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Chapter 14 Capital Budgeting DecisionsTrue/False Questions When cash flows are uneven and vary from year to year, the internal rate of return method is easier to use than the net present value method. Ans: False For capital budgeting decisions, the net present value method is superior to the simple ...

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Chapter 14 Capital Budgeting Decisions True/False Questions 1. When cash flows are uneven and vary from year to year, the internal rate of return method is easier to use than the net present value method. Ans: False 2. For capital budgeting decisions, the net present value method is superior to the simple rate of return method. Ans: True 3. Depreciation is included as a cash flow in capital budgeting decisions to ensure that the original cost of the asset is fully recovered. Ans: False 4. Even when done properly, the total-cost and incremental-cost approaches to choosing between alternatives will sometimes yield different answers. Ans: False 5. An increase in the expected salvage value at the end of a capital budgeting project will have no effect on the internal rate of return for that project. Ans: False 6. The intangible benefits of automation cannot be estimated with any accuracy and therefore should be ignored in capital budgeting decisions. Ans: False 7. When making preference decisions about competing investment proposals, the project profitability index is superior to the internal rate of return. Ans: True

8. The project profitability index is computed by dividing the net present value of the project by the investment required by the project. Ans: True 9. In calculating the “investment required” for the project profitability index, the amount invested should be reduced by any salvage recovered from the sale of old equipment. Ans: True 10. The payback method is most appropriate for projects whose cash flows extend far into the future. Ans: False

LO: 5

11. When using the payback method, any cash flows for a project that occur after the payback period are not considered in computing the payback period for that project. Ans: True

LO: 5

12. The present value of a given future cash flow will increase as the discount rate decreases. Ans: False

LO: 7

13. If a company is operating at a profit, the cash inflow resulting from the depreciation tax shield is computed by multiplying the depreciation deduction by one minus the tax rate. Ans: False

Appendix: 14C

LO: 8

14. All cash inflows are taxable. Ans: False

Appendix: 14C

LO: 8

15. The after-tax benefit, or net cash inflow, realized from a particular taxable cash receipt can be obtained by multiplying the cash receipt by one minus the tax rate. Ans: True

Appendix: 14C

LO: 8

Multiple Choice Questions 16. Suture Corporation's discount rate is 12%. If Suture has a 5-year investment project that has a project profitability index of zero, this means that: A) the net present value of the project is equal to zero. B) the internal rate of return of the project is equal to the discount rate. C) the payback period of the project is equal to the project's useful life. D) both A and B above are true. Ans: D

LO: 1,2,4,5

17. Amster Corporation has not yet decided on the required rate of return to use in its capital budgeting. This lack of information will prevent Amster from calculating a project's: Payback Net Present Value A) No No B) Yes Yes C) No Yes D) No Yes Ans: D

LO: 1,2,5

Internal Rate of Return No Yes Yes No

Source: CMA, adapted

18. If income taxes are ignored, how is depreciation used in the following capital budgeting techniques?

A) B) C) D)

Internal Rate of Return Net Present Value Excluded Excluded Excluded Included Included Excluded Included Included

Ans: A

Source: CPA, adapted

19. If the net present value of a project is zero based on a discount rate of 16%, then the internal rate of return is: A) equal to 16%. B) less than 16%. C) greater than 16%. D) cannot be determined from this data. Ans: A 20. Three potential investment projects (A, B, and C) at Nit Corporation all require the same initial investment, have the same useful life (3 years), and have no expected salvage value. Expected net cash inflows from these three projects each year is as follows: A B C Year 1 $1,000 $2,000 $3,000 Year 2 $2,000 $2,000 $2,000 Year 3 $3,000 $2,000 $1,000 What can be determined from the information provided above? A) the net present value of project C will be the highest. B) the internal rate of return of projects A and C cannot be computed. C) the net present value and the internal rate of return will be the same for all three projects. D) both A and B above. Ans: A 21. A project's net present value, ignoring income taxes, is affected by: A) the net book value of an asset that is replaced. B) the depreciation on an asset that is replaced. C) the depreciation to be taken on assets used directly on the project. D) proceeds from the sale of an asset that is replaced. Ans: D

Source: CPA, adapted

22. A company has unlimited funds to invest at its discount rate. The company should invest in all projects having: A) an internal rate of return greater than zero. B) a net present value greater than zero. C) a simple rate of return greater than the discount rate. D) a payback period less than the project's estimated life. Ans: B

Source: CMA, adapted

23. When the cash flows are the same every period after the initial investment in a project, the payback period is equal to: A) the net present value. B) the simple rate of return. C) the factor of the internal rate of return. D) the payback rate of return. Ans: C

LO: 2,5

Source: CMA, adapted

24. The internal rate of return method assumes that a project's cash flows are reinvested at the: A) internal rate of return. B) simple rate of return. C) required rate of return. D) payback rate of return. Ans: A

Source: CMA, adapted

25. (Ignore income taxes in this problem.) Which of the following would be used in the calculation of the internal rate of return of an investment in new machinery to replace old machinery? A) The annual depreciation expense on the new machinery. B) The cost of an overhaul that would be needed on the old machinery in three years. C) The salvage value of the old machinery in ten years. D) both B and C above. Ans: D

26. The project profitability index and the internal rate of return: A) will always result in the same preference ranking for investment projects. B) will sometimes result in different preference rankings for investment projects. C) are less dependable than the payback method in ranking investment projects. D) are less dependable than net present value in ranking investment projects. Ans: B

LO: 4,5

27. Zonifugal Corporation needs to purchase a new conveyor system for its factory. Four different conveyor systems have been proposed. Which calculation would be the best one for Zonifugal to use to determine which system to purchase? A) payback period B) simple rate of return C) net present value D) project profitability index Ans: D 28. A preference decision: A) is concerned with whether a project clears the minimum required rate of return hurdle. B) comes before the screening decision. C) is concerned with determining which of several acceptable alternatives is best. D) responses A, B, and C are all correct. Ans: C 29. In an equipment investment decision, which of the following amounts would be unaffected by a change in the tax rate? A) the present value of the initial investment in the equipment. B) the present value of the increase in working capital needed. C) the present value of the salvage value of the equipment. D) both A and B above. Ans: D

Appendix: 14C

LO: 8

30. When evaluating a project, the portion of the fixed corporate headquarters expense that would be allocated to the project should be: A) included as a cash outflow on an after-tax basis by multiplying the expense by one minus the tax rate. B) included as a cash outflow on an after-tax basis by multiplying the expense by the tax rate. C) included as a cash outflow on a before-tax basis. D) ignored. Ans: D

Appendix: 14C

LO: 8

31. (Ignore income taxes in this problem.) Given the following data: Cost of equipment Annual cash inflows Internal rate of return

$55,750 $10,000 16%

The life of the equipment must be: A) it is impossible to determine from the data given B) 15 years C) 12.5 years D) 5.75 years Ans: B Solution: The internal rate of return factor is 5.575, or $55,750 ÷ $10,000. In the table for the Present Value of an Annuity of $1 in Arrears, the factor of 5.575 can be found in the 16% column in the 15th row; 15 then represents the life of the equipment.

32. (Ignore income taxes in this problem.) Heap Company is considering an investment in a project that will have a two year life. The project will provide a 10% internal rate of return, and is expected to have a $40,000 cash inflow the first year and a $50,000 cash inflow in the second year. What investment is required in the project? A) $74,340 B) $77,660 C) $81,810 D) $90,000 Ans: B

Source: CMA, adapted

Solution: Cash inflow−1st year Cash inflow−2nd year Net present value

Year(s) 1 2

Amount 40,000 50,000

10% Factor 0.909 0.826

PV $36,360 41,300 $77,660

For the net present value of this project to be zero, the initial investment should be equal to the present value of the cash inflows, or $77,660. 33. (Ignore income taxes in this problem.) Congener Beverage Corporation is considering an investment in a capital budgeting project that has an internal rate of return of 20%. The only cash outflow for this project is the initial investment. The project is estimated to have an 8 year life and no salvage value. Cash inflows from this project are expected to be $100,000 per year in each of the 8 years. Congener's discount rate is 16%. What is the net present value of this project? A) $5,215 B) $15,464 C) $50,700 D) $55,831 Ans: C

Solution: Internal rate of return factor = Initial investment ÷ Annual inflows Look up the factor in the table Present Value of an Annuity of $1 in Arrears for 8 periods, 20% column; the factor is 3.837. Substituting into the above equation, 3.837 = Initial investment ÷ $100,000 Initial investment = $383,700.

Initial investment Annual net cash receipts Net present value

Year(s) Now 1-8

Amount 16% Factor PV ($383,700) 1.000 ($383,700) $100,000 4.344 434,400 $ 50,700

34. (Ignore income taxes in this problem.) The Able Company is considering buying a new donut maker. This machine will replace an old donut maker that still has a useful life of 2 years. The new machine will cost $2,500 a year to operate, as opposed to the old machine, which costs $2,700 per year to operate. Also, because of increased capacity, an additional 10,000 donuts a year can be produced. The company makes a contribution margin of $0.02 per donut. The old machine can be sold for $5,000 and the new machine costs $25,000. The incremental annual net cash inflows provided by the new machine would be: A) $200 B) $400 C) $5,200 D) $5,400 Ans: B Solution: Operating cost savings per year ($2,700 − $2,500) Additional contribution margin provided by the new donut maker ($0.02 × 10,000) Incremental annual net cash inflows provided by new machine

$200 200 $400

35. (Ignore income taxes in this problem.) Given the following data: Initial investment Annual cash inflow Salvage value Net present value Life of the project Discount rate

$80,000 ? $0 $13,600 6 years 16%

Based on the data given above, the annual cash inflow from the project after the initial investment is closest to: A) $50,116 B) $21,710 C) $25,400 D) $38,376 Ans: C Solution: First, set up table: Initial investment Annual cash inflows Net present value

Year(s) Now 1-6

Amount 16% Factor $80,000 1.000 ? 3.685

Second, solve for the present value of the annual cash inflow: PV of annual cash inflow = $13,600 − (-$80,000) = $93,600 Finally, solve for the annual cash inflow: Annual cash inflow × 3.685 = $93,600 Annual cash inflow = $25,400

PV ($80,000) ? $13,600

36. (Ignore income taxes in this problem.) Virginia Company invested in a four-year project. Virginia's discount rate is 10%. The cash inflows from this project are: Year Cash Inflow 1 $4,000 2 $4,400 3 $4,800 4 $5,200 Assuming a positive net present value of $1,000, the amount of the original investment was closest to: A) $2,552 B) $4,552 C) $13,427 D) $17,400 Ans: C

Source: CPA, adapted

Solution: Net present value of cash inflows − Original investment = Net present value of project Original investment = NPV of cash inflows − NPV of project = $14,427 − $1,000 = $13,427 Year 1 inflow Year 2 inflow Year 3 inflow Year 4 inflow Net present value of cash inflows

Year(s) 1 2 3 4

Amount $4,000 $4,400 $4,800 $5,200

10% Factor 0.909 0.826 0.751 0.683

PV $ 3,636 3,634 3,605 3,552 $14,427

37. (Ignore income taxes in this problem.) Para Corporation is reviewing the following data relating to an energy saving investment proposal: Initial investment Life of the project Salvage value Annual cash savings

$50,000 5 years $10,000 ?

What annual cash savings would be needed in order to satisfy the company's 12% required rate of return (rounded to the nearest one hundred dollars)? A) $10,600 B) $11,100 C) $12,300 D) $13,900 Ans: C

Source: CPA, adapted

Solution: Total investment Annual cash savings Salvage value Net present value

Years Now 1-5 5

Amount 12% Factor ($50,000) 1.000 ? 3.605 $10,000 0.567

Present Value ($50,000) ? 5,670 $ 0

To solve for the present value of the annual cash savings: -$50,000 + PV of annual cash savings + $5,670 = $0 PV of annual cash savings = $44,330 To solve for the amount of the annual cash savings: Amount of annual cash savings × 3.605 = $44,330 Amount of annual cash savings = $12,297, which rounds to $12,300

38. (Ignore income taxes in this problem.) Nevus Tattoo Parlor is considering a capital budgeting project. This project will initially require a $25,000 investment in equipment and a $3,000 working capital investment. The useful life of this project is 5 years with an expected salvage value of zero on the equipment. The working capital will be released at the end of the 5 years. The new system is expected to generate net cash inflows of $9,000 per year in each of the 5 years. Nevus' discount rate is 14%. The net present value of this project is closest to: A) $(3,088) B) $3,383 C) $4,454 D) $5,897 Ans: C Solution:

Initial investment Working capital needed Annual cost savings Working capital released Net present value

Year(s) Now Now 1-5 5

Amount 14% Factor ($25,000) 1.000 ($3,000) 1.000 $9,000 3.433 $3,000 0.519

PV ($25,000) ( 3,000) 30,897 1,557 $ 4,454

39. (Ignore income taxes in this problem.) The Malaise Prevention Agency is a non-profit organization that does all of its own informational printing. The printing press that Malaise currently is using needs a $20,000 overhaul. This will extend the useful life of the press by 8 years. As an alternative, Malaise could buy a brand new modern press for $45,000. The new press would also last 8 years. The annual operating expenses of the old press are $12,000. The annual operating expenses of the new press will only be $7,000. The old press is not expected to have a salvage value in 8 years. The new press is expected to have a $6,000 salvage value in 8 years. Malaise's discount rate is 14%. The net present value of the decision to buy the new press instead of overhauling the old press is closest to: A) $301 B) $(301) C) $4,195 D) $(46,089) Ans: A Solution: Initial investment Annual cost savings ($12,000 − $7,000) Salvage value Net present value of new press

Year(s) Now

Cost to overhaul old press NPV of new press NPV of new press vs. old press

1-8 8

Amount 14% Factor ($45,000) 1.000 $5,000 $6,000

4.639 0.351

PV ($45,000) 23,195 2,106 ($19,699)

$20,000 19,699 $ 301

40. (Ignore income taxes in this problem.) Nevland Corporation is considering the purchase of a machine that would cost $130,000 and would last for 6 years. At the end of 6 years, the machine would have a salvage value of $18,000. By reducing labor and other operating costs, the machine would provide annual cost savings of $44,000. The company requires a minimum pretax return of 19% on all investment projects. The net present value of the proposed project is closest to: A) $38,040 B) $26,376 C) $74,902 D) $20,040 Ans: B Solution: Initial investment Annual cost savings Salvage value Net present value

Year(s) Now 1-6 6

Amount 19% Factor PV ($130,000) 1.000 ($130,000) $44,000 3.410 150,040 $18,000 0.352 6,336 $ 26,376

41. (Ignore income taxes in this problem) The management of Penfold Corporation is considering the purchase of a machine that would cost $440,000, would last for 7 years, and would have no salvage value. The machine would reduce labor and other costs by $102,000 per year. The company requires a minimum pretax return of 16% on all investment projects. The net present value of the proposed project is closest to: A) -$28,022 B) $96,949 C) -$79,196 D) $274,000 Ans: A Solution: Initial investment Annual cost savings Net present value

Year(s) Now 1-7

Amount 16% Factor PV ($440,000) 1.000 ($440,000) $102,000 4.039 411,978 ($ 28,022)

42. (Ignore income taxes in this problem.) Dowlen, Inc., is considering the purchase of a machine that would cost $150,000 and would last for 6 years. At the end of 6 years, the machine would have a salvage value of $23,000. The machine would reduce labor and other costs by $36,000 per year. Additional working capital of $6,000 would be needed immediately. All of this working capital would be recovered at the end of the life of the machine. The company requires a minimum pretax return of 12% on all investment projects. The net present value of the proposed project is closest to: A) $9,657 B) -$2,004 C) $6,699 D) $13,223 Ans: C Solution:

Initial investment Working capital needed Annual cost savings Working capital released Salvage value Net present value

Year(s) Now Now 1-6 6 6

Amount 12% Factor PV ($150,000) 1.000 ($150,000) ($6,000) 1.000 (6,000) $36,000 4.111 147,996 $6,000 0.507 3,042 $23,000 0.507 11,661 $ 6,699

43. (Ignore income taxes in this problem.) The Poteran Company is considering a machine that will save $3,000 a year in cash operating costs each year for the next six years. At the end of six years it would have no salvage value. If this machine costs $9,060 now, the machine's internal rate of return is closest to: A) 18% B) 20% C) 22% D) 24% Ans: D Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $9,060 ÷ $3,000 = 3.020 The factor of 3.020 for 6 years represents an internal rate of return of 24%.

44. (Ignore income taxes in this problem) The management of Elamin Corporation is considering the purchase of a machine that would cost $365,695 and would have a useful life of 9 years. The machine would have no salvage value. The machine would reduce labor and other operating costs by $61,000 per year. The internal rate of return on the investment in the new machine is closest to: A) 9% B) 11% C) 12% D) 10% Ans: A Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $365,695 ÷ $61,000 = 5.995 The factor of 5.995 for 9 years represents an internal rate of return of 9%. 45. (Ignore income taxes in this problem.) Bau Long-Haul, Inc., is considering the purchase of a tractor-trailer that would cost $281,656, would have a useful life o...