BEC - Capital Budgeting
Phillips Company is considering the acquisition of a new machine that would cost $66,000, has an expected life of 6 years, and an expected salvage value of $16,000. The company expects the machine to provide annual incremental income before taxes of $7,200. Phillips has a tax rate of 30%. If Phillips uses average values in its calculations, which one of the following will be the average accounting rate of return on the machine?
The (average) accounting rate of return is determined by dividing the average annual after-tax net income by the average cost of the investment. The after-tax income would be $7,200 x .70 = $5,040. The average cost of the investment would be beginning book value ($66,000) + ending book value of ($16,000), or $82,000/2 = $41,000. Therefore, the accounting rate of return is: $5,040/$41,000 = 12.29%.
Lin Co. is buying machinery it expects will increase average annual operating income by $40,000. The initial increase in the required investment is $60,000, and the average increase in required investment is $30,000. To compute the accrual accounting rate of return, what amount should be used as the numerator in the ratio?
The accounting rate of return (ARR) is calculated as: ARR = Average annual incremental income/Initial (or Average) investment. For the facts given, the equation would be: ARR = $40,000/$60,000 (or $30,000). Thus, the numerator is given as $40,000.
If it is determined that a project investment is expected to generate $1.20 in present value for each $1.00 invested, which one of the following was most likely used to reach that conclusion?
The profitability index computes the expected return for each dollar invested. It is computed as: Net Present Value/Project Cost.
What is the formula for calculating the profitability index of a project?
The profitability index is computed by dividing the present value of annual after-tax cash flows by the original cash invested in the project.
The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?
Depreciation increases cash flow by reducing income taxes. You Answered Correctly! Determining the net present value of an investment is done by comparing the present value of the expected cash inflows (revenues or savings) of the project with the initial cash investment in the project (outflows). Since the amount of depreciation expense taken reduces taxes due, it reduces cash outflow by the amount of taxes saved. The present value of that saving enters into the determination of present values for net present value assessment purposes.
The following information pertains to Krel Co.'s computation of net present value relating to a contemplated project: Discounted expected cash inflows $1,000,000 Discounted expected cash outflows 700,000 Net present value is:
Net present value (NPV) is computed as: NPV = present value of cash inflows - present value of cash outflows. Using the facts in this question: NPV = $1,000,000 - $700,000 = $300,000.
A client wants to know how many years it will take before the accumulated cash flows from an investment exceeds the initial investment, without taking the time value of money into account. Which of the following financial models should be used?
The payback period approach to assessing an investment (e.g., a capital project) determines the number of years (or other periods) needed to recover the initial cash investment in the project and compares the resulting time with a pre-established maximum payback period. It uses nominal cash flow and ignores the time value of money.
Neu Co. is considering the purchase of capital equipment that has a positive net present value based on Neu's 12% hurdle rate. The internal rate of return would be:
greater than 12% You Answered Correctly! Since the internal rate of return determines the discount rate, which equates the present value of future cash inflows with the cost of the investment, if the project has a positive net present value, the discount rate (or internal rate of return) must be greater than the hurdle rate.
The discount rate is determined in advance for which of the following capital budgeting techniques?
npv The discount rate is determined in advance when using the net present value capital budgeting technique. The net present value technique compares the present value of expected cash inflows with the present value of cash outflows to determine whether or not a capital project is economically feasible. Determining present values requires the use of a predetermined discount rate. Often the firm's cost of capital is used as the discount rate.
Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment is acquired. The equipment's estimated useful life is 10 years, with no residual value, and it would be depreciated by the straight-line method. Tam's predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322. Accrual accounting rate of return based on initial investment is
10% The accounting rate of return = (Change in) Annual accounting income/Initial Investment. For the facts given, the annual change in accounting income will be $20,000 - ($100,000/10 years) = $10,000. The accounting rate of return would be: $10,000/$100,000 = 10%.
Major Corp. is considering the purchase of a new machine for $5,000 that will have an estimated useful life of five years and no salvage value. The machine will increase Major's after-tax cash flow by $2,000 annually for five years. Major uses the straight-line method of depreciation and has an incremental borrowing rate of 10%. The present value factors for 10% are as follows: Ordinary annuity with five payments 3.79 Annuity due for five payments 4.17 Using the payback method, how many years will it take to pay back Major's initial investment in the machine?
2.5 The payback period method determines how many years would be required to recover the initial project investment cost. It is calculated as: Payback = investment cost/annual cash savings. For the facts given, the calculation would be: Payback period = $5,000/$2,000 = 2.5 years.
A company purchases an item for $43,000. The salvage value of the item is $3,000. The cost of capital is 8%. Pertinent information related to this purchase is as follows: Net cash flow Present value factor at 8% Year 1 $10,000 0.926 Year 2 15,000 0.857 Year 3 20,000 0.794 Year 4 27,000 0.735 What is the discounted payback period in years?
3.25 The discounted payback period method is a variation of the payback period approach that takes the time value of money into account. It does so by discounting the expected future cash flows to their present value and uses the present values to determine the length of time required to recover the initial investment. Therefore, using the given facts the calculation would be: Net cash flow Present value factor at 8% Present Value Sum of Present Values Year 1 $10,000 0.926 $ 9,260 $ 9,260 Year 2 15,000 0.857 12,855 22,115 Year 3 20,000 0.794 15,880 37,995 Year 4 27,000 0.735 19,845 57,840 Initial Investment = $43,000 PV of Expected Cash Flows Years 1 - 3 = 37,995 Years = 3.000 (1 - 3) An addition amount of $5,005 is needed to fully recover the initial investment ($43,000 − $37,995 = $5,005) Balance Needed - Year 4 = $ 5,005/$19,845 Year 4 PV the fraction of year 4 needed to recover the remaining $5,005. Discounted Payback Period Years = 3.252
A project has an initial outlay of $1,000. The projected cash inflows earned evenly over each year are: Year 1 $200 Year 2 200 Year 3 400 Year 4 400 What is the investment's payback period?
3.5 The payback period is 3.5 years, computed as follows: Year Annual Amount Cumulative Amount Balance Needed 1 $200 $ 200 $800 2 $200 $ 400 $600 3 $400 $ 800 $200 4 $200/$400 = ½ Year $1,000 $ -0-
Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment is acquired. The equipment's estimated useful life is 10 years, with no residual value, and it would be depreciated by the straight-line method. Tam's predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322. In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns closest to
5 The IRR is the rate of return that equates the present value of inflows with the present value of outflows. Expressed mathematically it is: Present value of inflows using IRR = present value of outflows using IRR. The calculation for the facts given would be: $20,000 x (PV of annuity factor for 10 years at IRR percent) = $100,000 Rearranged: (PV of annuity factor for 10 years at IRR percent) = $100,000/$20,000 = 5.00 Using the present value of an annuity table, for n = 10, the factors nearest to 5.00 would be used to determine the IRR.
Eval Co. is evaluating a major capital project to determine its economic feasibility. The following data have been accumulated: Initial cost of project $40,000 Estimated annual net cash inflow (revenue) 8,000 Estimated periods benefited 10 years Estimated project residual value -0- Cost of capital 12% Eval Co. uses straight-line depreciation for capital investments of this type. Excerpts from present value tables showed the following: Using the information above, which one of the following is the payback period in years for this project? (Ignore income tax.)
5 The payback period is computed as the initial cost of the project divided by the undiscounted annual expected net cash inflows (or cash savings). In this case the calculation is: Initial cost $40,000 = 5 years (to recover investment) Annual net cash inflow $ 8,000
What is an internal rate of return?
A time-adjusted rate of return from an investment. You Answered Correctly! An internal rate of return is a time-adjusted rate of return from an investment. In capital budgeting an internal rate of return approach (also called a time adjusted rate of return) evaluates a project by determining the discount rate that equates the present value of the project's future cash inflows with the present value of the project's cash outflows. The rate so determined is the expected rate of return to be earned by the project.
If income taxes are ignored, which of the following methods of evaluating capital investment projects includes the use of depreciation expense?
Accounting Rate of Return - includes Internal Rate of Return - excludes The accounting rate of return is calculated by dividing the accrual-based (accounting) net income (or savings) by the initial cost of the project. The accrual-based net income would include deduction of depreciation expense from revenues generated by the project. Thus, the accounting rate of return includes use of depreciation expense in the calculation. The internal rate of return is determined as the rate of interest that equates the present value of future new cash inflows (or savings) with the cost of the project. Because depreciation expense does not affect cash flows (it is a non-cash expense on the income statement), the internal rate of return method excludes the use of depreciation expense in the calculation (when income tax considerations are ignored). If tax considerations are taken into account, any tax saved as a result of recognizing depreciation expense would have to be recognized as part of the annual net cash flow from the project in determining the internal rate of return.
A company is considering four projects (A, B, C and D), which have the following expected cash flows: Investment Project Cash Outlay Present Value of Cash Inflows A $1,100,000 $ 980,000 B 250,000 600,000 C 1,400,000 1,830,000 D 650,000 790,000 In order not to overextend its management capabilities, the company has decided to invest in only one project. If it bases its project selection on the profitability index (PI_, which project will the company undertake?
B The company will undertake Project B. The net present value for Project B is $600,000 expected cash inflows - $250,000 expected cash outflows = $350,000 NPV. The PI for Project B is NPV $350,000/Cost $250,000 = 1.4 PI, which is greater than the PI for Projects C or D.
Smarti Co. has determined the following data in connection with its evaluation of a capital investment project: Initial cost of project $75,000 Estimated periods benefited 10 years Estimated annual savings $15,000 Estimated residual value $ 5,000 Cost of capital 10% Smarti uses straight-line depreciation for capital investments of this type. Excerpts from present value tables showed the following: Using the above information, which one of the following is the present value of total estimated future cash inflows and savings? (Ignore income taxes.)
B is correct. The total present value is the sum of the present value of a series (annuity) of savings plus the present value of the one-time residual value. The calculation of these elements is: PV of savings = $15,000 x PV of an annuity at 10% for 10 years PV of savings = $15,000 x 6.145=$92,175 PV of residual value = $5,000 x PV of $1.00 at 10% for 10 years PV of residual value = $5,000 x .386 = $1,930 Total PV = $92,175 + $1,930 = $94,105 $94,105 = Present value of total estimated future cash inflows and savings.
A company is considering four projects (A, B, C and D), which have the following expected cash flows: Investment Project Cash Outlay Present Value of Cash Inflows A $1,100,000 $ 980,000 B 250,000 600,000 C 1,400,000 1,830,000 D 650,000 790,000 In order not to overextend its management capabilities, the company has decided to invest in only one project. If it bases its project selection on net present value (NPV), which project will the company undertake?
C The company will undertake Project C because it has the highest NPV. Specifically, the NPV of Project C is $1,830,000 expected cash inflows - $1,400,000 expected cash outflows = $430,000 NPV, which is greater than the NPV of the other projects.
Which of the following statements is correct regarding financial decision making?
Capital budgeting is based on predictions of an uncertain future. You Answered Correctly! Capital budgeting is the process of measuring, evaluating, and selecting long-term investment opportunities. Inherent in every capital investment opportunity (i.e., capital project) are elements of risk and reward. Risk is the possibility of loss or other unfavorable results that derives from the uncertainty implicit in future outcomes. The time periods, expected costs and savings, and other elements used in capital budgeting are largely estimates or predictions about an uncertain future.
Net present value as used in investment decision-making is stated in terms of which of the following options?
Cash flow. You Answered Correctly! Net present value as used in investment decision-making is stated in terms of cash flow; specifically, in terms of the present value of cash flow. If the net present value of cash flow is zero or positive, an investment project is economically feasible.
Tootco, Inc. is evaluating a new project using the net present value approach and a 12% hurdle rate. It has determined that, in addition to an investment in plant and equipment, the project will require a $12,000 investment in net working capital. The project is expected to have a 5-year life, at the end of which the investment in net working capital will be recovered. The present value of $1 and the future value of $1 factors for 5 years at 10% are 0.5674 and 1.7623, respectively. In carrying out its net present value analysis, how should Tootco treat the working capital requirement both when it is made at the beginning of the project and at the end of the project? Treatment of Working Capital Requirement Beginning of Project End of Project A. Ignore Ignore B. Cash outflow of $12,000 Ignore C. Cash outflow of $12,000 Cash inflow of $12,000 D. Cash outflow of $12,000 Cash inflow of $6,809
D This answer is not correct. The net investment in working capital would be recognized both as a cash outflow at the beginning of the project and as a cash inflow occurring at the end of the project.
Which of the following events would decrease the internal rate of return of a proposed asset purchase?
Decrease tax credits on the asset. The internal rate of return method (also called the time adjusted rate of return) evaluates a project by determining the discount rate that equates the present value of the project's future cash inflows with the present value of the project's cash outflows. The first step in the calculation is to divide the initial cost of the project (numerator) by the annual savings of the project (denominator) to get a present value factor. Decreases in the tax credits on an asset, which means that tax savings on the purchase of the asset are reduced, serve to increase the effective initial cost of the asset. Increasing the initial cost of the asset (numerator) results in a higher present value factor and, therefore, a lower discount (interest) rate, which is the internal rate of return.
technique or approach for evaluating capital budgeting opportunities?
Discounted payback period approach. Payback period approach. Profitability index approach. The regression analysis approach is not one of the techniques (or approaches) used for evaluating capital budgeting opportunities. Regression analysis is a statistical tool for investigating relationships between variables, not for assessing capital budgeting opportunities.
a project should be accepted if the present value of cash flows from the project is:
Greater than the initial investment The present value of future cash flows from a project is subtracted from the initial cost of the investment to determine the economic feasibility of the project. If the present value of future cash flows is greater than the initial cost of the investment, the project has a positive net present value and is economically feasible - it should be accepted. If the present value of future cash flows is not greater than the initial cost of the investment, the project should not be accepted.
Polo Co. requires higher rates of return for projects with a life span greater than five years. Projects extending beyond five years must earn a higher specified rate of return. Which of the following capital budgeting techniques can readily accommodate this requirement?
Internal rate of return Net present value IRR is the rate that equates the present value of project net cash inflows and the cost of the investment. If the IRR, which is the expected compounded rate of return on a project, exceeds a specified return, the project is accepted. IRR can be compared to any specified rate for the purpose of accepting or rejecting projects. NPV is the difference between the present value of project inflows and the present value of outflows. The interest rate used to compute the present values is the rate that must be achieved. If the NPV is equal to or greater than 0, the project is accepted. NPV can accommodate any specified rate for the purpose of accepting or rejecting projects.
Which of the following is an advantage of net present value modeling?
It accounts for compounding of returns. You Answered Correctly! The net present value modeling assesses projects by comparing the present value of the expected cash flows (revenues or savings) of the project with the initial cash investment in the project. The use of present value provides for the compounding of amounts over time.
Which of the following is a limitation of the profitability index?
It requires detailed long-term forecasts of the project's cash flows. You Answered Correctly! Because the profitability index is based on cash flow and because projects may be of very long duration, the use of the profitability index requires detailed long-term forecasts (i.e., amount and timing) of projects' cash flows. The longer the projection period, the greater the uncertainty of those cash flows.
Which of the following capital budgeting techniques, if any, implicitly assumes that all cash inflows are immediately reinvested to earn a return for the company?
Net Present Value Internal Rate of Return Both the net present value method and the internal rate of return method of evaluating capital projects assume that all cash inflows (or savings) that result from the project are immediately reinvested to earn a return for the company. The earnings from these investments constitute part of the benefit derived by the company from its investment in a project. There is, however, a difference in the rate of return of the reinvestment implicitly assumed under the two methods: 1) The net present value method implicitly assumes that reinvestment of cash inflows earns the hurdle rate of return, the same rate used to discount future cash flows to get present value. 2) The internal rate of return method implicitly assumes that reinvestment of cash inflows earns a rate of return equal to the internal rate of return.
A project's net present value, ignoring income tax considerations, is normally affected by the
Proceeds from the sale of the asset to be replaced. The net present value approach is based on cash flows. Only the proceeds from sale of the asset to be replaced is a cash flow. The remaining alternatives are not cash flows, and do not cause cash flows to change when income tax effects are ignored. In the equipment replacement decision, the proceeds from the sale of the old asset (not its carrying value) increase the net present value of the replacement alternative.
Which of the following methods should be used if capital rationing needs to be considered when comparing capital projects?
Profitability index. You Answered Correctly! The profitability index (PI) method of capital project evaluation should be the method used in comparing capital projects when capital rationing needs to be considered. The profitability index method (also called the cost/benefit ratio) is primarily intended for use in ranking projects. It does so by taking into account both the present value and the cost of each project.
Which one of the following represents the formula used to calculate the profitability index for ranking projects?
Project Net Present Value divided by Project Cost The formula used to calculate the profitability index is project net present value divided by the project cost. The resulting percentage gives a ranking that takes into account both project net present value and initial cost. The higher the percentage, the higher the project rank.
Disco is considering three capital projects that have the following costs and net present values (NPV): Project Cost NVP X $40,000 $60,000 Y $60,000 $75,000 Z $50,000 $30,000 Using the profitability index, which project, if any, would be ranked as the most desirable?
Project X has a profitability index of 1.50, computed as NPV = $60,000/Cost = $40,000. Project Y has a profitability index of 1.25 and Project Z has an index of .60. Therefore, Project X, with the highest profitability index, would be the most desirable project.
How are the following used in the calculation of the internal rate of return of a proposed project? Ignore income tax considerations.
Residual sales value of project - include Depreciation expense - exclude The IRR is the rate that equates the present value of net cash inflows with a project's investment cost. Depreciation expense is not a cash flow and does not affect cash flows when income taxes are ignored; it should be excluded. The residual value of an asset at the end of a project is a cash flow, is discounted, and affects the present value of net cash inflows; it should be included.
The Bread Company is planning to purchase a new machine that it will depreciate on a straight-line basis over a 10-year period. A full year's depreciation will be taken in the year of acquisition. The machine is expected to produce cash flow from operations, net of income taxes, of $3,000 in each of the 10 years. The accounting rate of return is expected to be 10% on the initial required investment. What is the cost of the new machine?
The accounting rate of return is calculated as: ARR = Annual incremental accounting income/Initial (or average) investment By rearranging the formula: Initial investment = Incremental annual income/ARR Initial investment = [$3,000 - .10 (Initial investment)]/.10 .10 Initial investment = [$3,000 - .10 (Initial investment)] .20 Initial investment = $3,000 Initial investment = $3,000/.20 Initial investment = $15,000 Proof: $15,000 = [$3,000 - (.10× $15,000)]/.10 $15,000 = [$3,000 - $1,500]/.10 $15,000 = $1,500/.10 = $15,000
Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment is acquired. The equipment's estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam's predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322. Net present value is
The computation of net present value (NPV) is: NPV = Present value of cash inflows - Present value of cash outflows. For the facts given, the calculation would be: NPV = ($20,000 x 5.65) - $100,000 = $113,000 - $100,000 = $13,000. With positive NPV of $13,000, the decision should be to accept the project.
Which of the following phrases defines the internal rate of return on a project?
The discount rate at which the net present value of the project equals zero The internal rate of return on a project is defined as the discount rate at which the net present value of the project equals zero. Specifically, the internal rate of return assesses a project by determining the discount rate that equates the present value of the project's future cash inflows with the present value of the project's future cash outflows.
Salem Co. is considering a project that yields annual net cash inflows of $420,000 for years 1 through 5, and net cash inflow of $100,000 in year 6. The project will require an initial investment of $1,800,000. Salem's cost of capital is 10%. Present value information is present below: Present value of $1 for 5 years at 10% is .62. Present value of $1 for 6 years at 10% is .56. Present value of an annuity of $1 for 5 years at 10% is 3.79. What was Salem's expected net present value for this project?
The expected net present value for this project is $152,200. The calculation would be the net present value for the first 5 years using the annuity factor ($420,000 x 3.79) plus the present value for year 6 using the present value of $1 factor ($100,000 x .56), both subtracted from the initial investment to get the net present value. Thus, the computation would be $1,591,800 (which is $420,000 x 3.79) + $56,000 (which is $100,000 x .56) equals $1,647,800 (the present value of future cash inflows), subtracted from the present value of the initial investment of $1,800,000, resulting in a net present value of $152,200. In summary, the calculation is $1,800,000 - ($1,591,800 + $56,000) = $152,200, the expected net present value.
A company invested in a new machine that will generate revenues of $35,000 annually for seven years. The company will have annual operating expenses of $7,000 on the new machine. Depreciation expense, included in the operating expenses, is $4,000 per year. The expected payback period for the new machine is 5.2 years. What amount did the company pay for the new machine?
The expected payback period is computed as the length of time needed for net cash flows to recover the initial cash investment in a project. Since the payback period is given, that period multiplied by the annual net cash inflow will result the cost of the new machine. The annual revenue is $35,000 and the annual cash expenses are $3,000, which is determined as the total operating expenses less the amount of depreciation expense included (since it is a non-cash expense). Thus, the annual net cash flow is $35,000 - $3,000 = $32,000 x 5.2 = $166,400, the correct answer.
ProCo Inc. is considering a major capital undertaking. It uses the net present value approach for evaluating the economic feasibility of projects. Its prior projects are returning 12% on the amounts invested. At the time of evaluating the project being currently considered, ProCo's capital structure consisted of: Source of Capital Proportion of Capital Structure After-Tax Cost of Capital Long-term debt 60% 7.1% Preferred stock 20% 10.5% Common stock 20% 14.2% What minimum hurdle (discount) rate should ProCo use in evaluating the project using the net present value approach?
The minimum return (rate) used when applying the net present value approach should be equal to or greater than the firm's weighted-average cost of capital. This amount is computed as: Long-term debt 60% × 7.1% = 4.26% Preferred stock 20% × 10.5% = 2.10% Common stock 20% × 14.2% = 2.84% 9.20%
Given a 10% discount rate with cash inflows of $3,000 at the end of each year for five years and an initial investment of $11,000, what is the net present value?
The net present value is $370. The present value (PV) of expected cash inflows is determined by discounting those flows to their present value using the firm's discount rate (also called the hurdle rate). The difference between the resulting PV of cash inflows and the initial cost (which is at present value) is the net present value of the project. Cash inflows are $3,000 at the end of each year for five years, which is an ordinary annuity. If (in the absence of a PV table of factors) you know the formula for the PV of an ordinary annuity it can be used. That would be: PVoa = C x [(1 - (1 / (1 + i)n)) / i] Where: C = Cash flow per year; i = interest rate; and n = number of years. Substituting: PV = $3,000 x [(1 - (1/(1 + .10)5))/.10]; PV = $3,000 x 3.79; PV of cash inflows = $11,370 - initial investment $11,000 = $370 net present value. Even if you don't have PV factors or don't know the formula for PVoa, you can compute the answer (even easier than using the formula). For each year, discount the $3,000 by the discount rate times the number of years, as follows:
Oak Company bought a machine that they will depreciate on a straight-line basis over an estimated life of seven years. The machine has no salvage value. They expect the machine to generate after-tax net cash inflows from operations of $110,000 in each of the seven years. Oak's minimum rate of return is 12%. Information on present value factors is as follows: Present value of $1 at 12% at the end of 7 periods 0.0452 Present value of an ordinary annuity of $1 at 12% for 7 periods 4.564 Assuming a positive net present value of $12,000, what was the cost of the machine?
The net present value of a project is determined by subtracting the cost of the investment from the present value of future cash inflows (or savings), using a hurdle rate of return as the discount rate. In this case, the hurdle rate is expressed as Oak's minimum rate of return, 12%. Thus, the equation for solution would be: NPV = ($110,000 x PV of an annuity @ 12% for 7 years) - Investment Cost $12,000 = ($110,000 x 4.564) - Investment Cost $12,000 = $502,040 - Investment Investment = $502,040 - $12,000 = $490,040
Yarrow Co. is considering the purchase of a new machine that costs $450,000. The new machine will generate net cash flow of $150,000 per year and net income of $100,000 per year for five years. Yarrow's desired rate of return is 6%. The present value factor for a five-year annuity of $1, discounted at 6%, is 4.212. The present value factor of $1, at compound interest of 6% due in five years, is 0.7473. What is the new machine's net present value?
The net present value of the new machine is determined as the present value of future cash inflows less the present value of the current costs of the machine. Net income is not relevant in computing the net present value. In this question, the cash inflow is $150,000 per year for five years. The present value of that inflow is $150,000 x 4.212 (the present value of an annuity for five years) = $631,800. The present value of the cost of the new machine is $450,000. Thus, the net present value of the machine is $631,800 - $450,000 = $181,800.
A corporation is considering purchasing a machine that costs $100,000 and has a $20,000 salvage value. The machine will provide net annual cash inflows of $25,000 per year and has a six-year life. The corporation uses a discount rate of 10%. The discount factor for the present value of a single sum six years in the future is 0.564. The discount factor for the present value of an annuity for six years is 4.355. What is the net present value of the machine?
The net present value of the new machine is determined as the present value of future cash inflows less the present value of the current costs of the machine. The facts of this question contain two cash inflows: (1) the cash inflow of $25,000 per year for six years; and (2) the cash inflow from the salvage value of $20,000 at the end of the asset's life. The present values of those inflows are $25,000 x 4.355 (the present value of an annuity for six years) = $108,875 and $20,000 x .564 (the present value of $1 discounted for six years) = $11,280, for a total of $108,875 + $11,280 = $120,155. The present value of the cost of the new machine is $100,000. Thus, the net present value of the machine is $120,155 - $100,000 = $20,155.
Which one of the following methods of evaluating investment projects is most likely to be least acceptable for making project ranking decisions?
The payback period method is least likely to be used for ranking projects because of its serious shortcomings, including its failure to use discounted amounts and the fact that it is only concerned with the period required to recover the initial investment, not with the entire life of a project.
Which of the following statements about investment decision models is true?
The payback rule ignores all cash flows after the end of the payback period. The payback (period) rule or approach to assessing investments (e.g., capital projects) determines the number of years or other periods needed for future cash flows from an investment to recover the initial cost of the investment. It does not take into account cash flows for all periods, but measures only the present value of cash flows needed to recover the initial investment; cash flows received in periods after the initial investment is recovered (the payback period) are ignored.
Which one of the following methods of evaluating investment projects is most likely to be used to rank projects competing for limited capital investment funds?
The profitability index method is specifically designed to rank projects by taking into account both the time value of money and the initial cost of the project.
A company is considering two projects, which have the following details: Project A Project B Expected sales $1,000 $1,500 Cash operating expense 400 700 Depreciation 150 250 Tax rate 30% 30% Which project would provide the largest after-tax cash inflow?
The project with the largest after-tax [net] cash inflow would be project B, with a net cash inflow of $635. The net cash inflow would be computed as: $1,500 - $700 = $800 x (1 - .30) = $800 x .70 = $560 + ($250 x .30) = $560 + $75 = $635. The ($250 x .30) is the tax savings from the deductibility of the depreciation for tax purposes.
Which of the following rates is most commonly compared to the internal rate of return to evaluate whether to make an investment?
The weighted-average cost of capital is the cost of financing with each source of capital weighted by the proportion of total capital provided by each source, with the resulting weighted cost summed to get the total weighted-average cost of capital. The weighted-average cost also is the minimum rate of return that a firm must earn on its investments (i.e., uses of capital) and the calculated internal rate of return would be compared with the weighted-average cost of capital to determine whether or not an investment is economically feasible.
A graph of the relationship between financial risk and expected financial reward would show a curve that has a:
There is a positive relationship between financial risk and expected financial reward. The more perceived risk a financial investment or undertaking has, the higher the expected return associated with that risk.
Which of the following limitations is common to the calculations of payback period, discounted cash flow, internal rate of return, and net present value?
They rely on the forecasting of future data. You Answered Correctly! The calculation of payback period, discounted cash flow, internal rate of return and net present value all rely on the forecasting of future data. All of the listed calculations require that expected future cash flows be forecasted.
When estimating cash flow for use in capital budgeting, depreciation is
Utilized in determining the tax costs or benefit. You Answered Correctly! Depreciation may be used to determine the effect on tax costs or benefit from the recognition of depreciation expense for tax purposes. Specifically, depreciation expense recognized for tax purposes reduces taxable income and, therefore, the amount of tax paid (cash outflow).
