True-false
Indicate whether each of the following is true or false.
- Depreciation does not involve a cash outflow; it is deductible in arriving at federal taxable income.
- The price a company is going to pay for a machine is an out-of-pocket cost.
- Sunk costs and out-of-pocket costs are relevant to capital-budgeting decisions.
A formula for unadjusted rate of return is as follows:
Unadjusted rate of return = Average annual income after taxes/Average amount of investment When investment projects cost different amounts are being compared, the net present value doesnot provide a valid means by which to rank projects in order of contribution to income or desirability assuming limited financial resources.
Multiple-choice
Choose the best answer for each of the following questions.
Which of the following is incorrect regarding the payback period method?
a. The payback period ignores the time period beyond the payback period.
b. When using payback analysis for investment decisions, one rule is to select the shortest payback period investment.
c . The formula for the payback period is:
Payback period = Initial cash outlay/Annual amount of investment
d. Payback analysis ignores the time value of money
When using time value of money concepts, all aspects of the investment should be considered including which of the following?
a. Employee morale.
b. No single time value of money method should be used by itself to make capital budgeting decisions.
c. Company flexibility.
d. All of the above.
Which of the following correctly describe(s) the limitations when using the unadjusted rate of return.
a. Timing of cash flows is not considered.
b. It allows a sunk cost, depreciation, to enter into the calculation
c. The length of time over which the return will be earned is not considered.
d. All of the above.
Which of the following statements is (are) true regarding the profitability index?
a. Only proposals with profitability indexes greater than 1.00 should be considered.
b. Only proposals with profitability indexes less than 1.00 should be considered.
c. The profitability index is the ratio of the initial cash outlay divided by the present value of cash benefits (before taxes).
d. b and c.
Which of the following statements is (are) true regarding net present value?
a. When determining an appropriate discount rate, management uses net cash outflow.
b. With projects that require an investment at a later date, management must discount the cash outflow to its present value before it is compared to the present value of cash inflows.
c. When using the net present value to screen alternative projects, as long as the project's net present value is equal to the investment the project is desirable.
d. b and c.
Which of the following statements is (are) true regarding the time-adjusted rate of return?
a. The first step in computing the rate of return is determining the payback period.
b. The annual after-tax net cash inflow also is called an annuity.
c. The cost of capital is used only as a cutoff point in deciding which projects should be considered further.
d. All of the above.
Questions
- What is the profitability index, and of what value is it?
- What is the time-adjusted rate of return on a capital investment?
- What role does the cost of capital play in the time-adjusted rate of return method and in the net present value method?
- What is the purpose of a postaudit? When should a postaudit be performed?
- A friend who knows nothing about the concepts in this chapter is considering purchasing a house for rental to students. In just a few words, what would you tell your
- friend to think about in making this decision?
- How do capital expenditures differ from ordinary expenditures?
- What effects can capital-budgeting decisions have on a company?
- What effect does depreciation have on cash flow?
- Give an example of an out-of-pocket cost and a sunk cost by describing a situation in which both are encountered.
- A machine is being considered for purchase. The salesperson attempting to sell the
- machine says that it will pay for itself in five years. What is meant by this statement?
- Discuss the limitations of the payback period method.