Easy Practice Test

Capital Investments

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

1. When the internal rate of return is used for the discount rate the net present value will be

a. positive
b. negative
c. zero
d. not enough information to determine

Answer

C. A net present value of zero means that the internal rate of return is equal to the discount rate that is used to determine the net present value.

2. The method of capital budgeting that uses time value of money to discount cash flows using a required rate of return is

a. payback method
b. net present value
c. net master budget
d. net cash flow

Answer

B. The net present value method discounts all cash flows to determine the present value of all future cash flows given a required rate of return. The payback method ignores the time value of money and so does net cash flow. Capital investments become part of the master budget.

3. The net present value of an investment is

a. present value of cash inflows less present value of cash outflows
b. total cash flows less the present value of cash out flows
c. total cash flows in less the cost of the asset invested in
d. what the investment will be worth in the future

Answer

A. The net present value method discounts net cash flows to the present value. It considers all cash inflows and all cash outflows. It computes the value of those cash flows in today’s dollars.

4. Which capital budgeting method considers that a dollar today is worth more than a dollar in the future?

a. net present value method
b. payback method
c. internal rate of return
d. both a. and c.

Answer

D. Both the net present value method and the internal rate of return method consider the time value of money when they consider the present value of future cash flows. The payback method does not consider the time value of money.

5. An asset has a net present value of 0 when using a discount rate of 10%. Using a discount rate of 6% will most likely result in

a. a positive net present value
b. a negative net present value
c. zero, there is no change in cash flows
d. can’t determine, there is not enough information

Answer

A. A higher discount rate will give a lower net present value and a lower discount rate will give a higher net present value. When you are required to earn a higher rate, the excess return over and above the higher rate will be lower.

6. The discount rate that is used to determine net present value is also called

a. minimum required rate of return
b. the management hurdle rate
c. weighted average cost of capital
d. all of the above

Answer

D. The discount rate that is used to determine the net present value of future cash flows is referred to in the same context meaning the same thing as all of the other terms.

7. Management making a decision based on the payback period

a. recognize the time value of money
b. are only investing in the most profitable assets
c. are more concerned about liquidity
d. believe the accounting rate of return is a more accurate return

Answer

C. The payback period gives the amount of years it takes to get the cost of the investment returned. It is concerned with how fast cash will be received, which is called liquidity. Payback is not an indication of profitability. The accounting rate of return is concerned with income, which includes other non cash expenses.

8. An investment with a positive net present value has

a. an internal rate of return higher than the cost of capital
b. an internal rate of return lower than the discount rate
c. an acceptable payback period
d. an accounting rate of return that is acceptable

Answer

A. A positive net present value means that the investment is expected to return more than the required rate of return, which is also referred to as cost of capital or the discount rate. Net present value has nothing to do with payback period since payback period ignores the time value of money. Net present value uses only discounted cash flows and the accounting rate of return considers non cash expenses so the two are not comparable.

9. Making a capital investment decision requires

a. the company to ignore the cost of capital
b. can’t be done if the asset will not produce direct revenues
c. isn’t necessary if the company will use cash on hand
d. requires the company to forecast net cash flows

Answer

D. All capital investing decisions require forecasted cash flows. How the investment is actually financed or paid for is a separate decision. Some capital investments reduce costs and do not directly produce additional revenues. The cost of capital is a key consideration in capital investment decisions as this typically determines what the investment must return.

10. Which of the following is relevant when calculating net present value

a. depreciation expense
b. cash on hand available to invest in the asset
c. future cash inflows
d. future operating expenses

Answer

C. Net present value is the net present value of future cash flows. Depreciation is not a cash flow and is not considered. All operating expenses include depreciation which is not a cash flow. Cash on hand to invest is not relevant. Paying for the investment is a separate decision than determining if the investment should be made.

11. A company is trying to decide whether to make an investment in a machine with a 10-year life. The machine will cost $825,000 and will have $50,000 salvage value. The company’s required rate of return is 8%. Financial estimates associated with the products that can be produced by the machine follow:

Sales $550,000
– Variable cash expenses $125,000
Contribution margin $425,000
– Fixed cash expenses $250,000
– Fixed depreciation expense $ 77,500
= Operating Income $ 97,500

A. Compute the net present value of investing in the machine
B. Compute the internal rate of return for investing in the machine
C. Compute the payback period of the investment in the machine
D. Determine the accounting annual rate of return related to the machine

Answer

A. Compute the net present value of investing in the machine

Cash Flow Descr.	Years	Amount of cash	x	8% PV Factor	=	Present Value of CF

Purchase	0	($825,000)		1.0		($825,000)

Net annual cash flows	1-10	$175,000		6.7101		$1,174,268

Salvage value	yr 10	$ 50,000		.4632		$ 23,160

Total Net Present Value						$372,428

Sales of $550,000 less variable cash outflows of $125,000 less fixed cash outflows of $250,000 = $175,000 net annual cash flows.

Depreciation is ignored – it is not a cash flow and taxes are not considered

The NPV of $372,428 means the investment will yield that much more than 8%. It does not mean the investment will earn this much and is not the profit on the investment. It is the discounted profit on the investment over and above 8%.

B. Compute the internal rate of return for investing in the machine

PV Factor = 4.714

Investment required             $825,000
Net annual cash flows          $175,000

Go to the present value of an annuity table for the 10-year period and go across until you get closest to 4.714. 16% is 4.833. 18% is 4.494

The internal rate of return is closer to 16%, most likely about 17%.

C. Compute the payback period of the investment in the machine

Payback = 4.714 years

Investment required             $825,000
Net annual cash flows          $175,000

The initial investment will be paid back in cash after 4.7 years
Present value of cash flows is not considered

D. Determine the accounting annual rate of return

Annual net cash flows – Annual depreciation
Initial Investment

$175,000 – $77,500 = 0.118 = 11.8%
$825,000

Depreciation = Cost $825,000 – $50,000 salvage / 10 years = 77,500 year

12. A company is considering the purchase of a new machine that would reduce labor costs and increase maintenance costs. The company’s cost of capital is 10%. Information gathered related to the machine follows:

Initial Investment $300,000
Useful Life 8 years
Salvage Value $ 25,000
Cash labor savings $ 60,000
Cash maintenance expense increase $ 12,000

A. Compute the net present value of investing in the machine
B. Compute the internal rate of return for investing in the machine
C. Compute the payback period of the investment in the machine

Answer

A. Compute the net present value of investing in the machine

10%
PV Present
Cash flow descr. Years Amount of cash x Factor = Value of CF

Purchase 0 ($300,000) 1.0 ($300,000)

Labor Savings 1-8 $60,000 5.3349 $320,094

Added maintenance
expense 1-8 ($12,000) 5.3349 ($64,019)

Salvage value yr 8 $ 25,000 .4665 $ 11,663

Total Net Present Value ($32,262)

The machine has an internal rate of return less than 10% and does not meet the required rate of return for investment.

The negative amount does not mean the investment loses money.
It means it does not earn the required rate of return of 10%.

B. Compute the internal rate of return for investing in the machine

PV Factor = 6.25 Investment required $300,000
Net annual cash flows $ 48,000

Net annual cash flows consist of the cash flows that occur every year.
$60,000 savings less $12,000 additional cash outflow = $48,000

Go to the present value of an annuity table to year 8 and go across until you get closest to 6.25.

6.2098 is 6%, the closest.

The internal rate of return is approximately 6%.

C. Compute the payback period of the investment in the machine

Investment required $300,000
Net annual cash flows $ 48,000

Payback is 6.25 years.

It will take 6.25 years to get the cash back for the initial investment in the machine earning 0%. Payback ignores the present value of cash flows.

13. A company is considering the purchase of a machine that will cost $139,000. The machine is expected to generate additional cash for the next 4 years as follows:

Year 1 $28,000
Year 2 $39,000
Year 3 $47,000
Year 4 $35,000

The machine will have a salvage value of $15,000 at the end of the 4 years. The company’s cost of capital and discount rate (required rate of return) is 12%.

A. Compute the net present value of investing in the machine
B. Compute the payback period of the investment in the machine

Answer

A. Compute the net present value of investing in the machine.

12%
PV Present
Cash flow descr. Years Amount of cash x Factor = Value of CF

Purchase 0 ($139,000) 1.0 ($139,000)

Added Revenue 1 $28,000 .8929 $25,001

Added Revenue 2 $39,000 .7972 $31,091

Added Revenue 3 $47,000 .7118 $33,455

Added Revenue 4 $35,000 .6355 $22,243

Salvage value yr 4 $ 15,000 .6355 $ 9,533

Total Net Present Value ($17,677)

A negative net present value means that the machine will give an internal rate of return of lower than 12%.

NPV does not mean the machine will lose $17,677.

B. Compute the payback period of the investment in the machine

Because the years do not provide equal cash flows, the formula cannot be used. You have to determine how many years until the $139,000 investment will be recovered.

Cumulative
Investment ($139,000)

Added revenues – year 1 $28,000 ($111,000)
Added revenues – year 2 $39,000 ($72,000)
Added revenues – year 3 $47,000 ($25,000)
Added revenues – year 4 $35,000 $10,000 positive

In year 4 after you have received 25,000 of the 35,000 cash flows, or about 25/35, 71% of the year through, the investment is recovered.

Payback is therefore about 3.71 years or 4 full years if cash flow is received at the end of the year.

Capital Investments