Ch9 Capital Budgeting Test Bank Answers

Chapter 9

Capital Budgeting

Chapter Learning Objectives

1. Identify the cash flows associated with capital budgeting decisions. (Unit 9.1)

Cash flows will differ depending on the project under consideration. Common cash flows include the following:

• Purchase price of new assets – buildings, equipment, etc. (outflow)
• Revenues from new sales generated by the project (inflow)
• Operating costs generated by the project (outflow)
• Sale of old equipment (inflow)
• Savings on operating costs generated by the project (inflow)

1. Explain the time value of money and calculate present values of lump sums and annuities. (Unit 9.2)

A dollar received today is worth more than a dollar received in the future because today’s dollar can be invested to earn interest. To determine what an amount of money to be received in the future is worth today, you need to know: (1) how much money is to be received; (2) when the money is to be received; and (3) the relevant interest rate. If the money to be received in the future is a lump sum (received once), the present value is determined as follows:

If the money to be received in the future is an annuity (an equal series of identical payments), the present value is determined as follows:

1. Use the net present value to determine the acceptability of a project. (Unit 9.3)

The net present value of a project is the present value of its cash inflows less the present value of its cash outflows. If the net present value is greater than or equal to zero, the project is acceptable. If the net present value is less than zero, the project should be rejected.

1. Use the internal rate of return to determine the acceptability of a project. (Unit 9.3)

The internal rate of return of a project is the discount rate (interest rate) that returns a net present value of zero. If the project includes both an investment (initial cash outflow) and an annuity (series of equal cash inflows), the internal rate of return can be found by (a) solving for the present value of an annuity factor (PVAn,i) in the following equation and (b) locating that factor in the present value of an annuity table.

If the project returns a series of uneven cash flows, the internal rate of return can be found either by trial and error or by using Microsoft Excel’s IRR function.

1. Calculate a project’s payback period. (Unit 9.4)

The payback period shows how quickly the initial investment in a project will be recovered from the yearly cash flows. If the annual cash flows are even, the payback period can be calculated as follows:

If the annual cash flows are uneven, then they must be added up until they equal the net initial investment. The number of years it takes for the annual cash inflows to equal the net initial investment is the payback period. The payback period has two flaws: It ignores both time value of money and cash flows that occur after the payback period.

1. Calculate a project’s accounting rate of return. (Unit 9.4)

The accounting rate of return is the only capital budgeting technique that is based on accounting income rather than cash flows. It can be calculated as follows:

Chapter 9

Capital Budgeting

TRUE-FALSE STATEMENTS

1. The process of evaluating an organization’s investment in long-term assets is called investment control.
2. Capital budgeting differs from cash budgeting in terms of its time horizon.
3. Those assets that are expected to provide economic benefits for several years are called capital assets.
4. All capital assets are depreciable assets.
5. Capital assets are also referred to as long-lived assets.
6. Assets used by an organization to build products or deliver services are called investment assets.
7. When a company invests in a capital asset, recouping the original investment is called return on investment.
8. Any return a company receives over and above the original investment in a capital asset is called return on investment.
9. In a predictable decision, a proposed project is compared to a performance benchmark to determine whether the project should be considered further.
10. The goal of the screening decision is to narrow the list of capital proposals to include only those that are expected to bring the desired level of return.
11. The original purchase price of an old machine that is being replaced must be considered in capital budgeting decisions.
12. Capital budgeting decisions involve both outflows of cash at one or more times and inflows of cash at other times.
13. The process of determining how much an amount of money to be received in the future is worth today is called future value.
14. The present value of a future amount may be smaller or larger than the future value.
15. A stream of equal cash flows received at set time intervals is called an annuity.
16. To calculate the present value of an annuity, divide the amount to be received each year by the present value of an annuity factor.
17. The net present value approach to capital budgeting requires you to calculate the present value of each cash flow and then add those present values to arrive at the capital project’s net present value.
18. The first step in calculating the net present value of a product is to determine the appropriate discount rate.
19. In calculating the net present value of a project, the appropriate discount rate should be similar across companies.

LO: 3, Bloom: C, Unit: 9-3, Difficulty: Easy, Min: 1, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Business Operations

1. Once the cash flows and discount rate have been determined, calculate the present value of each cash flow by multiplying each cash flow by the appropriate present value factor.
2. If the net present value of a project is greater than or equal to zero, the project has achieved the required rate of return and should be accepted.
3. The decision to replace an old automobile with a new one must be analyzed using incremental analysis.
4. Like net present value, the internal rate of return considers the amount and timing of future cash flows.
5. When the annual cash flows are uneven, you must use the annuity table method to calculate the internal rate of return.
6. The payback period is the time it takes, in years, for a company to recover the original amount of invested capital.
7. The payback period is used most often as a screening tool, by companies that have established a maximum acceptable payback period.
8. The payback period is a simple technique using the time value of money as its basis.
9. The accounting rate of return differs from the internal rate of return and the payback period in that, the accounting rate of return does not focus on cash flows.
10. The accounting rate of return is also known as the unadjusted rate of return.
11. Two major weaknesses of the accounting rate of return are that it does not consider cash flows and it is the least accurate capital budgeting technique.

Answers to True-False Questions

MULTIPLE-CHOICE QUESTIONS

1. The process of evaluating an organization’s investment in long-term assets is called
   1. activity-based evaluation.
   2. capital budgeting.
   3. investment control.
   4. A preference decision.
2. Capital budgeting differs from cash budgeting in that
   1. Cash budgeting focuses on short-term results while capital budgeting focuses on five, ten, or even twenty years in the future.
   2. Cash budgeting focuses on the balance sheet while capital budgeting focuses on the income statement.
   3. A cash budget contains only expected cash outflows for capital assets while capital budgeting includes both cash inflows and outflows.
   4. Cash budgeting is based on cash-basis accounting while capital budgeting is based on accrual-basis.
3. A capital asset is
   1. a variable cost.
   2. an item on the income statement.
   3. a long-term asset.
   4. a return of investment.
4. Assets that are expected to provide economic benefits for several years are referred to as
   1. cash assets.
   2. short-term assets.
   3. capital assets.
   4. balance sheet assets.
5. Which of the following capital assets is not a depreciable asset?
   1. Building
   2. Equipment
   3. Automobiles
   4. Land
6. Capital assets are also referred to as
   1. long-lived assets.
   2. balance sheet asset.
   3. cash assets.
   4. investment assets.
7. Capital assets are
   1. used to promote the company.
   2. used to produce products or deliver services.
   3. depreciable.
   4. investments in stock.
8. Which of the following is a reason that organizations invest in capital assets?
   1. Expectation that they will generate a future return
   2. Expectation that they will be sold to customers
   3. Expectation that they can be depreciated
   4. Expectation that the capital asset can be held for resale
9. Two types of return can be expected from investment in long-term assets. There are
   1. positive contribution margin and positive segment margin.
   2. interest and dividends.
   3. return of investment and return on investment.
   4. return of investment and a positive contribution margin.
10. Any return a company receives over and above the original investment is referred to as
    1. return on investment.
    2. return of investment.
    3. return of contribution.
    4. return for profit.
11. When a company recoups its original investment, the company has received a
    1. return on investment.
    2. return of investment.
    3. return of contribution.
    4. hurdle rate.
12. Within the organization, which of the following groups reviews capital project requests?
    1. Capital asset committee
    2. Financial expenditures committee
    3. Capital budgeting committee
    4. Investment committee
13. Which of the following is a reason capital budget requests should be reviewed and approved by executive management?
    1. These investments are made for the short-term on a non-routine basis.
    2. These investments will likely have a significant impact on the company’s future financial health.
    3. They must be aborted if future losses are occurring.
    4. They often require significant maintenance costs each year.
14. Managers use capital budgeting techniques to make which of the following two types of capital budgeting decisions?
    1. Screening decisions and preference decisions
    2. Screening decisions and pricing decisions
    3. Preference decisions and pricing decisions
    4. Preference decisions and investment decisions
15. In which of the following decisions is a proposed project compared to a performance benchmark to determine whether the project should be considered further?
    1. Hurdle
    2. Screening
    3. Performance
    4. Benchmark
16. When a company compares a proposed project to a performance benchmark, which of the following benchmarks might the company use?
    1. Minimum required return of investment
    2. Minimum number of years in which the project must return the original investment
    3. A post-implementation audit target
    4. Total future cash flows
17. The goal of the screening decision process is to
    1. Narrow the list of capital proposals to those expected to bring the desired level of return.
    2. Select the project with the best level of return.
    3. Arrange for the completion of the proposed project.
    4. Perform a post-implementation audit.
18. The minimum required rate of return is often referred to as the
    1. benchmark rate.
    2. hurdle rate.
    3. project rate.
    4. future value rate.
19. In which of the following decisions do managers determine which projects will actually receive funds by rank-ordering them based on selected criteria?
    1. Hurdle
    2. Screening
    3. Capital
    4. Preference
20. In a preference decision, which of the following criteria might be used to rank-order the projects?
    1. Rate of return
    2. Return on investment
    3. Expected opportunities in a new market niche
21. While most accounting decisions focus on income, most capital budgeting decisions focus on
    1. expenses.
    2. costs.
    3. income.
    4. cash flows.
22. Which of the following items is not included in the decision to purchase a new capital asset to replace an old one?
    1. The price of the new machine
    2. Shipping on the new machine
    3. The original purchase price of the old machine
    4. Installation costs
23. Which of the following items is not included as a cash flow in the decision to purchase a new capital asset to replace an old one?
    1. Depreciation on the new machine
    2. Sales tax
    3. Installation cost of the new machine
    4. Salvage value of the old machine
24. Why is the original purchase price of an old machine that is being replaced never included in capital budgeting decisions?
    1. It is an opportunity cost, and thus not relevant.
    2. No future cash flows are associated with its purchase.
    3. It will affect future costs.
    4. It is a cost expensed when the new machine is acquired.
25. Which of the following is a cash flow that might occur when new equipment is purchased?
    1. Cash outflow for depreciation
    2. Cash inflow in the form of cost savings
    3. Cash outflow to pay the salvage value of the old equipment
    4. Cash inflow for interest paid
26. When a new piece of equipment is purchased, which of the following is considered a cash inflow?
    1. Cost savings
    2. Salvage value of the new equipment
    3. Additional revenue generated
27. Mauldin Welding Shop is considering the purchase of new high-tech welding equipment. If the equipment is purchased, Mauldin can avoid the cost of updating the old equipment estimated to be $3,000. In determining the cash flows associated with the new equipment, the cost of updating the old equipment is
    1. a cash outflow.
    2. a cash inflow.
    3. a sunk cost.
    4. not relevant.
28. Mauldin Welding Shop is considering the purchase of new high-tech welding equipment. If the equipment is purchased, Mauldin will incur $2,000 to install the equipment and pay a technician to adjust the computer settings. In determining the cash flows associated with the new equipment, the $2,000 is
    1. a cash outflow.
    2. a cash inflow.
    3. an opportunity cost.
    4. not relevant.
29. Mauldin Welding Shop is considering the purchase of new high-tech welding equipment. If the equipment is purchased, Mauldin will incur an additional $8,000 in annual depreciation expense for the next five years. In determining the cash flows associated with the new equipment, the $8,000 of annual depreciation expense is
    1. a cash outflow.
    2. a cash inflow.
    3. a sunk cost.
    4. ignored in the cash flow analysis.
30. Bend Manufacturers is considering investing in a new truck that will be used to deliver its custom-made furniture. The truck currently used by Bend cost the company $72,000 eight years ago. Two years from now, the company anticipates spending $20,000 to overhaul the old truck, at which time the truck could be used for an additional 10 years. The old truck costs $8,000 per month in gas, insurance, and other costs to operate. Ron Shop, Controller of Bend Manufacturers, is considering the purchase of a new truck which will cost $100,000 and which has a useful life of 10 years. The new truck will only cost $4,800 per month to operate but will require an overhaul 8 years from now that is expected to cost $8,000. Ron believes the old truck can be sold for $16,000. If the new truck is purchased, he estimates that the new truck could be sold for $28,000 at the end of its useful life. Which of the following is not a relevant cash flow in the decision to replace the truck?
31. $3,200 per month in operating cost savings
32. $20,000 overhaul avoided on old truck
33. $72,000 purchase price of old truck
34. $16,000 salvage value of old truck
35. Capital budgeting decisions involve all of the following except
    1. Outflows of cash at one or more times
    2. Inflows of cash at one or more times
    3. Consideration of depreciation expense
    4. A review and approval process
36. In making a capital budgeting decision, one needs to compare cash flows in terms of
    1. their costs and revenues.
    2. when they occur and their costs and revenues.
    3. their amounts and when they occur.
    4. past and future expectations.
37. In making a capital budgeting decision, one needs to compare cash flows in terms of their amounts and when they occur. One way to do so is to determine their
    1. future value.
    2. present value.
    3. average cash outflows.
    4. opportunity costs.
38. The value today of the dollars to be paid or received in the future is referred to as
    1. present value.
    2. future value.
    3. present and past values.
    4. net cash flows.
39. The process of determining how much an amount of money to be received in the future is worth today is called
    1. the present value.
    2. hurdling
    3. discounting.
    4. screening.
40. The interest rate used in present value calculations is called the
    1. discount rate.
    2. preference rate.
    3. compound rate.
    4. screening rate.
41. To determine the present value of any future amount, you need to know
    1. the future amount to be received, the interest rate, and the hurdle rate.
    2. the interest rate, the cash flows to purchase the asset, and the future amount to be received.
    3. when the future amount will be received, the future amount to be received, and the interest rate.
    4. when the future amount will be received, the hurdle rate, and the cost of acquiring the asset.
42. To determine the present value of any future amount, you need to know all of the following except?
    1. the interest rate.
    2. the future amount to be received.
    3. the preference decision.
    4. when the future amount will be received.
43. To determine the present value of any future amount, you need to know
    1. the opportunity cost.
    2. the stated maximum rate of return.
    3. the future amount to be received.
    4. the depreciation expense on the asset to be acquired.
44. To calculate the present value of a future amount, which of the following tables do you use?
    1. Present value of $1 received in n periods
    2. Future value of $1 received in n periods
    3. Present value of an annuity
    4. Future value of an annuity
45. In looking at the table for “Present Value of $1 Received in n Periods,” the columns represent
    1. possible hurdle rates.
    2. number of periods in the future.
    3. discount factors.
    4. the cash flow amounts.
46. In looking at the table for “Present Value of $1 Received in n Periods,” the rows represent
    1. possible hurdle rates.
    2. number of periods in the future.
    3. discount factors.
    4. cash flow amounts.
47. When the interest from year one is built into the principal balance, the interest is referred to as
    1. differential interest.
    2. discounted interest.
    3. compound interest.
    4. future interest accrued.
48. Compounding interest more frequently than annually causes a change in
    1. the time period during which the asset is to be used in operations.
    2. the annual discount rate.
    3. the number of periods to be used.
    4. required rate of return.
49. The relationship between the discount rate and the present value is
    1. inverse.
    2. proportional.
    3. constant.
    4. sporadic.
50. A stream of equal cash flows received at set time intervals is called
    1. an annuity.
    2. the present value cash flow.
    3. discounted cash flows.
    4. continuing cash flows.
51. To calculate the present value of an annuity, multiply the
    1. principal amount by the present value factor.
    2. amount to be received each year by the present value factor.
    3. principal by the discounted interest rate.
    4. amount to be received each year by the discounted interest rate.
52. To calculate the present value of an annuity, multiply the
    1. total dollars to be received by the present value factor.
    2. total dollars to be received by the discounted interest rate.
    3. amount to be received each year by the present value factor.
    4. amount to be received each year by the discounted interest rate.
53. A dollar received today is worth
    1. less than a dollar received in the future discounted at 12% interest.
    2. more than a dollar received at any time in the future.
    3. less than a dollar received in the future if the current interest rate is lower than the anticipated future interest rate.
    4. a dollar times the future value interest rate.
54. Given a present value factor of 0.7921, assuming a 6% discount rate, the present value of $16,000 payment received in 4 years is
    1. $3,168.
    2. $12,674.
    3. $20,199.
55. Wilson, Inc. has 6% discount rate. Using the tables, how much is the present value of a $22,000 payment received in 3 years?
    1. $18,471
    2. $23,812
    3. $25,123
    4. $32,947
56. Given a present value factor of 3.7907, assuming a 10% discount rate, the present value of an annuity of $20,000 payment each year for five years is
    1. $5,276.
    2. $26,380.
    3. $75,814.
    4. $379,070.
57. Dina Jones just learned that she received an inheritance from her grandmother. The inheritance provides for Dina to receive $5,000 per year at the end of the year for each of the next 5 years. Assuming a discount rate of 10%, what is the value of this inheritance to Dina today?

1. $15,523
2. $20,849
3. $18,954
4. $30,526
5. Chris Mann will deposit $22,400 into an account today that earns 10% per year compounded annually. Using the following factors, what is the amount that will be in the account at the end of the 5 years?

1. $36,075
2. $13,909
3. $27,351
4. $18,681
5. Stacey Trail has just won the Lotto. Her prize pays $40,000 at the end of each year for 5 years. In addition, she will receive a one-time payment of $240,000 at the end of 5 years. Using the following factors at 10%, what amount has Stacey really won in the Lotto?

1. $440,000
2. $300,653
3. $553,317
4. $484,204

$149,021 + $151,632 = $300,653

1. Which of the following is not a step in the net present value approach to capital budgeting?
   1. Identify the amount and timing of each cash flow.
   2. Determine the appropriate discount rate.
   3. Compare the discount rate to the hurdle rate.
   4. Calculate the net present value of the project.
2. Which of the following is not a step in the net present value approach to capital budgeting?
   1. Identify the amount and timing of each cash flow.
   2. Determine the payback period.
   3. Calculate the present value of each cash flow.
   4. Calculate the net present value of the project.
3. Before you can calculate the present value of a cash flow, you must
   1. identify the expenses and revenues for each time period.
   2. determine the appropriate discount rate.
   3. look up interest factors in the tables.
   4. use the replacement approach for the capital asset being evaluated.
4. Which of the following pairs of items is inversely related?
   1. Hurdle rate and payback period
   2. Discount rate and hurdle rate
   3. Discount rate and present value
   4. Return of investment and return on investment
5. Which of the following is a factor that influences the discount rate?
   1. Level of risk
   2. Accounting rate of return
   3. Financing options
   4. Amount of cash flows
6. Which of the following is not a factor that influences the discount rate?
   1. Amount of the cash flows
   2. Level of risk
   3. Investor’s expected rate of return
7. Discount rates are used to value which of the following items?
   1. Future cash flows
   2. Past cash flows
   3. The market value of assets being evaluated in capital budgeting projects
   4. Cash payments made for maintenance of old assets being retired
8. Once you have determined the net present value of a project, if the net present value is less than zero, the project should be
   1. accepted.
   2. rejected.
   3. evaluated further by evaluating future cash flows
   4. evaluated further by assessing future revenues and costs.
9. The decision to replace old equipment with new equipment can be analyzed by the
   1. incremental analysis or the replacement method.
   2. replacement method or use Excel.
   3. incremental analysis or calculating the cost of each decision separately.
   4. screening analysis or calculating the cost of each decision separately.
10. The actual return earned on a project is called the
    1. internal rate of return.
    2. required rate of return value.
    3. payback amount.
    4. hurdle rate.
11. In which of the following situations will a project never be accepted?
    1. Internal rate of return is less than the discount rate
    2. Internal rate of return is equal to the discount rate
    3. Internal rate of return is greater than the discount rate
    4. Internal rate of return is greater than zero
12. When a project’s internal rate of return equals the discount rate,
    1. the analysis should be ranked against other projects.
    2. the net present value is zero.
    3. the discount rate is greater than zero.
    4. the discount rate is greater than the internal rate of return.
13. The net initial investment is the net cash outflow
    1. in year 0.
    2. for all years combined.
    3. as computed at the initial discount rate.
    4. to be paid out over the discount period.
14. You can use the factors in an annuity table method to calculate
    1. the hurdle rate.
    2. the internal rate of return with uneven cash flows.
    3. the present value of a capital asset.
    4. the discount rate.
15. Which of the following is not an assumption of the internal rate of return model?
    1. The amount and timing of all cash flows is known exactly.
    2. All cash flows occur at the end of the year.
    3. Cash inflows from the project are reinvested in another project earning a return equal to the internal rate of return.
16. Which of the following does not use interest expense as a component of amounts in its computations?
    1. Net present value using tables
    2. Internal rate of return
    3. Required rate of return
    4. Net present value using Excel
17. Braxton Manufacturing is considering the purchase of new computerized equipment. The machine costs $85,000 and would generate $22,000 in annual cost savings over its 5-year life. At the end of 5 years, the equipment would have a $5,000 salvage value. Braxton’s required rate of return is 12%. Using the interest tables, the machine’s net present value is nearest
    1. ($2,857).
    2. ($5,694).
    3. $79,306.
    4. $110,000.
18. Braxton Manufacturing is considering the purchase of new computerized equipment. The machine costs $75,000 and would generate $22,000 in annual cost savings over its 5-year life. At the end of 5 years, the equipment would have a $5,000 salvage value. Braxton’s required rate of return is 12%. Using the interest tables, the machine’s net present value is
    1. $695.
    2. $4,305.
    3. $7,143.
    4. $79,306.
19. Logan, Inc. is considering the purchase of a warehouse directly across the street from its manufacturing plant. Logan currently warehouses its inventory in a public warehouse across town. Rent on the warehouse and delivering and picking up inventory cost Logan $48,000 per year. The building will cost Logan $450,000. Logan will depreciate the building for 20 years. At the end of 20 years, the building will have a $125,000 salvage value. Logan’s required rate of return is 10%. Using the interest tables, the building’s net present value is
    1. ($41,347).
    2. ($22,772).
    3. $427,228.
    4. $960,000.
20. Logan, Inc. is considering the purchase of a warehouse directly across the street from its manufacturing plant. Logan currently warehouses its inventory in a public warehouse across town. Rent on the warehouse and delivering and picking up inventory cost Logan $48,000 per year. The building will cost Logan $400,000. Logan will depreciate the building for 20 years. At the end of 20 years, the building will have a $125,000 salvage value. Logan’s required rate of return is 10%. Using the interest tables, the building’s net present value is
    1. ($41,347).
    2. $27,228.
    3. $427,228.
    4. $960,000.
21. Woods Manufacturing is considering the purchase of a new sewing machine that costs $18,000. The machine, because of its efficiency, will save about $4,000 in cost each year. The machine is expected to have a salvage value of $3,000 and a life of 6 years. Woods’ required rate of return is 12%. Using the interest tables, what is the machine’s net present value?
    1. ($34)
    2. $1,520
    3. $15,000
    4. $24,000
22. Woods Manufacturing is considering the purchase of a new sewing machine that costs $16,000. The machine, because of its efficiency, will save about $4,000 in cost each year. The machine is expected to have a salvage value of $3,000 and a life of 6 years. Woods’ required rate of return is 12%. Using the interest tables, what is the machine’s net present value?
    1. ($34)
    2. $1,966
    3. $15,000
    4. $24,000
23. Bend Manufacturers is considering investing in a new truck that will be used to deliver its custom-made furniture. Ron Shop, Controller of Bend Manufacturers, is considering a truck which will cost $80,000 and which has a useful life of 5 years. The new truck will save $9,600 per year in operating costs which are realized at the end of each year. Ron believes if the new truck is purchased it could be sold for $64,500 at the end of its useful life. Bend’s required rate of return is 10%. What is the new truck’s net present value?

1. ($80)
2. ($8,049)
3. ($3,559)
4. $18,658
5. Keltner Enterprises is considering investing in a new packing machine. The new machine will provide annual cash operating inflows of $12,300 for 5 years. The cost of the machine is $42,300 and it can be sold at the end of its 5-year useful life for $6,800. Keltner’s required rate of return is 10%. What is the machine’s net present value?

1. ($105)
2. $13,211
3. $8,549
4. $15,278
5. Keltner Enterprises is considering investing in a new packing machine. The new machine will provide annual cash operating inflows of $12,300 for 5 years. The cost of the machine is $50,430. The machine currently being used is 3 years old and could be sold for $1,320. What is the machine’s internal rate of return?

1. 6%
2. 8%
3. 10%
4. 12%
5. James Bruce is the CEO of Bruce Industries. James is interested in purchasing new pollution abatement equipment because the current equipment is outdated and not efficient. The controller of the company has identified equipment that costs $104,110 and will provide annual cash operating inflows of $28,290 for 5 years. The equipment currently being used is 3 years old and could be sold for $2,130. What is the equipment’s internal rate of return?

1. 8%
2. 10%
3. 12%
4. 15%
5. The time it takes, in years, for an investment to return the original amount of invested capital is referred to as
   1. the payback period.
   2. period of return.
   3. the investment return period.
   4. the internal rate of return.
6. The payback period is defined as the amount of time, in years, that it takes
   1. the company to provide a required return on the capital asset.
   2. for an investment to return the original amount of the capital plus the required rate of return.
   3. the company to earn enough profit generated from the capital asset to cover its cost.
   4. for an investment to return the original amount of invested capital.
7. The payback period is most often used as which of the following tools?
   1. Preference
   2. Screening
   3. Budgeting
   4. Evaluation
8. The payback period of a project that produces even cash flows each year is calculated by dividing the
   1. net initial investment by the projected net annual cash flow.
   2. gross initial investment by the projected net annual cash flow.
   3. net initial investment by the projected annual cash inflows.
   4. gross initial investment by the projected annual cash inflows.
9. Lorman Manufacturing purchases equipment with an expected life of 10 years for $50,000. The equipment has an estimated salvage value of $2,000. Lorman expects the new equipment to generate annual cost savings of $8,000. What is the payback period of the equipment?
   1. 6 years
   2. 6.25 years
   3. 6.50 years
   4. 10 years
10. Welcher, Inc. plans to purchase equipment with a cost of $142,500. The company expects annual net cash inflows from the equipment of $30,000. The equipment has an estimated life of 8 years, no estimated salvage life, and a required rate of return is 6%. The payback period for the equipment is closest to
    1. 1 year.
    2. 1.5 years.
    3. 4.8 years.
    4. 8 years.
11. Minor Company is going to invest in a new product line. Minor estimates that the net cash flows from the new line will be $25,000 per year. The initial investment required to implement the new line will be $500,000. The company requires a rate of return of 8% and the new product line is expected to span a time period of 15 years. What is the payback period of the new product line?
    1. 1.6 years
    2. 12.5 years
    3. 20 years
    4. 25 years
12. Which of the following is a limitation of the payback period?
    1. This method includes an internal rate of return that is usually less than the required rate of return.
    2. The cash flows after the payback period needed for the calculation are not easy to estimate.
    3. This method ignores the time value of money.
    4. The discount rate used in the calculation often changes.
13. Which of the following is a limitation of the payback period method?
    1. It ignores the time value of money.
    2. It ignores cash flows.
    3. It fails to consider the salvage value.
    4. It fails to consider the initial net cost of the asset.
14. The return generated by an investment based on its operating income is the
    1. internal rate of return.
    2. discounted rate of return.
    3. accounting rate of return.
    4. payback period.
15. The accounting rate of return differs from other methods of capital budgeting in that it
    1. does not focus on cash flows.
    2. uses an inflated discount rate.
    3. ignores the time value of money.
16. The accounting rate of return is also known as the
    1. simple rate of return.
    2. internal rate of return.
    3. present value of an investment.
    4. required rate of return.
17. The accounting rate of return is also known as the
    1. internal rate of return.
    2. unadjusted rate of return.
    3. return on investment.
    4. payback period.
18. Which of the following is not used in the calculation of the accounting rate of return?
    1. Additional revenues generated by the investment
    2. All additional operating expenses
    3. Amount of the initial investment
    4. Present value of an annuity factor
19. Which of the following is the formula for the accounting rate of return?

a. Net initial investment ÷ Annual cash flow

b. (Project revenue – Project operating expenses) ÷ (Initial investment – salvage of old asset)

c. Present value of future cash flows ÷ Net initial investment

d. Net initial investment ÷ Present value of future cash flows

1. Which of the following is a weakness of the accounting rate of return?
   1. It does not consider profit projections.
   2. It does not consider the time value of money.
   3. It ignores cash flows after the end of its useful life.
   4. It ignores the amount of revenues and expenses the project may generate.
2. Which of the following is not a weakness of the accounting rate of return?
   1. It does not consider cash flows.
   2. It does not consider the time value of money.
   3. The discount rate used in the calculation may change over the life of the investment.
3. Which of the following is an advantage of the accounting rate of return?
   1. It is easy to determine the time value of money used in the calculation.
   2. Accounting records are generally not based on cash flow, so the information for the calculation is readily available.
   3. Since depreciation is not included in the calculation, the result is not distorted.
   4. It uses actual profit amounts from previous accounting periods.
4. The payback period measures
   1. the present value of an investment.
   2. the actual cost of an investment.
   3. the time, in years, for an investment to return the original amount of invested capital.
   4. the profit that is recovered during the capital asset’s useful life.
5. Which of the following is an advantage of the payback period?
   1. It is a simple technique.
   2. Accounting records are generally not based on cash flow, so the information for the calculation is readily available.
   3. Since depreciation is not included in the calculation, the result is not distorted.
   4. It provides a clear indicator of when the investment will be recovered.
6. Bowen is considering the purchase of equipment costing $150,000. The equipment has a 12- year useful life, has an estimated salvage value of zero, and is expected to generate $25,000 in annual cash flows. The company has a 10% required rate of return and uses the straight-line depreciation method. The accounting rate of return on this equipment is closest to
   1. 1.6%.
   2. 8.3%.
   3. 10%.
   4. 25%.

$12,500 ÷ $150,000 = 8.3%

1. Morrow Company is considering a purchase of equipment that costs $70,000. The equipment has a 7-year life and no salvage value. Morrow uses straight-line depreciation. The equipment has a payback period of 4 years. The accounting rate of return is closest to
   1. 3.5%.
   2. 10.7%.
   3. 25%.
   4. 39%.

Solutions: ($70,000 ÷ 4) – ($70,000 ÷ 7) = $7,500;

$7,500 ÷ $70,000 = 10.7%

1. Pilot Corporation is considering the purchase of equipment costing $100,000. The equipment will reduce operating cash expenses by $25,000 each year. The new equipment has a salvage value of $2,000 and will be depreciated over a 10-year useful life. The accounting rate of return is closest to
   1. 15.2%.
   2. 25%.
   3. 25.5%.
   4. 35%.

$15,200 ÷ $100,000 = 15.2%

1. Johnson Whole Distributors is anticipating investing in equipment that cost $120,000. The equipment has an 8-year life and no salvage value. Johnson uses straight-line depreciation. The equipment has a payback period of 5 years. The accounting rate of return is closest to
   1. 5%.
   2. 6.25%.
   3. 7.8%.
   4. 7.5%.

Depreciation: $120,000 ÷ 8 = $15,000;

($24,000 ̶ $15,000) ÷ $120,000 = 7.5%

1. Keltner Enterprises is considering investing in a new packing machine. The new machine will provide annual cash operating inflows of $12,300 for 5 years. The cost of the machine is $42,300 and it can be sold at the end of its 5-year useful life for $6,800. Keltner’s required rate of return is 10%. What is the packing machine’s payback period?
2. 3.44 years
3. 2.89 years
4. 3.99 years
5. 7.69 years
6. Andrea Kris is opening a small flower shop that will focus primarily on delivery, though it will provide a small showroom for walk-in customers. A local florist is retiring and selling her small flower shop to Andrea for $162,500. The shop has a remaining life of 20 years. Andrea expects to have incremental revenues of $81,250 per year and pay approximately 60% of revenues in operating costs. What is the payback period for Andrea’s flower shop?
7. 5 years
8. 2 years
9. 3.33 years
10. 6.66 years
11. Andrea Kris is opening a small flower shop that will focus primarily on delivery, but will provide a small showroom for walk-in customers. A local florist is retiring and selling her small flower shop to Andrea for $162,500. The shop has a remaining life of 20 years. Andrea expects to have revenues of $81,250 per year and pay approximately 60% of revenues in operating costs. What is the accounting rate of return for Andrea’s flower shop?
12. 15%
13. 20%
14. 45%
15. 25%
16. Judy Blue, CEO of the clothing store All Blue, is planning to open a new store in Manhattan. She plans to purchase a small storefront for $5,250,000 which has a remaining useful life of 15 years. She plans to hire 2 part-time sales clerks and will pay each of them $34,000 per year in wages and other benefits. Judy expects that revenues will average $86,000 per month and other monthly operating costs will run $13,200. What is the accounting rate of return for the Manhattan store?
17. 15.3%
18. 8.7%
19. 10%
20. 1.1%

455,600 ÷ $5,250,000 = 8.7%

Answers to Multiple-Choice Questions

MATCHING

1. Match the following terms to the appropriate statement by placing the letter to the left of each statement.

1. h – Return on investment
2. f – Present value
3. d – Internal rate of return
4. g – Profitability index
5. e – Preference decision
6. c – Hurdle rate
7. a - Annuity
8. i – Screening decision
9. J – Simple rate of return
10. b – Discount rate

LO: 1,2,3,4, Bloom: K, Unit: 9-1,9-2,9-3, Difficulty: Easy, Min: 5-6, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

BRIEF EXERCISES

1. Identify which of the following items is classified as part of capital assets.
   1. Pollution prevention technology
   2. Direct material
   3. Computer-generated manufacturing system
   4. Office supplies
   5. Delivery van

a, c and e are capital assets.

LO: 1, Bloom: C, Unit: 9-1, Difficulty: Easy, Min: 2-3, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

1. Identify which of the following items are classified as capital assets.
   1. Manufacturing equipment
   2. Forklift
   3. Janitorial supplies
   4. Manufacturing overhead
   5. Office furniture

a, b and e are capital assets.

LO: 1, Bloom: C, Unit: 9-1, Difficulty: Easy, Min: 2-3, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

1. Assume that on January 1, 2021 you purchased ten shares of XYZ Corporate stock for $22 each. On September 30, 2023, you sell one-half of your stock for $28 per share. What is your return on your investment?

($28 − $22) × 5 = $30; $30 ÷ ($22 × 5) = 27.27%

LO: 1, Bloom: AP, Unit: 9-1, Difficulty: Moderate, Min: 2-3, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Business Operations

1. The following data pertain to an investment proposal:

Using the tables, what is the present value of the proposed investment?

Present value of cost savings, 10%, 5 yrs. ($10,000 × 3.7907) $37,907

Less initial investment, 0 periods 45,000

Net present value of proposed investment ($7,093)

LO: 2, Bloom: AP, Unit: 9-2, Difficulty: Moderate, Min: 2-3, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

1. You wish to have $25,000 in five years. Using the tables, how much must you deposit today if you will earn 12% compounded annually on your investment?

$25,000 × 0.5674 = $14,185

LO: 2, Bloom: AP, Unit: 9-2, Difficulty: Moderate, Min: 2, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Business Operations

1. If you wish to have $25,000 at the end of five years, Using the tables, how much must your deposit each year if you earn 12% compounded annually?

$25,000 ÷ 3.6048 = $6,935

LO: 2, Bloom: AN, Unit: 9-2, Difficulty: Moderate, Min: 2, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

1. Your company is considering a capital project that will require a net initial investment of $249,972. The project is expected to have a 7-year life and will generate an annual net cash inflow of $43,200. Using the tables, what is the internal rate of return?

$249,972 ÷ $43,200 =5.7864

Internal rate of return = 5%

LO: 4, Bloom: AP, Unit: 9-3, Difficulty: Moderate, Min: 2, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

1. ABC Manufacturing is evaluating two capital projects. The company’s choice will be based on the profitability index. Project #1 has a present value of cash flows of $200,000 and a net initial investment of $180,000 while Project #2 has a present value of future cash flows of $820,000 and a net initial investment of $800,000. Using the tables, which project will ABC choose? Why?

Project #1 – $200,000 ÷ $180,000 = 1.111

Project #2 ̶ $820,000 ÷ $800,000 = 1.025

ABC should choose Project #1 since its profitability index (1.11) is higher than the profitability index of Project #2 (1.025).

LO: 4, Bloom: AP, Unit: 9-3, Difficulty: Moderate, Min: 3-4, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. Complete the following table by answering “Yes” and “No” in the columns that apply to each item. (First item is done for you.)

*Cash flows beyond payback period are ignored.

LO: 1,2,3,4, 5, 6, Bloom: C, Unit: 9-1,9-2,9-3,9-4, Difficulty: Easy, Min: 6, AACSB: Analytic, AICPA FN: Decision Modeling, AICPA PC: None, IMA: Strategy

1. Marple Industries is evaluating a capital project with a net initial investment of $120,000. The project is expected to generate net cash inflows of $15,000 each year. Calculate the payback period for the project.

$120,000 ÷ $15,000 = 8 years

LO: 5, Bloom: AP, Unit: 9-4, Difficulty: Moderate, Min: 2, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

EXERCISES

1. Identify which of the following items is classified as capital assets.
   1. New Ultrasound equipment for pediatric department of General Hospital
   2. Depreciation on hospital equipment
   3. Fitness equipment at local gym
   4. Land held for future development
   5. Cost of painting factory building
   6. Manufacturing overhead
   7. Recycle machine purchased by local waste management center
   8. Steel used to produce automobiles
   9. Laser machine used in factory to cut marble
   10. Salary of computer technician

a, c, d, g, and i are capital assets.

LO: 1, Bloom: C, Unit: 9-1, Difficulty: Easy, Min: 5-6, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

1. Identify which of the following items is classified as capital assets.
   1. New equipment to replace less efficient old equipment
   2. Car wash business
   3. Depreciation on building
   4. 150 acres of land to be used to build a new factory building
   5. Computed Axial Tomography Machine (CAT Scan machine)
   6. Manufacturing overhead
   7. Pollution prevention technology
   8. Direct material
   9. Computer-generated manufacturing system
   10. Office supplies

a, b, d, e, g, and i are capital assets.

LO: 1, Bloom: C, Unit: 9-1, Difficulty: Easy, Min: 5-6, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

1. Felder’s manufacturing is considering the purchase of new equipment that costs $750,000 to replace equipment that is old and inefficient. Felder has found a buyer for the old equipment who will pay $8,000 for it. The new equipment is expected to produce $12,000 of additional revenue each year but will result in additional maintenance cost of $2,000. The new equipment will have a salvage of $10,000 and will be depreciated over 10 years.

Required:

Identify the amount and timing of the cash flows relevant to Felder’s decision to purchase the new equipment.

LO: 1, Bloom: AP, Unit: 9-1, Difficulty: Moderate, Min: 4-5, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

1. Friendly Freddie’s Furniture Store uses an 8-year old van to deliver furniture to customers within a 50-mile radius of the store. The van has an original cost of $22,000. It costs $1,000 each month to operate the van. Unfortunately, the van was in an accident last week and it will cost $5,000 for repairs. Freddie has found a new van that will cost $35,000. Freddie expects to get 10 years use from the new van and estimates that the operating costs will be $800 each month. Freddie can sell his old van as is for $2,500.

Required:

Identify the amount and timing of the cash flows relevant to Friendly Freddie’s decision to replace the van.

Operating cost savings = ($1,000 − $800) × 12 = $2,400

LO: 1, Bloom: AP, Unit: 9-1, Difficulty: Moderate, Min: 6-7, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

1. Patricia is 66 years old and is planning to retire this year. She is covered under her company’s retirement policy which gives her two payment options. The first option is to receive annuity payments of $20,000 each year for the next 20 years. The second option is to receive $250,000 immediately upon retirement. The interest rate is 4%.

Required:

• 1. What is the present value of Patricia’s first option?
  2. What is the present value of Patricia’s second option?
  3. Which option should Patricia choose?

1. $20,000 × 13.5903 = $271,806
2. $250,000
3. Patricia should take the annuity option as the present value of the annuity is greater than the $250,000 immediate payment.

LO: 2, Bloom: AP, Unit: 9-2, Difficulty: Moderate, Min: 3-4, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. Marilyn’s parents have agreed to help her purchase a new car upon graduation in four years. They have given her two choices. The first choice is that they will give her $4,000 each year for the next four years for her to invest herself. The second choice is that they will wait four years and give her $18,000. Marilyn can invest the money at a 4% rate.

Required:

• 1. Which option should Marilyn choose? Why?
  2. If Marilyn can invest the money at 8%, which options should she choose? Why?

1. Option 1 – $4,000 × 3.6299 = $14,520; Option 2 – $18,000 × 0.8548 = $15,386;

Marilyn should take option 2 since the present value is greater than in option 1.

1. Option 1 ̶ $4,000 × 3.3121 = $13,248; Option 2 ̶ $18,000 × 0.7350 = $13,230

Marilyn should take option 1 since the present value is slightly greater than option 2.

LO: 2, Bloom: AN, Unit: 9-2, Difficulty: Moderate, Min: 4-5, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. The following data pertain to an investment proposal:

What is the present value of the proposed investment?

Present value of cost savings, 10%, 5 yrs. ($20,000 × 3.7907) $75,814

Less initial investment, 0 periods 90,000

Net present value of proposed investment ($14,186)

LO: 3, Bloom: AP, Unit: 9-3, Difficulty: Moderate, Min: 3, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

1. Jonathan, a student at Local University, has decided to major in accounting because his goal is to become an FBI agent. Jonathan knows that accounting is one of the entry programs that qualify an applicant for a special agent career. As most students do, Jonathan wants to purchase a nice car when he graduates in five years with his master’s degree. Because his expected salary will be good, he wants a high-performance sports car. He has found the car of his dreams for $58,000. Jonathan’s parents have promised him a graduation present of $25,000 when he finishes his master’s degree.

Required:

• 1. Calculate how much money Jonathan needs to deposit in his savings account today to be able to pay cash for the car upon graduation, assuming that his parents contribute what Jonathan expects. Jonathan can earn 8% on his deposit, compounded annually.
  2. Calculate how much money Jonathan needs to deposit in his savings accountant today to be able to pay cash for the car upon graduation, assuming that his parents contribute what Jonathan expects. Jonathan can earn 8% on his deposit, compounded semi-annually.

1. $33,000* × 0.6806 = $22,460

*$58,000 - $25,000 =

1. N = 5 × 2 = 10; I = 8% ÷ 2 = 4%; $33,000 × 0.6756 = $22,295

LO: 2, Bloom: AP, Unit: 9-2, Difficulty: Moderate, Min: 4, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

1. Rayburn Industries is evaluating the investment of $140,000 in a new packing machine that should provide annual cash operating inflows of $30,000 for 6 years. At the end of 6 years, the packing machine will be sold for $5,000. Rayburn’s required rate of return is 8%.

Required:

• 1. What is the machine’s net present value?
  2. Based on net present value, should Rayburn purchase the new packing machine? Why or Why not?
  3. List two qualitative items that Rayburn should consider in the decision to purchase the new machine.

1. Present value of an annuity $30,000 × 4.6229 $138,687

Present value of $1 5,000 × 0.6302 3,151

Present value of initial investment (140,000)

Net present value $ 1,838

1. Rayburn should purchase the new packing machine because the net present value is positive.
2. (Answers will vary) One qualitative consideration might be the impact on the employees. If the new packing machine will result in the layoff of employees, morale of the other employees may be negatively affected. Other considerations might be the impact on the environment, the economy due to fewer jobs available, and safety features of the new machine.

LO: 3, Bloom: AN, Unit: 9-3, Difficulty: Moderate, Min: 6-7, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. Betty’s Bakery needs to purchase a new oven costing $8,000 to replace her old oven that cannot be repaired. The new oven has several new features and is expected to have a useful life of 12 years. Betty does not expect the oven will have any salvage value at the end of its life.

Required:

• 1. If Betty’s required rate of return is 8%, what level of annual cash savings must the oven generate to be considered an acceptable investment under the net present value method?
  2. If Betty decides the cash savings will not be sufficient to justify the cost of the new oven, list two alternatives she might consider.

1. $8,000 ÷ 7.5361 = $1,062
2. (Answers may vary)

• Purchase an oven with fewer features.
• Select other ovens with different expected lives that may be more profitable include used ovens.
• Rent an oven until such time that the profitability justifies the price of the new oven.

LO: 3, Bloom: AN, Unit: 9-3, Difficulty: Moderate, Min: 4-5, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. General Hospital is planning to add a new diagnostic machine which should improve its quality of certain blood tests. The machine under consideration has a cost of $79,189 and is expected to save the hospital $8,000 each year. The machine has an expected useful life of 14 years.

Required:

• 1. Calculate the internal rate of return on the diagnostic machine.
  2. If the hospital uses a hurdle rate of 6%, should the diagnostic machine be purchased? Why or why not?

1. $79,189 ÷ $8,000 = 9.8986; internal rate of return = 5%
2. No. The investment generates a return than is less than the minimum required rate of return of 6%.

LO: 4, Bloom: AN, Unit: 9-3, Difficulty: Moderate, Min: 3-4, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. ABC Company is considering the purchase of a new piece of equipment costing $138,875. The equipment has a 7-year useful life and is expected to generate $24,000 in annual cost savings. ABC has a 4% required rate of return.

Required:

• 1. What is the internal rate of return for the equipment, rounded to nearest factor?
  2. Should ABC purchase the new equipment? Why or Why not?

1. $138,875 ÷ $24,000 = 5.7864; Internal rate of return = 5%
2. Yes. The investment generates a return than is greater than the minimum required rate of return of 4%.

LO: 4, Bloom: AN, Unit: 9-3, Difficulty: Moderate, Min: 3-4, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. Sycamore Industries has provided the following information on a proposed project:

Required:

• 1. What is the payback period for the investment?
  2. What is the simple rate of return on the investment?
  3. What is the internal rate of return on the investment?

1. $140,000 ÷ $20,000 = 7 years
2. ($20,000 ̶ $14,000) ÷ $140,000 = 4.29%
3. $140,000 ÷ $20,000 = 7;

Factor from Present Value of an Annuity Table nearest 7 for 10 years = 7%

LO: 4,5,6, Bloom: AP, Unit: 9-3,9-4, Difficulty: Moderate, Min: 4, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

1. Birch manufacturing is considering the addition of another product line to its offerings. Equipment needed to produce the new line will cost $200,000. Birch estimates that the net annual cash inflows from the new product line will be as follows:

Required:

• 1. What is the payback period for the new product line?
  2. If the company can establish a steady customer base before production starts and the cash inflows will be $15,000 per year for years 1 – 15, with years 16 through 20 remaining at $2,000 annually, what will be the payback period?

1. $18,000 × 10 = $180,000; $200,000 ̶ $180,000 = $20,000; $20,000 ÷ $5,000 = 4 years;

10 years + 4 years = 14 years

1. $200,000 ÷ $15,000 = 13.33 years

LO: 5, Bloom: AP, Unit: 9-4, Difficulty: Moderate, Min: 3-4, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

1. Murphy’s Manufacturing has provided the following information on a proposed project:

Required:

• 1. What is the payback period for the investment?
  2. What is the simple rate of return on the investment?

1. $80,000 ÷ $10,000 = 8 years
2. ($10,000 ̶ $8,000) ÷ $80,000 = 2.5%

LO: 5,6, Bloom: AP, Unit: 9-4, Difficulty: Moderate, Min: 3-4, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

PROBLEMS

1. Carla’s Citrus packs and ships high-quality oranges, grapefruit, and other fruit to retailers in the U.S. Carla has been experiencing an increase in demand for its products and is considering the purchase of a new packaging machine to replace the machine currently in use. The new machine will cost $202,500, and installation will require an additional $4,050. The machine has a useful life of 10 years and is expected to have a salvage value of $5,400 at the end of its useful life. The variable cost to operate the new machine is $13.50 per carton compared to the current machine’s variable cost of $13.65 per carton. Carla expects to pack 250,000 cartons each year. If the new machine is purchased, Carla will avoid a required $13,500 overhaul of the current machine in three years. The current machine has a market value of $16,200 and will be disposed of.

Required

a. Calculate the net present value of the new packaging machine. Assume that Carla uses a 10% discount rate.

b. Do you recommend that Carla purchase the new machine? Why or why not?

c. Assume that Carla has adopted a new 15% discount rate. Do you recommend that Carla purchase the new machine? Why or why not?

1. Cost savings annually = ($13.65 − $13.50) × 250,000 = $37,500;

1. Yes. The NPV is greater than $0, indicating that the return on the machine exceeds the minimum required rate of return of 10%.

The machine should be purchased. The NPV is greater than $0, meaning the return in the machine is greater than the 16% required rate of return.

LO: 3, Bloom: AN, Unit: 9-3, Difficulty: Moderate, Min: 12-15, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Reporting

1. Jodi Jarvis won a $10 million lottery and elected to receive her winnings in 20 equal undiscounted annual installments. After receiving the first 10 installments, Jodi and her husband divorced, and the remaining 10 payments became part of the property settlement. The judge who presided over the divorce proceedings awarded one-half interest in the future lottery payments to Jodi and the other half to her ex-husband. Following the divorce, Jodi decided to sell her interest in the 10 remaining lottery payments to raise the cash needed to open a bakery. An investor has offered Jodi $1,677,520.

Required

• 1. What discount rate did the investor use in calculating the purchase price?
  2. If Jodi can invest the money she gets at 6%, which is the better option, keeping the annuity or accepting the investor’s offer? Why?
  3. What needs might Jodi have that would make the investor’s offer the preferable option, no matter what the interest rate (within reason)?

a. The original lottery payments were $500,000 per year ($10,000,000 ÷ 20), so Jodi’s share is $250,000 per year.

Row 10 of the present value of an annuity table 6.71008 as the factor for 8%.

1. PV = $250,000 × PVA_{10, 6%}

PV = $1,840,025

At a 6% discount rate, the annuity is worth $1,840,025, so the investor’s offer is too low. Jodi should keep the annuity.

c. After the divorce, Jodi may need cash immediately to make living arrangements. Additionally, she will incur up-front costs to open the bakery that will require cash payments in the near future.

LO: 2, Bloom: AN, Unit: 9-2, Difficulty: Moderate, Min: 8-10, AACSB: Analytic, Communication, AICPA FN: None, AICPA PC: Communication, IMA: Reporting

1. Major Emig owns a pet store. Major wants to convert a storeroom into a space that can be leased to a pet groomer. Major believes that pet owners coming to the store to have their pets groomed will shop while they wait and generate additional revenues for the store. The conversion would cost $180,000 and will have a useful life of 20 years. The space will be leased to a local pet groomer for $36,000 per year. Electricity, water and other utilities are expected to be $7,200 per year.

Required:

a. Calculate the annual operating income generated by the conversion project.

b. Calculate the accounting rate of return for the conversion project.

c. If the conversion project is successful in generating new business for the pet store, how will the accounting rate of return be affected?

a. OI = $36,000 ̶ $7,200 – ($180,000 ÷ 20) = $19,800

b. $19,800 ÷ 180,000 = 11%

c. If the conversion project is successful, additional revenues and profits will be generated, increasing the accounting rate of return.

LO: 6, Bloom: AN, Unit: 9-4, Difficulty: Moderate, Min: 4-5, AACSB: Analytic, Communication, AICPA FN: None, AICPA PC: Communication, IMA: Reporting

1. Press Smart’s pressing machine sells for $185,556. At this price, the annual cost savings that the pressing machine will generate for Rob’s Dry Cleaner over its 8-year life will yield an internal rate of return of 12%. Rob’s Dry Cleaner requires that all projects achieve a return of 15%.

Required:

What price does Rob’s Dry Cleaner need to negotiate with Press Smart so that the system will achieve that return?

At the list price of $185,556, the annual cost savings required to generate a 12% internal rate of return is $37,253.25.

$185,556 ÷ Annual Cost Savings = PVA_{8, 12%}

$185,556 ÷ Annual Cost Savings = 4.9676

Annual Cost Savings = $37,353.25

Rob’s Dry Cleaners must negotiate a price of $167,167 to generate an internal rate of return of 15%.

Purchase Price ÷ $37,253.25 = PVA_{8, 15}

Purchase Price ÷ $37,253.25 = 4.6389

Purchase Price = $172,814

LO: 4, Bloom: AN, Unit: 9-3, Difficulty: Moderate, Min: 8-10, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Reporting

1. List three specific capital assets each of the following companies would acquire?
2. Toyota
3. Dole Pineapple Company
4. McDonalds
5. Delta Airlines
6. St. Jude’s Hospital
7. Buildings, Robotic welding equipment, computer-aided manufacturing equipment
8. Factory building, Land, Equipment for processing fruit
9. Store fixtures, kitchen equipment, buildings
10. Airplanes, luggage handling equipment, aircraft maintenance equipment
11. Building, diagnostic equipment, surgical room equipment, emergency vehicles

LO: 1, Bloom: C, Unit: 9-1, Difficulty: Easy, Min: 5-6, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

1. What are three specific capital assets each of the following companies might acquire?
2. Friendly Freddie’s Furniture Store
3. Fishing boat manufacturer
4. Cancer research institute
5. Manufacturer of women’s dresses
6. City Taxi Service
7. Store fixtures, warehouse, delivery trucks, forklift
8. Manufacturing equipment, warehouse, retail store building, engineering equipment
9. Research and development lab, research equipment, treatment equipment, furniture for treatment area
10. Manufacturing equipment, warehouse, factory building, computers and software for accounting department
11. Taxis, maintenance equipment, shop building, computers

LO: 1, Bloom: C, Unit: 9-1, Difficulty: Easy, Min: 5-6, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

1. One of your managers has requested the purchase of a new capital asset and as part of your analysis you are calculating the present value of the project’s cash flow. Your manager has argued that your analysis is flawed. You believe the manager is trying to manipulate the analysis. You have determined the amount and timing of the project’s cash flows.

Required:

• 1. Discuss how a manager can increase the project’s present value without substantially altering it.
  2. How can a company prevent managers from using such a method to their benefit?

1. If the manager lowers the discount rate, the present value will increase and thus, the manager’s project will look better than it actually is.
2. Companies can prevent managers from lowering the discount rate to make his or her project look more attractive than it is, thus making it acceptable, by having a company-wide minimum discount rate that all projects must meet or exceed.

LO: 2, Bloom: AN, Unit: 9-2, Difficulty: Moderate, Min: 5, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. What are the three factors needed to determine the present value of any future amount?

To determine the present value of any future amount, you need to know three pieces of information:

1. The future amount to be received
2. The interest rate
3. When the future amount will be received

LO: 2, Bloom: K, Unit: 9-2, Difficulty: Easy, Min: 2-3, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Business Operations

1. The net present value approach to capital budgeting involves four steps. List the steps.
2. Identify the amount and timing of each cash flow
3. Determine the appropriate discount rate
4. Calculate the present value of each cash flow
5. Calculate the net present value of the project

LO: 3, Bloom: K, Unit: 9-3, Difficulty: Easy, Min: 3-4, AACSB: Analytic, AICPA FN: None, AICPA PC: None, IMA: Strategy

Required:

• 1. What does the payback period measure?
  2. How is the payback period calculated when the annual cash flows are equal?
  3. How is the payback period calculated when the annual cash flows are not equal?

1. The payback period measures the time it takes, in years, for a company to recover its entire investment.
2. The payback period of a project that produces even cash flows each year is calculated by dividing the net initial investment by the projected annual cash flow.
3. The payback period of a project that does not produce even cash flows each year is calculated by adding up the annual cash flows until the cumulative total cash flow equals the net initial investment.

LO: 5, Bloom: C, Unit: 9-4, Difficulty: Easy, Min: 4-5, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

ESSAY

1. Investing in a capital project may involve making screening decisions, preference decisions, and funding decisions. Discuss how each of these decisions is made, the goal of each, and give an example of each.

In a screening decision, a proposed project is compared to a performance benchmark to determine whether the project should be considered further. Organizations may set a minimum required return on investment, a minimum number of years in which the project must return the original investment, or both. As projects are proposed, they are compared to the benchmark. If a project’s expected outcome is greater than or equal to the benchmark, it becomes a candidate for funding, otherwise, it is dismissed from consideration. The goal of the screening decision is to narrow the list of capital proposals to include only those that are expected to bring the desired level of return. An example of a screening decision is a manager wishing to purchase a new piece of equipment for the factory. If the minimum rate of return set by the company is 8% and the calculated rate of return is 6%, the project will not be considered for funding.

In a preference decision, the projects that have been subjected to a screening decision compete against one another for the available capital funds. In a preference decision, managers determine which project will actually receive funds by rank-ordering them based on selected criteria, both financial and non-financial. The goal of a preference decision is to order the projects from most desirable moving down until funds are not available. An example is when a project meets the minimum rate of return, but because of environmental issues, the managers determine that the benefits of the project do not outweigh the risks of an environmental disaster, penalties, loss of reputation, etc.

Even though managers believe projects deserve funding, in the preference decision phase, funds that were expected may not actually be available. In that case, only those projects for which funds are available will be undertaken. An example might be that a new product line has been accepted for funding. However, because an expected loan for the project was not approved by the bank, the project cannot go forward.

LO: 1, Bloom: AN, Unit: 9-1, Difficulty: Moderate, Min: 15-18, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. When making the decision to replace an old factory machine with a new one, financial and non-financial factors are considered. As with any investment, a company investing in factory machinery expects that the new machinery will generate a future return.

Required:

• 1. Define the two types of returns that can be expected from investments in a long-term asset such as factory machinery.
  2. List three financial factors that a company might consider before making an investment in factory machinery.
  3. List three non-financial factors that a company might consider before making an investment in factory machinery.
  4. List one cost that is not included in a decision to replace an old factory machine with a new one.

1. Two types of return can be expected from investment in a long-term asset: return of investment and return on investment. Return of investment means recouping the original investment. Return on investment is any return you receive over and above the original investment.
2. Answers will vary. Several examples are cash inflows generated, cost savings, whether or not the project meets the company’s minimum required rate of return, how much cash is required for the project, or the payback period.
3. Answers will vary. Several examples are the impact of the investment on employee morale, environmental considerations, impact on customer satisfaction, expertise needed for the project, and alternative use of assets if project fails.
4. Sunk cost, or the cost of the old machine.

LO: 1, Bloom: C, Unit: 9-1, Difficulty: Easy, Min: 16, AACSB: Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. Long-term decisions, including capital budgeting decisions, involve outflows of cash at one time or more and inflows of cash at other times. Managers must decide whether the inflows justify the outflows.

Required:

• 1. List three examples of cash inflows and three examples of cash outflows that might be involved in making a capital budgeting decision.
  2. Many capital budgeting decisions are made using present value calculations. What three factors does present value depend on?

1. Answers will vary.

Outflows – cash paid for asset, taxes and shipping charges, cost of removing old asset, cost of installation of new asset, cost of operations

Inflows – additional revenue generated, reduced labor costs, reduced material cost, estimated salvage value of new equipment, sale of old equipment

1. To determine the present value of any future amount, you need to know three pieces of information: (1) the future amount to be received, (2) the interest rate, and (3) when the future amount will be received.

LO: 2, Bloom: C, Unit: 9-2, Difficulty: Easy, Min: 4-5, AACSB: Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. You are a member of a team responsible for screening capital budgeting projects. Another team member has come to you in private and explained that she has become confused with so many “returns” that the team has been discussing. She has made a list of the terms she is having trouble understanding. Her list includes the following:
2. Return on investment
3. Return of investment
4. Internal rate of return
5. Simple rate of return
6. Accounting rate of return
7. Unadjusted rate of return

Required:

Prepare a brief summary of each of the above terms.

1. Return on investment – any return you receive over and above the original investment
2. Return of investment – getting your money back, or recouping your original investment
3. Internal rate of return – the actual return earned by the project. Compare the internal rate of return to the company’s minimum required rate of return. If the internal rate is greater or equal to the minimum, the project is acceptable.
4. Simple rate of return – another name for the accounting rate of return. It is the return generated by an investment based on its operating income. It does not focus on cash flows.
5. Accounting rate of return – also referred to as the simple rate of return and the unadjusted rate of return. It is the return generated by an investment based on its operating income. It does not focus on cash flows.
6. Unadjusted rate of return – another name for the accounting rate of return. It is the return generated by an investment based on its operating income. It does not focus on cash flows.

LO: 1,4,6, Bloom: K, Unit: 9-1,9-3,9-4, Difficulty: Easy, Min: 10, AACSB: Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy

1. The payback period and the accounting rate of return are two methods of evaluating capital budgeting decisions. Like other approaches, these two methods have advantages and disadvantages.

Required:

• 1. What is an advantage of these two methods?
  2. List two disadvantages of the payback period and explain how to calculate the payback period.
  3. List two advantages and two disadvantages of the accounting rate of return and explain how to calculate the return.

1. An advantage of the payback period and the accounting rate of return is that they are simpler to calculate than other methods that use the time value of money.
2. Disadvantages of the payback period is that it ignores the time value of money and it ignores cash flows that occur after the payback period. The payback period is calculated by dividing the net initial investment by the projected annual cash flow.
3. Two major weaknesses of accounting rate of return are that it doesn’t consider cash flows or the time value of money. The accounting rate of return is determined by calculating the additional revenues generated by the investment and then subtracting all additional operating expenses to determine the incremental net operating income. The net operating income is then divided by the amount of the initial investment. If any existing equipment is sold as part of the project, the initial investment is reduced by its salvage value.

LO: 5,6, Bloom: C, Unit: 9-4, Difficulty: Easy, Min: 8-10, AACSB: Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Strategy