ACG 2071 Test 2 Review Problems
Completing these problems BEFORE we go over them in class will help you learn
the material more effectively. I will cover them in class as if you have already
completed them, so you will likely not have time to copy down the answers as we
go through them, and you will miss out on participation points if you don’t have
the answers quickly.
Problem 1 Income information for Company X is presented below.
Sales revenue
$620,000
Variable costs
340,000
Fixed costs
120,000
Operating Income
$160,000
A. Compute the operating leverage for Company X.
B. Use the operating leverage approach as support (with calculations) to determine
what change would occur to profits if Company X experiences a 25% decrease in sales
volume.
C. Use your answer to part B to determine the profit if the change is made.
D. What is cost structure? How does it impact operating leverage? How is risk
associated with cost structure?
Problem 2 Kirk Company plans to produce 50,000 buckets next year at a total cost of
$850,000. Fixed costs are $3 per unit at this level of operations. Selling price is $8 per
unit. Kirk is considering lowering the price to $7 per unit, and feels that this action will
cause sales to climb to 60,000 buckets. Use incremental analysis to calculate
incremental profit or loss if the change is made to the sales price.
Use Case A and Case B for problems 3 through 7.
CASE A Elpers, Inc. is contemplating the purchase of a new piece of equipment for
expansion. This would alleviate $4,800 per year in rental costs for the current machine
which is quite antiquated. The following information pertains to the new equipment:
Initial cost of proposed new equipment
$152,000
Estimated useful life
6 years
Estimated disposal value at end of useful life
$28,000
Elpers estimates the new equipment will cause revenues to increase from the current
level of $300,000 to $355,000 per year. Cash operating expenses related to the
increase in revenue are expected to be $20,800 per year. Elpers uses straight-line
depreciation. Elper’s required rate of return is 8.7%, its cost of capital is 5.6% and its
income tax rate is 30%.
CASE B Murphy, Inc. is contemplating the purchase of a new piece of equipment for
expansion. Murphy’s required rate of return is 7.2%. its cost of capital is 5.3% Its
income tax rate is 33%. The following information pertains to the decision:
Initial cost of proposed new equipment
$266,000
Predicted useful life
8 years
Predicted disposal value at end of useful life
$17,000
Murphy predicts its revenues will be $102,000 more per year as a result of acquiring the
machine. It also expects to save $12,000 a year in machine rental costs. Cash
operating expenses related to the increase in revenue are expected to be $40,000 per
year. Murphy uses straight-line depreciation.
Problem 3:
For case A and case B, calculate the incremental operating cash flow if the new
equipment is purchased.
Problem 4:
For case A and case B, draw a time line of all cash flows.
Problem 5:
For case A and case B, determine the NPV and IRR using Excel. Explain the meaning
of your answers.
Problem 6:
For case A and case B, determine the NPV and IRR using the BAII plus professional
calculator. Show field names and all input into the BAIIPP as part of your answer.
Problem 7:
For case A and case B, determine the payback period, ARR, and the depreciation tax
shield. Explain the meaning of these answers.
Problem 8 Jackson, Inc. purchases a machine for $40,000 that has an estimated
salvage value of $4,000, and an estimated life of 4 years. Jackson’s required rate of
return is 11%. The machine is expected to generate the following cash flows and
income over the next 4 years:
Operating cash flows
Operating income
Year 1
$15,300
6,300
Year 2
$16,700
7,700
Year 3
$16,000
7,000
Year 4
$14,600
5,600
Round final answers to two decimal places. Use the BAIIPP when necessary. Show
field names and all input into the BAIIPP as part of your answer.
A. Determine the machine's payback period.
B. Determine the IRR of the machine.
C. Determine the ARR
D. Determine the payback period.
E. Interpret each answer. Should the machine be purchased? Why or why not?
Problem 9 The following table shows the results of two budgeting calculations for three
possible investments, each with a six year expected useful life:
Method
Cash payback method
Net present value
Proposal T4
Proposal H6
Proposal Z8
7
$800
6
($200)
5
$100
Problem 10 JP Company received the following requests for capital investments for the
year 2003:
Project Amount of Investment Projected Rate of Return (%)
A
$102,000
14
B
250,000
16
C
98,000
16.5
D
265,000
20
E
180,000
15
F
100,000
19
The company's minimum rate of return is 17 percent and $725,000 is available for
capital investments for the year 2003. Which capital investment proposals should JP
Company consider? Rank the proposals in order, with the most desirable first.