Perform Capital Budgeting Analysis
Help Questions
CPA Business Analysis and Reporting (BAR) › Perform Capital Budgeting Analysis
A project requires an initial investment of $500,000 and generates after-tax cash flows of $150,000 per year for 5 years. The discount rate is 10% and the PV annuity factor for 5 years at 10% is 3.791. What is the NPV?
$250,000
$68,650
$150,000
-$68,650
Explanation
PV of cash flows = $150,000 x 3.791 = $568,650. NPV = $568,650 - $500,000 = $68,650. A positive NPV indicates the project creates value above the cost of capital. Option A sums undiscounted cash flows and subtracts the investment. Option C reports only one year's cash flow. Option D applies the correct formula but labels the sign incorrectly.
A capital project uses straight-line depreciation of $80,000 per year. The tax rate is 25%. What is the annual depreciation tax shield?
$80,000
$20,000
$40,000
$60,000
Explanation
Depreciation tax shield = Depreciation x Tax rate = $80,000 x 25% = $20,000. Depreciation is a non-cash expense that reduces taxable income; the tax savings from this reduction equals the depreciation amount multiplied by the tax rate. Option A is the full depreciation amount before the tax effect. Option B is the after-tax operating income effect of depreciation ($80,000 x 75%). Option C uses a 50% tax rate.
A company is replacing equipment. The old machine has a book value of $50,000 and a current market value of $30,000. The tax rate is 30%. What are the after-tax proceeds from selling the old equipment?
$44,000
$50,000
$30,000
$36,000
Explanation
Loss on sale = Book value - Market value = $50,000 - $30,000 = $20,000. Tax benefit from loss = $20,000 x 30% = $6,000. After-tax proceeds = Market value + Tax benefit = $30,000 + $6,000 = $36,000. Selling at below book value creates a tax-deductible loss that increases the after-tax proceeds above the market value. Option B ignores the tax benefit. Option C applies the tax rate to the market value rather than the loss. Option D uses book value instead of market value.
The profitability index (PI) is calculated as which of the following?
IRR divided by the weighted average cost of capital
Net present value divided by the IRR
Total undiscounted cash flows divided by the payback period
Present value of future cash flows divided by the initial investment
Explanation
PI = PV of future cash flows / Initial investment. A PI greater than 1.0 indicates the project creates value (equivalent to a positive NPV). PI is particularly useful for capital rationing because it measures value created per dollar invested, allowing comparison of projects with different investment amounts. Option A is not a standard capital budgeting ratio. Option C describes an undiscounted return metric, not PI. Option D is a ratio used to assess whether an IRR-based hurdle is met, not the PI formula.
A $300,000 equipment purchase will generate pre-tax cost savings of $90,000 per year for 5 years. The tax rate is 25% and straight-line depreciation produces $60,000 per year. The PV annuity factor at 10% for 5 years is 3.791. What is the NPV?
$55,650
$42,892
$12,758
$12,000
Explanation
After-tax annual cash flow = After-tax savings + Depreciation tax shield = ($90,000 x 0.75) + ($60,000 x 0.25) = $67,500 + $15,000 = $82,500. PV of cash flows = $82,500 x 3.791 = $312,758. NPV = $312,758 - $300,000 = $12,758. Option A uses an incorrect after-tax rate. Option C uses the full pre-tax savings as the cash flow base. Option D applies only the after-tax savings without the depreciation tax shield.
Project L has a payback of 4.5 years and NPV of $420,000. Project S has a payback of 1.8 years and NPV of $95,000. A risk-averse CFO proposes selecting Project S for its faster payback. Which concern is most analytically relevant?
Both projects carry equivalent risk because they operate in the same industry
Selecting Project S sacrifices $325,000 of value; payback ignores cash flows beyond the recovery point and does not discount for time value of money
Payback period is always the appropriate criterion for risk-averse decision makers
Shorter payback always indicates lower investment risk
Explanation
Choosing Project S over Project L gives up $325,000 of NPV ($420,000 - $95,000). The payback period has two known limitations: it ignores all cash flows after the payback point (which is where much of Project L's value may be generated) and it does not apply time value discounting. While faster payback does reduce some forms of liquidity risk, it is an incomplete metric for value creation. A risk-averse investor should consider a risk-adjusted NPV or scenario analysis rather than relying on payback as a proxy for risk. Options A and B overstate the reliability of payback as a risk measure. Option D is an unsupported assumption.
A project has positive NPV of $45,000 at the company's WACC of 12%. The project involves a new market with no prior company experience. The CFO adds a 3% risk premium, reducing NPV to -$28,000 at 15%. Which analytical conclusion is most appropriate?
The 3% risk premium is excessive and should be ignored in the analysis
Any project with positive NPV at WACC should always be accepted regardless of risk adjustments
The project should be accepted because the base-case NPV is positive at WACC
The project's viability depends critically on whether 12% or 15% appropriately reflects the risk of this specific investment; management should validate the risk premium before deciding
Explanation
When a modest change in the discount rate flips NPV from positive to negative, the investment's acceptance hinges on the accuracy of the risk adjustment. The WACC reflects the average risk of the company's existing operations; a new-market project may legitimately warrant a higher rate. The analytical imperative is to validate whether 3% is the right incremental risk premium based on the specific characteristics of this project - market risk, execution uncertainty, competitive dynamics - rather than accepting or dismissing it arbitrarily. Options A and D ignore the risk signal. Option C dismisses the risk premium without analytical basis.
Equipment costs $200,000 to purchase or can be leased with annual payments of $44,000 for 5 years paid at year beginning (annuity due). The tax rate is 25% and the PV annuity due factor for 5 years at 8% is 4.312. What is the present value of the after-tax lease payments?
$142,296
$165,000
$158,500
$192,024
Explanation
After-tax annual lease payment = $44,000 x (1 - 0.25) = $33,000. PV of after-tax lease payments (annuity due) = $33,000 x 4.312 = $142,296. Option A uses the pre-tax payment without the tax reduction. Option B applies the pre-tax payment to the annuity due factor. Option C uses a different annuity factor.
A company consistently approves capital projects with positive total NPV, yet company-wide ROIC has declined for three consecutive years. Which analytical concern does this pattern raise?
ROIC and NPV measure fundamentally different things and cannot be compared
Individual project NPVs are the only relevant measure and company-wide ROIC should be ignored
Projects may be approved based on optimistic projections that are not achieved in practice; the gap between expected and actual project performance suggests biased forecasting, poor project selection, or inadequate post-implementation review of capital allocations
NPV analysis must be incorrect if ROIC is declining simultaneously
Explanation
A persistent ROIC decline despite an apparently sound capital approval process signals a disconnect between projected and actual project performance. This can result from: overly optimistic forecasts in project proposals (benefits overstated, costs understated), selection bias toward projects that look good on paper, or failure to track and learn from post-implementation performance. A rigorous capital allocation process should include systematic comparison of project outcomes against original forecasts to detect and correct persistent biases. Option A incorrectly attributes the problem to the NPV method itself. Option B incorrectly claims they are unrelated. Option C prioritizes a forecast metric over an outcome metric.
A project requires an initial investment of $240,000 and generates cash flows of $60,000 (Year 1), $90,000 (Year 2), $80,000 (Year 3), and $70,000 (Year 4). What is the payback period?
4.0 years
3.14 years
2.7 years
3.0 years
Explanation
Cumulative cash flows: End of Year 1 $60,000; Year 2 $150,000; Year 3 $230,000. Remaining after Year 3 = $240,000 - $230,000 = $10,000. Year 4 fraction = $10,000 / $70,000 = 0.143. Payback = 3 + 0.143 = 3.14 years. Option A assumes the full investment is recovered exactly at Year 3. Option B calculates an earlier payback based on incorrect cumulative totals. Option D assumes recovery requires the full Year 4 cash flow.