Accnt-6610-Chapter 16

A capital budget provides the organization an overall blueprint to help the organization meet its:

long-term growth and profitability objectives

Investment proposal X would be considered inferior to investment proposal Z if the capital budgeting analysis indicated a:

longer payback period

Outsourcing is a fundamental decision alternative of the __________ type of decision.

make or buy

Using present value table factors, assume that all the cash flows each year are received at the end of the year; however, it is more likely that the cash flows will be received fairly evenly throughout the year. This practice is ______________ (acceptable/unacceptable) because the resulting calculations produce a more ______________ (liberal/conservative) present value amount.

acceptable conservative

The capital budgeting method that calculates the rate of return on the investment based on the impact of the investment on the financial statements is known as the:

accounting rate of return method

A capital budgeting technique that calculates the rate of return on the investment based on the impact of the investment on the financial statements is known as the method ________________ _________________ ___________________ ______________.

accurate rate of return

Costs that have been assigned to a product or activity using some sort of systematic process are known as ________________ costs.

allocated

When considering two decision alternatives, _____________ costs are those costs that have been assigned to a product or activity using some sort of arbitrary process and will not differ given the decision alternatives.

allocated

When considering the make or buy decision, the relevant cost of making a component product part is the cost that _________ (can/cannot) be avoided by acquiring the component part from an outside supplier.

can

When analyzing capital expenditure decisions, the key factor used to equate the value of money over varying lengths of time is:

compound interest

Louis and Lyla Inc. is considering to discontinue Department A as it is making losses. In the last quarter, Department A had incurred an operating loss of $50,000. Its total fixed expenses for the quarter was $60,000. The company identified that 90 percent of the department's fixed expenses is the company's common fixed expense allocated to the department. Based on the scenario, Louis and Lyla Inc. should _____.

continue Department A as the net decrease in the company's segment margin is $4,000

Alpha and Omega Inc. produces laptops and the selling price per laptop is $300. Currently, the company has a separate division that produces the internal hard drive used in the laptop. To produce one such hard drive, it spends $10 in the raw materials, $15 in direct labor, $5 in variable manufacturing overhead, and $10 in fixed manufacturing overhead. If the company decides to purchase the internal hard drive from outside, then it will cost $35 per hard drive. Also, 20 percent of the fixed cost is avoidable if the division is outsourced. Based on the scenario, Alpha and Omega Inc. should _____.

continue to produce the hard drives as the company will save $3 by producing them

When considering the decision for solving product mix problems involving multiple products and scarce production resources, the decision should focus on:

contribution margin per unit of scarce resource

Costs that will differ according to the alternative activity being considered are known as ___________ costs.

differential

When considering two decision alternatives, _____________ costs are those costs that would result from selecting one alternative instead of the other.

differential

When considering the decision to continue or discontinue a segment of the organization, _________________ (common/direct) fixed expenses will always be relevant to the decision and _________________ (common/direct) fixed expenses will never be relevant to the decision.

direct common

The principal ________________ (advantage/disadvantage) of the payback method for evaluating proposed capital investments is that it _______________ (considers/ignores) the time value of money.

disadvantage ignoes

The principal ___________ (advantage/disadvantage) of the accounting rate of return method for evaluating proposed capital investments is that it ____________ (considers/ignores) the time value of money.

disadvantage ignores

In capital budgeting, the present value of future cash flows from an investment is determined by using the appropriate ________ rate.

discount

When considering capital budgeting decisions, the ____________ rate is the common term used to describe the cost of capital.

discount

Capital budgeting is different than operational budgeting because of the long-term time frame of the capital budget. Therefore, capital budgeting:

focuses on the present value of cash flows from investments

The operating condition when all available production resources are being utilized is known as ______________ _______________ .

full capacity

Relevant costs in short-run decisions are:

future costs that represent differences between decision alternatives

The operating condition when some available production resources are not being utilized is known as ___________________ ________________ .

idle capacity

Given the challenges of estimating cash flows, capital budgeting analysis typically ________________ (ignores/uses) cash flows that are expected to occur more than 10 years in the future.

ignores

Sometimes when management decisions are reached, the investment project with the highest NPV or IRR is not selected because ____________ (qualitative/quantitative) factors override _______________ (qualitative/quantitative) analysis.

qualitative factors override quantitative analysis techniques

Future costs that represent differences between decision alternatives and are the key to effective decision making are called ________________ costs.

relevant

When considering the product mix decision and the allocation of scarce production capacity resources, the objective is to maximize contribution margin in terms of the ___________________ _________________ .

scarce resource

A cost in the decision-making process that has been incurred and that cannot be unincurred, or reversed, by some future action is known as a(n) ____________ cost.

sunk

A cost in the decision-making process that has been incurred and that cannot be unincurred, or reversed, by some future action is known as a(n) ______________cost.

sunk

When considering pricing decision alternatives, a(n) _____________ cost is the maximum cost that can be incurred, which allows for a desired profit to be earned at a predetermined selling price.

target

A cost management technique in which the firm determines the required cost for a product or service to earn a desired profit when the selling price is determined by the marketplace is known as ______________________ _________________.

target costing

The cost of capital used in the capital budgeting analytical process is primarily a function of:

the cost of acquiring funds to be invested

If the net present value of a proposed investment is positive, _____.

the cost of capital is less than the expected rate of return to be earned

In the capital budgeting process, companies generally use the end-of-the-year assumption while evaluating the cash inflows from the new investment because _____.

this assumption results in a slightly lower and more conservative present value amount compared with results from other assumptions

Dormamu Inc. is planning to buy new equipment that costs $100,000, has a useful life of 10 years, and no salvage value. The company's average investment is $95,000 and the depreciation is $10,000 every year for 10 years. In the year following the purchase, if the company estimates the accounting rate of return to be 30 percent and the cost of production to be $200,000, then estimated sales will be _____.

$238,500

ABC Company has calculated the net present value of two investment opportunities but must decide which option to pursue: Project X: Present value of cash flows = $117,000 Investment = $100,000 Net present value = $17,000 Project Z: Present value of cash flows = $138,000 Investment = $120,000 Net present value = $18,000 Complete the following: Present value ratio of Project X =_________________ Present value ratio of Project Z = ______________ Decision = Invest in _________ (Project X/Project Z)

1.17 1.15 Project X

ABC Company has two investment options Project A and Project B. Project A requires an initial investment of $500,000 and the expected present value of cash inflow from the project is $608,000. Project B requires an initial investment of $1,000,000 and the present value of cash inflows is $1,180,000. Assume that the company does not have any fund constraint to invest. Based on the given scenario, the profitability index for Project A is _____ and that for Project B is _____.

1.22, 1.18 Reason: For Project A, Profitability index = Present value of cash flows / Investment = $608,000 / $500,000 = 1.22; For Project B, Profitability index = $1,180,000 / $1,000,000 = 1.18

ABC Company is considering investing in new production equipment at a cost of $60,000 with a 10-year useful life and no salvage value. The following are estimated for Year 1 of the project: Sales = $100,000 Production costs = $82,600 Depreciation expense = $6,000 Calculate the following for ABC Company for Year 1: Operating income = $ _______________ Average investment = $ ________________Accounting rate of return = % __________________

11400 57000 20%

ABC Company produces a product that currently sells for $72 per unit. Current production costs per unit include the following: Direct materials = $20 Direct labor = $24 Variable overhead = $10 Fixed overhead = $10 Product engineering has determined that certain production changes could refine the product quality and functionality. These changes would increase material and labor costs by 25 percent per unit. ABC could sell the refined version of its product for $84 per unit. Identify the following relevant costs to process further: Difference in selling price = $___________ per unit Difference in processing costs = $_____________ per unit Difference in profit/(loss) = $______________ per unit Decision to process further = _______________ (Yes/No)

12 11 1 yes

ABC Company is using net present value analysis at various discount rates in order to determine the internal rate of return of an investment proposal. NPV using a discount rate of 12 percent = $2,095 NPV using a discount rate of 14 percent = $(2,108) By interpolating these results, an approximate internal rate of return on the investment is estimated to be ___________ percent. (Round your answer to the nearest whole percentage.)

13%

ABC Company is considering an opportunity to produce and sell Product X that currently sells for $20 in the marketplace. If ABC wants to earn a 25 percent profit margin on the sales of Product X, what is the target cost that must be achieved to compete in the market? Target cost = $____________.

15

ABC Company estimated that it can generate $42,000 per year in additional cash inflows for the next five years if it automates some of its production equipment at an investment cost of $150,000. ABC's discount rate is 10 percent. Present value factors: Present value of $1 for 5 years @ 10 percent = 0.6209. Present value of an annuity of $1 for 5 years @ 10 percent = 3.7908. Calculate the following: Present value of additional cash inflows = $_________ (Round your answer to two decimal places.) Net present value of investment = $________ (Round your answer to two decimal places.) Investment decision = _________(Yes/No)

159213.60 9213.60 Yes

ABC Company produces a product that currently sells for $72 per unit. Current production costs per unit include the following: Direct materials = $20 Direct labor = $24 Variable overhead = $10 Fixed overhead = $10. Product engineering has determined that a certain portion of the product conversion could be outsourced. Direct labor and variable overhead would be reduced by 50 percent. Raw material would not be affected and no other alternative use for any idle production capacity is apparent. The outsourcing supplier would charge ABC $15 to provide this product conversion. Identify the following relevant costs to process further: Avoidable cost if outsourced = $ _________ per unit Cost to buy = $ _________ per unit Difference in conversion cost = $ _________ per unit Decision to make or buy = _________ (Make/Buy)

17 15 2 Buy

ABC Company produces a product that currently sells for $72 per unit. Current production costs per unit include the following: Direct materials = $20 Direct labor = $24 Variable overhead = $10 Fixed overhead = $10 Total production costs = $64 ABC has received a special pricing offer from a nonprofit organization to buy 3,000 units at $60 per unit. ABC is currently operating at full production capacity. Identify the following relevant costs of this special pricing offer: Current contribution margin at full capacity = $ ____________ per unit Contribution margin of special pricing offer = $ ____________ per unit Difference in contribution margin = $ _____________ per unit Decision to accept special pricing offer = _________________ (Yes/No)

18 6 -12 no

Shifu Inc. is analyzing the cash inflows from an investment in a new equipment. The investment requires an initial cash outlay of $100,000. In Year 1, the company expects to earn a net income of $15,000 and the depreciation on the equipment for the year is $10,000. If the income tax rate is 40 percent, the cash inflow in Year 1 is _____.

19000

ABC Company is considering an opportunity to produce and sell Product Z that currently sells for $50 in the marketplace. ABC wants to earn a 20 percent profit margin on the sales of Product Z, and product engineering has estimated production costs for product Z will be $45. Should ABC enter the market to produce Product Z? Target cost = $___________. Estimated profit margin for Product Z = ____________% Decision to produce Product Z = ______________ (Yes/No)

40 10 no

ABC Company is considering eliminating Division X as a result of its current operating performance: Sales = $80,000 Variable expenses = $40,000 Contribution margin = $40,000 Fixed expenses = $46,000 Operating income = $(6,000) ABC determines that $16,000 of the $46,000 fixed expenses are common fixed expenses allocated to Division X. Identify the following relevant costs to process further: Decrease in contribution margin = $__________ Decrease in direct fixed expenses = $_____________ Increase/(Decrease) in segment margin = $ Decision to continue or discontinue Division X = __________(Continue/Discontinue)

40,000 30,000 -10,000 Continue

ABC Company will invest $120,000 in new production equipment that is projected to provide the following annual net cash inflows: Year 1 = $40,000; Year 2 = $50,000; Year 3 = $60,000; Year 4 = $50,000 Calculate ABC's cumulative cash flows each year: Year 1 = __________ $ Year 2 = ___________ $ Year 3 = ___________ $ Calculate ABC's payback period: Payback = ___________ years

40000 90000 150000 2.5

ACB Company sells Product X for $20 per unit, but if the product is enhanced, it can be sold for $26 per unit. The enhancement process will cost $80,000 for the 10,000 units that are currently sold. If sales of Product X remain the same, identify the following relevant costs to process further: Difference in selling price = $_____________ per unit Difference in processing costs = $______________ per unit Difference in profit/(loss) = $______________ per unit Based on the relevant costs information identified above, should ACB Company sell Product X as-is or process further? Decision to process further = __________(Yes/No)

6 8 (2) No

ABC Company produces Product A and Product B and provides the following information: Product A: Contribution margin = $300 per unit; Machining time = 5 hours per unit. Product B: Contribution margin = $400 per unit; Machining time = 8 hours per unit. The capacity of machine time is limited to 1,200 hours and only one product can be produced. Calculate the contribution margin per machine hour for each product: Product A contribution margin = $ ________________ per machine hour Product B contribution margin = $ _______________ per machine hour Decision = Use 1,200 machine hours to produce _____________ (Product A/Product B)

60 50 Product A

ABC Company produces a product that currently sells for $72 per unit. Current production costs per unit include the following: Direct materials = $20 Direct labor = $24 Variable overhead = $10 Fixed overhead = $10 Total production costs = $64 ABC has received a special pricing offer from a nonprofit organization to buy 3,000 units at $60 per unit. ABC currently has idle production capacity. Identify the following relevant costs of this special pricing offer: Special offer selling price = _______ per unit Incremental production costs = __________ per unit Special offer contribution margin = $______________ per unit Decision to accept special pricing offer = ____________(Yes/No)

60 54 6 Yes

ABC Company is analyzing the cash inflows from an investment in a new product line and determines the following amounts for Year 1 of the investment: Operating income = $80,000 Less income taxes @ 35 percent = $28,000 Net income = $52,000 Included in the calculation to determine operating expense is $12,000 of depreciation expense on the new equipment. Cash flow during Year 1 for this new product line = $ ______________.

64000

IIf an investment in new equipment is $160,000, has an expected useful life of 10 years, is expected to have a $20,000 salvage value, and generates net annual cash inflows of $40,000 a year, the cash payback period is __________ years.

8

allocated cost

A cost that has been assigned to a product or activity using some sort of arithmetic process.

sunk cost

A cost that has been incurred and that cannot be unincurred, or reversed, by some future action.

Relevant cost

A cost that is used in analyzing costs of decision alternatives representing future differences between the alternatives

differential cost

A cost that will differ based on the selection of an alternative activity.

opportunity cost

An economic concept relating to income forgone because an opportunity to earn income was not pursued.

When considering the investment in new production equipment, the resulting depreciation expense on the new equipment is not a cash flow item but it will affect the calculation of which cash flow item?

Income taxes

After the results of a present value analysis has been obtained for a capital investment opportunity, overriding _____________ factors should also be considered before a final decision is made.

qualitative factors

A capital budgeting technique that solves for the time-adjusted rate of return on an investment over the life of the investments is known as the ________ ___________ _____________ ___________method.

Internal Rate of Return (IRR) Method

Which of the following statements describes the internal rate of return method used in capital budgeting?

It calculates the investment proposal's actual rate of return.

Identify the two major disadvantages of the payback method for evaluating proposed investments in capital projects.

It does not consider cash flows that continue after the investment has been recovered. It does not consider the time value of money.

A capital budgeting technique that uses a given cost of capital to relate the present value of the returns from an investment to the present value of the investment is known as the method.

Net Present Value (NPV) Method

Identify the elements used in calculating the accounting rate of return.

Operating income Average investment Depreciation expense

Identify the cost classifications that are considered relevant in comparing decision alternatives.

Opportunity cost Differential cost

When considering the make or buy decision, which of the following items should management consider?

Opportunity cost of making internally Technical expertise of supplier Costs that are avoidable by buying outside the company

Long-Run Inc. produces two products, Product X and Product Y. The contribution margin that the company can earn by selling Product X is $1,000 per unit, but it requires 20 machine hours to produce the product. From Product Y, the company can earn a contribution margin of $600 per unit, but its production requires 10 machine hours. As the capacity of machine time is limited to 1,500 hours, the company can produce only one product. Based on the scenario, the company should produce _____.

Product Y because the contribution margin per hour for Product Y is $60 whereas the contribution margin per hour for Product X is $50

The ratio of the present value of the cash flows from an investment to the investment that is used for ranking proposed capital expenditures is known as the ______________ ______________.

Profitability Index

The cost of capital is the minimum ___________ (ROI/IRR/NPV) that must be earned to permit an organization to meet its interest obligations and provide the owners their expected return.

ROI

Miller and Jones Inc. is planning to invest $150,000 to purchase equipment. It has an estimated life of 10 years and no salvage value. The firm expects to save $27,000 every year by using the new equipment. The firm's cost of capital is 12 percent. The net present value (NPV) of the investment in the new equipment is _____. (Present value of an annuity of $1 for 10 years at 12 percent is 5.6502.)

Reason: NPV of investment = Present value of cash inflows - Present value of cash outflow = ($27,000 × 5.6502) - $150,000 = $152,555 - $150,000 = $2,555

Which of the following items are relevant in a decision to continue or discontinue a segment of an organization?

Segment contribution margin Segment variable expenses Segment sales Segment direct fixed expenses

ABC Inc. is planning to invest $100,000 on a new project that has a useful life of 10 years. For this project, the firm estimates that $10,000 additional working capital will be required for the operations to run smoothly. Based on the scenario, identify the true statements regarding the treatment of additional working capital in the capital budgeting decision.

The additional working capital of $10,000 is considered cash inflow at the end of Year 10. The additional working capital of $10,000 is considered cash outflow in Year 1.

In a capital budgeting decision using the net present value method and a 10 percent discount rate, what does a net present value equal to zero indicate?

The proposal's rate of return is equal to the minimum rate required

Identify the true statements regarding sunk costs.

These costs have been incurred and cannot be eliminated. These costs are never considered differential in nature. These costs are never relevant in the decision-making process.

True or false: A project is too risky to accept if the project does not have a satisfactory return considering the cash flows in the first 10 years.

True

True or false: The validity of present value calculations of a project will be a function of the accuracy with which future cash flows of the project can be estimated.

True

True or false: When a company has idle capacity, the variable cost items of direct material, direct labor, and variable overhead are relevant costs while deciding whether to accept a special offer or not.

True

True or false: When a company is operating at full capacity, the company will incur loss if it accepts any special offer whose price is less than the normal selling price.

True

When will the present value ratio of a proposed investment be less than 1.0?

When the net present value is negative

A company is planning to invest in new equipment. Identify the true statements regarding cash flows from the new investment.

While identifying the cash inflows and outflows from the new investment, depreciation should be added back to the net income. The cash flows identified with the new investment should include all the associated cash inflows and outflows, including income taxes.

When analyzing capital expenditures, the time value of money concept implies:

a dollar received today is worth more than a dollar received five years from today

Alpha Inc. produces a product that currently sells for $110 per unit. Current production costs per unit includes direct materials of $30, direct labor of $25, variable overhead of $15, fixed overhead of $20, and total production costs of $90. Alpha Inc. has received a special pricing offer from a nonprofit organization to buy 5,000 units at $60 per unit. Alpha Inc. currently has idle production capacity. Based on the scenario, Alpha Inc. should _____.

not accept the special offer because the contribution margin from the offer is ($10)

Beta and Gama Inc. produces a product that currently sells for $250 per unit. Current production costs per unit includes direct materials of $30, direct labor of $25, variable overhead of $15, fixed overhead of $20, and total production costs of $90. Beta and Gama Inc. has received a special pricing offer from a nonprofit organization to buy 1,000 units at $200 per unit. Beta and Gama Inc. is currently operating at its full production capacity. Based on the scenario, Beta and Gama Inc. should _____.

not accept the special order as the company will lose $50,000 if it accepts the special order

When considering the sell as-is or process further decision, relevant costs to be consider are:

only those costs or revenue opportunities that are different between the alternatives

An organization's _____________(operating/capital) budget reflects its plans to achieve short-term profitability goals, while the organization's _____________ (operating/capital) budget reflects its plans to achieve long-term profitability goals.

operating captial

An economic concept relating to income forgone because a decision alternative to earn income was not pursued is known as a(n) _______________ cost.

opportunity

When considering decision alternatives, a(n) __________ cost can be measured as the income that could have been earned on an asset, based on the potential rate of return that is lost or sacrificed when one alternative use of the asset is chosen over another.

opportunity

Capital expenditure proposals that involve new products typically require a working capital increase because accounts receivable and inventories will increase. The working capital increase required is treated as a cash _______ (inflow/outflow) at the beginning of the project and as a cash ________(inflow/outflow) at the end of the project.

outflow inflow

The acquisition of resources or services from outside the organization as opposed to producing those resources or services internally is known as _______.

outsourcing

A capital budgeting technique that calculates the length of time for the cash flows from an investment to recover the investment is known as the ____________ method.

payback

The process of comparing the assumptions used in a capital project analysis with the actual results of the investment is referred to as a(n) _________________ of the project to determine if anticipated results are actually being received.

postaudit