### Capital Investments

### Easy Practice Test

## Easy Practice Test

**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

b. negative

c. zero

d. not enough information to determine

##### Answer

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

b. net present value

c. net master budget

d. net cash flow

##### Answer

3. The net present value of an investment is

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

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

b. payback method

c. internal rate of return

d. both a. and c.

##### Answer

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

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

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

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

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

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

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 |

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% Purchase 0 ($300,000) 1.0 ($300,000) Labor Savings 1-8 $60,000 5.3349 $320,094 Added maintenance Salvage value yr 8 $ 25,000 .4665 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% 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 Added revenues – year 1 $28,000 ($111,000) |

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.