Chp - CPA Diary
CHAPTER 21: CAPITAL BUDGETING AND COST ANALYSIS
TRUE/FALSE
1. Capital budgeting focuses on projects over their entire lives in order to consider all the cash flows or cash savings from investing in a single project.
Answer: True Difficulty: 2 Objective: 1
2. The identification stage of capital budgeting explores alternative capital investments that will achieve the objectives of the organization.
Answer: False Difficulty: 1 Objective: 2
This is the definition of the search stage.
3. The information-acquisition stage of capital budgeting considers the expected costs and the expected benefits of alternative capital investments.
Answer: True Difficulty: 1 Objective: 2
4. The selection stage of the capital budgeting process consists of choosing projects for possible implementation.
Answer: True Difficulty: 1 Objective: 2
5. Discounted cash flow methods measure all the expected future cash inflows and outflows of a project as if they occurred at equal intervals over the life of the project.
Answer: False Difficulty: 2 Objective: 3
As if they occurred at a single point in time.
6. Discounted cash flow methods focus on operating income.
Answer: False Difficulty: 2 Objective: 3
Discounted cash flow method focus on cash inflows and cash outflows.
7. The net present value method 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 hurdle rate.
Answer: True Difficulty: 2 Objective: 3
8. 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 Difficulty: 2 Objective: 3
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.
9. A capital budgeting project is accepted if the required rate of return equals or exceeds the internal rate of return.
Answer: False Difficulty: 2 Objective: 3
A capital budgeting project is accepted if the internal rate of return equals or exceeds the required internal rate of return.
10. 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 Difficulty: 2 Objective: 3
11. Relevant cash flows are expected future cash flows that differ among the alternative uses of investment funds.
Answer: True Difficulty: 2 Objective: 4
12. Deducting depreciation from operating cash flows would result in counting the initial investment twice, in the discounted cash flow analysis.
Answer: True Difficulty: 2 Objective: 4
13. 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 Difficulty: 2 Objective: 5
None of the three capital budgeting methods distinguish between the origins of the cash flows.
14. The payback method is only useful when the expected cash flows in the later years of the project are highly uncertain.
Answer: False Difficulty: 3 Objective: 5
The payback method is only useful when the expected cash flows in the later years are highly certain.
15. The accrual accounting rate-of-return method is similar to the internal rate-of-return method in that both methods calculate a rate-of-return percentage.
Answer: True Difficulty: 2 Objective: 6
16. A manager who uses discounted cash flow methods to make capital budgeting decisions does not face goal-congruence issues if the accrual accounting rate of return is used for performance evaluation.
Answer: False Difficulty: 2 Objective: 7
The manager does face goal-congruence issues.
17. Depreciation tax deductions result in tax savings that partially offset the cost of acquiring the capital asset.
Answer: True Difficulty: 2 Objective: 8
18. The use of an accelerated method of depreciation for tax purposes would usually increase the present value of the investment.
Answer: True Difficulty: 3 Objective: 8
19. An example of an intangible asset would be a corporation’s customer base.
Answer: True Difficulty: 2 Objective: 8
20. The nominal approach to incorporating inflation into the net present value method predicts cash inflows in real monetary units and uses a real rate as the required rate of return.
Answer: False Difficulty: 2 Objective: A
This is the definition of the real approach.
MULTIPLE CHOICE
21. 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 Difficulty: 1 Objective: 1
22. 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 Difficulty: 1 Objective: 1
23. The stage of the capital budgeting process which distinguishes which types of capital expenditure projects are necessary to accomplish organization objectives is the
a. identification stage.
b. search stage.
c. information-acquisition stage.
d. selection stage.
Answer: a Difficulty: 1 Objective: 2
24. The stage of the capital budgeting process which explores alternative capital investments that will achieve organization objectives is the
a. identification stage.
b. search stage.
c. information-acquisition stage.
d. selection stage.
Answer: b Difficulty: 1 Objective: 2
25. The stage of the capital budgeting process which considers the expected costs and the expected benefits of alternative capital investments is the
a. identification stage.
b. search stage.
c. information-acquisition stage.
d. selection stage.
Answer: c Difficulty: 1 Objective: 2
26. The stage of the capital budgeting process which chooses projects for implementation is the
a. selection stage.
b. search stage.
c. identification stage.
d. management-control stage.
Answer: a Difficulty: 1 Objective: 2
27. The stage of the capital-budgeting process in which projects get underway and performance is monitored is the
a. implementation and control stage.
b. search stage.
c. identification stage.
d. management-control stage.
Answer: a Difficulty: 1 Objective: 2
28. Capital budgeting emphasizes two factors
a. qualitative and nonfinancial.
b. quantitative and nonfinancial.
c. quantitative and financial
d. qualitative and financial.
Answer: c Difficulty: 1 Objective: 2
29. 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 Difficulty: 2 Objective: 2
30. 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).
Answer: d Difficulty: 2 Objective: 3
31. Discounted cash flow methods for capital budgeting focus on
a. cash inflows.
b. operating income.
c. cash outflows.
d. both (a) and (c).
Answer: d Difficulty: 2 Objective: 3
32. Net present value is calculated using
a. the internal rate of return.
b. the required rate of return.
c. the rate of return required by the investment bankers.
d. none of the above.
Answer: b Difficulty: 2 Objective: 3
33. 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 Difficulty: 2 Objective: 3
34. 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 Difficulty: 2 Objective: 3
35. Assume your goal in life is to retire with one 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. $14,565
b. $27,184
c. $120,102
d. $376,476
Answer: b Difficulty: 3 Objective: 3
S (36.786) = $1,000,000
S = $ 27,184.25
36. 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 of now, it may be sold for $60,000. The new machine will cost $200,000 and an additional cash investment in working capital of $60,000 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 $50,000 in additional cash inflows during the year of acquisition and $150,000 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.
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. $82,000; yes
b. $50,000; no
c. $(50,000); yes
d. $(82,000); no
Answer: a Difficulty: 3 Objective: 3
Yr. 0 ($60,000 - $200,000 - $60,000) x 1.000 = $(200,000)
Yr. 1 $50,000 x 0.909 = 45,450
Yr. 2 $150,000 x 0.826 = 123,900
Yr. 3 $150,000 x 0.751 = 112,650
$ 82,000
37. 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 of now, it may be sold for $60,000. The new machine will cost $200,000 and an additional cash investment in working capital of $60,000 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 $50,000 in additional cash inflows during the year of acquisition and $150,000 each additional year of use. The new machine has a three-year life. 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.
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. $(32,800); yes
b. $(16,400); no
c. $16,400; yes
d. $32,800; no
Answer: c Difficulty: 3 Objective: 3
Yr. 0 ($60,000 - $200,000 - $60,000) x 1.000 = $(200,000)
Yr. 1 $ 50,000 x 0.806 = 40,300
Yr. 2 $150,000 x 0.650 = 97,500
Yr. 3 $150,000 x 0.524 = 78,600
$ 16,400
38. 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. of both (a) and (b).
Answer: a Difficulty: 2 Objective: 3
39. 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 the above are appropriate terms
Answer: d Difficulty: 2 Objective: 3
40. Which of the following results of the net present value method in capital budgeting is the LEAST acceptable?
a. $(10,000)
b. $(7,000)
c. $(18,000)
d. $0
Answer: c Difficulty: 2 Objective: 3
41. 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 Difficulty: 2 Objective: 3
42. The net present value method focuses on
a. cash inflows.
b. accrual-accounting net income.
c. cash outflows.
d. both (a) and (c).
Answer: d Difficulty: 2 Objective: 3
43. If the net present value for a project is zero or positive, this means
a. the project should be accepted.
b. the project should not be accepted.
c. the expected rate of return is below the required rate of return.
d. both (a) and (c).
Answer: a Difficulty: 2 Objective: 3
44. Shirt Company wants to purchase a new cutting machine for its sewing plant. The investment is expected to generate annual cash inflows of $300,000. 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. $507,000
b. $720,600
c. $791,740
d. $911,100
Answer: d Difficulty: 3 Objective: 3
X = $300,000 x PV Ann 4 (12%) = $300,000 x 3.037
X= $911,100
45. The Zeron Corporation wants to purchase a new machine for its factory operations at a cost of $950,000. The investment is expected to generate $350,000 in annual cash flows for a period of four years. The required rate of return is 14%. The old machine can be sold for $50,000. 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. $119,550; yes
b. $69,550; no
c. $1,019,550; yes
d. $326,750; no
Answer: a Difficulty: 3 Objective: 3
Year 0 = ($50,000 - $950,000) = $(900,000)
Year 1 = $350,000 x 0.877 = 306,950
Year 2 = $350,000 x 0.769 = 269,150
Year 3 = $350,000 x 0.675 = 236,250
Year 4 = $350,000 x 0.592 = 207,200
$ 119,550
46. 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 $160,000
Working capital $ 32,000
Operations (per year for four years):
Cash receipts $160,000
Cash expenditures $ 88,000
Disinvestment:
Salvage value of drill (existing) $ 16,000
Discount rate 20%
What is the net present value of the investment? Assume there is no recovery of working capital.
a. $(62,140)
b. $10,336
c. $42,362
d. $186,336
Answer: b Difficulty: 3 Objective: 3
- $32,000 - $160,000 + $16,000= $(176,000)
Yr 1 = $72,000 x 0.833= 59,976
Yr 2 = $72,000 x 0.694= 49,968
Yr 3 = $72,000 x 0.579= 41,688
Yr 4 = $72,000 x 0.482= 34,704
$ 10,336
47. 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 Difficulty: 2 Objective: 3
48. In capital budgeting, a project is accepted only if the internal rate of return
a. equals or exceeds the required rate of return.
b. equals or is less than the required rate of return.
c. equals or exceeds the net present value.
d. equals or exceeds the accrual accounting rate of return.
Answer: a Difficulty: 2 Objective: 3
49. 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 Difficulty: 3 Objective: 3
$921,250= $250,000 F
F = 3.685
Chart criteria for six years is 3.685 = 16%
50. 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 Difficulty: 2 Objective: 3
$339,013.20 = $60,000F
F = 5.65022
Chart criteria for 10 years is 5.65022 = 12%
51. 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 Difficulty: 2 Objective: 3
$52,650 = $25,000F
F = 2.106
Chart criteria for 3 years is 2.106 = 20%
52. 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. no advantage.
d. both (a) and (b).
Answer: b Difficulty: 2 Objective: 3
53. 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 Difficulty: 2 Objective: 3
54. 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 Difficulty: 1 Objective: 3
55. Investment A requires a net investment of $800,000. 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. $189,483
b. $263,418
c. $274,848
d. $ 295,733
Answer: b Difficulty: 3 Objective: 3
3.037 x ACI - $800,000 = $0
= $ 263,418
56. 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 the above.
Answer: c Difficulty: 2 Objective: 4
57. 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 Difficulty: 2 Objective: 4
58. An example of a sunk cost in a capital budgeting decision for new equipment is
a. increase in working capital required by a particular investment choice.
b. the book value of the old equipment.
c. the necessary transportation costs on the new equipment.
d. all of the above are examples of sunk costs.
Answer: b Difficulty: 2 Objective: 4
59. Depreciation is usually not considered an operating cash flow in capital budgeting because
a. depreciation is usually a constant amount each year over the life of the capital investment.
b. deducting depreciation from operating cash flows would be counting the lump-sum amount twice.
c. depreciation usually does not result in an increase in working capital.
d. depreciation usually has no effect on the disposal price of the machine.
Answer: b Difficulty: 1 Objective: 4
60. The relevant terminal disposal price of a machine equals
a. the difference between the salvage value of the old machine and the ultimate salvage value of the new machine.
b. the total of the salvage values of the old machine and the new machine.
c. the salvage value of the old machine.
d. the salvage value of the new machine.
Answer: a Difficulty: 3 Objective: 4
61. 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 Difficulty: 1 Objective: 5
62. The net initial investment for a piece of construction equipment is $1,000,000. Annual cash inflows are expected to increase by $200,000 per year. The equipment has an 8-year useful life. What is the payback period?
a. 8.00 years
b. 7.00 years
c. 6.00 years
d. 5.00 years
Answer: d Difficulty: 2 Objective: 5
$1,000,000/$200,000 = 5.0 years
63. 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 Difficulty: 2 Objective: 5
64. The approach to capital budgeting which divides an accounting measure of income by an accounting measure of investment is
a. net present value.
b. internal rate of return.
c. payback method.
d. accrual accounting rate of return.
Answer: d Difficulty: 1 Objective: 6
65. 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 Difficulty: 2 Objective: 7
66. 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. There are no after-tax consequences of any of the above.
Answer: c Difficulty: 2 Objective: 8
67. The Alpha Beta Corporation disposes of a capital asset with an original cost of $85,000 and accumulated depreciation of $54,500 for $25,000. Alpha Beta's tax rate is 40%. Calculate the after-tax cash inflow from the disposal of the capital asset.
a. $2,200
b. ($2,200)
c. $27,200
d. $31,500
Answer: c Difficulty: 3 Objective: 8
($85,000 - 54,500) = $30,500 - $25,000 = $5,500 loss x 0.4 = $2,200 tax savings from loss plus $25,000 proceeds = $27,200.
68. The Phenom Corporation has an annual cash inflow from operations from its investment in a capital asset of $50,000 for five years. The corporation's income tax rate is 40%. Calculate the five years total after-tax cash inflow from operations.
a. $250,000
b. $175,000
c. $150,000
d. $50,000
Answer: c Difficulty: 3 Objective: 8
$50,000 x 5 = $250,000 x (1- 0.4) = $150,000 net cash flow
69. 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 postinvestment audit.
d. a cost-benefit analysis.
Answer: c Difficulty: 2 Objective: 8
70. A capital budgeting tool 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 Difficulty: 2 Objective: 8
EXERCISES AND PROBLEMS
71. Match each one of the examples below with one of the stages of the capital budgeting decision model.
Stages:
1. Identification
2. Search
3. Information-acquisition
4. Selection
5. Financing
6. Implementation and control
______ a. Issuing corporate stock in order to supply 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. Utilization of the internal rate of return for each alternative
Answer:
a. Financing
b. Information-acquisition
c. Identification
d. Implementation and control
e. Identification
f. Information-acquisition
g. Search
h. Selection
Difficulty: 2 Objective: 2
72. The Zero Machine Company is evaluating a capital expenditure proposal that requires an initial investment of $20,960 and has predicted cash inflows of $5,000 per year for 10 years. It will have no salvage value.
Required:
a. Using a required rate of return of 16%, determine the net present value of the investment proposal.
b. Determine the proposal's internal rate of return.
Answer:
a.
| |Predicted |Year(s) |PV Factor |PV of Cash Flows |
| |Cash Flows | | | |
|Initial investment |$(20,960) |0 |1.000 |$(20,960) |
|Annual operations |5,000 |10 |4.833 |24,165 |
| Net present value | | | |$ 3,205 |
b. Present value factor of an annuity of $1.00 = $20,960/$5,000 = 4.192.
From annuity table, the 4.192 factor is closest to the 10-year row at the 20% column. Therefore, the IRR is 20%.
Difficulty: 2 Objective: 3
73. 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 $5,000 in working capital. Taxes are not considered.
Required:
a. If the company has a required rate of return of 14%, what is the net present value of the proposed investment?
b. What is the internal rate of return?
Answer:
a.
| |Predicted |Year(s) |PV Factor |PV of |
| |Cash Flows | | |Cash Flows |
|Initial investment |$(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 |Year(s) |PV Factor |PV Of |
| |Cash Flows | | |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%.
Difficulty: 3 Objective: 3
74. EIF Manufacturing Company needs to overhaul its drill press or buy a new one. The facts have been gathered, and are as follows:
| |Current Machine |New Machine |
|Purchase Price, New |$80,000 |$100,000 |
|Current book value |30,000 | |
|Overhaul needed now |40,000 | |
|Annual cash operating costs |70,000 |40,000 |
|Current salvage value |20,000 | |
|Salvage value in five years |5,000 |20,000 |
Required:
Which alternative is the most desirable with a current required rate of return of 20%? Show computations, and assume no taxes.
Answer:
Present value of keeping current system:
| |Predicted |Year(s) |PV Factor |PV of |
| |Cash Flows | | |Cash Flows |
|Overhaul |$(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 | | | |$(247,360) |
Present value of new system:
| |Predicted |Year(s) |PV Factor |PV of |
| |Cash Flows | | |Cash Flows |
|Investment |$(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).
Difficulty: 3 Objective: 4
75. ABC Boat Company is interested in replacing a molding machine with a new improved model. The old machine has a salvage value of $20,000 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 $40,000.
The new machine costs $160,000 and has a predicted salvage value of $24,000 at the end of six years. If purchased, the new machine will allow cash savings of $40,000 for each of the first three years, and $20,000 for each year of its remaining six-year life.
Required:
What is the net present value of purchasing the new machine if the company has a required rate of return of 14%?
Answer:
| |Predicted |Year(s) |PV Factor |PV of |
| |Cash Flows | | |Cash Flows |
|Initial Investment |$(160,000) |0 |1.000 |$(160,000) |
|Salvage of old |20,000 |0 |1.000 |20,000 |
|Annual operations |40,000 |1-3 |2.322 |92,880 |
|Annual operations |20,000 |4-6 |(3.889-2.322) |31,340 |
|Save by not rebuilding |40,000 |1 |0.877 |35,080 |
|Salvage of new |24,000 |6 |0.456 |10,944 |
| Net present value | | | |$ 30,244 |
Difficulty: 3 Objective: 4
76. 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 |$0 |
|Payback period in year |(b) |(d) |5.65 |
| Internal rate of return |12% |24% |(f) |
Answer:
a.
|Annual cash inflow |$ 60,000 |
|Present value factor for 10 years |x 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 x 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%.
Difficulty: 3 Objectives: 3, 5
77. 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
Difficulty: 3 Objective: 5
78. 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 $10,000.
Required:
a. Compute the net present value at a 14% required rate of return.
b. Compute the internal rate of return.
c. Determine the payback period of the investment.
Answer:
a.
| |Predicted |Year(s) |PV Factor |PV of |
| |Cash Flows | | |Cash Flows |
|Investment |$(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 |Year(s) |PV Factor |PV of |
| |Cash Flows | | |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.
Difficulty: 3 Objectives: 3, 5
79. Jensen Manufacturing is considering buying an automated machine that costs $250,000. It requires working capital of $25,000. Annual cash savings are anticipated to be $103,000 for five years. The company uses straight-line depreciation. The salvage value at the end of five years is expected to be $10,000. 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 = $103,000 - (($250,000 - $10,000)/5)
= $103,000 - $48,000
= $ 55,000
AARR with initial investment = $55,000/($250,000 + $25,000)
= $55,000/$275,000
= 0.20
Difficulty: 2 Objective: 6
80. 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?
80. 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 |$90,000 |
|Payback is 1 year | | |
Net Present Value:
|Proposal A: |Predicted |Year(s) |PV Factor |PV of |
| |Cash Flows | | |Cash Flows |
| | | | | |
|Investment |$(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 |Year(s) |PV Factor |PV of |
| |Cash Flows | | |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 |Year(s) |PV Factor |PV Of |
| |Cash Flows | | |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 |
80. (continued)
Accrual Accounting Rate of Return:
Proposal A: (80,000 + 10,000 + 45,000)/3 - (90,000/3) = 0.167
90,000
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.
Difficulty: 3 Objectives: 3, 5, 6
CRITICAL THINKING
81. 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 your 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.
Difficulty: 2 Objective: 1
82. 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.
Difficulty: 2 Objective: 2
83. 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.
Difficulty: 2 Objective: 3
84. Explain why the term tax shield is used in conjunction with depreciation.
Answer:
Depreciation tax deductions result in tax savings, which offset the cost of acquiring the capital equipment. The more rapid for tax purposes an asset's costs can be written off for tax purposes, the earlier the reductions in taxes can be realized. The term tax shield refers to the reduction in the tax payments owed. Thus the faster the depreciation, the earlier the reductions in taxes and the greater the net present value of the tax shield.
Difficulty: 2 Objective: 8
85. 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.
Difficulty: 2 Objectives: 3-6
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