Reading 28: Capital Budgeting LOS c～ Q7-12

repeated, investment, equivalent, net

Q7. Jayco, Inc. is evaluating two mutually exclusive investment projects. Assume both projects can be repeated indefinitely. Printer A has a net present value (NPV) of $20,000 over a three-year life and Printer B has a NPV of $25,000 over a five-year life. The project types are equally risky and the firm's cost of capital is 12%. What is the equivalent annual annuity (EAA) of Project A and B?

Project A Project B

A) $8,327 $6,935

B) $8,327 $5,326

C) $7,592 $6,935

Q8. Which of the following statements about the equivalent annual annuity approach for capital budgeting is FALSE?

A) The replacement chain approach assumes that it is possible to make continuous replacements each time the asset's life ends.

B) A 5-year project has a NPV of $2,000, if the firm's cost of capital is 10% the equivalent annual annuity is $725.

C) When comparing mutually exclusive projects with unequal lives, replacement chain analysis yields the same decision as the equivalent annual annuity method.

Q9. Which of the following statements about mutually exclusive projects with unequal lives is FALSE?

A) Mutually exclusive projects sometimes have long and different lives, which makes applying the replacement chain method difficult because the lowest common denominator is very large. The equivalent annual annuity is a substitute method that uses the annuity concept to value a project's cash flows.

B) For comparing mutually exclusive projects with unequal lives, replacement chain analysis leads to the same decision as obtained by calculating the equivalent annual annuity.

C) In comparing mutually exclusive projects with unequal lives, you should always choose the project which has the highest NPV.

Q10. In the absence of capital rationing, a firm should take on the most profitable investments first and keep expanding their investments to the point where the marginal:

A) cost of debt equals the marginal cost of equity.

B) return of the last investment equals the marginal cost of capital.

C) return of the last investment equals the risk free rate.

Q11. A given firm cannot invest in all projects that have a higher return than the associated cost of capital. Therefore, the firm must engage in:

A) capital rationing.

B) sensitivity analysis.

C) a pure play.

Q12. A firm is unable to raise the necessary funding for all projects that have positive expected net present values. Therefore, this firm must:

A) declare bankruptcy.

B) engage in capital rationing.

C) cut overhead and other costs.