Part 2 Project Evaluation Techniques Payback, ARR (with Exercises) Sol 04 Dec 2021 PDF

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Materials for CMA Exam Review for reference and increase chances of passing the said examinations. International Certifications at its best....

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11/23/21, 3:57 PM

CMA Exam Review - Part 2 - Assessment Review

2.E.2.j 2E3-LS04 LOS: 2.E.2.j Lesson Reference: The Payback Method Difficulty: medium Bloom Code: 3 What is the payback period for a capital budgeting project where the total initial capital investment is $900,000 and the expected annual net after-tax cash flow is $150,000? 4 years. 7 years. Correct

6 years. 3 years.

 4 years. This answer is incorrect. A project's payback is the length of time it takes for the cash flows generated by the initial investment to equal the initial investment, not exceed half the initial investment.

 7 years. This answer is incorrect. A project's payback is the length of time it takes for the cash flows generated by the initial investment to equal the initial investment, not exceed the initial investment.

 6 years. The following calculation is used to determine the payback period for a series of uniform net cash flows: Payback Period = Total Initial Investment ÷ Expected Annual Net After-tax Cash Flow = $900,000 ÷ $150,000 = 6 Years.

 3 years. This answer is incorrect. A project's payback is the length of time it takes for the cash flows generated by the initial investment to equal the initial investment, not equal half the initial investment.

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11/23/21, 3:57 PM

CMA Exam Review - Part 2 - Assessment Review

2.E.2.j tb.payback.meth.025_1809 LOS: 2.E.2.j Lesson Reference: The Payback Method Difficulty: hard Bloom Code: 4 FCB Industries is evaluating two projects based on the discounted payback method. The company's weighted average cost of capital is 12%. Project A is deemed to be of average risk, but Project B has very low risk, so the company has decided to adjust the discount rate by 2% for Project B. The investments and operating cash flows follow:

Investment ($5,000) ($6,000) Cash Flows 1 2

$2,500 $2,000

$3,000 $2,250

3 4

$1,500 $1,000

$1,750 $1,500

A chart with present value factors follows:

1 0.9091 0.8929 0.8772 2 0.8264 0.7972 0.7695 3 0.7513 0.7118 0.6750 4 0.6830 0.6355 0.5921 5 0.6209 0.5674 0.5194 Calculate the discounted payback period for Project A. Your Answer

3.10 years 2.95 years 2.33 years Correct

3.17 years

 3.10 years This answer is incorrect. This amount is the discounted payback period for Project B. Use Project A's cash flow and discount rate to calculate the discounted payback period for Project A.

 2.95 years This answer is incorrect. This amount is the discounted payback period for Project A using a 10% discount rate. Because Project A is deemed to be of average risk, no adjustment is needed to the weighted average cost of capital.

 2.33 years This answer is incorrect. This amount is the payback period for Project A, not the discounted payback period.

 3.17 years Correct. A chart of the present value calculations follows:

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CMA Exam Review - Part 2 - Assessment Review

$2,500 0.8929 $2,000 0.7972

$2,232.25 $1,594.40

$2,232.25 $3,826.65

$1,500 0.7118 $1,000 0.6355

$1,067.70 $ 635.50

$4,894.35 $5,529.85

Project A pays back its original investment of $5,000 between Years 3 and 4. The fraction of the fourth year equals ($5,000 − $4,894.35) ÷ 635.50 = 0.17 years, so the discounted payback period is 3.17 years.

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11/23/21, 3:57 PM

CMA Exam Review - Part 2 - Assessment Review

2.E.1.j tb.risk.analy.cap.qi.004_1712 LOS: 2.E.1.j Lesson Reference: Risk Analysis and Qualitative Issues in Capital Budgeting Difficulty: easy Bloom Code: 2 A manager who tends to be risk averse is setting a discount rate to be used for investment projects. The manager will likely apply what type of adjustment to the weighted-average cost of capital (WACC) for a risky project? No change; use the WACC as the discount rate. Set a discount rate that is lower than the WACC. Correct

Set a discount rate that is higher than the WACC. The discount rate is not related to the WACC.

 No change; use the WACC as the discount rate. The WACC by definition is the appropriate discount rate when the project has average risk. Thus, for a risky project, the WACC would need to be changed to account for the higher risk. Therefore, this is an incorrect answer.

 Set a discount rate that is lower than the WACC. The WACC by definition is the appropriate discount rate when the project has average risk. Thus, the WACC would be adjusted lower for a project with decreased risk. Therefore, this is an incorrect answer.

 Set a discount rate that is higher than the WACC. The WACC by definition is the appropriate discount rate when the project has average risk. Thus, for a risky project, the WACC would need to be increased to offset the higher risk. Therefore, this the correct answer.

 The discount rate is not related to the WACC. The WACC by definition is the appropriate discount rate when the project has average risk. Therefore, this is an incorrect answer.

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11/23/21, 3:57 PM

CMA Exam Review - Part 2 - Assessment Review

2.E.2.j tb.payback.meth.022_1809 LOS: 2.E.2.j Lesson Reference: The Payback Method Difficulty: hard Bloom Code: 4 LZ Company ranks projects on the basis of payback. LZ Company only accepts projects with a payback period of less than 3 years. Project A has an investment of $10,000 and generates incremental cash flows of $5,000 a year for 10 years. Project B has an investment of $20,000 and generates incremental cash flows of $8,000 per year for 8 years. Project C has an investment of $30,000 and generates cash flows of $9,000 per year for 6 years. Assuming LZ Company has $30,000 of capital available and the projects are mutually exclusive, which project(s) should LZ Company accept? Your Answer

Project B only Project C only Project A first then Project B Correct

Project A only

 Project B only This answer is incorrect. While Project B does have an acceptable payback period, the projects are mutually exclusive, meaning only one project may be accepted. There is another project with a shorter payback period than Project B.

 Project C only This answer is incorrect. Project C does not have a payback period acceptable to LZ Company, so this project should not be accepted.

 Project A first then Project B This answer is incorrect. LZ Company cannot accept both Project A and Project B, even though it has enough capital, because the projects are mutually exclusive meaning only one project may be accepted.

 Project A only Correct. The payback period for Project A is $10,000 ÷ $5,000 = 2.0 years. The payback period for Project B is $20,000 ÷ $8,000 = 2.5 years. The payback period for Project C is $30,000 ÷ $$9,000 = 3.3 years. Project A has the lowest payback period, followed by Project B. Project C is not acceptable because the project's payback period is greater than 3 years. Because the projects are mutually exclusive, LZ Company can only choose one of the projects even though it has adequate capital. LZ should accept the project with the lowest payback period, which is Project A.

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CMA Exam Review - Part 2 - Assessment Review

2.E.2.j aq.payback.discount.0008_0720 LOS: 2.E.2.j Lesson Reference: The Payback Method Difficulty: hard Bloom Code: 5 Topper Manufacturing is considering converting a step in its manufacturing process to an automated process. The machinery identified for this capital investment will cost $410,000 with a four-year useful life and no salvage value. Topper Manufacturing uses straight-line depreciation for all equipment. Its effective tax rate is 30%. Management estimates that the investment will provide before-tax operating cash flows of $198,500 per year before consideration of any tax shields from depreciation expense. Based on this information, what is the project's discounted payback period assuming management has set a 10% hurdle rate on similar projects? *Solutions are computed using a financial calculator. Due to rounding errors, the solution may be slightly different if present value tables are used. Correct

2.9 years 2.4 years 2.0 years 2.1 years

 2.9 years The calculation is as follows: Annual depreciation expense = $410,000 ÷ 4 = $102,500. Before-tax income = $198,500 – $102,500 = $96,000. Tax expense = $96,000 × 30% = $28,800. After-tax income = $96,000 – $28,800 = $67,200. After-tax cash flow = $67,200 + $102,500 = $169,700. The PV calculation of after-tax cash flows for Year 1: Calculator steps: Clear All Enter 10 in the I/YR key Enter 1 in the N key Enter 169,700 in the FV key Compute PV → –154,273* is the present value solution. *The present value is negative because the calculator is indicating the $154,273 current investment (outflow) is equal to the future lump sum (positive) payment, assuming a 10% discount rate.

Repeat this process for the other three years, entering the corresponding year into N. The PV calculation of after-tax cash flows for Year 2: –140,248 The PV calculation of after-tax cash flows for Year 3: –127,498 The PV calculation of after-tax cash flows for Year 4: –115,907 The cumulative present value of the after-tax cash flows indicates that the discounted payback period is between Years 2 and 3 given the cumulative present value of the after-tax cash flows at the end of Year 2 = $294,521. For a more precise precise calculation, find out at what point in Year 3 the initial investment was paid back, calculated as 2 + ($410,000 – $294,521) ÷ $127,498 (the PV calculation of after-tax cash flows for Year 3) = 2.9 years.

 2.4 years The calculation for this solution fails to calculate the present value of the after-tax cash flows as needed for discounted payback period.

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CMA Exam Review - Part 2 - Assessment Review

 2.0 years The calculation for this solution does not consider the precise calculation of payback period by determining at what point in Year 3 the initial investment was paid back.

 2.1 years The calculation for this solution calculates a payback period using before-tax cash flows. Two errors inherent in this answer are using before-tax cash flows and not calculating the present value of the after-tax cash flow needed for a discounted payback period.

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CMA Exam Review - Part 2 - Assessment Review

2.E.2.j aq.payback.discount.0002_0720 LOS: 2.E.2.j Lesson Reference: The Payback Method Difficulty: medium Bloom Code: 3 Fitzgerald Company is planning to acquire a $250,000 machine that will provide increased efficiencies, thereby reducing annual pretax operating costs by $80,000. The machine will be depreciated by the straight-line method over a five-year life with no salvage value at the end of five years. Assuming a 40% income tax rate, the machine's payback period is: Correct

3.68 years. 5.21 years. 2.50 years. Your Answer

3.13 years.

 3.68 years. The payback period is computed by dividing the initial cost by the annual net after-tax cash inflows (assuming equal inflows each year). The inflows consist of two items, the first of which is the $80,000 in operating cost savings. If the tax rate is 40%, the company keeps 60% of the $80,000 after tax, which is $48,000. The second inflow is the depreciation tax shield. The company will deduct depreciation expense of $50,000 per year. At a 40% tax rate, this will save the company 40% of $50,000, which is $20,000. Thus, the total after-tax cash inflow per year is $48,000 + $20,000, or $68,000. Finally, the payback period is $250,000 ÷ $68,000 savings per year, or 3.68 years.

 5.21 years. Remember to consider the tax effect on the depreciation expense of $50,000, which results in a tax shield.

 2.50 years. Remember to consider the tax effect on the $80,000 in operating cost savings.

 3.13 years. Remember to consider the tax effect on the $80,000 in operating cost savings. Also, remember to consider the tax effect on the depreciation expense of $50,000, which results in a tax shield.

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CMA Exam Review - Part 2 - Assessment Review

2.E.2.j 2E3-AT11 LOS: 2.E.2.j Lesson Reference: The Payback Method Difficulty: medium Bloom Code: 4 Fitzgerald Company is planning to acquire a $250,000 machine that will provide increased efficiencies, thereby reducing annual operating costs by $80,000. The machine will be depreciated by the straight-line method over a five-year life with no salvage value at the end of five years. Assuming a 40% income tax rate, the machine's payback period is: 3.13 years. Your Answer

1.84 years. Correct

3.68 years. 4.00 years.

 3.13 years. This answer is incorrect. This answer did not consider depreciation or tax in the calculation of after-tax cash flows for the calculation of the payback period.

 1.84 years. This answer is incorrect. A project's payback is the length of time it takes for the cash flows generated by the initial investment to equal the initial investment, not to equal half the initial investment.

 3.68 years. A project's payback (PB) is the length of time it takes for the cash flows generated by the initial investment to equal the initial investment. Assuming the cash flows occur uniformly throughout the year, the PB is calculated by dividing the initial investment by the annual after-tax cash flow (ATCF). PB = $250,000 ÷ $68,000 = 3.68 years. The ATCF for each year is calculated as: ATCF = [(Annual Savings − Depreciation)(1 − Tax Rate)] + Depreciation. Note that depreciation is deducted from the annual savings amount, since it reduces the annual savings. However, it is added back to compute the after-tax cash flow, since depreciation does not result in a cash flow. The annual depreciation is $50,000 ($250,000 ÷ 5 years). Therefore, ATCF =[($80,000 − $50,000)(1 − 0.4)] + $50,000 ATCF = $30,000(0.6) + $50,000 ATCF = $18,000 + $50,000 = $68,000.

 4.00 years. This answer is incorrect. A project's payback is the length of time it takes for the cash flows generated by the initial investment to equal the initial investment. This can occur at any point during the year.

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CMA Exam Review - Part 2 - Assessment Review

2.E.2.h aq.payback.discount.0005_0720 LOS: 2.E.2.h Lesson Reference: The Payback Method Difficulty: medium Bloom Code: 3 Which of the following is a limitation inherent in the payback method? It is difficult to compute and understand. Your Answer

It encourages investment in long-term projects to the detriment of considering short-term opportunities. It does not consider the risk of a project. Correct

It fails to consider the cash flows over a project's entire useful life.

 It is difficult to compute and understand. The period method is easy to compute and understand once the cash flows are identified.

 It encourages investment in long-term projects to the detriment of considering short-term opportunities. The payback method calculates the time it takes to recover the initial investment in a project. Thus, shorter payback periods are desirable, which gives an incentive for managers to choose short-term projects over projects that have a longer payback period but may be better aligned with organizational strategy.

 It does not consider the risk of a project. The payback method is a measure of a project's risk, although it is a rather crude and simplistic approach. The longer a project takes to return the initial investment, the more risky the ultimate recovery of that investment becomes.

 It fails to consider the cash flows over a project's entire useful life. The payback method determines the length of time it takes to return the initial investment. Once that payback point is reached, further cash flows are ignored.

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CMA Exam Review - Part 2 - Assessment Review

2.E.2.j tb.payback.meth.015_1809 LOS: 2.E.2.j Lesson Reference: The Payback Method Difficulty: medium Bloom Code: 3 RTS Company is evaluating two mutually exclusive projects on the basis of payback. RTS is risk averse and will not accept any project with a payback period over 3 years. Project A has an initial investment of $400,000 and produces incremental operating annual cash flows of $150,000 per year for 5 years. Project B has an initial investment of $350,000 and produces incremental operating annual cash flows of $110,000 for 6 years. Which project(s) should RTS accept? Correct

RTS should accept Project A and reject Project B. RTS should reject both projects. Your Answer

RTS should accept Project B and reject Project A. RTS should accept both projects.

 RTS should accept Project A and reject Project B. Correct. The payback period for Project A is $400,000 ÷ 150,000 = 2.67 years. The payback period for Project B is $350,000 ÷ $110,000 = 3.18 years. Therefore, Project A is acceptable because it has a payback period of less than 3 years, and Project B is unacceptable because it has a payback period greater than 3 years.

 RTS should reject both projects. This answer is incorrect. At least one of the projects does achieve the payback period desired by RTS, so it should not reject both projects.

 RTS should accept Project B and reject Project A. This answer is incorrect. Only one of the projects achieves the payback period desired by RTS, and that project should be the one accepted.

 RTS should accept both projects. This answer is incorrect. Because the projects are mutually exclusive, RTS is unable to accept both projects. Only one of the projects achieves the payback period desired by RTS.

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CMA Exam Review - Part 2 - Assessment Review

2.E.2.i 2E3-LS02 LOS: 2.E.2.i Lesson Reference: The Payback Method Difficulty: easy Bloom Code: 2 Which of the following statements is true of using the payback method in capital budgeting? The payback method: Correct

takes into account the time value of money. represents the breakeven point for an investment. Your Answer

provides a rough measure of project risk. does not distinguish between types of cash inflows.

 takes into account the time value of money. A disadvantage of the payback method is that it ignores the time value of money.

 represents the breakeven ...