Cost Exam 2

Limitations of ARR

- ignores TMV (undiscounted data is used) - no objective criteria - what is a good accounting rate? relies on accounting numbers, not cash flows

Advantages of ARR

- readily available data - consistency between data for capital budgeting purposes and data for subsequent performing evaluation - aligns incentives with how management normally evaluates -aligns with financial reporting

Limitations of IRR

-assumes cash flows are reinvested at IRR rate -conventional IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great (can result in budgeting distortions)

Advantages of Payback

-easy to compute and understand (business people know it) -increased flexibility in the sense that they provide funds for other investment opportunity (you get your money back sooner) -serve as a rough measure of risk - the sooner you get your cash flows back the less risky

Limitations of Payback

-fails to consider returns over the life of the investment - does not consider TMV - the decision rule for accepting projects is subjective/ not well defined - use of the model may encourage excessive investment in short-lived projects

In applying the Capital Asset Pricing Model (CAPM) to estimate a firm's cost of equity capital, the beta coefficient (β) in the model represents

A measure of the sensitivity of the firm's stock return to fluctuations in the returns of the overall market.

What does the modified internal rate of return (MIRR) assume for the duration of the project?

All positive cash flows are reinvested at a particular rate of return

When the net present value (NPV) of a project is calculated based on the assumption that the after-tax cash inflows occur at the end of the year when they actually occur uniformly throughout each year, the net present value (NPV) will:

Be slightly understated but probably usable.

degree of operating leverage

Contribution Margin / Net Operating Income

Which one of the following is true for the internal rate of return (IRR) method?

Depending on the pattern of after-tax cash flows, multiple IRRs for a given proposed investment are possible

In capital budgeting, the accounting rate of return (ARR) decision model:

Does not provide an unambiguous decision criterion (rule) regarding the acceptance of capital investment projects.

Research has shown that in framing capital investment decisions past (i.e., "sunk") costs or losses tend to:

Escalate commitment in making capital budgeting decisions.

Given two projects with the same total (project lifetime) cash flow returns (CFRs), the IRR method would favor a proposal having yearly CFRs that were

Heavier toward the beginning of a proposal's life

Which of the following is always true regarding the net present value (NPV) decision model?

If a project is found to be acceptable under the NPV approach, it would also be acceptable under the internal rate of return (IRR) approach.

Which one of the following methods assumes (inherently, according to some) that all interim cash inflows generated by an investment earn a return equal to the internal rate of return (IRR) of the investment?

Internal rate of return method (IRR)

a capital budgeting model that accounts for an assumed rate of return on interim-period cash inflows from an investment is the

Modified internal rate of return model (MIRR)

Which of the following gives capital asset pricing model (CAPM) equation in words

The expected rate of return on a stock is equal to the risk-free rate plus the specific stock's beta coefficient times the market risk premium.

True or False? Fixed cost per unit of output decreases as volume increases

True

What is the hurdle rate for average-risk projects

Weighted-average cost of capital (WACC)

a 15% IRR on a proposed capital investment indicates all of the following EXCEPT:

an acceptable capital project if the cost of capital is 16 percent or higher

what is another name for a relevant cost?

avoidable cost

what can the weighted average contribution margin ratio be used for

breakeven and profit planning for sales volume expressed in dollars (Y) rather than units (Q)

a useful concept for solving production-planning problems involving multiple products and limited resources is:

contribution per unit of scarce resource

Cost Escalation (behavioral issue)

decision makers may consider past costs or losses as relevant

a cost is NOT relevant for decision making if it:

does not differ for each option available to the decision maker

Account Analysis Method

estimates cost functions by classifying various cost accounts as variable, fixed, or mixed with regard to identified level of activity - practitioners use this a lot -experience and judgement / eyeballing it - accurate, cost effective, easy to use

Conference Method

estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of a company (opinions, common for banks)

high-low and regression cost estimation methods are alike in that they both

have an intercept term and a slope term

variable costs will generally be relevant for decision making because they

have not been committed and are likely different between decision alternatives

higher operating leverage represents increased risk associated with relatively:

high fixed costs in the firm's structure

what is NOT a major assumption underlying a conventional CVP analysis

in multi-product situations, the sales mix changes as volume changes

in performing short-term cost-volume profit (CVP) analysis for a new product or service, the decision-maker would

include only incremental fixed costs

a relatively low margin of safety ratio (MOS%) for a product is usually an indication that the product

is riskier than a product with a higher margin of safety ratio

Regression analysis is better than the high-low method of cost estimation because

it can provide greater precision and reliability

which of the following statements regarding cost of capital is NOT true

it is used when calculating IRR of a proposed investment

why might relevant cost analysis be bad for a company if used too frequently?

it overemphasizes short term goals and neglects long-term goals

what costs are not traceable to individual products?

joint production costs

when there are two or more cost drivers, regression is termed

multiple

which of the following cost drivers pairs with product design cost as a cost to be estimated

number of design elements

Simple Regression analysis involves the use of

one dependent and one independent variable

operating at or near full capacity will require a firm considering a "special sales order" to potentially recognize the:

opportunity cost from lost sales

Without knowing the required rate of return (i.e., discount rate) used for capital investment projects, a company will be able to calculate and evaluate a project's:

payback period, and book rate of return

Uncertainty Intolerance (behavioral issue)

risk-averse managers may require excessively short payback periods

In the situation where a firm produces multiple products and has a single resource constraint (ex: machine hours), the most profitable use of available capacity (machine hours) requires that we assess

the CM of each product per machine hour

which of the following statements regarding a joint production process is NOT true

the allocation of join production costs to individual products helps management determine which products should be processed beyond the split off point

which two factors make up a relevant cost?

the cost differs among options and is discretionary

Goal Congruency Issues (behavioral issue)

the need to align DCF decision models with models used for subsequent financial performance

Incrementalism (behavioral issue)

the practice of choosing multiple, small investments

when deciding whether to discontinue a segment of a business, managers should focus on

the total CM generated by the segment relative to any avoidable fixed costs associated with the segment

Cost-volume profit (CVP) analysis with multiple products assumes that sales will continue at the same mix of products, expressed in either sales units or sales dollars. This assumption is essential because a change in the product mix will probably change:

the weighted-average contribution margin (per unit or ratio)

the identification of cost drivers is perhaps the most important step in developing the cost estimate because:

there may be a number of relevant drivers, some no immediately obvious

"special sales orders" as this term is used in chapter 11:

typically comes directly from the customer rather than through normal sales or distribution channels

fixed costs will often be irrelevant for short-term decision making because they

typically do not differ in total between decision alternatives being considered

Especially for projects with long lives, estimation of revenues, costs, and cash flows is a difficult task principally because of

uncertainty about future events

in what situation does management make trade-offs about the quantity of each product to manufacture

when demand exceeds production capacity

when does depreciation expense become a relevant cost?

when tax effects are considered in decision making

Advantages of IRR

widely used in practice because of its appeal to managers

Industrial Engineering Method

work-measurement method --> estimates cost functions by analyzing the relationship between inputs and outputs in physical terms (physical relationship; governmental contracts)