ACC 350 | Chapter 26

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What is Capital Budgeting?

-Capital budgeting is plannng to invest in capital assets in a way that returns the moost profitability to the company

Caliber Lawnmowers is considering the purchase of a new machine costing​ $804,000. The​ company's management is estimating that the new machine will generate additional cash flows of​ $180,000 a year for ten years and have a residual value of​ $62,000 at the end of ten years. What is the​ machine's payback​ period? (Round your answer to two decimal​ places.)

4.47 years

Accounting Rate of Return (ARR)

A capital investment analysis method that measures the profitability of an investment. Average annual operating income / Average amount invested. *uses operating income rather than cash flows *Decision Rue: if the expected ARR meets or exceeds the required rate of return, invest in the asset

Which of the following describes the time value of​ money?

A dollar received today is worth more than a dollar to be received in the future.

What is the second step of capital budgeting?

B. Identifyig potential projects

Which method does not consider the investment's profitability of the following options? A. ARR B. Payback C. NPV D. IRR

B. Payback

Profitability Index

Computes the number of dollars returned for every dollar invested, with all calculations performed in present value dollars. The present value of net cash inflows / Initial investment.

which affects the PV of an investment A. type of investment (annuity v. lump sum) B. # of time periods (length of investmetn) C. the interest rate D. all the above

D. all the above

The capital budgeting process involves the following steps:

Develop strategies, plan, act, control

Both the payback and the accounting rate of return methods focus on cash flows that an asset generates.

FALSE

When the internal rate of return is the same as the required rate of​ return, the net present value of an investment will be positive.

FALSE

Managers generally use payback as the sole method for deciding whether to invest in an asset.

False

Criticism of Payback Method

Focuses is on time--not profitability Ignores cash flows after payback period

Cash Outflows include

Initial investment (acquisition cost) Additional operating costs Refurbishment, repairs, and maintenance

which is the most reliable method of making capital budgeting decisions

NPV method

NPV

Net Present Value - the difference between the present value of cash inflows and the present value of the investment's net cash inflows and the investment's costs.

Capital budgeting decisions typically require large invesments and affect ________ for several years

Operations

Your rich aunt is giving you 2,000 a year for 4 years. Using a discount rate of 12% the PV of the gift can be stated as

PV = 2000 ( annuinity PV factor, i=12, n=4)

Lora Corporation will receive​ $10,000 a year at the end of each of the next five years. Using a discount rate of​ 14%, the present value of the receipts can be stated as​ ________.

PV​ = $10,000​ (Ordinary Annuity PV​ factor, i​ = 14%, n​ = 5)

Zane Set Designs Company has received an award which entitles it to receive annual payments of​ $10,000 at the end of each year for the next ten years. Which of the following is used to calculate​ today's value of this​ award?

Present Value of an Ordinary Annuity of​ $1

Net present value represents the difference between the​ ________.

Present value of the​ investment's net cash inflows and the​ investment's initial cost

Cash flows include

Revenue generated from the investment Savings in operating costs Residual Value

-Capital Assets are long-term, operational Assets

TRUE

An opportunity cost is the benefit foregone by choosing an alternative course of action.

TRUE

A​ post-audit in capital budgeting is a comparison of the actual results of capital investments with the projected results.

TRUE

Net cash inflows from a capital investment arise from an increase in​ revenues, a decrease in​ expenses, or both.

TRUE

The Accounting Rate of Return method evaluates the lifetime return of an​ investment, whereas Return on Investment evaluates the annual return of an investment.

TRUE

The accounting rate of return also is known as the average rate of return or annual rate of return.

TRUE

The accounting rate of return is calculated by dividing the average annual operating income by the average amount invested.

TRUE

The accounting rate of return shows the effect of the investment on the​ company's accrual-based income.

TRUE

The discounted cash flow methods of evaluating capital investments are superior because they consider both the time value of money and the profitability of the investment.

TRUE

The fact that invested cash earns income over time is called the time value of money.

TRUE

The internal rate of return​ (IRR) is the rate of​ return, based on discounted cash​ flows, of a capital investment.

TRUE

The net present value of future cash inflows received in earlier years is higher than future cash inflows received in later years.

TRUE

The only difference between the present value and future value of a lump sum is the amount of interest that is earned in the intervening time span.

TRUE

The payback and accounting rate of return methods are often used to perform an initial screening of investments.

TRUE

The payback method provides management with valuable information about the time period in which the cash invested will be recouped.

TRUE

Which of the following situations suggests the acceptance of an investment​ proposal?

The present value of the net cash inflows exceeds the initial investment.

An operational asset used for a long period of time is known as a capital asset.

True

The accounting rate of return is calculated by dividing the average annual operating income by the average amount invested.

True

The fact that invested cash earns income over time is called the time value of money.

True

Payback

a capital investment analysis method that measures the length of time it takes to recover, in net cash inflows, the cost of the initial investment = Amount Invested/ expected annual cash inflow

Which of the following best describes the term capital​ rationing?

a process of ranking and choosing among alternative capital investments based on the availability of funds

Which of the following most accurately describes an​ annuity?

a stream of equal cash payments made at equal time intervals

Which of the following is a capital budgeting method used to screen potential​ investments?

accounting rate of return

Sensativity analysis

allows managers to evaluate differences when underlying assumptions change

NPV

analysis is a capital investment analysis method that measure the net differences between the PV and the investment's net cash inflows and the investment's costs

Internal Rate of Return

based on discounted cash flows of a capital investment, it is the interest rate taht makes the NPV of the investment equal to zero *if IRR meets or exceeds the required rate of return, invest

-Capital investments are acquisitions of _____ ________

capital assets

Capital budgeting has a focus on ______ ______

cash flows

Protitability Index

computes the numbers of dollars returned for every dollar invested, with all calculations perfromed in PV dollars. It is useful to rank projcects in differenct sizes

in computing the IRR a company should consider

depreciation on the assets built int he company's expaniseon

When comparing several investments with the same initial​ cost, the decision should be made on the basis of the​ ________.

highest NPV

Discounted Cash Flow Methods

incorporate compound interest and make comparisons by converting all cash flows to the same point in time--aka the PV

At the internal rate of​ return, the present value of net cash inflows will equal the​ ________.

initial cost of the investment

Which of the following best describes the internal rate of​ return?

interest rate that makes the net present value of the investment equal to zero

Which of the following is the rate of​ return, based on discounted cash​ flows, a company can expect to earn by investing in a capital​ asset?

internal rate of return

Decision Rule- Payback

investment with SHORTER payback periods are more desirable, all else being equal

Discount Rate

is managmenet's minimum desired rate of return on a capital investment and is used to selevet the PV facotrs used when calculating the NPV of a procjet *if NPV is positive, invest

Capital Rationing

is the process of ranking and choosing among alternative capital investments based on the availability of funds.

IRR

is the rate of return based on discounted cash flows, of a capitla investment. It is the interest rate that amkes the NPV of the invsest equal to zero

Compound interest

means that interest is calculated on the principal and on all previously earned interest

Simple interest

means that interst is calculated only on the principal amount

Reagrding Capital rationing investments companies should

not choose the highest NPV, ARR of payback--must think

Caital rationing

occures when funds for capital investments are limited *qualitative and quantitative factors should be considered

Lump Sum Payment

one-time cash payment PV Caclculation for Lump sum PV = future cvalue x PV facotr for i=?, n=?

Capital budgeting is the​ ________.

process of planning for investments in​ long-term assets

The discount rate used in a net present value analysis is the​ ________.

required rate of return or the hurdle rate

Sensitivity analysis is a technique that​ ________.

shows how results differ when underlying assumptions change

Annuities

streams of equal cash payments made at equal time intervals PV calculation for annuity PV= amount of each cash inflow x annuity PV factor for i=?, n=?

Ian Corp. is considering two expansion projects. The first project streamlines the company's warehousing facilities. The second project automates inventory utilizing bar code scanners. Both projects generate postivie NPV, yet Ian Corp. only chooses the bar coding project. Why? A. The IRR of the warehousing project is less than the company's required rate of return for capital projects. B. The company is practicing capital rationing. C. The payback is greater than the warehouse project's life. D. All of the above are true.

the company is practicing capital rationing

Time value of money

the fact that money can be invested to earn income over time *explains why we'd want money now rather than later

When projecting future cash flows of an investment​ ________.

the initial investment is a significant cash outflow that is treated separately from all other cash flows

the IRR is

the interest rate at which NPV of the investment is zero

discount rate

the minimum desired rate of return on a capital investment and is used to select the PV factors used when calculating the net PV of a project *if positive invest in the capital asset

Software Hub is deciding whether to purchase new accounting software. The cost of the software package is​ $68,000, and its expected life is ten years. The payback for this investment is four years. Assuming equal yearly cash​ flows, what are the expected annual net cash savings from the new​ software? (Assume the investment has no residual​ value.)

​$17,000

Software Hub is deciding whether to purchase new accounting software. The cost of the software package is​ $68,000, and its expected life is ten years. The payback for this investment is four years. Assuming equal yearly cash​ flows, what are the expected annual net cash savings from the new​ software? (Assume the investment has no residual​ value.)

​$17,000 | **68,000 / 4 = $17,000


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