CHAPTER 12: PLANNING FOR CAPITAL INVESTMENTS. All Answers and Calculated Solutions Provided.

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CHAPTER 12 PLANNING FOR CAPITAL INVESTMENTS SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOM’S TAXONOMY SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE Note: TF = True-False C = Completion... Ex = Exercise MC = Multiple Choice BE = Brief 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 ÷ Initial investment. The higher the index, the more desirable the project. 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. 2. The capital budgeting committee ultimately approves the capital expenditure budget for the year. 3. For purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision tools. 4. The cash payback technique is a quick way to calculate a project's net present value. 5. The cash payback period is computed by dividing the cost of the capital investment by the annual cash inflow. 6. The cash payback method is frequently used as a screening tool but it does not take into consideration the profitability of a project. 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. 8. Using the net present value method, a net present value of zero indicates that the project would not be acceptable. 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. 10. By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company. 11. To avoid accepting projects that actually should be rejected, a company should ignore intangible benefits in calculating net present value. 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. 13. The profitability index is calculated by dividing the total cash flows by the initial investment. 14. The profitability index allows comparison of the relative desirability of projects that require differing initial investments. 15. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns. 16. A well-run organization should perform an evaluation, called a post-audit, of its investment projects before their completion. 17. Post-audits create an incentive for managers to make accurate estimates, since managers know that their results will be evaluated. 18. A post-audit is an evaluation of how well a project's actual performance matches the projections made when the project was proposed. 19. The internal rate of return method is, like the NPV method, a discounted cash flow technique. 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. 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. 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. 23. The annual rate of return method requires dividing a project's annual cash inflows by the economic life of the project. 24. A major advantage of the annual rate of return method is that it considers the time value of money. 25. An advantage of the annual rate of return method is that it relies on accrual accounting numbers rather than actual cash flows. Answers to True-False Statements 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. 27. 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. 28. Most of the capital budgeting methods use a. accrual accounting numbers. b. cash flow numbers. c. net income. d. accrual accounting revenues. 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. 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. 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. 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. 33. 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 34. Capital expenditure proposals are initially screened by the a. board of directors. b. executive committee. c. capital budgeting committee. d. stockholders. 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. 36. The corporate capital budget authorization process consists of how many steps? a. 4 b. 3 c. 2 d. 1 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 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 39. 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. 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 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 Net Annual Cash Flow 1 $ 3,000 2 8,000 3 15,000 4 9,000 The cash payback period is a. 2.63 years. b. 2.80 years. c. 2.20 years. d. 2.37 years. 42. Bradshaw Inc. is contemplating a capital investment of $85,000. The cash flows over the project’s four years are: Expected Annual Expected Annual Year Cash Inflows Cash Outflows 1 $30,000 $12,000 2 45,000 20,000 3 60,000 25,000 4 50,000 30,000 The cash payback period is a. 2.17 years. b. 3.35 years. c. 2.30 years. d. 3.47 years. 43. Jordan Company is considering the purchase of a machine with the following data: Initial cost $130,000 One-time training cost 12,000 Annual maintenance costs 15,000 Annual cost savings 75,000 Salvage value 20,000 The cash payback period is a. 2.37 years. b. 2.17 years. c. 1.89 years. d. 1.73 years. 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. 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 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. 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. 48. 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. 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. 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. 51. When using the cash payback technique, the payback period is expressed in terms of a. a percent. b. dollars. c. years. d. months. 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. 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. 54. 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. 55. 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. 56. 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. 57. 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%. 58. 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. 59. 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. 60. 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. 61. 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. 62. 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. 63. 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. 64. 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. 65. 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. 66. 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. 67. 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 68. 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. 69. 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. 70. 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. 71. Sloan Inc. recently invested in a project with a 3-year life span. The net present value was $3,000 and annual cash inflows were $7,000 for year 1; $8,000 for year 2; and $9,000 for year 3. The initial investment for the project, assuming a 15% required rate of return, was Present Value PV of an Annuity Year of 1 at 15% of 1 at 15% 1 .870 .870 2 .756 1.626 3 .658 2.283 a. $15,264. b. $15,060. c. $9,744. d. $12,792. 72. 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. Present Value PV of an Annuity Year of 1 at 10% of 1 at 10% 1 .909 .909 2 .826 1.736 3 .751 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. 73. Johnson Corp. has an 8% required rate of return. It’s considering a project that would provide annual cost savings of $20,000 for 5 years. The most that Johnson would be willing to spend on this project is Present Value PV of an Annuity Year of 1 at 8% of 1 at 8% 1 .926 .926 2 .857 1.783 3 .794 2.577 4 .735 3.312 5 .681 3.993 a. $50,364. b. $66,240. c. $79,860. d. $13,620. 74. 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 $(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 Present Value PV of an Annuity Year of 1 at 12% of 1 at 12% 1 .893 .893 2 .797 1.690 3 .712 2.402 a. $10,239. b. $9,158. c. $10,058. d. $9,339. 75. 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. 76. Miles, Inc. is considering the purchase of a new machine for $100,000 that has an estimated useful life of 5 years and no salvage value. The machine will generate net annual cash flows of $17,500. 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 Present Value PV of an Annuity Year of 1 at 8% of 1 at 8% 1 .926 .926 2 .857 1.783 3 .794 2.577 4 .735 3.312 5 .681 3.993 a. $3,993 per year. b. $8,277 per year. c. $3,044 per year. d. $7,544 per year. 77. 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. 78. 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. 79. To avoid rejecting projects that actually should be accepted, 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. a. 1 b. 2 c. 3 d. both 2 and 3 are correct. 80. 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. 81. 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. 82. 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. 83. 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. 84. 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. 85. 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. 86. 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. 87. 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. 88. The following information is available for a potential investment for Panda Company: Initial investment $80,000 Net annual cash inflow 20,000 Net present value 36,224 Salvage value 10,000 Useful life 10 yrs. The potential investment’s profitability index is a. 4.00. b. 2.85. c. 2.50. d. 1.45. 89. 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. 90. 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. 91. 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. 92. 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. 93. 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. 94. 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 95 and 96. Selma Inc. is comparing several alternative capital budgeting projects as shown below: Projects A B C Initial investment $40,000 $60,000 $ 80,000 Present value of net cash flows 60,000 55,000 100,000 95. Using the profitability index, the projects rank as a. A, C, B. b. A, B, C. c. C, A, B. d. C, B, A. 96. Using the profitability index, how many of the projects are acceptable? a. 3 b. 2 c. 1 d. 0 97. 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. 98. 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. 99. 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. 100. 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%. Use the following information for questions 101–103. 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. Present Value of an Annuity of 1 Period 8% 9% 10% 11% 12% 15% 6 4.623 4.486 4.355 4.231 4.111 3.784 101. What is the approximate net present value of this investment? a. $13,800 b. $1,792 c. $886 d. $2,748 102. What is the approximate profitability index associated with this equipment? a. 1.23 b. 1.03 c. 1.06 d. .73 103. What is the approximate internal rate of return for this investment? a. 9% b. 10% c. 11% d. 12% Use the following table for questions 104–106. Present Value of an Annuity of 1 Periods 8% 9% 10% 1 .926 .917 .909 2 1.783 1.759 1.736 3 2.577 2.531 2.487 104. A company has a minimum required rate of return of 9%. It is considering investing in a project that costs $175,000 and is expected to generate cash inflows of $70,000 at the end of each year for three years. The net present value of this project is a. $177,170. b. $35,000. c. $17,718. d. $2,170. 105. A company has a minimum required rate of return of 9%. It is considering investing in a project that costs $75,000 and is expected to generate cash inflows of $30,000 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. 106. A company has a minimum required rate of return of 8%. It is considering investing in a project that costs $91,116 and is expected to generate cash inflows of $36,000 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%. Use the following information for questions 107–110. Carr Company is considering two capital investment proposals. Estimates regarding each project are provided below: Project Soup Project Nuts Initial investment $600,000 $900,000 Annual net income 30,000 63,000 Net annual cash inflow 150,000 213,000 Estimated useful life 5 years 6 years Salvage value -0- -0- The company requires a 10% rate of return on all new investments. Present Value of an Annuity of 1 Periods 9% 10% 11% 12% 5 3.890 3.791 3.696 3.605 6 4.486 4.355 4.231 4.111 107. The cash payback period for Project Soup is a. 20 years. b. 10 years. c. 5 years. d. 4 years. 108. The net present value for Project Nuts is a. $927,615. b. $274,368. c. $150,000. d. $27,615. 109. The internal rate of return for Project Nuts is approximately a. 10%. b. 11%. c. 12%. d. 9%. 110. The annual rate of return for Project Soup is a. 5%. b. 10%. c. 25%. d. 50%. 111. 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. 112. 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. 113. 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. 114. 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. 115. 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. 116. In using the internal rate of return method, the internal rate of return factor was 4.0 and the equal annual cash inflows were $16,000. The initial investment in the project must have been a. $16,000. b. $4,000. c. $64,000. d. $32,000. 117. 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. 118. 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. 119. If the internal rate of return is used as the discount rate in the net present value calcula-tion, the net present value will be a. zero. b. positive. c. negative. d. undeterminable. 120. 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. 121. 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. 122. 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. 123. If a 2-year capital project has an internal rate of return factor equal to 1.690 and net annual cash flows of $25,000, the initial capital investment was a. $42,250. b. $14,793. c. $21,125. d. $29,586. 124. 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. 125. 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. 126. 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. 127. 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. 128. 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. 129. 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 130. 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. 131. 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. 132. 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. 133. 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 134. 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. 135. A project has an annual rate of return of 15%. The project cost $60,000, has a 5-year useful life, and no salvage value. Straight-line depreciation is used. The annual net income, exclusive of depreciation, was a. $21,000. b. $16,500. c. $31,800. d. $9,000. 136. 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. 137. A project has annual income exclusive of depreciation of $48,000. The annual rate of return is 15% and annual depreciation is $12,000. There is no salvage value. The internal rate of return is 12%. The initial cost of the project was a. $240,000. b. $300,000. c. $600,000. d. $480,000. 138. 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%. Use the following information for questions 139 and 140. 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. 139. 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%. 140. The cash payback period on the equipment is a. 13.3 years. b. 8.0 years. c. 6.2 years. d. 3.1 years. 141. 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. 142. 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. 143. 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. 144. A company projects an increase in net income of $90,000 each year for the next five years if it invests $450,000 in new equipment. The equipment has a five-year life and an estimated salvage value of $150,000. What is the annual rate of return on this investment? a. 20% b. 30% c. 25% d. 50% 145. Colaw Company is considering buying equipment for $60,000 with a useful life of five years and an estimated salvage value of $4,000. If annual expected income is $5,000, the denominator in computing the annual rate of return is a. $60,000. b. $30,000. c. $32,000. d. $28,000. 146. 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. 147. 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. Answers to Multiple Choice Questions BRIEF EXERCISES BE 148 Diamond Company is considering investing in new equipment that will cost $600,000 with a 10-year useful life. The new equipment is expected to produce annual net income of $40,000 over its useful life. Depreciation expense, using the straight-line rate, is $60,000 per year. Instructions Compute the cash payback period. BE 149 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. BE 150 LakeFront Company is considering investing in a new dock that will cost $280,000. The company expects to use the dock for 5 years, after which it will be sold for $150,000. LakeFront anticipates annual cash flows of $55,000 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. BE 151 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 for each project. (c) Which project should Mobil accept? BE 152 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 $18,150. BE 152 (cont.) Instructions What is the approximate internal rate of return associated with this investment? BE 153 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. EXERCISES Ex. 154 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 $262,000. In addition, Austin estimates that the new machine will increase the company’s annual net cash inflows by $40,300. 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? Ex. 155 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. Annual Cash Flow: Ex. 156 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 $630,000. 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 $329,000 Less: Utility cost 40,000 Supplies 8,000 Labor 141,000 Depreciation 52,500 Other 38,500 280,000 Net income $ 49,000 Instructions For this investment, calculate: (a) The net present value. (b) The internal rate of return. (c) The cash payback period. Ex. 157 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. Ex. 158 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 50,000 80,000 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? Ex. 159 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. Present Value of an Annuity of 1 Period 8% 9% 10% 11% 12% 15% 8 5.747 5.535 5.335 5.146 4.968 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. Ex. 160 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 $25,000 Annual net cash flows 4,000 Salvage value 3,000 Estimated useful life 8 years Cost of capital 10% Present value of an annuity of 1 5.335 Present value of 1 .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. Ex. 161 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 Cool Hot 1 $ 38,000 $ 42,000 2 42,000 42,000 3 48,000 42,000 $128,000 $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 Present Value of an Annuity of 1 Period 12% Period 12% 1 .893 1 .893 2 .797 2 1.690 3 .712 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? Ex. 162 Santana Company is considering investing in a project that will cost $110,000 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 $30,000 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 6% 8% 9% 10% 11% 12% 15% 5 4.212 3.993 3.890 3.791 3.696 3.605 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? Ex. 163 Johnson Company is considering purchasing one of two new machines. The following estimates are available for each machine: Machine 1 Machine 2 Initial cost $148,000 $165,000 Annual cash inflows 50,000 60,000 Annual cash outflows 15,000 20,000 Estimated useful life 6 years 6 years The company's minimum required rate of return is 10%. Present Value of an Annuity of 1 Period 8% 9% 10% 11% 12% 15% 6 4.623 4.486 4.355 4.231 4.111 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? Ex. 164 Platoon Company is performing a post-audit of a project that was estimated to cost $300,000, have a useful life of 6 years with a zero salvage value, and result in net cash inflows of $75,000 per year. After the investment was in operation for a year, revised figures indicate that it actually cost $345,000, will have a 9-year useful life, and will produce net cash inflows of $58,000. The present value of an annuity of 1 for 6 years at 10% is 4.355 and for 9 years is 5.759. Ex. 164 (cont.) Instructions Determine whether the project should have been accepted based on (a) the original estimates and then on (b) the actual amounts. Ex. 165 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 $ 600,000 Cost to build dorm and dining facility 2,100,000 Annual cash inflows assuming 100 players and 10 weeks 2,520,000 Annual cash outflows 2,260,000 Estimated useful life 20 years Salvage value 3,900,000 Discount rate 10% Present value of an annuity of 1 8.514 Present value of 1 .149 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. COMPLETION STATEMENTS 166. For purposes of capital budgeting, estimated ____________ and outflows are preferred for inputs into the capital budgeting decision tools. 167. The technique which identifies the time period required to recover the cost of the investment is called the ________________ method. 168. The two discounted cash flow techniques used in capital budgeting are (1) the _______________________ method and (2) the ______________________ method. 169. Under the net present value method, the interest rate to be used in discounting the future cash inflows is the ________________. 170. In using the net present value approach, a project is acceptable if the project's net present value is ____________ or_______________. 171. A project’s ________________, such as increased quality or safety, are often incorrectly ignored in capital budgeting decisions. 172. The _______________ is a method of comparing alternative projects that takes into account both the size of the investment and its discounted future cash flows. 173. A well-run organization should perform an evaluation, called a _____________, of its investment projects after their completion. 174. The internal rate of return method differs from the net present value method in that it results in finding the ___________________ of the potential investment. 175. A major limitation of the annual rate of return approach is that it does not consider the _______________ of money. Answers to Completion Statements MATCHING 176. Match the items below by entering the appropriate code letter in the space provided. A. Profitability index E. Annual rate of return method B. Internal rate of return method F. Cash payback technique C. Discounted cash flow techniques G. Cost of capital D. Capital budgeting H. 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. Answers to Matching SHORT-ANSWER ESSAY QUESTIONS S-A E 177 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. Solution 177 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 178 (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. S-A E 179 (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: Option #1 Option #2 Initial Investment $(95,000) $(270,000) Returns Year 1 55,000 90,000 Year 2 30,000 90,000 Year 3 10,000 90,000 Net present value 0 0 Required: Prepare a brief report for management in which you make a recommendation for one system or the other, using the information given. [Show More]

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