

Statement 1: Kasual Kat would accept the project based on the project’s internal rate of return (IRR) and the IRR rule

Statement 2: Kasual Kat would accept the project based on the project’s discounted payback period and the discounted payback rule if the discounted payback threshold is 2.65 years

A. Statement 1 is true and statement 2 is true

B. Statement 1 is true and statement 2 is false

C. Statement 1 is false and statement 2 is true

D. Statement 1 is false and statement 2 is false

E.   None of the above assertions about statement 1 and statement 2 is true

(Fall 2011, quiz 3, question 9)

(Spring 2012, quiz 3, question 9)

29. The following table presents information on a potential project currently being evaluated by Snow Day Amusements Inc.  Which one of the assertions about statement 1 and statement 2 is true?

 Expected cash flows (number of years from today) Cost of capital 0 1 2 3 4 -50,000 33,000 11,000 35,000 9,000 14%

Statement 1: Snow Day Amusements would accept the project based on the project’s payback period and the payback rule if the payback threshold is 2.25 years

Statement 2: Snow Day Amusements would accept the project based on the project’s discounted payback period and the discounted payback rule if the discounted payback threshold is 2.65 years

A. Statement 1 is true and statement 2 is true

B.   Statement 1 is true and statement 2 is false

C.   Statement 1 is false and statement 2 is true

D. Statement 1 is false and statement 2 is false

E.   None of the above assertions about statement 1 and statement 2 is true

(Spring 2011, quiz 3, question 9)

(Fall 2012, quiz 3, question 9)

(Spring 2013, quiz 3, question 9)

(Fall 2013, quiz 3, question 10)

30. Which of the following assertions is true if all payback and discounted payback thresholds are a finite, positive number of years(such as 0.6 years or 3.9 years, but not -4.5 years or infinity), and all projects have conventional cash flows?

A. Projects with negative NPV can sometimes be accepted using the payback rule and projects with negative NPV can sometimes be accepted using the discounted payback rule

B. Projects with negative NPV can sometimes be accepted using the payback rule and projects with negative NPV are never accepted using the discounted payback rule

C. Projects with negative NPV are never accepted using the payback rule and projects with negative NPV can sometimes be accepted using the discounted payback rule

D. Projects with negative NPV are never accepted using the payback rule and projects with negative NPV are never accepted using the discounted payback rule

E.   None of the above assertions is true

(Spring 2010, quiz 4,question 3)

(Spring 2011, final, question 12)

31. Which of the following assertions is true if all payback and discounted payback thresholds are a finite, positive number of years (such as 0.6 years or 3.9 years, but not -4.5 years or infinity), and all projects have conventional cash flows?

A. Projects with positive NPV are never rejected using the payback rule and projects with positive NPV are never rejected using the discounted payback rule

B. Projects with positive NPV are never rejected using the payback rule and projects with positive NPV can sometimes be rejected using the discounted payback rule

C. Projects with positive NPV can sometimes be rejected using the payback rule and projects with positive NPV are never rejected using the discounted payback rule

D. Projects with positive NPV can sometimes be rejected using the payback rule and projects with positive NPV can sometimes be rejected using the discounted payback rule

E.   None of the above assertions is true

(Spring 2014, quiz 3, question 10)

32. Which one of the assertions about statement 1 and statement 2 is true?  Statement 1: Projects with conventional cash flows that have negative NPV are neveraccepted using the payback rule.  Statement 2: It is appropriate to use the internal rate of return (IRR) ruleto analyze 2 or fewer (in other words, 0, 1, or 2) of the 5 projects described in the table.  Therefore, it is not appropriate to use the IRR ruleto analyze 3 or more (in other words, 3, 4, or 5) of the 5 projects described in the table.  Note that this statement is addressing the appropriateness or inappropriateness of using the IRR rule to evaluate projects, where appropriateness refers to whether the IRR rule would always result in the selection of positive NPV projects and rejection of negative NPV projects.Suggestion: identify which (if any) projects are appropriate for IRR analysis and which (if any) projects are inappropriate for IRR analysis and then count.

 Expected cash flows (number of years from today) Project 0 1 2 A -12 3 0 B 12 -3 0 C -12 3 3 D 12 3 15 E -12 3 -15

A. Statement 1 is true and statement 2 is true

B. Statement 1 is true and statement 2 is false

C. Statement 1 is false and statement 2 is true

D. Statement 1 is false and statement 2 is false

(Spring 2012, quiz 3, question 8)

33. The managers of Logical Balance Financial have evaluated five potential projects.  Each project has conventional cash flows.  Based on the information given in this paragraph and presented in the table, which one of the projects is the riskiest?

 Project Cost of capital (in %) Net present value (in \$ millions) Payback period (in years) Discounted payback period (in years) Internal rate of return (in %) A 11.0 0.2 7.6 8.1 11.1 B 7.1 53.3 5.6 8.7 13.5 C 13.2 12.6 2.4 3.2 13.4 D 6.7 8.9 5.8 8.2 14.3 E 9.2 -1.5 2.1 ∞ 8.6

(Fall 2009, final, question 10)

(Spring 2010, final, question 17)

(Fall 2010, final, question 10)

(Fall 2011, quiz 3, question 10)

(Spring 2012, quiz 3, question 10)

34. The managers of Logical Balance Financial have evaluated five potential projects.  Each project has conventional cash flows.  Based on the information given in this paragraph and presented in the table, which one of the projectsis the safest?

 Project Cost of capital (in %) Net present value (in \$ millions) Payback period (in years) Discounted payback period (in years) Internal rate of return (in %) A 11.0 0.2 7.6 8.1 11.1 B 7.1 53.3 5.6 8.7 13.5 C 13.2 12.6 2.4 3.2 13.4 D 6.7 8.9 5.8 8.2 14.3 E 9.2 -1.5 2.1 ∞ 8.6

(Fall 2012, quiz 3, question 10)

(Spring 2013, quiz 3, question 10)

(Spring 2014, final, question 10)