CIS 3325 - chapter 21 Capital Budgeting and Cost Analysis

Cost Accounting, 14e (Horngren/Datar/Rajan) Chapter 21 Capital Budgeting and Cost Analysis Objective 21.1 1) Which of the following involves significant financial investments in projects to develop new products, expand production capacity, or remodel current production facilities? A) capital budgeting B) working capital C) master budgeting D) project-cost budgeting Answer: A Diff: 1 Terms: capital budgeting Objective: 1 AACSB: Reflective thinking 2) The accounting system that corresponds to the project dimension in capital budgeting is the: A) net present value method B) internal rate of return C) accrual accounting rate of return D) life-cycle costing Answer: D Diff: 1 Terms: capital budgeting Objective: 1 AACSB: Reflective thinking 3) Capital budgeting is the process of making long-run planning decisions for investments in projects. Answer: TRUE Diff: 2 Terms: capital budgeting Objective: 1 AACSB: Analytical skills 4) A capital budget spans only a one-year period. Answer: FALSE Explanation: A capital budget normally is for a period of time greater than one year. Diff: 2 Terms: capital budgeting Objective: 1 AACSB: Analytical skills 5) The identify projects stage of capital budgeting gathers information from all parts of the value chain to evaluate alternative projects. Answer: FALSE Explanation: This is the definition of the obtain information stage. Diff: 1 Terms: capital budgeting Objective: 1 AACSB: Analytical skills 6) The obtain information stage of capital budgeting gathers information from all parts of the value chain to evaluate alternative projects. Answer: TRUE Diff: 1 Terms: capital budgeting Objective: 1 AACSB: Analytical skills 7) The make decisions by choosing among alternatives stage of the capital budgeting process consists of determining which investment yields the greatest benefit and the least cost to the organization. Answer: TRUE Diff: 1 Terms: capital budgeting Objective: 1 AACSB: Analytical skills 8) The make predictions stage of the capital budgeting process consists of forecasting all potential net income additions that are attributable to the alternative projects. Answer: FALSE Explanation: The make predictions stage of the capital budgeting process consists of forecasting all potential cash flows attributable to the alternative projects. Diff: 1 Terms: capital budgeting Objective: 1 AACSB: Analytical skills 9) The final activity in the capital budgeting process is to obtain funding and make the investments identified in the make decisions by choosing among alternatives stage of the process. Answer: FALSE Explanation: The implement decision, evaluate performance, and learn stage requires that after the funding is obtained and the investment is made, there is a follow-up wherin the realized cash flows are tracked, compared against the estimates, and plans are revised if necessary. Diff: 1 Terms: capital budgeting Objective: 1 AACSB: Analytical skills 10) Match each one of the examples below with one of the stages of the capital budgeting decision model. Stages: 1. Identify Projects 2. Obtain Information 3. Make Predictions 4. Make Decisions by Choosing Among Alternatives 5. Implement the Decision, Evaluate Performance, and Learn ________ a. Issuing corporate stock for the funds to purchase new equipment ________ b. Learning how to effectively operate Machine #8 only takes 15 minutes ________ c. The need to reduce the costs to process the vegetables used in producing goulash ________ d. Monitoring the costs to operate a new machine ________ e. Percentage of defective merchandise considered too high ________ f. Will introducing the new product substantially upgrade our image as a producer of quality products? ________ g. Research indicates there are five machines on the market capable of producing our product at a competitive cost. ________ h. Use of the internal rate of return for each alternative Answer: a. 5. Implement the Decision, Evaluate Performance, and Learn b. 2. Obtain Information c. 1. Identify Projects d. 5. Implement the Decision, Evaluate Performance, and Learn e. 1. Identify Projects f. 2. Obtain Information g. 2. Obtain Information h. 4. Make Decisions by Choosing Among Alternatives Diff: 2 Terms: capital budgeting Objective: 1 AACSB: Reflective thinking 11) Explain why a corporation's customer base is considered an intangible asset. Answer: A corporation's customer base is considered an intangible asset because if it is handled properly, a corporation's existing customers will be a source of revenues for an indefinite time period. One could make the case that the customer base is like an annuity ? a steady source of revenues and earnings. Thus it is an asset, although an intangible one. An existing customer usually will stay with a corporation if he or she is handled properly. Usually there is minimal marginal cost in retaining a customer other than producing a satisfactory product. In contrast, attracting new customers takes time, effort, and most times substantial marketing dollars. Thus, it is much easier to retain a current customer than to obtain a new one. This is why the existing customer base is considered an asset. Diff: 2 Terms: capital budgeting Objective: 1 AACSB: Analytical skills 12) Explain capital budgeting and then briefly discuss each of the five stages of a capital budgeting project? Answer: Capital budgeting is long-run planning for investment projects that usually have a life that is greater than one year. Stage 1 of a capital budgeting project is the identify projects stage in which a firm determines which types of capital investments are necessary to accomplish organization objectives and strategies. Stage 2 is the obtain information stage in which a firm gathers information from all parts of the value chain to analyze alternative projects. Stage 3 is the make predictions stage in which the firm forecasts all potential cash flows attributable to the alternative projects. Stage 4 is the make decisions by choosing among alternatives stage in which the firm determines which investment yields the greatest benefit and the least cost to the organization. Stage 5 is the implement the decision, evaluate performance, and learn stage that is further separated into two sub stages: (1) obtain funding and make the investments selected in the stage 4 process, and (2) track the realized cash flows, compare against the forecast numbers, and revise plans if necessary. Diff: 2 Terms: capital budgeting Objective: 1 AACSB: Reflective thinking 13) Cast Iron Stove Company wants to buy a molding machine that can be integrated into its computerized manufacturing process. It has received three bids for the machine and related manufacturer's specifications. The bids range from $3,500,000 to $3,550,000. The estimated annual savings of the machines range from $260,000 to $270,000. The payback periods are almost identical and the net present values are all within $8,000 of each other. The president just doesn't know what to do about which vendor to choose since all of the selection criteria are so close together. Required: What suggestions do you have for the president? Answer: The president needs to consider nonfinancial and qualitative factors between the three vendors. Quality of output units, manufacturing flexibility, and cycle time are all additional factors that can be considered about the machines. Other items might include worker safety, ease of learning and using, and ease of maintenance. Diff: 2 Terms: capital budgeting Objective: 1 AACSB: Reflective thinking Objective 21.2 1) The stage of the capital budgeting process that distinguishes which types of capital expenditure projects are necessary to accomplish organization objectives is the: A) identify projects stage B) make predictions stage C) obtain information stage D) make decisions by choosing among alternatives stage Answer: A Diff: 1 Terms: capital budgeting Objective: 2 AACSB: Reflective thinking 2) The stage of the capital budgeting process during which marketing is queried for potential revenue numbers is the: A) identify projects stage B) obtain information stage C) make predictions stage D) make decisions by choosing among alternatives stage Answer: B Diff: 1 Terms: capital budgeting Objective: 2 AACSB: Reflective thinking 3) The stage of the capital budgeting process that considers the expected costs and the expected benefits of alternative capital investments is the: A) identify projects stage B) make decisions by choosing among alternatives stage C) obtain information stage D) make predictions stage Answer: D Diff: 1 Terms: capital budgeting Objective: 2 AACSB: Reflective thinking 4) The stage of the capital budgeting process that chooses projects for implementation is the: A) make decisions by choosing among alternatives stage B) make predictions stage C) identify projects stage D) management-control stage Answer: A Diff: 1 Terms: capital budgeting Objective: 2 AACSB: Reflective thinking 5) The stage of the capital-budgeting process in which projects get underway and performance is monitored is the: A) implement the decision, evaluate performance, and learn stage B) make predictions stage C) identify projects stage D) management-control stage Answer: A Diff: 1 Terms: capital budgeting Objective: 2 AACSB: Reflective thinking 6) The two factors capital budgeting emphasizes are: A) qualitative and nonfinancial B) quantitative and nonfinancial C) quantitative and financial D) qualitative and financial Answer: C Diff: 1 Terms: capital budgeting Objective: 2 AACSB: Reflective thinking 7) Which of the following are NOT included in the formal financial analysis of a capital budgeting program? A) quality of the output B) safety of employees C) cash flow D) Neither A nor B are included. Answer: D Diff: 2 Terms: capital budgeting Objective: 2 AACSB: Reflective thinking 8) The stage of the capital budgeting process in which a firm obtains funding for the project is the: A) make decisions by choosing among alternatives stage. B) make predictions stage. C) obtain information stage. D) implement the decision, evaluate performance, and learn stage. Answer: D Diff: 1 Terms: net present value (NPV) method Objective: 2 AACSB: Reflective thinking 9) Which capital budgeting technique(s) measure all expected future cash inflows and outflows as if they occurred at a single point in time? A) net present value B) internal rate of return C) payback D) Both A and B are correct. Answer: D Diff: 2 Terms: capital budgeting, NPV method, IRR method Objective: 2 AACSB: Reflective thinking 10) Discounted cash flow methods for capital budgeting focus on: A) cash inflows B) operating income C) cash outflows D) Both A and C are correct. Answer: D Diff: 2 Terms: discounted cash flow (DCF) methods Objective: 2 AACSB: Reflective thinking 11) Net present value is calculated using the: A) internal rate of return B) required rate of return C) rate of return required by the investment bankers D) None of these answers is correct. Answer: B Diff: 2 Terms: net present value (NPV) method Objective: 2 AACSB: Reflective thinking 12) All of the following are methods that aid management in analyzing the expected results of capital budgeting decisions EXCEPT: A) accrual accounting rate-of-return method B) discounted cash-flow method C) future-value cash-flow method D) payback method Answer: C Diff: 2 Terms: capital budgeting Objective: 2 AACSB: Reflective thinking 13) The capital budgeting method which calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time using the required rate of return is the: A) payback method B) accrual accounting rate-of-return method C) sensitivity method D) net present value method Answer: D Diff: 2 Terms: net present value (NPV) method Objective: 2 AACSB: Reflective thinking 14) Assume your goal in life is to retire with two million dollars. How much would you need to save at the end of each year if interest rates average 6% and you have a 20-year work life? A) $29,130 B) $54,369 C) $240,204 D) $752,952 Answer: B Explanation: B) S (36.786) = $2,000,000 S = $54,368.51 Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 15) Assume your goal in life is to retire with three million dollars. How much would you need to save at the end of each year if interest rates average 5% and you have a 25-year work life? A) $ 49,110 B) $ 55,596 C) $ 62,858 D) $67,508 Answer: C Explanation: C) Look up annuity factor in the table or use function on a calculator or computer. S (47.727) = $3,000,000 S = $62,857.50 Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 16) Assume your goal in life is to retire with 2 million dollars. How much would you need to save at the end of each year if investment rates average 9% and you have a 15-year work life? A) $51,108 B) $ 68,118 C) $ 75,706 D) $ 82,572 Answer: B Explanation: B) Look up annuity factor in the table or use function on a calculator or computer. S (29.361) = $2,000,000 S = $68,117.57 Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills Answer the following questions using the information below: Hawkeye Cleaners has been considering the purchase of an industrial dry-cleaning machine. The existing machine is operable for three more years and will have a zero disposal price. If the machine is disposed now, it may be sold for $120,000. The new machine will cost $400,000 and an additional cash investment in working capital of $120,000 will be required. The new machine will reduce the average amount of time required to wash clothing and will decrease labor costs. The investment is expected to net $100,000 in additional cash inflows during the year of acquisition and $300,000 each additional year of use. The new machine has a three-year life, and zero disposal value. These cash flows will generally occur throughout the year and are recognized at the end of each year. Income taxes are not considered in this problem. The working capital investment will not be recovered at the end of the asset's life. 17) What is the net present value of the investment, assuming the required rate of return is 10%? Would the company want to purchase the new machine? A) $164,000; yes B) $100,000; no C) $(100,000); yes D) $(164,000); no Answer: A Explanation: A) Yr. 0 ($120,000 - $400,000 - $120,000) × 1.000 = $(400,000) Yr. 1 $100,000 × 0.909 = 90,900 Yr. 2 $300,000 × 0.826 = 247,800 Yr. 3 $300,000 × 0.751 = 225,300 $ 164,000 Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 18) What is the net present value of the investment, assuming the required rate of return is 24%? Would the company want to purchase the new machine? A) $(65,600); yes B) $(32,800); no C) $32,800; yes D) $65,600; no Answer: C Explanation: C) Yr. 0 ($120,000 - $400,000 - $120,000) × 1.000 = $(400,000) Yr. 1 $ 100,000 × 0.806 = 80,600 Yr. 2 $300,000 × 0.650 = 195,000 Yr. 3 $300,000 × 0.524 = 157,200 $ 32,800 Diff: 3 Terms: net present value (NPV) method, required rate of return (RRR) Objective: 2 AACSB: Analytical skills Answer the following questions using the information below: Jonesville Hospital has been considering the purchase of a new x-ray machine. The existing machine is operable for five more years and will have a zero disposal price. If the machine is disposed now, it may be sold for $90,000. The new machine will cost $650,000 and an additional cash investment in working capital of $20,000 will be required. The new machine will reduce the average amount of time required to take the x-rays and will allow an additional amount of business to be done at the hospital. The investment is expected to net $60,000 in additional cash inflows during the year of acquisition and $230,000 each additional year of use. The new machine has a five-year life, and zero disposal value. These cash flows will generally occur throughout the year and are recognized at the end of each year. Income taxes are not considered in this problem. The working capital investment will not be recovered at the end of the asset's life. 19) What is the net present value of the investment, assuming the required rate of return is 12%? Would the hospital want to purchase the new machine? A) $(97,340); no B) $51,430 no C) $ 97,340; yes D) $166,830; yes Answer: C Explanation: C) Yr. 0 ($90,000 - $650,000 - $20,000) × 1.000 = $(580,000) Yr. 1 $ 60,000 × 0.893 = 53,580 Yr. 2 $230,000 × 0.797 = 183,310 Yr. 3 $230,000 × 0.712 = 163,760 Yr. 4 $230,000 × 0.636 = 146,280 Yr. 5 $230,000 × 0.567 = 130,410 $ 97,340 Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 20) What is the net present value of the investment, assuming the required rate of return is 20%? Would the hospital want to purchase the new machine? A) $33,910; yes B) $(33,910); no C) $(33,910); yes D) $50,700; yes Answer: B Explanation: B) Yr. 0 ($90,000 - $650,000 - $20,000) × 1.000 = $(580,000) Yr. 1 $ 60,000 × 0.833 = 49,980 Yr. 2 $230,000 × 0.694 = 159,620 Yr. 3 $230,000 × 0.579 = 133,170 Yr. 4 $230,000 × 0.482 = 110,860 Yr. 5 $230,000 × 0.402 = 92,460 $(33,910) Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 21) In using the net present value method, only projects with a zero or positive net present value are acceptable because: A) the return from these projects equals or exceeds the cost of capital B) a positive net present value on a particular project guarantees company profitability C) the company will be able to pay the necessary payments on any loans secured to finance the project D) Both A and B are correct. Answer: A Diff: 2 Terms: net present value (NPV) method Objective: 2 AACSB: Reflective thinking 22) Which of the following is NOT an appropriate term for the required rate of return? A) discount rate B) hurdle rate C) cost of capital D) All of these answers are correct. Answer: D Diff: 2 Terms: RRR, discount rate, hurdle rate, opportunity cost of capital Objective: 2 AACSB: Reflective thinking 23) Which of the following results of the net present value method in capital budgeting is the LEAST acceptable? A) $(5,000) B) $(7,000) C) $(15,000) D) $0 Answer: C Diff: 2 Terms: net present value (NPV) method Objective: 2 AACSB: Reflective thinking 24) The definition of an annuity is: A) similar to the definition of a life insurance policy B) a series of equal cash flows at intervals C) an investment product whose funds are invested in the stock market D) Both A and B are correct. Answer: B Diff: 2 Terms: net present value (NPV) method Objective: 2 AACSB: Reflective thinking 25) The net present value method focuses on: A) cash inflows B) accrual-accounting net income C) cash outflows D) Both A and C are correct. Answer: D Diff: 2 Terms: net present value (NPV) method Objective: 2 AACSB: Reflective thinking 26) If the net present value for a project is zero or positive, this means that the: A) project should be accepted B) project should not be accepted C) expected rate of return is below the required rate of return D) Both A and C are correct. Answer: A Diff: 2 Terms: net present value (NPV) method Objective: 2 AACSB: Reflective thinking 27) Upper Darby Park Department is considering a new capital investment. The following information is available on the investment. The cost of the machine will be $300,000. The annual cost savings if the new machine is acquired will be $80,000. The machine will have a 5-year life, at which time the terminal disposal value is expected to be $40,000. Upper Darby Park Department is assuming no tax consequences. If Upper Darby Park Department has a required rate of return of 10%, which of the following is closest to the present value of the project? A) $3,264 B) $24,836 C) $28,120 D) $300,000 Answer: C Explanation: C) ($80,000 × 3.791) + ($40,000 × .621) - $300,000 = $28,120 Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 28) Shirt Company wants to purchase a new cutting machine for its sewing plant. The investment is expected to generate annual cash inflows of $150,000. The required rate of return is 12% and the current machine is expected to last for four years. What is the maximum dollar amount Shirt Company would be willing to spend for the machine, assuming its life is also four years? Income taxes are not considered. A) $263,500 B) $360,300 C) $395,870 D) $455,550 Answer: D Explanation: D) X = $150,000 × PV Ann 4 (12%) = $150,000 × 3.037 X= $455,550 Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 29) The Zeron Corporation wants to purchase a new machine for its factory operations at a cost of $475,000. The investment is expected to generate $175,000 in annual cash flows for a period of four years. The required rate of return is 14%. The old machine can be sold for $25,000. The machine is expected to have zero value at the end of the four-year period. What is the net present value of the investment? Would the company want to purchase the new machine? Income taxes are not considered. A) $59,775; yes B) $34,775; no C) $509,775; yes D) $163,375; no Answer: A Explanation: A) Year 0 = ($25,000 - $475,000) = $(450,000) Year 1 = $175,000 × 0.877 = 153,475 Year 2 = $175,000 × 0.769 = 134,575 Year 3 = $175,000 × 0.675 = 118,125 Year 4 = $175,000 × 0.592 = 103,600 $59,775 Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 30) Wet and Wild Water Company drills small commercial water wells. The company is in the process of analyzing the purchase of a new drill. Information on the proposal is provided below. Initial investment: Asset $320,000 Working capital $ 64,000 Operations (per year for four years): Cash receipts $320,000 Cash expenditures $ 176,000 Disinvestment: Salvage value of drill (existing) $ 32,000 Discount rate 20% What is the net present value of the investment? Assume there is no recovery of working capital. A) $(124,280) B) $20,672 C) $84,724 D) $372,672 Answer: B Explanation: B) -$64,000 - $320,000 + $32,000 = $(352,000) Yr 1 = $144,000 × 0.833 = 119,952 Yr 2 = $144,000 × 0.694 = 99,936 Yr 3 = $144,000 × 0.579 = 83,376 Yr 4 = $144,000 × 0.482 = 69,408 $ 20,672 Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 31) The capital budgeting method that calculates the discount rate at which the present value of expected cash inflows from a project equals the present value of expected cash outflows is the: A) net present value method B) accrual accounting rate-of-return method C) payback method D) internal rate of return Answer: D Diff: 2 Terms: internal rate-of-return (IRR) method Objective: 2 AACSB: Reflective thinking 32) In capital budgeting, a project is accepted only if the internal rate of return equals or: A) exceeds the required rate of return B) is less than the required rate of return C) exceeds the net present value D) exceeds the accrual accounting rate of return Answer: A Diff: 2 Terms: internal rate-of-return (IRR) method, required rate of return (RRR) Objective: 2 AACSB: Reflective thinking 33) The Zeron Corporation recently purchased a new machine for its factory operations at a cost of $921,250. The investment is expected to generate $250,000 in annual cash flows for a period of six years. The required rate of return is 14%. The old machine has a remaining life of six years. The new machine is expected to have zero value at the end of the six-year period. The disposal value of the old machine at the time of replacement is zero. What is the internal rate of return? A) 15% B) 16% C) 17% D) 18% Answer: B Explanation: B) $921,250 = $250,000F F = 3.685 Chart criteria for six years is 3.685 = 16% Diff: 3 Terms: internal rate-of-return (IRR) method, required rate of return (RRR) Objective: 2 AACSB: Analytical skills 34) Brown Corporation recently purchased a new machine for $339,013.20 with a ten-year life. The old equipment has a remaining life of ten years and no disposal value at the time of replacement. Net cash flows will be $60,000 per year. What is the internal rate of return? A) 12% B) 16% C) 20% D) 24% Answer: A Explanation: A) $339,013.20 = $60,000F F = 5.65022 Chart criteria for 10 years is 5.65022 = 12% Diff: 2 Terms: internal rate-of-return (IRR) method Objective: 2 AACSB: Analytical skills 35) Soda Manufacturing Company provides vending machines for soft-drink manufacturers. The company has been investigating a new piece of machinery for its production department. The old equipment has a remaining life of three years and the new equipment has a value of $52,650 with a three-year life. The expected additional cash inflows are $25,000 per year. What is the internal rate of return? A) 20% B) 16% C) 10% D) 8% Answer: A Explanation: A) $52,650 = $25,000F F = 2.106 Chart criteria for 3 years is 2.106 = 20% Diff: 2 Terms: internal rate-of-return (IRR) method Objective: 2 AACSB: Analytical skills 36) Crystal Manufacturing Company provides glassware machines for major department store retailers. The company has been investigating a new piece of machinery for its production department. The old equipment has a remaining life of five years and the new equipment has a value of $117,320 with a five-year life. The expected additional cash inflows are $35,000 per year. What is the internal rate of return? A) 10% B) 12% C) 15% D) 20% Answer: C Explanation: C) $117,320 = $35,000F F = 3.352 Chart criteria for 5 years is 3.352 = 15% Diff: 2 Terms: internal rate-of-return (IRR) method Objective: 2 AACSB: Analytical skills 37) Springtime Flower Company provides flowers and other nursery products for decorative purposes in medium to large sized restaurants and businesses. The company has been investigating the purchase of a new specially equipped van for deliveries. The van has a value of $62,755 with a seven-year life. The expected additional cash inflows are $13,750 per year. What is the internal rate of return? A) 10% B) 12% C) 15% D) 20% Answer: B Explanation: B) $62,755 = $13,750F F = 4.564 Chart criteria for 7 years is 4.564 = 12% Diff: 2 Terms: internal rate-of-return (IRR) method Objective: 2 AACSB: Analytical skills 38) An important advantage of the net present value method of capital budgeting over the internal rate-of-return method is: A) the net present value method is expressed as a percentage B) the net present values of individual projects can be added to determine the effects of accepting a combination of projects C) There is no advantage. D) Both A and B are correct. Answer: B Diff: 2 Terms: net present value (NPV) method, internal rate-of-return (IRR) method Objective: 2 AACSB: Reflective thinking 39) In situations where the required rate of return is NOT constant for each year of the project, it is advantageous to use: A) the adjusted rate-of-return method B) the internal rate-of-return method C) the net present value method D) sensitivity analysis Answer: C Diff: 2 Terms: required rate of return (RRR), net present value (NPV) method Objective: 2 AACSB: Reflective thinking 40) A "what-if" technique that examines how a result will change if the original predicted data are NOT achieved or if an underlying assumption changes is called: A) sensitivity analysis B) net present value analysis C) internal rate-of-return analysis D) adjusted rate-of-return analysis Answer: A Diff: 1 Terms: capital budgeting, sensitivity analysis Objective: 2 AACSB: Reflective thinking 41) Investment A requires a net investment of $1,600,000. The required rate of return is 12% for the four-year annuity. What are the annual cash inflows if the net present value equals 0? (rounded) A) $378,966 B) $526,836 C) $549,696 D) $591,466 Answer: B Explanation: B) 3.037 × ACI - $1,600,000 = $0 = $526,836 Diff: 3 Terms: net present value (NPV) method, internal rate-of-return (IRR) method Objective: 2 AACSB: Analytical skills 42) The minimum annual acceptable rate of return on an investment is the: A) accrual accounting rate of return B) hurdle rate C) internal rate of return D) net present value Answer: B Diff: 2 Terms: hurdle rate Objective: 2 AACSB: Reflective thinking 43) Upper Darby Park Department is considering a new capital investment. The following information is available on the investment. The cost of the machine will be $432,576. The annual cost savings if the new machine is acquired will be $120,000. The machine will have a 5-year life, at which time the terminal disposal value is expected to be zero. Upper Darby Park Department is assuming no tax consequences. What is the internal rate of return for Upper Darby Park Department? A) 10% B) 12% C) 14% D) 16% Answer: B Explanation: B) PV Factor is $432,576 / $120,000 = 3.6048. This corresponds to a 12% IRR using the annuity table for a 5-year annuity. Diff: 3 Terms: internal rate-of-return (IRR) method Objective: 2 AACSB: Analytical skills 44) The Required Rate of Return (RRR) is set externally by creditors as the interest rate on long term liabilities. Answer: FALSE Explanation: The RRR is internally set, usually by upper management, and typically reflects the return that an organization could expect to receive elsewhere for an investment of comparable risk. Diff: 2 Terms: required rate of return (RRR), net present value (NPV) method Objective: 2 AACSB: Analytical skills 45) Discounted cash flow methods focus on operating income. Answer: FALSE Explanation: Discounted cash flow methods focus on cash inflows and cash outflows. Diff: 2 Terms: discounted cash flow (DCF) methods Objective: 2 AACSB: Analytical skills 46) The three common discounted cash flow methods are net present value, internal rate of return, and payback. Answer: FALSE Explanation: The two common discounted cash flow methods are net present value and internal rate of return. The traditional payback method is not a discounted cash flow method. Diff: 2 Terms: discounted cash flow (DCF) methods Objective: 2 AACSB: Reflective thinking 47) The net present value (NPV) method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows back to the present point in time using the required rate of return. Answer: TRUE Diff: 2 Terms: net present value (NPV) method, hurdle rate Objective: 2 AACSB: Reflective thinking 48) Internal rate of return is a method of calculating the expected net monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time. Answer: FALSE Explanation: The internal rate of return calculates the discount rate at which the present value of expected cash inflows from a project equals the present value of expected cash outflows. Diff: 2 Terms: internal rate-of-return (IRR) method Objective: 2 AACSB: Reflective thinking 49) A capital budgeting project is accepted if the required rate of return equals or exceeds the internal rate of return. Answer: FALSE Explanation: A capital budgeting project is accepted if the internal rate of return equals or exceeds the required internal rate of return. Diff: 2 Terms: required rate of return (RRR), internal rate-of-return (IRR) method Objective: 2 AACSB: Reflective thinking 50) The net present value method can be used in situations where the required rate of return varies over the life of the project. Answer: TRUE Diff: 2 Terms: net present value (NPV) method, required rate of return (RRR) Objective: 2 AACSB: Reflective thinking 51) The net present value method accurately assumes that project cash flows can only be reinvested at the company's required rate of return. Answer: TRUE Diff: 2 Terms: net present value (NPV) method, required rate of return (RRR) Objective: 2 AACSB: Reflective thinking 52) The Zero Machine Company is evaluating a capital expenditure proposal that requires an initial investment of $41,920 and has predicted cash inflows of $10,000 per year for 10 years. It will have no salvage value. Required: a. Using a required rate of return of 16%, determine the net present value of the investment proposal. b. Determine the proposal's internal rate of return. Answer: a. Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Initial investment $(41,920) 0 1.000 $(41,920) Annual operations 10,000 10 4.833 48,330 Net present value $ 6,410 b. Present value factor of an annuity of $1.00 = $41,920/$10,000 = 4.192 From the annuity table, the 4.192 factor is closest to the 10-year row at the 20% column. Therefore, the IRR is 20%. Diff: 2 Terms: NPV method, RRR, internal rate-of-return (IRR) method Objective: 2 AACSB: Analytical skills 53) Network Service Center is considering purchasing a new computer network for $82,000. It will require additional working capital of $13,000. Its anticipated eight-year life will generate additional client revenue of $33,000 annually with operating costs, excluding depreciation, of $15,000. At the end of eight years, it will have a salvage value of $9,500 and return $5,000 in working capital. Taxes are not considered. Required: a. If the company has a required rate of return of 14%, what is the net present value of the proposed investment? b. What is the internal rate of return? Answer: a. Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Initial investment $(95,000) 0 1.000 $(95,000) Annual operations, net 18,000 1-8 4.639 83,502 Salvage value, work cap 14,500 8 0.351 5,090 Net present value $(6,408) b. Trial and error is necessary. You know it is below 14% because the answer to Part A was negative and, therefore, less than the discount rate. Therefore, let's try 12%. Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Initial investment $(95,000) 0 1.000 $(95,000) Annual operations, net 18,000 1-8 4.968 89,424 Salvage value, work cap 14,500 8 0.404 5,858 Net present value $282 The (almost) zero net present value indicates an internal rate of return of approximately 12%. Diff: 3 Terms: NPV method, RRR, internal rate-of-return (IRR) method Objective: 2 AACSB: Analytical skills 54) EIF Manufacturing Company needs to overhaul its drill press or buy a new one. The facts have been gathered, and they are as follows: Current Machine New Machine Purchase Price, New $80,000 $100,000 Current book value 30,000 Overhaul needed now 40,000 Annual cash operating costs 70,000 40,000 Current salvage value 20,000 Salvage value in five years 5,000 20,000 Required: Which alternative is the most desirable with a current required rate of return of 20%? Show computations, and assume no taxes. Answer: Present value of keeping current system: Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Overhaul $(40,000) 0 1.000 $(40,000) Annual operations (70,000) 1-5 2.991 (209,370) Salvage value 5,000 5 0.402 2,010 Net present value $(247,360) Present value of new system: Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Investment $(100,000) 0 1.000 $(100,000) Salvage value, old 20,000 0 1.000 20,000 Annual operations (40,000) 1-5 2.991 (119,640) Salvage value 20,000 5 0.402 8,040 Net present value $(191,600) Buying the new equipment is the most desirable by $55,760 ($247,360 - $191,600). Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 55) Maremount Tire Company needs to overhaul its auto lift system or buy a new one. The facts have been gathered, and they are as follows: Current Machine New Machine Purchase Price, New $112,500 $148,000 Current book value 33,500 Overhaul needed now 27,500 Annual cash operating costs 63,000 48,000 Current salvage value 40,000 Salvage value in five years 8,000 35,000 Required: Which alternative is the most desirable with a current required rate of return of 15%? Show computations, and assume no taxes. Answer: Present value of keeping current system: Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Overhaul $(27,500) 0 1.000 $(27,500) Annual operations (63,000) 1-5 3.352 (211,176) Salvage value 8,000 5 0.497 3,976 Net present value $(234,700) Present value of new system: Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Investment $(148,000) 0 1.000 $(148,000) Salvage value, old 40,000 0 1.000 40,000 Annual operations (48,000) 1-5 3.352 (160,896) Salvage value 35,000 5 0.497 17,395 Net present value $(251,501) Overhauling the existing system is the most desirable by $16,801 [$(234,700) - $(251,501)]. Diff: 3 Terms: net present value (NPV) method Objective: 2 AACSB: Analytical skills 56) ABC Boat Company is interested in replacing a molding machine with a new improved model. The old machine has a salvage value of $10,000 now and a predicted salvage value of $4,000 in six years, if rebuilt. If the old machine is kept, it must be rebuilt in one year at a predicted cost of $20,000. The new machine costs $80,000 and has a predicted salvage value of $12,000 at the end of six years. If purchased, the new machine will allow cash savings of $20,000 for each of the first three years, and $10,000 for each year of its remaining six-year life. Required: What is the net present value of purchasing the new machine if the company has a required rate of return of 14%? Answer: Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Initial investment $(80,000) 0 1.000 $(80,000) Salvage of old 10,000 0 1.000 10,000 Annual operations 20,000 1-3 2.322 46,440 Annual operations 10,000 4-6 (3.889-2.322) 15,670 Save by not rebuilding 20,000 1 0.877 17,540 Salvage of new 12,000 6 0.456 5,472 Net present value $15,122 Diff: 3 Terms: net present value (NPV) method, required rate of return (RRR) Objective: 2 AACSB: Analytical skills 57) Retail Outlet is looking for a new location near a shopping mall. It is considering purchasing a building rather than leasing, as it has done in the past. Three retail buildings near a new mall are available but each has its own advantages and disadvantages. The owner of the company has completed an analysis of each location that includes considerations for the time value of money. The information is as follows: Location A Location B Location C Internal rate of return 13% 17% 20% Net present value $25,000 $40,000 $20,000 The owner does not understand how the location with the highest percentage return has the lowest net present value. Required: Explain to the owner what is (are) the probable cause(s) of the comparable differences. Answer: The highest probability is that location C has a much lower initial investment than the other two. Therefore, it can show a higher rate of return with fewer dollars of inflow. Unfortunately, this may cause it to have the lowest net present value since this model is presented in dollar terms. Location C could also have a shorter life which could give it a higher percentage return during its life but fewer dollars overall. Diff: 2 Terms: net present value (NPV) method Objective: 2 AACSB: Reflective thinking Objective 21.3 1) The method that measures the time it will take to recoup, in the form of future cash inflows, the total dollars invested in a project is called: A) the accrued accounting rate-of-return method B) payback method C) internal rate-of-return method D) the book-value method Answer: B Diff: 1 Terms: payback Objective: 3 AACSB: Reflective thinking 2) The net initial investment for a piece of construction equipment is $2,000,000. Annual cash inflows are expected to increase by $400,000 per year. The equipment has an 8-year useful life. What is the payback period? A) 8 years B) 7 years C) 6 years D) 5 years Answer: D Explanation: D) $2,000,000/$400,000 = 5.0 years Diff: 2 Terms: payback Objective: 3 AACSB: Analytical skills 3) The payback method of capital budgeting approach to the investment decision highlights: A) cash flow over the life of the investment B) the liquidity of the investment C) the tax savings of the depreciation amounts D) having as lengthy payback time as possible Answer: B Diff: 2 Terms: payback Objective: 3 AACSB: Reflective thinking 4) Upper Darby Park Department is considering a new capital investment. The following information is available on the investment. The cost of the machine will be $72,096. The annual cost savings if the new machine is acquired will be $20,000. The machine will have a 5-year life, at which time the terminal disposal value is expected to be zero. Upper Darby Park is assuming no tax consequences. Upper Darby Park has a 10% required rate of return. What is the payback period on this investment? A) 3 years B) 3.6 years C) 4.2 years D) 5 years Answer: B Diff: 2 Terms: payback Objective: 3 AACSB: Analytical skills 5) Crystal Manufacturing Company provides glassware machines for major department store retailers. The company has been investigating a new piece of machinery for its production department. The old equipment has a remaining life of five years and the new equipment has a value of $231,000 with a five-year life. The expected additional cash inflows are $70,000 per year. What is the payback period on this investment? A) 2.5 years B) 3 years C) 3.3 years D) 5 years Answer: C Explanation: C) $231,000/$70,000 = 3.3 years. Diff: 2 Terms: payback Objective: 3 AACSB: Analytical skills 6) Springtime Flower Company provides flowers and other nursery products for decorative purposes in medium to large sized restaurants and businesses. The company has been investigating the purchase of a new specially equipped van for deliveries. The van has a value of $123,750 with a seven-year life. The expected additional cash inflows are $27,500 per year. What is the payback period on this investment? A) 3 years B) 4.5 years C) 6 years D) NA - project not feasible Answer: B Explanation: B) $123,750/$27,500 = 4.5 years. Diff: 2 Terms: payback Objective: 3 AACSB: Analytical skills 7) Unlike the net present value method and the internal rate-of-return method, the payback method does NOT distinguish between the origins of the cash flows. Answer: FALSE Explanation: None of the three capital budgeting methods distinguish between the origins of the cash flows. Diff: 2 Terms: NPV method, internal rate-of-return (IRR) method, payback Objective: 3 AACSB: Reflective thinking 8) The payback method is only useful when the expected cash flows in the later years of the project are highly uncertain. Answer: FALSE Explanation: The payback method is only useful when the expected cash flows in the later years are highly certain. Diff: 3 Terms: payback Objective: 3 AACSB: Analytical skills 9) A weaknesses of the payback method is that it does not consider a project's cash flows after the payback period. Answer: TRUE Diff: 2 Terms: payback Objective: 3 AACSB: Analytical skills 10) Supply the missing data for each of the following proposals: Proposal A Proposal B Proposal C Initial investment (a) $62,900 $226,000 Annual net cash inflow $60,000 (c) (e) Life, in years 10 6 10 Salvage value $0 $10,000 $0 Payback period in years (b) (d) 5.65 Internal rate of return 12% 24% (f) Answer: a. Annual cash inflow $ 60,000 Present value factor for 10 years × 5.650 Initial investment $339,000 b. Payback period = $339,000/$60,000 = 5.65 years c. Initial investment $62,900 PV of salvage value ($10,000 × 0.275) (2,750) Net PV of annual net cash inflow $60,150 Annual cash inflow = $60,150/3.020 = $19,917.22 d. Payback = $62,900/$19,917.22 = 3.158 e. Annual net cash inflow = $226,000/5.650 = $40,000 f. PV factor for 10 years = $226,000/$40,000 = 5.650 Look up value 5.650 in PV of annuity table under 10 years and the internal rate of return is 12%. Diff: 3 Terms: payback, internal rate-of-return (IRR) method Objective: 2, 3 AACSB: Analytical skills 11) Book & Bible Bookstore desires to buy a new coding machine to help control book inventories. The machine sells for $36,586 and requires working capital of $4,000. Its estimated useful life is five years and will have a salvage value of $4,000. Recovery of working capital will be $4,000 at the end of its useful life. Annual cash savings from the purchase of the machine will be $10,000. Required: a. Compute the net present value at a 14% required rate of return. b. Compute the internal rate of return. c. Determine the payback period of the investment. Answer: a. Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Investment $(36,586) 0 1.000 $(36,586) Working capital needed (4,000) 0 1.000 (4,000) Annual operations 10,000 1-5 3.433 34,330 Working capital returned 4,000 5 0.519 2,076 Salvage value 4,000 5 0.519 2,076 Net present value $(2,104) b. Trial and error is required. Because net present value is negative in part a, the internal rate of return is less than 14%. Start by trying 12%. Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Investment $(36,586) 0 1.000 $(36,586) Working capital needed (4,000) 0 1.000 (4,000) Annual operations 10,000 1-5 3.605 36,050 Working capital returned 4,000 5 0.567 2,268 Salvage value 4,000 5 0.567 2,268 Net present value $-0- With a zero net present value, the internal rate of return is 12%. c. Payback period = ($36,586 + $4,000)/$10,000 = 4.06 years. Diff: 3 Terms: NPV method, required rate of return (RRR), IRR method, payback Objective: 2, 3 AACSB: Analytical skills 12) Sam's Structures desires to buy a new crane and accessories to help move and install modular buildings. The machine sells for $75,000 and requires working capital of $10,000. Its estimated useful life is six years and it will have a salvage value of $17,560. Recovery of working capital will be $10,000 at the end of its useful life. Annual cash savings from the purchase of the machine will be $20,000. Required: a. Compute the net present value at a 12% required rate of return. b. Compute the internal rate of return. c. Determine the payback period of the investment. Answer: a. Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Investment $(75,000) 0 1.000 $(75,000) Working capital needed (10,000) 0 1.000 (10,000) Annual operations 20,000 1-6 4.111 82,220 Working capital returned 10,000 6 0.507 5,070 Salvage value 17,560 6 0.507 8,903 Net present value $11,193 b. Trial and error is required. Because net present value is negative in part a, the internal rate of return is greater than 12%. Start by trying any % above 12% and the solution is listed below: Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Investment $(75,000) 0 1.000 $(75,000) Working capital needed (10,000) 0 1.000 (10,000) Annual operations 20,000 1-6 3.685 73,700 Working capital returned 10,000 6 0.410 4,100 Salvage value 17,560 6 0.410 7,200 Net present value $-0- With a zero net present value, the internal rate of return is 16%. c. Payback period = ($75,000 + $10,000)/$20,000 = 4.25 years. Diff: 3 Terms: NPV method, required rate of return (RRR), IRR method, payback Objective: 2, 3 AACSB: Analytical skills 13) Terrain Vehicle has received three proposals for its new vehicle-painting machine. Information on each proposal is as follows: Proposal X Proposal Y Proposal Z Initial investment in equipment $180,000 $120,000 $190,000 Working capital needed 0 0 10,000 Annual cash saved by operations: Year 1 75,000 50,000 80,000 Year 2 75,000 48,000 80,000 Year 3 75,000 44,000 80,000 Year 4 75,000 8,000 80,000 Salvage value end of year: Year 1 100,000 80,000 60,000 Year 2 80,000 60,000 50,000 Year 3 40,000 40,000 30,000 Year 4 10,000 20,000 15,000 Working capital returned 0 0 10,000 Required: Determine each proposal's payback. Answer: Proposal X payback = $180,000/$75,000 = 2.4 years Proposal Y Cash Savings Savings Accumulated To Be Recovered Year 0 $120,000 Year 1 $50,000 $ 50,000 70,000 Year 2 48,000 98,000 22,000 Year 3 44,000 142,000 0 Proposal Y payback = 2 years plus $22,000/$44,000 or 2.5 years. Proposal Z payback = ($190,000 + $10,000)/$80,000 = 2.5 years Diff: 3 Terms: payback Objective: 3 AACSB: Analytical skills 14) Central Trailer Supply has received three proposals for its new trailer assembly line. Information on each proposal is as follows: Proposal X Proposal Y Proposal Z Initial investment in equipment $115,000 $130,000 $145,0000 Working capital needed 0 0 15,000 Annual cash saved by operations: Year 1 55,000 60,000 60,000 Year 2 55,000 40,000 60,000 Year 3 55,000 40,000 60,000 Year 4 55,000 10,000 60,000 Salvage value end of year: Year 1 30,000 25,000 45,000 Year 2 25,000 20,000 40,000 Year 3 20,000 15,000 35,000 Year 4 15,000 10,000 25,000 Working capital returned: 0 0 15,000 Required: Determine each proposal's payback. Answer: Proposal X payback = $115,000/$55,000 = 2.09 years Proposal Y Cash Savings Savings Accumulated To Be Recovered Year 0 $130,000 Year 1 $60,000 $ 60,000 70,000 Year 2 40,000 100,000 30,000 Year 3 40,000 140,000 0 Proposal Y payback = 2 years plus $30,000/$40,000 or 2.75 years. Proposal Z payback = ($145,000 + $15,000)/$60,000 = 2.67 years Diff: 3 Terms: payback Objective: 3 AACSB: Analytical skills Objective 21.4 1) The approach to capital budgeting which divides an accounting measure of income by an accounting measure of investment is the: A) net present value B) internal rate of return C) payback method D) accrual accounting rate of return Answer: D Diff: 1 Terms: accrual accounting rate of return (AARR) Objective: 4 AACSB: Reflective thinking 2) For capital budgeting decisions, the use of the accrual accounting rate of return for evaluating performance is often a stumbling block to the implementation of the: A) net cash flow B) most effective goal-congruence choice C) discounted cash flow method for capital budgeting D) most effective tax strategy Answer: D Diff: 2 Terms: accrual accounting rate of return (AARR) Objective: 4 AACSB: Reflective thinking 3) The most significant manager evaluation and goal congruence issues arise because of inconsistencies between the following methods of choosing among alternatives for capital budgeting purposes: A) net present value method and the internal rate of return method B) payback method and the net present value method C) net present value method and the accrual accounting rate of return method D) payback method and the internal rate of return method Answer: C Diff: 2 Terms: accrual accounting rate of return (AARR) Objective: 4 AACSB: Reflective thinking 4) The accrual accounting rate of return method divides the average annual income of a project by a measure of the investment in it. Answer: TRUE Diff: 2 Terms: accrual accounting rate of return (AARR) Objective: 4 AACSB: Reflective thinking 5) The accrual accounting rate-of-return method is similar to the internal rate-of-return method because both methods calculate a rate-of-return percentage. Answer: TRUE Diff: 2 Terms: accrual accounting rate of return (AARR) Objective: 4 AACSB: Reflective thinking 6) Managers using discounted cash flow methods to make capital budgeting decisions make the same decisions that they would make in using the accrual accounting rate-of-return methods. Answer: FALSE Explanation: Managers using discounted cash flow methods to make capital budgeting decisions make different decisions that they would make in using the accrual accounting rate-of-return methods. Diff: 2 Terms: discounted cash flow (DCF) methods, accrual accounting rate of return (AARR) Objective: 4 AACSB: Reflective thinking 7) The accrual accounting rate-of-return method has a significant weakness for use in making capital budgeting decisions because it does NOT track cash flows and it ignores the time value of money. Answer: TRUE Diff: 2 Terms: discounted cash flow (DCF) methods, accrual accounting rate of return (AARR) Objective: 4 AACSB: Reflective thinking 8) Gavin and Alex, baseball consultants, are in need of a microcomputer network for their staff. They have received three proposals, with related facts as follows: Proposal A Proposal B Proposal C Initial investment in equipment $90,000 $90,000 $90,000 Annual cash increase in operations: Year 1 80,000 45,000 90,000 Year 2 10,000 45,000 0 Year 3 45,000 45,000 0 Salvage value 0 0 0 Estimated life 3 yrs 3 yrs 1 yr The company uses straight-line depreciation for all capital assets. Required: a. Compute the payback period, net present value, and accrual accounting rate of return with initial investment, for each proposal. Use a required rate of return of 14%. b. Rank each proposal 1, 2, and 3 using each method separately. Which proposal is best? Why? Answer: a. Payback Method Payback for Proposal A: Year 1 $80,000 Year 2 10,000 Payback is 2 years $90,000 Payback for Proposal B: Year 1 $45,000 Year 2 45,000 Payback is 2 years $90,000 Payback for proposal C: Year 1 $90,000 Payback is 1 year Net Present Value: Proposal A: Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Investment $(90,000) 0 1.000 $(90,000) Annual operations Year 1 80,000 1 0.877 70,160 Year 2 10,000 2 0.769 7,690 Year 3 45,000 3 0.675 30,375 Net present value $18,225 Proposal B: Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Investment $(90,000) 0 1.000 $(90,000) Annual operations Year 1 45,000 1 0.877 39,465 Year 2 45,000 2 0.769 34,605 Year 3 45,000 3 0.675 30,375 Net present value $14,445 Proposal C: Predicted Cash Flows Year(s) PV Factor PV of Cash Flows Investment $(90,000) 0 1.000 $(90,000) Annual operations Year 1 90,000 1 0.877 78,930 Net present value $11,070 Accrual Accounting Rate of Return: Proposal A: = 0.167 Proposal B: ($45,000 - $30,000)/$90,000 = 0.167 Proposal C: ($90,000 - $90,000)/$90,000 = 0.0 b. Summary: Method Proposal A Proposal B Proposal C Payback method ranks 2.5 2.5 1.0 Net present value 1.0 2.0 3.0 AARR 1.5 1.5 3.0 Even though Proposal C is Number 1 for payback, it comes in last with the other two methods. Because the net present value method takes into account the time value of money and the other proposals are less comprehensive, Proposal A would be the best alternative. Diff: 3 Terms: NPV method, required rate of return (RRR), payback, AARR Objective: 2, 3, 4 AACSB: Analytical skills 9) Jensen Manufacturing is considering buying an automated machine that costs $500,000. It requires working capital of $50,000. Annual cash savings are anticipated to be $206,000 for five years. The company uses straight-line depreciation. The salvage value at the end of five years is expected to be $20,000. The working capital will be recovered at the end of the machine's life. Required: Compute the accrual accounting rate of return based on the initial investment. Answer: Accrual accounting income = $206,000 - (($500,000 - $20,000)/5) = $206,000 - $96,000 = $ 110,000 AARR with initial investment = $110,000/($500,000 + $50,000) = $110,000/$550,000 = 0.20 Diff: 2 Terms: accrual accounting rate of return (AARR) Objective: 4 AACSB: Analytical skills 10) What are the four alternative methods for evaluating capital budgeting projects? What is an advantage and disadvantage of each method? Answer: The four methods are: 1. Net Present Value (NPV); 2. Internal Rate of Return (IRR); 3. Payback; and 4. Accrual Accounting Rate of Return (AARR). NPV has advantages in that it uses discounted cash flows, and can deal with uneven cash flows, considers the inflows and outflows of the project. A disadvantage of NPV is that the results indicate if it achieves a particular cost of capital or not, but it does not indicate what the rate of return actually is. The IRR method generates an expected rate of return for the investment given the time of the project and the discounting of cash flows. A disadvantage of the IRR is that the results are expressed in the form of a percentage rather than in dollars and it is difficult to use when the project has uneven cash flows. The payback is simple to use, and adapts to both even and uneven cash flows. It also highlights the liquidity of a project. A disadvantage to the payback is that it does not consider either the time value of money, or the cash flows that occur after the payback time period. The AARR method uses the information that is most often found in financial statements ? including net income and depreciation. A drawback is that the method does not take into account the time value of money or the cash flows of the project. Diff: 2 Terms: capital budgeting Objective: 2, 3, 4 AACSB: Reflective thinking 11) Bock Construction Company is considering four proposals for the construction of new loading facilities that will include the latest in ship loading/unloading equipment. After careful analysis, the company's accountant has developed the following information about the four proposals: Proposal 1 Proposal 2 Proposal 3 Proposal 4 Payback period 4 years 4.5 years 6 years 7 years Net present value $80,000 $178,000 $166,000 $308,000 Internal rate of return 12% 14% 11% 13% Accrual accounting rate of return 8% 6% 4% 7% Required: How can this information be used in the decision-making process for the new loading facilities? Does it cause any confusion? Answer: The managers can use the information to determine which proposal is best under the various alternatives. This may be accomplished by ranking each alternative. Also, the managers must determine the factors that are the most important to the company. For example, if short-run risk is high, a short payback period may be highly desirable. In this case, Proposal 1 is best. However, if total cash returned is critical to the company's operations, then Proposal 4 is probably best. Any time that multiple measures are used there may be confusion because very seldom will one proposal appear to be the best with all models. In this case, payback ranks Proposal 1 the best, NPV ranks Proposal 4 the best, IRR ranks Proposal 2 the best, and AARR ranks Proposal 1 the best. The importance of each ranking will depend upon the circumstances of the organization and the managers must be attuned as to what is most favorable. The net present value and the internal rate-of-return methods are superior because they consider the time value of money. Diff: 2 Terms: payback; NPV, IRR method; accrual accounting rate of return (AARR) Objective: 2, 3, 4 AACSB: Analytical skills Objective 21.5 1) In the analysis of a capital budgeting proposal, for which of the following items are there NO after-tax consequences? A) cash flow from operations B) gain or loss on the disposal of the asset C) reduction of working capital balances at the end of the useful life of the capital asset D) None of these answers is correct. Answer: C Diff: 2 Terms: capital budgeting Objective: 5 AACSB: Reflective thinking 2) The Alpha Beta Corporation disposes a capital asset with an original cost of $170,000 and accumulated depreciation of $109,000 for $50,000. Alpha betas tax rate is 40%. Calculate the after-tax cash inflow from the disposal of the capital asset. A) $4,400 B) ($4,400) C) $54,400 D) $63,000 Answer: C Explanation: C) ($170,000 - $109,000) = $61,000 - $50,000 = $11,000 loss × 0.4 = $4,400 tax savings from loss plus $50,000 proceeds = $54,400 Diff: 3 Terms: capital budgeting Objective: 5 AACSB: Analytical skills 3) The Silver Shades Corporation disposes a capital asset with an original cost of $230,000 and accumulated depreciation of $125,000 for a salvage price of $36,000. Silver Shades's tax rate is 30%. Calculate the after-tax cash inflow from the disposal of the capital asset. A) $2,070 B) $38,070 C) $36,000 D) $56,700 Answer: D Explanation: D) ($230,000 - $125,000) = $105,000 - $36,000 = $69,00 loss × .3 = $20,700 tax savings from loss plus $36,000 proceeds = $56,700 Diff: 3 Terms: capital budgeting Objective: 5 AACSB: Analytical skills 4) The phenol Corporation has an annual cash inflow from operations from its investment in a capital asset of $25,000 each year for five years. The corporation's income tax rate is 40%. Calculate the five years total after-tax cash inflow from operations. A) $ 125,000 B) $ 150,000 C) $ 75,000 D) $25,000 Answer: C Explanation: C) $25,000 × 5 = $125,000 × (1 - 0.4) = $ 75,000 net cash flow Diff: 3 Terms: capital budgeting Objective: 5 AACSB: Analytical skills 5) The Lancaster Corporation has an annual cash inflow from operations from its investment in a capital asset of $22,000 each year for five years. The corporation's income tax rate is 25%. Calculate the five years total after-tax cash inflow from operations. A) $10,000 B) $82,500 C) $88,000 D) $110,000 Answer: B Explanation: B) $22,000 × 5 = $110,000 × (1 - 0.25) = $82,500 net cash flow Diff: 3 Terms: capital budgeting Objective: 5 AACSB: Analytical skills 6) Comparison of the actual results for a project to the costs and benefits expected at the time the project was selected is referred to as: A) the audit trail B) management control C) a post-investment audit D) a cost-benefit analysis Answer: C Diff: 2 Terms: capital budgeting Objective: 5 AACSB: Reflective thinking 7) A capital budgeting tool that management can use to summarize the difference in the future net cash inflows from an intangible asset at two different points in time is referred to as: A) the accrual accounting rate-of-return method B) the net present value method C) sensitivity analysis D) the payback method Answer: B Diff: 2 Terms: net present value (NPV) method Objective: 5 AACSB: Reflective thinking 8) The focus in capital budgeting should be on: A) the tax consequences of different investment strategies B) the internal rate of return of different strategies C) expected future cash flows that differ between alternatives D) None of these answers is correct. Answer: C Diff: 2 Terms: capital budgeting Objective: 5 AACSB: Reflective thinking 9) All of the following are major categories of cash flows in capital investment decisions EXCEPT: A) the initial investment in machines and working capital B) recurring operating cash flows C) the initial working capital investment D) depreciation expense reported on the income statement Answer: D Diff: 2 Terms: capital budgeting Objective: 5 AACSB: Reflective thinking 10) An example of a sunk cost in a capital budgeting decision for