Accounting Chapter 14

Which of the following statements are true

- A project with a positive NPV will recover the original cost of the investment plus sufficient cash inflows to compensate for tying up funds. - The net present value method automatically provides for return of the original investment.

Internal Rate of Return

- Investment required ÷ Annual net cash inflow - is the discount rate that makes NPV equal zero for a project

Which of the following statements are true?

- The cost of capital may be used to screen out undesirable projects. - When the net present value method is used, the discount rate equals the hurdle rate. - When using the internal rate of return method, the cost of capital is used as the hurdle rate.

Working Capital

- current assets minus current liabilities - often increases when a company takes on a new project

The payback method

- does not consider the time value of money - is not a true measure of investment profitability - ignores all cash flows that occur after the payback period

If the internal rate of return is

- greater than the hurdle rate the project is acceptable - less than the hurdle rate the project should be rejected

When using net present value to compare projects, the total cost approach ______.

- includes all cash inflows and outflows under each alternative - is the most flexible method available to compare projects

Conducting a postaudit ______.

- provides an opportunity to cut losses on floundering projects - provides an opportunity to reinforce and possibly expand successful projects - flags any manager's attempts to inflate benefits or downplay costs in a project proposal

Capital budgeting decisions

- require a great deal of analysis prior to acceptance - involve an immediate cash outlay in order to obtain a future return

The net present value of a project is

- used in determining whether or not a project is an acceptable capital investment - the difference between the present value of cash inflows and present value of cash outflows for a project

Working capital is

-treated as a cash inflow when released at the end of a project. -treated as a cash outflow when required at the beginning of a project.

Capital budgeting decisions include ______.

1) choosing to lease or buy new equipment 2) determining which equipment to purchase among available alternatives 3) deciding to replace old equipment 4) purchasing new equipment to reduce cost 5) acquiring a new facility to increase capacity

Calderon Kitchen Supplies is planning to invest $210,000 in a new product. If the present value of the cash inflows is $266,700, the project profitability index is ______.

1.27 Reason: $266,700 ÷ $210,000 = 1.27

State Bank is implementing a new marketing campaign that requires an initial investment of $35,000. If the project profitability index is 1.2, the present value of the campaign's future cash flows is

42000 Reason: 35,000 X 1.2

Least Cost Decisions

A net present value decision that does not involve any revenues

total cost approach

All cash flows are included, and a net present value is computed for each alternative

Sandy's Soda Co. is planning an investment in new cooling equipment that would cost $56,000. The new equipment would save on operating costs over the next 5 years as follows: $21,500 in year 1; $23,100 in year 2; $19,000 in year 3; $13,900 in year 4; and $15,200 in year 5.The payback period for the cooling equipment is ______ years.

Answer: 2.6 Reason: After two years $44,600 ($21,500 + $23,100) will have been paid back leaving $11,400 ($56,000 - $44,600). $11,400 ÷ $19,000 = .6, so the total payback period is 2.6 years.

True or false: When a capital investment decision is being made between two or more alternatives, the project with the shortest payback period is always the most desirable investment.

False

Capital Budgeting

How managers plan significant investments in projects that have long term implications such as purchasing new equipment or introducing new products

A dollar today is worth (more/less) , than a dollar earned a year from now.

More

The concept of the time value of money is based on the notion that a dollar today is worth (more/less) than a dollar a year from now.

More

A shorter payback period does not necessarily mean that one investment is more desirable than another.

TRUE

Payback Period

The length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates

True or false: When calculating the payback period, the depreciation on the investment is excluded in the calculation of net cash flow.

True

Cash inflow

Working capital is released for use elsewhere within the company

Cash outflow

Working capital is tied up for project needs

Synonyms for the simple rate of return are the ______ rate of return and the ______ rate of return.

accounting, unadjusted

A postaudit is a valuable process because ______.

actual values can be used to determine if the project is performing as expected

When a project with a negative NPV has significant intangible benefits, the ______.

annual intangible benefit necessary to make the investment worthwhile should be calculated

screen out undesirable investments using the cost of capital.

both the net present value and internal rate of return methods

determine if a project is acceptable

by comparing the internal rate of return to the company's hurdle rate

When the cash flows associated with an investment project change from year to year, the payback period must be calculated ______.

by tracking the unrecovered investment year by year

Future cash flows expected from investment projects ______.

can be difficult to estimate

A postaudit involves ______.

checking whether expected results are actually realized

When computing the payback period for a new piece of equipment, the salvage value of the equipment being replaced is

deducted from the cost of the new equipment

Suppose that a project's net present value is negative, but the project would provide intangible benefits that have not yet been estimated. To estimate the annual value of intangible benefits needed to accept the project, ______ the negative net present value excluding intangible benefits by the ______.

divide, present value factor for an annuity

Simple rate of return

focuses on net operating income rather than cash flows

The internal rate of return is compared against the minimum _____ rate of return when analyzing the acceptability of an investment project.

hurdle

In an equipment capital budgeting decision, recovering the original investment means that the ______.

investment has generated enough cash inflows to completely cover the cost of the equipment

When a capital budgeting decision does not involve any revenues, the most desirable alternative is the one with the ______.

least total cost from a present value perspective

The Eye Clinic of Dr. Christensen is investing in some equipment to perform corrective eye surgery. It is expected that the equipment purchase will generate an internal rate of return of 24%. This equipment was chosen over equipment to perform cataract eye surgery. Thus, the internal rate of return of the cataract eye surgery equipment must have been ______.

less than the internal rate of return of the corrective eye surgery equipment

When analyzing an investment project, uncertain future cash flows ______.

may be estimated using computer simulations

Reggie's Refrigerators is considering the purchase of some new equipment. The company has limited its purchase options to two alternatives. Option A has an internal rate of return of 10%, and option B has an internal rate of return of 13%. If the required rate of return on the project is 9.5%, ______.

option B is the preferred choice Reason: When given the choice, choose the option with the higher internal rate of return.

Instead of focusing on a project's profitability, _______ period focuses on the time it takes for an investment to pay for itself.

payback

If the original investment in a capital project has been recovered, the net present value will be ______.

positive or zero

Preference decisions are also called ______ decisions.

rationing ranking

Little Tots Gym has a required rate of return of 13%. The gym is considering the purchase of $12,500 of new equipment. The internal rate of return on the project has been calculated to be 11%. This project ______.

should be rejected

Net Present Value

the difference between the present value of a project's cash inflows and the present value of the project's cash outflows

When using the internal rate of return method to rank competing investment projects ______.

the higher the internal rate of return, the more desirable the project

The internal rate of return is

the rate of return of an investment project over its useful life