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Chapter 11: Capital Budgeting Decisions

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Chapter 11: Capital Budgeting Decisions

20 problems · 0 figures

Multiple Choice 11.1 §11.1 source ↗

Capital investment decisions often involve all of the following except ________.
  1. a.
    qualitative factors or considerations
  2. b.
    short periods of time
  3. c.
    large amounts of money
  4. d.
    risk

Answer

B. short periods of time

Multiple Choice 11.3 §11.1 source ↗

The third step for making a capital investment decision is to establish baseline criteria for alternatives. Which of the following would not be an acceptable baseline criterion?
  1. a.
    payback method
  2. b.
    accounting rate of return
  3. c.
    internal rate of return
  4. d.
    inventory turnover

Answer

D. inventory turnover

Multiple Choice 11.5 §11.3 source ↗

If you are saving the same amount each month in order to buy a new sports car when the new models are released, which of the following will help you determine the savings needed?
  1. a.
    future value of one dollar
  2. b.
    present value of one dollar
  3. c.
    future value of an ordinary annuity
  4. d.
    present value of an ordinary annuity

Answer

C. future value of an ordinary annuity

Multiple Choice 11.7 §11.3 source ↗

Using the information provided, what transaction represents the best application of the present value of an annuity due of $1?
  1. a.
    Falcon Products leases an office building for 8 years with annual lease payments of $100,000 to be made at the beginning of each year.
  2. b.
    Compass, Inc., signs a note of $32,000, which requires the company to pay back the principal plus interest in four years.
  3. c.
    Bahwat Company plans to deposit a lump sum of $100,000 for the construction of a solar farm in 4 years.
  4. d.
    NYC Industries leases a car for 4 yearly annual lease payments of $12,000, where payments are made at the end of each year.

Answer

A. Falcon Products leases an office building for 8 years with annual lease payments of $100,000 to be made at the beginning of each year.

Multiple Choice 11.9 §11.3 source ↗

The process that determines the present value of a single payment or stream of payments to be received is ________.
  1. a.
    compounding
  2. b.
    discounting
  3. c.
    annuity
  4. d.
    lump-sum

Answer

B. discounting

Multiple Choice 11.11 §11.4 source ↗

The NPV method assumes that cash inflows associated with a particular investment occur when?
  1. a.
    only at the time of the initial investment
  2. b.
    only at the end of the year
  3. c.
    only at the beginning of the year
  4. d.
    at any of these times

Answer

D. at any of these times

Multiple Choice 11.13 §11.4 source ↗

Which of the following discounts future cash flows to their present value at the expected rate of return, and compares that to the initial investment?
  1. a.
    internal rate of return (IRR) method
  2. b.
    net present value (NPV)
  3. c.
    discounted cash flow model
  4. d.
    future value method

Answer

B. net present value (NPV)

Multiple Choice 11.15 §11.5 source ↗

The IRR method assumes that cash flows are reinvested at ________.
  1. a.
    the internal rate of return
  2. b.
    the company’s discount rate
  3. c.
    the lower of the company’s discount rate or internal rate of return
  4. d.
    an average of the internal rate of return and the discount rate

Answer

A. the internal rate of return

Question 11.1 §11.1 source ↗

What are the steps involved in the process for capital decision-making?

Answer

The process for capital decision-making involves five steps: 1. Determine capital needs. 2. Explore resource limitations. 3. Establish baseline criteria for alternatives. 4. Evaluate alternatives using screening and preference decisions. 5. Make the decision.

Question 11.3 §11.1 source ↗

What is the next thing a company needs to do after it establishes investment criteria?

Answer

The company then needs to establish alternatives, which are options available for investment, and evaluate the options using common measurement methods, including the payback method, accounting rate of return, net present value, and internal rate of return.

Question 11.5 §11.1 source ↗

Your supervisor is on the company’s capital investment decision team that is to decide on alternatives for the acquisition of a new computer system for the company. The supervisor says, “The book value of the existing computer system for the firm that we are considering replacing is nothing but an accounting amount and as such is irrelevant in the capital expenditure analysis.” Does this reasoning make sense? Why or why not?

Answer

From the standpoint of the decision to replace the asset, the book value of an existing asset is irrelevant. Book value is just the historical cost (or value) of the asset less the total depreciation calculated to date. A gain or loss situation often happens when the asset is sold for more or less than its book value, respectively. It is only at that point that the company truly realizes whether they have extra value or not enough value in the assets. This difference can provide either a gain or a loss to the company that will impact the taxes at year-end. Therefore, gains or losses affecting tax payments, plus cash flows, are important, since cash-flow effects are relevant in capital investment decisions.

Question 11.7 §11.2 source ↗

What is the payback method used to determine?

Answer

It is used to determine the length of time needed for a long-term project to recapture or pay back the initial investment in the project.

Question 11.9 §11.2 source ↗

What are one advantage and one disadvantage of the accounting rate of return method?

Answer

Advantage: The ARR compares income to the initial investment rather than to cash flows; thus, incremental revenues, cost savings, and incremental expenses associated with the investment are reviewed and provide a more complete picture than payback, which uses cash flows. Disadvantage: ARR is limited in that it does not consider the value of a dollar over time.

Question 11.11 §11.2 source ↗

What is the equation to calculate the accounting rate of return?

Answer

Accounting Rate of Return = (Incremental revenues – Incremental expenses) ÷ Initial Investment

Question 11.13 §11.3 source ↗

Why do businesses consider time value of money before making an investment decision?

Answer

They need to know what the future value is of their investment compared to today’s present value, and what potential earnings they could see because of delayed payment.

Question 11.15 §11.3 source ↗

To calculate present value of a lump sum, which table would be used?

Answer

The Present Value of $1 table.

Question 11.17 §11.4 source ↗

What is the difference between the discount rate used for net present value and the internal rate of return methods?

Answer

For NPV computations, a minimum required rate of return or discount rate is used as a screening tool to determine whether or not a capital investment decision meets a predetermined set of criteria. If the net present value of an investment is positive, then the capital investment generates an actual return greater than the discount rate and the project will be deemed acceptable. The discount rate, however, is not the actual rate of return earned by the project.
The internal rate of return determines the actual rate of return that a project earns.

Question 11.19 §11.4 source ↗

What is the basic benefit of using IRR?

Answer

The internal rate of return (IRR) shows the profitability or growth potential of an investment. All external factors are removed from calculation, such as inflation concerns, and the project with the highest return rate percentage is considered for investment. A company may have several viable alternatives that need a differentiating factor. IRR gives a solid differentiation, presented as a percentage rather than a dollar figure, as seen in NPV. This removes bias from projects with dissimilar NPVs and is a way to compare more than one option.

Question 11.21 §11.5 source ↗

A fellow student studying managerial accounting says, “The net present value (NPV) weighs early receipts of cash much more heavily than more distant receipts of cash.” Do you agree or disagree? Why?

Answer

Answers will vary but should include something like the following: the NPV weighs the early receipt of cash more heavily because when the receipts come in earlier, the discount is closer to 100%; however, the interest rate also impact the NPV.

Question 11.23 §11.5 source ↗

What are the strengths and weaknesses of IRR?

Answer

Strengths: It considers the time value of money, removes the dollar bias, and allows for a company to make a decision, unlike non-time value methods. Weaknesses: It has a bias toward return rates instead of higher risk investment consideration, uses a more difficult calculation, and does not consider the time it will take to recoup an investment.

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Problems and answers are adapted from Principles of Accounting, Volume 2: Managerial Accounting by Mitchell Franklin, Patty Graybeal and Dixon Cooper, OpenStax, and are used under the CC BY-NC-SA 4.0 licence. Access for free at https://openstax.org/books/principles-managerial-accounting/pages/1-why-it-matters. Illustrations: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license. This adaptation is released under the same licence, is non-commercial, and is neither affiliated with nor endorsed by OpenStax or Rice University.