ACG chapter 7

When making a capital budgeting decision, it is most useful to calculate the payback period:

if a company is "cash poor" as part of the screening process

Investment required/Annual net cash inflow is the formula to find the factor that enables calculation of the:

internal rate of return

When using the internal rate of return method to rank competing investment projects, an investment that has an internal rate of return of 20% is ________ than an investment that has an internal rate of return of 17%.

more desirable

An investment proposal with an initial investment of $100,000 generates annual net cash inflow of $20,000 for a period of 10 years. The project has a net present value of $10,000. What is this investment proposal's payback period?

5 years (100,000/20,000)

When a conflict between capital budgeting methods exists, the most reliable method to use for making preference decisions is:

NPV

A postaudit involves:

checking whether expected results are actually realized

The phenomenon of earning interest on both the interest and the amount invested is known as ________.

compound interest

calculating the present value of money is referred to as ___ cash flows

discounting

You are expecting a series of annual cash flows of $25,000 for six years. What is the present value of this annuity if the discount rate is 12%?

$102,775 4.111x 25,000 (reference the present value of an annuity of $1 in Arrears table)

Bo's Baseball Equipment is planning to invest in some new equipment that has a purchase price of $30,000. The new equipment will save Bo $7,500 in operating expenses annually. The factor of the internal rate of return for this project is:

4

Cost of equipment- 0 working capital $100,000 annual cash inflow 16,000 salvage value 0 life of project 6 years discount rate 14% Compute NPV

$16,000 x 3.889 (arrears)= 62,224 $100,000 x .456= 45,600 45,600+62,224= 107,824 107,824-100,000= $7,824

Identify the simplifying assumptions usually made in net present value analysis

-all cash flows other than the initial investment occur at the end of the period -all cash flows generated by the investment project are immediately reinvested at a rate of return equal to the discount rate

Year 1- Investment $14,000; cash inflow $6,000 Year 2- cash inflow 4,000 Year3- investment 4,000; cash inflow 0 Year 4- cash inflow 8,000 Year 5- cash inflow 9,000 Year 6- cash inflow 12,000 Year 7 cash inflow 2,000 Given here are the cash flows of an investment under consideration. What is the payback period of this investment?

4 years

A manager with a current ROI of 22% has been offered a project with a positive net present value and a simple rate of return of 18%. Which of the following statements are true?

If the manager is evaluated based on ROI he will probably reject the project. The company will want the manager to accept the project.

A postaudit is a valuable process because:

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

The simple rate of return is also called all of the following except ________.

annual rate of return

When computing the simple rate of return, the annual incremental net operating income in the numerator should ______ the investment's depreciation charges.

be reduced by

NPV formula

cash flow x (1- (1/ (1+interest rate)^n))/interest rate)- initial investment

Which of the following ignores the time value of money?

payback period

Which method should be used when ranking competing projects with different initial investments?

profitability index

a screening decision

relates to whether a proposed project is acceptable

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

required or hurdle

Which of the following is NOT a taxable income assumption when using income taxes in net present value analysis?

salvage value affects depreciation calculations

Which of the following is NOT another term used to describe preference decision making?

screening decisions **other names are rationing and ranking**

Which of the following is NOT one of the two broad categories of capital budgeting decisions?

selection decisions

All cash flows are included and a net present value is computed for each alternative when using the ____-_____ approach

total cost

Current assets minus current liabilities is called

working capital

Investment required/Annual net cash inflow is the formula for the:

payback period

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

positive or zero

The required rate of return is

the minimum rate of return a project must yield to be acceptable

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: Both options are acceptable because they each have an internal rate or return greater than the required rate of return, but Option B is preferred because it has a higher internal rate of return.

Select the capital budgeting approaches that use discounted cash flows.

NPV and IRR

cash outflow

Working capital is tied up for project needs

Future cash flows expected from investment projects:

can be difficult to estimate

Preference decisions are also called _______ decisions.

rationing ranking

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:

0.27 Reason: ($266,700 - $210,000) = $56,700 ÷ $210,000 = 0.27

Project Marvel is a five-year project. The project has a total cash inflow of $350,000. The present value of such inflows is $275,000. The project requires an initial investment of $200,000 and additional working capital of $25,000. What is the net present value of the project?

Net present value of cash flows= present value of cash inflows- present value of cash outflows (inflows -outflows) Net present value of cash flows= $275,000- (200,000+25,000)= 50,000

Poppy's Gumball Co. is planning to invest in a new marketing campaign that would require an initial investment of $85,000. The project is expected to create incremental annual income of $27,200. The simple rate of return on the project is:

Reason: $27,200/$85,000 = 32%

Which of the following capital budgeting decision tools focuses on net operating income rather than cash flows?

Simple rate of return

Which of the following is a limitation of the simple rate of return?

The simple rate of return method uses accounting income.

Cash inflow

Working capital is released for use elsewhere within the company

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

true -depreciation is a non cash expense and therefore should not be included in the calculation of the net cash inflows of a capital investment. Thus it must be added back to net income to determine the annual net cash inflow

Which of the following statements about a postaudit is not true?

uses estimated data

When analyzing an investment project, uncertain future cash flows:

may be estimated using computer simulations

The required rate of return is the ______ rate of return a project must yield to be acceptable.

minimum

Fill in the blanks to complete the sentence. 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

The cost of capital serves as a ___ tool

screening

Water World is planning to build a new attraction at its water park. A new wave pool has a project profitability index of 0.09, and a new water slide has a profitability index of 0.14. The best choice for Water World is the:

water slide Reason: The higher the profitability index, the more desirable the project.

Which of the following are true regarding the time value of money?

-Projects that provide earlier returns are preferable to those that promise later returns. -By collecting a project's return quickly, the investor has the opportunity to re-invest that money to earn even more

Which of the following statements are true?

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

capital budgeting decisions

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

Actual cash outlays for operating expenses are:

out of pocket costs

negative NPV

unacceptable

True or false: Preference decisions relate to whether a proposed project is acceptable based on preset criteria.

false

The basic premise of the payback method is the ________, the more desirable the investment.

faster the cost of the investment is recovered

Two capital budgeting approaches that use discounted cash flows are the ___ ____ value method and the ___ ___ of return method

net present value internal rate of return

Working Capital

often increase when a company takes on a new project

When making a preference decision, comparing the net present value of one project to the net present value of another project can:

only be done if the initial investments are equal

True or false: To verify the internal rate of return (IRR) compute the project's net present value using the IRR as the discount rate to determine if it is zero.

True

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

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

The cost of capital is the:

average rate of return a company must pay its long-term creditors and shareholders for the use of their funds

When using the simple rate of return, the initial investment should be reduced by the ___ value of old equipment

salvage

What assumption underlies net present value analysis?

All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.

To screen out undesirable investments, ________ use(s) the cost of capital.

both the net present value and internal rate of return methods

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

Another term for the minimum required rate of return is the cost of ____

capital

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

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

True or false: The payback method is useful in industries where products become obsolete very quickly.

true

Typical capital budgeting cash outflows include:

working capital invested installation costs initial equipment investments

A new machine requires an investment of $630,000 and will generate $100,000 in cash inflows for 7 years, at which time the salvage value of the machine will be $130,000. Using a discount rate of 10%, the net present value of the machine is $

-76,510

capital budgeting decisions include

-acquiring a new facility to increase capacity -choosing to lease or buy new equipment -purchasing new equipment to reduce cost -deciding to replace old equipment -determining which equipment to purchase among available alternative

The net present value of a project is:

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

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.

Building Blocks Co. is considering the purchase of a new specialty saw. The saw has a useful life of 10 years, but the salvage value is unknown. The net present value excluding the salvage value of the saw is negative $13,950. If the present value factor is 0.558, then the salvage value must be $_____ in order to make this investment acceptable.

25,000 $13,950/.558

Which of the following statements is false?

The net present value method assumes that cash flows are not reinvested.

Cost of equipment- $100,000 working capital 0 annual cash inflow 21,000 salvage value 8,000 life of project 6 years discount rate 14% Compute NPV

$21,000 x 3.889= 81,669 *3.889 using arrears table* $8,000 x .456= $3,648 *.456 using PV of $1 table* 81,669+3,648= 85317 85,317-100,000= -14,683

Robot, Inc. is expecting a taxable cash flow of $100,000. If Robot has a tax rate of 30%, the after-tax benefit of this cash flow is ________.

$70,000 After tax benefit of the taxable cash flow= cash flow of $100,000 x (1- tax rate of .30)= $70,000

Which of the following statements are true?

-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. -The cost of capital may be used to screen out undesirable projects.

Capri Industries is considering an investment that has an initial cost of $26,500 and the following expected cash inflows: Year 1- $6,000 Year 2- $8,000 Year 3- $10,000 Year 4- $5,000 Year 5- $3,000 The expected payback period is ___ years

3.5

Studio Films is considering the purchase of some new film equipment that costs $150,000. It has a 5 year useful life with no salvage value. The new equipment is expected to increase revenues by $115,000 annually. Annual incremental cash operating expenses are expected to be $40,000.The simple rate of return of the equipment is %____ (Enter your answer as a whole number.)

30

Spicer Dentistry is considering the purchase of a new x-ray machine. The machine costs $2,400 and has a useful life of 10 years. The new machine is expected to reduce operating costs by $400 per year. The payback period for the x-ray machine is years. (Enter your answer as a whole number.)

6 years 2,400/400

State Bank is implementing a new marketing campaign that requires an initial investment of $35,000. If the project profitability index is 0.2, the net present value of the campaign's future cash flows is $____. (Enter your answer as a whole number.)

7,000 $35,000x.2

Clean Tel, Inc. is considering investing in an 11-year project with annual cash inflows of $1,000,000. These cash inflows have an initial investment of $7,139,000. At what discount rate would this present value be the same as the initial investment?

8% The present value of the cash inflows of the project will be the same as its initial investment when discounted using the internal rate of return of the project. Dividing present value of the cash inflow by the annual cash flows, we determine the factor of the internal rate of return to be 7.1390 or (7,139,000/1,000,000) Using the "present value of an annuity of $1 in arrears" table 13B-2, we find that the factor of 7.1390 for 11 periods represent an 8% return

Farm Central is considering the purchase of a larger combine to increase productivity. Combine A costs $210,000 and has a useful life of 10 years. The combine will reduce labor costs by $25,000 per year. The payback period of the combine is:

8.4 years $210,000/$25,000

A new investment project currently under consideration has a negative net present value of $85,000. The project has a life of 10 years and the minimum required rate of return is 8%. The present value factor for an annuity at 8% for 10 periods is 6.71. What is the amount of annual additional cash flow that is required to make this investment attractive?

annual additional required to make investment attractive= negative NPV to be offset of $85,000/present value factor at 8% for 10 period of 6.7100= $12,668 (or $85,000/6.7100)

Which of the following is the term used to describe the discount rate at which the present value of a project's cash inflows will equal the present value of its cash outflows?

internal rate of return

When the annual net cash inflow is the same each year, the payback period equals the___ required divided by the annual net cash___ . (Enter only one word per blank.)

investment inflow

When net cash inflow is the same every year, the equation used to calculate the factor of the internal rate of return is:

investment required/annual net cash inflow

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

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

When the outcomes of the net present value method and the internal rate of return method do not agree,:

it is best to rely on the net present value method.

A dollar today is worth ___ than a dollar earned a year from now

more

Capital budgeting methods that focus on cash flows rather than incremental operating income are:

payback net present value internal rate of return

The Copy Center is considering a project that would increase cash receipts by $50,000 annually. The initial cost of the project is $175,000. Working capital of $40,000 which would be released at the end of the project is required. The project has an estimated 10 year life. If the project is added, operating expense will increase by $18,000 annually. Repairs costing $7,000 will be done in year 5. Using a discount rate of 8%, and the tables in the appendix, what is the net present value of this project?

$13,473 Reason: Present value of net cash inflows: $214,720 [($50,000 -$ 18,000) x 6.710] + $18,520 [($40,000 x .463)] - Present value of net cash outflows: $(215,000) [Cost + Working Capital] - $(4,767) [Year 5 Repair ($7,000 x .681)] = $13,473

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

accounting, unadjusted

An investment of $10,000 today is estimated to return $11,500 a year from now. The $11,500 is called the ________ of the investment.

future value

Pam's Pet Palace is considering an investment in dog grooming equipment that would increase cash receipts by $12,000 annually. The initial cost of the equipment is $50,000. The equipment has an estimated 10 year life and will have a $5,000 salvage value. Using a discount rate of 8%, and the tables in the appendix, what is the net present value of this equipment?

$32,835 $12,000x 6.710=$80,520 $5,000 x .463=$2,315 $80,520+$2,315= $82,835-$50,000= $32,835

Packaging Place is considering a new investment, but is unsure of the intangible benefits it will provide. The net present value excluding the intangible benefit is negative $380,990. If the present value factor is 6.145, then the minimum intangible benefit per year needed to make the investment acceptable is:

$62,000 $380,990/6.145

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:

2.6 years 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 2+.6=2.6

View Perfect is considering an investment in a new line of windows. The project is expected to last 10 years. If the factor of the internal rate of return is 5.889, the internal rate of return is:

11% Present value of an annuity of $1 in Arrears- the 10 period 5.889 factor is 11%

Addison Corporation is considering the purchase of equipment that would increase sales revenues by $250,000 per year and cash operating expenses by $100,000 per year. The equipment would cost $400,000 and have a 5-year life with no salvage value. The simple rate of return on the investment is closest to ________.

17.5% Annual depreciation= (cost of $400,000- salvage value of $0)/ 5 year life= $80,000 Annual incremental net operating income= annual incremental revenue of $250,000- annual depreciation of $80,000- annual incremental cash operating expense of $100,000= $70,000 Simple rate of return= annual incremental net operating income of $70,000/initial investment of $400,000= 17.5%

Pizza Pizazz is considering purchasing a new pizza oven that will speed up cooking time and save costs. The oven costs $180,000 and will last 5 years. It should increase net operating income by $14,000 year and will be depreciated using the straight-line method. The old pizza oven will be traded in and has a salvage value of $20,000. The payback period for the new oven is:

3.2 years $180,000/5= $36,000 $36,000+$14,000=$50,000 ($180,000-$20,000)/$50,000= 3.2

Sander Technologies is considering a research project. If successful, the project is expected to lead to sales totaling $60,000 annually. The initial cost of the research is expected to be $331,500. The factor of the internal rate of return is:

5.525 331,500/60,000

The factor of the internal rate of return is 5.033 for a project lasting 7 years. The internal rate of return is

9%

Positive or zero NPV

accpetable

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

capital budgeting

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

capital budgeting

When discussing capital investments, the term out-of-pocket costs refers to:

cash outlays for salaries, advertising, and other operating expenses.

Wallis Company has an annual depreciation deduction of $50,000. At a tax rate of 20%, what is the impact of the annual depreciation deduction?

cash savings of $10,000 Although depreciation expense is a noncash expense, it does impact the computation of taxable income, which in turn affects the cash outflows pertaining to income tax expense cash savings= annual depreciation of $50,000 x tax rate of 20%= $10,000

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

Net present value is the:

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

Because of the time value of money, projects that promise ______ returns are preferable to those that promise the opposite.

earlier

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

To determine if a project is acceptable compare the internal rate of return to the company's:

hurdle rate

The payback method:

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

The simple rate of return:

ignores the time value of money fluctuates from year to year along with fluctuations in revenue and expense

Committed funds today with the expectation of earning a return on those funds in the future in the form of additional cash flows is required when a company makes a(n) _______

investment

The internal rate of return:

is the discount rate that makes NPV equal zero for a project

In situations where no revenues are involved, which of the following is the most desirable alternative?

least cost approach

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

A negative net present value indicates that the project's return is ________.

less than the minimum required rate of return

Stephan Photography has an 18% required rate of return and is analyzing competing investments in new camera equipment. Option A has a project profitability index of 0.16, and Option B has a project profitability index of 0.13. The best choice for Stephan Photography would be:

option A Reason: Projects with positive present value indexes are acceptable but the higher the profitability index, the more desirable the project.

Instead of focusing on a projects profitability, the ___ period focuses on the time it takes for an investment to pay for itself

payback

The basic premise of the____ method is that the more quickly the cost of an investment can be recovered, the more desirable the investment is. (Enter only one word per blank.)

payback

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

payback period

One of the two broad categories of capital budgeting decisions, a ___ decision related to selecting from among several acceptable alternatives

preference

The term discounting cash flows refers to the process of calculating the ______ value of those cash flows. (Enter only one word per blank.)

present

Typical capital budgeting cash inflows include:

salvage value working capital released cost reductions

One of the two broad categories of capital budgeting decisions, a ___ decision, related to whether a proposed project is acceptable based on a present criterion

screening

the two broad categories into which capital budgeting decisions fall are ___ and ___ decisions

screening and preference

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 In order for a project to be acceptable, the internal rate of return must be equal to or exceed the required rate of return

an investment requires committing funds today with

the expectation of earning a return on those funds in the future

the internal rate of return is the discount rate that results in a net present value of ___ for the investment

zero