CHAPTER 12 PLANNING FOR CAPITAL INVESTMENTS SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOM’S TAXONOMY Item SO BT Item SO BT Item S BT Item SO BT 6 6 6 7 7 K C K K K 107. 108. 109. 110. 111. 112. 113. 114. 115. 116. 117. 118. 119. 120. 121. 122. 123. 124. 125. 126. 127. 128. 129. 130. 131. 132. 133. 5 7 3 5 7 2 3 7 8 6 6 6 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 AP AP AP AP AP AP AP AP AP K K C K C AP K C K C C K AP AP C C C C 162. 163. 3,4 6 AN E Item SO BT 21. 22. 23. 24. 25. 7 8 8 8 8 C C K K C 134. 135. 136. 137. 138. 139. 140. 141. 142. 143. 144. 145. 146. 147. 148. 149. 150. 151. 152. 153. 154. 155. 156. 157. 7 7 7 7 8 8 8 8 8 8 8 8 8 8 8 8 2 8 8 8 8 8 8 8 K C K AP AP AP C AP K K K AN AN AN AP AP AP K K C AP C K C True-False Statements 1. 2. 3. 4. 5. 1 1 1 2 2 K K C C K 6. 7. 8. 9. 10. 2 3 3 3 4 C K C C K 11. 12. 13. 14. 15. 4 4 5 5 5 C C K K C 16. 17. 18. 19. 20. Multiple Choice Questions 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 K K K K K K C K K K K C C K K AP AP AP C K K AP C C K K C 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71. 72. 73. 74. 75. 76. 77. 78. 79. 2 2 2 2 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 AP AP AP AP AP AP K K C C AN K C K C K C C C K K K C AN AP AP AN 80. 81. 82. 83. 84. 85. 86. 87. 88. 89. 90. 91. 92. 93. 94. 95. 96. 97. 98. 99. 100. 101. 102. 103. 104. 105. 106. 4 4 4 4 4 4 4 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 3 K AN K K C C K K C K K C K AP K C C C AP AP AP AP C C C C AP Brief Exercises 158. 159. 2 3 AP E 160. 161. 3 3,5 AP E 164. 165. 7 8 E AP 12-2 Test Bank for Managerial Accounting, Fifth Edition Exercises 166. 167. 168. 169. * 2,3 2,3,8 2,3,8 E E AP AP 183. 184. 1 2 K K 170. 2,3,7 AN 174. 2,8 AP 178. 3,5,7 171. 2,3,8 AP 175. 3,4 E 179. 3,5,8 172. 2,3,8 E 176. 3,5 E 180. 3,6 173. ** E 177. 3,5 E 181. 3,7 . Completion Statements 185. 3 K 187. 3 K 189. 5 186. 3 K 188. 4 K 190. 6 E E E E 182. 7 AP K K 191. 192. 7 8 K K *1,2,3,5,7 **2,3,5,7,8 SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE Item Type Item Type Item 1. 2. 3. TF TF TF 26. 27. 28. MC MC MC 29. 30. 31. 4. 5. 6. 38. 39. TF TF TF MC MC 40. 41. 42. 43. 44. MC MC MC MC MC 45. 46. 47. 48. 49. 7. 8. 9. 56. 57. 58. 59. TF TF TF MC MC MC MC 60. 61. 62. 65. 66. 67. 68. MC MC MC MC MC MC MC 69. 70. 71. 72. 73. 74. 75. 10. 11. TF TF 12. 80. TF MC 81. 82. 13. 14. 15. 87. 88. TF TF TF MC MC 89. 90. 91. 92. 93. MC MC MC MC MC 94. 95. 96. 97. 98. 16. 17. TF TF 18. 116. TF MC 117. 118. Type Item Type Item Study Objective 1 MC 32. MC 35. MC 33. MC 36. MC 34. MC 37. Study Objective 2 MC 50. MC 55. MC 51. MC 112. MC 52. MC 158. MC 53. MC 166. MC 54. MC 167. Study Objective 3 MC 76. MC 159. MC 77. MC 160. MC 78. MC 161. MC 79. MC 166. MC 106. MC 167. MC 109. MC 168. MC 113. MC 169. Study Objective 4 MC 83. MC 85. MC 84. MC 86. Study Objective 5 MC 99. MC 104. MC 100. MC 105. MC 101. MC 107. MC 102. MC 110. MC 103. MC 161. Study Objective 6 MC 180. Ex MC 190. C Type Item Type Item Type MC MC MC 166. 183. Ex C MC MC BE Ex Ex 168. 169. 170. 171. 172. Ex Ex Ex Ex Ex 173. 174. 184. Ex Ex C BE BE BE Ex Ex Ex Ex 170. 171. 172. 173. 175. 176. 177. Ex Ex Ex Ex Ex Ex Ex 178. 179. 180. 181. 185. 186. 187. Ex Ex Ex Ex C C C MC MC 175. 188. Ex C MC MC MC MC BE 166. 173. 176. 177. 178. Ex Ex Ex Ex Ex 179. 189. Ex C Planning for Capital Investments 19. 20. 21. 108. 111. 22. 23. 24. 25. 115. TF TF TF MC MC TF TF TF TF MC 114. 119. 120. 121. 122. 138. 139. 140. 141. 142. MC MC MC MC MC MC MC MC MC MC 12-3 123. 124. 125. 126. 127. Study Objective 7 MC 128. MC 133. MC 129. MC 134. MC 130. MC 135. MC 131. MC 136. MC 132. MC 137. MC MC MC MC MC 164. 166. 170. 173. 178. BE Ex Ex Ex Ex 181. 182. 191. Ex Ex C 143. 144. 145. 146. 147. Study Objective 8 MC 148. MC 153. MC 149. MC 154. MC 150. MC 155. MC 151. MC 156. MC 152. MC 157. MC MC MC MC MC 165. 168. 169. 171. 172. BE Ex Ex Ex Ex 173. 174. 179. 192. Ex Ex Ex C Note: TF = True-False MC = Multiple Choice C = Completion BE = Brief Exercise Ex = Exercise The chapter also contains one set of eight Matching questions and three Short-Answer Essay questions. CHAPTER STUDY OBJECTIVES 1. Discuss capital budgeting evaluation, and explain inputs used in capital budgeting. Management gathers project proposals from each department; a capital budget committee screens the proposals and recommends worthy projects. Company officers decide which projects to fund, and the board of directors approves the capital budget. In capital budgeting, estimated cash inflows and outflows, rather than accrual-accounting numbers, are the preferred inputs. 2. Describe the cash payback technique. The cash payback technique identifies the time period required to recover the cost of the investment. The formula when net annual cash flows are equal is: Cost of capital investment ÷ Estimated net annual cash flow = Cash payback period. The shorter the payback period, the more attractive the investment. 3. Explain the net present value method. The net present value method compares the present value of future cash inflows with the capital investment to determine net present value. The NPV decision rule is: Accept the project if net present value is zero or positive. Reject the project if net present value is negative. 4. Identify the challenges presented by intangible benefits in capital budgeting. Intangible benefits are difficult to quantify, and thus are often ignored in capital budgeting decisions. This can result in incorrectly rejecting some projects. One method for considering intangible benefits is to calculate the NPV, ignoring intangible benefits; if the resulting NPV is below zero, evaluate whether the benefits are worth at least the amount of the negative net present value. Alternatively, intangible benefits can be incorporated into the NPV calculation, using conservative estimates of their value. 5. Describe the profitability index. The profitability index is a tool for comparing the relative merits of alternative capital investment opportunities. It is computed as: Present value of net cash flows ÷ Initial investment. The higher the index, the more desirable the project. 12-4 Test Bank for Managerial Accounting, Fifth Edition 6. Indicate the benefits of performing a post-audit. A post-audit is an evaluation of a capital investment’s actual performance. Post-audits create an incentive for managers to make accurate estimates. Post-audits also are useful for determining whether a company should continue, expand, or terminate a project. Finally, post-audits provide feedback that is useful for improving estimation techniques. 7. Explain the internal rate of return method. The objective of the internal rate of return method is to find the interest yield of the potential investment, which is expressed as a percentage rate. The IRR decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate of return. 8. Describe the annual rate of return method. The annual rate of return uses accrual accounting data to indicate the profitability of a capital investment. It is calculated as: Expected annual net income ÷ Amount of the average investment. The higher the rate of return, the more attractive the investment. TRUE-FALSE STATEMENTS 1. Capital budgeting decisions usually involve large investments and often have a significant impact on a company's future profitability. Ans: T, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 2. The capital budgeting committee ultimately approves the capital expenditure budget for the year. Ans: F, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 3. For purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision tools. Ans: T, SO: 1, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 4. The cash payback technique is a quick way to calculate a project's net present value. Ans: F, SO: 2, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 5. The cash payback period is computed by dividing the cost of the capital investment by the annual cash netflow. Ans: T, SO: 2, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Decision Analysis 6. The cash payback method is frequently used as a screening tool but it does not take into consideration the profitability of a project. Ans: T, SO: 2, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Decision Analysis 7. The cost of capital is a weighted average of the rates paid on borrowed funds, as well as on funds provided by investors in the company's stock. Ans: T, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Planning for Capital Investments 8. 12-5 Using the net present value method, a net present value of zero indicates that the project would not be acceptable. Ans: F, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 9. The net present value method can only be used in capital budgeting if the expected cash flows from a project are an equal amount each year. Ans: F, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 10. By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company. Ans: T, SO: 4, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 11. To avoid accepting projects that actually should be rejected, a company should ignore intangible benefits in calculating net present value. Ans: F, SO: 4, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Decision Analysis 12. One way of incorporating intangible benefits into the capital budgeting decision is to project conservative estimates of the value of the intangible benefits and include them in the NPV calculation. Ans: T, SO: 4, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Strategic/Critical Thinking, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Decision Analysis 13. The profitability index is calculated by dividing the total cash flows by the initial investment. Ans: F, SO: 5, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 14. The profitability index allows comparison of the relative desirability of projects that require differing initial investments. Ans: T, SO: 5, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 15. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns. Ans: T, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Decision Analysis 16. A well-run organization should perform an evaluation, called a post-audit, of its investment projects before their completion. Ans: F, SO: 6, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 17. Post-audits create an incentive for managers to make accurate estimates, since managers know that their results will be evaluated. Ans: T, SO: 6, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 18. A post-audit is an evaluation of how well a project's actual performance matches the projections made when the project was proposed. Ans: T, SO: 6, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 12-6 19. Test Bank for Managerial Accounting, Fifth Edition The internal rate of return method is, like the NPV method, a discounted cash flow technique. Ans: T, SO: 7, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Applications 20. The interest yield of a project is a rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows. Ans: T, SO: 7, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 21. Using the internal rate of return method, a project is rejected when the rate of return is greater than or equal to the required rate of return. Ans: F, SO: 7, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 22. Using the annual rate of return method, a project is acceptable if its rate of return is greater than management's minimum rate of return. Ans: T, SO: 8, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 23. The annual rate of return method requires dividing a project's annual cash inflows by the economic life of the project. Ans: F, SO: 8, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 24. A major advantage of the annual rate of return method is that it considers the time value of money. Ans: F, SO: 8, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 25. An advantage of the annual rate of return method is that it relies on accrual accounting numbers rather than actual cash flows. Ans: F, SO: 8, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement Answers to True-False Statements Item 1. 2. 3. 4. Ans. T F T F Item 5. 6. 7. 8. Ans. T T T F Item 9. 10. 11. 12. Ans. F T F T Item 13. 14. 15. 16. Ans. F T T F Item 17. 18. 19. 20. Ans. T T T T Item 21. 22. 23. 24. Ans. F T F F Item 25. Ans. F MULTIPLE CHOICE QUESTIONS 26. The capital budget for the year is approved by a company's a. board of directors. b. capital budgeting committee. c. officers. d. stockholders. Ans: a, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation Planning for Capital Investments 27. 12-7 All of the following are involved in the capital budgeting evaluation process except a company's a. board of directors. b. capital budgeting committee. c. officers. d. stockholders. Ans: d, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 28. Most of the capital budgeting methods use a. accrual accounting numbers. b. cash flow numbers. c. net income. d. accrual accounting revenues. Ans: b, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 29. The first step in the capital budgeting evaluation process is to a. request proposals for projects. b. screen proposals by a capital budgeting committee. c. determine which projects are worthy of funding. d. approve the capital budget. Ans: a, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 30. The capital budgeting decision depends in part on the a. availability of funds. b. relationships among proposed projects. c. risk associated with a particular project. d. all of these. Ans: d, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 31. Capital budgeting is the process a. used in sell or process further decisions. b. of determining how much capital stock to issue. c. of making capital expenditure decisions. d. of eliminating unprofitable product lines. Ans: c, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 32. Net annual cash flow can be estimated by a. deducting credit sales from net income. b. adding depreciation expense to net income. c. deducting credit purchases from net income. d. adding advertising expense to net income. Ans: b, SO: 1, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 12-8 33. Test Bank for Managerial Accounting, Fifth Edition Which of the following is not a typical cash flow related to equipment purchase and replacement decisions? a. Increased operating costs b. Overhaul of equipment c. Salvage value of equipment when project is complete d. Depreciation expense Ans: d, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 34. Capital expenditure proposals are initially screened by the a. board of directors. b. executive committee. c. capital budgeting committee. d. stockholders. Ans: c, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 35. Capital budgeting decisions depend in part on all of the following except the a. relationships among proposed projects. b. profitability of the company. c. company’s basic decision making approach. d. risks associated with a particular project. Ans: b, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 36. The corporate capital budget authorization process consists of how many steps? a. 4 b. 3 c. 2 d. 1 Ans: a, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 37. Which of the following is not a capital budgeting decision? a. Constructing new studios b. Replacing old equipment c. Scrapping obsolete inventory d. Remodeling an office building Ans: c, SO: 1, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 38. Which of the following is a disadvantage of the cash payback technique? a. It is difficult to calculate b. It relies on the time value of money c. It can only be calculated when there are equal annual net cash flows d. It ignores the expected profitability of a project Ans: d, SO: 2, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Planning for Capital Investments 39. 12-9 The payback period is often compared to an asset’s a. estimated useful life. b. warranty period. c. net present value. d. internal rate of return. Ans: a, SO: 2, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 40. Which of the following ignores the time value of money? a. Internal rate of return b. Profitability index c. Net present value d. Cash payback Ans: d, SO: 2, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 41. Brady Corp. is considering the purchase of a piece of equipment that costs $23,000. Projected net annual cash flows over the project’s life are: Year 1 2 3 4 Net Annual Cash Flow $ 3,000 8,000 15,000 9,000 The cash payback period is a. 2.63 years. b. 2.80 years. c. 2.20 years. d. 2.37 years. Ans: b, SO: 2, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Measurement, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 42. Bradshaw Inc. is contemplating a capital investment of $85,000. The cash flows over the project’s four years are: Expected Annual Year 1 2 3 4 Expected Annual Cash Inflows $30,000 45,000 60,000 50,000 Cash Outflows $12,000 20,000 25,000 30,000 The cash payback period is a. 2.17 years. b. 3.35 years. c. 2.30 years. d. 3.47 years. Ans: b, SO: 2, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Measurement, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 12-10 43. Test Bank for Managerial Accounting, Fifth Edition Jordan Company is considering the purchase of a machine with the following data: Initial cost One-time training cost Annual maintenance costs Annual cost savings Salvage value $130,000 12,000 15,000 75,000 20,000 The cash payback period is a. 2.37 years. b. 2.17 years. c. 1.89 years. d. 1.73 years. Ans: a, SO: 2, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Measurement, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 44. If project A has a lower payback period than project B, this may indicate that project A may have a a. lower NPV and be less profitable. b. higher NPV and be less profitable. c. higher NPV and be more profitable. d. lower NPV and be more profitable. Ans: c, SO: 2, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 45. Which of the following does not consider a company’s required rate of return? a. Net present value b. Internal rate of return c. Annual rate of return d. Cash payback Ans: d, SO: 2, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 46. The cash payback technique a. considers cash flows over the life of a project. b. cannot be used with uneven cash flows. c. is superior to the net present value method. d. may be useful as an initial screening device. Ans: d, SO: 2, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 47. If an asset costs $210,000 and is expected to have a $30,000 salvage value at the end of its ten-year life, and generates annual net cash inflows of $30,000 each year, the cash payback period is a. 8 years. b. 7 years. c. 6 years. d. 5 years. Ans: b, SO: 2, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Planning for Capital Investments 48. 12-11 If a payback period for a project is greater than its expected useful life, the a. project will always be profitable. b. entire initial investment will not be recovered. c. project would only be acceptable if the company's cost of capital was low. d. project's return will always exceed the company's cost of capital. Ans: b, SO: 2, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 49. The cash payback technique a. should be used as a final screening tool. b. can be the only basis for the capital budgeting decision. c. is relatively easy to compute and understand. d. considers the expected profitability of a project. Ans: c, SO: 2, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 50. The cash payback period is computed by dividing the cost of the capital investment by the a. annual net income. b. net annual cash inflow. c. present value of the cash inflow. d. present value of the net income. Ans: b, SO: 2, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 51. When using the cash payback technique, the payback period is expressed in terms of a. a percent. b. dollars. c. years. d. months. Ans: c, SO: 2, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 52. A disadvantage of the cash payback technique is that it a. ignores obsolescence factors. b. ignores the cost of an investment. c. is complicated to use. d. ignores the time value of money. Ans: d, SO: 2, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 53. Bark Company is considering buying a machine for $180,000 with an estimated life of ten years and no salvage value. The straight-line method of depreciation will be used. The machine is expected to generate net income of $12,000 each year. The cash payback period on this investment is a. 15 years. b. 10 years. c. 6 years. d. 3 years. Ans: c, SO: 2, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 12-12 54. Test Bank for Managerial Accounting, Fifth Edition A company is considering purchasing a machine that costs $320,000 and is estimated to have no salvage value at the end of its 8-year useful life. If the machine is purchased, annual revenues are expected to be $100,000 and annual operating expenses exclusive of depreciation expense are expected to be $38,000. The straight-line method of depreciation would be used. The cash payback period on the machine is a. 8.0 years. b. 7.3 years. c. 5.2 years. d. 2.6 years. Ans: c, SO: 2, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 55. Nance Company is considering buying a machine for $120,000 with an estimated life of ten years and no salvage value. The straight-line method of depreciation will be used. The machine is expected to generate net income of $3,000 each year. The cash payback on this investment is a. 20 years. b. 10 years. c. 8 years. d. 4 years. Ans: c, SO: 2, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 56. Giraldi Company has identified that the cost of a new computer will be $60,000, but with the use of the new computer, net income will increase by $5,000 a year. If depreciation expense is $3,000 a year, the cash payback period is: a. 30 years. b. 20 years. c. 12 years. d. 7.5 years. Ans: d, SO: 2, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 57. Richman Co. purchased some equipment 3 years ago. The company's required rate of return is 12%, and the net present value of the project was $(450). Annual cost savings were: $5,000 for year 1; $4,000 for year 2; and $3,000 for year 3. The amount of the initial investment was Year 1 2 3 a. b. c. d. Present Value of 1 at 12% .893 .797 .712 PV of an Annuity of 1 at 12% .893 1.690 2.402 $10,239. $9,158. $10,058. $9,339. Ans: a, SO: 3, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Planning for Capital Investments 58. 12-13 Use the following table, Present Value of an Annuity of 1 Period 8% 9% 10% 1 .926 .917 .909 2 1.783 1.759 1.736 3 2.577 2.531 2.487 A company has a minimum required rate of return of 9%. It is considering investing in a project which costs $420,000 and is expected to generate cash inflows of $168,000 at the end of each year for three years. The net present value of this project is a. $425,208. b. $252,000. c. $42,516. d. $5,208. Ans: d, SO: 3, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 59. The discount rate is referred to by all of the following alternative names except the a. cost of capital. b. cutoff rate. c. hurdle rate. d. required rate of return. Ans: a, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 60. The rate that a company must pay to obtain funds from creditors and stockholders is known as the a. hurdle rate. b. cost of capital. c. cutoff rate. d. all of these. Ans: b, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 61. The higher the risk element in a project, the a. more attractive the investment. b. higher the net present value. c. higher the cost of capital. d. higher the discount rate. Ans: d, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 62. If a company's required rate of return is 10% and, in using the net present value method, a project's net present value is zero, this indicates that the a. project's rate of return exceeds 10%. b. project's rate of return is less than the minimum rate required. c. project earns a rate of return of 10%. d. project earns a rate of return of 0%. Ans: c, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 12-14 63. Test Bank for Managerial Accounting, Fifth Edition Using the profitability index method, the present value of cash inflows for Project Flower is $88,000 and the present value of cash inflows of Project Plant is $48,000. If Project Flower and Project Plant require initial investments of $90,000 and $40,000, respectively, and have the same useful life, the project that should be accepted is a. Project Flower. b. Project Plant. c. Either project may be accepted. d. Neither project should be accepted. Ans: b, SO: 3, Bloom: AN, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 64. The primary capital budgeting method that uses discounted cash flow techniques is the a. net present value method. b. cash payback technique. c. annual rate of return method. d. profitability index method. Ans: a, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 65. When the annual cash flows from an investment are unequal, the appropriate table to use is the a. future value of 1 table. b. future value of annuity table. c. present value of 1 table. d. present value of annuity table. Ans: c, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 66. A company's cost of capital refers to the a. rate the company must pay to obtain funds from creditors and stockholders. b. total cost of a capital project. c. cost of printing and registering common stock shares. d. rate of return earned on common stock. Ans: a, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 67. When a capital budgeting project generates a positive net present value, this means that the project earns a return higher than the a. internal rate of return. b. annual rate of return. c. required rate of return. d. profitability index. Ans: c, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 68. A negative net present value indicates that the a. project is acceptable. b. wrong discount rate was used. c. project’s annual rate of return exceeds the discount rate. d. present value of the cash inflows was less than the present value of the cash out flows. Ans: d, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Planning for Capital Investments 69. 12-15 A company’s discount rate is based on the a. cost of capital and the internal rate of return. b. cost of capital and the risk element. c. cut-off rate and the risk element. d. cut-off rate and the internal rate of return. Ans: b, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 70. The discount rate that will result in the lowest net present value for a project is a. any rate lower that the cost of capital. b. any rate higher than the cost of capital. c. the lowest rate used to evaluate the project. d. the highest rate used to evaluate the project. Ans: d, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 71. The discount rate that will result in the highest net present value for a project is a. any rate lower that the cost of capital. b. any rate higher than the cost of capital. c. the lowest rate used to evaluate the project. d. the highest rate used to evaluate the project. Ans: c, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 72. Which of the following will increase the net present value of a project? a. An increase in the initial investment b. A decrease in annual cash inflows c. An increase in the discount rate d. A decrease in the discount rate Ans: d, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 73. A project with a zero net present value indicates that it is a. unacceptable. b. profitable. c. acceptable. d. going to have an acceptable cash payback period. Ans: c, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 74. Companies often assume that the risk element in the discount rate is a. zero. b. greater that zero. c. less than zero. d. known with certainty. Ans: a, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 75. If a project has a salvage value greater than zero, the salvage value will a. have no effect on the net present value. b. increase the net present value. c. increase the payback period. d. decrease the net present value. Ans: b, SO: 3, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 12-16 76. Test Bank for Managerial Accounting, Fifth Edition Sloan Inc. recently invested in a project with a 3-year life span. The net present value was $6,000 and annual cash inflows were $14,000 for year 1; $16,000 for year 2; and $18,000 for year 3. The initial investment for the project, assuming a 15% required rate of return, was Year 1 2 3 a. b. c. d. Present Value of 1 at 15% .870 .756 .658 PV of an Annuity of 1 at 15% .870 1.626 2.283 $30,528. $30,120. $19,488. $25,584. Ans: b, SO: 3, Bloom: AN, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 77. Mini Inc. is contemplating a capital project costing $31,346. The project will provide annual cost savings of $12,000 for 3 years and have a salvage value of $2,000. The company’s required rate of return is 10%. The company uses straight-line depreciation. Year 1 2 3 Present Value of 1 at 10% .909 .826 .751 PV of an Annuity of 1 at 10% .909 1.736 2.487 This project is a. unacceptable because it earns a rate less than 10%. b. acceptable because it has a positive NPV. c. unacceptable because it has a negative NPV. d. acceptable because it has a zero NPV. Ans: d, SO: 3, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 78. Johnson Corp. has an 8% required rate of return. It’s considering a project that would provide annual cost savings of $30,000 for 5 years. The most that Johnson would be willing to spend on this project is Year 1 2 3 4 5 a. b. c. d. Present Value of 1 at 8% .926 .857 .794 .735 .681 PV of an Annuity of 1 at 8% .926 1.783 2.577 3.312 3.993 $75,546. $99,360. $119,790. $20,430. Ans: c, SO: 3, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Planning for Capital Investments 79. 12-17 Benaflek Co. purchased some equipment 3 years ago. The company’s required rate of return is 12%, and the net present value of the project was $(900). Annual cost savings were: $10,000 for year 1; $8,000 for year 2; and $6,000 for year 3. The amount of the initial investment was Year 1 2 3 a. b. c. d. Present Value of 1 at 12% .893 .797 .712 PV of an Annuity of 1 at 12% .893 1.690 2.402 $20,478. $18,316. $20,116. $18,678. Ans: a, SO: 3, Bloom: AN, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 80. In capital budgeting, intangible benefits should be a. excluded entirely. b. included using optimistic estimated values. c. included using conservative estimated values. d. included only when benefits are known with certainty. Ans: c, SO: 4, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 81. Miles, Inc. is considering the purchase of a new machine for $200,000 that has an estimated useful life of 5 years and no salvage value. The machine will generate net annual cash flows of $35,000. It is believed that the new machine will reduce downtime because of its reliability. Assume the discount rate is 8%. In order to make the project acceptable, the reduction in downtime must be worth Year 1 2 3 4 5 a. b. c. d. Present Value of 1 at 8% .926 .857 .794 .735 .681 PV of an Annuity of 1 at 8% .926 1.783 2.577 3.312 3.993 $7,986 per year. $16,554 per year. $6,088 per year. $15,088 per year. Ans: d, SO: 4, Bloom: AN, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 82. Intangible benefits in capital budgeting would include all of the following except increased a. product quality. b. employee loyalty. c. salvage value. d. product safety. Ans: c, SO: 4, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 12-18 83. Test Bank for Managerial Accounting, Fifth Edition Intangible benefits in capital budgeting a. should be ignored because they are difficult to determine. b. include increased quality or employee loyalty. c. are not considered because they are usually not relevant to the decision. d. have a rate of return in excess of the company’s cost of capital. Ans: b, SO: 4, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 84. To avoid rejecting projects that actually should be accepted, a. b. c. d. 1. intangible benefits should be ignored. 2. conservative estimates of the intangible benefits' value should be incorporated into the NPV calculation. 3. calculate net present value ignoring intangible benefits and then, if the NPV is negative, estimate whether the intangible benefits are worth at least the amount of the negative NPV. 1 2 3 both 2 and 3 are correct. Ans: d, SO: 4, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 85. All of the following statements about intangible benefits in capital budgeting are correct except that they a. include increased quality and employee loyalty. b. are difficult to quantify. c. are often ignored in capital budgeting decisions. d. cannot be incorporated into the NPV calculation. Ans: d, SO: 4, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 86. In evaluating high-tech projects, a. only tangible benefits should be considered. b. only intangible benefits should be considered. c. both tangible and intangible benefits should be considered. d. neither tangible nor intangible benefits should be considered. Ans: c, SO: 4, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 87. Using a number of outcome estimates to get a sense of the variability among potential returns is a. financial analysis. b. post-audit analysis. c. sensitivity analysis. d. outcome analysis. Ans: c, SO: 5, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation Planning for Capital Investments 88. 12-19 If a company's required rate of return is 9%, and in using the profitability index method, a project's index is greater than 1, this indicates that the project's rate of return is a. equal to 9%. b. greater than 9%. c. less than 9%. d. unacceptable for investment purposes. Ans: b, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 89. The profitability index is computed by dividing the a. total cash flows by the initial investment. b. present value of cash flows by the initial investment. c. initial investment by the total cash flows. d. initial investment by the present value of cash flows. Ans: b, SO: 5, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 90. The capital budgeting method that takes into account both the size of the original investment and the discounted cash flows is the a. cash payback method. b. internal rate of return method. c. net present value method. d. profitability index. Ans: d, SO: 5, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 91. The profitability index a. does not take into account the discounted cash flows. b. is calculated by dividing total cash flows by the initial investment. c. allows comparison of the relative desirability of projects that require differing initial investments. d. will never be greater than 1. Ans: c, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 92. The capital budgeting method that allows comparison of the relative desirability of projects that require differing initial investments is the a. cash payback method. b. internal rate of return method. c. net present value method. d. profitability index. Ans: d, SO: 5, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 12-20 93. Test Bank for Managerial Accounting, Fifth Edition The following information is available for a potential investment for Panda Company: Initial investment Net annual cash inflow Net present value Salvage value Useful life $80,000 20,000 36,224 10,000 10 yrs. The potential investment’s profitability index is a. 4.00. b. 2.85. c. 2.50. d. 1.45. Ans: d, SO: 5, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 94. An approach that uses a number of outcome estimates to get a sense of the variability among potential returns is a. the discounted cash flow technique. b. the net present value method. c. risk analysis. d. sensitivity analysis. Ans: d, SO: 5, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 95. If a project’s profitability index is greater than 1, then the a. project should always be accepted. b. project’s net present value is negative. c. project’s internal rate of return is less than the discount rate. d. project should be accepted if funds are available. Ans: d, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 96. If a project’s profitability index is less than 1, then a. its net present value is zero. b. its net present value is positive. c. it should be rejected. d. its internal rate of return is greater than the discount rate. Ans: c, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 97. If a project’s profitability index is equal to 1, then a. its net present value is zero. b. its net present value is positive. c. it should be rejected. d. its internal rate of return is greater than the discount rate. Ans: a, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Planning for Capital Investments 98. 12-21 A project with an initial investment of $50,000 and a profitability index of 1.239 also has an internal rate of return of 12%. The present value of net cash flows is a. $56,000. b. $61,950. c. $40,355. d. $50,000. Ans: b, SO: 5, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 99. A project with a profitability index of 1.156 also has net cash flows with a present value of $46,240. The project’s internal rate of return was 10%. The initial investment was a. $44,000. b. $53,453. c. $40,000. d. $41,616. Use the following information for questions 100 and 101. Selma Inc. is comparing several alternative capital budgeting projects as shown below: Initial investment Present value of net cash flows A $40,000 60,000 Projects B C $60,000 $ 80,000 55,000 100,000 Ans: c, SO: 5, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 100. Using the profitability index, the projects rank as a. A, C, B. b. A, B, C. c. C, A, B. d. C, B, A. Ans: a, SO: 5, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 101. Using the profitability index, how many of the projects are acceptable? a. 3 b. 2 c. 1 d. 0 Ans: b, SO: 5, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 102. If a project has a negative net present value, its profitability index will be a. one. b. greater than one. c. less than one. d. undeterminable. Ans: c, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 12-22 103. Test Bank for Managerial Accounting, Fifth Edition If a project has a positive net present value, its profitability index will be a. one. b. greater than one. c. less than one. d. undeterminable. Ans: b, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 104. If a project has a zero net present value, its profitability index will be a. one. b. greater than one. c. less than one. d. undeterminable. Ans: a, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 105. If a project has a profitability index of 1.20, then the project’s internal rate of return is a. equal to the discount rate. b. less than the discount rate. c. greater than the discount rate. d. equal to 20%. Ans: c, SO: 5, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Use the following information for questions 106–108. Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful life. The equipment will provide cost savings of $7,300 and will be depreciated straight-line over its useful life with no salvage value. Cleaners requires a 10% rate of return. Period 6 106. 8% 4.623 Present Value of an Annuity of 1 9% 10% 11% 12% 4.486 4.355 4.231 4.111 15% 3.784 What is the approximate net present value of this investment? a. $13,800 b. $1,792 c. $886 d. $2,748 Ans: b, SO: 3, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 107. What is the approximate profitability index associated with this equipment? a. 1.23 b. 1.03 c. 1.06 d. .73 Ans: c, SO: 5, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Planning for Capital Investments 108. 12-23 What is the approximate internal rate of return for this investment? a. 9% b. 10% c. 11% d. 12% Ans: d, SO: 7, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Use the following table for questions 109–111. Periods 1 2 3 109. Present Value of an Annuity of 1 8% 9% 10% .926 .917 .909 1.783 1.759 1.736 2.577 2.531 2.487 A company has a minimum required rate of return of 9%. It is considering investing in a project that costs $140,000 and is expected to generate cash inflows of $56,000 at the end of each year for three years. The net present value of this project is a. $141,736. b. $28,000. c. $14,174. d. $1,736. Ans: d, SO: 3, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 110. A company has a minimum required rate of return of 9%. It is considering investing in a project that costs $50,000 and is expected to generate cash inflows of $20,000 at the end of each year for three years. The profitability index for this project is a. .99. b. 1.00. c. 1.01. d. 1.20. Ans: c, SO: 5, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 111. A company has a minimum required rate of return of 8%. It is considering investing in a project that costs $68,337 and is expected to generate cash inflows of $27,000 each year for three years. The approximate internal rate of return on this project is a. 8%. b. 9%. c. 10%. d. less than the required 8%. Ans: b, SO: 7, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 12-24 Test Bank for Managerial Accounting, Fifth Edition Use the following information for questions 112–115. Carr Company is considering two capital investment proposals. Estimates regarding each project are provided below: Project Soup Project Nuts Initial investment $400,000 $600,000 Annual net income 20,000 42,000 Net annual cash inflow 100,000 142,000 Estimated useful life 5 years 6 years Salvage value -0-0The company requires a 10% rate of return on all new investments. Periods 5 6 112. Present Value of an Annuity of 1 9% 10% 11% 12% 3.890 3.791 3.696 3.605 4.486 4.355 4.231 4.111 The cash payback period for Project Soup is a. 20 years. b. 10 years. c. 5 years. d. 4 years. Ans: d, SO: 2, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 113. The net present value for Project Nuts is a. $618,410. b. $182,912. c. $100,000. d. $18,410. Ans: d, SO: 3, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 114. The internal rate of return for Project Nuts is approximately a. 10%. b. 11%. c. 12%. d. 9%. Ans: b, SO: 7, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 115. The annual rate of return for Project Soup is a. 5%. b. 10%. c. 25%. d. 50%. Ans: b, SO: 8, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Planning for Capital Investments 116. 12-25 A post-audit should be performed using a. a different evaluation technique than that used in making the original decision. b. the same evaluation technique used in making the original decision. c. estimated amounts instead of actual figures. d. an independent CPA. Ans: b, SO: 6, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 117. A thorough evaluation of how well a project's actual performance matches the projections made when the project was proposed is called a a. pre-audit. b. post-audit. c. risk analysis. d. sensitivity analysis. Ans: b, SO: 6, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 118. Performing a post-audit is important because a. managers will be more likely to submit reasonable data when they make investment proposals if they know their estimates will be compared to actual results. b. it provides a formal mechanism by which the company can determine whether existing projects should be terminated. c. it improves the development of future investment proposals because managers improve their estimation techniques by evaluating their past successes and failures. d. all of these. Ans: d, SO: 6, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 119. A capital budgeting method that takes into consideration the time value of money is the a. annual rate of return method. b. return on stockholders' equity method. c. cash payback technique. d. internal rate of return method. Ans: d, SO: 7, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 120. The internal rate of return is the interest rate that results in a a. positive NPV. b. negative NPV. c. zero NPV. d. positive or negative NPV. Ans: c, SO: 7, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 121. In using the internal rate of return method, the internal rate of return factor was 4.0 and the equal annual cash inflows were $12,000. The initial investment in the project must have been a. $12,000. b. $3,000. c. $48,000. d. $24,000. Ans: c, SO: 7, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 12-26 122. Test Bank for Managerial Accounting, Fifth Edition The capital budgeting technique that finds the interest yield of the potential investment is the a. annual rate of return method. b. internal rate of return method. c. net present value method. d. profitability index method. Ans: b, SO: 7, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 123. All of the following statements about the internal rate of return method are correct except that it a. recognizes the time value of money. b. is widely used in practice. c. is easy to interpret. d. can be used only when the cash inflows are equal. Ans: d, SO: 7, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 124. If the internal rate of return is used as the discount rate in the net present value calculation, the net present value will be a. zero. b. positive. c. negative. d. undeterminable. Ans: a, SO: 7, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 125. If a project costing $50,000 has a profitability index of 1.00 and the discount rate was 12%, then the present value of the net cash flows was a. $50,000. b. less than $50,000. c. greater than $50,000. d. undeterminable. Ans: a, SO: 7, Bloom: C, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 126. If a project costing $40,000 has a profitability index of 1.00 and the discount rate was 9%, then the project’s internal rate of return was a. less than 9%. b. equal to 9%. c. greater than 9%. d. undeterminable. Ans: b, SO: 7, Bloom: C, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 127. The internal rate of return factor is equal to the a. capital investment divided by the net cash flows. b. present value of net cash flows divided by the capital investment. c. present value of net cash flows divided by the profitability index. d. capital investment divided by the present value of the net cash flows. Ans: a, SO: 7, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Planning for Capital Investments 128. 12-27 If a 2-year capital project has an internal rate of return factor equal to 1.690 and net annual cash flows of $40,000, the initial capital investment was a. $67,600. b. $23,669. c. $33,800. d. $47,338. Ans: a, SO: 7, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 129. If a 3-year capital project costing $38,655 has an internal rate of return factor equal to 2.577, the net annual cash flows assuming straight-line depreciation are a. $12,885. b. $15,000. c. $5,000. d. $19,328. Ans: b, SO: 7, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 130. If the internal rate of return exceeds the discount rate, then the net present value of a project is a. positive. b. negative. c. zero. d. one. Ans: a, SO: 7, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 131. If the internal rate of return is less than the discount rate, then the net present value of a project is a. positive. b. negative. c. zero. d. one. Ans: b, SO: 7, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 132. If a project has a negative net present value, the internal rate of return will be a. less than the discount rate. b. greater than the discount rate. c. equal to the discount rate. d. a negative rate of return. Ans: a, SO: 7, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 133. If a project has a zero net present value, then the internal rate of return will be a. less than the discount rate. b. greater than the discount rate. c. equal to the discount rate. d. a negative rate of return. Ans: c, SO: 7, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 12-28 134. Test Bank for Managerial Accounting, Fifth Edition Which of the following will cause the internal rate of return to increase? a. An increase in the annual cash inflows b. A decrease in the annual cash inflows c. An increase in the discount rate d. A decrease in the discount rate Ans: a, SO: 7, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 135. If project A has a lower internal rate of return than project B, then project A will have a a. lower NPV and a shorter payback period. b. higher NPV and a longer payback period. c. lower NPV and a longer payback period. d. higher NPV and a shorter payback period. Ans: c, SO: 7, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 136. The internal rate of return factor is also the a. annual rate of return. b. profitability index. c. cash payback period. d. present value factor for a single amount. Ans: c, SO: 7, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 137. Use the following table, Present Value of an Annuity of 1 Period 8% 9% 10% 1 .926 .917 .909 2 1.783 1.759 1.736 3 2.577 2.531 2.487 A company has a minimum required rate of return of 8%. It is considering investing in a project that costs $227,790 and is expected to generate cash inflows of $90,000 each year for three years. The approximate internal rate of return on this project is a. 8%. b. 9%. c. 10%. d. The IRR on this project cannot be approximated. Ans: b, SO: 7, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 138. A company is considering purchasing a machine that costs $320,000 and is estimated to have no salvage value at the end of its 8-year useful life. If the machine is purchased, annual revenues are expected to be $100,000 and annual operating expenses exclusive of depreciation expense are expected to be $38,000. The straight-line method of depreciation would be used. If the machine is purchased, the annual rate of return expected on this machine is a. 19.4%. b. 38.8%. c. 6.9%. d. 13.8%. Ans: d, SO: 8, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Planning for Capital Investments 139. 12-29 A company projects an increase in net income of $225,000 each year for the next five years if it invests $900,000 in new equipment. The equipment has a five-year life and an estimated salvage value of $300,000. What is the annual rate of return on this investment? a. 25.0% b. 37.5% c. 50.0% d. 57.5% Ans: b, SO: 8, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 140. Garza Company is considering buying equipment for $240,000 with a useful life of five years and an estimated salvage value of $12,000. If annual expected income is $21,000, the denominator in computing the annual rate of return is a. $240,000. b. $120,000. c. $126,000. d. $252,000. Ans: c, SO: 8, Bloom: C, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 141. Mussina Company had an investment which cost $260,000 and had a salvage value at the end of its useful life of zero. If Mussina's expected annual net income is $15,000, the annual rate of return is: a. 5.8%. b. 9.8%. c. 11.5%. d. 15%. Ans: c, SO: 8, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 142. Discounted cash flow techniques include all of the following except a. profitability index. b. annual rate of return. c. internal rate of return. d. net present value. Ans: b, SO: 8, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 143. Which of the following is based directly on accrual accounting data rather than cash flows? a. Profitability index b. Internal rate of return c. Net present value d. Annual rate of return Ans: d, SO: 8, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 144. When calculating the annual rate of return, the average investment is equal to a. (initial investment plus $0) divided by 2. b. initial investment divided by life of project. c. initial investment divided by 2. d. (initial investment plus salvage value) divided by 2. Ans: d, SO: 8, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 12-30 145. Test Bank for Managerial Accounting, Fifth Edition A project has an annual rate of return of 15%. The project cost $80,000, has a 5-year useful life, and no salvage value. Straight-line depreciation is used. The annual net income, exclusive of depreciation, was a. $28,000. b. $22,000. c. $31,800. d. $12,000. Ans: b, SO: 8, Bloom: AN, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 146. A project that cost $50,000 has a useful life of 5 years and a salvage value of $2,000. The internal rate of return is 12% and the annual rate of return is 18%. The amount of the annual net income was a. $4,680. b. $4,320. c. $3,120. d. $2,880. Ans: a, SO: 8, Bloom: AN, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 147. A project has annual income exclusive of depreciation of $60,000. The annual rate of return is 15% and annual depreciation is $15,000. There is no salvage value. The internal rate of return is 12%. The initial cost of the project was a. $300,000. b. $375,000. c. $750,000. d. $600,000. Ans: d, SO: 8, Bloom: AN, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 148. A project that cost $80,000 with a useful life of 5 years is being considered. Straight-line depreciation is being used and salvage value is $5,000. The project will generate annual cash flows of $21,375. The annual rate of return is a. 15%. b. 50.3%. c. 16%. d. 17%. Ans: a, SO: 8, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Use the following information for questions 149 and 150. A company is considering purchasing factory equipment that costs $480,000 and is estimated to have no salvage value at the end of its 8-year useful life. If the equipment is purchased, annual revenues are expected to be $135,000 and annual operating expenses exclusive of depreciation expense are expected to be $57,000. The straight-line method of depreciation would be used. 149. If the equipment is purchased, the annual rate of return expected on this equipment is a. 32.5%. b. 3.8%. c. 7.5%. d. 16.3%. Ans: c, SO: 8, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Planning for Capital Investments 150. 12-31 The cash payback period on the equipment is a. 13.3 years. b. 8.0 years. c. 6.2 years. d. 3.1 years. Ans: c, SO: 2, Bloom: AP, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 151. The capital budgeting technique that indicates the profitability of a capital expenditure is the a. profitability index method. b. net present value method. c. internal rate of return method. d. annual rate of return method. Ans: d, SO: 8, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 152. The annual rate of return method is based on a. accounting data. b. the time value of money data. c. market values. d. cash flow data. Ans: a, SO: 8, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 153. Disadvantages of the annual rate of return method include all of the following except that a. it relies on accrual accounting numbers instead of actual cash flows. b. it does not consider the time value of money. c. no consideration is given as to when the cash inflows occur. d. management is unfamiliar with the information used in the computation. Ans: d, SO: 8, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics 154. A company projects an increase in net income of $60,000 each year for the next five years if it invests $300,000 in new equipment. The equipment has a five-year life and an estimated salvage value of $100,000. What is the annual rate of return on this investment? a. 20% b. 30% c. 25% d. 50% Ans: b, SO: 8, Bloom: AP, Difficulty: Medium, Min: 3, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 155. Colaw Company is considering buying equipment for $80,000 with a useful life of five years and an estimated salvage value of $4,000. If annual expected income is $7,000, the denominator in computing the annual rate of return is a. $80,000. b. $40,000. c. $42,000. d. $84,000. Ans: c, SO: 8, Bloom: C, Difficulty: Medium, Min: 2, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Test Bank for Managerial Accounting, Fifth Edition 12-32 156. The annual rate of return is computed by dividing expected annual a. cash inflows by average investment. b. net income by average investment. c. cash inflows by original investment. d. net income by original investment. Ans: b, SO: 8, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 157. All of the following statements about the annual rate of return method are correct except that it a. indicates the profitability of a capital expenditure. b. ignores the salvage value of an investment. c. does not consider the time value of money. d. compares the annual rate of return to management’s minimum rate of return. Ans: b, SO: 8, Bloom: C, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Answers to Multiple Choice Questions Item 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. Ans. a d b a d c b d c b a c d a d b b a c Item 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. Ans. d d b b c b c d c c c d a d a b d c b Item 64. 65. 66. 67. 68. 69. 70. 71. 72. 73. 74. 75. 76. 77. 78. 79. 80. 81. 82. Ans. Item Ans. Item Ans. Item Ans. a c a c d b d c d c a b b d c a c d c 83. 84. 85. 86. 87. 88. 89. 90. 91. 92. 93. 94. 95. 96. 97. 98. 99. 100. 101. b d d c c b b d c d d d d c a b c a b 102. 103. 104. 105. 106. 107. 108. 109. 110. 111. 112. 113. 114. 115. 116. 117. 118. 119. 120. c b a c b c d d c b d d b b b b d d c 121. 122. 123. 124. 125. 126. 127. 128. 129. 130. 131. 132. 133. 134. 135. 136. 137. 138. 139. c b d a a b a a b a b a c a c c b d b Item 140. 141. 142. 143. 144. 145. 146. 147. 148. 149. 150. 151. 152. 153. 154. 155. 156. 157. Ans. c c b d d b a d a c c d a d b c b b BRIEF EXERCISES BE 158 Diamond Company is considering investing in new equipment that will cost $900,000 with a 10year useful life. The new equipment is expected to produce annual net income of $30,000 over its useful life. Depreciation expense, using the straight-line rate, is $90,000 per year. Instructions Compute the cash payback period. Ans: N/A, SO: 2, Bloom: AP, Difficulty: Medium, Min: 5, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Planning for Capital Investments Solution 158 12-33 (5 min.) $900,000 ÷ ($30,000 + $90,000) = 7.5 years BE 159 Madeline Company is proposing to spend $160,000 to purchase a machine that will provide annual cash flows of $30,000. The appropriate present value factor for 10 periods is 5.65. Instructions Compute the proposed investment’s net present value and indicate whether the investment should be made by Madeline Company. Ans: N/A, SO: 3, Bloom: E, Difficulty: Medium, Min: 5, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 159 (5 min.) Cash inflows ($30,000 × 5.65) Cash outflow—investment ($160,000 × 1.00) Net present value Present Value $169,500 160,000 $ 9,500 The investment should be made because the net present value is positive. BE 160 LakeFront Company is considering investing in a new dock that will cost $350,000. The company expects to use the dock for 5 years, after which it will be sold for $190,000. LakeFront anticipates annual cash flows of $70,000 resulting from the new dock. The company’s borrowing rate is 8%, while its cost of capital is 10%. Instructions Calculate the net present value of the dock and indicate whether LakeFront should make the investment. Ans: N/A, SO: 3, Bloom: AP, Difficulty: Medium, Min: 5, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 160 (5 min.) Present value of annual cash flows Present value of salvage value Cash Flows × 10% Discount Factor $70,000 × 3.79079 190,000 × .62092 Capital investment Net present value Solution 160 (cont.) Since the net present value is positive, LakeFront should accept the project. = = = Present Value $265,355 117,975 383,330 350,000 $ 33,330 12-34 Test Bank for Managerial Accounting, Fifth Edition BE 161 Mobil Company has hired a consultant to propose a way to increase the company’s revenues. The consultant has evaluated two mutually exclusive projects with the following information provided for each project: Project Turtle Project Snake Capital investment $790,000 $440,000 Annual cash flows 130,000 75,000 Estimated useful life 10 years 10 years Mobil Company uses a discount rate of 9% to evaluate both projects. Instructions (a) Calculate the net present value of both projects. (b) Calculate the profitability index for each project. (c) Which project should Mobil accept? Ans: N/A, SO: 3,5, Bloom: E, Difficulty: Medium, Min: 10, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 161 (10–15 min.) Project Turtle (a) and (b) Present value of annual cash flows Present value of salvage value Cash Flows × 9% Discount Factor $130,000 × 6.41766 0 × .42241 = = = Present Value $834,296 0 834,296 790,000 $ 44,296 = = = Present Value $481,325 0 481,325 440,000 $ 41,325 Capital investment Net present value Profitability index = $834,296 ÷ $790,000 = 1.06 Project Snake (a) and (b) Present value of annual cash flows Present value of salvage value Cash Flows × 9% Discount Factor $75,000 × 6.41766 0 × .42241 Capital investment Net present value Profitability index = $481,325 ÷ $440,000 = 1.09 (C)Project Snake has a lower net present value than Project Turtle, but because of its lower capital investment, it has a higher profitability index. Based on its profitability index, Project Snake should be accepted. Planning for Capital Investments 12-35 Ex. 162 Carlson Bottling Corporation is considering the purchase of a new bottling machine. The machine would cost $250,000 and has an estimated useful life of 8 years with zero salvage value. Management estimates that the new bottling machine will provide net annual cash flows of $44,000. Management also believes that the new bottling machine will save the company money because it is expected to be more reliable than other machines, and thus will reduce downtime. How much would the reduction in downtime have to be worth in order for the project to be acceptable? Assume a discount rate of 9% Ans: N/A, SO: 7, Bloom: E, Difficulty: Medium, Min: 8, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 162 (8 min.) Present value of annual cash flows Present value of salvage value Cash Flows × 9% Discount Factor $44,000 × 5.53482 0 × .50817 = = = Capital investment Net present value Present Value $243,532 0 243,532 250,000) $ (6,468) The reduction in downtime would have to have a present value of at least $6,468 in order for the project to be acceptable. Ex. 163 Stanton Company is performing a post-audit of a project completed one year ago. The initial estimates were that the project would cost $350,000, would have a useful life of 9 years, zero salvage value, and would result in net annual cash flows of $65,000 per year. Now that the investment has been in operation for 1 year, revised figures indicate that it actually cost $365,000, will have a useful life of 11 years, and will produce net annual cash flows of $55,000 per year. Evaluate the success of the project. Assume a discount rate of 10% Ans: N/A, SO: 8, Bloom: AP, Difficulty: Medium, Min: 12, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 163 (12–15 min.) Original estimate Cash Flows × 10% Discount Factor Present value of net annual cash flows Present value of salvage value Capital investment Net present value $65,000 0 × × 5.75902 .42410 = = = Present Value $374,336 0 374,336 350,000 $ 24,336 Test Bank for Managerial Accounting, Fifth Edition 12-36 Solution 163 (Cont.) Revised estimate Cash Flows × 10% Discount Factor Present value of net annual cash flows Present value of salvage value $55,000 0 × × 6.49506 .42410 = = = Capital investment Net present value Present Value 357,228 0 357,228 365,000 $ 24,336 The original net present value was projected to be a positive $24,336; however, the revised estimate is a negative $7,772. The project is not a success. BE 164 Mint Company is contemplating an investment costing $90,000. The investment will have a life of 8 years with no salvage value and will produce annual cash flows of $16,870. Instructions What is the approximate internal rate of return associated with this investment? Ans: N/A, SO: 3,4, Bloom: AN, Difficulty: Medium, Min: 5, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 164 (5 min.) When net annual cash inflows are expected to be equal, the internal rate of return can be approximated by dividing the capital investment by the net annual cash inflows to determine the discount factor and then locating this discount factor on the present value of an annuity table. $90,000 ÷ $16,870 = 5.33 By tracing across on the 8-year row, we see that the discount factor of 10% is 5.33493. Thus the internal rate of return on this project is approximately 10%. BE 165 Salt Company is considering investing in a new facility to extract and produce salt. The facility will increase revenues by $250,000, but it will also increase annual expenses by $160,000. The facility will cost $980,000 to build, and it will have a $20,000 salvage value at the end of its useful life. Instructions Calculate the annual rate of return on this facility. Ans: N/A, SO: 6, Bloom: E, Difficulty: Medium, Min: 5, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 165 (5 min.) The annual rate of return is calculated by dividing expected annual income by the average investment. The company’s annual income is $250,000 – $160,000 = $90,000. Its average investment is ($980,000 + $20,000) ÷ 2 = $500,000. Therefore, it annual rate of return is $90,000 ÷ $500,000 = 18%. Planning for Capital Investments 12-37 EXERCISES Ex. 166 Corn Doggy, Inc. produces and sells corn dogs. The corn dogs are dipped by hand. Austin Beagle, production manager, is considering purchasing a machine that will make the corn dogs. Austin has shopped for machines and found that the machine he wants will cost $217,000. In addition, Austin estimates that the new machine will increase the company’s annual net cash inflows by $35,000. The machine will have a 12-year useful life and no salvage value. Instructions (a) Calculate the cash payback period. (b) Calculate the machine’s internal rate of return. (c) Calculate the machine’s net present value using a discount rate of 10%. (d) Assuming Corn Doggy, Inc.’s cost of capital is 10%, is the investment acceptable? Why or why not? Ans: N/A, SO: 1,2,3,5,7, Bloom: E, Difficulty: Medium, Min: 13, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 166 (13–18 min.) (a) Cash payback period: $317,000 ÷ $35,000 = 6.2 years (b) Internal rate of return: Scanning the 12-year line, a factor of 6.2 represents an internal rate of return of approximately 12%. (c) Net present value using a discount rate of 10%: Time Period -01-12 Cash Flow PV Factor $(217,000) 1.00000 35,000 6.81369 Net Present Value Present Value $(217,000) 238,479 $ 21,479 (d) Yes, the investment is acceptable. Indications are that the investment will earn a greater return than 10%. The internal rate of return is estimated to be 12%, and the net present value is positive. Ex. 167 Cepeda Manufacturing Company is considering three new projects, each requiring an equipment investment of $20,000. Each project will last for 3 years and produce the following cash inflows. Year 1 2 3 Total AA $ 7,000 9,000 15,000 $31,000 BB $ 9,500 9,500 9,500 $28,500 CC $11,000 10,000 9,000 $30,000 The equipment's salvage value is zero. Cepeda uses straight-line depreciation. Cepeda will not accept any project with a payback period over 2 years. Cepeda's minimum required rate of return is 12%. Instructions (a) Compute each project's payback period, indicating the most desirable project and the least desirable project using this method. (Round to two decimals.) 12-38 Test Bank for Managerial Accounting, Fifth Edition Ex. 167 (Cont.) (b) Compute the net present value of each project. Does your evaluation change? (Round to nearest dollar.) Ans: N/A, SO: 2,3,5,7,8, Bloom: E, Difficulty: Medium, Min: 25, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 167 (25 min.) (a) Year 1 2 3 AA Annual Net Cash Flow $ 7,000 9,000 15,000 Cumulative Net Cash Flow $ 7,000 16,000 31,000 Cash payback 2.27 years $20,000 – $16,000 = $4,000 $4,000 ÷ $15,000 = .27 BB 20,000 ÷ (28,500 ÷ 3) = 2.11 years CC Year 1 2 3 $11,000 10,000 9,000 $11,000 21,000 30,000 Cash payback 1.9 years $20,000 – 11,000 = $9,000 $9,000 ÷ $10,000 = .9 The most desirable project is CC because it has the shortest payback period. The least desirable project is AA because it has the longest payback period. As indicated, only CC is acceptable because its cash payback is 1.9 years. (b) Discount Year Factor 1 .89286 2 .79719 3 .71178 Total present value Investment Net present value AA Net Annual Cash Flow $ 7,000 9,000 15,000 BB Present Value $ 6,250 7,175 10,677 24,102 20,000 $ 4,102 Net Annual Cash Flow $9,500 9,500 9,500 CC Present Net Cash Value Flow $ 8,482 $11,000 7,573 10,000 6,762 9,000 22,817(1) 20,000 $ 2,817 Present Value $ 9,821 7,972 6,406 24,199 20,000 $ 4,199 Planning for Capital Investments Solution 167 12-39 (Cont.) (1) This total may also be obtained from Table 4: $9,500 2.40183 = $22,817. Project CC is still the most desirable project. Also, on the basis of net present values, all of the projects are acceptable. Project BB is the least desirable. Ex. 168 Gantner Company is considering a capital investment of $200,000 in additional productive facilities. The new machinery is expected to have a useful life of 5 years with no salvage value. Depreciation is computed by the straight-line method. During the life of the investment, annual net income and cash inflows are expected to be $18,000 and $58,000, respectively. Gantner has a 12% cost of capital rate, which is the minimum acceptable rate of return on the investment. Instructions (Round to two decimals.) (a) Compute (1) the annual rate of return and (2) the cash payback period on the proposed capital expenditure. (b) Using the discounted cash flow technique, compute the net present value. Ans: N/A, SO: 2,3,8, Bloom: AP, Difficulty: Medium, Min: 16, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 168 (a) (16 min.) (1) Annual rate of return: $18,000 ÷ [(200,000 + $0) ÷ 2] = 18% (2) Cash payback: $200,000 ÷ $58,000 = 3.45 years. (b) Item Net annual cash flows Capital investment Positive net present value Amount $ 58,000 $200,000 Years 1-5 Now PV Factor 3.60478 1.00000 Present Value $209,077 200,000 $ 9,077 Ex. 169 Top Growth Farms, a farming cooperative, is considering purchasing a tractor for $455,500. The machine has a 10-year life and an estimated salvage value of $32,000. Delivery costs and set-up charges will be $12,100 and $400, respectively. Top Growth uses straight-line depreciation. Top Growth estimates that the tractor will be used five times a week with the average charge to the individual farmers of $350. Fuel is $50 for each use of the tractor. The present value of an annuity of 1 for 10 years at 9% is 6.418. Instructions For the new tractor, compute the: (a) cash payback period. (b) net present value. (c) annual rate of return. Ans: N/A, SO: 2,3,8, Bloom: AP, Difficulty: Medium, Min: 12, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 12-40 Test Bank for Managerial Accounting, Fifth Edition Solution 169 (16–22 min.) (a) Cost of the tractor: $455,500 + $12,100 + $400 = $468,000 Annual Cash Flow: Number of uses: 52 × 5 = 260 Contribution margin per use: $350 – $50 = $300 Total annual cash flow: 260 × $300 = $78,000 $468,000 Cash payback: ———— = 6 years $78,000 (b) Present value of cash flow ($78,000 × 6.418) = Capital investment Net present value (c) $500,604 468,000 $ 32,604 $468,000 + $32,000 Average Investment: ————————— = $250,000 2 $468,000 – $32,000 Annual Depreciation: ————————— = $43,600 10 years Annual Net Income: $78,000 – $43,600 = $34,400 $34,400 Average Annual Rate of Return: ———— = 13.76% $250,000 Ex. 170 Tom Bat became a baseball enthusiast at a very early age. All of his baseball experience has provided him valuable knowledge of the sport, and he is thinking about going into the batting cage business. He estimates the construction of a state-of-the-art building and the purchase of necessary equipment will cost $840,000. Both the facility and the equipment will be depreciated over 12 years using the straight-line method and are expected to have zero salvage values. His required rate of return is 10% (present value factor of 6.8137). Estimated annual net income and cash flows are as follows: Revenue Less: Utility cost Supplies Labor Depreciation Other Net income $356,500 40,000 8,000 141,000 70,000 38,500 297,500 $ 59,000 Instructions For this investment, calculate: (a) The net present value. (b) The internal rate of return. (c) The cash payback period. Ans: N/A, SO: 2,3,7, Bloom: AN, Difficulty: Medium, Min: 12, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Planning for Capital Investments Solution 170 12-41 (12–16 min.) (a) Net present value of the investment: Item Initial Investment Revenue $356,500 Expense (227,500)* Present Value Cash Flow $(840,000) 129,000 Factor 1.0000 6.8137 Net Present Value Present Value $(840,000) 878,967 $ 38,967 *$40,000 + $8,000 + $141,000 + $38,500 (b) Internal rate of return of the investment: $840,000 ÷ $129,000 = 6.5116 Scanning the 12-year line, a factor of 6.5116 represents an IRR of approximately 11%. (c) Cash payback period of the investment: $840,000 ÷ $129,000 = 6.51 years. Ex. 171 Mimi Company is considering a capital investment of $250,000 in new equipment. The equipment is expected to have a 5-year useful life with no salvage value. Depreciation is computed by the straight-line method. During the life of the investment, annual net income and cash inflows are expected to be $25,000 and $75,000, respectively. Mimi's minimum required rate of return is 10%. The present value of 1 for 5 periods at 10% is .621 and the present value of an annuity of 1 for 5 periods at 10% is 3.791. Instructions Compute each of the following: (a) cash payback period. (b) net present value. (c) annual rate of return. Ans: N/A, SO: 2,3,8, Bloom: AP, Difficulty: Medium, Min: 10, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 171 (10–15 min.) (a) Cash payback period = $250,000 ÷ $75,000 = 3.33 years (b) Present value of cash inflows ($75,000 × 3.791) = $284,325 Capital investment 250,000 Net present value $ 34,325 (c) Annual rate of return = $25,000 ÷ [($250,000 + $0) ÷ 2] = 20% 12-42 Test Bank for Managerial Accounting, Fifth Edition Ex. 172 Savanna Company is considering two capital investment proposals. Relevant data on each project are as follows: Project Red Project Blue Capital investment $400,000 $560,000 Annual net income 30,000 60,000 Estimated useful life 8 years 8 years Depreciation is computed by the straight-line method with no salvage value. Savanna requires an 8% rate of return on all new investments. The present value of 1 for 8 periods at 8% is .540 and the present value of an annuity of 1 for 8 periods is 5.747. Instructions (a) Compute the cash payback period for each project. (b) Compute the net present value for each project. (c) Compute the annual rate of return for each project. (d) Which project should Savanna select? Ans: N/A, SO: 2,3,8, Bloom: E, Difficulty: Medium, Min: 14, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 172 (14–18 min.) (a) Project Red $ 30,000 50,000* $ 80,000 Annual net income Annual depreciation Annual cash inflow *($400,000 ÷ 8) **($560,000 ÷ 8) Cash payback period: $400,000 ———— = 5.0 years $80,000 (b) Present value of cash inflows: Capital investment Net present value *($80,000 × 5.747) (c) Annual rate of return: Project Blue $ 60,000 70,000** $130,000 Project Red $459,760* 400,000 $59,760 $560,000 ———— = 4.3 years $130,000 Project Blue $747,110** 560,000 $187,110 **(130,000 × 5.747) Project Red $30,000 ————————— = 15% ($400,000 + $0) ÷ 2 Project Blue $60,000 ————————— = 21.4% ($560,000 + $0) ÷ 2 (d) Savanna should select Project Blue because it has a larger positive net present value and a higher annual rate of return. In addition, Project Blue has a slightly shorter cash payback period. Planning for Capital Investments 12-43 Ex. 173 Yappy Company is considering a capital investment of $320,000 in additional equipment. The new equipment is expected to have a useful life of 8 years with no salvage value. Depreciation is computed by the straight-line method. During the life of the investment, annual net income and cash inflows are expected to be $25,000 and $65,000, respectively. Yappy requires a 10% return on all new investments. Period 8 8% 5.747 Present Value of an Annuity of 1 9% 10% 11% 12% 5.535 5.335 5.146 4.968 15% 4.487 Instructions (a) Compute each of the following: 1. Cash payback period. 2. Net present value. 3. Profitability index. 4 Internal rate of return. 5. Annual rate of return. (b) Indicate whether the investment should be accepted or rejected. Ans: N/A, SO: 2,3,5,7,8, Bloom: E, Difficulty: Medium, Min: 15, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 173 (a) 1. (b) (15–20 min.) Cash payback period: $320,000 ÷ $65,000 = 4.92 years 2. Present value of cash inflows ($65,000 × 5.335) Capital investment Net present value $346,775 320,000 $ 26,775 3. Profitability index: $346,775 ÷ $320,000 = 1.08 4. Internal rate of return factor: $320,000 ÷ $65,000 = 4.92 Internal rate of return = 12% (4.968 factor) 5. Annual rate of return: $25,000 ÷ [($320,000 + $0) ÷ 2] = 15.63% Yappy should accept the investment, since its net present value is positive and its internal rate of return of 12% is greater than the company's required rate of return of 10%. In addition, its cash payback period of 4.92 years is significantly shorter than the equipment's useful life of 8 years. Ex. 174 Laramie Service Center just purchased an automobile hoist for $15,000. The hoist has a 5-year life and an estimated salvage value of $960. Installation costs were $2,900, and freight charges were $820. Laramie uses straight-line depreciation. The new hoist will be used to replace mufflers and tires on automobiles. Laramie estimates that the new hoist will enable his mechanics to replace four extra mufflers per week. Each muffler sells for $65 installed. The cost of a muffler is $35, and the labor cost to install a muffler is $10. Instructions (a) Compute the payback period for the new hoist. (b) Compute the annual rate of return for the new hoist. (Round to one decimal.) Ans: N/A, SO: 2,8, Bloom: AP, Difficulty: Medium, Min: 10, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Test Bank for Managerial Accounting, Fifth Edition 12-44 Solution 174 (10 min.) (a) Cost of hoist: $15,000 + $2,900 + $820 = $18,720. Net annual cash flow: Number of extra mufflers: 4 × 52 weeks Contribution margin per muffler ($65 – $35 – $10) Total net annual cash flow: (a) × (b) Cash payback = $18,720 ÷ $4,160 = 4.5 years. (a) (b) 208 $ 20 $4,160 (b) Average investment: ($18,720 + $960) ÷ 2 = $9,900. Annual depreciation: ($18,720 – $960) ÷ 5 = $3,528. Annual net income: $4,160 – $3,528 = $632. Average annual rate of return = $632 ÷ $9,900 = 6.4% (rounded). Ex. 175 Sophie’s Pet Shop is considering the purchase of a new delivery van. Sophie Smith, owner of the shop, has compiled the following estimates in trying to determine whether the delivery van should be purchased: Cost of the van Annual net cash flows Salvage value Estimated useful life Cost of capital Present value of an annuity of 1 Present value of 1 $30,000 5,000 4,000 8 years 10% 5.335 .467 Sophie's assistant manager is trying to convince Sophie that the van has other benefits that she hasn't considered in the initial estimates. These additional benefits, including the free advertising the store's name painted on the van's doors will provide, are expected to increase net cash flows by $500 each year. Instructions (a) Calculate the net present value of the van, based on the initial estimates. Should the van be purchased? (b) Calculate the net present value, incorporating the additional benefits suggested by the assistant manager. Should the van be purchased? (c) Determine how much the additional benefits would have to be worth in order for the van to be purchased. Ans: N/A, SO: 3,4, Bloom: E, Difficulty: Medium, Min: 15, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 175 (15–19 min.) (a) Present value of annual cash flows ($5,000 × 5.335) Present value of salvage value ($4,000 × .467) Capital investment Net present value $26,675 1,868 $28,543 30,000 $( 1,457) Based on the negative net present value of $1,457, the van should not be purchased. Planning for Capital Investments Solution 175 12-45 (Cont.) (b) Present value of annual cash flows [($5,000 + $500) × 5.335] Present value of salvage value ($4,000 × .467) Capital investment Net present value $29,343 1,868 $31,211 30,000 $ 1,211 Incorporating the additional benefits of $500/year into the calculation produces a positive net present value of $1,211. Therefore, the van should be purchased. (c) The additional benefits would need to have a total present value of at least $1,457 in order for the van to be purchased. Ex. 176 Vista Company is considering two new projects, each requiring an equipment investment of $95,000. Each project will last for three years and produce the following cash inflows: Year 1 2 3 Cool $ 38,000 42,000 48,000 $128,000 Hot $ 42,000 42,000 42,000 $126,000 The equipment will have no salvage value at the end of its three-year life. Vista Company uses straight-line depreciation and requires a minimum rate of return of 12%. Present value data are as follows: Present Value of 1 Period 12% 1 .893 2 .797 3 .712 Present Value of an Annuity of 1 Period 12% 1 .893 2 1.690 3 2.402 Instructions (a) Compute the net present value of each project. (b) Compute the profitability index of each project. (c) Which project should be selected? Why? Ans: N/A, SO: 3,5, Bloom: E, Difficulty: Medium, Min: 12, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 176 (a) Year 1 2 3 (12–16 min.) Project Cool Annual Cash Inflows Present Value of 1 $ 38,000 .893 42,000 .797 48,000 .712 $128,000 Present Value $ 33,934 33,474 34,176 $101,584 12-46 Test Bank for Managerial Accounting, Fifth Edition Solution 176 (Cont.) Present value of cash inflows Capital investment Net present value $101,584 95,000 $ 6,584 Project Hot Present value of cash inflows ($42,000 × 2.402) Capital investment Net present value $100,884 95,000 $ 5,884 (b) Profitability index: Cool $101,584 ÷ $95,000 = 1.07 Hot ($100,884 ÷ $95,000) = 1.06 (c) Both projects are acceptable because both show a positive net present value. Project Cool is the preferred project because its net present value is greater than project Hot's net present value and it has a slightly higher profitability index. Ex. 177 KSU Corp. is considering purchasing one of two new diagnostic machines. Either machine would make it possible for the company to bid on jobs that it currently isn't equipped to do. Estimates regarding each machine are provided below. Original cost Estimated life Salvage value Estimated annual cash inflows Estimated annual cash outflows Machine A $104,000 8 years -0$30,000 $10,000 Machine B $ 180,000 8 years -0$45,000 $15,000 Instructions Calculate the net present value and profitability index of each machine. Assume a 9% discount rate. Which machine should be purchased? Ans: N/A, SO: 3,5, Bloom: E, Difficulty: Medium, Min: 15, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 177 (15–20 min.) Machine A Cash Flows × 9% Discount Factor Present value of net annual cash flows Present value of salvage value $20,000 0 Capital investment Net present value Profitability index = 110,696/104,000 = 1.06 × × 5.53482 .50187 = = = Present Value $110,696 0 110,696 104,000 $ 6,696 Planning for Capital Investments Solution 177 12-47 (Cont.) Machine B Cash Flows × 9% Discount Factor Present value of net annual cash flows Present value of salvage value $30,000 0 × × 5.53482 .50187 = = = Capital investment Net present value Present Value $166,045 0 166,045 180,000 $(13,955) Profitability index = 166,045/180,000 = .92 Machine B has a negative net present value, and also a lower profitability index. Machine B should be rejected and machine a should be purchased. Ex. 178 Santana Company is considering investing in a project that will cost $144,000 and have no salvage value at the end of its 5-year life. It is estimated that the project will generate annual cash inflows of $40,000 each year. The company requires a 10% rate of return and uses the following compound interest table: Present Value of an Annuity of 1 Period 5 6% 4.212 8% 3.993 9% 3.890 10% 3.791 11% 3.696 12% 3.605 15% 3.352 Instructions (a) Compute (1) the net present value and (2) the profitability index of the project. (b) Compute the internal rate of return on this project. (c) Should Santana invest in this project? Ans: N/A, SO: 3,5,7, Bloom: E, Difficulty: Medium, Min: 10, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 178 (10–18 min.) (a) (1) Present value of cash inflows ($40,000 × 3.791) Capital investment Net present value (2) Profitability index: $151,640 ÷ $144,000 = 1.05 (b) Capital Investment —————————— Net Annual Cash Inflow $151,640 144,000 $ 7,640 = Internal Rate of Return Factor $144,000 ———— = 3.60 $40,000 Since the calculated internal rate of return factor of 3.60 is very near the factor 3.605 for five periods and 12% interest, this project has an approximate interest yield of 12%. Test Bank for Managerial Accounting, Fifth Edition 12-48 Solution 178 (Cont.) (c) Santana should invest in this project because it has a positive net present value, a profitability index above 1, and its internal rate of return of 12% is greater than the company's 10% required rate of return. Ex. 179 Johnson Company is considering purchasing one of two new machines. The following estimates are available for each machine: Machine 1 $148,000 50,000 15,000 6 years Initial cost Annual cash inflows Annual cash outflows Estimated useful life Machine 2 $165,000 60,000 20,000 6 years The company's minimum required rate of return is 10%. Period 6 8% 4.623 Present Value of an Annuity of 1 9% 10% 11% 12% 4.486 4.355 4.231 4.111 15% 3.784 Instructions (a) Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for each machine. (b) Which machine should be purchased? Ans: N/A, SO: 3,5,8, Bloom: E, Difficulty: Medium, Min: 12, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 179 (12–16 min.) (a) (1) Present value of net cash flows Capital investment Net present value *($35,000 × 4.355) **($40,000 × 4.355) Machine 1 $152,425* 148,000 $ 4,425 Machine 2 $174,200** 165,000 $ 9,200 Machine 1 $152,425 ———— = 1.03 $148,000 Machine 2 $174,200 ———— = 1.06 $165,000 Internal rate of return factor Machine 1 $148,000 ———— = 4.23 $35,000 Machine 2 $165,000 ———— = 4.13 $40,000 Internal rate of return 11% (4.231 factor) 12% (4.111 factor) (2) Profitability index (3) (b) Both machines are acceptable because both show a positive net present value, have a profitability index above 1, and have an internal rate of return greater than the company's minimum required rate of return. Machine 2 is preferred because its net present value, profitability index, and internal rate of return are all greater than Machine 1's amounts. Planning for Capital Investments 12-49 Ex. 180 Platoon Company is performing a post-audit of a project that was estimated to cost $400,000, have a useful life of 6 years with a zero salvage value, and result in net cash inflows of $100,000 per year. After the investment was in operation for a year, revised figures indicate that it actually cost $460,000, will have a 9-year useful life, and will produce net cash inflows of $77,000. The present value of an annuity of 1 for 6 years at 10% is 4.355 and for 9 years is 5.759. Instructions Determine whether the project should have been accepted based on (a) the original estimates and then on (b) the actual amounts. Ans: N/A, SO: 3,6, Bloom: E, Difficulty: Medium, Min: 8, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 180 (8–12 min.) (a) Present value of the estimated net cash inflows ($100,000 × 4.355) Estimated capital investment Net present value $435,500 400,000 $ 35,500 Yes, Platoon Company should have invested in the project based on the original estimates, since the net present value is positive. (b) Present value of the actual net cash inflows ($77,000 × 5.759) Actual capital investment Net present value $443,443 460,000 $ (16,557) Platoon should not have invested in the project based on the actual amounts, since the net present value is negative. The decrease of $52,057 in net present value was caused due to a decrease of $23,000 per year in net cash inflows and a $60,000 increase in the cost of the capital investment. This more than offsets the 3-year increase in useful life. Ex. 181 Shilling Corp. is thinking about opening a baseball camp in Florida. In order to start the camp, the company would need to purchase land, build five baseball fields, and a dormitory-type sleeping and dining facility to house 100 players. Each year the camp would be run for 10 sessions of 1 week each. The company would hire college baseball players as coaches. The camp attendees would be baseball players age 12-18. Property values in Florida have enjoyed a steady increase in value. It is expected that after using the facility for 20 years, Shilling can sell the property for more than it was originally purchased for. The following amounts have been estimated: Cost of land Cost to build dorm and dining facility Annual cash inflows assuming 100 players and 10 weeks Annual cash outflows Estimated useful life Salvage value Discount rate Present value of an annuity of 1 Present value of 1 $ 600,000 2,100,000 2,520,000 2,260,000 20 years 3,900,000 10% 8.514 .149 12-50 Ex. 181 Test Bank for Managerial Accounting, Fifth Edition (Cont.) Instructions (a) Calculate the net present value of the project. (b) To gauge the sensitivity of the project to these estimates, assume that if only 80 campers attend each week, revenues will be $2,085,000 and expenses will be $1,865,000. What is the net present value using these alternative estimates? Discuss your findings. (c) Assuming the original facts, what is the net present value if the project is actually riskier than first assumed, and a 12% discount rate is more appropriate? The present value of 1 at 12% is .104 and the present value of an annuity of 1 is 7.469. Ans: N/A, SO: 3,7, Bloom: E, Difficulty: Medium, Min: 15, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Solution 181 (15–20 min.) (a) Present value of net cash flows ($260,000 × 8.514) Present value of salvage value ($3,900,000 × .149) Capital investment ($600,000 + $2,100,000) Net present value (b) Present value of net cash flows ($220,000 × 8.514) Present value of salvage value Capital investment Net present value $2,213,640 581,100 $2,794,740 2,700,000 $ 94,740 $1,873,080 581,100 $2,454,180 2,700,000 $ (245,820) If the number of campers attending each week is only 80 instead of 100, the net present value decreases by $340,560 (from a positive $94,740 to a negative $245,820). This indicates that the camp should not be invested in unless the number attending is closer to 100. (c) Present value of net cash flows ($260,000 × 7.469) Present value of salvage value ($3,900,000 × .104) Capital investment Net present value $1,941,940 405,600 $2,347,540 2,700,000 $ (352,460) Ex. 182 Ace Corporation recently purchased a new machine for its factory operations at a cost of $840,000. The investment is expected to generate $250,000 in annual cash flows for a period of five years. The required rate of return is 12%. The new machine is expected to have zero salvage value at the end of the five-year period. Instructions Calculate the internal rate of return. (Table 4 from Appendix C is needed.) Ans: N/A, SO: 7, Bloom: AP, Difficulty: Medium, Min: 4, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods Planning for Capital Investments Solution 182 12-51 (4 min.) IRR = Capital investment ÷ Annual cash inflows = Factor $840,000 ÷ $250,000 = 3.36. This factor is found in the PVA table at n = 5 periods. IRR = 15% COMPLETION STATEMENTS 183. For purposes of capital budgeting, estimated ____________ and outflows are preferred for inputs into the capital budgeting decision tools. Ans: N/A, SO: 1, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Budget Preparation 184. The technique which identifies the time period required to recover the cost of the investment is called the ________________ method. Ans: N/A, SO: 2, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 185. The two discounted cash flow techniques used in capital budgeting are (1) the _______________________ method and (2) the ______________________ method. Ans: N/A, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 186. Under the net present value method, the interest rate to be used in discounting the future cash inflows is the ________________. Ans: N/A, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 187. In using the net present value approach, a project is acceptable if the project's net present value is ____________ or_______________. Ans: N/A, SO: 3, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 188. A project’s ________________, such as increased quality or safety, are often incorrectly ignored in capital budgeting decisions. Ans: N/A, SO: 4, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 189. The _______________ is a method of comparing alternative projects that takes into account both the size of the investment and its discounted future cash flows. Ans: N/A, SO: 5, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 12-52 Test Bank for Managerial Accounting, Fifth Edition 190. A well-run organization should perform an evaluation, called a _____________, of its investment projects after their completion. Ans: N/A, SO: 6, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Performance Measurement 191. The internal rate of return method differs from the net present value method in that it results in finding the ___________________ of the potential investment. Ans: N/A, SO: 7, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Problem Solving/Decision Making, IMA: Quantitative Methods 192. A major limitation of the annual rate of return approach is that it does not consider the _______________ of money. Ans: N/A, SO: 8, Bloom: K, Difficulty: Easy, Min: 1, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Answers to Completion Statements 183. 184. 185. 186. 187. 188. 189. 190. 191. 192. cash inflows cash payback net present value, internal rate of return required rate of return zero, positive intangible benefits profitability index post audit interest yield time value Planning for Capital Investments 12-53 MATCHING 193. Match the items below by entering the appropriate code letter in the space provided. A. B. C. D. Profitability index Internal rate of return method Discounted cash flow techniques Capital budgeting E. F. G. H. Annual rate of return method Cash payback technique Cost of capital Net present value method ____ 1. A capital budgeting technique that identifies the time period required to recover the cost of a capital investment from the annual cash inflow produced by the investment. ____ 2. Capital budgeting techniques that consider both the estimated total cash inflows from the investment and the time value of money. ____ 3. A method used in capital budgeting in which cash inflows are discounted to their present value and then compared to the capital outlay required by the capital investment. ____ 4. A method of comparing alternative projects that take into account both the size of the investment and its discounted cash flows. ____ 5. A method used in capital budgeting that results in finding the interest yield of the potential investment. ____ 6. The average rate of return that the firm must pay to obtain borrowed and equity funds. ____ 7. The determination of the profitability of a capital expenditure by dividing expected annual net income by the average investment. ____ 8. The process of making capital expenditure decisions in business. Ans: N/A, SO: 1, Bloom: K, Difficulty: Easy, Min: 4, AACSB: Reflective Thinking, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving/Decision Making, IMA: Business Economics Answers to Matching 1. 2. 3. 4. F C H A 5. 6. 7. 8. B G E D SHORT-ANSWER ESSAY QUESTIONS S-A E 194 Management uses several capital budgeting methods in evaluating projects for possible investment. Identify those methods that are more desirable from a conceptual standpoint, and briefly explain what features these methods have that make them more desirable than other methods. Also identify the least desirable method and explain its major weaknesses. Ans: N/A, SO: , Bloom: , Difficulty: Easy, Min: 3, AACSB: Communications, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Communications, IMA: Business Economics 12-54 Test Bank for Managerial Accounting, Fifth Edition Solution 194 From a conceptual standpoint, the discounted cash flow methods (net present value and internal rate of return) are considered more desirable because they consider both the estimated cash flows and the time value of money. The time value of money is critical because of the long-term impact of capital budgeting decisions. Capital budgeting methods which do not consider the time value of money include annual rate of return and cash payback. The cash payback method is the least desirable because it also ignores the expected profitability of the project. S-A E 195 Manny Perez is trying to understand the term "cost of capital." Define the term, and indicate its relevance to the decision rule under the annual rate of return technique. Ans: N/A, SO: , Bloom: , Difficulty: Easy, Min: 3, AACSB: Communications, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Communications, IMA: Business Economics Solution 195 Cost of capital is the rate of return that management expects to pay on all borrowed and equity funds. The decision rule is: A project is acceptable if its rate of return is greater than or equal to management's minimum rate of return (which often is its cost of capital), and the project is unacceptable when the rate of return is less than the minimum rate of return. S-A E 196 (Ethics) Sam Stanton is on the capital budgeting committee for his company, Canton Tile. Ed Rhodes is an engineer for the firm. Ed expresses his disappointment to Sam that a project that was given to him to review before submission looks extremely good on paper. "I really hoped that the cost projections wouldn't pan out," he tells his friend. "The technology used in this is pie in the sky kind of stuff. There are a hundred things that could go wrong. But the figures are very convincing. I haven't sent it on yet, though I probably should." "You can keep it if it's really that bad," assures Sam. "Anyway, you can probably get it shot out of the water pretty easily, and not have the guy who submitted it mad at you for not turning it in. Just fix the numbers. If you figure, for instance, that a cost is only 50% likely to be that low, then double it. We do it all the time, informally. Best of all, the rank and file don't get to come to those sessions. Your engineering genius need never know. He'll just think someone else's project was even better than his." Required: 1. Who are the stakeholders in this situation? 2. Is it ethical to adjust the figures to compensate for risk? Explain. 3. Is it ethical to change the proposal before submitting it? Explain. Ans: N/A, SO: , Bloom: , Difficulty: Easy, Min: 3, AACSB: Ethics, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA PC: Communications, IMA: Decision Analysis Planning for Capital Investments 12-55 Solution 196 1. The stakeholders include: Ed Rhodes Canton Tile the engineer who submitted the proposal. 2. It is ethical, in general, to adjust projections to compensate for risk. However, it should be clearly stated that the projections have been adjusted for risk, and the method used should be available for review. Otherwise, the entire selection process is undermined, and it becomes entirely subjective. 3. It is probably not ethical to modify a proposal at all; certainly not in the way described. The person submitting the proposal should have the right to know about any changes that were made, and should have the right to review those changes. S-A E 197 (Communication) You are the general accountant for Word Systems, Inc., a typing service based in Los Angeles, California. The company has decided to upgrade its equipment. It currently has a widely used version of a word processing program. The company wishes to invest in more up-to-date software and to improve its printing capabilities. Two options have emerged. Option #1 is for the company to keep its existing computer system, and upgrade its word processing program. The memory of each work station would be enhanced, and a larger, more efficient printer would be used. Better telecommunications equipment would allow for the electronic transmission of some documents as well. Option #2 would be for the company to invest in an entirely different computer system. The software for this system is impressive, and it comes with individual laser printers. However, the company is not well known, and the software does not connect well with well-known software. The net present value information for these options follows: Initial Investment Returns Year 1 Year 2 Year 3 Net present value Option #1 $(95,000) 55,000 30,000 10,000 0 Option #2 $(270,000) 90,000 90,000 90,000 0 Required: Prepare a brief report for management in which you make a recommendation for one system or the other, using the information given. Ans: N/A, SO: , Bloom: , Difficulty: Easy, Min: 3, AACSB: Communications, AICPA BB: Resource Management, AICPA FN: Risk Analysis, AICPA PC: Communications, IMA: Quantitative Methods Solution 197 The company should accept Option #1, to purchase upgrades to its present system and to buy a more efficient printer. In the first place, the changes will be easier to implement because the equipment is similar to that which is already in use. Secondly, the company will have less money invested in the project, which decreases the risk of loss should the project fail. Option #2 appears to be too risky.