Chapter 14 SmartBook

S&P Enterprises is considering purchasing a new piece of equipment that costs $125,000 and has an estimated useful life of 5 years The equipment should increase annual cash receipts by $75,000 per year. Cash expenses to operate the equipment should be $20,000. The company uses straight-line depreciation. If the after-tax cost of capital is 10% and the tax rate is 30%, what is the net present value of this project based on the tables in the appendix?

$49,386 Incremental net income: $75,000 - $20,000 - $25,000 depreciation expense = $30,000 × 30% = $9,000 tax expense. $55,000 - $9,000 = $46,000 annual cash flow × 3.791 = $174,386 - $125,000 = $49,386.

Which of the following statements are true?

- The cost of capital may be used to screen out undesirable projects. - When using the internal rate of return method, the cost of capital is used as the hurdle rate. - When the net present value method is used, the discount rate equals the hurdle rate.

Which of the following statements are true?

- The more frequently interest is compounded, the faster the balance grows. - Compound interest means that interest is paid on interest

Capital budgeting decisions include ______.

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

The payback method ______.

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

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

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

Capital budgeting decisions ______.

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

Working capital is ______.

- treated as a cash outflow when required at the beginning of a project. - treated as a cash inflow when released at the end of a project.

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

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 ______.

1.27 Reason: $266,700 ÷ $210,000 = 1.27

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 ______ years.

2.6 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, so the total payback period is 2.6 years.

State Bank is implementing a new marketing campaign that requires an initial investment of $35,000. If the project profitability index is 1.2, the present value of the campaign's future cash flows is $_____.

42,000

A company is considering purchasing a new piece of equipment that costs $100,000 and has an estimated useful life of 5 years. The equipment should increase annual cash receipts by $80,000 per year. Cash expenses to operate the equipment should be $25,000. The company uses straight-line depreciation. If the after-tax cost of capital is 10% and the tax rate is 30%, the net present value of this project based on the tables in the appendix is $_____.

68,700

Cash inflow <<<--->>> Working capital is released for use elsewhere within the company

Cash outflow <<<--->>> Working capital is tied up for project needs

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

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

Simple rate of return

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

True

The simple rate of return is also referred to as the _____ or _____ rate of return.

accounting unadjusted

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

accounting, unadjusted

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 equals the ______.

annual incremental net operating income ÷ initial investment

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

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

A series of equal cash flows is a(n) _____.

annuity

An investment that pays the investor $1,000 per year for the next 10 years is an example of a(n) _____.

annuity

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

Future cash flows expected from investment projects ______.

can be difficult to estimate

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

A postaudit involves ______.

checking whether expected results are actually realized

An investor deposits $100.00 and earns $6.00 of interest in the first year and $6.36 of interest in the second year. This means the investment is earning 6% _____ interest.

compound

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

The interest factor used to find the present value is called the _____ rate.

discount

Finding the present value of a future cash flow is called _____.

discounting

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

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

hurdle rate

Investment required ÷ Annual net cash inflow is the formula to find the factor that enables calculation of the ______.

internal rate of return

In an equipment capital budgeting decision, recovering the original investment means that the ______.

investment has generated enough cash inflows to completely cover the cost of the equipment

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

The internal rate of return ______.

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

It is important to know the present value of an investment because a dollar ______.

is worth more today than it will be worth a year from today

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 net present value decision that does not involve any revenues is known as a(n) _____-_____ decision.

least-cost

A capital investment project's payback period is the ______.

length of time it takes for the project to recover its initial cost from the net cash inflows generated

The term capital budgeting is used to describe how managers plan significant investments in projects that have ______ implications.

long-term

When analyzing an investment project, uncertain future cash flows ______.

may be estimated using computer simulations

A dollar today is worth _____ (more/less) than a dollar earned a year from now.

more

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

One dollar earned today is worth ______.

more than one dollar earned at a future point in time

A dollar today is ______ a dollar received a year from today.

more valuable than

The simple rate of return method focuses on ______, rather than ______.

net operating income, cash flows

Working capital ______.

often increases when a company takes on a new project

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

When computing net present value after tax, income tax expense is treated as a cash _____.

outflow

Instead of focusing on a project's profitability, the V period focuses on the time it takes for an investment to pay for itself.

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

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

positive or zero

Preference decisions are also called _____ or _____ decisions.

rationing ranking

Preference decisions are also called ______ decisions.

rationing ranking

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

required

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

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

The internal rate of return is ______.

the rate of return of an investment project over its useful life

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

total-cost

When computing net present value after tax, income tax expense is ______.

treated like every other cash flow

Current assets minus current liabilities is called _____ _____.

working capital

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

zero