CHAPTER Capital Budgeting Decisions Summary of Questions by Objectives and Bloom’s Taxonomy Item SO BT Item True-False Statements 1 K K K 10 C 11 AP 12 K 13 2,6 K 14 Multiple Choice Questions 35 C 59 36 K 60 37 K 61 38 K 62 39 K 63 40 2,3 K 64 41 C 65 42 C 66 43 C 67 44 AP 68 45 1,2 C 69 46 C 70 47 K 71 48 K 72 49 AP 73 50 AP 74 51 K 75 52 K 76 53 AP 77 54 2,3 C 78 55 C 79 56 K 80 57 AP 81 58 AP 82 Matching 154 1,2,3 K 4,6 Exercises 155 AP 159 156 1,2 AP 160 157 AP 161 158 AP 162 SO BT Item SO BT Item SO BT 2 2 3 K K K K C K C 15 16 17 18 19 20 21 3 3 3 K K K K K K K 22 23 24 25 26 27 28 4 4 3,6 C K K K K K C 2,4 3 2 2 3 2,3 3 2,3 2,6 3 3 3 AP AP K K C AP AP AP AP AP K K K K K K C C K K AP AP AP AP 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 *102 103 104 *105 *106 2,3 4 4 6 6 6 6 A1 A1 AP C AP C K C K AP AP AP AP K K K AP C C C AP AP AP AP K K 107 *108 A1,2 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 2 AP AP AP AP 163 164 165 166 2,4 2 AP AP AP AP 167 168 169 170 2,4 4 2,4 Item SO BT 29 30 31 32 *33 *34 6 A1 A1 K K C K K K AP AP AP C C C AP AP AP AP AP AP AP K K C AP C AP C C AP AP AP 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 6 6 6 6 6 6 6 AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP AP 171 172 2,3,6 2,6 AP AP 9-2 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition Challenge Exercises 173 2,4 AP 174 2,3 Short-Answer Essays 178 K 180 179 K 181 2,3,6 AN 175 AP 176 3,6,7 K C 182 183 3 K K 184 185 4 AN 177 1,2 AP K K 186 187 K C Chapter Capital Budgeting Decisions 9-3 True-False One possible capital budgeting decision is the potential acquisition of a patent from a competitor The time value of money concept recognizes that a dollar received today is worth more than a dollar received in the future Present value techniques are developed to equate future dollars to current dollars In evaluating an investment opportunity, a company must know how much cash it receives from or pays for an investment and the timing of the cash flows because receipts and payments that occur in the future are worth more than those that occur earlier If your required rate of return is 6%, the present value of $1,000 to be received three years from today is $839.60 The process of determining present value removes the cost of interest from future cash flows to determine the value of the amount today Both the payback period and the net present value methods take into account the timing of future cash flows The net present value method equates cash inflows to revenues, and cash outflows to expenses, as if occurring in the same accounting period If the net present value is equal to zero, the project should be accepted 10 In net present value analysis, the purchase of equipment today results in a cash outflow that is not discounted 11 The future value of all cash inflows minus the cash outflows equals the net present value of the investment 12 The only cash outflow that may exist in a net present value analysis is the initial investment 13 If the required rate of return is greater than the internal rate of return of a potential investment, the company should deem the investment acceptable 14 If the internal rate of return is used to calculate the net present value of a project, the net present value will be zero 15 The internal rate of return method ignores the time value of money 16 The internal rate of return is the rate of return that management desires to earn on its investments 17 If the internal rate of return is greater than the required rate of return, the project should be accepted 18 The cost of capital is the weighted average of the costs of debt and equity financing used to generate capital for investments 9-4 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 19 Riskier investments demand lower rates of return 20 Soft benefits are those that often have a significant nonfinancial impact on an investment decision and as such, should be included in the decision analysis 21 The more risky a potential investment is, the lower the company’s required rate of return will be 22 If an investment project generates tax-deductible expenses, cash inflows from the project will be reduced by the taxes resulting from the increase in income taxes payable 23 Depreciation itself is not a cash outflow, though it reduces the amount of income taxes that a company must pay 24 Cash flows used in calculating the net present value need not be adjusted for inflation because the interest rate used to discount the cash flows has already considered inflation 25 The depreciation tax shield is the amount of income taxes that the company avoids as a result of reporting depreciation expense 26 The net present value method can be used to determine the effect of discontinuing one of a company’s products 27 Neither the accounting rate of return method nor the payback period method consider the timing of all future cash flows related to a potential investment 28 The internal rate of return method and the payback period method will always give the same decision as to whether to accept a project, if the same inputs are used 29 All else being equal, a company prefers projects with long payback periods, as these benefit the company for longer time periods 30 The payback period method ignores cash flows that occur after the end of the payback period 31 A project with positive cash flows will always generate an acceptable accounting rate of return 32 Managers may be discouraged from using present value techniques for evaluating investments because of the way in which their own performance is evaluated *33 When using the NPV function in Microsoft © Excel, the initial cash flow at time zero is omitted from the range selected for the function *34 When using the internal rate of return function in Microsoft © Excel to calculate the internal rate of return, the initial cash flow at time zero is omitted from the range selected for the function because it is not discounted Material from the appendix to the chapter is marked with an asterisk (*) Chapter Capital Budgeting Decisions 9-5 Answers T T T F T T 10 11 12 F T T T F F 13 14 15 16 17 18 F T F F T T 19 20 21 22 23 24 F T F F T F 25 26 27 28 29 30 T T T F F T 31 32 33 34 F T T F 9-6 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition MULTIPLE CHOICE 35 Which of the following is not considered a capital budgeting project? A Purchase of a new packaging machine B Purchase of land on which to build a new factory C Purchase of a new delivery truck to replace an old truck D Purchase of inventory to be sold in the future 36 Capital expenditure decisions A are useful for estimating inventory acquisition costs B always involve the acquisition of long-lived assets C consist of a final list of approved projects D All of these answer choices are correct 37 Which of the following is not a component of a time value of money calculation? A The amount of cash to be received B The time until the cash will be received C The opportunity costs of the alternative actions D The required rate of return 38 The basic concept involved in time value of money calculations is that A it is better to receive a dollar today than to receive a dollar in the future B incremental revenues must exceed incremental costs C you get what you measure D revenue must be earned in order for net income to be generated 39 Present value techniques A determine the effects of time value of money on future net income that will be generated B are a way of converting future dollars into their equivalent current dollars C provide more conservative results than similar time value of money computations D treat a dollar received today to be worth the value of a dollar to be received a year from today 40 Which of the following pairs of techniques use the time value of money concept? A Payback period method and the internal rate of return method B Internal rate of return method and the accounting rate of return method C Accounting rate of return method and the payback period method D Internal rate of return method and the net present value method 41 Your required rate of return is greater than zero How much is a payment of $3,000 to be received a year from today worth? A Less than $3,000 today B Exactly $3,000 today C More than $3,000 today D Not enough information is provided to determine the answer Chapter Capital Budgeting Decisions 9-7 42 Which of the following would most likely be the present value of a 4-year annuity of $2,000 per year, assuming a positive discount rate? A $8,000 B $7,000 C $9,500 D $2,000 43 Assuming a 6% rate of return, how does the present value of an amount to be received two years from today compare to the present value of the same amount to be received three years from today? A The present value of the amount to be received in two years is greater than the present value of amount to be received three years from today B The present value of the amount to be received in two years is lesser than the present value of amount to be received three years from today C The present values of the two amounts are equal D It is impossible to tell unless the actual amount to be received is known 44 Suppose you face the prospect of receiving $800 per year for the next five years and a $200 payment at the end of six years How much is this prospect worth today if the required rate of return is 9%? A $4,200 B $3,112 C $3,242 D $3,231 45 In which of the following situations will an annuity table be useful? I Calculating the net present value of an investment with equal cash flows for the first nine years, but a different flow in year 10 II Calculating the internal rate of return of an investment with unequal cash flows each year III Calculating the net present value of an investment with an equal cash flow in years one through four, and a different equal cash flow in years through 10 A I, II, and III B II and III C I and III D I and II 46 What is the present value factor for a $4,000 cash outflow that is made today? A 0.00 B Some value greater than 1.00 C 1.00 D It depends on the rate of return that is required 47 If the time value of money techniques are used correctly, the present value of cash flows far in the future will be A lesser than the present value of the same amount of cash flows in the present B greater than the present value of the same amount of cash flows in the present C same as the future value of the same amount of cash flows in the present D greater than the future value of the same amount of cash flows in the present 9-8 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 48 An annuity is A the time period in which the cash flows paid out for an investment will be recovered B a series of equal payments C necessary in order to calculate the net present value D used to calculate depreciation in order to provide a tax shield 49 If a 14% rate of return can be achieved, how much will need to be invested today in order to receive $12,000 at the end of years plus $10,000 at the end of years? Round to the nearest whole number A $33,053 B $5,194 C $11,426 D $13,294 50 To achieve exactly a 13% rate of return, how much would need to be invested today in an investment that returns $12,000 at the end of years and $10,000 at the end of years? Round to the nearest whole number A $8,239 B $13,745 C $12,862 D $60,920 51 Which of the following is not one of the steps in the net present value method? A Identify the amount and timing of the cash flows B Discount the cash flows C Calculate the number of years required to recover the initial investment D Compare the discounted net cash flows to zero 52 What is the sum of the present values of all cash flows (inflows and outflows) called? A Cost of capital B Internal rate of return C Net present value D Required rate of return 53 Projects A and B both have an initial outflow of $100,000 Project A will return a cash flow of $30,000 each year for the next years Project B will return $40,000 in year 1, $30,000 in year 2, $30,000 in year 3, $30,000 in year 4, and $20,000 in year Which project will have the higher net present value? A Project A B Project B C The answer cannot be determined without knowing the required rate of return D The answer cannot be determined without knowing the initial investment 54 Projects with a negative net present value will always have a(n) A payback period longer than the useful life of the investment B internal rate of return that is less than the required rate of return C accounting rate of return that is negative D series of cash outflows that is greater than the initial cost of the project Chapter Capital Budgeting Decisions 9-9 55 Projects with a negative net present value will always have a(n) A payback period shorter than the life of the project B accounting rate of return that is greater than zero C an internal rate of return greater than the cost of capital D None of these answer choices are correct 56 The required rate of return used to calculate an investment’s net present value is related to the firm’s A contribution margin B cost of capital C depreciation methods D fixed costs 57 Maude Company’s required rate of return on capital budgeting projects is 9% The company is considering an investment that would yield a cash flow of $12,000 per year for five years Ignoring taxes, what is the most that the company will be willing to invest in this project? A $46,676 B $38,994 C $60,000 D $55,046 58 An investment that costs $50,000 will return $15,000 operating cash flows per year for five years Determine the net present value of the investment if the required rate of return is 14 percent Should the investment be undertaken? A Yes, the profit is $25,000 B No, the accounting return is less than 14% C No, the net present value is negative at $11,045 D Yes, the net present value is positive at $1,496.50 59 Santo Automotive is considering producing a new automobile product, No Text, which disengages the ability to text while driving Marketing data indicate that the company will be able to sell 40,000 units per year at $16 each The product will be produced in a section of an existing factory that is currently not in use To produce No Text, Santo must buy a machine that costs $820,000 The machine has an expected life of five years and will have an ending residual value of $50,000 Santo will depreciate the machine over five years using the straight-line method In addition to the cost of the machine, the company will incur incremental annual manufacturing costs of $390,000 The income tax rate is 30% and the company’s required rate of return is 10% How much is net operating cash flow each year? A $67,200 B $221,200 C $175,000 D $250,000 9-10 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 60 Santo Automotive is considering producing a new automobile product, No Text, which disengages the ability to text while driving Marketing data indicate that the company will be able to sell 39,000 units per year at $16 each The product will be produced in a section of an existing factory that is currently not in use To produce No Text, Santo must buy a machine that costs $820,000 The machine has an expected life of five years and will have an ending residual value of $50,000 Santo expects to generate net income of $56,000 per year The income tax rate is 30% and the company’s required rate of return is 10% How much is the net present value? A ($23,932) B $7,113 C $52,498 D None of these answer choices are correct 61 What does the cost of capital represent? A The weighted average of fixed and variable costs B The weighted average of the incremental cash inflows and outflows C The weighted average of debt and equity financing D The weighted average of the cost of borrowing on a long and short-term basis 62 The return demanded by shareholders for the risk that they bear in supplying capital to the firm is A less for riskier firms B only considered when a corporation has no debt C measured by the internal rate of return D called the cost of equity 63 Since present value analysis is concerned with cash flows, which of the following is not true? A Depreciation is always an incremental cash inflow B Revenues are inflows in the period when the cash is received C Expenses are outflows in the period when they are paid D The salvage value of equipment is considered in the analysis 64 Natchez, Inc is considering the purchase of a new machine costing $200,000 The company will incur $5,000 per year in operating expenses but it will allow the company to earn an additional $100,000 per year in revenues Natchez expects the machine to provide future benefits for years and salvage value at the end of the 3-year period to be $10,000 The company uses straight-line depreciation method The income tax rate is 30% If the required rate of return is 10%, how much is the net present value of this project? A $20,143 B $12,629 C $43,769 D None of these answer choices are correct 65 Discount Dollar Store is considering the purchase of a new machine costing $220,000 This machine is estimated to generate an additional $88,000 per year in revenues The machine will be depreciated using the straight-line method over its 4-year life There is no expected salvage value at the end of its life Expected annual net cash flows are $67,240 and expected annual net income from the new machine total $12,240 The required rate of return is 8% and the income tax rate is 28% How much is the net present value of this project? A $2,706 B ($179,460) C $71,465 D $153,390 9-30 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 159 Brown Shoe Company is considering investing in one of two machines that cut leather for shoes Machine A costs $55,000 and is expected to save the company $13,000 annual operating cash flows for six years Machine B costs $89,000 and is expected to save the company $22,000 annual cash flows for six years Determine the net present value for each machine and decide which machine should be purchased if the required rate of return is 10 percent Answer Machine A Cost of machine Annual savings Net present value Cash Flow ($55,000) 13,000 PV Factor 1.0000 4.3553 PV Amounts ($55,000) 56,619 $ 1,619 Machine B Cost of machine Annual savings Net present value Cash Flow ($89,000) 22,000 PV Factor 1.0000 4.3553 PV Amounts ($89,000) 95,817 $ 6,817 Machine B should be purchased since it generates a higher return than the required rate of return 160 Sports & More is considering the development of an e-commerce business The company estimates that development will require an initial outlay of $350,000 Other cash flows are estimated as follows: Year Year Year Year ($60,000) $140,000 $210,000 $130,000 Assuming the company limits its analysis to four years due to economic uncertainties, determine the net present value of the e-commerce business Should the company develop the e-commerce business if the required rate of return is percent? Answer The e-commerce business should not be developed as the investment’s return will generate less than the 6% required rate of return Cash Flow ($350,000) (60,000) 140,000 210,000 130,000 Present value at 6% 161 Factor 1.0000 0.9434 0.8900 0.8396 0.7921 Total ($350,000) (56,604) 124,600 176,316 102,973 ($ 2,715) An investment of $185,575 is expected to generate returns of $65,000 per year for each of the next four years What is the investment’s internal rate of return? Answer $185,575 ÷ $65,000 = 2.855 at years = 15% Chapter Capital Budgeting Decisions 162 9-31 A project will require an initial investment of $620,000 and will return $165,000 of operating cash flows each year for five years The required rate of return is 9% How much is the project’s net present value? Based on this analysis, should the company proceed with the project? Answer ($165,000 × 3.8897) – $620,000 = $21,801 Yes, since the net present value is greater than zero, the company should proceed with the project 163 The accountant of Fixer Depot prepared the following annual analysis of a $65,000 investment in equipment that has a life of years: Cost savings Taxes on savings Depreciation tax shield Operating cash flows $ 4,000 (1,200) 19,500 22,300 After reviewing the calculation, the operations manager made the following observation: “You’ve assumed that there won’t be inflation I think it is reasonable to assume that labor and costs other than depreciation will increase by 3% per year Why don’t you redo the analysis with that assumption?” The accountant replied: “Inflation is built into our 8% required rate of return.” a b Answer a What does the accountant mean by “inflation is built into our 8% required rate of return?” Redo the analysis assuming an inflation rate of 3% Should the company make the investment in the equipment? The required rate of return includes an allowance for expected inflation In periods where expected inflation is high, the required rate of return will be high, and firms will demand a high return on their investments b Cost savings Taxes on savings Depreciation tax shield Operating cash flows Year Initial Investment Year $4,000 (1,200) 19,500 $22,300 Cash Flows ($65,000) 22,300 22,384 22,471 22,560 Year $4,120 (1,236) 19,500 $22,384 Factor 1.0000 0.9259 0.8573 0.7938 0.7350 NPV Year $4,244 (1,273) 19,500 $22,471 Year $4,371 (1,311) 19,500 $22,560 NPV ($65,000) 20,648 19,190 17,837 16,581 $ 9,256 Since the investment is expected to generate a higher return than the required rate of return, the company should invest in the equipment 9-32 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition Chapter Capital Budgeting Decisions 164 9-33 Saren Millworks is contemplating the purchase of a new casting oven The oven will cost $40,000 but will generate additional revenue of $30,000 per year for ten years Additional costs, other than depreciation, will equal $15,000 per year The oven has an expected life of ten years, at which time it will have no residual value Saren uses the straight-line method of depreciation Determine the net present value of the investment if the required rate of return is 14% and the tax rate is 40% Should Saren Millworks make the investment in the boiler? Answer Revenue Costs other than depreciation Depreciation Income before taxes Less taxes at 40% Net income Add depreciation Operating cash flows $30,000 $15,000 4,000 19,000 11,000 4,400 6,600 4,000 $10,600 The oven should be purchased since it generates a higher return than the required rate of return Cash Flows $10,600 (40,000) Net present value 165 Factor 5.2161 1.0000 Total $55,291 (40,000) $15,291 3-D Studios is evaluating a film project The president estimates the film will cost $7,200,000 to produce In its first year, 2014, the film is expected to generate $5,800,000 in net revenue, after which the film will be released to video The video is expected to generate $900,000 in net revenue 2014, $1,200,000 in 2015, and $400,000 in 2016 Amortization of the film cost will be $5,500,000 in 2014 and $1,700,000 in 2015 The company’s tax rate is 30% and it requires an 8% rate of return on its films All outlays to produce the film occur at the beginning of January 2014 How much is the net present value of the film project? Should the company produce the film? Answer Revenue Amortization Income before taxes Income tax expense Net income Add amortization Operating cash flows Year Initial Investment 2014 $6,700,000 (5,500,000) 1,200,000 (360,000) 840,000 5,500,000 $6,340,000 Cash Flows ($7,200,000) 6,340,000 1,350,000 280,000 2015 $1,200,000 (1,700,000) (500,000) 150,000 (350,000) 1,700,000 $1,350,000 2016 $400,000 400,000 (120,000) 280,000 $280,000 Factor NPV 1.0000 ($7,200,000) 0.9259 5,870,206 0.8573 1,157,355 0.7938 222,264 NPV $ 49,825 The company should produce the film since it generates a higher return than the required rate of return 9-34 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 166 Sweet Thing Limo is considering an acquisition of an additional vehicle for its limo chauffeur service The model under consideration will cost $140,000, have a 5-year life, and a $25,000 residual value The company anticipates that the effect on annual net income will be as follows: Revenue Expenses Driver Fuel Maintenance Insurance Depreciation Miscellaneous Income before taxes Income tax expense Net income $138,000 $49,000 9,000 2,000 1,800 23,000 2,000 86,800 51,200 20,480 $ 30,720 The company has a required rate of return of 14% Calculate the net present value of the investment Should the company invest in the new limo? Answer Net income Add depreciation Annual cash flows Cash Flow $ 53,720 25,000 (140,000) Net present value $30,720 23,000 $53,720 PV Factor at 14% 3.4331 0.5194 1.0000 Total $184,426 12,985 (140,000) $ 57,411 The company should invest in the new limo since it is expected to generate a higher return than the required rate of return 167 Recording Tunes is planning a $120,000 investment in microphones for its recording business The microphones has an expected 4-year life with a salvage value of $12,000 The company uses the straight-line method of depreciation, has an income tax rate of 30%, and a required rate of return of 9% How much is the present value of the tax savings related to depreciation of the equipment? Answer Annual depreciation: ($120,000 – $12,000) ÷ years = $27,000 Annual tax savings: $27,000 30% = $8,100 Present value: $8,100 3.2397 = $26,242 168 Chap Creations reported revenues of $540,000 and expenses of $480,000 last year, which included depreciation expense totaling $62,000 The company pays income taxes at a 35% rate How much is the company’s annual operating cash flows? Answer $540,000 – $480,000 – [35% × ($540,000 – $480,000)] + $62,000 = $101,000 Chapter Capital Budgeting Decisions 169 9-35 U-Vision is deciding whether to buy a machine that packages products so that it can reduce labor costs The machine has an initial cost of $580,000 The company estimates the new machine will speed up production and be able to generate annual revenues totaling $716,000 up from the current revenue of $660,000 U-Vision estimates the machine can be sold at the end of its estimated 8-year life for $60,000 Labor saved per year as a result of acquiring the machine is expected to be $26,000 Additional maintenance and operating expenses as a result of the pending acquisition are expected to be $12,000 per year U-Vision’s required rate of return is 8% and its income tax rate is 35% Calculate annual operating cash flows for U-Vision Answer Revenue ($716,000 – $660,000) Labor savings Maintenance and operating costs Depreciation expense ($580,000 – $60,000) ÷ Income before taxes Income taxes expense Net income Add depreciation Annual cash flows 170 $56,000 26,000 (12,000) (65,000) 5,000 (1,750) 3,250 65,000 $68,250 Deli Pizza is considering an investment that will generate cash revenues of $91,000 per year for years, and have cash expenses of $80,000 per year for years The cost of the asset is $60,000, and it will be depreciated using straight-line depreciation over its 8-year life The company pays income taxes at a rate of 30% The required rate of return is 6% a Prepare a schedule showing the annual cash flows associated with this asset b Compute the net present value of this investment Answer a Cash revenues Cash expenses Depreciation expense Income before taxes Income tax expense Net income Add depreciation Annual cash flows $91,000 $80,000 7,500 87,500 3,500 1,050 2,450 7,500 $9,950 b Year Initial investment Years 1-8 Cash Flows ($60,000) 9,950 Factor 1.0000 6.2098 NPV NPV ($60,000) 61,788 $ 1,788 9-36 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 171 Harry’s Seafood is considering the addition of a fish hatchery Construction of the facility is estimated to cost $1,100,000 and will be depreciated over 10 years using the straight-line method The hatchery is expected to have no estimated residual value Harry’s Seafood has a required rate of return of 12% Incremental net income related to each year of the investment is as follows: Revenue Expenses: Material cost Labor Depreciation Other Income before taxes Income tax expense at 40% Net income a b c d Answer a $450,000 $ 60,000 100,000 110,000 10,000 280,000 170,000 68,000 $102,000 Determine the net present value of the investment Should Harry’s Seafood invest in the hatchery? Calculate the internal rate of return of the investment to the nearest ½ percent Calculate the payback period of the investment Calculate the accounting rate of return The company should invest in the hatchery because the investment will generate a return greater than the company’s required minimum of 12% Net income $102,000 Add depreciation 110,000 Annual cash flow $212,000 Cash Flow $212,000 (1,100,000) Factor 5.6502 1.0000 Total $1,197,842 (1,100,000) $ 97,842 b PV of annuity factor = $1,100,000 ÷ 212,000 = 5.189 PVA factor of 5.189 implies an internal rate of return of approximately 14.5% c $1,100,000 ÷ $212,000 = 5.189 years d $102,000 ÷ [($1,100,000 – $0) ÷ 2] = 18.55% Chapter Capital Budgeting Decisions 172 9-37 A project will require an initial investment of $580,000 and is expected to generate the following cash flows: Year $ 60,000 Year 250,000 Year 250,000 Year 200,000 Year 100,000 a b Answer a b What is the project’s payback period? If the required rate of return is 20% and taxes are ignored, what is the project’s net present value? $60,000 + $250,000 + $250,000 = $560,000 Portion of year 4: $20,000 ÷ $200,000 = 0.10 Payback period = 3.1 years ($580,000) × 1.000 $60,000 × 0.8333 $250,000 × 0.6944 $250,000 × 0.5787 $200,000 × 0.4823 $100,000 × 0.4019 Net present value ($580,000) 49,998 173,600 144,675 96,460 40,190 ($75,077) CHALLENGE EXERCISES 173 Tow’em Away is considering the purchase of a tow truck with a cost of $54,400 to be acquired on January 1, 2014 Tow’em estimates the truck can be sold for $10,400 at the end of its 5-year estimated life Tow’em has a cost of capital of 6% and a required rate of return of 8% This purchase would allow Tow’em to make 2,200 more tows per year Annual cash basis net income relating to the tow truck is estimated at $20,200 Income taxes are 32% a Calculate the depreciation tax shield for 2014 b What is the nature of the depreciation tax shield? Why is the depreciation tax shield a component of analyzing investment decisions? c Calculate Tow’em’s annual operating cash flows relating to the tow truck purchase Answer a (($54,400 $10,400) ữ 5) ì 32% = $2,816 b The tax shield represents the amount of cash saved from depreciation Depreciation expense lowers income tax expense to be paid, even though no cash flow occurs for the depreciation amount c $20,200 + $2,816 = $23,016 9-38 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 174 For each capital budgeting project below, indicate whether management should Accept or Reject by placing an A or R, respectively, in the space provided next to each project Select the best reason for the respective action from the list of reasons by printing a legible uppercase letter in the space provided Possible Reasons A The investment’s return is less than the cost of capital B The investment earns a return rate equal to the company’s hurdle rate C The cash outflows equal the cash inflows D The investment’s internal rate of return is greater than the required rate of return E The investment generates a return on profit less than the required rate of return G The investment generates a cash return greater than the required rate of return H The investment generates a cash return less than the required rate of return J The hurdle rate is greater than the required rate of return K The hurdle rate is less than the required rate of return M The total cash paid out is less than the total cash received Capital budgeting projects Accept (A) or Reject (R)? Reason Accept (A) or Reject (R)? Reason R C and H A B A D R H JT Corp has a cost of capital at 6.2% and a required rate of return at 7.9% The company evaluated an investment and determined the IRR was zero Save Company evaluated a potential investment and determined the NPV to be zero Save Company’s required rate of return is 9.1% and its cost of capital is 6.4% An investment project has an internal rate of return of 10.8% The initial outlay for the investment is $91,000 The hurdle rate is 10.2% An investment project has an NPV of ($5,200) The hurdle rate is 10% Answer Capital budgeting projects The zero IRR indicates the investment will generate a return of zero cents of cash per dollar of assets invested An NPV of zero means the investment’s present value of cash inflows equal present value of cash outflows The investment’s IRR is higher than the required rate of return The investment earns a cash return that is less than the required rate of return of 10% Chapter Capital Budgeting Decisions 175 9-39 A proposed acquisition of a forklift on January 1, 2014 will cost $86,000, and have an estimated salvage value at the end of its estimated 5-year estimated life of $21,000 Net income Operating cash flows 2014 $ 7,300 20,300 2015 $ 8,700 21,700 2016 $ 8,000 21,000 2017 $ 5,100 18,100 2018 $ 1,400 14,400 The company’s required rate of return is 7% and its cost of capital is 6% The income tax rate is 32% a b c d Determine the payback period of the proposed acquisition Interpret the meaning of your answer in part A Suppose that the amounts for 2018 are a loss of $9,000 and cash flows of $4,000 instead of the amounts given How will the payback period differ? What are the criticisms against the payback period? Answer a Cost to recover 2014 2015 2016 2017 Amount to recover during 2018 Portion of 2018: $4,900 ÷ $14,400 Payback period = 4.34 years $ 86,000 (20,300) (21,700) (21,000) (18,100) $ 4,900 0.3403 b In 4.34 years, the company will have recovered all of its cash investment it used to purchase the forklift c The $4,900 not recovered as of the end of 2017 will be recovered in two parts: To be recovered through 2018 cash flows $4,000 To be recovered through salvage value 900 The payback period will be years d The payback period does not consider the time value of money, as money received today is worth more than amounts received in the future In addition, it does not consider all of the cash flows that occur after the end of the payback period It also does not consider the time value of the cash flows within the payback period 9-40 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 176 Markly, Inc is planning a new capital investment The company has a 7.8% required rate of return and a 6.3% cost of capital Markly currently has a return of 8% on its other investments The proposed new investment has equal annual cash inflows expected Management calculated the payback period using the computation of the investment and annual cash flows, and the IRR for investments that are displayed below Each investment has a 7-year expected useful life and no salvage value Project A2 Project B4 Project C6 Project D7 Project E9 Project F8 Project G3 a b c Answer a Payback Period 5.2 6.9 6.0 5.8 4.2 5.0 7.3 IRR 8.5% 3.1% 11.4% 5.4% 10.1% 7.9% 7.8% Investment Cost $125,000 62,000 78,000 56,000 110,000 60,000 71,000 Identify which project(s) is/are unacceptable and briefly state the conceptual justification as to why each of your choices is unacceptable Markly has $334,000 available to spend List the project(s) in which Markly should invest, in the order the investments should be undertaken Will Markly be motivated to invest in all of the projects you selected in Part b if Markly is evaluated using return on investment? Project B4 and D7 ==> The return of B4 and of D7 are less than the required rate of return of 7.8% Project G3 ==> The cash investment will never be recovered b C6, E9, A2 Remaining cash: $334,000 – $78,000 – $110,000 – $125,000 = $21,000 There is not enough cash to acquire F8 c Markly would not be motivated to invest in project F8 because its return is less than Markly’s current return of 8% Chapter Capital Budgeting Decisions 177 9-41 JayTree, Inc is considering a purchase of a patent with a cost of $47,000 and an estimated revenue producing life for JayTree of years JayTree has a required rate of return is 8% and a cost of capital of 7% The patent is expected to generate the following amounts of annual income and cash flows: Net income Operating cash flows a b c Year $ 5,300 17,050 Year $ 6,700 18,450 Year $ 6,500 18,250 Year $ 3,100 14,850 Calculate the NPV of the investment What does the NPV calculation do, i.e., what is the nature of the NPV amount? If the required rate of return increases, will the NPV increase or decrease? Explain why Answer a Year Initial investment Cash Flows ($47,000) 17,050 18,450 18,250 14,850 Factor 1.0000 0.9259 0.8573 0.7938 0.7350 NPV NPV ($47,000) 15,787 15,817 14,487 10,915 $10,006 b Interest is removed from the future cash flows to reflect the cost of money over time The NPV is the amount of the cash flows that could be invested at the required rate of return to generate the future cash amounts the investment is expected to generate c If the required rate of return increases, more interest is removed from the future cash flows causing the NPV to be smaller 9-42 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition SHORT-ANSWER ESSAYS 178 Division managers at Swearingen Investments are evaluated and rewarded based on returns on investments it accepts In the current year, Bill Christ, the president of the commercial products division, has an ROI target of 12% If the division has an ROI of 12% or greater, Christ will receive 250,000 options on Swearingen stock in addition to a base salary of $500,000 The Commercial Products Division is considering a major investment in product development, which has a net present value of $25,000,000 However, the investment will have a negative effect on reported profit over the next two years, after which the investment will begin to have a significant positive effect on firm profitability for the next eight years Suppose Christ currently holds stock in Swearingen Investments with a market value of $1,250,000 and has options on 500,000 shares (awarded in previous years) Is this likely to aggravate or mitigate the conflict? Answer It will mitigate the problem If Christ owns a great deal of stock and/or options, he will have a strong incentive to work to increase the firm’s stock price Stock prices are likely to be positively impacted when the firm takes on projects with positive net present values 179 What are capital budgeting decisions? Answer Investment decisions involving the acquisition of long-lived assets that require a company or organization to expend significant amounts of capital (company funds) are considered capital budgeting decisions 180 What is meant by “the time value of money” concept? Answer The time value of money concept recognizes that it is better to receive a dollar today than it is to receive a dollar at any time in the future The dollar that is received today can be invested so that it is worth more than a dollar to be received in the future 181 What is the most significant difference between the net present value and internal rate of return methods and the payback period and accounting rate of return methods? Answer The net present value and internal rate of return methods use the time value of money concept and are therefore superior to the payback period and accounting rate of return methods, which ignore the time value of money Chapter Capital Budgeting Decisions 182 9-43 How does a firm determine its required rate of return? Answer Management must estimate the firm’s required rate of return, remembering that riskier investments demand higher rates of return Under certain conditions, the required rate of return should be equal to the cost of capital for the firm The required rate of return is based on the firm’s cost of capital, the weighted average of the firm’s cost of debt and cost of equity 183 What are “soft” benefits? What are the effects of ignoring “soft” benefits in capital budgeting decisions? Answer Soft benefits are the benefits that are difficult to quantify Soft benefits include a number of benefits such as reduced number of customer complaints, improved customer satisfaction, improved customer retention, early identification of market trends, improved reputation of firm, etc Often, soft benefits are ignored when capital budgeting decisions are made as it is difficult and expensive to quantify them This leads firms or companies to pass up investments that are of strategic importance, especially investments in advanced manufacturing technology 184 Explain the importance of depreciation in a capital budgeting analysis Answer Capital budgeting focuses on cash flows., Although depreciation reduces taxable income and thereby taxes paid, it is not a cash outflow This reduction in taxes is referred to as the depreciation tax shield Since it represents a reduction in cash outflows, it should be included in the analysis If there are no taxes present, depreciation is not relevant 185 Why is it important to adjust future cash flows for inflation? What is the impact of failing to so? Answer The cost of capital includes a factor for inflation to the extent that the rates used reflect market rates If the cash flows are not inflated, investment returns will be understated and the required rate of return will be relatively high, resulting in profitable opportunities being forgone 186 The payback period method of evaluating capital budgeting alternatives has two significant drawbacks What are they? Answer The payback period ignores any cash flows that occur after the end of the payback period It also does not make use of the time value of money concept 9-44 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 187 Why is the impact of accepting a sound capital project often negative in terms of short-term profits? Answer The inflows are often lower in the initial stages of a project, and there may be substantial start-up expenses Additionally, accelerated depreciation can cause low initial net income amounts ... exceeds the cost by $26,000 9-14 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 83 An investment that costs $120,000 is estimated to reduce cash operating costs by $40,000 per... $74,600 9-16 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition 94 Testor Labs determined it would recover its investment of a new laboratory at 12.5 years What did Testor Labs... 24 F T F F T F 25 26 27 28 29 30 T T T F F T 31 32 33 34 F T T F 9-6 Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition MULTIPLE CHOICE 35 Which of the following is not considered