Introduction to Corporate Finance What Companies Do, 3rd Edition by John Graham – Test Bank

Overview of Corporate Finance What Organizations Perform, 3rd Version by John Graham – Question Bank

ISBN-10:1111222282 , ISBN-13:978-1111222284

MULTIPLE CHOICE

1. The process of capital budgeting involves
a. identifying possible investments and assessing the incremental cash inflows and outflows linked to each investment
b. evaluating and ranking the investments using numerous evaluation criteria
c. executing and overseeing the selected investment projects
d. calculating an appropriate rate of return on each investment considering its risk
e. all of the above

ANS: E PTS: 1 DIF: E
REF: 8.1 Overview of Capital Budgeting NAT: Reflective thinking
LOC: acquisition of capital budgeting knowledge and the cost of capital

2. The preferred method for evaluating most capital investments is
a. payback period
b. discounted payback period
c. internal rate of return
d. net present value

ANS: D PTS: 1 DIF: E
REF: 8.1 Overview of Capital Budgeting NAT: Reflective thinking
LOC: acquisition of capital budgeting knowledge and the cost of capital

NARRBEGIN: Gamma Electronics
Gamma Electronics
Gamma Electronics is evaluating the purchase of testing equipment that will cost $500,000 to replace old equipment. Assume the new machine will generate after-tax savings of $250,000 per year over the next 4 years.
NARREND

3. Look at Gamma Electronics. What is the payback period for the investment?
a. 1.8 years
b. 2.0 years
c. 2.5 years
d. 2.8 years

ANS: B
The investment requires $500,000. By its second year, this investment generates $500,000.

PTS: 1 DIF: E REF: 8.2 Payback Strategies NAT: Analytical skills
LOC: acquisition of capital budgeting knowledge and the cost of capital

4. Look at Gamma Electronics. If the firm has a 15% cost of capital, what is the discounted payback period of the investment?
a. 1.5 years
b. 2.0 years
c. 2.4 years
d. 2.6 years

ANS: D
Present value
PV of year 1 = 250,000/1.15 = 217,391
PV of year 2 = 250,000/1.152 = 189,036
PV of year 3 = 250,000/1.153 = 164,379

By the end of year 3, the project generates a cumulative cash flow exceeding $500,000. Hence the project recovers the initial $500,000 at some point during the third year.

(500,000 – 217,391 – 189,036)/164,379 = 93,573/164,379 = 0.569

The discounted payback period is 2.6 years.

PTS: 1 DIF: M REF: 8.2 Payback Strategies NAT: Analytical skills
LOC: acquisition of capital budgeting knowledge and the cost of capital

5. If Gamma Electronics has a 15% cost of capital, what is the NPV of the investment?
a. $213,745
b. $185,865
c. $713,745
d. $500,000

ANS: A
NPV = -500,000 + 250,000/1.15 + 250,000/1.152 + 250,000/1.153 + 250,000/1.154 = 213,745

PTS: 1 DIF: E REF: 8.4 Net Present Value NAT: Analytical skills
LOC: acquisition of capital budgeting knowledge and the cost of capital

6. If Gamma Electronics has a 15% cost of capital, what is the IRR of the investment?
a. 23.4%
b. 15.0%
c. 34.9%
d. 100.0%

ANS: C
Let r represent the IRR of the investment.

-500,000 + 250,000/(1+r) + 250,000/(1+r)2 + 250,000/(1+r)3 + 250,000/(1+r)4 = 0
r = 34.9%

PTS: 1 DIF: E REF: 8.5 Internal Rate of Return NAT: Analytical skills
LOC: acquisition of capital budgeting knowledge and the cost of capital

7. If Gamma Electronics has a 15% cost of capital, what is the profitability index of the investment?
a. 1.4
b. 0.4
c. 2.0
d. 1.0

ANS: A
(250,000/1.15 + 250,000/1.152 + 250,000/1.153 + 250,000/1.154 )/500,000 = 713,745/500,000 = 1.4

PTS: 1 DIF: E REF: 8.6 Profitability Index NAT: Analytical skills
LOC: acquisition of capital budgeting knowledge and the cost of capital

NARRBEGIN: Exhibit 8-1 Invst Csh Prj
Exhibit 8-1
The cash flows associated with an investment project are as follows:

Cash Flows
Initial Outflow -$70,000
Year 1 $20,000
Year 2 $30,000
Year 3 $30,000
Year 4 $30,000

NARREND

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