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Chapter 14 Capital Budgeting Decisions True/False F Medium The present value of a given sum to be received in five years will be exactly twice as great as the present value of an equal sum to be received in ten years F Medium An increase in the discount rate will result in an increase in the present value of a given cash flow T Easy The present value of a cash flow decreases as it moves further into the future F Medium When the net present value method is used, the internal rate of return is the discount rate used to compute the net present value of a project F Medium If net present value is negative, then interpolation is needed in order to make a proposed investment acceptable T Medium The net present value method assumes that cash flows from a project are immediately reinvested at a rate of return equal to the discount rate F Easy When using internal rate of return to evaluate investment projects, if the internal rate of return is less than the required rate of return, the project should be accepted T Easy The internal rate of return for a project is the discount rate that makes the net present value of the project equal to zero T Medium In comparing two investment alternatives, the difference between the net present values of the two alternatives obtained using the total cost approach will be the same as the net present value obtained using the incremental cost approach 10 T Easy The payback period is the length of time it takes for an investment to recoup its own initial cost out of the cash receipts it generates Managerial Accounting, 9/e 11 F Medium Projects with shorter payback periods are always more profitable than projects with longer payback periods 12 F Easy The payback method of making capital budgeting decisions gives full consideration to the time value of money 13 F Easy If new equipment is replacing old equipment, any salvage received from sale of the old equipment should not be considered in computing the payback period of the new equipment 14 F Easy One strength of the simple rate of return method is that it takes into account the time value of money in computing the return on an investment project 15 T Easy The preference rule for ranking projects by the profitability index is: the higher the profitability index, the more desirable the project Multiple Choice 16 C Medium An increase in the discount rate: a. will increase the present value of future cash flows b. will have no effect on net present value c. will reduce the present value of future cash flows d. is one method of compensating for reduced risk 17 B Medium Suppose an investment has cash inflows of R dollars at the end of each year for two years. The present value of these cash inflows using a 12% discount rate will be: a. greater than under a 10% discount rate b. less than under a 10% discount rate c. equal to that under a 10% discount rate d. sometimes greater than under a 10% discount rate and sometimes less; it depends on R 18 B Medium CPA adapted The net present value and internal rate of return methods of capital budgeting are superior to the payback method in that they: a. are easier to implement b. consider the time value of money c. require less input d. reflect the effects of depreciation and income taxes Managerial Accounting, 9/e 19 C Medium CPA adapted How are the following used in the calculation of the net present value of a proposed project? Ignore income tax considerations 20 D Medium CPA adapted The net present value method takes into account: 21 C Easy CMA adapted The net present value method of capital budgeting assumes that cash flows are reinvested at: a. the internal rate of return on the project b. the rate of return on the company's debt c. the discount rate used in the analysis d. a zero rate of return 22 C Medium Some investment projects require that a company expand its working capital to service the greater volume of business that will be generated. Under the net present value method, the investment of working capital should be treated as: a. an initial cash outflow for which no discounting is necessary b. a future cash inflow for which discounting is necessary c. both an initial cash outflow for which no discounting is necessary and a future cash inflow for which discounting is necessary d. irrelevant to the net present value analysis 23 A Medium CMA adapted (Ignore income taxes in this problem.) How is depreciation handled by the following capital budgeting techniques? Depreciation expense Salvage value a. Include Include b. Include Exclude c. Exclude Include d. Exclude Exclude Cash Flow Over Time Value Life of Project of Money a. No Yes b. No No c. Yes No d. Yes Yes Internal Simple Rate of Return Rate of Return Payback a. Excluded Included Excluded b. Included Excluded Included c. Excluded Excluded Included d. Included Included Excluded Managerial Accounting, 9/e 24 B Easy CPA adapted Which of the following capital budgeting techniques consider(s) cash flow over the entire life of the project? 25 C Medium CMA adapted A weakness of the internal rate of return method for screening investment projects is that it: a. does not consider the time value of money b. implicitly assumes that the company is able to reinvest cash flows from the project at the company's discount rate c. implicitly assumes that the company is able to reinvest cash flows from the project at the internal rate of return d. does not take into account all of the cash flows from a project 26 A Medium If the net present value of a project is zero based on a discount rate of sixteen percent, then the timeadjusted rate of return: a. is equal to sixteen percent b. is less than sixteen percent c. is greater than sixteen percent d. cannot be determined from the information given 27 A Easy CMA adapted The payback method measures: a. how quickly investment dollars may be recovered b. the cash flow from an investment c. the economic life of an investment d. the profitability of an investment 28 B Medium An investment project that requires a present investment of $210,000 will have cash inflows of "R" dollars each year for the next five years. The project will terminate in five years. Consider the following statements (ignore income tax considerations): Internal rate of return Payback a. Yes Yes b. Yes No c. No Yes d. No No I. If "R" is less than $42,000, the payback period exceeds the life of the project II. If "R" is greater than $42,000, the payback period exceeds the life of the project III. If "R" equals $42,000, the payback period equals the life of the project Which statement(s) is (are) true? a. Only I and II b. Only I and III c. Only II and III d. I, II, and III Managerial Accounting, 9/e 29 A Easy CMA adapted Which one of the following statements about the payback method of capital budgeting is correct? a. The payback method does not consider the time value of money b. The payback method considers cash flows after the payback has been reached c. The payback method uses discounted cash flow techniques d. The payback method will lead to the same decision as other methods of capital budgeting 30 B Medium The evaluation of an investment having uneven cash flows using the payback method: a. cannot be done b. can be done only by matching cash inflows and investment outflows on a yearbyyear basis c. will product essentially the same results as those obtained through the use of discounted cash flow techniques d. requires the use of a sophisticated calculator or computer software 31 B Medium CMA adapted The capital budgeting method that divides a project's annual incremental net income by the initial investment is the: a. internal rate of return method b. the simple ( or accounting) rate of return method c. the payback method d. the net present value method 32 B Medium CMA adapted When determining a net present value in an inflationary environment, adjustments should be made to: a. decrease the discount rate only b. increase the estimated cash flows and increase the discount rate c. increase the estimated cash flows only d. increase the estimated cash flows and decrease the discount rate 33 B Hard CPA adapted (Ignore income taxes in this problem.) Kipling Company has invested in a project that has an eightyear life. It is expected that the annual cash inflow from the project will be $20,000. Assuming that the project has a internal rate of return of 12%, how much was the initial investment in the project? a. $160,000 b. $99,360 c. $80,800 d. $64,640 Managerial Accounting, 9/e 34 D Medium (Ignore income taxes in this problem.) White Company's required rate of return on capital budgeting projects is 12%. The company is considering an investment opportunity which would yield a cash flow of $10,000 in five years. What is the most that the company should be willing to invest in this project? a. $36,050 b. $2,774 c. $17,637 d. $5,670 35 C Easy (Ignore income taxes in this problem.) In order to receive $12,000 at the end of three years and $10,000 at the end of five years, how much must be invested now if you can earn 14% rate of return? a. $12,978 b. $8,100 c. $13,290 d. $32,054 36 C Hard (Ignore income taxes in this problem.) Sue Falls is the president of Sports, Inc. She is considering buying a new machine that would cost $14,125. Sue has determined that the new machine promises a internal rate of return of 12%, but Sue has misplaced the paper which tells the annual cost savings promised by the new machine. She does remember that the machine has a projected life of 10 years. Based on these data, the annual cost savings are: a. it is impossible to determine from the data given b. $1,412.50 c. $2,500.00 d. $1,695.00 37 C Hard (Ignore income taxes in this problem.) The following information is available on a new piece of equipment: Cost of the equipment $21,720 Annual cash inflows $5,000 Internal rate of return 16% Required rate of return 10% The life of the equipment is approximately: a. 6 years b. 4.3 years c. 8 years d. it is impossible to determine from the data given 10 Managerial Accounting, 9/e 38 C Hard CPA adapted (Ignore income taxes in this problem.) A planned factory expansion project has an estimated initial cost of $800,000. Using a discount rate of 20%, the present value of future cost savings from the expansion is $843,000. To yield exactly a 20% internal rate of return, the actual investment cost cannot exceed the $800,000 estimate by more than: a. $160,000 b. $20,000 c. $43,000 d. $1,075 39 D Hard CPA adapted (Ignore income taxes in this problem.) Hilltop Company invested $100,000 in a twoyear project. The cash flow was $40,000 for the first year. Assuming that the internal rate of return was exactly 12%, what was the cash flow for the second year of the project? a. $51,247 b. $60,000 c. $64,284 d. $80,652 40 C Hard (Ignore income taxes in this problem.) Joe Flubup is the president of Flubup, Inc. He is considering buying a new machine that would cost $25,470. Joe has determined that the new machine promises a internal rate of return of 14%, but Joe has misplaced the paper which tells the annual cost savings promised by the new machine. He does remember that the machine has a projected life of 12 years. Based on these data, the annual cost savings are: a. impossible to determine from the data given b. $2,122.50 c. $4,500.00 d. $4,650.00 41 B Hard (Ignore income taxes in this problem.) The Baker Company purchased a piece of equipment with the following expected results: Useful life 7 years Yearly net cash inflow $50,000 Salvage value . 0 Internal rate of return . 20% Discount rate . 16% The initial cost of the equipment was: a. $300,100 b. $180,250 c. $190,600 d. Cannot be determined from the information given Managerial Accounting, 9/e 11 42 B Hard (Ignore income taxes in this problem.) Highpoint, Inc., is considering investing in automated equipment with a tenyear useful life. Managers at Highpoint have estimated the cash flows associated with the tangible costs and benefits of automation, but have been unable to estimate the cash flows associated with the intangible benefits. Using the company's 10% discount rate, the net present value of the cash flows associated with just the tangible costs and benefits is a negative $184,350. How large would the annual net cash inflows from the intangible benefits have to be to make this a financially acceptable investment? a. $18,435 b. $30,000 c. $35,000 d. $37,236 43 B Hard (Ignore income taxes in this problem.) Given the following data: Present investment required $12,000 Net present value $ 430 Annual cost savings $ ? Discount rate 12% Life of the project 10 years Based on the data given, the annual cost savings would be: a. $1,630.00 b. $2,200.00 c. $2,123.89 d. $2,553.89 44 A Medium (Ignore income taxes in this problem.) The following data pertain to an investment in equipment: Investment in the project $10,000 Net annual cash inflows 2,400 Working capital required 5,000 Salvage value of the equipment 1,000 Life of the project 8 years At the completion of the project, the working capital will be released for use elsewhere. Compute the net present value of the project, using a discount rate of 10%: a. $606 b. $8,271 c. ($1,729) d. $1,729 12 Managerial Accounting, 9/e 45 A Medium (Ignore income taxes in this problem.) A piece of equipment has a cost of $20,000. The equipment will provide cost savings of $3,500 each year for ten years, after which time it will have a salvage value of $2,500. If the company's discount rate is 12%, the equipment's net present value is: a. $580 b. ($225) c. $17,500 d. $2,275 46 D Medium (Ignore income taxes in this problem.) Parks Company is considering an investment proposal in which a working capital investment of $10,000 would be required. The investment would provide cash inflows of $2,000 per year for six years. The working capital would be released for use elsewhere when the project is completed. If the company's discount rate is 10%, the investment's net present value is: a. $1,290 b. ($1,290) c. $2,000 d. $4,350 47 A Medium (Ignore income taxes in this problem.) The following data pertain to an investment proposal: Investment in the project (equipment) $14,000 Net annual cash inflows promised . 2,800 Working capital required . 5,000 Salvage value of the equipment . 1,000 Life of the project 10 years The working capital would be released for use elsewhere when the project is completed. What is the net present value of the project, using a discount rate of 8%? a. $2,566 b. ($251) c. $251 d. $5,251 Managerial Accounting, 9/e 13 48 C Medium (Ignore income taxes in this problem.) Boston Company is contemplating the purchase of a new machine on which the following information has been gathered: Cost of the machine . $38,900 Annual cash inflows expected $10,000 Salvage value $ 5,000 Life of the machine . 6 years The company's discount rate is 16%, and the machine will be depreciated using the straightline method. Given these data, the machine has a net present value of: a. $26,100 b. $23,900 c. $0 d. +$26,100 49 B Hard (Ignore income taxes in this problem.) Benz Company is considering the purchase of a machine that costs $100,000 and has a useful life of 18 years. The company's required discount rate is 12%. If the machine's net present value is $5,850, then the annual cash inflows associated with the machine must be (round to the nearest whole dollar): a. $42,413 b. $14,600 c. $13,760 d. it is impossible to determine from the data given 50 C Hard CPA adapted (Ignore income taxes in this problem.) Horn Corporation is considering investing in a fouryear project. Cash inflows from the project are expected to be as follows: Year 1, $2,000; Year 2, $2,200; Year 3, $2,400; Year 4, $2,600. If using a discount rate of 8%, the project has a positive net present value of $500, what was the amount of the original investment? a. $1,411 b. $2,411 c. $7,054 d. $8,054 51 B Medium (Ignore income taxes in this problem.) The Whitton Company uses a discount rate of 16%. The company has an opportunity to buy a machine now for $18,000 that will yield cash inflows of $10,000 per year for each of the next three years. The machine would have no salvage value. The net present value of this machine to the nearest whole dollar is: a. $22,460 b. $4,460 c. $(9,980) d. $12,000 14 Managerial Accounting, 9/e Reference: 148 (Ignore income taxes in this problem.) The Becker Company is interested in buying a piece of equipment that it needs. The following data have been assembled concerning this equipment: Cost of required equipment $250,000 Working capital required $100,000 Annual operating cash inflows $ 80,000 Cash repair at end of 4 years . $ 40,000 Salvage value at end of 6 years $ 90,000 This equipment is expected to have a useful life of 6 years. At the end of the sixth year the working capital would be released for use elsewhere. The company's discount rate is 10% 89 C Easy Refer To: 148 The present value of all future operating cash inflows is closest to: a. $480,000 b. $452,300 c. $348,400 d. $278,700 90 B Easy Refer To: 148 The present value of the net cash flows (all cash inflows less all cash outflows) occurring during year 4 is: a. $40,000 b. $27,320 c. $54,640 d. $42,790 91 D Medium Refer To: 148 The present value of the net cash flows (all cash inflows less all cash outflows) occurring during year 6 is closest to: a. $270,000 b. $195,900 c. $107,200 d. $152,300 Reference: 149 (Ignore income taxes in this problem.) UR Company is considering rebuilding and selling used alternators for automobiles. The company estimates that the net operating cash flows (sales less cash operating expenses) arising from the rebuilding and sale of the used alternators would be as follows (numbers in parentheses indicate an outflow): Years 1 10 $ 90,000 Year 11 (20,000) Year 12 100,000 In addition to the above net operating cash flows, UR Company would purchase production equipment costing $200,000 now to use in the rebuilding of the alternators. The equipment would have a 12year life and a $15,000 salvage value. The company's discount rate is 10% Managerial Accounting, 9/e 25 92 C Medium Refer To: 149 The present value of the net operating cash flows (sales less cash operating expenses) arising from the rebuilding and sale of the alternators (rounded to the nearest dollar) is: a. $582,735 b. $596,735 c. $577,950 d. $591,950 93 B Medium Refer To: 149 The net present value of all cash flows associated with this investment (rounded to the nearest dollar) is: a. $377,950 b. $382,735 c. $392,950 d. $362,950 Reference: 1410 (Ignore income taxes in this problem.) Westland College has a telephone system that is in poor condition. The system either can be overhauled or replaced with a new system. The following data have been gathered concerning these two alternatives: Present Proposed New System System Purchase cost new . $250,000 $300,000 Accumulated depreciation $240,000 Overhaul costs needed now . $230,000 Annual cash operating costs $180,000 $170,000 Salvage value now . $160,000 Salvage value at the end of 8 years $152,000 $165,000 Working capital required $200,000 Westland College uses a 10% discount rate and the total cost approach to capital budgeting analysis. Both alternatives are expected to have a useful life of eight years 94 B Hard Refer To: 1410 The net present value of the alternative of overhauling the present system is: a. $(1,279,316) b. $(1,119,316) c. $801,284 d. $(1,194,036) 95 A Hard Refer To: 1410 The net present value of the alternative of purchasing the new system is: a. $(1,076,495) b. $(1,236,495) c. $(1,169,895) d. $(969,895) 26 Managerial Accounting, 9/e Reference: 1411 (Ignore income taxes in this problem.) Lambert Manufacturing has $60,000 to invest in either Project A or Project B. The following data are available on these projects: Project A Project B Cost of equipment needed now $120,000 $70,000 Working capital investment needed now $50,000 Annual net operating cash inflows . $ 50,000 $45,000 Salvage value of equipment in 6 years $ 15,000 Both projects have a useful life of 6 years. At the end of 6 years, the working capital investment will be released for use elsewhere. Lambert's discount rate is 14% 96 D Medium Refer To: 1411 The net present value of Project A is closest to: a. $82,241 b. $67,610 c. $74,450 d. $81,290 97 A Medium Refer To: 1411 The net present value of Project B is closest to: a. $77,805 b. $127,805 c. $55,005 d. $105,005 98 C Medium Refer To: 1411 Which of the following statements is (are) correct? I. Project A is acceptable according to the net present value method II. Project A has an internal rate of return greater than 14% a. Only I b. Only II c. Both I and II d. Neither I nor II Reference: 1412 (Ignore income taxes in this problem.) Fast Food, Inc., has purchased a new donut maker. It cost $16,000 and has an estimated life of 10 years. The following annual donut sales and expenses are projected: Sales $22,000 Expenses: Flour, etc., required in making donuts $10,000 Salaries . 6,000 Depreciation 1,600 17,600 Net income $ 4,400 Managerial Accounting, 9/e 27 99 B Medium Refer To: 1412 The payback period on the new machine is closest to: a. 5 years b. 2.7 years c. 3.6 years d. 1.4 years 100 C Easy Refer To: 1412 The simple rate of return for the new machine is closest to: a. 20% b. 37.5% c. 27.5% d. 80.0% Reference: 1413 (Ignore income taxes in this problem.) Purvell Company has just acquired a new machine. Data on the machine follow: Purchase cost $50,000 Annual cost savings 15,000 Life of the machine 8 years The company uses straightline depreciation and a $5,000 salvage value. (The company considers salvage value in making depreciation deductions.) Assume cash flows occur uniformly throughout a year 101 A Easy Refer To: 1413 The payback period would be closest to: a. 3.33 years b. 3.0 years c. 8.0 years d. 2.9 years 102 C Medium Refer To: 1413 The simple rate of return would be closest to: a. 30.0% b. 17.5% c. 18.75% d. 12.5% Reference: 1414 (Ignore income taxes in this problem.) Hanley Company purchased a machine for $125,000 that will be depreciated on the straightline basis over a fiveyear period with no salvage value. The related cash flow from operations is expected to be $45,000 a year. These cash flows from operations occur uniformly throughout the year 103 C Easy CPA adapted Refer To: 1414 What is the payback period? a. 2.1 years b. 2.3 years c. 2.8 years d. 4.2 years 28 Managerial Accounting, 9/e 104 A Easy CPA adapted Refer To: 1414 What is the simple rate of return on the initial investment? a. 16% b. 24% c. 28% d. 36% Essay 105 Medium (Ignore income taxes in this problem.) Prince Company’s required rate of return is 10%. The company is considering the purchase of three machines, as indicated below. Consider each machine independently Required: a. Machine A will cost $25,00 and have a life of 15 years. Its salvage value will be $1,000, and cost savings are projected at $3,500 per year. Compute the machine’s net present value b. How much will Prince Company be willing to pay for Machine B if the machine promises annual cash inflows of $5,000 per year for 8 years? c. Machine C has a projected life of 10 years. What is the machine's internal rate of return if it costs $30,000 and will save $6,000 annually in cash operating costs? Interpolate to the nearest tenth of a percent. Would you recommend purchase? Explain Answer: a. 10% Present Year Amount Factor Value Investment required now ($25,000) 1.000 ($25,000) Annual cost savings 115 3,500 7.606 26,621 Salvage value 15 1,000 0.239 239 Net present value $ 1,860 b. 10% Present Year Amount Factor Value Annual cash inflows 18 $ 5,000 5.335 $26,675 Since the present value of the cash inflows is $26,675, the company should be willing to pay up to this amount to acquire the machine Managerial Accounting, 9/e 29 c. Investment required ÷ Net annual cash flow = Factor of the internal rate of return $30,000 ÷ %6,000 = 5.000 14% factor 5.216 5.216 True factor 5.000 16% factor 4.833 0.216 0.383 14% + 2%(0.216 ÷ 0.383) = 15.1% The machine should be purchased, since the internal rate of return is greater than the required rate of return 106 Medium Ignore income taxes in this problem.) Ursus, Inc., is considering a project that would have a tenyear life and would require a $1,000,000 investment in equipment. At the end of ten years, the project would terminate and the equipment would have no salvage value. The project would provide net income each year as follows: Sales $2,000,000 Less variable expenses . 1,400,000 Contribution margin 600,000 Less fixed expenses 400,000 Net income $ 200,000 All of the above items, except for depreciation of $100,000 a year, represent cash flows. The depreciation is included in the fixed expenses. The company's required rate of return is 12% Required: a. Compute the project's net present value b. Compute the project's internal rate of return, interpolating to the nearest tenth of a percent c. Compute the project's payback period d. Compute the project's simple rate of return Answer: a. Since depreciation is the only noncash item on the income statement, the net annual cash flow can be computed by adding back depreciation to net income Net income $200,000 Depreciation 100,000 Net annual cash flow $300,000 12% Present Years Amount Factor Value Initial investment Now $(1,000,000) 1.000 $(1,000,000) Net annual cash flows 110 300,000 5.650 1,695,000 30 Managerial Accounting, 9/e Net present value $ 695,000 Managerial Accounting, 9/e 31 b. The formula for computing the factor of the internal rate of return (IRR) is: Investment required ÷ Net annual cash inflow = Factor of the IRR $1,000,000 ÷ $300,000 = 3.333 26% factor 3.465 3.465 True factor . 3.333 28% factor 3.269 0.132 0.196 26% + 2%(0.132 ÷0.196) = 27.3% c. The formula for the payback period is: Investment required ÷ Net annual cash inflow = Payback period $1,000,000 ÷ $300,000 = 3.33 years d. The formula for the simple rate of return is: Net income ÷ Initial investment = Simple rate of return $200,000 ÷ $1,000,000 = 20.0% 107 Medium (Ignore income taxes in this problem.) The following data concern an investment project: Investment in equipment $16,000 Net annual cash inflows $ 3,600 Working capital required $ 4,500 Salvage value of the equipment $ 2,000 Life of the project . 12 years Discount rate 14% The working capital will be released for use elsewhere at the conclusion of the project Required: Compute the project's net present value Answer: 14% Present Item Years Amount Factor Value Investment now ($16,000) 1.000 ($16,000) Annual cash inflows . 112 3,600 5.660 20,376 Working capital required now (4,500) 1.000 (4,500) Working capital released 12 4,500 0.208 936 Salvage value equipment 12 2,000 0.208 416 Net present value . $ 1,228 32 Managerial Accounting, 9/e Managerial Accounting, 9/e 33 108 Medium (Ignore income taxes in this problem.) Bradley Company's required rate of return is 14%. The company has an opportunity to be the exclusive distributor of a very popular consumer item. No new equipment would be needed, but the company would have to use onefourth of the space in a warehouse it owns. The warehouse cost $200,000 new. The warehouse is currently half empty and there are no other plans to use the empty space. In addition, the company would have to invest $100,000 in working capital to carry inventories and accounts receivable for the new product line. The company would have the distributorship for only 5 years. The distributorship would generate a $17,000 net annual cash inflow Required: What is the net present value of the project at a discount rate of 14%? Should the project be accepted? Answer: 14% Present Years Amount Factor Value Working capital investment Now $(100,000) 1.000 $(100,000) Annual cash inflows 15 17,000 3.433 58,361 Working capital released 5 100,000 0.519 51,900 Net present value $ 10,261 Yes, the distributorship should be accepted since the project has a positive net present value 109 Medium (Ignore income taxes in this problem.) Monson Company is considering three investment opportunities with cash flows as described below: Project A: Cash investment now $15,000 Cash inflow at the end of 5 years . $21,000 Cash inflow at the end of 8 years . $21,000 Project B: Cash investment now $11,000 Annual cash outflow for 5 years . $ 3,000 Additional cash inflow at the end of 5 years $21,000 Project C: Cash investment now $21,000 Annual cash inflow for 4 years $11,000 Cash outflow at the end of 3 years $ 5,000 Additional cash inflow at the end of 4 years $15,000 Required: Compute the net present value of each project assuming Monson Company uses a 12% discount rate 34 Managerial Accounting, 9/e Answer: Project A: 12% Present Amount Factor Value Cash investment now ($15,000) 1.000 ($15,000) Cash inflow at the end of 5 years $21,000 0.567 $11,907 Cash inflow at the end of 8 years $21,000 0.404 $ 8,484 Net present value $ 5,391 Project B: 12% Present Amount Factor Value Cash investment now ($11,000) 1.000 ($11,000) Annual cash outflow for 5 years ($ 3,000) 3.605 ($10,815) Additional cash inflow at the end of 5 years . $21,000 0.567 $11,907 Net present value ($ 9,908) Project C: 12% Present Amount Factor Value Cash investment now ($21,000) 1.000 ($21,000) Annual cash inflow for 4 years $11,000 3.037 $33,407 Cash outflow at the end of 3 years ($ 5,000) 0.712 ($ 3,560) Additional cash inflow at the end of 4 years . $15,000 0.636 $ 9,540 Net present value $18,387 110 Medium (Ignore income taxes in this problem.) Jim Bingham is considering starting a small catering business. He would need to purchase a delivery van and various equipment costing $125,000 to equip the business and another $60,000 for inventories and other working capital needs. Rent for the building used by the business will be $35,000 per year. Jim's marketing studies indicate that the annual cash inflow from the business will amount to $120,000. In addition to the building rent, annual cash outflow for operating costs will amount to $40,000. Jim wants to operate the catering business for only six years. He estimates that the equipment could be sold at that time for 4% of its original cost. Jim uses a 16% discount rate Required: Would you advise Jim to make this investment? Managerial Accounting, 9/e 35 Answer: 16% Present Description Years Amount Factor Value Van & equipment 0 ($125,000) 1.000 ($125,000) Working capital 0 ($ 60,000) 1.000 ($ 60,000) Building rent . 16 ($ 35,000) 3.685 ($128,975) Net annual cash inflow 16 $ 80,000 3.685 $294,800 Salvage value, equipment . 6 $ 5,000 0.410 $ 2,050 Release of working capital 6 $ 60,000 0.410 $ 24,600 Net present value $ 7,475 111 Medium (Ignore income taxes in this problem.) General Manufacturing Company consists of several divisions, one of which is the Transportation Division. The company has decided to dispose of this division since it no longer fits the company's longterm strategy. An offer of $9,000,000 has been received from a prospective buyer. If General retained the division, the company would operate the division for only nine years, after which the division would no longer be needed and would be sold for $600,000. If the company retains the division, an immediate investment of $500,000 would need to be made to update equipment to current standards. Annual net operating cash flows would be $1,805,000 if the division is retained. The company’s discount rate is 12% Required: Using the net present value method, determine whether General Manufacturing should accept or reject the offer made by the potential buyer Answer: 12% Present Year Explanation Amount Factor Value o 0 Investment to update assets $ (500,000) 1.000 $ (500,000) 19 Annual cash inflows . 1,805,000 5.328 9,617,040 9 Selling price for the division 600,000 0.361 216,600 Net present value . $9,333,640 The sales price of $9,000,000 is less than the present value of the cash flows resulting from retaining the division. General thus should not accept the offer 36 Managerial Accounting, 9/e 112 Medium (Ignore income taxes in this problem.) Mark Stevens is considering opening a hobby and craft store. He would need $100,000 to equip the business and another $40,000 for inventories and other working capital needs. Rent on the building used by the business will be $24,000 per year. Mark estimates that the annual cash inflow from the business will amount to $90,000. In addition to building rent, annual cash outflow for operating costs will amount to $30,000. Mark plans to operate the business for only six years. He estimates that the equipment and furnishings could be sold at that time for 10% of their original cost. Mark uses a discount rate of 16% Required: Would you advise Mark to make this investment? Use the net present value method Answer: 16% Present Description Years Amount Factor Value o Equipment 0 ($100,000) 1.000 ($100,000) Working capital 0 ($ 40,000) 1.000 ($ 40,000) Building rent . 16 ($ 24,000) 3.685 ($ 88,440) Net annual cash inflow 16 $ 60,000 3.685 $221,100 Salvage value, equipment . 6 $ 10,000 0.410 $ 4,100 Release of working capital 6 $ 40,000 0.410 $ 16,400 Net present value $ 13,160 113 Medium (Ignore income taxes in this problem.) Vernon Company has been offered a 7year contract to supply a part for the military. After careful study, the company has developed the following estimated data relating to the contract: Cost of equipment needed $300,000 Working capital needed . $ 50,000 Annual cash receipts from the delivery of parts, less cash operating costs $ 70,000 Salvage value of equipment at termination of the contract . $ 5,000 It is not expected that the contract would be extended beyond the initial contract period. The company's discount rate is 10% Required: Use the net present value method to determine if the contract should be accepted. Round all computations to the nearest dollar Managerial Accounting, 9/e 37 Answer: 10% Present Description Years Amount Factor Value o Equipment 0 ($300,000) 1.000 ($300,000) Working capital 0 ($ 50,000) 1.000 ($ 50,000) Net annual cash inflow 17 $ 70,000 4.868 $340,760 Salvage value, equipment . 7 $ 5,000 0.513 $ 2,565 Release of working capital 7 $ 50,000 0.513 $ 25,650 Net present value $ 18,975 114 Hard (Ignore income taxes in this problem.) AB Company is considering the purchase of a machine that promises to reduce operating costs by the same amount for every year of its 6year useful life. The machine will cost $83,150 and has no salvage value. The machine has a 20% internal rate of return Required: What is the annual cost savings promised by the machine? Answer: Investment required ÷ Net annual cash inflow = Factor of the internal rate of return $83,150 ÷ Net annual cash inflow = 3.326 $83,150 ÷ 3.326 = Net annual cash inflow = $25,000 115 Easy (Ignore income taxes in this problem.) Ferris Company has an old machine that is fully depreciated but has a current salvage value of $5,000. The company wants to purchase a new machine that would cost $60,000 and have a 5year useful life and zero salvage value. Expected changes in annual revenues and expenses if the new machine is purchased are: Increased revenues . $63,000 Increased expenses: Salary of additional operator $20,000 Supplies . 9,000 Depreciation 12,000 Maintenance 4,000 45,000 Increased net income $18,000 Required: a. Compute the payback period on the new equipment b. Compute the simple rate of return on the new equipment Answer: a. Investment required ÷ Net annual cash inflow = Payback period $60,000 $5,000) ÷ ($18,000 + $12,000) = 1.83 years (rounded) b. Incremental net income ÷ Investment = Simple rate of return 38 Managerial Accounting, 9/e $18,000 ÷ $55,000 = 32.7% (rounded) Managerial Accounting, 9/e 39 ... Managerial Accounting, 9/e 34 D Medium (Ignore income taxes in this problem.) White Company''s required rate of return on? ?capital? ?budgeting projects is 12%. The company is considering an investment opportunity which would ... a. does not consider the time value of money b. implicitly assumes that the company is able to reinvest cash flows from the project at the company''s discount rate c. implicitly assumes that the company is able to reinvest cash flows from the project at the internal rate of return... d. requires the use of a sophisticated calculator or computer software 31 B Medium CMA adapted The? ?capital? ?budgeting method that divides a project''s annual incremental net income by the initial investment is the:
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