Question 1

For project Gemini of Space Company the net investment was be $400,000. The net present value of all future net cash inflows was $800,000. The company's tax rate is 40 percent. The profitability index was

Accepted Answer

The profitability index is calculated by dividing the net present value (NPV) of future cash inflows by the initial investment. Here, the NPV is $800,000 and the initial investment is $400,000. Thus, the profitability index is $800,000 / $400,000 = 2.00.

Question 2

For the capital budgeting decision regarding the acquisition of a new piece of equipment the following is available: investment, $60,000; present value of net cash inflows, $40,000. What is the excess present value index?

Accepted Answer

The excess present value index is calculated as the present value of net cash inflows divided by the investment. Here, it is $40,000 / $60,000 = 0.67.

Question 3

The excess present value index is the total present value of future net cash outflows of a project divided by the total present value of cash inflows.

Accepted Answer

The excess present value index is the total present value of cash inflows divided by the total present value of future net cash outflows of a project.

Question 4

The profitability index

Accepted Answer

The profitability index is also known as the excess present value index.

Question 5

Discounted cash flow analysis can be applied in a non-profit organization.

Accepted Answer

Discounted cash flow analysis can be used in non-profit organizations to evaluate the present and future value of cash flows and to assess the feasibility of investment projects or fundraising campaigns. Non-profit organizations may use this technique to plan their long-term financial decisions, such as capital investments, endowment funds, or major programs. However, the use of discounted cash flow analysis in non-profits may require some adaptations to account for peculiarities such as donor restrictions, uncertain funding streams, or social impact considerations.

Question 6

Using the certainty equivalent approach means that

Accepted Answer

The certainty equivalent approach involves adjusting the expected cash flows downward for projects with higher perceived risk, reflecting the risk-averse nature of investors.

Question 7

Which of the following methods is not used to adjust for risk in capital budgeting?

Accepted Answer

Changing the method of depreciation to an accelerated method is an accounting decision and does not directly adjust for risk in capital budgeting.

Question 8

Broughton Ltd. manufactures and sells one product with a projected contribution margin of $17.00 for year 1. The total budgeted fixed costs are $925,000. Selling prices and variable costs are projected to increase by 8% per year, while fixed costs are forecast to grow at a rate of 5% per year. Existing production capacity is 105,000 units.
The probability distribution on its forecasted demand is as follows:
  The company is considering purchasing a new machine which will increase its production capacity by 30,000 units. The machine costs $175,000 with a residual value of $40,000 after its useful life of 5 years. The applicable Capital Cost Allowance rate is 20%. The company's tax rate is 40% and it requires an after-tax rate of return on capital of 10% (including provision for inflation).
Required:
Should Broughton purchase the new machine based on NPV analysis? Assume the machine will be sold on January 1 of year 6 for tax purposes.

Accepted Answer

The answer of Broughton Ltd. manufactures and sells one product...

Question 9

Explain how the profitability index can be used to rank investments and how it might be used in conjunction with NPV analysis.

Accepted Answer

The answer of Explain how the profitability index can be...

Question 10

The required rate of return is a critical variable in discounted cash flow analysis because it

Accepted Answer

The required rate of return is the rate of return that the firm forgoes by investing in a particular project rather than investing in an alternative project of comparable risk.

Question 11

The division manager of Bagley Company asked her assistant to gather information for a new investment. She is impressed with all the information but is unsure about which investment to choose because they are of such different sizes. Since the investments are mutually exclusive, she can choose only one. As might be expected, she wants the one that will return the most for the money. The relevant information for each project is as follows.
  Required:
Someone told the manager the profitability index helped to solve decisions when the other factors were confusing. What is the profitability index for each project?

Accepted Answer

The answer of The division manager of Bagley Company asked...

Question 12

The excess present value index is

Accepted Answer

The excess present value index measures the present value of future net cash inflows for every dollar invested. It is calculated as the total present value of future net cash inflows divided by the total present value of the initial investment. This index helps in comparing different investment alternatives by providing a measure of the profitability of the investment. The option A is incorrect because the excess present value is not divided by the payback period. The option C is incorrect because it does not take into account the initial investment. The option D is incorrect because it does not consider the future cash flows. The option E is incorrect because the excess present value index and the certainty equivalent approach are not the same.

Question 13

Discuss the ways a company can account for risk in its capital budgeting projects.

Accepted Answer

The answer of Discuss the ways a company can account...

Question 14

Sensitivity analysis can be used to assess how vulnerable a proposed capital project is to changes in its estimates.

Accepted Answer

Sensitivity analysis is a technique used to determine how changes in different variables affect the overall outcome of a project. It is commonly used in capital budgeting to evaluate the vulnerability of a proposed project to changes in its estimates. Therefore, the statement is true.

Question 15

The required rate of return is

Accepted Answer

The required rate of return is the opportunity cost of capital, representing the return that could be earned on an alternative investment of similar risk.

Question 16

The NPV method always indicates the project or set of projects that maximizes the NPV of future cash flows.

Accepted Answer

The NPV method involves calculating the present value of all expected future cash inflows and outflows of a project or set of projects, discounted at a chosen rate of return. The project or projects with the highest NPV value compared to their initial investment are considered the most financially viable. Therefore, the NPV method always indicates the project or set of projects that maximizes the NPV of future cash flows, making option A true.

Question 17

The excess present value index is also known as the profitability index.

Accepted Answer

The excess present value index and profitability index are the same thing.

Question 18

The certainty equivalent is calculate as the expected value based on the probability distribution of a project's cash flows.

Accepted Answer

The certainty equivalent is the guaranteed amount of cash that an individual would accept instead of taking a gamble with higher, but uncertain, expected value. It adjusts the expected value for risk preferences, not just the probability distribution.

Question 19

Which of the following statements is False?

Accepted Answer

The profitability index is not superior to the internal rate of return on small projects. In fact, the profitability index may not even be applicable for projects with negative net present values. The internal rate of return method is generally preferred for evaluating small projects.

Question 20

Which of the following statements about non-profit organizations and capital budgeting is true?

Accepted Answer

In the non-profit sector, there is often a tendency to cut capital-budget projects first when there is a need to balance a budget or cut a deficit. While cost-benefit analysis is important, capital budgeting is still utilized in non-profit organizations to prioritize and allocate limited resources. Non-profit organizations also use a variety of techniques for long-term capital budgeting decisions, including discounted cash-flow analysis. Required rates of return are not exclusive to profit organizations, as non-profit organizations also have to consider the opportunity cost of investing in a particular project.

Quiz 22: Capital Budgeting: a Closer Look