Chapter 14

Chapter 14 Capital Budgeting Decisions True/False Questions 1. When cash flows are uneven and vary from year to year, the internal rate of return method is easier to use than the net present value method. Ans: False AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Hard 2. For capital budgeting decisions, the net present value method is superior to the simple rate of return method. Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,6 Level: Easy 3. Depreciation is included as a cash flow in capital budgeting decisions to ensure that the original cost of the asset is fully recovered. Ans: False AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Medium 4. Even when done properly, the total-cost and incremental-cost approaches to choosing between alternatives will sometimes yield different answers. Ans: False AACSB: Analytic AICPA FN: Reporting LO: 1

AICPA BB: Critical Thinking Level: Medium

5. An increase in the expected salvage value at the end of a capital budgeting project will have no effect on the internal rate of return for that project. Ans: False AACSB: Analytic AICPA FN: Reporting LO: 2


6. The intangible benefits of automation cannot be estimated with any accuracy and therefore should be ignored in capital budgeting decisions. Ans: False AACSB: Analytic AICPA FN: Reporting LO: 3


7. When making preference decisions about competing investment proposals, the project profitability index is superior to the internal rate of return. Ans: True AACSB: Analytic AICPA FN: Reporting LO: 4


Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition

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Chapter 14 Capital Budgeting Decisions 8. The project profitability index is computed by dividing the net present value of the project by the investment required by the project. Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Easy 9. In calculating the “investment required” for the project profitability index, the amount invested should be reduced by any salvage recovered from the sale of old equipment. Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Medium 10. The payback method is most appropriate for projects whose cash flows extend far into the future. Ans: False AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: 5 Level: Medium 11. When using the payback method, any cash flows for a project that occur after the payback period are not considered in computing the payback period for that project. Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: 5 Level: Medium 12. The present value of a given future cash flow will increase as the discount rate decreases. Ans: False AACSB: Analytic AICPA FN: Reporting LO: 7


13. If a company is operating at a profit, the cash inflow resulting from the depreciation tax shield is computed by multiplying the depreciation deduction by one minus the tax rate. Ans: False AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Medium 14. All cash inflows are taxable. Ans: False AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Easy

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Chapter 14 Capital Budgeting Decisions 15. The after-tax benefit, or net cash inflow, realized from a particular taxable cash receipt can be obtained by multiplying the cash receipt by one minus the tax rate. Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Easy Multiple Choice Questions 16. Suture Corporation's discount rate is 12%. If Suture has a 5-year investment project that has a project profitability index of zero, this means that: A) the net present value of the project is equal to zero. B) the internal rate of return of the project is equal to the discount rate. C) the payback period of the project is equal to the project's useful life. D) both A and B above are true. Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2,4,5 Level: Hard 17. Amster Corporation has not yet decided on the required rate of return to use in its capital budgeting. This lack of information will prevent Amster from calculating a project's: A) B) C) D)

Payback Net Present Value Internal Rate of Return No No No Yes Yes Yes No Yes Yes No Yes No

Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2,5 Level: Medium Source: CMA, adapted 18. If income taxes are ignored, how is depreciation used in the following capital budgeting techniques? A) B) C) D)

Internal Rate of Return Net Present Value Excluded Excluded Excluded Included Included Excluded Included Included

Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Medium Source: CPA, adapted


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Chapter 14 Capital Budgeting Decisions 19. If the net present value of a project is zero based on a discount rate of 16%, then the internal rate of return is: A) equal to 16%. B) less than 16%. C) greater than 16%. D) cannot be determined from this data. Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Medium 20. Three potential investment projects (A, B, and C) at Nit Corporation all require the same initial investment, have the same useful life (3 years), and have no expected salvage value. Expected net cash inflows from these three projects each year is as follows: A B C Year 1......... $1,000 $2,000 $3,000 Year 2......... $2,000 $2,000 $2,000 Year 3......... $3,000 $2,000 $1,000 What can be determined from the information provided above? A) the net present value of project C will be the highest. B) the internal rate of return of projects A and C cannot be computed. C) the net present value and the internal rate of return will be the same for all three projects. D) both A and B above. Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Hard 21. A project's net present value, ignoring income taxes, is affected by: A) the net book value of an asset that is replaced. B) the depreciation on an asset that is replaced. C) the depreciation to be taken on assets used directly on the project. D) proceeds from the sale of an asset that is replaced. Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Source: CPA, adapted

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Chapter 14 Capital Budgeting Decisions 22. A company has unlimited funds to invest at its discount rate. The company should invest in all projects having: A) an internal rate of return greater than zero. B) a net present value greater than zero. C) a simple rate of return greater than the discount rate. D) a payback period less than the project's estimated life. Ans: B AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Source: CMA, adapted 23. When the cash flows are the same every period after the initial investment in a project, the payback period is equal to: A) the net present value. B) the simple rate of return. C) the factor of the internal rate of return. D) the payback rate of return. Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2,5 Level: Hard Source: CMA, adapted 24. The internal rate of return method assumes that a project's cash flows are reinvested at the: A) internal rate of return. B) simple rate of return. C) required rate of return. D) payback rate of return. Ans: A AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Medium Source: CMA, adapted 25. (Ignore income taxes in this problem.) Which of the following would be used in the calculation of the internal rate of return of an investment in new machinery to replace old machinery? A) The annual depreciation expense on the new machinery. B) The cost of an overhaul that would be needed on the old machinery in three years. C) The salvage value of the old machinery in ten years. D) both B and C above. Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Medium


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Chapter 14 Capital Budgeting Decisions 26. The project profitability index and the internal rate of return: A) will always result in the same preference ranking for investment projects. B) will sometimes result in different preference rankings for investment projects. C) are less dependable than the payback method in ranking investment projects. D) are less dependable than net present value in ranking investment projects. Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4,5 Level: Medium 27. Zonifugal Corporation needs to purchase a new conveyor system for its factory. Four different conveyor systems have been proposed. Which calculation would be the best one for Zonifugal to use to determine which system to purchase? A) payback period B) simple rate of return C) net present value D) project profitability index Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Medium 28. A preference decision: A) is concerned with whether a project clears the minimum required rate of return hurdle. B) comes before the screening decision. C) is concerned with determining which of several acceptable alternatives is best. D) responses A, B, and C are all correct. Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Easy 29. In an equipment investment decision, which of the following amounts would be unaffected by a change in the tax rate? A) the present value of the initial investment in the equipment. B) the present value of the increase in working capital needed. C) the present value of the salvage value of the equipment. D) both A and B above. Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Medium

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Chapter 14 Capital Budgeting Decisions 30. When evaluating a project, the portion of the fixed corporate headquarters expense that would be allocated to the project should be: A) included as a cash outflow on an after-tax basis by multiplying the expense by one minus the tax rate. B) included as a cash outflow on an after-tax basis by multiplying the expense by the tax rate. C) included as a cash outflow on a before-tax basis. D) ignored. Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Hard 31. (Ignore income taxes in this problem.) Given the following data: Cost of equipment.............. Annual cash inflows........... Internal rate of return.........

$55,750 $10,000 16%

The life of the equipment must be: A) it is impossible to determine from the data given B) 15 years C) 12.5 years D) 5.75 years Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Hard Solution: The internal rate of return factor is 5.575, or $55,750 ÷ $10,000. In the table for the Present Value of an Annuity of $1 in Arrears, the factor of 5.575 can be found in the 16% column in the 15th row; 15 then represents the life of the equipment.


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Chapter 14 Capital Budgeting Decisions 32. (Ignore income taxes in this problem.) Heap Company is considering an investment in a project that will have a two year life. The project will provide a 10% internal rate of return, and is expected to have a $40,000 cash inflow the first year and a $50,000 cash inflow in the second year. What investment is required in the project? A) $74,340 B) $77,660 C) $81,810 D) $90,000 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Hard Source: CMA, adapted Solution: st

Cash inflow−1 year.......... Cash inflow−2nd year.......... Net present value................

Year(s) 1 2

Amount 40,000 50,000

10% Factor 0.909 0.826

PV $36,360 41,300 $77,660

For the net present value of this project to be zero, the initial investment should be equal to the present value of the cash inflows, or $77,660. 33. (Ignore income taxes in this problem.) Congener Beverage Corporation is considering an investment in a capital budgeting project that has an internal rate of return of 20%. The only cash outflow for this project is the initial investment. The project is estimated to have an 8 year life and no salvage value. Cash inflows from this project are expected to be $100,000 per year in each of the 8 years. Congener's discount rate is 16%. What is the net present value of this project? A) $5,215 B) $15,464 C) $50,700 D) $55,831 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Hard

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Chapter 14 Capital Budgeting Decisions Solution: Internal rate of return factor = Initial investment ÷ Annual inflows Look up the factor in the table Present Value of an Annuity of $1 in Arrears for 8 periods, 20% column; the factor is 3.837. Substituting into the above equation, 3.837 = Initial investment ÷ $100,000 Initial investment = $383,700. Initial investment............... Annual net cash receipts.... Net present value................

Year(s) Amount 16% Factor PV Now ($383,700) 1.000 ($383,700) 1-8 $100,000 4.344 434,400 $ 50,700

34. (Ignore income taxes in this problem.) The Able Company is considering buying a new donut maker. This machine will replace an old donut maker that still has a useful life of 2 years. The new machine will cost $2,500 a year to operate, as opposed to the old machine, which costs $2,700 per year to operate. Also, because of increased capacity, an additional 10,000 donuts a year can be produced. The company makes a contribution margin of $0.02 per donut. The old machine can be sold for $5,000 and the new machine costs $25,000. The incremental annual net cash inflows provided by the new machine would be: A) $200 B) $400 C) $5,200 D) $5,400 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Hard Solution: Operating cost savings per year ($2,700 − $2,500)........................ Additional contribution margin provided by the new donut maker ($0.02 × 10,000).......................................................................... Incremental annual net cash inflows provided by new machine....


$200 200 $400

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Chapter 14 Capital Budgeting Decisions 35. (Ignore income taxes in this problem.) Given the following data: Initial investment............... Annual cash inflow............ Salvage value..................... Net present value................ Life of the project............... Discount rate......................

$80,000 ? $0 $13,600 6 years 16%

Based on the data given above, the annual cash inflow from the project after the initial investment is closest to: A) $50,116 B) $21,710 C) $25,400 D) $38,376 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Hard Solution: First, set up table: Initial investment............... Annual cash inflows........... Net present value................

Year(s) Now 1-6

Amount 16% Factor $80,000 1.000 ? 3.685

PV ($80,000) ? $13,600

Second, solve for the present value of the annual cash inflow: PV of annual cash inflow = $13,600 − (-$80,000) = $93,600 Finally, solve for the annual cash inflow: Annual cash inflow × 3.685 = $93,600 Annual cash inflow = $25,400

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Chapter 14 Capital Budgeting Decisions 36. (Ignore income taxes in this problem.) Virginia Company invested in a four-year project. Virginia's discount rate is 10%. The cash inflows from this project are: Year Cash Inflow 1 $4,000 2 $4,400 3 $4,800 4 $5,200 Assuming a positive net present value of $1,000, the amount of the original investment was closest to: A) $2,552 B) $4,552 C) $13,427 D) $17,400 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Hard Source: CPA, adapted Solution: Net present value of cash inflows − Original investment = Net present value of project Original investment = NPV of cash inflows − NPV of project = $14,427 − $1,000 = $13,427 Year 1 inflow................................ Year 2 inflow................................ Year 3 inflow................................ Year 4 inflow................................ Net present value of cash inflows

Year(s) 1 2 3 4


Amount $4,000 $4,400 $4,800 $5,200

10% Factor 0.909 0.826 0.751 0.683

PV $ 3,636 3,634 3,605 3,552 $14,427

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Chapter 14 Capital Budgeting Decisions 37. (Ignore income taxes in this problem.) Para Corporation is reviewing the following data relating to an energy saving investment proposal: Initial investment............... Life of the project............... Salvage value..................... Annual cash savings...........

$50,000 5 years $10,000 ?

What annual cash savings would be needed in order to satisfy the company's 12% required rate of return (rounded to the nearest one hundred dollars)? A) $10,600 B) $11,100 C) $12,300 D) $13,900 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Hard Source: CPA, adapted Solution: Total investment................. Annual cash savings........... Salvage value..................... Net present value................

Years Amount 12% Factor Now ($50,000) 1.000 1-5 ? 3.605 5 $10,000 0.567

Present Value ($50,000) ? 5,670 $ 0

To solve for the present value of the annual cash savings: -$50,000 + PV of annual cash savings + $5,670 = $0 PV of annual cash savings = $44,330 To solve for the amount of the annual cash savings: Amount of annual cash savings × 3.605 = $44,330 Amount of annual cash savings = $12,297, which rounds to $12,300

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Chapter 14 Capital Budgeting Decisions 38. (Ignore income taxes in this problem.) Nevus Tattoo Parlor is considering a capital budgeting project. This project will initially require a $25,000 investment in equipment and a $3,000 working capital investment. The useful life of this project is 5 years with an expected salvage value of zero on the equipment. The working capital will be released at the end of the 5 years. The new system is expected to generate net cash inflows of $9,000 per year in each of the 5 years. Nevus' discount rate is 14%. The net present value of this project is closest to: A) $(3,088) B) $3,383 C) $4,454 D) $5,897 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Medium Solution: Initial investment............... Working capital needed...... Annual cost savings........... Working capital released.... Net present value................

Year(s) Now Now 1-5 5

Amount 14% Factor ($25,000) 1.000 ($3,000) 1.000 $9,000 3.433 $3,000 0.519


PV ($25,000) ( 3,000) 30,897 1,557 $ 4,454

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Chapter 14 Capital Budgeting Decisions 39. (Ignore income taxes in this problem.) The Malaise Prevention Agency is a non-profit organization that does all of its own informational printing. The printing press that Malaise currently is using needs a $20,000 overhaul. This will extend the useful life of the press by 8 years. As an alternative, Malaise could buy a brand new modern press for $45,000. The new press would also last 8 years. The annual operating expenses of the old press are $12,000. The annual operating expenses of the new press will only be $7,000. The old press is not expected to have a salvage value in 8 years. The new press is expected to have a $6,000 salvage value in 8 years. Malaise's discount rate is 14%. The net present value of the decision to buy the new press instead of overhauling the old press is closest to: A) $301 B) $(301) C) $4,195 D) $(46,089) Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Hard Solution: Initial investment............... Annual cost savings ($12,000 − $7,000)......... Salvage value..................... Net present value of new press................................

Year(s) Now 1-8 8

Amount 14% Factor ($45,000) 1.000 $5,000 $6,000

4.639 0.351

PV ($45,000) 23,195 2,106 ($19,699)

Cost to overhaul old press................ $20,000 NPV of new press............................. 19,699 NPV of new press vs. old press........ $ 301

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Chapter 14 Capital Budgeting Decisions 40. (Ignore income taxes in this problem.) Nevland Corporation is considering the purchase of a machine that would cost $130,000 and would last for 6 years. At the end of 6 years, the machine would have a salvage value of $18,000. By reducing labor and other operating costs, the machine would provide annual cost savings of $44,000. The company requires a minimum pretax return of 19% on all investment projects. The net present value of the proposed project is closest to: A) $38,040 B) $26,376 C) $74,902 D) $20,040 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Initial investment............... Annual cost savings........... Salvage value..................... Net present value................

Year(s) Amount 19% Factor PV Now ($130,000) 1.000 ($130,000) 1-6 $44,000 3.410 150,040 6 $18,000 0.352 6,336 $ 26,376

41. (Ignore income taxes in this problem) The management of Penfold Corporation is considering the purchase of a machine that would cost $440,000, would last for 7 years, and would have no salvage value. The machine would reduce labor and other costs by $102,000 per year. The company requires a minimum pretax return of 16% on all investment projects. The net present value of the proposed project is closest to: A) -$28,022 B) $96,949 C) -$79,196 D) $274,000 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Initial investment............... Annual cost savings........... Net present value................

Year(s) Amount 16% Factor PV Now ($440,000) 1.000 ($440,000) 1-7 $102,000 4.039 411,978 ($ 28,022)


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Chapter 14 Capital Budgeting Decisions 42. (Ignore income taxes in this problem.) Dowlen, Inc., is considering the purchase of a machine that would cost $150,000 and would last for 6 years. At the end of 6 years, the machine would have a salvage value of $23,000. The machine would reduce labor and other costs by $36,000 per year. Additional working capital of $6,000 would be needed immediately. All of this working capital would be recovered at the end of the life of the machine. The company requires a minimum pretax return of 12% on all investment projects. The net present value of the proposed project is closest to: A) $9,657 B) -$2,004 C) $6,699 D) $13,223 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Initial investment............... Working capital needed...... Annual cost savings........... Working capital released.... Salvage value..................... Net present value................

Year(s) Amount 12% Factor PV Now ($150,000) 1.000 ($150,000) Now ($6,000) 1.000 (6,000) 1-6 $36,000 4.111 147,996 6 $6,000 0.507 3,042 6 $23,000 0.507 11,661 $ 6,699

43. (Ignore income taxes in this problem.) The Poteran Company is considering a machine that will save $3,000 a year in cash operating costs each year for the next six years. At the end of six years it would have no salvage value. If this machine costs $9,060 now, the machine's internal rate of return is closest to: A) 18% B) 20% C) 22% D) 24% Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Medium Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $9,060 ÷ $3,000 = 3.020 The factor of 3.020 for 6 years represents an internal rate of return of 24%.

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Chapter 14 Capital Budgeting Decisions 44. (Ignore income taxes in this problem) The management of Elamin Corporation is considering the purchase of a machine that would cost $365,695 and would have a useful life of 9 years. The machine would have no salvage value. The machine would reduce labor and other operating costs by $61,000 per year. The internal rate of return on the investment in the new machine is closest to: A) 9% B) 11% C) 12% D) 10% Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Easy Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $365,695 ÷ $61,000 = 5.995 The factor of 5.995 for 9 years represents an internal rate of return of 9%. 45. (Ignore income taxes in this problem.) Bau Long-Haul, Inc., is considering the purchase of a tractor-trailer that would cost $281,656, would have a useful life of 7 years, and would have no salvage value. The tractor-trailer would be used in the company's hauling business, resulting in additional net cash inflows of $76,000 per year. The internal rate of return on the investment in the tractor-trailer is closest to: A) 19% B) 18% C) 21% D) 16% Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Easy Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $281,656 ÷ $76,000 = 3.706 The factor of 3.706 for 7 years represents an internal rate of return of 19%.


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Chapter 14 Capital Budgeting Decisions 46. (Ignore income taxes in this problem.) Golab Roofing is considering the purchase of a crane that would cost $69,846, would have a useful life of 6 years, and would have no salvage value. The use of the crane would result in labor savings of $21,000 per year. The internal rate of return on the investment in the crane is closest to: A) 18% B) 20% C) 19% D) 17% Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Easy Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $69,846 ÷ $21,000 = 3.326 The factor of 3.326 for 6 years represents an internal rate of return of 20%. 47. (Ignore income taxes in this problem) Boe Corporation is investigating buying a small used aircraft for the use of its executives. The aircraft would have a useful life of 9 years. The company uses a discount rate of 10% in its capital budgeting. The net present value of the investment, excluding the salvage value of the aircraft, is $439,527. Management is having difficulty estimating the salvage value of the aircraft. To the nearest whole dollar how large would the salvage value of the aircraft have to be to make the investment in the aircraft financially attractive? A) $439,527 B) $43,953 C) $4,395,270 D) $1,036,620 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum salvage value = Negative net present value to the offset ÷ Present value factor = $439,527 ÷ 0.424 = $1,036,613 (answer is slightly off due to rounding)

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Chapter 14 Capital Budgeting Decisions 48. (Ignore income taxes in this problem) The management of Byrge Corporation is investigating buying a small used aircraft to use in making airborne inspections of its above-ground pipelines. The aircraft would have a useful life of 8 years. The company uses a discount rate of 10% in its capital budgeting. The net present value of the investment, excluding the intangible benefits, is -$448,460. To the nearest whole dollar how large would the annual intangible benefit have to be to make the investment in the aircraft financially attractive? A) $44,846 B) $56,058 C) $84,060 D) $448,460 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum annual cash flows from the intangible benefits = Negative net present value to be offset ÷ Present value factor = $448,460 ÷ 5.335 = $84,060 49. (Ignore income taxes in this problem) The management of Osborn Corporation is investigating an investment in equipment that would have a useful life of 8 years. The company uses a discount rate of 12% in its capital budgeting. The net present value of the investment, excluding the annual cash inflow, is -$401,414. To the nearest whole dollar how large would the annual cash inflow have to be to make the investment in the equipment financially attractive? A) $48,170 B) $50,177 C) $80,800 D) $401,414 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum annual cash flows = Negative net present value to be offset ÷ Present value factor = $401,414 ÷ 4.968 = $80,800


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Chapter 14 Capital Budgeting Decisions 50. (Ignore income taxes in this problem.) Croce, Inc., is investigating an investment in equipment that would have a useful life of 7 years. The company uses a discount rate of 8% in its capital budgeting. The net present value of the investment, excluding the salvage value, is -$515,967. To the nearest whole dollar how large would the salvage value of the equipment have to be to make the investment in the equipment financially attractive? A) $41,277 B) $885,021 C) $515,967 D) $6,449,588 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum salvage value = Negative net present value to the offset ÷ Present value factor = $515,967 ÷ 0.583 = $885,021 51. A project has an initial investment of $100,000 and a project profitability index of 0.15. The discount rate is 12%. The net present value of the project is closest to: A) $15,000 B) $115,000 C) $112,000 D) $12,000 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Medium Source: CMA, adapted Solution: Project profitability index = Net present value ÷ Investment required 0.15 = Net present value ÷ $100,000 Net present value = $15,000

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Chapter 14 Capital Budgeting Decisions 52. A company is pondering an investment project that has an internal rate of return which is equal to the company's discount rate. The project profitability index of this investment project is: A) 0.0 B) 0.5 C) 1.0 D) 1.5 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Medium 53. (Ignore income taxes in this problem.) The management of Solar Corporation is considering the following three investment projects: Investment required....................... Present value of cash inflows.........

Project L Project M Project N $37,000 $55,000 $82,000 $38,480 $62,150 $90,200

Rank the projects according to the profitability index, from most profitable to least profitable. A) M,N,L B) L,N,M C) N,L,M D) N,M,L Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Easy Solution: Investment required (a)......................... Present value of cash inflows............... Net present value (b)............................. Project profitability index (b) ÷ (a)....... Ranked by project profitability index...

Project L Project M Project N ($37,000) ($55,000) ($82,000) 38,480 62,150 90,200 $ 1,480 $ 7,150 $ 8,200 0.04 0.13 0.10 3 1 2


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Chapter 14 Capital Budgeting Decisions 54. (Ignore income taxes in this problem.) Trovato Corporation is considering a project that would require an investment of $48,000. No other cash outflows would be involved. The present value of the cash inflows would be $51,840. The profitability index of the project is closest to: A) 0.07 B) 0.08 C) 0.92 D) 1.08 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Easy Solution: Investment required (a)......................... Present value of cash inflows............... Net present value (b)............................. Project profitability index (b) ÷ (a).......

Project Q ($48,000) 51,840 $ 3,840 0.08

55. (Ignore income taxes in this problem.) Ryner Corporation is considering three investment projects-S, T, and U. Project S would require an investment of $20,000, Project T of $69,000, and Project U of $83,000. No other cash outflows would be involved. The present value of the cash inflows would be $23,200 for Project S, $77,970 for Project T, and $94,620 for Project U. Rank the projects according to the profitability index, from most profitable to least profitable. A) U,T,S B) T,S,U C) U,S,T D) S,U,T Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Easy Solution: Project S Project T Project U Investment required (a)......................... ($20,000) ($69,000) ($83,000) Present value of cash inflows............... 23,200 77,970 94,620 Net present value (b)............................. $ 3,200 $ 8,970 $11,620 Project profitability index (b) ÷ (a)....... 0.16 0.13 0.14 Ranked by project profitability index... 1 3 2

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Chapter 14 Capital Budgeting Decisions 56. (Ignore income taxes in this problem.) The management of Leitheiser Corporation is considering a project that would require an initial investment of $51,000. No other cash outflows would be required. The present value of the cash inflows would be $57,630. The profitability index of the project is closest to: A) 1.13 B) 0.87 C) 0.13 D) 0.12 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Easy Solution: Project Q Investment required (a)......................... ($51,000) Present value of cash inflows............... 57,630 Net present value (b)............................. $ 6,630 Project profitability index (b) ÷ (a)....... 0.13 57. (Ignore income taxes in this problem.) Olinick Corporation is considering a project that would require an investment of $343,000 and would last for 8 years. The incremental annual revenues and expenses generated by the project during those 8 years would be as follows: Sales................................... Variable expenses............... Contribution margin........... Fixed expenses: Salaries............................ Rents............................... Depreciation.................... Total fixed expenses........... Net operating income.........

$227,000 52,000 175,000 27,000 41,000 40,000 108,000 $ 67,000

The scrap value of the project's assets at the end of the project would be $23,000. The payback period of the project is closest to: A) 3.0 years B) 5.1 years C) 3.2 years D) 4.8 years Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 5 Level: Easy


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Chapter 14 Capital Budgeting Decisions Solution: Net annual cash flow = Net operating income + Depreciation = $67,000 + $40,000 = $107,000 Payback period = Investment required ÷ Net annual cash flow = $343,000 ÷ $107,000 = 3.2 years In this case the salvage value plays no part in the payback period since all of the investment is recovered before the end of the project. 58. (Ignore income taxes in this problem.) The management of Lanzilotta Corporation is considering a project that would require an investment of $263,000 and would last for 8 years. The annual net operating income from the project would be $66,000, which includes depreciation of $31,000. The scrap value of the project's assets at the end of the project would be $15,000. The payback period of the project is closest to: A) 3.8 years B) 2.6 years C) 2.7 years D) 4.0 years Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 5 Level: Easy Solution: Net annual cash flow = Net operating income + Depreciation = $66,000 + $31,000 = $97,000 Payback period = Investment required ÷ Net annual cash flow = $263,000 ÷ $97,000 = 2.7 years In this case the salvage value plays no part in the payback period since all of the investment is recovered before the end of the project.

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Chapter 14 Capital Budgeting Decisions 59. (Ignore income taxes in this problem.) Slomkowski Corporation is contemplating purchasing equipment that would increase sales revenues by $298,000 per year and cash operating expenses by $143,000 per year. The equipment would cost $712,000 and have a 8 year life with no salvage value. The annual depreciation would be $89,000. The simple rate of return on the investment is closest to: A) 9.3% B) 21.8% C) 22.1% D) 12.5% Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 6 Level: Easy Solution: The simple rate of return is computed as follows: Cost of machine, net of salvage value (a)........... Useful life (b)...................................................... Annual depreciation (a) ÷ (b)..............................

$712,000 8 years $89,000

Annual incremental revenue ($298,000 − $143,000)......................................................... Less annual depreciation..................................... Annual incremental net operating income..........

$155,000 89,000 $ 66,000

Simple rate of return = Annual incremental net operating income ÷ Initial investment = $66,000 ÷ $712,000 = 9.3% 60. (Ignore income taxes in this problem.) The management of Plotnik Corporation is investigating purchasing equipment that would increase sales revenues by $269,000 per year and cash operating expenses by $156,000 per year. The equipment would cost $294,000 and have a 6 year life with no salvage value. The simple rate of return on the investment is closest to: A) 16.7% B) 38.4% C) 23.8% D) 21.8% Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 6 Level: Easy


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Chapter 14 Capital Budgeting Decisions Solution: The simple rate of return is computed as follows: Cost of machine, net of salvage value (a).......................... Useful life (b)..................................................................... Annual depreciation (a) ÷ (b).............................................

$294,000 6 years $49,000

Annual incremental revenue ($269,000 − $156,000)........ Less annual depreciation.................................................... Annual incremental net operating income.........................

$113,000 49,000 $ 64,000

Simple rate of return = Annual incremental net operating income ÷ Initial investment = $64,000 ÷ $294,000 = 21.8% 61. (Ignore income taxes in this problem.) An expansion at Fey, Inc., would increase sales revenues by $150,000 per year and cash operating expenses by $47,000 per year. The initial investment would be for equipment that would cost $328,000 and have a 8 year life with no salvage value. The annual depreciation on the equipment would be $41,000. The simple rate of return on the investment is closest to: A) 41.3% B) 18.9% C) 12.5% D) 31.4% Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 6 Level: Easy Solution: The simple rate of return is computed as follows: Annual incremental revenue ($150,000 − $47,000)............. $103,000 Less annual depreciation....................................................... 41,000 Annual incremental net operating income............................ $ 62,000 Simple rate of return = Annual incremental net operating income ÷ Initial investment = $62,000 ÷ $328,000 = 18.9%

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Chapter 14 Capital Budgeting Decisions 62. (Ignore income taxes in this problem.) Crowl Corporation is investigating automating a process by purchasing a machine for $792,000 that would have a 9 year useful life and no salvage value. By automating the process, the company would save $132,000 per year in cash operating costs. The new machine would replace some old equipment that would be sold for scrap now, yielding $21,000. The annual depreciation on the new machine would be $88,000. The simple rate of return on the investment is closest to: A) 11.1% B) 16.7% C) 5.7% D) 5.6% Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 6 Level: Easy Solution: The simple rate of return is computed as follows: Cost of machine, net of scrap (a) ($792,000 − $21,000)..

$771,000

Annual cost savings.......................................................... Less annual depreciation.................................................. Annual incremental net operating income........................

$132,000 88,000 $ 44,000

Simple rate of return = Annual incremental net operating income ÷ Initial investment = $44,000 ÷ $771,000 = 5.7% 63. (Ignore income taxes in this problem.) The management of Ro Corporation is investigating automating a process. Old equipment, with a current salvage value of $11,000, would be replaced by a new machine. The new machine would be purchased for $243,000 and would have a 9 year useful life and no salvage value. By automating the process, the company would save $69,000 per year in cash operating costs. The simple rate of return on the investment is closest to: A) 18.1% B) 11.1% C) 28.4% D) 17.3% Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 6 Level: Easy


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Chapter 14 Capital Budgeting Decisions Solution: The simple rate of return is computed as follows: Cost of machine, net of salvage value (a)........... Useful life (b)...................................................... Annual depreciation (a) ÷ (b)..............................

$243,000 9 years $27,000

Annual cost savings............................................ Less annual depreciation..................................... Annual incremental net operating income..........

$69,000 27,000 $42,000

Simple rate of return = Annual incremental net operating income ÷ Initial investment, less salvage value = $42,000 ÷ ($243,000 − $11,000) = 18.1% 64. (Ignore income taxes in this problem.) A company wants to have $20,000 at the end of a ten-year period by investing a single sum now. How much needs to be invested in order to have the desired sum in ten years, if the money can be invested at 12%? A) $3,254.68 B) $3,539.82 C) $6,440.00 D) $7,720.00 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 7 Level: Easy Solution: Factor from Present Value of $1 table, 12%, 10 years: 0.322 $20,000 × 0.322 = $6,440.00

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Chapter 14 Capital Budgeting Decisions 65. (Ignore income taxes in this problem.) At an interest rate of 14%, approximately how much would you need to invest today if you wanted to have $2,000,000 in 10 years? A) $383,436 B) $540,000 C) $740,741 D) $1,043,200 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 7 Level: Easy Solution: Factor from Present Value of $1 table, 14%, 10 years: 0.270 $2,000,000 × 0.270 = $540,000 66. (Ignore income taxes in this problem.) How much would you have to invest today in the bank at an interest rate of 8% to have an annuity of $4,800 per year for 7 years, with nothing left in the bank at the end of the 7 years? Select the amount below that is closest to your answer. A) $33,600 B) $2,798 C) $24,989 D) $31,111 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 7 Level: Easy Solution: Factor from Present Value of an Annuity of $1 in Arrears Table, 8%, 7 years: 5.206 $4,800 × 5.206 = $24,989


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Chapter 14 Capital Budgeting Decisions 67. (Ignore income taxes in this problem.) You have deposited $24,764 in a special account that has a guaranteed interest rate. If you withdraw $4,300 at the end of each year for 9 years, you will completely exhaust the balance in the account. The guaranteed interest rate is closest to: A) 6% B) 10% C) 17% D) 56% Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 7 Level: Hard Solution: $4,300 × Factor from PV of Annuity table = $24,764 Factor from PV of Annuity table = 5.759 Looking in Present Value of an Annuity of $1 in Arrears in the 9th row, 5.759 is found in the 10% column which is the guaranteed interest rate. 68. (Ignore income taxes in this problem.) You have deposited $7,620 in a special account that has a guaranteed interest rate of 19% per year. If you are willing to completely exhaust the account, what is the maximum amount that you could withdraw at the end of each of the next 7 years? Select the amount below that is closest to your answer. A) $1,295 B) $2,056 C) $2,219 D) $1,089 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 7 Level: Medium Solution: Factor from Present Value of an Annuity of $1 in Arrears table, 19%, 7 years: 3.706 $7,620 ÷ 3.706 = $2,056

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Chapter 14 Capital Budgeting Decisions 69. (Ignore income taxes in this problem.) Suddeth Corporation has entered into a 6 year lease for a building it will use as a warehouse. The annual payment under the lease will be $2,468. The first payment will be at the end of the current year and all subsequent payments will be made at year-ends. What is the present value of the lease payments if the discount rate is 5%? A) $12,528 B) $14,103 C) $14,808 D) $11,050 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 7 Level: Easy Solution: Factor from Present Value of an Annuity of $1 in Arrears table, 5%, 6 years: 5.076 $2,468 × 5.076 = $12,528 70. (Ignore income taxes in this problem.) Domebo Corporation has entered into a 7 year lease for a piece of equipment. The annual payment under the lease will be $3,400, with payments being made at the beginning of each year. If the discount rate is 14%, the present value of the lease payments is closest to: A) $9,511 B) $16,623 C) $20,877 D) $23,800 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 7 Level: Hard Solution: Annual payments made at the beginning of the year mean that the first lease payment would be paid immediately; the present value of the first lease payment is therefore $3,400. The next six lease payments for years 2-7 made at the beginning of each year is equivalent to six payments at the end of each year for years 1 through 6. The table for the Present Value of an Annuity of $1 in Arrears can be used to calculate the years 1-6. Factor from Present Value of an Annuity of $1 in Arrears table, 14%, 6 years: 3.889 ($3,400 × 3.889) + $3,400 = $16,623


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Chapter 14 Capital Budgeting Decisions 71. Wedge Corporation uses a discount rate of 14% and has a tax rate of 30%. The following cash flows occur in the last year of a 10-year equipment selection investment project: Cost savings for the year............................ Working capital released............................ Salvage value from sale of equipment.......

$180,000 $120,000 $25,000

At the end of the ten years when the equipment is sold, its net book value for tax purposes is zero. The total after-tax present value of the cash flows above is closest to: A) $45,765 B) $48,465 C) $61,425 D) $71,145 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Medium Solution: Net cash inflow................... Salvage value...................... Working capital released..... Net present value................

Net annual cash inflow....... Salvage value...................... Working capital released..... Net present value................

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Years 10 10 10

Amount $180,000 $25,000 $120,000

After-Tax Cash Flows $126,000 $17,500 $120,000

14% Factor 0.270 0.270 0.270

Tax Effect 0.70 0.70

Present Value $34,020 4,725 32,400 $71,145


Chapter 14 Capital Budgeting Decisions 72. A company anticipates a taxable cash receipt of $80,000 in year 3 of a project. The company's tax rate is 30% and its discount rate is 10%. The present value of this future cash flow is closest to: A) $42,056 B) $56,000 C) $24,000 D) $18,032 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Medium Solution: After-tax cash flow = Before-tax cash flow × (1 − Tax rate) = $80,000 × (1 − 0.30) = $56,000 Present value factor from Present Value of $1: 0.751 Present value = $56,000 × 0.751 = $42,056 73. A company anticipates a taxable cash expense of $30,000 in year 4 of a project. The company's tax rate is 30% and its discount rate is 14%. The present value of this future cash flow is closest to: A) $(21,000) B) $(5,329) C) $(9,000) D) $(12,432) Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Medium Solution: After-tax cash flow = Before-tax cash flow × (1 − Tax rate) = $30,000 × (1 − 0.30) = $21,000 Present value factor from Present Value of $1: 0.592 Present value = $21,000 × 0.592 = $12,432


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Chapter 14 Capital Budgeting Decisions 74. A company anticipates a depreciation deduction of $70,000 in year 4 of a project. The company's tax rate is 30% and its discount rate is 12%. The present value of the depreciation tax shield resulting from this deduction is closest to: A) $31,140 B) $49,000 C) $21,000 D) $13,356 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Medium Solution: Depreciation tax shield = $70,000 × 30% = $21,000 Present value of depreciation shield = $21,000 × 0.636* = $13,356 *Factor from Present Value of $1 table, 12%, 4 years 75. A company needs an increase in working capital of $50,000 in a project that will last 4 years. The company's tax rate is 30% and its discount rate is 14%. The present value of the release of the working capital at the end of the project is closest to: A) $15,000 B) $20,723 C) $29,600 D) $35,000 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Medium Solution: Present value of working capital release = $50,000 × 0.592* = $29,600 *Factor from Present Value of $1 table

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Chapter 14 Capital Budgeting Decisions 76. Dunn Construction, Inc., has a large crane that cost $35,000 when purchased ten years ago. Depreciation taken to date totals $25,000. The crane can be sold now for $6,000. Assuming a tax rate of 40%, if the crane is sold the total after-tax cash inflow for capital budgeting purposes will be: A) $8,400 B) $12,000 C) $7,600 D) $10,000 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Hard Solution: Sale proceeds....................................................... $ 6,000 Less book value of crane ($35,000 − $25,000).... 10,000 Loss on sale of crane............................................ ($ 4,000) Cash proceeds from sale...................................... $6,000 Add tax benefit of loss ($4,000 × 0.40)............... 1,600 Total after-tax cash inflow from sale................... $7,600 77. If an investment of $90,000 made now has annual cash operating inflows of $5,000, and if the tax rate is 40%, then the after-tax cash operating inflow each year would be: A) $2,000 B) $36,000 C) $3,000 D) $54,000 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Easy Solution: After-tax cash operating inflow = $5,000 × (1 – 0.40) = $3,000


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Chapter 14 Capital Budgeting Decisions 78. If a company's income tax rate is 30% and its annual depreciation deduction is $80,000, then the annual tax savings from the depreciation tax shield is: A) $56,000 B) $24,000 C) $80,000 D) $32,000 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Easy Solution: Annual tax savings from depreciation tax shield = $80,000 × 0.30 = $24,000 79. Garfield, Inc., is considering a ten-year investment project with forecasted cash revenues of $40,000 per year and forecasted cash expenses of $29,000 per year. The initial cost of the equipment for the project is $23,000. The salvage value of the equipment is $9,000 at the end of the ten years of the project. The net book value of the equipment for tax purposes will be zero at the end of the ten years. The project requires a working capital investment of $7,000 at its inception and another working capital infusion of $5,000 at the end of year five. All of this working capital would be released for use elsewhere at the end of the project. The company's tax rate is 40%. What is the after-tax net cash flow in the tenth year of the project? A) $32,000 B) $24,000 C) $20,000 D) $11,000 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: 8 Level: Medium Source: CMA, adapted

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Chapter 14 Capital Budgeting Decisions Solution: Salvage sale proceeds......... $9,000 Less book value.................. 0 Gain on sale........................ $9,000 Net after-tax cash flow in year 10: Gain on sale [$9,000 × (1 − 0.40)]....................................... Initial working capital.......................................................... 5th year working capital........................................................ Net revenue per year [($40,000 − $29,000) × (1 − 0.40)].... Net after-tax cash flow.........................................................

$ 5,400 7,000 5,000 6,600 $24,000

Use the following to answer questions 80-81: The Golden Company is analyzing projects A, B, and C as possible investment opportunities. Each of these projects has a useful life of eight years. The following information has been obtained: Initial investment....................................... Present value of future net cash inflows.... Internal rate of return.................................

Project A Project B Project C $250,000 $475,000 $380,000 $290,000 $503,000 $422,000 16% 20% 18%


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Chapter 14 Capital Budgeting Decisions 80. Consider the following statements: I. II.

Project A is preferred to Project B according to a net present value ranking. Project A is preferred to Project B according to an internal rate of return ranking. III. Project A is preferred to Project B according to a project profitability index ranking. Which is true? A) Only I B) Only II C) Only I and II D) Only I and III Ans: D AACSB: Analytic ACIPA FN: Decision Making

AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2,4

Level: Easy

Solution: Initial investment (a).................................. Present value of future net cash inflows.... Net present value (b).................................. Project profitability index (b) ÷ (a)............ Internal rate of return.................................

Project A Project B Project C $250,000 $475,000 $380,000 $290,000 $503,000 $422,000 $40,000 $28,000 $42,000 0.16 0.06 0.11 16% 20% 18%

81. Consider the following statements: I.

Project A has the highest ranking according to the project profitability index criterion. II. Project B has the highest ranking according to the internal rate of return criterion. III. Project C has the highest ranking according to the net present value criterion. Which is true? A) Only II B) Only I and III C) Only II and III D) I, II and III Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2,4 Level: Easy

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Chapter 14 Capital Budgeting Decisions Solution: Initial investment (a).................................. Present value of future net cash inflows.... Net present value (b).................................. Project profitability index (b) ÷ (a)............ Internal rate of return.................................

Project A Project B Project C $250,000 $475,000 $380,000 $290,000 $503,000 $422,000 $40,000 $28,000 $42,000 0.16 0.06 0.11 16% 20% 18%

Use the following to answer questions 82-85: (Ignore income taxes in this problem.) Chee Company has gathered the following data on a proposed investment project: Investment required in equipment............. Annual cash inflows................................... Salvage value............................................. Life of the investment................................ Required rate of return...............................

$240,000 $50,000 $0 8 years 10%

82. The payback period for the investment is closest to: A) 0.2 years B) 2.5 years C) 4.8 years D) 5.0 years Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 5 Level: Easy Solution: Payback period = Investment required ÷ Annual cash inflows = $240,000 ÷ $50,000 = 4.8 years


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Chapter 14 Capital Budgeting Decisions 83. The simple rate of return on the investment is closest to: A) 12.5% B) 10.0% C) 20.8% D) 8.3% Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 6 Level: Medium Solution: The simple rate of return is computed as follows: Cost of machine, net of salvage value (a). . $240,000 Useful life (b)............................................. 8 years Annual depreciation (a) ÷ (b)..................... $30,000 Annual cash inflows................................... Less annual depreciation............................ Annual incremental net operating income.

$50,000 30,000 $20,000

Simple rate of return = Annual incremental net operating income ÷ Initial investment = $20,000 ÷ $240,000 = 8.3% 84. The net present value on this investment is closest to: A) $160,000 B) $240,024 C) $58,800 D) $26,750 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Medium Solution: Annual cash inflows..... Initial investment......... Net present value..........

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Year(s) Amount 10% Factor 1-8 $50,000 5.335 Now ($240,000) 1.000

PV $266,750 ( 240,000) $ 26,750


Chapter 14 Capital Budgeting Decisions 85. The internal rate of return on the investment is closest to: A) 11% B) 13% C) 15% D) 17% Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Medium Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $240,000 ÷ $50,000 = 4.800 The factor of 4.800 for 8 years represents an internal rate of return of close to 13%. Use the following to answer questions 86-87: (Ignore income taxes in this problem.) The Rapp Company is considering buying a new machine which will require an initial outlay of $15,000. The company estimates that over the next four years this machine would save $6,000 per year in cash operating expenses. At the end of four years, the machine would have no salvage value. The company's required rate of return is 14%. 86. The net present value of this investment is closest to: A) $(12,632) B) $17,484 C) $2,484 D) $3,612 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Medium Solution: Annual cost savings..... Initial investment......... Net present value..........

Year(s) 1-4 Now

Amount 14% Factor $6,000 2.914 ($15,000) 1.000


PV $17,484 ( 15,000) $ 2,484

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Chapter 14 Capital Budgeting Decisions 87. The machine's internal rate of return is closest to: A) 16% B) 18% C) 20% D) 22% Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Medium Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $15,000 ÷ $6,000 = 2.500 The factor of 2.500 for 4 years represents an internal rate of return of almost 22%. Use the following to answer questions 88-89: (Ignore income taxes in this problem.) Allo Foundation, a tax-exempt organization, invested $200,000 in cost-saving equipment. The equipment has a five-year useful life with no salvage value. Allo estimates that the annual cash savings from this project will amount to $65,000. On investments of this type, Allo's required rate of return is 12%. 88. The net present value of the project is closest to: A) $34,300 B) $36,400 C) $90,000 D) $125,000 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Medium Source: CPA, adapted Solution: Annual cost savings..... Initial investment......... Net present value..........

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PV $234,325 ( 200,000) $ 34,325


Chapter 14 Capital Budgeting Decisions 89. Allo's internal rate of return on this project is closest to: A) 13% B) 15% C) 17% D) 19% Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Medium Source: CPA, adapted Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $200,000 ÷ $65,000 = 3.077 The factor of 3.077 for 5 years represents an internal rate of return of almost 19%. Use the following to answer questions 90-91: (Ignore income taxes in this problem.) Dumora Corporation is considering an investment project that will require an initial investment of $9,400 and will generate the following net cash inflows in each of the five years of its useful life: Year 1 Year 2 Year 3 Year 4 Year 5 Net cash inflows..... $1,000 $2,000 $4,000 $6,000 $5,000 Dumora’s discount rate is 16%. 90. Dumora's payback period for this investment project is closest to: A) 1.91 years B) 2.61 years C) 2.89 years D) 3.40 years Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 5 Level: Medium


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Chapter 14 Capital Budgeting Decisions Solution: Remaining Balance $9,400 $1,000 $8,400 $2,000 $6,400 $4,000 $2,400

Amount Initial investment......... Year 1 cash inflow........ Year 2 cash inflow........ Year 3 cash inflow........

Year 4: $2,400 ÷ $6,000 = 0.4 Therefore, the payback period for this investment is 3.4 years. 91. Dumora's net present value for this investment project is closest to: A) $(832) B) $1,204 C) $1,376 D) $2,386 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Medium Solution: Cost savings−Year 1..... Cost savings−Year 2..... Cost savings−Year 3..... Cost savings−Year 4..... Cost savings−Year 5..... Initial investment......... Net present value..........

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Year(s) 1 2 3 4 5 Now

Amount 16% Factor $1,000 0.862 $2,000 0.743 $4,000 0.641 $6,000 0.552 $5,000 0.476 ($9,400) 1.000

PV $ 862 1,486 2,564 3,312 2,380 ( 9,400) $1,204


Chapter 14 Capital Budgeting Decisions Use the following to answer questions 92-93: (Ignore income taxes in this problem.) Vandezande Inc. is considering the acquisition of a new machine that costs $370,000 and has a useful life of 5 years with no salvage value. The incremental net operating income and incremental net cash flows that would be produced by the machine are: Year 1...... Year 2...... Year 3...... Year 4...... Year 5......

Incremental net operating income Incremental net cash flows $54,000 $128,000 $31,000 $105,000 $52,000 $126,000 $49,000 $123,000 $48,000 $122,000

92. If the discount rate is 10%, the net present value of the investment is closest to: A) $370,000 B) $457,479 C) $234,000 D) $87,479 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Medium Source: CMA, adapted Solution: Initial investment............... Year 1 incremental net cash inflow.............................. Year 2 incremental net cash inflow.............................. Year 3 incremental net cash inflow.............................. Year 4 incremental net cash inflow.............................. Year 5 incremental net cash inflow.............................. Net present value................

Year(s) Amount 10% Factor PV Now ($370,000) 1.000 ($370,000) 1

$128,000

0.909

116,352

2

$105,000

0.826

86,730

3

$126,000

0.751

94,626

4

$123,000

0.683

84,009

5

$122,000

0.621

75,762 $ 87,479


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Chapter 14 Capital Budgeting Decisions 93. The payback period of this investment, rounded off to the nearest tenth of a year, is closest to: A) 2.9 years B) 4.9 years C) 3.1 years D) 5.0 years Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 5 Level: Medium Source: CMA, adapted Solution: Remaining Amount Balance Initial investment......... $370,000 Year 1 cash inflow........ $128,000 $242,000 Year 2 cash inflow........ $105,000 $137,000 Year 3 cash inflow........ $126,000 $11,000 Year 4: $11,000 ÷ $123,000 = 0.1 (rounded to nearest tenth) Therefore, the payback period for this investment is 3.1 years. Use the following to answer questions 94-95: (Ignore income taxes in this problem.) Oriol Inc. is considering the acquisition of equipment that costs $360,000 and has a useful life of 6 years with no salvage value. The incremental net cash flows that would be generated by the equipment are: Year 1......... Year 2......... Year 3......... Year 4......... Year 5......... Year 6.........

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Incremental net cash flows $115,000 $138,000 $95,000 $91,000 $133,000 $134,000


Chapter 14 Capital Budgeting Decisions 94. If the discount rate is 19%, the net present value of the investment is closest to: A) $346,000 B) $398,667 C) $38,667 D) $121,841 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Source: CMA, adapted Solution: Initial investment............... Year 1 incremental net cash inflow.............................. Year 2 incremental net cash inflow.............................. Year 3 incremental net cash inflow.............................. Year 4 incremental net cash inflow.............................. Year 5 incremental net cash inflow.............................. Year 6 incremental net cash inflow.............................. Net present value................

Year(s) Amount 19% Factor PV Now ($360,000) 1.000 ($360,000) 1

$115,000

0.840

96,600

2

$138,000

0.706

97,428

3

$95,000

0.593

56,335

4

$91,000

0.499

45,409

5

$133,000

0.419

55,727

6

$134,000

0.352

47,168 $38,667

95. The payback period of this investment is closest to: A) 4.1 years B) 2.9 years C) 5.0 years D) 3.1 years Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 5 Level: Easy Source: CMA, adapted


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Chapter 14 Capital Budgeting Decisions Solution: Remaining Balance Initial investment......... $360,000 Year 1 cash inflow........ $115,000 245,000 Year 2 cash inflow........ 138,000 107,000 Year 3 cash inflow........ 95,000 12,000 Amount

Year 4: $12,000 ÷ $91,000 = 0.1 (rounded to nearest tenth) Therefore, the payback period for this investment is 3.1 years. Use the following to answer questions 96-98: (Ignore income taxes in this problem.) Morrel University has a small shuttle bus that is in poor mechanical condition. The bus can be either overhauled now or replaced with a new shuttle bus. The following data have been gathered concerning these two alternatives: Purchase cost new.......................... Remaining net book value............. Major repair needed now............... Annual cash operating costs........... Salvage value now......................... Trade-in value in seven years.........

Present Bus New Bus $32,000 $40,000 $21,000 — $9,000 — $12,000 $8,000 $10,000 — $2,000 $5,000

The University could continue to use the present bus for the next seven years. Whether the present bus is used or a new bus is purchased, the bus would be traded in for another bus at the end of seven years. The University uses a discount rate of 12% and the total cost approach to net present value analysis in evaluating its investment decisions.

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Chapter 14 Capital Budgeting Decisions 96. If the new bus is purchased, the present value of the annual cash operating costs associated with this alternative is (rounded off to the nearest hundred dollars): A) $(54,800) B) $(36,500) C) $(16,200) D) $(42,800) Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Annual cash operating costs.

Year(s) 1-7

Amount 12% Factor ($8,000) 4.564

PV ($36,512)

97. If the present bus is repaired, the present value of the annual cash operating costs associated with this alternative is (rounded off to the nearest hundred dollars): A) $(36,500) B) $(16,200) C) $(47,200) D) $(54,800) Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Annual cash operating costs

Year(s) 1-7

Amount 12% Factor ($12,000) 4.564

PV ($54,768)

98. If the present bus is repaired, the present value of the salvage received on sale of the bus seven years from now is: A) $(2,260) B) $2,260 C) $904 D) $(904) Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Salvage value.....................

Year(s) 7

Amount 12% Factor $2,000 0.452


PV $904

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Chapter 14 Capital Budgeting Decisions Use the following to answer questions 99-100: (Ignore income taxes in this problem.) Becker Billing Systems, Inc., has an antiquated highcapacity printer that needs to be upgraded. The system either can be overhauled or replaced with a new system. The following data have been gathered concerning these two alternatives:

Purchase cost when new............. Accumulated depreciation.......... Overhaul costs needed now........ Annual cash operating costs........ Salvage value now...................... Salvage value in ten years........... Working capital required.............

Overhaul Present System $300,000 $220,000 $250,000 $120,000 $90,000 $30,000 —

Purchase New System $400,000 — — $90,000 — $80,000 $50,000

The company uses a 10% discount rate and the total-cost approach to capital budgeting analysis. The working capital required under the new system would be released for use elsewhere at the conclusion of the project. Both alternatives are expected to have a useful life of ten years. 99. The net present value of the overhaul alternative (rounded to the nearest hundred dollars) is: A) $(750,300) B) $(725,800) C) $(975,800) D) $(987,400) Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Hard Solution: Annual operating costs....... Overhaul costs.................... Salvage value..................... Net present value................

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Year(s) Amount 10% Factor PV 1-10 ($120,000) 6.145 ($737,400) Now ($250,000) 1.000 (250,000) 10 $30,000 0.386 11,580 ($975,820)


Chapter 14 Capital Budgeting Decisions 100. The net present value of the new system alternative (rounded to the nearest hundred dollars) is: A) $(862,900) B) $(552,900) C) $(758,400) D) $(987,400) Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Hard Solution: Initial investment............... Annual operating costs....... Salvage value−old equip.... Salvage value..................... Working capital required.... Working capital released.... Net present value................

Year(s) Amount 10% Factor PV Now ($400,000) 1.000 ($400,000) 1-10 ($90,000) 6.145 (553,050) Now $90,000 1.000 90,000 10 $80,000 0.386 30,880 Now ($50,000) 1.000 (50,000) 10 $50,000 0.386 19,300 ($862,870)

Use the following to answer questions 101-102: (Ignore income taxes in this problem.) Almendarez Corporation is considering the purchase of a machine that would cost $320,000 and would last for 7 years. At the end of 7 years, the machine would have a salvage value of $51,000. By reducing labor and other operating costs, the machine would provide annual cost savings of $72,000. The company requires a minimum pretax return of 18% on all investment projects. 101. The present value of the annual cost savings of $72,000 is closest to: A) $22,608 B) $874,298 C) $504,000 D) $274,464 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Annual cost savings...........

Year(s) 1-7

Amount $72,000


18% Factor 3.812

PV $274,464

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Chapter 14 Capital Budgeting Decisions 102. The net present value of the proposed project is closest to: A) -$29,522 B) -$45,536 C) $5,464 D) -$94,042 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Initial investment............... Annual cost savings........... Salvage value..................... Net present value................

Year(s) Amount 18% Factor PV Now ($320,000) 1.000 ($320,000) 1-7 $72,000 3.812 274,464 7 $51,000 0.314 16,014 ($ 29,522)

Use the following to answer questions 103-104: (Ignore income taxes in this problem.) The management of Opray Corporation is considering the purchase of a machine that would cost $360,000, would last for 7 years, and would have no salvage value. The machine would reduce labor and other costs by $78,000 per year. The company requires a minimum pretax return of 11% on all investment projects. 103. The present value of the annual cost savings of $78,000 is closest to: A) $763,064 B) $177,027 C) $546,000 D) $367,536 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Annual labor savings..........

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Year(s) 1-7

Amount $78,000

11% Factor 4.712

PV $367,536


Chapter 14 Capital Budgeting Decisions 104. The net present value of the proposed project is closest to: A) $15,646 B) $89,588 C) $7,536 D) $186,000 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Initial investment............... Annual net cash receipts.... Net present value................

Year(s) Amount 11% Factor PV Now ($360,000) 1.000 ($360,000) 1-7 $78,000 4.712 367,536 $ 7,536

Use the following to answer questions 105-106: (Ignore income taxes in this problem.) Paragas, Inc., is considering the purchase of a machine that would cost $370,000 and would last for 8 years. At the end of 8 years, the machine would have a salvage value of $52,000. The machine would reduce labor and other costs by $96,000 per year. Additional working capital of $4,000 would be needed immediately. All of this working capital would be recovered at the end of the life of the machine. The company requires a minimum pretax return of 19% on all investment projects. 105. The combined present value of the working capital needed at the beginning of the project and the working capital released at the end of the project is closest to: A) -$3,004 B) $0 C) -$12,080 D) $11,816 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Year(s) Amount 19% Factor PV Working capital required.... Now ($4,000) 1.000 ($4,000) Working capital released.... 8 $4,000 0.249 996 Net present value................ ($3,004)


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Chapter 14 Capital Budgeting Decisions 106. The net present value of the proposed project is closest to: A) $9,584 B) $78,530 C) $22,532 D) $19,528 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1 Level: Easy Solution: Initial investment............... Annual labor savings.......... Working capital required.... Working capital released.... Salvage value..................... Net present value................

Year(s) Amount 19% Factor PV Now ($370,000) 1.000 ($370,000) 1-8 $96,000 3.954 379,584 Now ($4,000) 1.000 (4,000) 8 $4,000 0.249 996 8 $52,000 0.249 12,950 $ 19,530

Use the following to answer questions 107-108: (Ignore income taxes in this problem.) Undersymington Company has an opportunity to invest in a machine that would cost $28,000, and that would produce cost savings of $8,000 each year for the next five years. 107. If the machine has zero salvage value, then the internal rate of return is closest to: A) 10.4% B) 10.9% C) 12.8% D) 13.2% Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Medium Solution: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $28,000 ÷ $8,000 = 3.500. The factor of 3.500 for 5 years represents an internal rate of return of somewhat more than 13%, or 13.2%.

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Chapter 14 Capital Budgeting Decisions 108. If the machine's salvage value at the end of the project is $4,000, then the internal rate of return is: A) less than 11% B) less than 12%, but greater than 11% C) less than 13%, but greater than 12% D) greater than 13% Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2 Level: Hard Solution: Factor of the internal rate of return without considering salvage value = Investment required ÷ Net annual cash inflow = $28,000 ÷ $8,000 = 3.500. The factor of 3.500 for 5 years represents an internal rate of return of somewhat more than 13%, or 13.2%. Since the IRR is more than 13% without considering the salvage value, adding in the present value of the salvage value will further increase the IRR. Use the following to answer questions 109-110: (Ignore income taxes in this problem.) Cabe Corporation uses a discount rate of 18% in its capital budgeting. Partial analysis of an investment in automated equipment with a useful life of 7 years has thus far yielded a net present value of -$155,606. This analysis did not include any estimates of the intangible benefits of automating this process nor did it include any estimate of the salvage value of the equipment. 109. Ignoring any salvage value, to the nearest whole dollar how large would the additional cash flow per year from the intangible benefits have to be to make the investment in the automated equipment financially attractive? A) $40,820 B) $22,229 C) $28,009 D) $155,606 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum annual cash flows from the intangible benefits = Negative net present value to be offset ÷ Present value factor = $155,606 ÷ 3.812 = $40,820


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Chapter 14 Capital Budgeting Decisions 110. Ignoring any cash flows from intangible benefits, to the nearest whole dollar how large would the salvage value of the automated equipment have to be to make the investment in the automated equipment financially attractive? A) $495,561 B) $28,009 C) $155,606 D) $864,478 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum salvage value = Negative net present value to the offset ÷ Present value factor = $155,606 ÷ 0.314 = $495,561 Use the following to answer questions 111-112: (Ignore income taxes in this problem.) The management of Hansley Corporation is investigating an investment in equipment that would have a useful life of 5 years. The company uses a discount rate of 18% in its capital budgeting. Good estimates are available for the initial investment and the annual cash operating outflows, but not for the annual cash inflows and the salvage value of the equipment. The net present value of the initial investment and the annual cash outflows is -$273,300. 111. Ignoring any salvage value, to the nearest whole dollar how large would the annual cash inflow have to be to make the investment in the equipment financially attractive? A) $54,660 B) $49,194 C) $87,400 D) $273,300 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum annual cash flows from the intangible benefits = Negative net present value to be offset ÷ Present value factor = $273,300 ÷ 3.127 = $87,400

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Chapter 14 Capital Budgeting Decisions 112. Ignoring the cash inflows, to the nearest whole dollar how large would the salvage value of the equipment have to be to make the investment in the equipment financially attractive? A) $625,400 B) $1,518,333 C) $273,300 D) $49,194 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum salvage value = Negative net present value to the offset ÷ Present value factor = $273,300 ÷ 0.437 = $625,400 Use the following to answer questions 113-114: (Ignore income taxes in this problem.) Lem Corporation is investigating buying a small used aircraft for the use of its executives. The aircraft would have a useful life of 7 years. The company uses a discount rate of 11% in its capital budgeting. The net present value of the initial investment and the annual operating cash cost is -$317,966. Management is having difficulty estimating the annual benefit of having the aircraft and estimating the salvage value of the aircraft. 113. Ignoring the annual benefit, to the nearest whole dollar how large would the salvage value of the aircraft have to be to make the investment in the aircraft financially attractive? A) $2,890,600 B) $317,966 C) $34,976 D) $659,680 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum salvage value = Negative net present value to the offset ÷ Present value factor = $317,966 ÷ 0.482 = $659,680


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Chapter 14 Capital Budgeting Decisions 114. Ignoring any salvage value, to the nearest whole dollar how large would the annual benefit have to be to make the investment in the aircraft financially attractive? A) $67,480 B) $317,966 C) $34,976 D) $45,424 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 3 Level: Easy Solution: Minimum annual cash flows from the intangible benefits = Negative net present value to be offset ÷ Present value factor = $317,966 ÷ 4.712 = $67,480 Use the following to answer questions 115-116: (Ignore income taxes in this problem.) Eddie Corporation is considering the following three investment projects: Investment required....................... Present value of cash inflows.........

Project C Project D Project E $36,000 $41,000 $85,000 $39,960 $47,560 $92,650

115. The profitability index of investment project D is closest to: A) 0.16 B) 0.84 C) 0.14 D) 1.16 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Easy Solution: Project D Investment required (a)......................... ($41,000) Present value of cash inflows............... 47,560 Net present value (b)............................. $ 6,560 Project profitability index (b) ÷ (a)....... 0.16

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Chapter 14 Capital Budgeting Decisions 116. Rank the projects according to the profitability index, from most profitable to least profitable. A) E,C,D B) E,D,C C) D,C,E D) C,E,D Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Medium Solution: Investment required (a)......................... Present value of cash inflows............... Net present value (b)............................. Project profitability index (b) ÷ (a)....... Ranked by project profitability index...

Project C Project D Project E ($36,000) ($41,000) ($85,000) 39,960 47,560 92,650 $ 3,960 $ 6,560 $ 7,650 0.11 0.16 0.09 2 1 3

Use the following to answer questions 117-118: (Ignore income taxes in this problem.) The management of Hibert Corporation is considering three investment projects-W, X, and Y. Project W would require an investment of $21,000, Project X of $66,000, and Project Y of $95,000. The present value of the cash inflows would be $22,470 for Project W, $73,920 for Project X, and $98,800 for Project Y. 117. The profitability index of investment project X is closest to: A) 0.11 B) 0.88 C) 1.12 D) 0.12 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Easy Solution: Project X Investment required (a)......................... ($66,000) Present value of cash inflows............... 73,920 Net present value (b)............................. $ 7,920 Project profitability index (b) ÷ (a)....... 0.12


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Chapter 14 Capital Budgeting Decisions 118. Rank the projects according to the profitability index, from most profitable to least profitable. A) Y,W,X B) X,Y,W C) X,W,Y D) W,Y,X Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4 Level: Medium Solution: Project W Project X Investment required (a)......................... ($21,000) ($66,000) Present value of cash inflows............... 22,470 73,920 Net present value (b)............................. $ 1,470 $ 7,920 Project profitability index (b) ÷ (a)....... 0.07 0.12 Ranked by project profitability index... 2 1

Project Y ($95,000) 98,800 $ 3,800 0.04 3

Use the following to answer questions 119-123: (Appendix 14C) Gibboney Inc. has provided the following data to be used in evaluating a proposed investment project: Initial investment............... Annual cash receipts.......... Life of the project............... Annual cash expenses........ Salvage value..................... Tax rate...............................

$880,000 $660,000 8 years $330,000 $88,000 30%

For tax purposes, the entire initial investment without any reduction for salvage value will be depreciated over 7 years. The company uses a discount rate of 12%.

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Chapter 14 Capital Budgeting Decisions 119. When computing the net present value of the project, what are the annual after-tax cash receipts? A) $462,000 B) $396,000 C) $198,000 D) $69,300 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Annual after-tax cash receipts = Annual cash receipts × (1 − Tax rate) = $660,000 × (1 − 0.30) = $462,000 120. When computing the net present value of the project, what are the annual after-tax cash expenses? A) $429,000 B) $242,000 C) $99,000 D) $231,000 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Annual after-tax cash expenses = Annual cash expenses × (1 − Tax rate) = $330,000 × (1 − 0.30) = $231,000


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Chapter 14 Capital Budgeting Decisions 121. When computing the net present value of the project, what is the annual amount of the depreciation tax shield? In other words, by how much does the depreciation deduction reduce taxes each year in which the depreciation deduction is taken? A) $37,714 B) $88,000 C) $77,000 D) $33,000 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Initial investment........................ $880,000 Life in years................................ 7 years Annual amount of depreciation... $125,714 Annual amount of depreciation tax shield = $125,714 × 0.30 = $37,714 122. When computing the net present value of the project, what is the after-tax cash flow from the salvage value in the final year? A) $0 B) $88,000 C) $26,400 D) $61,600 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Gain on sale (asset fully depreciated)..... $88,000 × (1 − Tax rate)........................................ 0.70 After-tax cash flow from salvage value. . $61,600

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Chapter 14 Capital Budgeting Decisions 123. The net present value of the project is closest to: A) $464,622 B) $439,736 C) $292,494 D) $267,608 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Annual after-tax cash receipts = Annual cash receipts × (1 − Tax rate) = $660,000 × (1 − 0.30) = $462,000 Annual after-tax cash expenses = Annual cash expenses × (1 − Tax rate) = $330,000 × (1 − 0.30) = $231,000 Initial investment........................ $880,000 Life in years................................ 7 years Annual amount of depreciation... $125,714 Annual amount of depreciation tax shield = $125,714 × 0.30 = $37,714 Initial investment............... Annual net cash receipts (after-tax) Annual net cash expenses (after-tax) Salvage value (after-tax).... Annual depreciation tax shield Net present value................

Year(s) Amount 12% Factor PV Now ($880,000) 1.000 ($ 880,000) 1-8 $462,000 4.968 2,295,216 1-8 ($231,000) 4.968 (1,147,608) 8 $61,600 0.404 24,886 1-7 $37,714 4.564 172,127 $ 464,621


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Chapter 14 Capital Budgeting Decisions Use the following to answer questions 124-127: (Appendix 14C) Shufflebarger Inc. has provided the following data to be used in evaluating a proposed investment project: Initial investment............... $280,000 Annual cash receipts.......... $196,000 Life of the project............... 6 years Annual cash expenses........ $78,000 Salvage value..................... $28,000 The company's tax rate is 30%. For tax purposes, the entire initial investment will be depreciated over 5 years without any reduction for salvage value. The company uses a discount rate of 16%. 124. When computing the net present value of the project, what are the annual after-tax cash receipts? A) $112,000 B) $137,200 C) $29,400 D) $58,800 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Annual after-tax cash receipts = Annual cash receipts × (1 − Tax rate) = $196,000 × (1 − 0.30) = $137,200

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Chapter 14 Capital Budgeting Decisions 125. When computing the net present value of the project, what are the annual after-tax cash expenses? A) $101,400 B) $50,000 C) $54,600 D) $23,400 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Annual after-tax cash expenses = Annual cash expenses × (1 − Tax rate) = $78,000 × (1 − 0.30) = $54,600 126. When computing the net present value of the project, what is the annual amount of the depreciation tax shield? In other words, by how much does the depreciation deduction reduce taxes each year in which the depreciation deduction is taken? A) $16,800 B) $39,200 C) $14,000 D) $32,667 Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Initial investment........................ $280,000 Life in years................................ 5 years Annual amount of depreciation... $56,000 Annual amount of depreciation tax shield = $56,000 × 0.30 = $16,800


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Chapter 14 Capital Budgeting Decisions 127. When computing the net present value of the project, what is the after-tax cash flow from the salvage value in the final year? A) $28,000 B) $8,400 C) $19,600 D) $0 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Gain on sale (asset fully depreciated)..... $28,000 × (1 − Tax rate)........................................ 0.70 After-tax cash flow from salvage value. . $19,600 Use the following to answer questions 128-129: (Appendix 14C) Valentin Inc. has provided the following data concerning an investment project that has been proposed: Initial investment............... Annual cash receipts.......... Life of the project............... Annual cash expenses........ Salvage value.....................

$890,000 $534,000 5 years $267,000 $45,000

The company's tax rate is 30%. For tax purposes, the entire initial investment will be depreciated over 3 years without any reduction for salvage value. The company uses a discount rate of 10%.

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Chapter 14 Capital Budgeting Decisions 128. When computing the net present value of the project, what is the after-tax cash flow from the salvage value in the final year? A) $13,500 B) $45,000 C) $0 D) $31,500 Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Gain on sale (asset fully depreciated)..... $45,000 × (1 − Tax rate)........................................ 0.70 After-tax cash flow from salvage value. . $31,500


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Chapter 14 Capital Budgeting Decisions 129. The net present value of the project is closest to: A) $39,881 B) $59,442 C) -$181,462 D) -$161,901 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Gain on sale (asset fully depreciated)..... $45,000 × (1 − Tax rate)........................................ 0.70 After-tax cash flow from salvage value. . $31,500 Initial investment.................................... $890,000 Depreciable life in years......................... 3 years Annual depreciation................................ $296,667 × Tax rate................................................ 0.30 Annual depreciation tax shield................ $89,000 Annual net cash inflows = Annual cash receipts − Annual cash expenses = $534,000 − $267,000 = $267,000 After-tax cash inflows = $267,000 × (1 − 0.30) = $186,900 Initial investment............... Annual net cash inflows (after-tax)........................ Depreciation tax shield...... Salvage value (after-tax).... Net present value................

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Year(s) Amount 10% Factor PV Now ($890,000) 1.000 ($890,000) 1-5 1-3 5

$186,900 $89,000 $31,500

3.791 2.487 0.621

708,538 221,343 19,562 $ 59,443


Chapter 14 Capital Budgeting Decisions Use the following to answer questions 130-131: (Appendix 14C) Nunoz Inc. is considering an investment project that would require an initial investment of $250,000 and that would last for 9 years. The annual cash receipts from the project would be $175,000 and the annual cash expenses would be $79,000. The equipment used in the project could be sold at the end of the project for a salvage value of $13,000. The company's tax rate is 30%. For tax purposes, the entire initial investment will be depreciated over 7 years without any reduction for salvage value. The company uses a discount rate of 10%. 130. When computing the net present value of the project, what are the annual after-tax cash receipts? A) $52,500 B) $122,500 C) $139,286 D) $96,000 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Annual after-tax cash receipts = Annual cash receipts × (1 − Tax rate) = $175,000 × (1 − 0.30) = $122,500


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Chapter 14 Capital Budgeting Decisions 131. The net present value of the project is closest to: A) $140,863 B) $137,005 C) $193,020 D) $189,162 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 8 Level: Medium Solution: Annual after-tax cash receipts = Annual cash receipts × (1 − Tax rate) = $175,000 × (1 − 0.30) = $122,500 Annual after-tax expenses = Annual expenses × (1 − Tax rate) = $79,000 × (1 − 0.30) = $55,300 Initial investment.................................... $250,000 Depreciable life in years......................... 7 years Annual depreciation................................ $35,714 × Tax rate................................................ 0.30 Annual depreciation tax shield................ $10,714 Gain on sale (asset fully depreciated)..... $13,000 × (1 − Tax rate)........................................ 0.70 After-tax cash flow from salvage value. . $9,100 Year(s) Initial investment............... Now Annual cash receipts (after-tax)........................ 1-9 Annual cash expenses (after-tax)........................ 1-9 Depreciation tax shield 1-7 Salvage value..................... 9 Net present value................

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Amount 10% Factor ($250,000) 1.000

PV ($250,000)

$122,500

5.759

705,478

($55,300) $10,714 $9,100

5.759 4.868 0.424

(318,473) 52,156 3,858 $193,019


Chapter 14 Capital Budgeting Decisions Essay Questions 132. (Ignore income taxes in this problem.) Cooney Inc. has provided the following data concerning a proposed investment project: Initial investment............... $160,000 Life of the project............... 7 years Annual net cash inflows..... $40,000 Salvage value..................... $16,000 The company uses a discount rate of 17%. Required: Compute the net present value of the project. Ans: Initial investment............... Annual net cash receipts.... Salvage value..................... Net present value................


AACSB: Analytic AICPA BB: Critical Thinking LO: 1 Level: Easy


AICPA FN: Reporting

14-77

Chapter 14 Capital Budgeting Decisions 133. (Ignore income taxes in this problem.) Strausberg Inc. is considering investing in a project that would require an initial investment of $270,000. The life of the project would be 6 years. The annual net cash inflows from the project would be $81,000. The salvage value of the assets at the end of the project would be $27,000. The company uses a discount rate of 10%. Required: Compute the net present value of the project. Ans: Initial investment............... Annual net cash receipts.... Salvage value..................... Net present value................



AICPA FN: Reporting

134. (Ignore income taxes in this problem.) Tiff Corporation has provided the following data concerning a proposed investment project: Initial investment.................. Life of the project.................. Working capital required....... Annual net cash inflows........ Salvage value........................

$960,000 6 years $20,000 $288,000 $144,000

The company uses a discount rate of 16%. The working capital would be released at the end of the project. Required: Compute the net present value of the project.

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Chapter 14 Capital Budgeting Decisions Ans: Initial investment..................... Annual net cash inflows........... Working capital invested.......... Working capital released.......... Salvage value........................... Net present value......................

Year(s) Amount 16% Factor Now ($960,000) 1.000 1-6 $288,000 3.685 Now ($20,000) 1.000 6 $20,000 0.410 6 $144,000 0.410


PV ($ 960,000) 1,061,280 (20,000) 8,200 59,040 $ 148,520

AICPA FN: Reporting

135. (Ignore income taxes in this problem.) Mattice Corporation is considering investing $490,000 in a project. The life of the project would be 7 years. The project would require additional working capital of $34,000, which would be released for use elsewhere at the end of the project. The annual net cash inflows would be $123,000. The salvage value of the assets used in the project would be $49,000. The company uses a discount rate of 11%. Required: Compute the net present value of the project. Ans: Initial investment............... Annual net cash inflows..... Working capital invested.... Working capital released.... Salvage value..................... Net present value................

Year(s) Amount 11% Factor PV Now ($490,000) 1.000 ($490,000) 1-7 $123,000 4.712 579,576 Now ($34,000) 1.000 (34,000) 7 $34,000 0.482 16,388 7 $49,000 0.482 23,618 $ 95,582



AICPA FN: Reporting

14-79

Chapter 14 Capital Budgeting Decisions 136. (Ignore income taxes in this problem.) Wary Corporation is considering the purchase of a machine that would cost $240,000 and would last for 9 years. At the end of 9 years, the machine would have a salvage value of $29,000. The machine would reduce labor and other costs by $63,000 per year. The company requires a minimum pretax return of 19% on all investment projects. Required: Determine the net present value of the project. Show your work! Ans: Annual cost savings..... Initial investment......... Salvage value............... Net present value..........

Year(s) Amount 19% Factor 1-9 $63,000 4.163 Now ($240,000) 1.000 9 $29,000 0.209


PV $262,269 (240,000) 6,061 $ 28,330

AICPA FN: Reporting

137. (Ignore income taxes in this problem.) The management of Kinion Corporation is considering the purchase of a machine that would cost $170,000, would last for 7 years, and would have no salvage value. The machine would reduce labor and other costs by $50,000 per year. The company requires a minimum pretax return of 17% on all investment projects. Required: Determine the net present value of the project. Show your work! Ans: Annual cost savings..... Initial investment......... Net present value..........



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PV $196,100 ( 170,000) $ 26,100

AICPA FN: Reporting


Chapter 14 Capital Budgeting Decisions 138. (Ignore income taxes in this problem.) Joanette, Inc., is considering the purchase of a machine that would cost $240,000 and would last for 5 years, at the end of which, the machine would have a salvage value of $48,000. The machine would reduce labor and other costs by $62,000 per year. Additional working capital of $7,000 would be needed immediately, all of which would be recovered at the end of 5 years. The company requires a minimum pretax return of 17% on all investment projects. Required: Determine the net present value of the project. Show your work! Ans: Initial investment............... Working capital needed...... Annual cost savings........... Working capital released.... Salvage value..................... Net present value................

Year(s) Amount 17% Factor PV Now ($240,000) 1.000 ($240,000) Now ($7,000) 1.000 (7,000) 1-5 $62,000 3.199 198,338 5 $7,000 0.456 3,192 5 $48,000 0.456 21,888 ($ 23,582)


AICPA FN: Reporting

139. (Ignore income taxes in this problem.) The management of Harling Corporation is considering the purchase of a machine that would cost $90,504 and would have a useful life of 5 years. The machine would have no salvage value. The machine would reduce labor and other operating costs by $27,000 per year. Required: Determine the internal rate of return on the investment in the new machine. Show your work! Ans: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $90,504 ÷ $27,000 = 3.352 The factor of 3.352 for 5 years represents an internal rate of return of 15%. AACSB: Analytic AICPA BB: Critical Thinking LO: 2 Level: Easy


AICPA FN: Reporting

14-81

Chapter 14 Capital Budgeting Decisions 140. (Ignore income taxes in this problem.) Maxcy Limos, Inc., is considering the purchase of a limousine that would cost $187,335, would have a useful life of 9 years, and would have no salvage value. The limousine would bring in cash inflows of $45,000 per year in excess of its cash operating costs. Required: Determine the internal rate of return on the investment in the new limousine. Show your work! Ans: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $187,335 ÷ $45,000 = 4.163 The factor of 4.163 for 9 years represents an internal rate of return of 19%. AACSB: Analytic AICPA BB: Critical Thinking LO: 2 Level: Easy

AICPA FN: Reporting

141. (Ignore income taxes in this problem.) The management of Zachery Corporation is considering the purchase of a automated molding machine that would cost $203,255, would have a useful life of 5 years, and would have no salvage value. The automated molding machine would result in cash savings of $65,000 per year due to lower labor and other costs. Required: Determine the internal rate of return on the investment in the new automated molding machine. Show your work! Ans: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $203,255 ÷ $65,000 = 3.127 The factor of 3.127 for 5 years represents an internal rate of return of 18%. AACSB: Analytic AICPA BB: Critical Thinking LO: 2 Level: Easy

14-82

AICPA FN: Reporting


Chapter 14 Capital Budgeting Decisions 142. (Ignore income taxes in this problem.) The management of an amusement park is considering purchasing a new ride for $60,000 that would have a useful life of 15 years and a salvage value of $8,000. The ride would require annual operating costs of $26,000 throughout its useful life. The company's discount rate is 10%. Management is unsure about how much additional ticket revenue the new ride would generateparticularly since customers pay a flat fee when they enter the park that entitles them to unlimited rides. Hopefully, the presence of the ride would attract new customers. Required: How much additional revenue would the ride have to generate per year to make it an attractive investment? Ans: Cost of asset....................... Annual operating costs....... Salvage value..................... Net present value................

Years Amount 10%Factor Present Value Now $(60,000) 1.000 ($ 60,000) 1-15 $(26,000) 7.606 ( 197,756) 15 $8,000 0.239 1,912 ($255,844)

$255,844 ÷ 7.606 = $33,637 additional revenue per year would be necessary to justify the investment. This much additional revenue would result in a zero net present value. Any less than this and the net present value would be negative. Any more than this and the net present value would be positive. AACSB: Analytic AICPA BB: Critical Thinking LO: 3 Level: Hard

AICPA FN: Reporting

143. (Ignore income taxes in this problem.) Devon Corporation uses a discount rate of 8% in its capital budgeting. Partial analysis of an investment in automated equipment with a useful life of 8 years has thus far yielded a net present value of -$496,541. This analysis did not include any estimates of the intangible benefits of automating this process nor did it include any estimate of the salvage value of the equipment. Required: a. Ignoring any salvage value, how large would the additional cash flow per year from the intangible benefits have to be to make the investment in the automated equipment financially attractive? b. Ignoring any cash flows from intangible benefits, how large would the salvage value of the automated equipment have to be to make the investment in the automated equipment financially attractive?


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Chapter 14 Capital Budgeting Decisions Ans: a. Minimum annual cash flows from the intangible benefits = Negative net present value to be offset ÷ Present value factor = $496,541 ÷ 5.747 = $86,400 b. Minimum salvage value = Negative net present value to the offset ÷ Present value factor = $496,541 ÷ 0.540 = $919,520 AACSB: Analytic AICPA BB: Critical Thinking LO: 3 Level: Easy

AICPA FN: Reporting

144. (Ignore income taxes in this problem.) The management of Crosson Corporation is investigating the purchase of a new satellite routing system with a useful life of 9 years. The company uses a discount rate of 17% in its capital budgeting. The net present value of the investment, excluding its intangible benefits, is -$173,055. Required: How large would the additional cash flow per year from the intangible benefits have to be to make the investment in the automated equipment financially attractive? Ans: Minimum annual cash flows from the intangible benefits = Negative net present value to be offset ÷ Present value factor = $173,055 ÷ 4.451 = $38,880 AACSB: Analytic AICPA BB: Critical Thinking LO: 3 Level: Easy

AICPA FN: Reporting

145. (Ignore income taxes in this problem.) Chipps Corporation uses a discount rate of 9% in its capital budgeting. Management is considering an investment in telecommunications equipment with a useful life of 5 years. Excluding the salvage value of the equipment, the net present value of the investment in the equipment is $530,985. Required: How large would the salvage value of the telecommunications equipment have to be to make the investment in the telecommunications equipment financially attractive?

14-84


Chapter 14 Capital Budgeting Decisions Ans: Minimum salvage value = Negative net present value to the offset ÷ Present value factor = $530,985 ÷ 0.650 = $816,900 AACSB: Analytic AICPA BB: Critical Thinking LO: 3 Level: Easy

AICPA FN: Reporting

146. (Ignore income taxes in this problem.) Choudhury Corporation is considering the following three investment projects: Investment required....................... Present value of cash inflows.........

Project H Project I Project J $11,000 $53,000 $89,000 $12,980 $61,480 $96,120

Required: Rank the investment projects using the project profitability index. Show your work Ans: Investment required (a)......................... Present value of cash inflows............... Net present value (b)............................. Project profitability index (b) ÷ (a)....... Ranked by project profitability index...

Project H Project I Project J ($11,000) ($53,000) ($89,000) 12,980 61,480 96,120 $ 1,980 $ 8,480 $ 7,120 0.18 0.16 0.08 1 2 3


AICPA FN: Reporting

147. (Ignore income taxes in this problem.) The management of Winstead Corporation is considering the following three investment projects: Investment required....................... Present value of cash inflows.........

Project Q Project R Project S $14,000 $48,000 $74,000 $14,140 $54,720 $82,140

The only cash outflows are the initial investments in the projects. Required: Rank the investment projects using the project profitability index. Show your work


14-85

Chapter 14 Capital Budgeting Decisions Ans: Project Q Project R Project S Investment required (a)......................... ($14,000) ($48,000) ($74,000) Present value of cash inflows............... 14,140 54,720 82,140 Net present value (b)............................. $ 140 $ 6,720 $ 8,140 Project profitability index (b) ÷ (a)....... 0.01 0.14 0.11 Ranked by project profitability index... 3 1 2 AACSB: Analytic AICPA BB: Critical Thinking LO: 4 Level: Easy

AICPA FN: Reporting

148. (Ignore income taxes in this problem.) Hady Company is considering purchasing a machine that would cost $688,800 and have a useful life of 7 years. The machine would reduce cash operating costs by $118,759 per year. The machine would have no salvage value. Required: a. Compute the payback period for the machine. b. Compute the simple rate of return for the machine. Ans: a. Payback period = Investment required ÷ Net annual cash flow = $688,800 ÷ $118,759 = 5.80 years b. The simple rate of return is computed as follows: Cost of machine, net of salvage value (a)........ Useful life (b)................................................... Annual depreciation (a) ÷ (b)...........................

$688,800 7 years $98,400

Annual cost savings......................................... Less annual depreciation.................................. Annual incremental net operating income.......

$118,759 98,400 $ 20,359

Simple rate of return = Annual incremental net operating income ÷ Initial investment = $20,359 ÷ $688,800 = 2.96% AACSB: Analytic AICPA BB: Critical Thinking LO: 5,6 Level: Easy

14-86

AICPA FN: Reporting


Chapter 14 Capital Budgeting Decisions 149. (Ignore income taxes in this problem.) Ramson Company is considering purchasing a machine that would cost $756,000 and have a useful life of 8 years. The machine would reduce cash operating costs by $132,632 per year. The machine would have a salvage value of $151,200 at the end of the project. Required: a. Compute the payback period for the machine. b. Compute the simple rate of return for the machine. Ans: a. Payback period = Investment required ÷ Net annual cash flow = $756,000 ÷ $132,632 = 5.70 years In this case the salvage value plays no part in the payback period since all of the investment is recovered before the end of the project. b. The simple rate of return is computed as follows: Cost of machine, net of salvage value (a)........... Useful life (b)...................................................... Annual depreciation (a) ÷ (b)..............................

$604,800 8 years $75,600

Annual cost savings............................................ Less annual depreciation..................................... Annual incremental net operating income..........

$132,632 75,600 $ 57,032

Simple rate of return = Annual incremental net operating income ÷ Initial investment = $57,032 ÷ $756,000 = 7.54% AACSB: Analytic AICPA BB: Critical Thinking LO: 5,6 Level: Medium


AICPA FN: Reporting

14-87

Chapter 14 Capital Budgeting Decisions 150. (Ignore income taxes in this problem.) Ostermeyer Corporation is considering a project that would require an initial investment of $247,000 and would last for 7 years. The incremental annual revenues and expenses for each of the 7 years would be as follows: Sales................................... Variable expenses............... Contribution margin........... Fixed expenses: Salaries............................ Rents............................... Depreciation.................... Total fixed expenses........... Net operating income.........

$198,000 46,000 152,000 22,000 32,000 33,000 87,000 $ 65,000

At the end of the project, the scrap value of the project's assets would be $16,000. Required: Determine the payback period of the project. Show your work! Ans: Net operating income................................. Add noncash deduction for depreciation. . . Net annual cash inflow...............................

$65,000 33,000 $98,000

Payback period = Investment required ÷ Net annual cash inflow = $247,000 ÷ $98,000 = 2.52 years AACSB: Analytic AICPA BB: Critical Thinking LO: 5 Level: Easy

14-88

AICPA FN: Reporting


Chapter 14 Capital Budgeting Decisions 151. (Ignore income taxes in this problem.) The management of Truelove Corporation is considering a project that would require an initial investment of $321,000 and would last for 7 years. The annual net operating income from the project would be $28,000, including depreciation of $42,000. At the end of the project, the scrap value of the project's assets would be $27,000. Required: Determine the payback period of the project. Show your work! Ans: Net operating income................................. Add noncash deduction for depreciation. . . Net annual cash inflow...............................

$28,000 42,000 $70,000

Payback period = Investment required ÷ Net annual cash inflow = $321,000 ÷ $70,000 = 4.59 years AACSB: Analytic AICPA BB: Critical Thinking LO: 5 Level: Easy

AICPA FN: Reporting

152. (Ignore income taxes in this problem.) Ducey Corporation is contemplating purchasing equipment that would increase sales revenues by $79,000 per year and cash operating expenses by $27,000 per year. The equipment would cost $150,000 and have a 6 year life with no salvage value. The annual depreciation would be $25,000. Required: Determine the simple rate of return on the investment to the nearest tenth of a percent. Show your work! Ans: Simple rate of return = Annual incremental net operating income ÷ Initial investment = [Incremental revenues − (Cash operating expenses + Depreciation)] ÷ Initial investment =79,000 − ($27,000 + $25,000) ÷ $150,000 = 27,000 ÷ $150,000 = 18.0% AACSB: Analytic AICPA BB: Critical Thinking LO: 6 Level: Easy


AICPA FN: Reporting

14-89

Chapter 14 Capital Budgeting Decisions 153. (Ignore income taxes in this problem.) The management of Nixon Corporation is investigating purchasing equipment that would cost $518,000 and have a 7 year life with no salvage value. The equipment would allow an expansion of capacity that would increase sales revenues by $364,000 per year and cash operating expenses by $211,000 per year. Required: Determine the simple rate of return on the investment to the nearest tenth of a percent. Show your work! Ans: Simple rate of return = Annual incremental net operating income ÷ Initial investment = [Incremental revenues − (Cash operating expenses + Depreciation)] ÷ Initial investment = 364,000 − ($211,000 + $74,000) ÷ $518,000 = 79,000 ÷ $518,000 = 15.3% AACSB: Analytic AICPA BB: Critical Thinking LO: 6 Level: Easy

AICPA FN: Reporting

154. (Ignore income taxes in this problem.) Russnak Corporation is investigating automating a process by purchasing a new machine for $198,000 that would have a 9 year useful life and no salvage value. By automating the process, the company would save $68,000 per year in cash operating costs. The company's current equipment would be sold for scrap now, yielding $18,000. The annual depreciation on the new machine would be $22,000. Required: Determine the simple rate of return on the investment to the nearest tenth of a percent. Show your work! Ans: Simple rate of return = Annual incremental net operating income ÷ Initial investment = (Cost savings - Depreciation) ÷ Initial investment = ($68,000 − $22,000) ÷ ($198,000 − $18,000) = $46,000 ÷ $180,000 = 25.6% AACSB: Analytic AICPA BB: Critical Thinking LO: 6 Level: Easy

14-90

AICPA FN: Reporting


Chapter 14 Capital Budgeting Decisions 155. (Ignore income taxes in this problem.) The management of Schenk Corporation is investigating automating a process by replacing old equipment by a new machine. The old equipment would be sold for scrap now for $13,000. The new machine would cost $648,000, would have a 9 year useful life, and would have no salvage value. By automating the process, the company would save $186,000 per year in cash operating costs. Required: Determine the simple rate of return on the investment to the nearest tenth of a percent. Show your work! Ans: Depreciation on the new machine = $648,000 ÷ 9 = $72,000 Simple rate of return = Annual incremental net operating income ÷ Initial investment = (Cost savings − Depreciation) ÷ Initial investment = ($186,000 − $72,000) ÷ ($648,000 - $13,000) = $114,000 ÷ $635,000 = 18.0% AACSB: Analytic AICPA BB: Critical Thinking LO: 6 Level: Easy


AICPA FN: Reporting

14-91

Chapter 14 Capital Budgeting Decisions 156. A company is considering purchasing an asset for $70,000 that would have a useful life of 5 years and would have a salvage value of $12,000. For tax purposes, the entire original cost of the asset would be depreciated over 5 years using the straight-line method and the salvage value would be ignored. The asset would generate annual net cash inflows of $22,000 throughout its useful life. The project would require additional working capital of $8,000, which would be released at the end of the project. The company's tax rate is 40% and its discount rate is 9%. Required: What is the net present value of the asset? Ans:

Cost of asset........................ Working capital needed...... Net annual cash inflows...... Depreciation tax shield....... Salvage value...................... Working capital released..... Net present value................

Cost of asset........................ Working capital needed...... Net annual cash inflows...... Depreciation tax shield....... Salvage value...................... Working capital released..... Net present value................

Years Amount Now ($70,000) Now ($8,000) 1-5 $22,000 1-5 $14,000 5 $12,000 5 $8,000 After-Tax Cash Flows ($70,000) ($8,000) $13,200 $5,600 $7,200 $8,000

Tax Effect

9% Factor 1.000 1.000 3.890 3.890 0.650 0.650

AACSB: Analytic AICPA BB: Critical Thinking Appendix: 14C LO: 8 Level: Medium

14-92

0.60 0.40 0.60

Present Value ($70,000) (8,000) 51,348 21,784 4,680 5,200 $ 5,012 AICPA FN: Reporting


Chapter 14 Capital Budgeting Decisions 157. Management is considering purchasing an asset for $40,000 that would have a useful life of 8 years and no salvage value. For tax purposes, the entire original cost of the asset would be depreciated over 8 years using the straight-line method. The asset would generate annual net cash inflows of $20,000 throughout its useful life. The project would require additional working capital of $5,000, which would be released at the end of the project. The company's tax rate is 40% and its discount rate is 12%. Required: What is the net present value of the asset? Ans:

Cost of asset........................ Working capital needed....... Net annual cash inflows...... Depreciation tax shield....... Working capital released..... Net present value.................

Cost of asset........................ Working capital needed....... Net annual cash inflows...... Depreciation tax shield....... Working capital released..... Net present value.................

Tax Years Amount Effect Now ($40,000) Now ($5,000) 1-8 $20,000 0.60 1-8 $5,000 0.40 8 $5,000 After-Tax Cash Present Flows 12%Factor Value ($40,000) 1.000 ($40,000) ($5,000) 1.000 (5,000) $12,000 4.968 59,616 $2,000 4.968 9,936 $5,000 0.404 2,020 $26,572



AICPA FN: Reporting

14-93

Chapter 14 Capital Budgeting Decisions 158. Belling Inc. has provided the following data concerning a proposed investment project: Initial investment............... Annual cash receipts.......... Life of the project............... Annual cash expenses........ Salvage value.....................

$168,000 $126,000 9 years $50,000 $8,000

The company's tax rate is 30%. For tax purposes, the entire initial investment without any reduction for salvage value will be depreciated over 7 years. The company uses a discount rate of 14%. Required: Compute the net present value of the project. Ans: Annual cash receipts........................................ $126,000 Annual cash expenses...................................... 50,000 Annual net cash receipts.................................. $ 76,000 Initial investment (a)........................................ $168,000 Tax life (b)........................................................ 7 years Annual depreciation deduction (a) ÷ (b).......... $24,000

Initial investment........................... Annual net cash receipts................ Salvage value................................. Annual depreciation deductions.....

Initial investment........................... Annual net cash receipts................ Salvage value................................. Annual depreciation deductions..... Net present value............................

Year(s) Amount Now ($168,000) 1-9 $76,000 9 $8,000 1-7 $24,000 After-Tax Cash Flows ($168,000) $53,200 $5,600 $7,200


14-94

14% Factor 1.000 4.946 0.308 4.288

Tax Effect 0.70 0.70 0.30

After-Tax Cash Flows ($168,000) $53,200 $5,600 $7,200

PV ($168,000) 263,127 1,725 30,874 $127,726

AICPA FN: Reporting


Chapter 14 Capital Budgeting Decisions 159. Camel Inc. is considering a project that would require an initial investment of $210,000 and would have a useful life of 6 years. The annual cash receipts would be $126,000 and the annual cash expenses would be $57,000. The salvage value of the assets used in the project would be $32,000. The company's tax rate is 30%. For tax purposes, the entire initial investment without any reduction for salvage value will be depreciated over 5 years. The company uses a discount rate of 10%. Required: Compute the net present value of the project. Ans: Annual cash receipts........................................ $126,000 Annual cash expenses...................................... 57,000 Annual net cash receipts.................................. $ 69,000 Initial investment (a)........................................ $210,000 Tax life (b)........................................................ 5 years Annual depreciation deduction (a) ÷ (b).......... $42,000

Initial investment........................... Annual net cash receipts................ Salvage value................................. Annual depreciation deductions.....

Initial investment........................... Annual net cash receipts................ Salvage value................................. Annual depreciation deductions..... Net present value............................

Year(s) Amount Now ($210,000) 1-6 $69,000 6 $32,000 1-5 $42,000 After-Tax Cash Flows ($210,000) $48,300 $22,400 $12,600



10% Factor 1.000 4.355 0.564 3.791

Tax Effect 0.70 0.70 0.30

After-Tax Cash Flows ($210,000) $48,300 $22,400 $12,600

PV ($210,000) 210,347 12,634 47,767 $ 60,747

AICPA FN: Reporting

14-95

Chapter 14 Capital Budgeting Decisions

14-96


Chapter 14

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