Capital Investments

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Things You Must Know

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Self Test

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Easy Practice Test

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Self Test

Click the “Check Your Answer” box below each question to reveal the correct answer and explanation.

1.The process of determining the present value of future cash flows is called

a. compounding
b. budgeting
c. discounting
d. planning

Answer
 C .Discounting future cash flows is the process of determining the present value of future cash flows.

2.The present value of $1 that will be received 2 years from now is

a.greater than $1
b.less than $1
c.same $1
d.can’t determine without the discount rate

Answer
B. Cash received at a later date is worth less than cash received now because of the interest that can be earned if you have the cash now.

3.Which of the following capital investments would have the greatest present value?

a.annual cash inflows of $25,000 at the end of the next 4 years
b.annual cash inflows of $50,000 at the end of the next 2 years
c.annual cash inflows of $100,000 at the end of the first year
d.annual cash inflows of $20,000 at the end of the first 5 years

Answer
C. The cash flows with the highest amount received earlier has the greatest present value.This is true because the sooner you have the cash the sooner you can earn on the cash.Receiving all $100,000 up front gives a higher present value than getting it in pieces in later years.

4.When using the net present value method you will always

a.multiply the cash flow by the cost of capital
b.divide the cash flow by the cost of capital
c.multiply the cash flow by the present value factor
d.divide the cash flow by the present value factor

Answer
 C. You will determine the cash flows first when calculating net present value.Once cash flows are established they are multiplied by the present value factor for the associated length of time and discount rate to get net present value.Cost of capital is the same term as discount rate and they are used to get the table factor used.

5.The formula used to compute payback period is

a.investment divided by annual revenues
b.investment divided by annual expenses
c.investment divided by annual net cash flows
d.investment divided by annual interest rate

Answer
  C. The payback period is the amount of time it takes to recover the cash related to the investment.The formula is:investment / annual net cash flows

6.The formula used to compute the factor used to determine internal rate of return is

a.investment divided by annual revenues
b.investment divided by annual expenses
c.investment divided by annual net cash flows
d.investment divided by annual interest rate

Answer
C. The formula used to determine internal rate of return gives a present value factor that is used in the present value factor tables to determine the rate.The same formula that is used for payback period is used for internal rate of return, however, the answer is used differently.

7.The formula used to compute the accounting rate of return is

a.investment divided by annual revenues
b.annual net income divided by investment
c.annual expenses divided by investment
d.investment divided by annual interest rate

Answer
  B. The formula is:annual net cash flows less annual depreciation expense divided by the investment.Net cash flows less depreciation is a representation of annual net income.Using just annual expenses leaves out cash inflows and revenues.

8.Making a decision relative to the purchase of a long term asset is

a. a cash budgeting decision
b. a capital budgeting/investment decision
c. a decision that involves inventory
d. a short term decision

Answer
  B. Long term assets are capital assets and they involve capital investing decisions.Cash budgets are typically done for the period of one year or less.Inventory and short term decisions are not long term.

9.The time it takes to get a return of the original investment is called

a.interest expense
b.net present value
c.the discount
d.payback period

Answer
  D. This is the technical definition of payback period.

10. Which method uses operating income?

a.internal rate of return
b.net present value
c.accounting rate of return
d.payback

Answer
 C. Internal rate of return, net present value, and payback methods use only cash inflows and outflows.The accounting rate of return considers all cash inflows and outflows and depreciation expense which is a representation of operating income.

11.An asset that has a net present value of 0 when the discount rate is 10% also has

a.an internal rate of return of less than 10%
b.an internal rate of return of more than 10%
c.an accounting rate of return of 10%
d.an internal rate of return of 10%

Answer
 D. A net present value of 0 means that the investment will give an internal rate of return that is equal to the discount rate.The internal rate of return is equal to the discount rate of 10%.

12.When the internal rate of return is equal to the discount rate, net present value will be

a. equal to the cost of capital
b. equal to 0
c. less than the cost of capital
d. greater than 0

Answer
 B. A net present value of 0 means that the investment will give a return that is equal to the discount rate.The return that the investment gives is called the internal rate of return.Net present value is not a percentage.

13.Cost of capital is

a.the amount of cash paid for long term assets
b.the cost the company incurs to finance long term assets
c.the cash paid for dividends to shareholders
d.the same thing as net present value

Answer
 B. Cost of capital is the weighted average interest rate the company normally pays to finance long term assets.It is an interest rate and not the amount of cash paid.Net present value is calculated using a cost of capital.Net present value is not an interest rate.

14.Which of the following describes the items that are discounted when the net present value method is used?

a.all incremental revenues and expenses
b.all revenues and expenses occurring in the first year
c.net cash flows related to the investment
d.only costs that incur during the first year

Answer
 C. The net present value method discounts all cash inflows and all cash outflows for the life of the investment only.Revenues and expenses that are non cash are not considered (except depreciation is considered a tax shield when tax is considered)

15.Which statement below reflects how depreciation expense is considered in a capital budget decision?

a.depreciation is never considered
b.depreciation is always considered
c.depreciation is considered only when income taxes are considered
d.depreciation is considered only as a cash outflow

Answer
C. Depreciation is considered as a tax shield, a cash inflow for the tax savings, when income taxes are considered in the decision.When taxes are ignored, depreciation is ignored because it is not a cash flow.