Test Bank Capital Budgeting Choices And Decisions Chapter 7

CHAPTER 7

CAPITAL BUDGETING CHOICES AND DECISIONS

CHAPTER LEARNING OBJECTIVES

1. Explain the purpose of capital budgeting and the context in which it occurs.
2. Compile the elements that comprise capital budgeting decisions.
3. Utilize different tools to evaluate capital budgeting choices.
4. Modify capital budgeting calculations to adjust for uncertainty.
5. Use the decision-making model and capital budgeting tools to make decisions.
6. Evaluate capital budgeting decisions after implementation.

Current count is:
Knowledge: 30
Comprehension: 34
Application: 56
Analysis: 4
Evaluation: 0
Synthesis: 0
Total: 124

Number and percentage of questions:

Easy: 33

Medium: 81
Hard: 10

Question types:
Multiple Choice: 100

Short Answer: 5

Brief Exercises: 9

Exercises: 8

Problems: 2

MULTIPLE-CHOICE QUESTIONS

1. Capital budgeting is typically used in considering what types of projects?
   a. The potential acquisition of current assets.
   b. Does not provide long-range economic benefits in the form of a target return.

c. Long-term time horizon projects that do not require a significant cash outflow.

d. Projects that require significant cash outflows and span a long-term time horizon.

Ans: D, LO 1, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Which statement is NOT true concerning the “Circle of Life” relationship?
   1. The “Circle of Life” relationship involves most organizations’ operating, financing, and investing activities.
   2. The “Circle of Life” relationship starts with the operating activities.
   3. The operating activities of an organization are the results of the products and services it provides.
   4. Financing activities include obtaining and/or repaying capital from lenders.

Ans: B, LO 1, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. One way to calculate the return on investment (ROI) is
   1. investment divided by net income.
   2. operating income divided by investment.
   3. investment divided by return.
   4. operating income divided by net income.

Ans: B, LO 1, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Cost accounting utilizes the return on investment to
   1. capture all transactions for the business.
   2. capture only financing activities of a business.
   3. optimize the outcomes of investing activities only.
   4. optimize the outcomes of operating and investing activities.

Ans: D, LO 1, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Which of the following would NOT change the return on investment (ROI)?
   1. Increase total invested assets.
   2. Increase operating income and total invested assets by the same amount.
   3. Decrease sales and expenses by the same dollar amount.
   4. Decrease sales and expenses by the same percentage.

Ans: C, LO 1, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Which statement is true regarding the definition of an investment, as it applies to return on investment (ROI)?
   1. All companies use long-term assets to comprise the investment in the ROI calculation.
   2. All companies use total assets to comprise the investment in the ROI calculation.
   3. Companies will use their own interpretation of which assets on the balance sheet comprise the investment in the ROI calculation.
   4. All companies will use total assets, less intangibles to comprise the investment in the ROI calculation.

Ans: C, LO 1, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Which of the following changes would increase return on investment (ROI)?
   1. Increase total invested assets.
   2. Increase operating income and total invested assets by the same amount.
   3. Decrease sales and expenses by the same dollar amount.
   4. Decrease sales and expenses by the same percentage.

Ans: B, LO 1, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. MacBeth Company had the following information:

Sales $200,000

Cost of goods sold 90,000

Gross margin 110,000

Other expenses 35,000

Operating income $75,000

Calculate the company’s return.

• 1. $75,000.
  2. $110,000.
  3. $125,000.
  4. $200,000.

Ans: A, LO 1, Bloom: AP, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $75,000 – the company’s return equals its operating income.

1. MacBeth Company had the following information:

Sales $200,000

Cost of goods sold 90,000

Gross margin 110,000

Other expenses 35,000

Operating income $75,000

If the company exactly met its required 10% ROI for the year, what must be its investment?

• 1. $7,500.
  2. $20,000.
  3. $750,000.
  4. $2,000,000.

Ans: C, LO 1, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $75,000 ÷ .10 = $750,000

(op inc. ÷ ROI)

1. Hamlet Inc. had the following information:

Invested assets $1,500,000

Operating income 175,000

Net income 85,000

Calculate the company’s return on investment (ROI), using the financial perspective.

• 1. 5.7%.
  2. 8.6%.
  3. 11.7%.
  4. 48.6%.

Ans: A, LO 1, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $85,000 ÷ $1,500,000 = 5.7%

(net inc. ÷ inv. assets)

1. Hamlet Inc. had the following information:

Operating income $175,000

Net income 85,000

ROI 11.2%

Calculate the company’s invested assets if the ROI was calculated using the cost accounting perspective.

• 1. $75,893.
  2. $156,250.
  3. $758,929.
  4. $1,562,500.

Ans: D, LO 1, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $175,000 ÷ .112 = $1,562,500

(op. inc. ÷ ROI)

1. Hamlet Inc. had the following information:

Invested assets $3,200,000

ROI 8.6%

Calculate the company’s operating income.

• 1. $275,200.
  2. $2,752,000.
  3. $3,720,930.
  4. $37,209,302.

Ans: A, LO 1, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $3,200,000 x .086 = $275,200

(inv. assets x ROI)

1. The statement of cash flows is separated into three sections, operating, investing, and financing. All three are essential to the “Circle of Life.” However, the process starts with which activity?
   1. Operating.
   2. Investing.
   3. Financing.
   4. All three options are correct.

Ans: C, LO 1, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The correct order of events for the “Circle of Life” is
   1. operating, investing, and then financing.
   2. financing, operating, and then investing.
   3. Investing, financing, and then operating.
   4. financing, investing, and then operating.

Ans: D, LO 1, Bloom: K, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Positive net earnings on the statement of cash flows signifies
   1. a positive net income.
   2. a thriving business.
   3. the company is liquid and can pay off its operating expenses.
   4. Both a positive net income and/or a thriving business.

Ans: D, LO 1, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. On the statement of cash flows, one of the purposes of buying long-term investments is to
   1. generate a target return.
   2. obtain financing from lenders.
   3. repay its creditors.
   4. None of the options are correct.

Ans: A, LO 1, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. All of the following are essential elements of capital budgeting decisions except
   1. cash flows.
   2. tax rates.
   3. inventory.
   4. depreciation.

Ans: C, LO 2, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Which statement is NOT true concerning timelines?
   1. Only industry standards inform companies on a particular asset’s useful life.
   2. Projects must have the same length of time for comparison purposes.
   3. Tax codes and industry guidelines inform companies on a particular asset’s useful life.
   4. The market’s reaction to a product can affect the timeline.

Ans: A, LO 2, Bloom: C, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. To calculate the present value, you need all of the following except the
   1. future value.
   2. rate of return.
   3. number of periods.
   4. current cost of the investment.

Ans: D, LO 2, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. All of the following are needed to calculate the future value of a single sum except
   1. Principal.
   2. number of periods.
   3. interest rate.
   4. maturity value.

Ans: D, LO 2, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Which of the following is NOT needed to calculate the future value of an ordinary annuity?
   1. interest rate.
   2. number of periods.
   3. amount of the payments.
   4. maturity value.

Ans: D, LO 2, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The factor 1.34587 is taken from the 2% column and 15 periods row in a certain table. From what table is this factor taken?
   1. Future value of a single sum.
   2. Future value of an ordinary annuity of 1.
   3. Present value of a single sum.
   4. Present value of an ordinary annuity of 1.

Ans: A, LO 2, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. If $25,000 is put in a savings account paying interest of 6% compounded annually, what amount will be in the account at the end of five years?
   1. $33,456.
   2. $18,682.
   3. $140,927.
   4. $105,309.

Ans: A, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

Solution: $25,000 x 1.33823 =$33,456

(FVIF n=5, i=6% x PV) = FV

1. The future value of 1 factor will always be
   1. less than 1.
   2. greater than 1.
   3. equal to the interest rate.
   4. equal to 1.

Ans: B, LO 2, Bloom: C, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision.

1. If $5,000 is put into a savings account at the end of each year and the account pays interest of 4% compounded annually, what amount will be in the account at the end of six years?
   1. $6,327.
   2. $3,952.
   3. $33,165.
   4. $26,211.

Ans: C, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

Solution: $5,000 x 6.63298 =$33,165

(Annuity x FV annuity factor, n=6, i=4%) = FV

1. Which discount rate will produce the smallest present value?
   1. 2%.
   2. 6%.
   3. 10%.
   4. 12%.

Ans: D, LO 2, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

1. If you can earn an 12% rate of return, what amount would you need to invest to have $20,000 on year from now?
   1. $22,400.
   2. $17,857.
   3. $20,000.
   4. $17,857.

Ans: B, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

Solution: $20,000 x .89286 =$17,857

(FV x PVIF annuity factor, n=1, i=12%) = PV

1. Allied Company is considering the purchase of a machine. The machine will produce cash flows for the next two years as follows:

Year 1 $80,000

Year 2 $90,000

What is the maximum price Allied should pay for this machine if they have a cost of capital of 12%?

• 1. $143,176.
  2. $170,000.
  3. $202,496.
  4. $223,533.

Ans: A, LO 2, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

Solution: ($80,000 x .89256) + ($90,000 x 71,.79719) = $143,176

(FV x PVIF, n = 1, I = 12%) + (FV x PVIF, n = 2, I = 12%)

1. To compute the present value of an annuity, the company must know the
2. discount rate.
3. number of discount periods and the amount of the periodic payments or receipts
   1. both 1 and 2.
   2. 1.
   3. 2.
   4. both 1 and 2, and additional information is needed.

Ans: A, LO 2, Bloom: C, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

1. The difference between the future value of an annuity and the future value of an annuity due is
   1. The future value of an annuity has recurring payments or receipts, and the future value of an annuity due receives or pays the amount only once.
   2. The future value of an annuity due has recurring payments or receipts, and the future value of an annuity receives or pays the amount only once.
   3. The future value of an annuity due receives payments at the beginning of each period, and the future value of an ordinary annuity receives payments at the end of each period.
   4. The future value of an annuity receives payments at the beginning of each period, and the future value due of an annuity receives payments at the end of each period.

Ans: C, LO 2, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision.

1. Ducky Company purchased a machine that requires annual payments of $25,000 to be paid at the end of each of the next seven years. The discount rate is 8%. What amount will be used to record the machine?
   1. $14,587.
   2. $223,070.
   3. $130,159.
   4. $140,572.

Ans: C, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

Solution: $25,000 x 5.20637 =$130,159

(Annuity x PVAF, n=7, i=8%) = PV

1. Ducky Company purchased a machine that requires annual payments of $25,000 to be paid at the beginning of each of the next seven years. The discount rate is 8%. What amount will be used to record the machine?
   1. $14,587.
   2. $223,070.
   3. $130,159.
   4. $140,572.

Ans: D, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

Solution: $25,000 x 5.62288 =$140,572

(Annuity x PVAF, n=7, i=8%) = PV

1. Companies must use a rate to determine the present value of future cash flows. All of the following can be considered the discount rate except
   1. actual rate of return.
   2. hurdle rate.
   3. weighted-average cost of capital.
   4. tax rate.

Ans: D, LO 2, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision.

1. Companies typically use a(n) _________ in capital budgeting decisions
   1. after-tax basis.
   2. pre-tax basis.
   3. actual tax liability.
   4. quarterly tax payment.

Ans: A, LO 2, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: FC, Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Following is selected financial information for Epic Inc.

Revenues $225,000

Operating expenses (including depreciation) $100,000

Depreciation $ 15,000

Decrease in accounts receivable balance $ 5,000

Tax rate 21%

Calculate the after-tax net cash flows for the year.

• 1. $90,850.
  2. $102,700.
  3. $86,900.
  4. $82,950.

Ans: A, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

Solution: ($225,000 + $5,000) – (100,000 - $15,000) =$115,000 x (1-.21) = $90,850

(Rev. + Dec. in AR) – (Op. Exp. – Depr.) = cash basis op. inc. x (1 – tax rate)

1. Which of the following statements is true regarding depreciation?
   1. All expenses that are deductible for accounting purposes are also deductible for tax purposes.
   2. All expenses that are deductible for tax purposes are also deductible for accounting purposes.
   3. Tax deductions (like depreciation) are cash savings.
   4. Buying a long-term asset to generate income entitles a company to a one-year tax deduction.

Ans: C, LO 2, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Random Company is considering purchasing a machine to create a widget. The following information pertains to the purchase:

Cost of machine $77,000

Useful Life 7 years

Salvage value $7,000

Tax rate 21%

Calculate the tax shield if the company makes the purchase.

• 1. $2,100.
  2. $2,310.
  3. $14,700.
  4. $16,170.

Ans: A, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decision

Solution: [($77,000 - $7,000) ÷ 7 years] x .21 = $2,100

[(cost – sal. val.) ÷ years] x tax rate

1. Which of the following capital budgeting tools uses net income instead of cash flows?
   1. Net present value.
   2. Internal rate of return.
   3. Payback period.
   4. Annual rate of return.

Ans: D, LO 3, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Which of the following capital budgeting tools does NOT consider the time value of money?
   1. Net present value.
   2. Internal rate of return.
   3. Simple payback period.
   4. Profitability index.

Ans: C, LO 3, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Which of the following statements is false when considering the net present value (NPV)?
   1. The NPV is the preferred capital budgeting tool used in most businesses.
   2. The NPV captures the surplus but not the deficit the project generates in today’s dollar.
   3. The NPV can be used to rank competing projects.
   4. The NPV can accommodate non-uniform cash flows from one year to the next.

Ans: B, LO 3, Bloom: C, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. If the net present value is positive, which of the following statements is true?
   1. The cost of capital is less than the discount rate.
   2. The investment is not profitable and should be rejected.
   3. It measures the increase in the value of a company that results from an investment.
   4. It measures the rate at which the discount rate has decreased.

Ans: C, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. A business is considering an investment that has a net present value (NPV) of $0 when they use a discount rate of 10%. A discount rate of 8% will result in a
   1. NPV of $0.
   2. positive NPV.
   3. negative NPV.
   4. there is not enough information to provide a solution.

Ans: B, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Blender Inc. purchased a new piece of equipment that cost $120,000. The equipment is will be used for 10 years and will have a salvage value of $10,000. The annual operating cash inflows will be $45,000, and the annual operating cash outflows will be $30,000. The tax rate is 21%, and the company requires an after-tax rate of return of 8%. Calculate the net present value (NPV) of the equipment
   1. ($20,353).
   2. $73,051.
   3. ($17,384).
   4. $68,419.

Ans: A, LO 3, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: (($45,000 - $30,000) x 6.71008 x (1 - .21)) + ((($120,000 – $10,000) ÷ 10) x 6.71008 x .21) + ($10,000 x .46319) - $120,000 = -$20,353

((Cash in. – Cash out) x PVAF, n 10, i=8% x (1-tax rate)) + (((cost – sal. val.) ÷ years) x PVAF, n 10, i=8% x tax rate) + (sal. val x PVIF, n10, i = 8%) – cost

1. A projected project requires an investment of $100,000 and has an expected life of four years. The project expects annual cash flows of $40,000 in year 1, $48,000 in year 2, $76,000 in year 3 and $56,000 in year 4. If the company has a discount rate of 8%, what is the net present value (ignoring income taxes)?
   1. $49,680.
   2. $79,682.
   3. ($79,682).
   4. ($49,680).

Ans: B, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($40,000 x .92593) + ($48,000 x .85734) + ($76,000 x .79383) + ($56,000 x .73503) - $100,000 = $79,682

(year 1 cash x PVIF, n=1, i=8%) + (year 2 cash x PVIF, n=2, i=8%) + (year 3 cash x PVIF, n=3, i=8%) +(year 4 cash x PVIF, n=4, i=8%) - cost

1. Sky High Company is considering the purchase of an investment of $250,000. Data related to the investment are as follows:

Cash flows (at the end of the next four years) $125,000

Salvage value $25,000

Tax Rate 21%

With a discount rate of 9%, what is the net present value of the investment.

• 1. $354,910.
  2. $189,185.
  3. $158,140.
  4. $125,902.

Ans: D, LO 3, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($125,000 x 3.23972 x (1 - .21)) + ((($250,000 – $25,000) ÷ 4) x 3.23972 x .21) + ($25,000 * .708430) - $250,000 = $125,902

(Cash flows x PVAF, n 4, i=9% x (1-tax rate)) + (((cost – sal. val.) ÷ years) x PVAF, n 4, i=9% x tax rate) + (sal. val x PVIF, n 4, i = 9%) – cost

1. Which of the following does NOT considered a company’s discount rate?
   1. Net present value.
   2. Internal rate of return.
   3. Accounting rate of return.
   4. Simple payback period.

Ans: D, LO 3, Bloom: C, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Which capital budgeting tool takes into account both the discounted cash flows and the original investment?
   1. Annual rate of return.
   2. Profitability index.
   3. Annual rate of return.
   4. Simple payback period.

Ans: B, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. All of the following are true regarding the internal rate of return (IRR), except
   1. The greater the project’s IRR, the greater the project’s desirability.
   2. The IRR is expressed as a percentage making it easier to compare projects.
   3. The IRR can be used to rank competing projects.
   4. The IRR is expressed as a percentage making it harder to compare projects.

Ans: D, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Blender Inc. purchased a new piece of equipment that cost $120,000. The equipment is will be used for 10 years and will have a salvage value of $10,000. The annual operating cash inflows will be $45,000, and the annual operating cash outflows will be $30,000. The tax rate is 21%, and the company requires an after-tax rate of return of 8%. Using Excel calculate the internal rate of return (IRR) of the equipment
   1. 4.3%.
   2. 3.1%.
   3. 6.0%.
   4. 2.6%.

Ans: A, LO 3, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: (($45,000 - $30,000) x (1 - .21)) + ((($120,000 – $10,000) ÷ 10) x .21) = $14,160 (years 1 – 9) $14,160 + $10,000 = $24,160 (year 10), -,120,000 (year 0)

=IRR(-$120,000, $14,160, $14,160, $14,160, $14,160, $14,160, $14,160, $14,160, $14,160, $14,160, $24,160) = 4.3%

((Cash in. – Cash out) x (1-tax rate)) + (((cost – sal. val.) ÷ years) x tax rate) = years 1 – 9, Years 1 – 9 + sal. val = (Year 10) - cost (Year 0)

1. Sky High Company is considering the purchase of an investment of $250,000. Data related to the investment are as follows:

Cash flows (at the end of the next four years) $125,000

Salvage value $25,000

Tax Rate 21%

With a discount rate of 9%, what is the internal rate of return of the investment?

• 1. 9.0%.
  2. 24.0%.
  3. 32.5%.
  4. 26.3%.

Ans: C, LO 3, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($125,000 x (1 - .21)) + ((($250,000 – $25,000) ÷ 4) x .21) = $$116,337.50 (Years 1 – 3), $116,337.50 + $25,000 = $141,337.50 (year 4), - $250,000 (Year 0)

=IRR(-$250,000, $116,337.50, $116,337.50, $116,337.50, $141,337.50) = 32.5%%

((Cash in. – Cash out) x (1-tax rate)) + (((cost – sal. val.) ÷ years) x tax rate) = years 1 – 3, Years 1 – 3 + sal. val = (Year 4) - cost (Year 0)

1. Which of the following formulas correctly depicts the payback period?
   1. Net initial investment divided by average net income.
   2. Investment divided by the net initial investment.
   3. Annual cash inflows divided by net initial investment.
   4. Net initial investment divided by annual cash inflows.

Ans: D, LO 3, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The primary difference between the simple payback period and the discounted payback period is
   1. the simple method puts cash flows into present value terms while the discounted method does not.
   2. the discounted method puts cash flows into present value terms while the simple method does not.
   3. The simple method uses a non-uniform cash flows approach, and the discounted method does not.
   4. The discounted method uses a non-uniform cash flows approach, and the simple method does not.

Ans: B, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. If the Alpha project has a lower payback period than the Omega project, it may indicate that the Omega project may have a
   1. lower NPV and be less profitable.
   2. higher NPV and be less profitable.
   3. higher NPV and be more profitable.
   4. lower NPV and be more profitable.

Ans: A, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Peaches Inc. is considering the purchase of a new machine for $140,000. The machine will generate an annual cash flow before depreciation and taxes of $52,688 for four years. At the end of four years, the machine will not have a salvage value. The company’s rate of return is 10 percent, with a tax rate of 21%. What is the net after-tax cash flow per year?
   1. $48,974.
   2. $18,414.
   3. $69,274.
   4. $38,714.

Ans: A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($52,688 x (1 - .21)) + (($140,000 ÷ 4) x .21) = $48,974

(ann. Cash flows x (1 – tax rate)) + ((cost ÷ life) x tax rate)

1. Justys Company is considering the purchase of equipment for $90,000. The equipment will generate an annual cash flow before depreciation and taxes of $32,887 for five years. At the end of five years, the equipment will not have a salvage value. The company’s rate of return is 8 percent, with a tax rate of 21%. What is the net after-tax cash flow per year?
   1. $21,126.
   2. $40,201.
   3. $10,686.
   4. $29,761.

Ans: D, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($32,887 x (1 - .21)) + (($90,000 ÷ 5) x .21) = $29,761

(ann. Cash flows x (1 – tax rate)) + ((cost ÷ life) x tax rate)

1. If a project has a payback period that is greater than the useful life, the
   1. project’s return will always be greater than the discount rate.
   2. project will only be accepted if the project has a lower discount rate.
   3. entire initial investment will not be recovered.
   4. project will always be profitable.

Ans: C, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Blender Inc. purchased a new piece of equipment that cost $120,000. The equipment included an investment in working capital of $19,000. The equipment is will be used for 10 years and will have a salvage value of $10,000. The annual operating cash inflows will be $45,000, and the annual operating cash outflows will be $30,000. The tax rate is 21%, and the company requires an after-tax rate of return of 8%. Calculate the simple payback period of the equipment.
   1. 9.3 years.
   2. 8.6 years.
   3. 8.0 years.
   4. 2.7 years.

Ans: A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($120,000 + $19,000) ÷ ($45,000 - $30,000) = 9.3 years

(cost + work cap.) ÷ (cash in – cash out)

1. Sky High Company is considering the purchase of an investment of $250,000. Data related to the investment are as follows:

Cash flows (at the end of the next 4 years) $125,000

Salvage value of new investment $25,000

Proceeds from disposal of old investment $22,000

Investment in working capital $14,000

Tax Rate 21%

With a discount rate of 9%, what is the simple payback period of the investment.

• 1. 2.1 years.
  2. 2.0 years.
  3. 1.9 years.
  4. 1.8 years.

Ans: C, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($250,000 + $14,000 - $22,000) ÷ $125,000 = 1.9 years

(cost + work cap. – Disp. proc.) ÷ (cash in – cash out)

1. Sky High Company is considering the purchase of an investment of $250,000. Data related to the investment are as follows:

Year 1 cash flows $133,000

Year 2 cash flows $137,000

Year 3 cash flows $125,000

Year 4 cash flows $130,000

Salvage value of new investment $25,000

Proceeds from disposal of old investment $22,000

Investment in working capital $14,000

Tax Rate 21%

With a discount rate of 9%, what is the payback period with non-uniform cash flows of the investment?

• 1. 2.1 years.
  2. 2.0 years.
  3. 1.9 years.
  4. 1.8 years.

Ans: D, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($250,000 + $14,000 - $22,000) = $242,000, ($133,000 + $137,000) = $270,000, ($242,000 - $133,000) ÷ $137,000 = .8 + 1 = 1.8 years

(cost + work cap. – Disp. proc.) = cost of invest., (year 1 + year 2) = cum year 2, (cost of invest. – year 1) ÷ ÷ year 2 + 1

1. Sky High Company is considering the purchase of an investment of $250,000. Data related to the investment are as follows:

Year 1 cash flows $133,000

Year 2 cash flows $137,000

Year 3 cash flows $125,000

Year 4 cash flows $130,000

Salvage value of new investment $25,000

Proceeds from disposal of old investment $22,000

Investment in working capital $14,000

Tax Rate 21%

With a discount rate of 9%, what is the discounted payback period of the investment.

• 1. 2.05 years.
  2. 2.0 years.
  3. 1.9 years.
  4. 1.4 years.

Ans: A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($250,000 + $14,000 - $22,000) = $242,000, ($133,000 x PVF, n=1, i=9% + $137,000 x PVF, n=2, i=9% + $125,000 x PVF, n=3, i=9%) = $333,851, ($242,000 - $237,328) ÷ $96,523 = .05 + 2 = 2.05 years

(cost + work cap. – Disp. proc.) = cost of invest., (PV year 1 + PV year 2 + PV year 3) = cum year 3, (cost of invest. – PV year 2) ÷ PV year 3 + 2

1. Which of the following is true when the simple payback period and the accounting rate of return is compared?
   1. Both methods ignore profitability and the time value of money.
   2. Both methods ignore profitability, and only the accounting rate of return takes into consideration the time value of money.
   3. Both methods ignore the time value of money, but only the accounting rate of return takes into consideration profitability.
   4. Both methods take into consideration the time value of money, but only the accounting rate of return takes into consideration profitability.

Ans: C, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The accounting rate of return on the initial investment is calculated as
   1. initial investment divided by average annual after-tax operating income.
   2. average annual after-tax operating income divided by debt.
   3. average annual after-tax operating income divided by the initial investment.
   4. total assets divided by total debt.

Ans: C, LO 3, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. All of the following statements regarding the accounting rate of return (ARR) are true except:
   1. The ARR is helpful when analyzing projects with a positive net present value.
   2. The ARR is the only method that uses accrual accounting instead of cash flows.
   3. The ARR uses total annual after-tax operating income earned by the projects over its lifespan.
   4. The ARR is most often used by managers that have bonuses tied to divisional profits.

Ans: C, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Sky High Company is considering the purchase of an investment of $250,000. Data related to the investment are as follows:

Cash flows (at the end of the next four years) $125,000

Salvage value of new investment $25,000

Proceeds from disposal of old investment $22,000

Book value of old investment $24,500

Investment in working capital $14,000

Tax Rate 21%

With a discount rate of 9%, what is the accounting rate of return of the investment?

• 1. 19.8%.
  2. 32.6%.
  3. 27.4%.
  4. 22.4%.

Ans: B, LO 3, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($250,000 + $14,000 - $22,000) = $242,000, ($125,000 – ($24,500 - $22,000) – (($250,000 - $25,000) ÷ 10) = $100,000 x (1-.21) = $79,000, $79,000 ÷ $242,000 = 32.6%

(cost + work cap. – Disp. proc.) = cost of invest., (cash flow – (book – proc.) – ((cost – sal. val.) ÷ 10) = Op. Inc. X (1- tax rate) = avg net inc., avg net inc. ÷ cost of invest

1. Project Duke has a present value of cash flows of $50,000 and an original investment of $35,000. Project Prince has a present value of cash flows of $90,000 and an original investment of $95,000. Both projects have the same useful life. Using the profitability index, which project should be accepted?
   1. Project Duke.
   2. Project Prince.
   3. Both projects should be accepted.
   4. Neither project should be accepted.

Ans: A, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: Profitability Index = Present Value of future cash flows ÷ Initial Investment

1. The profitability index is computed by dividing the
2. total future cash flows by the initial investment.
3. present value of future cash flows by the initial investment.
4. initial investment by the total future cash flows.
5. initial investment by the present value of future cash flows.

Ans: B, LO 3, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. If a company’s required rate of return is 6%, and a project has an index greater than 1, in using the profitability index method, this indicates that the project’s rate of return is
2. greater than 6%.
3. less than 6%.
4. equal to 6%.
5. not acceptable for investment.

Ans: A, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The capital budgeting tool that takes into account both the size of the initial investment and the present value of future cash flows is the
2. profitability index.
3. simple payback method.
4. annual rate of return.
5. internal rate of return.

Ans: A, LO 3, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The profitability index
2. can only be less than 1.
3. will not take into account the present value of future cash flows.
4. is calculated by dividing total cash flows by the initial investment.
5. allows projects to be compared on the relative desirability with different initial investments.

Ans: D, LO 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The capital budgeting tool that allows projects to be compared based on relative desirability with different initial investments is the
2. accounting rate of return.
3. internal rate of return.
4. net present value.
5. profitability index.

Ans: D, LO 3, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Mead Company is considering the purchase of an investment. The following information pertains to the potential investment:

Initial investment $225,000

Net annual cash flows 23,500

Net present value 42,867

Salvage value 20,000

Useful life 10 years

What is the profitability index of the potential investment?

• 1. 1.19.
  2. 1.10.
  3. 1.21.
  4. 1.11.

Ans: A, LO 3, Bloom: AP, Difficulty: Medium AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: ($42,867 + $225,000) ÷ $225,000 = 1.19

((Net present value + Initial investment) ÷ Initial investment = Profitability index)

1. Jabber Company is considering the purchase of an investment with a 4-year life span. The initial investment is $65,000 and net annual cash flows were $28,000 for year 1; $22,000 for year 2; $25,000 for year 3; and $30,000 for year 4. There is no salvage value. If the company has a cost of capital of 10%, what is the investment’s profitability index?
   1. 3.34.
   2. 0.34.
   3. 1.31.
   4. 1.28.

Ans: D, LO 3, Bloom: AP, Difficulty: Medium AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $25,455 + $18,182 + $18,783 + $20,490 = $82,910 as the PV of future net annual cash flows. $82,910÷$65,000 = 1.28.

([(Annual Cost Savings Year 1 x PV of 1 at 10% factor) + (Annual Cost Savings Year 2 x PV of 1 at 10% factor) + (Annual Cost Savings Year 3 x PV of 1 at 10% factor) + (Annual Cost Savings Year 4 x PV of 1 at 10% factor) + Initial investment)) ÷ Initial Investment

1. Twosome Company is considering a capital project costing $82,000 with a 3-year life span. The project is expected to have annual cost savings of $26,000 for the first two years and $20,000 for the third year. There is no salvage value. If the company has a cost of capital of 6%, what is the investment’s profitability index?
   1. .56.
   2. .79.
   3. 1.23.
   4. .49.

Ans: B, LO 3, Bloom: AP, Difficulty: Medium AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

(($26,000 x 1.83339) + ($20,000 x .83962) ÷ $82,000 = ( $47,668 +$16,792 ) ÷ $82,000 = .79

((Net Cash Flow for years 1 and 2 x PV of an Annuity of 1 at 6%) + (Net Cash Flow for year 3 x PV of 1 at 6%) ÷ Initial Investment = Profitability Index

1. Maximus Company has a cost of capital of 9% and is considering a capital project costing $210,000. The project is expected to have annual cost savings of $45,000 for the first two years and $75,000 for years 3 and 4. There is no salvage value. What is the investment’s profitability index?
   1. .91.
   2. .93.
   3. 1.53.
   4. .71.

Ans: A, LO 3, Bloom: AP, Difficulty: Medium AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

(($45,000 x 1.75911) + ($75,000 x .77218) + ($75,000 x .70843))÷ $210,000 = ($79,160 + $57,914 + $53,132÷ $210,000 = .91

((Cash flows for years 1 and 2 x Present Value of an Annuity of 1 at 18%) + (Cash flow for year 3 x Present value of $1 at 18%) + (Cash flow for year 4 x Present value of $1 at 18%) ÷ Initial Investment = Profitability Index

1. If a project has a profitability index greater than 1, then the
2. project should always be accepted.
3. project should always be accepted if funds are available.
4. project’s net present value is negative.
5. project has an internal rate of return that is less than the discount rate.

Ans: B, LO: 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. If a project has a profitability index less than 1, then the
2. project should be rejected.
3. project’s net present value if zero.
4. project’s net present value is positive.
5. project has an internal rate of return that is greater than the discount rate.

Ans: A, LO: 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. A project has a profitability index of 1.325. The project also has a future cash flows of $21,350 and an internal rate of 12%. What was the initial investment?
2. $16,113.
3. $28,289.
4. $3,395.
5. $14,775.

Ans: A, LO: 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $21,350 ÷ x = 1.325; x = $16,113

(Present Value of net cash flows ÷ initial investment (x) = Profitability index

1. A company is considering the following four projects. These projects have the following information:

A B C D
NPV $100 $250 $3,000 $3,200
IRR 9% 11% 8% 10%

Which project is preferred?

1. A.
2. B.
3. C.
4. D.

Ans: D, LO: 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: Project D has the highest NPV

1. When comparing the net present value (NPV) and the internal rate of return (IRR), what is the most significant difference?
2. Profitability is measured in relative terms using NPV and absolute terms using IRR.
3. The time value of money is used to calculate the NPV, but not the IRR.
4. The time value of money is used to calculate the IRR, but not the NPV.
5. The NPV assumes that each cash inflow received is reinvested at the rate of return, but the IRR assumed that each cash inflow is reinvested at the computed IRR.

Ans: D, LO: 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Daesha Inc. is considering several capital budgeting projects. The projects are as follows:

X Y Z

Initial investment $130,000 $110,000 $150,000

Present value of net cash flows 120,000 100,000 180,000

Rank the projects using the profitability index.

1. X, Y, Z.
2. Z, Y, X.
3. Z, X, Y.
4. Y, Z, X.

Ans: C, LO: 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: (X) $120,000 ÷ $130,000 = .92; (Y) $100,000 ÷ $110,000 = .91; (Z) $180,000 ÷ 150,000 = 1.20 (Present Value of net cash flows ÷ Initial Investment = Profitability index)

1. Daesha Inc. is considering several capital budgeting projects. The projects are as follows:

X Y Z

Initial investment $130,000 $110,000 $150,000

Present value of net cash flows 120,000 100,000 180,000

Using the profitability index, how many of the projects are acceptable?

1. 0.
2. 1.
3. 2.
4. 3.

Ans: B, LO: 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: (X) $120,000 ÷ $130,000 = .92; (Y) $100,000 ÷ $110,000 = .91; (Z) $180,000 ÷ 150,000 = 1.20 (Yes)

(Present Value of net cash flows ÷ Initial Investment = Profitability index)

1. If a project has a positive net present value then its profitability index will be
2. cannot be determined.
3. 1.
4. greater than 1.
5. less than 1.

Ans: C, LO: 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. If a project has a profitability index of 1.10, the project’s internal rate of return is
2. equal to 10%.
3. equal to the rate of return.
4. less than the rate of return.
5. greater than the rate of return.

Ans: D, LO: 3, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. A company using a variety of outcome estimates to get a sense of the variability amount potential returns is using what type of analysis?
2. financial analysis.
3. managerial analysis.
4. post-audit analysis.
5. sensitivity analysis.

Ans: D, LO: 4, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The purpose of the sensitivity analysis is to answer the question,
2. how much tolerance the company is willing to accept?
3. what-if the estimates provided are incorrect?
4. why is the net present value zero?
5. how much should the project duration be?

Ans: B, LO: 4, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. A project has a projected initial investment of $125,000, net annual cash flows of $56,000 for five years, and a rate of return of 10%. With a tax rate of 21% and a net present value of $62,606, how much cash flows must be earned to be left with $56,000 after-tax?
2. $70,887.
3. $266,667.
4. $298,123.
5. $79,248.

Ans: A, LO: 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $56,000 ÷ (1 - .21) = $70,887

After-tax cash flows ÷ (1 – tax rate)

1. A project has a projected initial investment of $125,000, net annual cash flows of $56,000 for five years, and a rate of return of 10%. With a tax rate of 21% and a net present value of $62,606, what are the breakeven cash flows to provide a net present value of zero?
2. $39,629.
3. $157,022.
4. $32,975.
5. $41,741.

Ans: D, LO: 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $125,000 ÷ 3.79079 = $32,975 ÷ (1 - .21) = $41,741

Int. Cost ÷ PVOA, n=5, i= 10% = after tax cash flow ÷ (1 – tax rate)

1. A project has a projected initial investment of $125,000, net annual cash flows of $56,000 for five years, and a rate of return of 10%. With a tax rate of 21% and a net present value of $62,606, how much can the project be off in the cash flow estimate before the project is less impressive with a net present value of zero?
2. $70,887.
3. $29,145.
4. $41,740.
5. $39,619.

Ans: B, LO: 4, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $56,000 ÷ (1 - .21) = $70,886, $125,000 ÷ 3.79079 = $32,975 ÷ (1 - .21) = $41,741, $70,886 - $41,741 = $29,145

After-tax cash flows ÷ (1 – tax rate) = before-tax NPV, Int. Cost ÷ PVOA, n=5, i= 10% = after tax cash flow ÷ (1 – tax rate) = before tax BE cash flows, before-tax NPV - before tax BE cash flows = difference

1. The first step in the decision-making framework is,
2. identify suitable options and gather relevant information.
3. outline the problem.
4. select the option that maximizes the benefits of the company.
5. calculate relevant costs and benefits for each option.

Ans: B, LO: 5, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The second step in the decision-making framework is,
2. identify suitable options and gather relevant information.
3. outline the problem.
4. select the option that maximizes the benefits of the company.
5. calculate relevant costs and benefits for each option.

Ans: A, LO: 5, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The third step in the decision-making framework is,
2. identify suitable options and gather relevant information.
3. implement your choice.
4. select the option that maximizes the benefits of the company.
5. calculate relevant costs and benefits for each option.

Ans: D, LO: 5, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The fourth step in the decision-making framework is,
2. identify suitable options and gather relevant information.
3. implement your choice.
4. select the option that maximizes the benefits of the company.
5. calculate relevant costs and benefits for each option.

Ans: C, LO: 5, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The fifth step in the decision-making framework is,
2. identify suitable options and gather relevant information.
3. implement your choice.
4. select the option that maximizes the benefits of the company.
5. calculate relevant costs and benefits for each option.

Ans: B, LO: 5, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. The five steps in the decision-making framework, in order, are,
2. outline the problem, identify options, calculate relevant costs, select the option that maximizes benefits and implement the choice.
3. outline the problem, identify options, select the option that maximizes benefits, calculate relevant costs, and implement the choice.
4. outline the problem, select the option that maximizes benefits, identify options, calculate relevant costs, and implement the choice.
5. identify options, outline the problem, calculate relevant costs, select the option that maximizes benefits and implement the choice.

Ans: A, LO: 5, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. All of the following are true regarding a post-investment audit except:
2. Post-investment audits are designed to detect problems and compare actual results to projected results.
3. Conducting a post-investment audit at the proper time is crucial to get accurate feedback.
4. Seasonal effects should not influence the outcomes of the investment.
5. If a post-investment audit is conducted too early, the project’s outcomes may not be stable.

Ans: C, LO: 6, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. A post-investment audit should be performed using
2. an independent third-party.
3. estimated amounts instead of actual figures.
4. different evaluation techniques than used to make the original decision.
5. the same evaluation technique using to make the original decision.

Ans: D, LO: 6, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. A thorough evaluation of how well a project’s actual performance matches the original project’s performance is called a
2. risk analysis.
3. sensitivity analysis.
4. post-investment audit.
5. pre-investment audit.

Ans: C, LO: 6, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. Performing a post-investment audit is crucial because
2. They provide a formal mechanism to determine if the project should be terminated.
3. Managers are more likely to make more accurate projections when they make investment proposals.
4. They improve the development of future proposals because managers can evaluate their past failures and successes.
5. All of these.

Ans: D, LO: 6, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. A post-investment audit compares
2. actual benefits and costs with estimated benefits and costs.
3. actual benefits with actual costs.
4. estimated benefits with estimated costs.
5. estimated benefits and costs with projected benefits and costs.

Ans: A, LO: 6, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

1. A project has a projected initial investment of $125,000, net annual cash flows of $56,000 for five years, and a rate of return of 10%. With a tax rate of 21% and a net present value of $62,606, how much can the project be off in the cash flow estimate before the project is less impressive with a net present value of zero?
2. $70,887.
3. $29,147.
4. $41,740.
5. $39,619.

Ans: B, LO: 4, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement Analysis and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution: $56,000 ÷ (1 - .21) = $70,887, $125,000 ÷ 3.79079 = $32,975 ÷ (1 - .21) = $41,740, $70,887 - $41,740 = $29,147

After-tax cash flows ÷ (1 – tax rate) = before-tax NPV, Int. Cost ÷ PVOA, n=5, i= 10% = after tax cash flow ÷ (1 – tax rate) = before tax BE cash flows, before-tax NPV - before tax BE cash flows = difference

SHORT ANSWER

101. Complete the table for the missing data from a cost accounting perspective. (Round to the nearest two decimal places.)

Bookkeeping Taxes Audits

Operating Income $70,000 $130,000 $( c)

Net Income $60,000 $110,000 $175,000

Investment $ (a) $900,000 $1,100,000

Return on investment 20.00% (b)% 16.50%

Ans: N/A, LO 1, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC, Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. $350,000
2. 14.44%
3. $181,500

Solution:

1. $70,000 ÷ (a) = 20.00%, $70,000 ÷ .2000 = $350,000
2. $130,000 ÷ $900,000 = 14.44%
3. (c) ÷ $1,100,000 = 16.50%, $1,100,000 x .1650 = $181,500

102. If a company wants to invest in a new building in five years that will cost $1,200,000, how much would the company need to invest today to have the necessary funds, using a discount rate of 6%? (round to the nearest dollar)

Ans: N/A, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC, Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

$896,712

Solution:

$1,200,000 x .74726 (table 7.2, n=5, I = 6%) = $896,712

103. Using the following setup, compare and contrast the different capital budgeting tools: net present value (NPV), internal rate of return (IRR), simple payback period and accounting rate of return (ARR).

Ans: N/A, LO 3, Bloom: K, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

104. Outline the five steps in the capital budgeting decision-making framework.

Ans: N/A, LO 5, Bloom: K, Difficulty: Easy, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

Step 1 – Outline the problem

Step 2 – Identify suitable options and gather relevant qualitative and quantitative information. May need to make informed assumptions.

Step 3 – Calculate relevant costs and benefits for each option.

Step 4 – Select the option that maximizes benefits to the organization and meets required qualitative criteria.

Step 5 – Implement your choice.

105. Define a post-investment audit and list two benefits.

Ans: N/A, LO 6, Bloom: C, Difficulty: Medium, AACSB: Knowledge, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

A post-investment audit detects problems and compares expectations to reality.

Benefits:

They provide a formal mechanism to determine if the project should be terminated.

Managers are more likely to make more accurate projections when they make investment proposals.

They improve the development of future proposals because managers can evaluate their past failures and successes.

Students could provide additional benefits as well.

BRIEF EXERCISES

106. Lakota is deciding between two vehicles that will be leased for the next three years. The SUV will require a monthly lease of $350 that will be paid at the beginning of each month. The sedan will have payments due at the end of each month with the same $350 lease payment. Lakota will have a 36% discount rate associated with the lease. What is the present value (PV) for the two vehicles, and which should she choose based on your calculations? (round calculations to the nearest dollar)

Ans: N/A, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

SUV present value = $7,871

Sedan PV = $7,641

Lakota should choose the sedan because it has a lower PV than the SUV.

Solution:

SUV present value = $350 x 22.48722 (table 7.5 PVAD, n = 36 (12 x 3), i = 3% (36% ÷3))

Sedan PV = $350 x 21.83225 (table 7.4 PVOA, n = 36 (12 x 3), i = 3% (36% ÷3))

107. Manuela is looking into purchasing a building for her new business. The building would cost $350,000 and have a life of 20 years. The building would have a salvage value of $40,000. She is estimating that the net operating cash flows will be $25,000. Determine the internal rate of return (IRR) and simple payback period of the building if the business will be subject to a 21% tax rate. (Calculate IRR using excel, round to the nearest 2 decimals)

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

IRR = 3.41%

Simple Payback = 14 years

Solution:

Simple Payback = $350,000 ÷ $25,000 = 14 years

IRR:

Depreciation = $15,500 (($350,000 - $40,000) ÷ 20)

Tax Savings from Depreciation = $15,500 x .21 = $3,255

After tax cash flows = $25,000 x (1 - .21) = $19,750

Annual after tax cash flows = $19,750 + $3,255 = $23,005

Year 20 cash inflow = $23,005 + $40,000 = $63,005

108. Taya and Herman are partners in a business. They have approached each other regarding possible investments to aid their business in creating more revenue. Taya’s investment would require an initial outlay of cash of $40,000 but would provide an additional revenue stream of $22,000 per year. Herman’s investment would cost $55,000 and would bring in additional revenue of $28,000 per year. Both investments would provide revenue for four years. Using a discount rate of 10%, calculate the discounted payback period for each investment and determine which investment would better use the company’s resources. (Round intermediary calculations to the nearest whole dollar and the final payback period to the nearest hundredth. Ignore taxes.)

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

Taya’s payback period = 2.11 years

Herman’s payback period = 2.30 years

Taya’s investment would be a better use of the company’s resources because it has a lower discounted payback period.

Solution:

Taya’s Investment

Year Cash Inflows PV Calculation Cumulative Discounted Cash Flows

1 $22,000 $22,000 x .90909 = $20,000 $20,000

2 $22,000 $22,000 x .82645 = $18,182 $20,000 + $18,182 = $38,182

3 $22,000 $22,000 x .75132 = $16,529 $38,182 + $16,529 = $54,711

4 $22,000 $22,000 x .68301 = $15,026 $54,711 + $15,026 = $69,737

After year 2 - $40,000 - $38,182 = $1,818

$1,818 ÷ $16,529 = .11, so 2.11 Years

Herman’s Investment

Year Cash Inflows PV Calculation Cumulative Discounted Cash Flows

1 $28,000 $28,000 x .90909 = $25,455 $25,455

2 $28,000 $28,000 x .82645 = $23,141 $25,455 + $23,141 = $48,596

3 $28,000 $28,000 x .75132 = $21,037 $48,596 + $21,037 = $69,633

4 $28,000 $28,000 x .68301 = $19,124 $69,633 + $19,124 = $88,757

After year 2 - $55,000 - $48,596 = $6,404

$6,404 ÷ $21,037 = .30, so 2.30 Years

109. Waggoner Cabins expects to see an increase in operating income over the next five years based on an initial investment of $85,000. Waggoner estimates that year one operating income will increase by $10,000, years 2 and 3 by $15,000, and years 4 and 5 by $20,000. The rate of return is estimated to be 8%, and the tax rate is 21%. What is the ARR of this investment, and should the company proceed with the investment? (round to the nearest 2 decimals)

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

ARR = 14.87%

Because the ARR is higher than the RRR, the company should invest.

Solution:

Year Op. Income After-Tax Calculation

1 $10,000 $10,000 x (1 - .21) = $7,900

2 $15,000 $15,000 x (1 - .21) = $11,850

3 $15,000 $15,000 x (1 - .21) = $11,850

4 $20,000 $20,000 x (1 - .21) = $15,800

5 $20,000 $20,000 x (1 - .21) = $15,800

Average after tax operating income = $7,900 + $11,850 + $11,850 + $15,800 + $15,800 = $63,200 ÷ 5 = $12,640

ARR = $12,640 ÷ $85,000 = 14.87%

110. Parsons and Sons wants to replace a fleet of vehicles with electric cars. The following is the relevant data associated with this investment:

Cost of old fleet $110,000

Book value of old fleet $10,000

Selling price of old fleet $10,000

Purchase price of new $180,000

Estimated salvage of new $20,000

Estimated useful life 5 years

Estimated annual net operating cash inflows

(per year for 5 years) $23,800

Discount rate 8%

Tax rate 21%

What is the net present value (NPV) for the new fleet, and should the company invest?

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

NPV = $(54,486)

Because the NPV is less than zero, the company should not invest in the new fleet of electric cars.

Solution:

Depreciation = ($180,000 - $20,000) ÷ 5 = $32,000

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(180,000) N/A N/A $(180,000)

Proceeds from sale 10,000 N/A N/A 10,000

Annual net op. cash flows 23,800 (1 - .21) .79 3.99271 75,071

Depreciation tax shield 32,000 .21 3.99271 26,831

Salvage value 20,000 .68058 13,612

Net present value $(54,486)

PVOA factor (5 years, 8%) is 3.99271, Table 7.4

PV factor (5 years, 8%) is .68058, Table 7.2

111. Celeste runs a daycare for pets. She is having issues finding employees to assist and needs to cut back on her hours. She is hoping to fully retire in 7 years. Her current NPV is $20,000, using a tax rate of 21% and a discount rate of 6%. She understands by cutting back hours, her NPV will drop. However, she would still like to maintain a NPV of $8,000 for the next 7 years. At what amount of revenue (before-tax) could she earn to meet her desired NPV? (round to the nearest dollar)

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

Before tax cash flows = $1,814 per year for 7 years at a 6% discount rate

Solution:

Before tax cash flows x (1-.21) x 5.58238 = $8,000

$8,000 ÷ 5,58238 ÷ .79 = $1,814

PVOA, n = 7, i = 6%, Table 7.4 = 5.58238

112. Barney is looking into the purchase of a machine for his manufacturing company. He has narrowed his decision down to 2 options. Both investments are expected to have a useful life of 3 years, and Barney uses a required rate of return of 5%. The first option will require an initial investment of $45,000 and provide net after-tax cash flows of $21,000. The second investment will require an initial cash outlay of $62,000 but will provide net after-tax cash flows of $29,000. Both after-tax cash flows factor in the depreciation tax shield.

Calculate the NPV and IRR for both investments. Which investment appears to be the better option?

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: I Strategy, Planning & Performance: Capital nvestment Decisions.

Answer:

Option 1: NPV = $12,188

IRR = 19%

Option 2: NPV = $16,974

IRR = 19%

Option 2 will be the better option as the NPV is higher. The IRR for both option are about 19%, so the company should reply more on the NPV.

Solution:

Option 1:

Item Cash Flow PV Factor Present Value

Investment $(45,000) N/A $(45,000)

Annual net op. cash flows 21,000 2.72325 57,188

Net present value $12,188

PVOA factor (3 years, 5%) 2.72325 Table 7.4

Option 2:

Item Cash Flow PV Factor Present Value

Investment $(62,000) N/A $(62,000)

Annual net op. cash flows 29,000 2.72325 78,974

Net present value $16,974

PVOA factor (3 years, 5%) 2.72325 Table 7.4

113. Victor is considering investing in a new restaurant. He also already used the necessary capital budgeting tools and calculated the following:

Required rate of return 8%

IRR 9%

Payback period 8.5 years

Useful life 10 years

NPV $2,500

Should Victor invest in the new restaurant based on his calculations?

Ans: N/A, LO 5, Bloom: AN, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

Yes, Victor should invest in the new restaurant. The IRR is greater than the RRR. The payback period is less than the useful life, and the investment has a positive NPV.

114. Perry Inc purchased three companies last year. The company uses a rate of return of 7% of its investments and is now reviewing these investments. Information for the three purchase are as follows:

Expected Actual Expected Actual

Cash inflow Cash inflow IRR IRR

Company 1 $30,000 $32,500 9% 10%

Company 2 120,000 128,000 6% 6.5%

Company 3 60,000 48,000 7% 6.5%

Based on the post-audit information, will the corporation get rid of any companies?

Ans: N/A, LO 6, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

Company 3 is not performing as it should. Perry should consider selling that company.

EXERCISES

115. Venus just won $23,150,000 in the Powerball. She has an option of receiving the lump sum today or annual payments of $350,000 for the next 25 years. Based on the current market, Venus could earn an 8% return on her investment.

Instructions

• 1. Which option should Venus choose?
  2. What would the annual payments need to be for Venus to be indifferent to the monetary options?
  3. If she decided to take the lump-sum payment, she would invest for the next 25 years, retire, and purchase a jet to travel the world. How much will she have to invest in the jet and travel the world in 25 years with an 8% return on investment? What if she only earns a 6% return?

Ans: N/A, LO 2, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. Annual payments. The annual payments have a PV of $3,736,173, while the lump sum has a PV of $3,380,363.
2. Approximately $316,668
3. 8% = $158,542,081

6% = $99,356,791

Solution:

1. $23,150,000 x .14602 (PV, n = 25, i = 8%) = $3,380,363

$350,000 x 10.67478 (PVOA, n = 25, i = 8%) = $3,736,173

1. $3,380,363 ÷ 10.67478 = $316,688 (rounded)
2. $23,150,000 x 6.84847 (FV, n = 25, i = 8%) = $158,542,081

$23,150,000 x 4.29187 (FV, n = 25, i = 6%) = $99,356,791

116. Reyes Consulting is considering an investment in equipment for $175,000. Information related to this purchase is as follows:

Year 1 cash flows $40,000

Year 2 cash flows 45,000

Year 3 cash flows 60,000

Year 4 cash flows 35,000

Salvage value $0

Estimated useful life 4 years

Discount rate 12%

Tax rate 21%

Instructions

1. Determine the net present value of the investment.
2. Calculate the simple payback period for the investment.
3. Using Excel, calculate the internal rate of return for the investment.
4. Calculate the profitability index.
5. Should the investment be undertaken?

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. $(39,230)
2. 3.86 or 3 years 10.3 months
3. 0%
4. .78
5. No, the investment has a negative NPV, a PI less than 1, an IRR of close to zero and will take almost the entire useful life to payback the investment.

Solution:

Depreciation = $175,000 ÷ 4 = $43,750

1. NPV:

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(175,000) N/A N/A $(175,000)

Year 1 cash flow 40,000 (1 - .21) .79 .89286 28,214

Year 2 cash flow 45,000 (1 - .21) .79 .79719 28,340

Year 3 cash flow 60,000 (1 - .21) .79 .71178 33,738

Year 4 cash flow 35,000 (1 - .21) .79 .63552 17,572

Depreciation tax shield 43,750 .21 3.03735 27,906

Net present value $(39,230)

1. Simple payback period

Year Cash Flow Cumulative cash flows

1 $40,000 $40,000

2 45,000 $40,000 + $45,000 = $85,000

3 60,000 $85,000 + $60,000 = $145,000

4 35,000 $145,000 + $35,000 = $180,000

It would take until year 4 to fully recover the investment. By the end of year 3, only $145,000 has been recovered, leaving an additional $30,000 ($175,000 - $145,000) to be recovered in year 4. $30,000 ÷ $35,000 = .86 of one year or (12 months x .86 = 10.3 months).

1. IRR:

Tax Savings from Depreciation = $43,750 x .21 = $9,188

After tax cash flows year 1 = $40,000 x (1 - .21) = $31,600 + 9,188 = $40,788

After tax cash flows year 2 = $45,000 x (1 - .21) = $35,550 + 9,188 = $44,738

After tax cash flows year 3 = $60,000 x (1 - .21) = $47,400 + 9,188 = $56,588

After tax cash flows year 4 = $35,000 x (1 - .21) = $27,650 + 9,188 = $36,838

1. From part a: $28,214 + $28,340 + $33,738 + $17,572 + $27,906 = $135,770

$135,770 ÷ $175,000 = .78

117. Artful Crossing Services is considering three new projects. Each project will last three years and will require an initial investment of $81,000 and they will not have a salvage value when completed. The following cash flow information is provided:

Year Alpha Delta Oscar

1 $39,000 $42,000 $50,000

2 $39,500 $42,000 $44,000

3 $47,000 $42,000 $30,000

Artful has a cost of capital of 10% and a tax rate of 21%.

Instructions

1. Calculate the discounted payback period for each investment.
2. Based on the payback period, rank the projects from best to worst.
3. Compute the net present value of each project.
4. Does the ranking prepared in part b change?

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. Alpha = 2.37, Delta = 2.26, Oscar = 1.98
2. Oscar, Delta, Alpha
3. Alpha = 14,795, Delta = 15,615, Oscar = 15,542
4. Yes, Delta is now slightly better than Oscar. New ranking would be Delta, Oscar, Alpha.

Solution:

Alpha:

Year Cash Inflows PV Calculation Cumulative Discounted Cash Flows

1 $39,000 $39,000 x .90909 = $35,455 $35,455

2 $39,500 $39,500 x .82645 = $32,645 $35,455 + $32,645 = $68,100

3 $47,000 $47,000 x .75132 = $35,312 $68,100 + $35,312 = $103,412

After year 2 - $81,000 - $68,100 = $12,900

$12,900 ÷ $35,312 = .37, so 2.37 Years

Delta:

Year Cash Inflows PV Calculation Cumulative Discounted Cash Flows

1 $42,000 $42,000 x .90909 = $38,182 $38,182

2 $42,000 $42,000 x .82645 = $34,711 $38,182 + $34,711 = $72,893

3 $42,000 $42,000 x .75132 = $31,555 $72,893 + $31,555 = $104,448

After year 2 - $81,000 - $72,893 = $8,107

$8,107 ÷ $31,555 = .26, so 2.26 Years

Oscar:

Year Cash Inflows PV Calculation Cumulative Discounted Cash Flows

1 $50,000 $50,000 x .90909 = $45,455 $45,455

2 $44,000 $44,000 x .82645 = $36,364 $45,455 + $36,364 = $81,819

3 $30,000 $30,000 x .75132 = $22,540 $81,819 + $22,540 = $104,359

After year 1 - $81,000 - $45,455 = $35,545

$35,545 ÷ $36,364 = .98, so 1.98 Years

c.

Depreciation = $81,000 ÷ 3 = $27,000

Alpha:

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(81,000) N/A N/A $(81,000)

Year 1 cash flow 39,000 (1 - .21) .79 .90909 28,009

Year 2 cash flow 39,500 (1 - .21) .79 .82645 25,789

Year 3 cash flow 47,000 (1 - .21) .79 .75132 27,897

Depreciation tax shield 27,000 .21 2.48685 14,100

Net present value $14,795

Delta:

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(81,000) N/A N/A $(81,000)

Year 1 cash flow 42,000 (1 - .21) .79 .90909 30,164

Year 2 cash flow 42,000 (1 - .21) .79 .82645 27,422

Year 3 cash flow 42,000 (1 - .21) .79 .75132 24,929

Depreciation tax shield 27,000 .21 2.48685 14,100

Net present value $15,615

Oscar:

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(81,000) N/A N/A $(81,000)

Year 1 cash flow 50,000 (1 - .21) .79 .90909 35,909

Year 2 cash flow 44,000 (1 - .21) .79 .82645 28,727

Year 3 cash flow 30,000 (1 - .21) .79 .75132 17,806

Depreciation tax shield 27,000 .21 2.48685 14,100

Net present value $15,542

118. Luis is a CPA and manages several accounting firms. He is in the process of upgrading the firm’s copiers. He believes he has chosen the right copiers but wants an analysis done to be sure he makes the best decision for the firms. He has hired you to analyze the potential investment. The current machines are leased and would be returned to the lessor. The new copiers would require an initial investment of $25,000 and would be expected to last 5 years and have a salvage value of $3,000. The firms have a cost of capital of 9% and a tax rate of 21%. They are expected to generate a cash inflow of $8,100 per year and would cost $1,500 per year to maintain.

Instructions

1. Calculate the net present value of the copiers.
2. Calculate the profitability index of the copiers.
3. Should Luis purchase the copiers?
4. If the firm’s cost of capital was 10%, would that change your decision?
5. If the copiers were only going to generate $7,000 at 9%, would your answer to part b change?

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. $825
2. 1.03
3. Yes, the NPV is positive
4. No, the NPV is stil positive $131.
5. Yes, because the NPV would be a negative $2,555.

Solution:

a.

Depreciation = ($25,000 - $3,000) ÷ 5 = $4,400

Net cash flows = $8,100 - $1,500 = $6,600

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(25,000) N/A N/A $(25,000)

Net cash flows 6,600 (1 - .21) .79 3.88965 20,281

Depreciation tax shield 4,400 .21 3.88965 3,594

Salvage value 3,000 N/A .64993 1,950

Net present value $825

b.

PV of future cash flows = $20,281 + 3,594 + $1,950 = $25,825

$25,825 ÷ $25,000 = 1.03

d.

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(25,000) N/A N/A $(25,000)

Net cash flows 6,600 (1 - .21) .79 3.79079 19,765

Depreciation tax shield 4,400 .21 3.79079 3,503

Salvage value 3,000 .N/A .62092 1,863

Net present value $131

e.

Net cash flows = $7,000 - $1,500 = $5,500

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(25,000) N/A N/A $(25,000)

Net cash flows 5,500 (1 - .21) .79 3.88965 16,901

Depreciation tax shield 4,400 .21 3.88965 3,594

Salvage value 3,000 .N/A .64993 1,950

Net present value $(2,555)

119. Torro’s construction company wants to expand its operations. To do this, the company will need to purchase a new excavator. There are several possible options for the new purchase. All options will have a 10-year life with no salvage value. The company has a 21% tax rate and a cost of capital of 9%. The following options have been provided.

130G 245G 470G

Cost $780,000 $960,000 $1,200,000

• The 130G will provide a consistent annual operating cash inflow of $110,000 per year for the 10 years.
• The 245G will provide annual operating cash inflows for years 1 and 2 of $170,000. Years 3 – 7 will drop to $130,000 per year, and years 8 – 10 will drop to $90,000 per year.
• The 470G will have no cash flows in year 1, $170,000 in years 2 – 8, and $220,000 in year years 9 and 10.

Instructions

1. Calculate the simple payback period for each option.
2. If Torro’s will only accept investments with a payback period of 8 years or less, would any of the options work for the company?
3. What are the total cash flows for each of the options over the 10-year life? Are these amounts taken into consideration when using the payback period?

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. 130G = 7.09 years

245G = 6.77 years

470G = 8.05 years

1. Yes, both excavators 130G and 245G have payback periods of less than 8 years.
2. 130G = $1,100,000

245G = $1,260,000

470G = $1,630,000

No, the payback period only considers how quickly the investment can be paid back. This method will not consider the total profitability of the investments, but can be used as a quick screening tool.

Solution:

1. 130G = $780,000 ÷ $110,000 = 7.09 years

245G

Year Cash Flow Cumulative cash flows

1 $170,000 $170,000

2 170,000 $170,000 + $170,000 = $340,000

3 130,000 $340,000 + $130,000 = $470,000

4 130,000 $470,000 + $130,000 = $600,000

5 130,000 $600,000 + $130,000 = $730,000

6 130,000 $730,000 + $130,000 = $860,000

7 130,000 $860,000 + $130,000 = $990,000

8 90,000 $990,000 + $90,000 = $1,080,000

9 90,000 $1,080,000 + $90,000 = $1,170,000

10 90,000 $1,170,000 + $90,000 = $1,260,000

It would take until year 7 to fully recover the investment. By the end of year 6, only $860,000 has been recovered, leaving an additional $100,000 ($960,000 - $860,000) to be recovered in year 7. $100,000 ÷ $130,000 = .77 of one year, so 6.77 years.

470G

Year Cash Flow Cumulative cash flows

1 $0 $0

2 170,000 $0 + $170,000 = $170,000

3 170,000 $170,000 + $170,000 = $340,000

4 170,000 $340,000 + $170,000 = $510,000

5 170,000 $510,000 + $170,000 = $680,000

6 170,000 $680,000 + $170,000 = $850,000

7 170,000 $850,000 + $170,000 = $1,020,000

8 170,000 $1,020,000 + $170,000 = $1,190,000

9 220,000 $1,190,000 + $220,000 = $1,410,000

10 220,000 $1,410,000 + $220,000 = $1,630,000

It would take until year 9 to fully recover the investment. By the end of year 8, only $1,190,000 has been recovered, leaving an additional $10,000 ($1,200,000 - $1,190,000) to be recovered in year 9. $10,000 ÷ $220,000 = .05 of one year, so 8.05 years.

120. WhiteCare Dry Cleaning has decided they need to open an additional facility. The younger generation would prefer to have their clothes dry cleaned instead of the hassle of doing laundry. The information for the additional facility is as follows:

Cost $550,000

Additional operating costs per year(Excluding depreciation) 21,000

Additional gross margin in year 1 45,000

Salvage value $400,000

Useful life 15 years

Average ARR 6%

Tax Rate 21%

Instructions

1. Calculate the accounting rate of return (ARR) for the first year of business.
2. Based on your calculations in part a, should WhiteCare move forward with the purchase?
3. In the 2^nd year of business, they are expecting their gross margins to double by the end of the year. What is the ARR for year 2? What is the ARR for the average of years 1 and 2?
4. The company believes the gross margin should equal year 2 for years 3 – 15. Based on these assumptions what will the ARR be over the useful life of the building?
5. Based on your calculations in part d, should WhiteCare make the investment?

Ans: N/A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. 2.01%
2. No, an ARR of 2.01% is lower than the companies average ARR of 6%.
3. Year 2 – 8.47%

Average years 1 & 2 – 5.24%

1. 8.04%
2. Yes, with an average 8.04% ARR over the life the building, White Clean should invest in the new building.

Solution:

a.

Gross margin $45,000

Operating costs 21,000

Depreciation 10,000 (($550,000 - $400,000) ÷ 15)

Operating income $14,000

Income taxes 2,940 ($14,000 x 21%)

After-tax operating income $11,060

$11,060 ÷ $550,000 = 2.01%

c.

Gross margin $90,000 ($45,000 x 2)

Operating costs 21,000

Depreciation 10,000 (($550,000 - $400,000) ÷ 15)

Operating income $59,000

Income taxes 12,390 ($12,390 x 21%)

After-tax operating income $46,610

$46,610 ÷ $550,000 = 8.47%

($46,610 + $11,060) ÷ 2 = $28,835, Average after-tax operating income

$28,835 ÷ $550,000 = 5.24%

1. ($11,060 + ($46,610 x 14) ÷ 15 = $44,240, Average after-tax operating income

$44,240 ÷ $550,000 = $8.04%

121. You and your spouse are not on the same page. You want to go back to school and obtain your master’s degree to allow you more career options, and your spouse wants you to continue with your current job, get experience and move up within the company ranks. You believe the master’s degree will pay off in the long run. The cost of borrowing would be 6%, and you have a current tax rate of 22%. If you obtain your master’s degree and earn more money, your tax rate will increase to 24%. The following information pertains to the two different career paths.

Master’s degree No additional education

Years until retirement 25 25

Average salary

*Master’s (Years 3 – 25) $80,000

Current (Years 1 – 25) $62,000

Cost of Tuition (Years 1 – 2) $15,000

*The master’s earning is considered a deferred annuity.

Instructions

1. What is the present value of each option, and should you spend the two years to get your master’s degree?
2. If the borrowing costs you 8%, what is the present value of the future cash flows?
3. Will it be beneficial for you to obtain your master’s degree using the 6% borrowing rate? 8% borrowing rate.

Ans: N/A, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. Master’s degree = $638,257

No additional education = $618,203

1. Master’s degree = $513,856

No additional education = $516,232

1. 6% - Yes

8% - No

Solution:

a.

Master’s degree after tax income $80,000 x (1 - .24) = $60,800

No additional education after tax income $62,000 x (1 - .22) = $48,360

Master’s degree

Item Amount PV Factor Present Value

After-tax income (years 3 – 25) $60,800 12.78336 $777,228

Less: After-tax income (years 1 – 2) 60,800 1.83339 111,470

Deferred annuity PV $665,758

Less: Cost of tuition (years 1 – 2) 15,000 1.83339 27,501

Present value $638,257

No additional education

Item Amount PV Factor Present Value

After-tax income (years 1 – 25) $48,360 12.78336 $618,203

Table 7.4, PVOA, n = 25 years, i= 6%, 12.78336

Table 7.4, PVOA, n = 2 years, i= 6%, 1.83339

b.

Master’s degree

Item Amount PV Factor Present Value

After-tax income (years 3 – 25) $60,800 10.67478 $649,027

Less: After-tax income (years 1 – 2) 60,800 1.78326 108,422

Deferred annuity PV $540,604

Less: Cost of tuition (years 1 – 2) 15,000 1.78326 26,749

Present value $513,856

No additional education

Item Amount PV Factor Present Value

After-tax income (years 1 – 25) $48,360 10.67478 $516,232

Table 7.4, PVOA, n = 25 years, i= 8%, 10.67478

Table 7.4, PVOA, n = 2 years, i= 8%, 1.78326

122. InterCo Systems and Services is going green. They are looking into a wind turbine to help power their facility. The initial cost of the turbine should reduce utility costs for the next 40 years. You are tasked with investigating this new project and are given the following parameters:

Initial cost $2,000,000

Salvage value $0

After-tax cost savings $145,000 per year

Cost of capital 8%

Tax rate 21%

Instructions

1. If the company wants to generate a breakeven NPV on this project, how much should it commit towards the investment?
2. If the company meets its cost savings above but decides to spend $2,000,000, will the earnings be less than 8%, more than 8%, or the same 8% return? Be sure to prove your answer.
3. If the company is willing to spend $2,000,000 on the turbine, how much in after-tax cost savings would the company need to generate to have a NPV of zero?

Ans: N/A, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Solution:

1. $1,729,068
2. Less than 8%, NPV will be a negative 270,932
3. $167,720 per year

Answer:

1. PV factor, Table 7-4, n = 40, i = 8%, 11.92461

$145,000 x 11.92461 = $1,729,068

Item Amount PV Factor Present Value

Initial Investment $(2,000,000) N/A $(2,000,000)

After-tax cash savings $145,000 11.92461 $1,729,068

Net present value $(270,932)

1. $2,000,000 ÷ 11.92461 = $167,720

Problems

123. You have decided you’re tired of working for someone else and would like to start up a business venture. You’ve applied to Shark Tank for investment but were turned down. You think the best fit for you is a fitness center, where you will be a personal trainer, sell nutrition supplements and sell a clothing line. You will need to find a location for your business, hire employees, buy equipment, and consider all of the other overhead items you will need to run your business. Following is the information you have obtained so far:

Initial costs for equipment $190,000

Estimated net annual operating cash inflows 120,000

Estimated net annual operating cash outflows 80,000

Estimated tax rate 21%

Required rate of return 12%

You would like to run the fitness center for 10 years and then decide to sell or continue the operations. (Note, depreciation will be calculated on the estimated 10-year life)

Instructions

1. Calculate the following
   1. NPV
   2. simple payback
   3. IRR (using excel)
   4. ARR
   5. profitability index
2. Should you invest in this new business venture?
3. What is the project’s breakeven before-tax and after-tax cash flows that will provide an NPV of zero?
4. What are the project’s current net before-tax and after-tax operating cash flows?
5. How much can you be off on your cash flow estimates and still have the business survive?
6. What does part e tell you about your estimated before-tax cash flows?

Ans: N/A, LO 3, 4 Bloom: AP, Difficulty: Hard, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. 11,091
2. 4.75 years
3. 13.41%
4. 8.73%
5. 1.06
6. Yes, based on the above calculations the business venture looks to be profitable for the next 10 years.
7. $29,637 after-tax cash flows

$37,515 before-tax cash flows

1. $40,000 before-tax cash flows

$31,600 after-tax cash flows

1. $2,485
2. This tells us that the before-tax cash flows can be reduced by $2,485 and still have a zero NPV.

Solution:

a.

Depreciation = $190,000 ÷ 10 = $19,000

Net cash flows = $120,000 - $80,000 = $40,000

NPV

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(190,000) N/A N/A $(190,000)

Net cash flows 40,000 (1 - .21) .79 5.65022 178,547

Depreciation tax shield 19,000 .21 5.65022 $22,544

Net present value $11,091

Simple payback period

$190,000 ÷ $40,000 = 4.75 years

IRR

Tax Savings from Depreciation = $19,000 x .21 = $3,990

After tax cash flows years 1 - 10 = $40,000 x (1 - .21) = $31,600 + 3,990 = $35,590

ARR

Net operating costs 40,000

Less: Depreciation 19,000

Operating income $21,000

Income taxes 4,410 ($21,000 x 21%)

After-tax operating income $16,590

$16,590 ÷ $190,000 = 8.73%

Profitability Index

PV of future cash flows (from part a) = $178,547 + $22,544 = $201,091

$201,091 ÷ $190,000 = 1.06

c.

($190,000 - $22,544) ÷ 5.65022 = $29,637 after-tax cash flows

$29,637 ÷ (1 - .21) = $37,515 before-tax cash flows

d.

$40,000 x (1 - .21) = $31,600

e.

Before-tax (part d) $40,000

Less: Before-tax (part c) $37,515

Different $2,485

124. Alexys, Justys, and Skylar are competing for a job as CEO of Athletic Angels, Inc. As part of the hiring process, they have been charged with choosing a suitable investment for the company that will bring in more student-athletes. The current board of directors has asked them to keep the proposal within a 4-year time frame. The minimum rate of return the company will accept is 10%, and its corporate tax rate is 21%. As outgoing CEO, you need to evaluate the three proposals and recommend one to the board of directors. Information for the three projects are as follows:

Alexys’s Project

Item Amount Timing

Upfront investment cost $150,000 Immediate

Salvage value 15,000 Year 4

Expected cash outflows 25,000 Years 1 – 4

Expected cash inflows 50,000 Year 1

75,000 Years 2 - 3

60,000 Year 4

Justys’s Project

Item Amount Timing

Upfront investment cost $90,000 Immediate

Salvage value 0 Year 4

Expected cash outflows 10,000 Years 1 – 4

Expected cash inflows 35,000 Years 1 - 2

45,000 Year 3

55,000 Year 4

Skylar’s Project

Item Amount Timing

Upfront investment cost $210,000 Immediate

Salvage value 40,000 Year 4

Expected cash outflows 60,000 Years 1 – 4

Expected cash inflows 130,000 Years 1 – 4

Instructions

1. For each of the three investments, calculate the
2. NPV.
3. IRR (using Excel).
4. ARR.
5. Profitability Index.
6. Rank the projects from most desirable to least desirable. Are there any proposals that should be immediately disregarded? Why?
7. Which proposal would you suggest to the board of directors?
8. Would your suggestion change if Skylar’s proposal had estimated outflows per year of $70,000? Recalculate the NPV, IRR, ARR, and profitability index to prove your answer.
9. For the proposal suggested in part c, calculate the project’s breakeven before-tax and after-tax cash flows that will provide an NPV of zero.
10. How much can the proposal you chose in part c be off and still be a reliable investment?
11. If Justys’s proposal was chosen and year 1’s data showed Cash outflow of $12,000 and cash inflow of $44,000, recalculate the NPV and IRR using years 1’s numbers is they are expected to continue for the next three years. Was this a good investment choice, and should the project continue for the additional 3 years?

Ans: N/A, LO 2, 3, 4, 6 Bloom: AN, Difficulty: Hard, AACSB: Analytic AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning & Performance: Capital Investment Decisions.

Answer:

1. Alexys’s
   1. $(18,127)
   2. 4.73%
   3. 3.29%
   4. .88

Justys’s

1. $4,310
2. 12.00%
3. 8.78%
4. 1.05

Skylar’s

1. $20,904
2. 14.18%
3. 10.35%
4. 1.10
5. Skylar, Justys, Alexys
6. Skylar’s project appears to the be most profitable.
7. NPV = $(4,138)

IRR = 9.16%

ARR = 6.58%

PI = .98

Yes, with a cash outflow of $70,000 per year, Skylar’s proposal is no longer profitable with a Negative NPV. Justys’s proposal would not be ranked #1.

1. After-tax = $48,705

Before-tax = $61,652

1. $8,348
2. NPV = $5,112

IRR = 12.60%

Yes, both the NPV and IRR have exceeded the original expectations of the proposal. The project should be continued.

Solution:

PV Factors:

Table 7.4, PVOA, n = 4, i = 10%, 3.16986

Table 7.4, PVOA, n = 2, i = 10%, 1.73554

Table 7.2, PV, n = 1, i = 10%, .90909

Table 7.2, PV, n = 2, i = 10%, .82645

Table 7.2, PV, n = 3, i = 10%, .75132

Table 7.2, PV, n = 4, i = 10%, .68301

a.

Alexys:

Depreciation = ($150,000 - $15,000) ÷ 4 = $33,750

Year 1 Net cash flows = $50,000 - $25,000 = $25,000

Year 2 & 3 Net cash flows = $75,000 - $25,000 = $50,000

Year 4 Net cash flows = $60,000 - $25,000 = $35,000

NPV

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(150,000) N/A N/A $(150,000)

Year 1 net cash flows 25,000 (1 - .21) .79 .90909 17,955

Year 2 net cash flows 50,000 (1 - .21) .79 .82645 32,645

Year 3 net cash flows 50,000 (1 - .21) .79 .75132 29,677

Year 4 net cash flows 35,000 (1 - .21) .79 .68301 18,885

Depreciation tax shield 33,750 .21 3.16986 22,466

Salvage value 15,000 N/A .68301 10,245

Net present value $(18,127)

IRR

Tax Savings from Depreciation = $33,750 x .21 = $7,087.50

After tax cash flows year 1 = $25,000 x (1 - .21) = $19,750 + 7,087.50 = $26,838

After tax cash flows years 2 & 3 = $50,000 x (1 - .21) = $39,500 + 7,087.50 = $46,588

After tax cash flows year 4 = $35,000 x (1 - .21) = $27,650 + 7,087.50 + 15,000 = $49,738

ARR

Year 1 Years 2 & 3 Year 4

Net cash flows 25,000 50,000 35,000

Depreciation 33,750 33,750 33,750

Operating income (8,750) 16,250 1,250

Income taxes (1,838) 3,413 263

After-tax operating income $(6,913) $12,838 $988

(($(6,913) + $12,838 + $12,838 + $988) ÷ 4 )) ÷ $150,000 = 3.29%

Profitability Index

PV of future cash flows (from NPV) = $17,955 + 32,645 + 29,677 + 18,885 + 22,466 + 10,245 = $131,873

$131,873 ÷ $150,000 = .88

Justys:

Depreciation = $90,000 ÷ 4 = $22,500

Years 1 & 2 Net cash flows = $35,000 - $10,000 = $25,000

Year 3 Net cash flows = $45,000 - $10,000 = $35,000

Year 4 Net cash flows = $55,000 - $10,000 = $45,000

NPV

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(90,000) N/A N/A $(90,000)

Years 1 & 2 net cash flows 25,000 (1 - .21) .79 1.73554 34,277

Year 3 net cash flows 35,000 (1 - .21) .79 .75132 20,774

Year 4 net cash flows 45,000 (1 - .21) .79 .68301 24,281

Depreciation tax shield 22,500 .21 3.16986 14,978

Net present value $4,310

IRR

Tax Savings from Depreciation = $22,500 x .21 = $4,725

After tax cash flows years 1 & 2 = $25,000 x (1 - .21) = $19,750 + 4,725 = $24,475

After tax cash flows year 3 = $35,000 x (1 - .21) = $27,650 + 4,725 = $32,375

After tax cash flows year 4 = $45,000 x (1 - .21) = $35,550 + 4,725 = $40,275

ARR

Years 1 & 2 Year 3 Year 4

Net cash flows 25,000 35,000 45,000

Depreciation 22,500 22,500 22,500

Operating income 2,500 12,500 22,500

Income taxes 525 2,625 4,725

After-tax operating income $1,975 $9,875 $17,775

(($1,975 + 1,975 + 9,875 + 17,775) ÷ 4 ) ÷ $90,000 = 8.78%

Profitability Index

PV of future cash flows (from NPV) = $34,277 + 20,774 + 24,281 + 14,978 = $94,310

$94,310 ÷ $90,000 = 1.05

Skylar:

Depreciation = ($210,000 - $40,000) ÷ 4 = $42,500

Years 1 - 4 Net cash flows = $130,000 - $60,000 = $70,000

NPV

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(210,000) N/A N/A $(210,000)

Years 1 – 4 net cash flows 70,000 (1 - .21) .79 3,16986 175,293

Depreciation tax shield 42,500 .21 3.16986 28,291

Salvage value 40,000 N/A .68301 27,320

Net present value $20,904

IRR

Tax Savings from Depreciation = $42,500 x .21 = $8,925

After tax cash flows years 1 - 3 = $70,000 x (1 - .21) = $55,300 + 8,925 = $64,225

After tax cash flows year 4 = $64,225 + $40,000 = $104,225

ARR

Years 1 - 4

Net cash flows 70,000

Depreciation 42,500

Operating income 27,500

Income taxes 5,775

After-tax operating income $21,725

21,725 ÷ $210,000 = 10.35%

Profitability Index

PV of future cash flows (from NPV) = $175,293 + 28,291 + 27,320 = $230,904

$230,904 ÷ $210,000 = 1.10

d.

Skylar:

Depreciation = ($210,000 - $40,000) ÷ 4 = $42,500

Years 1 - 4 Net cash flows = $130,000 - $70,000 = $60,000

NPV

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(210,000) N/A N/A $(210,000)

Years 1 – 4 net cash flows 60,000 (1 - .21) .79 3,16986 150,251

Depreciation tax shield 42,500 .21 3.16986 28,291

Salvage value 40,000 N/A .68301 27,320

Net present value $(4,138)

IRR

Tax Savings from Depreciation = $40,000 x .21 = $8,925

After tax cash flows years 1 - 3 = $60,000 x (1 - .21) = $47,400 + 8,925 = $56,325

After tax cash flows year 4 = $56,325 + $40,000 = $96,325

ARR

Years 1 - 4

Net cash flows 60,000

Depreciation 42,500

Operating income 17,500

Income taxes 3,675

After-tax operating income $13,825

$13,825 ÷ $210,000 = 6.58%

Profitability Index

PV of future cash flows (from NPV) = $150,251 + 28,291 + 27,320 = $205,862

$205,862 ÷ $210,000 = .98

e.

See NPV from Part c:

$210,000 - 28,291 - 27,320 = $154,389 ÷ 3.16986 = $48,705 after-tax

$48,705 ÷ ( 1 - .21) = $61,652 before tax

f.

Part c net cash flows $70,000

Less: Part e before tax cash flows 61,652

Difference $8,348

g.

Justys:

Years 1 - 4 Net cash flows = $44,000 - $12,000 = $32,000

NPV

Item Cash Flow Tax Rate PV Factor Present Value

Investment $(90,000) N/A N/A $(90,000)

Years 1 – 4 net cash flows 32,000 (1 - .21) .79 3,16986 80,134

Depreciation tax shield 22,500 .21 3.16986 14,978

Net present value $5,112

IRR

Tax Savings from Depreciation = $22,500 x .21 = $4,725

After tax cash flows years 1 - 4 = $32,000 x (1 - .21) = $25,280 + 4,725 = $30,005