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Chapter 14—Capital Investment DecisionsMULTIPLE CHOICE Which of the following is true of capital investment decision making? a. It is used only for independent projects. b. It is used only for mutually exclusive projects. c. It requires that funding for a project must come from sources with the same...

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Chapter 14—Capital Investment Decisions MULTIPLE CHOICE 1. Which of the following is true of capital investment decision making? a. It is used only for independent projects. b. It is used only for mutually exclusive projects. c. It requires that funding for a project must come from sources with the same opportunity cost of funds. d. It is used to determine whether or not a firm should accept a special order. e. None of these. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 2 min. 2. In general terms, a sound capital investment will earn a. back its original capital outlay. b. a return greater than existing capital investments. c. back its original capital outlay and provide a reasonable return on the original investment. d. back its original capital outlay by the midpoint of its useful life. e. None of these. ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 2 min. 3. To make a capital investment decision, a manager must estimate the a. quantity of cash flows. b. timing of cash flows. c. risk of the investment. d. impact of the investment on the firm's profitability. e. All of these. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 4. If the cash flows of a project are received evenly over the life of the project, the formula for the calculating the payback period is a. original investment/annual cash flow. b. original investment  annual cash flow. c. original investment + annual cash flow. d. original investment  annual cash flow. e. (original investment + annual cash flow)/annual cash flow. ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 5. The payback period provides information to managers that can be used to help a. control the risks associated with the uncertainty of future cash flows. b. minimize the impact of an investment on a firm's liquidity problems. c. control the risk of obsolescence. d. control the effect of the investment on performance measures.

e. All of these. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 6. Which of the following is a drawback of the payback period? a. It ignores a project's total profitability. b. It uses a set discount rate. c. It considers total profitability, requiring the forecasting of all future cash flows. d. It uses before-tax cash flows rather than after-tax cash flows. e. It uses operating income rather than cash flows. ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 7. A formula for the accounting rate of return is a. average income/initial investment. b. initial investment/annual cash flow. c. annual cash flow/initial investment. d. initial investment/average income. e. (average income + initial investment)/initial investment. ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 8. Managers may use the accounting rate of return to evaluate potential investment projects because a. debt contracts require that a firm maintain certain ratios that are affected by income and long-term asset levels. b. it serves as a screening measure to insure that new investments do not affect key financial ratios. c. bonuses to managers may be based on accounting income and/or return on assets. d. it can be tied to the manager's personal income. e. All of these. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 2 min. 9. The time required for a firm to recover its original investment is the a. internal rate of return. b. net present value. c. life of the project. d. accounting rate of return. e. payback period. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 10. When the risk of obsolescence is high, managers will want a. a shorter payback period. b. a longer payback period. c. a payback period equal to the life of the investment. d. All of these. e. None of these. ANS: A

PTS: 1

DIF: Difficulty: Easy

OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 2 min. 11. One disadvantage of the payback period is that a. it is sometimes used as a crude measure of risk. b. managers may choose investments with quick payback periods to maximize short term criteria on which their own bonuses, etc. may be based. c. it cannot be used for investments with unequal cash inflows. d. it cannot be used if the entire cost of the investment does not occur immediately. e. All of these. ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 2 min. 12. A division manager was considering a project that required a significant initial investment. If accepted, the project could have a negative impact on certain financial ratios that the firm was required to maintain to satisfy debt contracts. To ensure that the ratios would not be adversely affected by the investment, the manager would use which of the following capital investment models? a. payback period b. accounting rate of return c. net present value d. internal rate of return e. None of these. ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 2 min. 13. Greg Moss has just invested $120,000 in a coffee shop. He expects to receive cash income of $15,000 a year. What is the payback period? a. 5 years b. 7.7 years c. 4.5 years d. 6.5 years e. 8 years ANS: E Payback period = $120,000/$15,000 = 8 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 14. Carol Harrison is considering an investment in a retail shopping mall. The initial investment is $400,000. She expects to receive cash income of $80,000 a year. What is the payback period? a. 4 year b. 3.5 years c. 5 years d. 2.5 years e. 6 years ANS: C Payback period = $400,000/$80,000 = 5 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min.

15. Elena Wallace invested $150,000 in a project that pays her an even amount per year for 10 years. The payback period is 6 years. What are Elena's yearly cash inflows from the project? a. $150,000 b. $15,000 c. $25,000 d. $90,000 e. Cannot be determined from this information. ANS: C Cash inflows = $150,000/6 years = $25,000/year PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 16. Tessa Wilson invested in a project with a payback period of 6 years. The project brings $18,000 per year for a period of 9 years. What was the initial investment? a. $108,000 b. $107,500 c. $162,000 d. $240,000 e. Cannot be determined from this information. ANS: A 6 years x $18,000 = $108,000 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 17. Neil Morrison has just invested $130,000 in a restaurant. He expects to receive income of $24,000 a year, and to have the investment for 8 years. What is the accounting rate of return? a. 5.60% b. 18.46% c. 14.52% d. 12.41% e. 4.50% ANS: B ARR = $24,000/$130,000 = 18.46% PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 18. An investment of $5,000 provides an average net cash flows of $320 with zero salvage value. Depreciation is $35 per year. The accounting rate of return using the original investment is a. 4.0% b. 5.1% c. 5.7% d. 3.2% e. 2.4% ANS: C ARR = ($320 - $35)/$5,000 = .057 or 5.7% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 3 min.

19. Buster Evans is considering investing $20,000 in a project with the following annual cash revenues and expenses:

Year 1 Year 2 Year 3 Year 4 Year 5

Cash Revenues $ 8,000 $12,000 $15,000 $20,000 $20,000

Cash Expenses $ 8,000 $ 8,000 $ 9,000 $10,000 $10,000

Depreciation will be $4,000 per year. What is the accounting rate of return on the investment? a. 15% b. 35% c. 70% d. 75% e. None of these. ANS: E

Year 1 Year 2 Year 3 Year 4 Year 5 Total Income

Cash Revenues $ 8,000 $12,000 $15,000 $20,000 $20,000

Less: Cash Expenses $ 8,000 $ 8,000 $ 9,000 $10,000 $10,000

Less: Depreciation $4,000 $4,000 $4,000 $4,000 $4,000

Operating Income $ (4,000) $ 0 $ 2,000 $ 6,000 $ 6,000 $10,000

Average annual income = $10,000/5 = $2,000 ARR = $2,000/$20,000 = 0.1 or 10% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. 20. Coriander Company is considering a project with an initial investment of $426,800 in new equipment that will yield annual net cash flows of $80,000, and will be depreciated at $53,350 per year over its eight year life. What is the accounting rate of return? a. 320% b. 18.74% c. 6.24% d. 31.27% e. 50.0% ANS: C ARR = ($80,000  $53,350)/$426,800 = 0.0624 or 6.24% PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 21. When comparing the payback method and the accounting rate of return methods, which of the following is true?

i ii

Profitability Ignored by both methods Ignored by both methods

iii

Considered by accounting method, not by

Time Value of Money Ignored by both methods Used in accounting rate of return; ignored by payback method Ignored by both methods

iv

payback Considered by accounting method, not by payback

a. b. c. d.

i ii iii iv

Considered by both methods

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 3 min. 22. Oakland Shop is considering the purchase of a used printing press costing $9,600. The printing press would generate a net cash inflow of $4,000 per year for three years. At the end of three years, the press would have no salvage value. The company's cost of capital is 10%. The company uses straight-line depreciation with no mid-year convention. What is the accounting rate of return on the original investment in the press to the nearest percent, assuming no taxes are paid? a. 41.67% b. 8.33% c. 75.00% d. 10.00% ANS: B SUPPORTING CALCULATIONS: [$4,000  ($9,600/3)]/$9,600 = 8.33% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 4 min. Figure 14-1. A company is considering two projects.

Initial investment Cash inflow Year 1 Cash inflow Year 2 Cash inflow Year 3 Cash inflow Year 4 Cash inflow Year 5

Project I Project II $120,000 $120,000 $40,000 $20,000 $40,000 $20,000 $40,000 $32,000 $40,000 $48,000 $40,000 $50,000

23. Refer to Figure 14-1. What is the payback period for Project I? a. 1 year b. 3 years c. 2.5 years d. 3.5 years e. 5 years ANS: B Payback period = $120,000/$40,000 = 3 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 24. Refer to Figure 14-1. What is the payback period for Project II?

a. b. c. d. e.

1 year 2 years 3.5 years 4 years 5 years

ANS: D $20,000 + $20,000 + $32,000 + $48,000 = $120,000 4 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 4 min. Figure 14-2. A company is considering two projects. Project A $200,000 $50,000 $50,000 $50,000 $50,000 $50,000

Initial investment Cash inflow Year 1 Cash inflow Year 2 Cash inflow Year 3 Cash inflow Year 4 Cash inflow Year 5

Project B $200,000 $90,000 $90,000 $40,000 $30,000 $30,000

25. Refer to Figure 14-2. What is the payback period for Project A? a. 4.5 year b. 2.5 years c. 5 years d. 3.5 years e. 4 years ANS: E Payback period = $200,000/$50,000 = 4 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 26. Refer to Figure 14-2. What is the payback period for Project B? a. 2 years b. 4.5 years c. 3.5 years d. 2.5 years e. 3 years ANS: D $90,000 + $90,000 + 0.5($40,000) = $200,000 = 2.5 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. Figure 14-3. Davis Company is considering the purchase of a new piece of equipment that will cost $1,600,000 and have a life of five years with no expected salvage value. The expected cash flows associated with the project are as follows: Cash

Cash Expenses &

Year 1 2 3 4 5

Revenues $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000

Depreciation $900,000 $900,000 $900,000 $900,000 $900,000

27. Refer to Figure 14-3. What is the average annual income for this project? a. $900,000 b. $1,500,000 c. $600,000 d. $700,000 e. $300,000 ANS: C Income per year = $1,500,000 - $900,000 = $600,000 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 28. Refer to Figure 14-3. What is the accounting rate of return for the project? a. 83.33% b. 31.25% c. 47.00% d. 37.50% e. 43.75% ANS: D ARR = $600,000/$1,600,000 = 0.375 = 37.5% PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 3 min. Figure 14-4. Sony Lavery is considering investing $45,000 in a project with the following cash revenues and expenses:

Year Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Revenues $18,000 $22,000 $22,000 $24,000 $26,000 $28,000 $28,000 $28,000

Cash Expenses & Depreciation $8,000 $10,000 $9,000 $9,000 $9,000 $12,000 $11,000 $12,000

29. Refer to Figure 14-4. What is the average income for the project? a. $19,250 b. $30,000 c. $20,000 d. $14,500 e. $18,000 ANS: D Average income = (sum of revenues - sum of expenses)/years

Average income = ($196,000 - $80,000)/8 Average income = $116,000/8 = $14,500 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Measurement | IMA: Investment Decisions | ACBSP: APC-33-Incremental analysis KEY: Bloom's: Application NOT: 4 min. 30. Refer to Figure 14-4. What is the accounting rate of return for the project? a. 32% b. 41% c. 20% d. 26% e. 35% ANS: A Average income = (sum of revenues - sum of expenses)/years Average income = ($196,000 - $80,000)/8 Average income = $116,000/8 = $14,500 ARR = Average income/Investment ARR = $14,500/$45,000 = 0.32 or 32% PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 3 min. 31. Refer to Figure 14-4. Assuming straight-line depreciation over 8 years, what is the payback period for the project? a. between 4 and 5 years b. between 2 and 3 years c. between 5 and 6 years d. between 7 and 8 years e. between 6 and 7 years ANS: B Year

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Revenues Cash Expenses & Depreciation $18,000 $22,000 $22,000 $24,000 $26,000 $28,000 $28,000 $28,000 $196,000

$8,000 $10,000 $9,000 $9,000 $9,000 $12,000 $11,000 $12,000 $80,000

Depreciation

5,625 5,625 5,625 5,625 5,625 5,625 5,625 5,625

Revenues - Cash Net cash flow expenses & depreciation (add back depreciation) $10,000 $15,625 $12,000 $17,625 $13,000 $18,625 $15,000 $20,625 $17,000 $22,625 $16,000 $21,625 $17,000 $22,625 $16,000 $21,625

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. Figure 14-5. Sara Turner is considering investing $60,000 in a project with the following cash revenues and expenses:

Year

Revenues

Cash Expenses & Depreciation

Year 1 Year 2 Year 3 Year 4 Year 5

$16,000 $18,000 $17,000 $26,000 $26,000

$16,000 $16,000 $17,000 $14,000 $14,000

32. Refer to Figure 14-5. Assuming straight-line depreciation over five years, what is the payback period for this investment? a. between 3 and 4 years b. between 2 and 3 years c. between 3 and 4 years d. between 4 and 5 years e. between 1 and 2 years ANS: A Year

Revenues Cash Expenses & Depreciation

Year 1 Year 2 Year 3 Year 4 Year 5

$16,000 $18,000 $17,000 $26,000 $26,000

$16,000 $16,000 $17,000 $14,000 $14,000

Depreciation

Actual cash outflow

12,000 12,000 12,000 12,000 12,000

$4,000 $4,000 $5,000 $12,000 $12,000

Net cash flow (add back depreciation) $12,000 $14,000 $12,000 $24,000 $24,000

Net cash inflows for 4 years period is between 3 and 4 years. Net cash inflows $12,000 $14,000 $12,000 $22,000 $60,000 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. 33. Refer to Figure 14-5. What is the accounting rate of return for the project? a. 8.67% b. 15.60% c. 7.50% d. 3.10% e. Cannot be calculated w...