## Capital Budgeting Practice Test

Created by Pamela Peterson Drake

### Practice in Applying the Capital Budgeting Techniques

Consider the following two investment projects:

 Year Investment A end of year cash flows Investment B end of year cash flows 2001 +\$200,000 +\$100,000 2002 +400,000 +100,000 2003 +400,000 +100,000 2004 +400,000 +800,000 2005 +600,000 +1,000,000

Both projects require an investment of \$1,000,000 at the end of 2000. The required rate of return for both projects is 10%.

Complete the following chart:

 Technique Investment A Investment B Payback period Discounted payback period Net present value Internal rate of return Modified internal rate of return (reinvestment rate =10%)

### Multiple choice

1. Under what circumstances may the Internal Rate of Return provide an incorrect decision?
a. The projects are mutually exclusive.
b. There is no capital rationing.
c. Both selections (a) and (b) are correct circumstances.

2. The reinvestment assumption using the Internal Rate of Return method is that:
a. intermediate cash flows are reinvested at the required rate of return.
b. intermediate cash flows are reinvested at the internal rate of return.
c. intermediate cash flows are reinvested at the modified internal rate of return.

3. The Net Present Value method of evaluating projects is consistent with:
a. the maximization of earnings per share
b. the maximization of shareholder wealth
c. the maximization of net income

4. Suppose you are considering two projects, M and N, that each have a required rate of return of 12%. Both projects cost \$1,000 and have a Net Present Value of \$42. Project A has an IRR of 15% and Project B has an IRR of 16%. What is the cross-over rate for the NPV profiles of these two projects?
a.0%
b.12%
c.15%
d.16%
e.20%

Use the following information for the next four problems:

The president of Albatross Airlines has asked you to evaluate the proposed acquisition of a new airplane. The aircraft price is \$40,000 and it is classified in the 3-year MACRS class. The purchase of the plane would require an increase in net working capital of \$2,000. The airplane would increase the firm's before-tax revenues by \$20,000 per year, but would also increase operating costs by \$5,000 per year. The airplane is expected to be used for 3 years and then sold for \$25,000. The firm's marginal tax rate is 40% and the project's cost of capital is 14%. Use the following MACRS rates for 3-year property: 33%; 45%; 15%; 7%

5. What is the net investment outlay required at the beginning of the project?
a.\$42,000
b.\$40,000
c.\$38,600
d.\$37,600
e.\$36,600

6. What is the operating cash flow in the second year?
a.\$9,000
b.\$10,240
c.\$11,687
d.\$13,453
e.\$16,200

7. What is the total value of the non-operating cash flow in the third year?
a.\$18,120
b.\$19,000
c.\$21,000
d.\$25,000
e.\$27,000

8. What is the project's net present value?
a.\$2,622
b.\$2,803
c.\$2,917
d.\$5,712
e.\$6,438

### Solutions to Capital Budgeting Practice Test

Solutions to Practice in Applying the Capital Budgeting Techniques

 Technique Investment A Investment B Payback period 3 years 4 years Discounted payback period 4 years 5 years Net present value \$458,680 \$416,017 Internal rate of return 24.21% 19.95% Modified internal rate of return (reinvestment rate =10%) 18.63% 17.93%

(Note: terminal value for A = \$2,349,220; terminal value for B = \$2,280,510)

Solutions to multiple choice:

 Q A Notes 1 a When selecting among mutually exclusive projects or when there is capital rationing 2 b Implicit in the calculations 3 b Considers all cash flows, the time value of money, and the uncertainty of the cash flows 4 b If the NPVs are equal at the required rate of return, then the cross-over rate is the required rate of return 5 a -\$40,000 + (-\$2,000) = -\$42,000 6 e (\$20,000-5,000)(0.6) + (0.4)(\$18,000) = +\$16,200 7 a +\$2,000 (working capital) + \$25,000 (sales of plane) - \$8,880 (tax on sale) = +\$18,120 8 c NCFs: year 0 = -\$42,000 year 1 = +\$14,280 year 2 = +\$16,200 year 3 = +\$18,120 + 11,400 = \$29,520 Discount to year 0 at the 14% cost of capital