## Introduction to Corporate Finance What Companies Do, 3rd Edition by John Graham – Test Bank

Chapter 8—Capital Budgeting Process and Decision Criteria

MULTIPLE CHOICE

1. The capital budgeting process involves

a. identifying potential investments and estimating the incremental cash inflows and outflows of cash associated with each investment

b. analyzing and prioritizing the investments utilizing various decision criteria

c. implementing and monitoring the selected investment projects

d. estimating a fair rate of return on each investment given its risk

e. all of the above

ANS: E PTS: 1 DIF: E

REF: 8.1 Introduction to Capital Budgeting NAT: Reflective thinking

LOC: acquire knowledge of capital budgeting and the cost of capital

2. The preferred technique for evaluating most capital investments is

a. payback period

b. discount payback period

c. internal rate of return

d. net present value

ANS: D PTS: 1 DIF: E

REF: 8.1 Introduction to Capital Budgeting NAT: Reflective thinking

LOC: acquire knowledge of capital budgeting and the cost of capital

NARRBEGIN: Gamma Electronics

Gamma Electronics

Gamma Electronics is considering the purchase of testing equipment that will cost $500,000 to replace old equipment. Assume the new machine will generate after-tax savings of $250,000 per year over the next four years.

NARREND

3. Refer to Gamma Electronics. What’s the payback period for the investment?

a. 1.8 years

b. 2.0 years

c. 2.5 years

d. 2.8 years

ANS: B

The investment requires $500,000. In its first two years, this investment generates $500,000.

PTS: 1 DIF: E REF: 8.2 Payback Methods

NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

4. Refer to Gamma Electronics. If the firm has a 15% cost of capital, what’s the discount payback period of the investment?

a. 1.5 years

b. 2.0 years

c. 2.4 years

d. 2.6 years

ANS: D

Present value

PV of Year 1 = 250,000/1.15 = 217,391

PV of Year 2 = 250,000/1.152 = 189,036

PV of Year 3 = 250,000/1.153 = 164,379

By the end of year 3, the project produces a cumulative cash flow that’s greater than $500,000. Thus the project earns back the initial $500,000 at some point during the third year.

(500,000 – 217,391 – 189,036)/164,379 = 93,573/164,379 = 0.569

The discount payback period is 2.6 years.

PTS: 1 DIF: M REF: 8.2 Payback Methods

NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

5. If Gamma Electronics has a 15% cost of capital, what’s the NPV of the investment?

a. $213,745

b. $185,865

c. $713,745

d. $500,000

ANS: A

NPV = -500,000 + 250,000/1.15 + 250,000/1.152 + 250,000/1.153 + 250,000/1.154 = 213,745

PTS: 1 DIF: E REF: 8.4 Net Present Value

NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

6. If Gamma Electronics has a 15% cost of capital, what’s the IRR of the investment?

a. 23.4%

b. 15.0%

c. 34.9%

d. 100.0%

ANS: C

Let r represent the IRR of the investment.

-500,000 + 250,000/(1+r) + 250,000/(1+r)2 + 250,000/(1+r)3 + 250,000/(1+r)4 = 0

r = 34.9%

PTS: 1 DIF: E REF: 8.5 Internal Rate of Return

NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

7. If Gamma Electronics has a 15% cost of capital, what’s the profitability index of the investment?

a. 1.4

b. 0.4

c. 2.0

d. 1.0

ANS: A

(250,000/1.15 + 250,000/1.152 + 250,000/1.153 + 250,000/1.154 )/500,000 = 713,745/500,000 = 1.4

PTS: 1 DIF: E REF: 8.6 Profitability Index

NAT: Analytic skills

LOC: acquire knowledge of capital budgeting and the cost of capital

NARRBEGIN: Exhibit 8-1 Invst Csh Prj

Exhibit 8-1

The cash flows associated with an investment project are as follows:

Cash Flows

Initial Outflow -$70,000

Year 1 $20,000

Year 2 $30,000

Year 3 $30,000

Year 4 $30,000

NARREND

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