Ethical Behavior Is Required for Proper Capital Budgeting Selection

Chapter M7: The Capital Budget: Evaluating Capital Expenditures
Multiple Choice

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1.
/ Organizational goals --
are usually stated in specific terms that can be easily verified.
are short-term objectives for the company.
* / define "why" the organization exists.
are restricted to the financial goals of the company.
Hint for question 1
Organizational goals outline why an organization exists and are a combination of financial and non-financial goals that are usually communicated in the company mission statement.
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2.
/ The strategic plan --
is determined separately from the organizational goals.
is usually stated in general terms that are not quantifiable.
includes a short-term budget.
* / defines "what" actions a business plans to take to implement their long-range goals.
Hint for question 2
The strategic plan is a long-range plan that defines the actions a company will take to attain its organizational goals.
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3.
/ The capital budget --
* / plans for the acquisition and replacement of long-lived expensive assets such as land, buildings, and equipment.
is determined separately from the organizational goals and strategic plan.
is used by for-profit organizations but not by not-for-profit organizations.
is a short-term budget.
Hint for question 3
The capital budget outlines "how" a firm intends to allocate its scarce resources over a five-year, ten-year, or even longer period of time.
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4.
/ The operating budget --
is a long-term budget.
* / defines "who" is responsible for attaining the operating goals.
is determined separately from the organizational goals, strategic plan, and capital budget.
only pertains to special projects of the company.
Hint for question 4
The operating budget plans for the routine day-to-day business activities for one to five years. It establishes "who" is responsible for attaining the operating goals.
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5.
/ Capital projects share all of the following characteristics except --
they have a useful life of two years or more.
* / they include planning for all assets that benefit more than two years whether the cost is large or small.
they carry a high degree of risk.
they result in quickly sunk costs.
Hint for question 5
Capital projects deal with planning the purchase and disposal of assets that are depreciated over their useful life.
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6.
/ All of the following statements are true regarding the cost of capital except:
Acceptable projects promise returns that exceed the cost of capital.
* / The cost of capital usually exceeds the cost of debt financing plus the cost of equity financing.
Includes the cost of debt capital that is the rate of interest a company pays to its creditors.
Includes the cost of equity capital that may be as high as 20% for some publicly traded companies.
Hint for question 6
A company's cost of capital is the cost of obtaining financing from all sources. The average cost of debt and equity financing is referred to as the blended cost of capital.
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7.
/ The net present value (NPV) capital budgeting decision method --
can be directly compared between alternatives.
* / incorporates the time value of money in the calculations.
is based on accounting net income.
uses a negative value to indicate a capital project is acceptable.
Hint for question 7
The net present value capital budgeting decision method subtracts the present value of all cash outflows from the present value of all cash inflows associated with a proposed capital project.
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8.
/ A net present value of $1000 --
* / indicates the capital project exceeds the company's cost of capital.
is better than a net present value of $500.
indicates the return is $1,000.
indicates cash inflows total $1,000 for the capital project.
Hint for question 8
A positive value indicates a capital project is acceptable.
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9.
/ Project A: present value (PV) of the cash inflows is $55,000 and the PV of the cash outflows is $50,000. Project B: PV of the cash inflows is $24,000 and the PV of the cash outflows is $20,000. It is false that --
the net present value of project A is $5,000.
the net present value of project B is $4,000.
the profitability index for Project A is 1.1.
* / Project A is ranked higher than Project B.
Hint for question 9
Are capital projects ranked by net present value or by the profitability index?
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10.
/ The 16% internal rate of return (IRR) indicates all of the following except -
a better return than a 14% internal rate of return.
a 16% discount rate will result in the calculation of a net present value of zero.
* / accounting net income and the time value of money were used in this calculation.
an acceptable capital project if the cost of capital is 12%.
Hint for question 10
The internal rate of return is used to calculate the expected percentage return promised by the project.
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11.
/ Assume a capital project requires $42,000 as an initial investment and expects a net cash inflow of $12,000 per year. The payback period method --
would consider the capital project acceptable if the company has a maximum payback period of three years.
* / is often used as a screening device to eliminate capital projects from further investigation.
uses accounting net income rather than cash flows in the calculations.
compares the rate of return to the company's cost of capital.
Hint for question 11
The payback period in years = required initial investment / annual net cash flow.
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12.
/ Poor selection of capital projects can be generated by managers who
are optimistic.
manipulate the selection evaluation methods.
focus on winning a competition.
* / do some or all of the above.

Ethical behavior is required for proper capital budgeting selection.

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Chapter M7: The Capital Budget: Evaluating Capital Expenditures
True or False

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1.
/ For most businesses, the primary financial goal is to earn a profit for the shareholders or owners.
* / TRUE
FALSE
Hint for question 1
What can happen to a company that does not earn profits?
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2.
/ Capital projects are usually considered very high risk.
* / TRUE
FALSE
Hint for question 2
What are the four common characteristics of all capital projects?
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3.
/ If a company's cost of capital is 15%, a net present value of $10 indicates an acceptable capital project.
* / TRUE
FALSE
Hint for question 3
What does a positive net present value indicate? Acceptable projects exceed the company's cost of capital.
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4.
/ Choosing the greatest net present value is always the best decision choice.
TRUE
* / FALSE
Hint for question 4
Are the net present value dollar amounts comparable?
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5.
/ Only relevant costs are examined when evaluating a capital project.
* / TRUE
FALSE
Hint for question 5
Only future costs that differ between alternatives are considered relevant.
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Chapter M7: The Capital Budget: Evaluating Capital Expenditures
Fill In The Blanks

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1.
/ The budget that outlines how a company intends to allocate its scarce resources over the long term is referred to as the ______budget.
* / capital
accounting
strategic
operating
Hint for question 1
What type of assets need to be planned for over the long term?
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2.
/ When a purchased item is expected to benefit the company for more than one year, the item should be ______on the financial statements.
* / capitalized
expensed
budgeted
discounted
Hint for question 2
What type of assets are depreciated?
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3.
/ A company's cost of capital from all sources is referred to as the ______cost of capital.
equity
debt
discounted
* / blended
Hint for question 3
What are the two primary sources of financing for companies? When the rate of financing from each of these sources is averaged, it is referred to as what?
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4.
/ The ______method uses the time value of money to calculate the expected percentage return promised by a capital project.
payback period
* / internal rate of return
accounting rate of return
net present value
Hint for question 4
Which methods utilize the time value of money? Which of those methods calculate the expected percentage return?
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5.
/ The net present values of various capital projects cannot be ranked. That problem is solved by using the ______index to rank capital projects in order of preference.
* / profitability
operating
capital
blended
Hint for question 5
This index divides the present value of cash inflows by the net present value of cash outflows.
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Chapter M7: The Capital Budget: Evaluating Capital Expenditures
Essay Questions

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1. / Describe the four steps of the business planning process. Describe the interrelationships among the four steps.
2. / Explain how the cost of capital is determined and how it is used.
3. / List the two capital budgeting models that utilize the time value of money and explain how each ranks the performance of different alternatives. List the two capital budgeting models that do not utilize the time value of money and explain how they are used.

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