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Unformatted text preview: Chapter 8Capital Budgeting Process and Techniques MULTIPLE CHOICE 1. The capital budgeting process involves a. identifying potential investments b. analyzing the set of investment opportunities, and identifying those that will create shareholder value c. implementing and monitoring the selected investment projects d. all of the above ANS: D DIF: E REF: Introduction 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 DIF: E REF: 8.1 Introduction to Capital Budgeting 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 aftertax savings of $250,000 per year over the next four years. NARREND 3. Refer to Gamma Electronics. Whats 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. DIF: E REF: 8.3 Payback Methods NAR: Gamma Electronics 4. Refer to Gamma Electronics. If the firm has a 15% cost of capital, whats 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 = 250,000/1.15 2 = 189,036 PV of Year 3 = 250,000/1.15 3 = 164,379 By the end of year 3, the project produces a cumulative cash flow thats 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. DIF: M REF: 8.3 Payback Methods NAR: Gamma Electronics 5. If Gamma Electronics has a 15% cost of capital, whats 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 + 250,000/1.15 2 + 250,000/1.15 3 + 250,000/1.15 4 = 213,745 DIF: E REF: 8.4 Net Present Value NAR: Gamma Electronics 6. If Gamma Electronics has a 15% cost of capital, whats 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% DIF: E REF: 8.5 Internal Rate of Return NAR: Gamma Electronics 7. If Gamma Electronics has a 15% cost of capital, whats the profitability index of the investment? a. 1.4 b. 0.4 c. 2.0 d. 1.0 ANS: A (250,000/1.15 + 250,000/1.15 2 + 250,000/1.15 3 + 250,000/1.15 4 )/500,000 = 713,745/500,000 = 1.4 DIF: E REF: 8.6 Profitability IndexNAR: Gamma Electronics NARRBEGIN: Exhibit 81 Invst Csh Prj Exhibit 81 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 8. Refer to Exhibit 81. Whats the payback period of the project? If a firms cutoff payback period is 3 Refer to Exhibit 81....
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 Fall '10
 LOVELL
 Finance

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