ACCT Class 24 Vid & Quiz

Zeta Gaming Company has an opportunity to purchase a video game phone app that will cost $150,000. Zeta expects the demand for the app to start strong but to diminish as people tire of the game. The expected cash inflows are as follows: Year 1 Year 2 Year 3 Year 4 Year 5 $60,000 $50,000 $40,000 $30,000 $20,000 If Zeta uses the cumulative approach the payback period for this investment is

3 years. The payback period is the number of years it takes to accumulate total cash inflows of $150,000. In this case that is 3 years (year 1, $60,000 + year 2, $50,000 + Year 3, $40,000 = $150,000).

Property Associates (PA) is considering the purchase of an apartment complex. The company has the opportunity to purchase a complex at a cost of $9,000,000. PA also plans to incur $3,000,000 of renovation cost. The investment is expected to return a net cash inflow of $2,000,000 per year. The payback period for the investment in the complex is

6.0 years Payback period = Net cost of the investment ÷ Annual net cash inflow Payback period = ($9,000,000 + $3,000,000) ÷ $2,000,000 Payback period = 6 years

Which of the following items should be included as a cash outflow when determining the internal rate of return of an investment opportunity?

The initial cost of the asset. There are three main categories of cash outflows used in determining the cost of an investment opportunity. The cash outflow categories include the purchase price of the investment, increases in operating expenses, and increases in working capital. Cost savings and salvage value are cash inflows from an investment opportunity.

Which of the following statements regarding an internal rate of return analysis is false?

When the net present value is positive, the internal rate of return is lower than the required rate of return. A positive net present value indicates that the internal rate of return is higher not lower than the required rate of return.

The payback period is determined by

dividing the cost of the investment by the net annual cash inflows.

When choosing between two investment alternatives, the investor should always choose the alternative with the highest internal rate of return. This statement is

false. Internal rate of return is only one factor that should be considered in an investment decision. The size of the investment, the availability of funds, and how long the investment will last must be considered. Also, qualitative factors must be considered. For example, investments in tobacco may provide a high return but the investment may be rejected because the investor does not want to invest in a product with known health hazards.

Simmons Investment Group (SIG) used Excel to determine the net present value, the present value index, and the internal rate of return of two investment alternatives. A summary of the results is shown below: Alternative 1 Cost of the investment $ 426,000 Net Present Value (NPV) $ 11,120 Present Value Index 1.27 Internal Rate of Return (IRR) 10 % Alternative 2 Cost of the Investment $ 311,000 Net Present Value (NPV) $ 9,450 Present Value Index (NPV) 1.32 Internal Rate of Return (IRR) 11 % SIG has $430,000 to invest. Assuming there are no other investment opportunities available, SIG should

invest in Alternative 1 because the cost of the investment is higher. Investing in Alternative 1 leaves only $4,000 ($430,000 - 426,000) of funds that are sitting idle earning a zero return. In contrast, Alternative 2 leaves $119,000 ($430,000 - $311,000) of funds sitting idle. In other words, SIG can earn a $42,600 return ($426,000 x .10) on Alternative 1 or a $34,210 return ($311,000 x .11) from Alternative 2. In this case, Alternative 1 is the preferable investment.

The evaluation technique that focuses on how long it takes for cash inflows to cover the cost of an investment is commonly called

payback method.

The internal rate of return is compared to the required rate of return in order to evaluate an investment opportunity. This statement is

true. Once an internal rate of return is calculated for a particular investment opportunity, the internal rate of return is compared to the required rate of return. If the internal rate of return is equal to or greater than the required rate, the analysis suggests that the investment opportunity should be accepted. If the internal rate is less than the required rate, the investment opportunity should be rejected.