Foundations of Financial Management Canadian 11th Edition Block Test Bank

Foundations of Financial Management
Canadian 11th Edition Block Test Bank

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Chapter 12 - The Capital Budgeting Decision
Chapter 12
The Capital Budgeting Decision
Multiple Choice Questions
1. Which of the following is not a time-adjusted method for ranking investment proposals?
A. Net present value method
B. Payback period
C. Internal rate of return method
D. Profitability index
Accessibility: Keyboard Navigation

Blooms: Remember
Difficulty: Easy
Learning Objective: 12-03 Evaluate investments by the average accounting return; the payback period; the internal rate of return; the net
present value; and the profitability index.
Topic: 12-07 Payback Period
2. In using the internal rate of return method, it is assumed that cash flows can be reinvested
at:
A. the cost of equity.
B. the cost of capital.
C. the internal rate of return.
D. the prevailing interest rate.

Blooms: Remember
Difficulty: Easy
Topic: 12-09 Internal Rate of Return
12-1
3. An investment project has a positive net present value. The internal rate of return is:
A. less than the cost of capital.
B. greater than the cost of capital.
C. equal to the cost of capital.
D. indeterminate; it depends on the length of the project.

Blooms: Remember
Difficulty: Easy
4. Which of the following statements about the "payback period" is true?

A. The payback period considers cash flows after the payback has been reached.
B. The payback period does not consider the time value of money.
C. The payback period uses discounted cash-flow techniques.
D. The payback period generally leads to the same decision as other investment selection
methods.

Blooms: Remember
Difficulty: Medium
5. Cash flow can be said to equal:

A. income before amortization and taxes minus taxes.
B. income before amortization and taxes plus taxes.
C. income before amortization and taxes plus amortization.
D. income after taxes minus amortization.

Blooms: Remember
Difficulty: Easy
Topic: 12-06 Establishing Cash Flows
12-2
6. If projects are mutually exclusive:

A. they can only be accepted under capital rationing.
B. the selection of one alternative precludes the selection of other alternatives.
C. the payback method should be used.
D. the net present-value should be used.

Blooms: Remember
Difficulty: Easy
Learning Objective: 12-04 Appraise the use of the cost of capital as the discount rate in capital budgeting analysis.
Topic: 12-13 Mutually Exclusive Projects
7. The _________ assumes returns are reinvested at the cost of capital.

A. payback period
B. internal rate of return
C. net present value
D. capital rationing

Blooms: Remember
Difficulty: Easy
Topic: 12-08 Net Present Value
8. Capital rationing:
A. is a way of preserving the assets of the firm over the long term.
B. is a less than optimal way to arrive at capital budgeting decisions.
C. assures shareholder wealth maximization.
D. assures maximum potential profitability.

Blooms: Remember
Difficulty: Easy
Topic: 12-17 Capital Rationing
12-3
9. Using higher discount rates,:

A. accelerated amortization is more valuable than straight line amortization.
B. straight-line amortization is more valuable than accelerated amortization.
C. amortization policy makes no difference.
D. later year amortization has a higher net present value.

Blooms: Remember
Difficulty: Medium
Topic: 12-18 Net Present Value Profile
10. Which of the following is not a step in creating the net present value profile?
A. Determining the net present value at a zero discount rate.
B. Determining the net present value at a normal discount rate.
C. Determining the project's internal rate of return.
D. Determining the payback period for the project.

Blooms: Remember
Difficulty: Easy
11. Which statement is true about amortization?

A. Amortization is a cash expense that provides tax shield benefits.
B. The greater the amortization expenses in earlier years, the lower the present value of the
project
C. The CCA amortization schedules supersede other methods for tax purposes
D. The cash inflow from amortization increases profit.

Blooms: Remember
Difficulty: Hard
Topic: 12-20 Capital Cost Allowance
12-4
12. For acceptable investments, the discount rate assumption under the internal rate of return
is generally:
A. higher than under the net present-value method.
B. lower than under the net present-value method.
C. at the cost of capital.
D. below the cost of capital.

Blooms: Remember
Difficulty: Hard
13. As the cost of capital increases:

A. fewer projects are accepted.
B. more projects are accepted.
C. project selection remains unchanged.
D. projects become more profitable.

Blooms: Remember
Difficulty: Medium
Topic: 12-14 Discounting Consideration
14. Firm X is considering the replacement of an old machine with one that has a purchase
price of $70,000. The current market value of the old machine is $25,000 but the book value
is $32,000. What is the net cash outflow for the new machine with consideration for the sale
of the old machine?
A. $70,000
B. $45,000
C. $38,000
D. $32,000

Blooms: Apply
Difficulty: Medium
Learning Objective: 12-06 Perform net present value analysis to assist in the decision-making process concerning long-run investments.
Topic: 12-27 Comprehensive Investment Analysis (NPV)
12-5
15. A firm is selling an old asset below book value in a replacement decision. As the firm's
tax rate is raised, the net cash outflow (purchase price less proceeds from the sale of the old
asset plus CCA effects) would:
A. go up.
B. go down.
C. remain the same.
D. More information required.

Blooms: Apply
Difficulty: Medium
Learning Objective: 12-05 Integrate the cash flows that result from an investment decision; including the aftertax operating benefits and the
tax shield benefits of capital cost allowance (amortization).
Topic: 12-24 Combining CCA with Cash Flow Analysis
16. The net present value profile:

A. doesn't work if projects have a negative net present value.
B. is a substitute for the IRR.
C. graphically portrays the relationship between the discount rate and the net present value.
D. is determined by the cost of debt.

Blooms: Remember
Difficulty: Medium
17. The longer the life of an investment:

A. the more significant the discount rate.
B. the less significant the discount rate.
C. Makes no difference.
D. the easier it is to determine the discount rate.

Blooms: Remember
Difficulty: Easy
12-6
18. The reason cash flow is used in capital budgeting is because:

A. income is used to purchase new machines.
B. cash outlays need to be evaluated in terms of the present value of the resultant cash
inflows.
C. to include the tax shield provided from amortization ignores the cash flow provided by the
machine which should be reinvested to replace old worn out machines.
D. cash includes all accounting accruals.

Blooms: Remember
Difficulty: Easy
Learning Objective: 12-02 Explain that cash flows rather than accounting earnings are evaluated in the capital budgeting decision.
Topic: 12-03 Accounting Flows versus Cash Flows
19. The net present value method is a better method of evaluation than the internal rate of
return method because:
A. the NPV method discounts cash flows at the internal rate of return.
B. the NPV method is a more liberal method of analysis.
C. the NPV method discounts cash flows at the firm's more conservative cost of capital.
D. the NPV method includes accruals and other accounting discounts.

Blooms: Remember
Difficulty: Medium
20. Under the capital cost allowance system:

A. the life span over which an asset may be amortized is fixed at five years.
B. all assets are amortized down to their salvage value.
C. recovery periods for different types of assets are broken down into categories.
D. the tax effect of accounting depreciation is included.

Blooms: Remember
Difficulty: Medium
12-7
21. There are several disadvantages to the payback period, one of which is that:
A. payback ignores the time value of money.
B. payback emphasizes receiving money back as fast as possible for reinvestment.
C. payback is easy to use and to understand.
D. payback can be used in conjunction with time adjusted methods of evaluation.

Blooms: Remember
Difficulty: Medium
22. The payback period has several disadvantages, which include:

A. payback optimizes the most economical solution to a capital budgeting problem.
B. payback includes cash inflows after the payback period.
C. payback fails to choose the optimum or most economical solution to a capital budgeting
problem.
D. payback ignores liquidity concerns.

Blooms: Remember
Difficulty: Medium
23. The Net Present Value Method is a more conservative technique for selecting investment
projects than the Internal Rate of Return method because the NPV method:
A. discounts cash flows at the project's internal rate of return.
B. concentrates on the liquidity aspects of investment projects.
C. discounts cash flows at the firm's weighted average cost of capital.
D. ignores cash flows after the payback period.

Blooms: Remember
Difficulty: Medium
12-8
24. If the capital budgeting decision includes a replacement analysis, then:

A. a gain from the sale of the old asset will represent a tax savings inflow.
B. only incremental cash flows should be considered.
C. the sale price and tax savings will increase the cash inflows throughout the asset's life.
D. only initial cash in-flow should be considered.

Blooms: Understand
Difficulty: Medium
25. The Dammon Corp. has the following investment opportunities:
Machine A Machine B Machine C

($15,000) ($22,500) ($37,500)
Inflows Inflows Inflows
Year 1 $6,000 $12,000 $0
Year 2 9,000 12,000 30,000
Year 3 3,000 10,500 30,000
Year 4 0 10,500 15,000
Year 5 0 0 15,000
Under the payback period and assuming these machines are mutually exclusive, which
machine(s) would Dammon Corp. choose?
A. Machine A
B. Machine B
C. Machine C
D. None of the machines will be accepted.

Blooms: Apply
Difficulty: Medium
12-9
26. The Wet Corp. has an investment project that will reduce expenses by $15,000 per year
for 3 years. The project's cost is $20,000, with a 20% CCA rate. Using a 40% tax rate,
calculate the net operating cash flow at the end of year 1?
A. $-15,000
B. $+11,000
C. $+9,000
D. $+9,800

Blooms: Apply
Difficulty: Medium
27. An investment tax credit (ITC):

A. increases the amortization base for tax purposes.
B. decreases the amortization base for tax purposes.
C. does not affect the amortization base for tax purposes.
D. may increase or decrease the amortization base for tax purposes.

Blooms: Remember
Difficulty: Easy
Topic: 12-23 Investment Tax Credit
28. Assuming that a firm has no capital rationing constraint and that a firm's investment
alternatives are not mutually exclusive, the firm should accept all investment proposals:
A. for which it can obtain financing.
B. that have a positive net present value.
C. that have positive cash flows.
D. that provide returns greater than the after tax cost of debt.

Blooms: Remember
Difficulty: Medium
12-10
29. An equipment replacement decision, under resultant cash flow analysis, requires:
A. calculating the present value of all cash flows associated with the new equipment minus
the salvage value of the old asset.
B. calculating the present value of all changes in cash flows from the old equipment to the
new equipment.
C. subtracting the purchase price of the old equipment from the purchase price of the new
equipment.
D. recalculating the amortization schedule of the old equipment.

Blooms: Remember
Difficulty: Medium
30. For CCA amortization, automobiles and light trucks fit into the:
A. 30% category.
B. 20% category.
C. 10% category.
D. 5% category.

Blooms: Remember
Difficulty: Medium
31. Suppose that interest rates (and, therefore, the firm's Weighted Average Cost of Capital)
increase. This would not change the capital budgeting choices a firm would make if it:
A. uses payback period analysis.
B. uses net present value analysis.
C. uses internal rate of return analysis.
D. uses profitability indexes.

Blooms: Remember
Difficulty: Medium
12-11
32. The investment tax credit:

A. increases the tax bill for the year in which the asset is purchased.
B. has a provision for a cash refund.
C. increases the base upon which CCA is calculated.
D. increases the amount of CCA write-off available each year.

Blooms: Remember
Difficulty: Medium
33. Project A has a $5,000 net present value at a zero discount rate and an internal rate of
return of 12%. Project B has an $8,000 net present value at a 0% discount rate and an IRR of
return of 10%. If the projects are mutually exclusive, which one should be chosen?
A. Project A because it has a higher internal rate of return.
B. Project B if the cost of capital is less than the crossover point.
C. Both projects if the net present value is positive.
D. Neither project meets the investment criteria.

Blooms: Apply
Difficulty: Hard
Topic: 12-12 Selection Strategy
34. An investment tax credit (ITC) of $100 in comparison to CCA expense of $100 provides:
A. the same tax shield benefits.
B. less tax shield benefits.
C. greater tax shield benefits.
D. Cannot determine with the information given.

Blooms: Apply
Difficulty: Easy
12-12
35. An asset just purchased, qualifies for a 20% CCA rate and qualifies for a 5% ITC. If the
asset cost $60,000 what is the amortization base (UCC) in the second year before CCA is
taken?
A. $54,000
B. $51,000
C. $56,000
D. $48,000

Blooms: Apply
Difficulty: Medium
36. Capital budgeting is primarily concerned with:

A. capital formation in the economy.
B. planning future financing needs.
C. evaluating investment alternatives.
D. minimizing the cost of capital.

Blooms: Remember
Difficulty: Easy
Learning Objective: 12-01 Define capital budgeting decisions as long-run investment decisions.
Topic: 12-02 The Notion of Resultant Cash Flows
37. If a firm is experiencing no capital rationing, it should accept all investment proposals:
A. as long as it has available funds.
B. that return an amount equal to or greater than the cost of capital.
C. that return an amount greater than the cost of equity.
D. that are available, regardless of return.

Blooms: Remember
Difficulty: Easy
12-13
38. A characteristic of capital budgeting is:

A. a large amount of money is always involved.
B. the internal rate of return must be less than the cost of capital.
C. the internal rate of return must be greater than the cost of capital.
D. the time horizon is at least five years.

Blooms: Remember
Difficulty: Easy
39. With non-mutually exclusive projects:

A. the payback period will select the best project.
B. the net present value method will always select the best project.
C. the internal rate of return method will always select the best project.
D. the net present value and the internal rate of return methods will always accept or reject the
same project.

Blooms: Remember
Difficulty: Medium
40. If an old asset sells below book value (UCC) and the asset pool ends, from a tax
standpoint:
A. there is a decrease in cash flow.
B. there is an increase in cash flow.
C. there is no effect on cash flow.
D. there is a decrease in net present value.

Blooms: Remember
Difficulty: Medium
12-14
41. At higher tax rates, CCA amortization is:

A. more beneficial.
B. less beneficial.
C. decreased.
D. unaffected.

Blooms: Remember
Difficulty: Easy
42. The first step in the capital budgeting process is:

A. collection of data.
B. idea development.
C. assigning probabilities.
D. determining cash flow.

Blooms: Remember
Difficulty: Easy
Topic: 12-01 Administrative Considerations
43. NPV is superior to average accounting return as a capital budgeting technique because:
A. it employs the accounting definition of income.
B. it values each cash flow equally based on dollar value.
C. it employs the actual cost of an investment.
D. it employs cash flows.

Blooms: Remember
Difficulty: Easy
12-15
44. The profitability index will give the same investment decision as:
A. the payback period.
B. the average accounting return.
C. the net present value.
D. It can be different from each of these techniques.

Blooms: Remember
Difficulty: Medium
Topic: 12-10 Profitability Index
45. A firm may adapt capital rationing because:

A. it is hesitant to use external sources of financing.
B. it wishes to maximize value.
C. it is fearful of too much growth.
D. it has a constraint on the amount of funds

Blooms: Remember
Difficulty: Medium
46. The internal rate of return (IRR) assumes that funds are reinvested at the:
A. cost of capital.
B. yield on the investment.
C. minimal acceptable rate to the firm.
D. yield to maturity.

Blooms: Remember
Difficulty: Hard
12-16
47. The internal rate of return (IRR) and net present value (NPV) methods:
A. always give the same investment decision.
B. never give the same investment decision.
C. usually give the same investment decision.
D. always give a decision different from the payback period method.

Blooms: Remember
Difficulty: Medium
48. Capital rationing assumes that:

A. a limited amount of capital is available.
B. a limited number of investments are available.
C. maximum value creation will be obtained.
D. all projects are acceptable.

Blooms: Understand
Difficulty: Medium
49. The modified internal rate of return (MIRR) assumes:

A. inflows are invested at the traditional interest rate of return.
B. inflows are reinvested at the cost of capital.
C. outflows are funded with debt.
D. outflows are funded with equity.

Blooms: Understand
Difficulty: Medium
Topic: 12-15 Modified Internal Rate of Return
12-17
50. The internal rate of return is:

A. less than the weighted average cost of capital.
B. the discount rate that produces a project net present value of zero.
C. the discount rate that produces a positive project net present value.
D. unrelated to the weighted average cost of capital.

Blooms: Remember
Difficulty: Easy
51. Which of the following statements about the "payback period" is true?
A. The payback period considers cash flows after the payback has been reached.
B. The payback period considers the time value of money.
C. The payback period uses discounted cash-flow techniques.
D. The payback period fails to produce an objective decision to accept or reject an individual
project.

Blooms: Remember
Difficulty: Medium
52. Which statement is true about amortization?

A. Amortization is a cash expense that provides tax shield benefits.
B. The lesser the amortization expenses in earlier years, the higher the present value of the
project.
C. The CCA amortization schedules supersede other methods for tax purposes.
D. Amortization is a cash flow that represents the annual cost of an asset.

Blooms: Remember
Difficulty: Hard
12-18
53. The reason cash flow is used in capital budgeting is because:

A. income rather than cash is used to purchase new machines.
B. cash outlays need not be evaluated in terms of the present value of the resultant cash
inflows.
C. the tax shield provided from amortization ignores the cash flow provided by the machine
which should be reinvested to replace old worn out machines.
D. cash flow includes accounting accruals.

Blooms: Remember
Difficulty: Easy
54. The net present value method is a better method of evaluation than the internal rate of
return method because:
A. the NPV method discounts cash flows at the internal rate of return.
B. the NPV method is a more liberal method of analysis.
C. the NPV method discounts cash flows at higher than the firm's cost of capital.
D. the NPV method allows the financial manager to select between mutually exclusive
projects.

Blooms: Understand
Difficulty: Medium
The Horne Robinson Inc. has the following investment opportunities. Assume the discount
rate the firm uses is 10%:
12-19

($20,000) ($30,000) ($40,000)
Year 1 $10,000 $12,000 $0
Year 2 10,000 12,000 10,000
Year 3 5,000 10,500 30,000
Year 4 2,000 10,500 15,000
Year 5 0 0 15,000
55. Under the payback period and assuming these machines are mutually exclusive, which
machine(s) would Horne Robinson Inc. choose?
A. Machine A
B. Machine B
C. Machine C
D. Machine A and B

Blooms: Apply
Difficulty: Medium
56. Under NPV evaluation and assuming these machines are mutually exclusive, which
machine(s) would Horne Robinson Inc. choose?
A. Machine A
B. Machine B
C. Machine C
D. Machine A and B

Blooms: Apply
Difficulty: Medium
12-20
Using a required rate of return of 12%.
Perpetual Power Machine Co. – Purchase of a New High Machining Tool

Year Cash Flow
Year 1 $500
Year 2 500
Year 3 3,000
Year 4 3,000
Year 5 10,000
57. What is this project's NPV if the initial capital investment is $7,162?
A. $3,399
B. $12,000
C. $8,500
D. $3,000

Blooms: Apply
Difficulty: Medium
58. What is this project's payback period if initial capital investment is $7,500?
A. 3 years 3 months
B. 5 years
C. 9 years
D. 4 years 2 months

Blooms: Apply
Difficulty: Medium
12-21
59. Assume a corporation has earnings before depreciation and taxes of $82,000, depreciation
of $45,000, and that it has a 30 percent tax bracket. What are the after-tax cash flows for the
company?
A. $70,900
B. $82,000
C. $42,000
D. $37,000

Blooms: Apply
Difficulty: Medium
60. Assume a project has earnings before depreciation and taxes of $15,000, depreciation of
$25,000, and that the firm has a 30 percent tax bracket. What are the after-tax cash flows for
the project?
A. $18,000
B. $19,000
C. A loss of $21,000
D. $25,000

Blooms: Apply
Difficulty: Hard
61. Which of the following is not a time-adjusted method for ranking investment proposals?
A. Net present value method
B. Payback method
C. Internal rate of return method
D. Modified internal rate of return

Blooms: Understand
Difficulty: Easy
12-22
62. The "payback method" has the following advantages:

A. easy to understand, emphasis on liquidity, considers all cash flows.
B. easy to understand, emphasis on liquidity, quick view of investment risk.
C. easy to understand, uses the time value of money concept, quick view of investment risk.
D. accepts all projects that may add value to the firm, emphasis on liquidity, quick view of
investment risk.

Blooms: Remember
Difficulty: Easy
63. There are several disadvantages to the payback method, among them:
A. payback ignores the time value of money.
B. payback emphasizes receiving money back as fast as possible for reinvestment.
C. payback is basic to use and to understand.
D. payback can be used in conjunction with time adjusted methods of evaluation.

Blooms: Remember
Difficulty: Medium
64. The payback method has several advantages, among them:

A. payback indicates the optimum or most economical solution to a capital budgeting
problem.
B. payback ignores cash inflows after the payback period.
C. payback is easy to calculate.
D. payback utilizes the time value of money.

Blooms: Remember
Difficulty: Medium
12-23
The Dammon Corp. has the following investment opportunities:

($10,000) ($22,500) ($35,500)
Year 1 $6,000 $12,000 $0
Year 2 3,000 7,500 30,000
Year 3 3,000 1,500 5,000
Year 4 0 1,500 20,000
65. Under the payback method and assuming these machines are mutually exclusive, which
machine(s) would Dammon Corp. choose?
A. Machine A
B. Machine B
C. Machine C
D. Machine A and B

Blooms: Apply
Difficulty: Medium
12-24
66. You buy a new piece of equipment for $7,360, and you receive a cash inflow of $1,000
per year for 10 years. What is the internal rate of return?
A. 5%
B. 6%
C. 7%
D. More than 7%

Blooms: Apply
Difficulty: Medium
67. You require an IRR of 14% to accept a project. If the project will yield $10,000 per year
for 10 years, what is the maximum amount that you would be willing to invest in the project?
A. Less than $50,000
B. More than $50,000 and less than $60,000
C. More than $60,000 and less than $70,000
D. More than $70,000

Blooms: Apply
Difficulty: Medium
68. A long term investment:

A. may use various discount rates.
B. may ignore the discount rate.
C. is easier to determine the discount rate than a short term investment.
D. should use lower discount rates than a short term investment.

Blooms: Remember
Difficulty: Easy
True / False Questions
12-25
69. With a higher CCA rate, the present value of tax savings increases.
TRUE

Blooms: Remember
Difficulty: Easy
70. Under capital rationing, a firm will maximize profitability.

FALSE

Blooms: Remember
Difficulty: Medium
71. The first administrative consideration in any capital budgeting process is collection of
data.
FALSE

Blooms: Remember
Difficulty: Easy
72. We add amortization to net income to arrive at a true profit picture.

FALSE

Blooms: Remember
Difficulty: Medium
12-26
73. It is not unusual for a corporate president, who deals with security analysts, to be as
sensitive to after tax income as cash flow.
TRUE

Blooms: Remember
Difficulty: Medium
74. The payback period is easy to understand and places a heavy emphasis on liquidity.
TRUE

Blooms: Remember
Difficulty: Medium
75. The payback period is not really a theoretically correct approach.

TRUE

Blooms: Remember
Difficulty: Easy
76. With non-mutually exclusive events and no capital rationing, we will usually arrive at the
same conclusions using either the net present value or internal rate of return methods.
TRUE

Blooms: Remember
Difficulty: Medium
12-27
77. The internal rate of return is the average annual rate of return from the investment.
FALSE

Blooms: Remember
Difficulty: Easy
78. Non-mutually exclusive alternatives can be accepted at the same time.

TRUE

Blooms: Remember
Difficulty: Easy
79. It is the difference in the discount rate assumptions that can be significant in determining
when to use the present value or internal rate of return methods.
TRUE

Blooms: Remember
Difficulty: Medium
80. Under the capital cost allowance system of amortization, cash flow tends to decline with
the passage of time.
TRUE

Blooms: Remember
Difficulty: Medium
12-28
81. In a replacement decision, a book loss on an old asset can be a valuable feature.
FALSE

Blooms: Remember
Difficulty: Medium
82. Capital budgeting decisions involve a minimum time horizon of five years.
FALSE

Blooms: Understand
Difficulty: Easy
Topic: 12-02 The Notion of Resultant Cash Flows
83. A good capital budgeting program requires that a number of steps be taken in the decision
making process. The first step is the explanation of data.
FALSE

Blooms: Understand
Difficulty: Medium
84. Possibly the most overlooked part of the capital budgeting process is the search for new
opportunities through innovation and creative thinking.
TRUE

Blooms: Understand
Difficulty: Medium
12-29
85. In most capital budgeting decisions the emphasis is on reported earnings rather than cash
flows.
FALSE

Blooms: Understand
Difficulty: Medium
86. Even though one project may have superior cash flow, management may choose a project
that inflates earnings instead of cash flow.
TRUE

Blooms: Remember
Difficulty: Medium
87. The selection of a mutually exclusive project means that all other projects with a positive
net present value may also be selected.
FALSE

Blooms: Remember
Difficulty: Easy
88. A rapid payback may be important to firms having rapid technological development.
TRUE

Blooms: Remember
Difficulty: Easy
12-30
89. To find the exact internal rate of return for projects with uneven cash flows, we can
interpolate between two present value annuity factors.
FALSE

Blooms: Remember
Difficulty: Easy
90. The net present value profile's advantage over the internal rate of return method is that it
does not require the time consuming trial and error calculations of the IRR.
FALSE

Blooms: Remember
Difficulty: Easy
91. The net present value profile allows a firm to examine the project's net present value over
time.
FALSE

Blooms: Remember
Difficulty: Easy
92. The net present value profile examines the relationship of the discount rate to the net
present value.
TRUE

Blooms: Remember
Difficulty: Easy
12-31
93. The capital cost allowance rate for an asset is identical to the asset's estimated useful life.
FALSE

Blooms: Remember
Difficulty: Easy
94. The net present value profile's weakness is that it does not provide a decision for mutually
exclusive investments.
FALSE

Blooms: Remember
Difficulty: Medium
95. CCA amortization schedules have superseded other amortization methods for tax
purposes.
TRUE

Blooms: Remember
Difficulty: Medium
96. CCA standards have decreased the life span over which an asset may be amortized.
FALSE

Blooms: Understand
Difficulty: Medium
12-32
97. Most real estate property is amortized over a 10 year period.

FALSE

Blooms: Understand
Difficulty: Easy
98. Any asset with a life of 3 years or greater is entitled to a 10% investment tax credit.
FALSE

Blooms: Remember
Difficulty: Easy
99. The investment tax credit, when applicable, changes the amortization base for tax
purposes.
TRUE

Blooms: Remember
Difficulty: Easy
100. The investment tax credit lowers the present value of the inflows from the CCA tax
shield because of a decreased amortization base (UCC).
TRUE

Blooms: Remember
Difficulty: Easy
12-33
101. The cash inflow from the sale of an old asset effectively decreases the cost of the new
asset.
TRUE

Blooms: Understand
Difficulty: Medium
102. A tax loss on the sale of the last asset in a CCA pool used in business or trade may be
written off against ordinary income (even it is a capital loss).
TRUE

Blooms: Remember
Difficulty: Medium
103. Under CCA amortization you must first subtract out salvage value to determine the
amortization base (UCC).
TRUE

Blooms: Remember
Difficulty: Medium
12-34
104. Under CCA amortization, the tax life of an asset and its economically useful life are
assumed to be the same.
FALSE

Blooms: Understand
Difficulty: Medium
105. If an asset is sold for a price above its book value, and it is the last asset in a pool, the
difference is considered taxable income to the firm.
TRUE

Blooms: Remember
Difficulty: Medium
106. An investment tax credit (ITC) is assumed to be earned at the rate of 2% per year up to
10%.
FALSE

Blooms: Understand
Difficulty: Medium
Topic: 12-28 Incremental CCA Tax Savings (Shields)
107. If an asset is sold before its useful life is complete, part of the ITC must be returned to
the Canada Revenue Agency.
FALSE

Blooms: Remember
Difficulty: Easy
12-35
108. The internal rate of return is the interest rate that equates the cash outflows of an
investment with the subsequent inflows.
TRUE

Blooms: Remember
Difficulty: Easy
109. Under the net present value method, cash flows are assumed to be reinvested at the firm's
weighted average cost of capital.
TRUE

Blooms: Remember
Difficulty: Medium
110. For high-IRR investments, it is perfectly acceptable to assume that reinvestment will
occur at an equally high, if not higher, rate.
FALSE

Blooms: Remember
Difficulty: Medium
111. Capital budgeting is only a concern of finance and accounting personnel.

FALSE

Blooms: Remember
Difficulty: Easy
12-36
112. Use of the CCA tax shield formula assumes that the tax shields continue forever as long
as there is at least one asset in it.
TRUE

Blooms: Remember
Difficulty: Medium
Topic: 12-28 Incremental CCA Tax Savings (Shields)
113. The payback method considers all cash flows.

FALSE

Blooms: Remember
Difficulty: Easy
114. A strength of the average accounting return is that it uses accounting numbers in its
calculation.
FALSE

Blooms: Remember
Difficulty: Medium
115. The CCA tax shield formula produces the present value of all changes to a CCA pool.
TRUE

Blooms: Remember
Difficulty: Medium
12-37
116. If an asset is sold for a price above its book value and the asset pool ends, the difference
is considered taxable income for the firm.
TRUE

Blooms: Remember
Difficulty: Medium
117. The modified internal rate of return (MIRR) assumes that inflows are reinvested at 80%
of the internal rate of return.
FALSE

Blooms: Remember
Difficulty: Easy
118. A benefit of many new investments is the increased level of sales that can be obtained,
and it is likely that incremental increases in working capital will result from new investments.
TRUE

Blooms: Remember
Difficulty: Medium
Topic: 12-33 Other Resultant Costs
Short Answer Questions
12-38
119. Explain the Net Present Value (NPV) method of evaluating investment proposals. What
are the advantages of this method in comparison with the other methods discussed in the
text?
The net present value (NPV) of an investment discounts all the cash inflows over the life of
the investment to determine whether they equal or exceed the required investment. If the
present value of the inflows less the initial capital outflow is positive, value is added to the
firm. The basic discount rate is usually the cost of capital to the firm.
NPV is a superior method because it
• Includes all cash flows

• Utilizes time value of money concepts
• Utilizes an objective evaluation tool (the cost of capital)
• Can employ more than one discount rate (unlike the IRR method). The internal rate of return
method, which also incorporates the time value of money in its analysis, is a special case of
the NPV method. For theoretical reasons, the NPV method is preferred to the internal rate of
return method. Additionally, more complex problems can be handled with the NPV method
more easily than with the IRR without technical problems.

Blooms: Remember
Difficulty: Medium
12-39
120. Explain the Internal Rate of Return (IRR) method of evaluating investment proposals.
What are the advantages and disadvantages of this method in comparison with the other
methods discussed in the text?
The internal rate of return (IRR) calls for determining the yield on an investment; that is,
calculating the discount rate that equates the cash outflows (cost) of an investment with the
subsequent cash inflows. It is that discount rate that produces an NPV of zero.
The IRR method, like the NPV method
• Includes all cash flows

• Utilizes time value of money concepts
• Utilizes an objective evaluation tool (usually the cost of capital)
However, it is not as effective a method as the NPV, because
• Cumbersome trial-and-error or interpolation is required (automatically done with a financial

calculator).
• It may inappropriately suggest an incorrect decision between mutually exclusive projects.
• Multiple discount rates can result causing confusion.
• Unlike the NPV, more than one discount rate for different time periods cannot be utilized.

Blooms: Remember
Difficulty: Medium
121. Explain the Profitability Index (PI) method of evaluating investment proposals.
The profitability index is the ratio of cash inflows to cash outflows in present value terms. It is
an alternative presentation of the net present value method and is used to place returns from
different size investments onto a common measuring standard. The PI is a variation of the
NPV method.

Blooms: Remember
Difficulty: Easy
12-40
122. The Net Present Value (NPI) method of evaluating investment proposals is superior to
the other methods discussed in the text. Do you agree or disagree with this statement?
Explain.
The net present value, internal rate of return, and profitability index methods must have the
profitability based on the time value of money equal or exceed the cost of capital for the
project to be potentially acceptable. If profitability in these methods exceeds the cost of the
investment, value will be added to the firm. These methods are similar and generally lead to
the same decision. The profitability index is a variation of the NPV method. The IRR and
NPV methods are clearly superior to the payback period and the average accounting return
(AAR) methods, because they evaluate all the resultant cash flows from an investment
decision and employ the time value of money. Furthermore, the acceptance of an investment
when using the IRR and NPV methods is determined by the cost of capital. This is an
objective criterion determined in the financial markets. The payback period and AAR
methods fail to produce such an objective yardstick upon which to accept or reject an
individual project. However, the IRR method does have some flaws when compared to the
NPV method that may produce unclear results. These flaws include mutually exclusive
projects, discounting considerations, and multiple internal rates. These reasons are why the
NPV is a better methodology. The NPV method can also handle more complex problems that
require more than one discount rate. The nature of the IRR method is that there can be only
one discount rate.

Blooms: Understand
Difficulty: Hard
12-41
123. List the 5 steps in the decision making process of a good capital budgeting program.
A good capital budgeting program requires that a number of steps be taken in the decision
making process.
1. Search and discovery of investment opportunities

2. Collection of data
3. Evaluation of alternatives and decision making
4. Plan implementation
5. Ongoing reevaluation and adjustment

Blooms: Remember
Difficulty: Easy
124. List the 5 methods for evaluating cash flows as described in the text.
Five methods for evaluating capital expenditures are:
1. Average accounting return (AAR)

2. Payback period
3. Net present value (NPV)
4. Internal rate of return (IRR)
5. Profitability index (PI)

Blooms: Remember
Difficulty: Easy
12-42
125. The average accounting return (AAR) is fairly easy to calculate and makes use of
information readily prepared by the accounting conventions. Why is the AAR method for
evaluating investments flawed?
Firms frequently calculate the AAR, but it has serious flaws.
• Asset value comes from the amount and timing of cash flows. AAR does not take this into
consideration.
• Accounting earnings, not cash flows are used.
• All earnings are given equal treatment. (Equivalent cash flows in different years receive the
same value. This is not correct based on the time value of money.)
• Book values establish the value of the investment, not market values.
• No objective evaluation yardstick is suggested, such as the cost of capital used by the NPV
and IRR methods.

Blooms: Understand
Difficulty: Medium
12-43
126. Explain the payback period method for evaluating capital expenditures. What are the
disadvantages and advantages of this method?
The payback period method computes the time required to recoup the initial investment.
In using the payback period to select an investment, four important considerations are
ignored.
1. There is no consideration of the amount of cash flow generated after the initial investment
is recaptured.
2. The method fails to consider the time value of money. If we had two possible $10,000
investments with different timeline inflow patterns, the payback period would rank them
equally.
3. The payback period method fails to definitively discern the optimum or most economical
solution to a capital budgeting problem.
4. The payback period method may fail to accept projects that can add substantial value to the
firm.
The payback period has some features that help to explain its use by corporate management:
1. Easy to understand.
2. Heavy emphasis on liquidity (e.g., recoup initial investment quickly (3 to 5 years), or it will
not qualify).
3. Provides an initial view of an investment's risk
A rapid payback may be particularly important to firms in industries characterized by rapid

technological developments or other sources of uncertainty. Given that some decisions may
be justifiable only on the basis of cash flow estimates far in the future (and therefore relatively
more uncertain), managers often opt for the decisions with the more predictable cash flow
estimates.

Blooms: Analyze
Difficulty: Hard
12-44
127. The law firm of Bushmaster, Cobra and Asp is considering investing in a complete small
business computer system. The initial investment will be $35,000 and the hardware, which
will be used for 10 years with a salvage value of $5,000, and software of $20,000. In each of
years 3, 5, and 7, $5,000 will be spent for additional software. Hardware has a CCR rate 45
percent and software is class 12 (100 percent).
The computer system is expected to provide additional revenue of $15,000 per year for the
next 10 years, and to reduce expenses by $10,000 per year for the same period.
The firm's cost of capital is 12 percent and its tax rate is 40 percent. Based on a net present
value analysis, should this investment be accepted?
Time Event Cash flow After tax cash Present value

flow
0 Purchase hardware ($35,000) - ($35,000)
0 Purchase software (20,000) - (20,000)
1-10 Cash flow 25,000 15,000 84,753
10 Salvage 5,000 - 1,610
-- PV (CCA) hardware - - 9,979
-- PV (CCA) software - - 9,687
Net present value $42,671
12-45
PV (CCA) (Hardware)
PV (CCA) (Software)
Based on these calculations the investment should be made. However, one has to question the
assumed 10-year life of the technology.
Blooms: Analyze
Difficulty: Medium
128. Tabletop Ranches, Inc. is considering the purchase of a new helicopter for $325,000. The
firm's old helicopter has a book value of $85,000, but can only be sold for $60,000.
The new helicopter will be subject to 25% CCA. It is expected to save $62,000 for 7 years
after taxes through reduced fuel and maintenance expenses. Tabletop Ranch is in the 40% tax
bracket and has a 12% cost of capital.
Calculate the net present value of the helicopter purchase and state whether or not the firm
should buy it.

flow
0 Purchase helicopter ($325,000) - ($325,000)
0 Sell old helicopter 60,000 - 60,000
1-7 Annual savings 62,000 37,200 169,772
-- PV (CCA) tax shield - - 67,785
Net present value ($27,443)
12-46
PV (CCA) (Helicopter)
Decision: NPV is negative. Do not purchase the new helicopter.
Blooms: Analyze
Difficulty: Hard
129. The Taylor Corporation is using a machine that originally cost $66,000. The machine has
a book value of $66,000 and a current market value of $40,000. The asset is in the Class 8
CCA pool. It will have no salvage value after 5 years and the company tax rate is 40%.
Jacqueline Elliott, the Chief Financial Officer of Taylor, is considering replacing this machine
with a newer model costing $70,000. The new machine will cut operating costs by $10,000
each year for the next five years. Taylor's cost of capital is 8%.
Should the firm replace the asset? (Use NPV methodology to solve this problem.)

flow
0 Purchase machine ($70,000) - ($70,000)
0 Sell old machine 40,000 - 40,000
1-5 Annual savings 10,000 6,000 23,956
-- PV (CCA) tax shield - - 8,229
12-47
PV (CCA) (Machine)
Decision: NPV is positive, purchase the new machine.

Blooms: Analyze
Difficulty: Hard
130. A&B Enterprises is trying to select the best investment from among four alternatives.
Each alternative involves an initial outlay of $100,000. Their cash flows follow:
Year A B C D
1 $10,000 $50,000 $25,000 $0
2 20,000 40,000 25,000 0
3 30,000 30,000 25,000 45,000
4 40,000 0 25,000 55,000
5 50,000 0 5,000 60,000
Evaluate and rank each alternative based on a) payback period, b) net present value (use a
10% discount rate), and c) internal rate of return.
A) Payback period
12-48
Year A B C D
$100,000 $100,000 $100,000 $100,000
1 10,000 50,000 25,000 0
90,000 50,000 75,000 100,000
2 20,000 40,000 25,000 0
70,000 10,000 50,000 100,000
3 30,000 25,000 45,000
40,000 0 25,000 55,000
4 40,000 25,000 55,000
0 0 0
Payback 4 years 2 1/3 years 4 years 4 years
Based on payback period, our choice is B.

B) Net present value (NPV)
PV of Inflows @ 10%
Year A B C D
1 $9,091 $45,455 $22,727 $0
2 16,520 33,038 20,661 0
3 22,539 22,539 18,783 33,809
4 27,321 0 17,075 37,567
5 31,046 0 15,523 37,255
PV 106,526 101,052 94,769 108,631
Less than $6,526 $1,052 $(5,231) $8,631
100,000
12-49
Based on net present value analysis, our first choice is D, followed by A, then B. We would
not select alternative C.
C) Internal rate of return (IRR)
Alternative A:
Year Try 12% PV Try 13% PV

1 $8,929 $8,850
2 15,944 15,663
3 21,353 20,792
4 25,421 24,533
5 28,371 27,138
$100,018 $96,796
Interpolate:
@ 12% = $100,018
@ IRR = 100,000 18
@ 13% = 96,796 3,042
IRR = 12% + [$18/$3,042  1%] = 12.01%
Alternative B is already very close @ 10%
12-50
Year Try 11% PV Interpolate:

1 $45,045 @ 10% = $101,052
2 32,465 @ IRR = 100,000 1,052
3 21,936 @ 11% = 99,446 1,606
$99,446
IRR = 10% + [$1,052/$1,606  1%] = 10.66%
Alternative C is an annuity. (May use Appendix D)
@ 7% = $102,505
@ IRR = 100,000 2,505
@ 8% = 99,818 2,687
IRR = 7% + [$2,505/$2,687  1%] = 7.93%
Alternative D
Year Try 12% PV Try 13% PV

3 $32,031 $31,187
4 34,953 33,733
5 34,056 32,566
$101,040 $97,486
12-51
@ 12% = $101,040
@ IRR = 100,000 1,040
@ 13% = 97,486
IRR = 12% + [$1,040/$3,554  1%] = 12.29%

Choose D, then A, then B. Choose C only if required rate of return is below 7.9%.

Blooms: Analyze
Difficulty: Hard
131. Creative Impulse has done development work on an exciting new product, Yuppo. To
date, it has spent $1,000,000 on research and development and is wondering whether or not to
continue the development and eventual production of Yuppo. The work to date has no value
except to Creative Impulse for the further development and production of the product.
It is expected that another $400,000 will be incurred in development work over the next year
at which time it will be capitalized along with the equipment that will be purchased (one year
from today) to produce the new product. The cost of the equipment is estimated at
$1,000,000.
Creative Impulse will house the equipment and new production process in an unused
warehouse. The unused warehouse could have been rented out at $100,000 per year, but the
company had elected to keep it unoccupied until now.
Cash flow before taxes and CCA is estimated at $500,000 per year over the ten years of
Yuppo's product life. Working capital requirements necessitated by this new product line will
increase by $75,000. Potential salvage value of the Yuppo equipment is $100,000 eleven
years from today.
CCA rate: 40%

Tax rate: 39%
Cost of capital: 15%
12-52
Should Creative Impulse continue the development and production of Yuppo?

flow
0- - -
1 Development work ($400,000) - ($347,826)
1 Equipment (1,000,000) - (869,565)
1 Working capital (75,000) - (65,217)
2-11 Cash flow 500,000 305,000 1,331,064
2-11 Opportunity cost: rent (100,000) (61,000) (266,213)
11 Recovery: working capital 75,000 - 16,121
11 Salvage 100,000 - 21,494
-- PV (CCA) tax savings - - 317,078
PV (CCA) (Yuppo)
Decision: NPV is positive, proceed with the development.

Note: that the two annuities must be present valued another year to bring them to time zero.
Blooms: Analyze
Difficulty: Hard
12-53

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Multiple Choice Questions

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4. Which of the following statements about the "payback period" is true?

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5. Cash flow can be said to equal:

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6. If projects are mutually exclusive:

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7. The _________ assumes returns are reinvested at the cost of capital.

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9. Using higher discount rates,:

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11. Which statement is true about amortization?

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13. As the cost of capital increases:

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16. The net present value profile:

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17. The longer the life of an investment:

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18. The reason cash flow is used in capital budgeting is because:

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20. Under the capital cost allowance system:

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22. The payback period has several disadvantages, which include:

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24. If the capital budgeting decision includes a replacement analysis, then:

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25. The Dammon Corp. has the following investment opportunities:

Machine A Machine B Machine C

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27. An investment tax credit (ITC):

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32. The investment tax credit:

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36. Capital budgeting is primarily concerned with:

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