Chapter 14 — Capital Capital Investment Decisions TRUE/FALSE
1. Projects that do not affect affect the cash flows of other projects are called mutually exclusive projects. ANS: F Projects that do not affect affect the cash flows of other projects are called independent projects. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-36-Budgeting and Responsibility Responsibility KEY: Bloom's: Knowledge NOT: 1 min. 2. The process of planning, setting setting goals and priorities, priorities, arranging financing, financing, and using certain criteria to select long-term assets is called capital investment decisions. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-26-Management Functions KEY: Bloom's: Knowledge NOT: 1 min. 3. Projects that if accepted preclude the acceptance of all other competing competing projects are called mutually mutually exclusive projects. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 1 min. 4. In capital investment investment decision decision making, it is usually assumed assumed that managers managers should select select projects that that attempt to maximize the wealth of the owners of the firm. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-26-Management Functions KEY: Bloom's: Knowledge NOT: 1 min. 5. Taxes are important consideration in forecasting forecasting cash cash flows. flows. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 1 min. 6. Before-tax cash flows must must be forecasted forecasted and used used in capital capital investment investment decision making. making. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-27-Managerial
Accounting Features/Costs NOT: 1 min.
KEY: Bloom's: Knowledge
7. The two major categories of capital capital investment investment decision models models are independent independent and mutually mutually exclusive. ANS: F The two major categories of capital investment decision models are nondiscounting models and discounting models. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-25-Managerial Characteristics/Terminology Characteristics/Terminology KEY: Bloom's: Knowledge NOT: 1 min. 8. In order to use the payback period model, the the proposed investment must have have even cash inflows. i nflows. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 9. If cash flows are uneven, the payback period assumes assumes that the inflows during the last fraction of a year occur evenly. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 10. One way to to use the payback payback period is to to set a maximum payback payback period for all all projects and to reject any project that exceeds this level. ANS: T One way to use the payback period is to set a maximum payback period for all projects and to reject any project that exceeds this level. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 11. Sometimes firms firms require riskier riskier projects to have longer payback payback periods. ANS: F Sometimes firms require riskier projects to have shorter payback periods. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 1 min. 12. Companies considering considering projects projects with shorter lives are interested in longer longer payback periods.
Accounting Features/Costs NOT: 1 min.
KEY: Bloom's: Knowledge
7. The two major categories of capital capital investment investment decision models models are independent independent and mutually mutually exclusive. ANS: F The two major categories of capital investment decision models are nondiscounting models and discounting models. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-25-Managerial Characteristics/Terminology Characteristics/Terminology KEY: Bloom's: Knowledge NOT: 1 min. 8. In order to use the payback period model, the the proposed investment must have have even cash inflows. i nflows. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 9. If cash flows are uneven, the payback period assumes assumes that the inflows during the last fraction of a year occur evenly. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 10. One way to to use the payback payback period is to to set a maximum payback payback period for all all projects and to reject any project that exceeds this level. ANS: T One way to use the payback period is to set a maximum payback period for all projects and to reject any project that exceeds this level. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 11. Sometimes firms firms require riskier riskier projects to have longer payback payback periods. ANS: F Sometimes firms require riskier projects to have shorter payback periods. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 1 min. 12. Companies considering considering projects projects with shorter lives are interested in longer longer payback periods.
ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 13. A disadvantage of the payback period is that it ignores a project's total profitability. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 14. A disadvantage of the payback period is that it ignores the time value of money. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 15. Only accounting accounting rate of return ignores ignores the time value of money. ANS: F Both the payback period and the accounting rate of return ignore the time value of money. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 1 min. 16. The payback period considers the profitability profitability of a project over its its entire life span. span. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 17. Two discounting discounting models for capital capital investment investment decision making are net present present value and and internal rate of return. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 18. The difference between the present present value of the cash inflows and outflows associated with with a project is is the internal rate of return model. ANS: F The difference between the present value of the cash inflows and outflows associated with a project is the net present value model. PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic Analytic
OBJ: LO: 14-3
STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 19. The minimum minimum acceptable rate of return return for a project project is the required required rate of return. return. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 20. In practice, managers managers often choose a discount rate rate that is higher higher than the cost of capital. capital. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 21. Suppose that that the actual cost cost of capital is is 10%, but the the firm chooses a discount rate of 18%. Managers of that company will be more likely to choose relatively short term investments. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 1 min. 22. If the net present present value of an investment is zero, the investment investment earns less than the minimum minimum required rate of return. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 1 min. 23. The interest rate that sets the present value value of a project's project's cash inflows inflows equal to the present value value of the project's cost is called called the internal rate of return. return. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 24. The internal rate of return is the the least widely widely used of the capital capital investment investment techniques. techniques. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 25. One drawback to the internal internal rate of return model is that cash inflows must occur evenly over the life of the investment. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-38-NPV/IRR
Methods
KEY: Bloom's: Knowledge
NOT: 1 min.
26. The internal rate of return is the the most widely widely used of the capital investment investment techniques. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 27. A postaudit postaudit evaluates the the overall outcome of the investment investment and proposes corrective action if needed. needed. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-26-Management Functions KEY: Bloom's: Knowledge NOT: 1 min. 28. In general, it is best if postaudits postaudits are done done by company management, since they they understand the the actual operating conditions. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: APC-26-Management Functions KEY: Bloom's: Comprehension NOT: 1 min. 29. A disadvantage of postaudits is that they are costly. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 1 min. 30. A postaudit postaudit is an an analysis of a capital capital project before before it is implemented. ANS: F A key element in the capital investment process is a follow-up analysis of a capital project once it is implemented. This analysis is called a post audit. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 1 min. 31. A key element in the capital investment investment process process is called a postaudit. postaudit. ANS: T A key element in the capital investment process is a follow-up analysis of a capital project once it is implemented. This analysis is called a post audit. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic Analytic STA: AICPA: FN-Decision FN-Decision Modeling | IMA: Investment Investment Decisions Decisions | ACBSP: ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge
NOT: 1 min. 32. Companies that perform postaudits of capital projects experience a number of benefits. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 1 min. 33. Postaudits ensure that resources are used wisely by evaluating profitability. ANS: T First, by evaluating profitability, post-audits ensure that resources are used wisely. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 1 min. 34. Because of the postaudit, managers are more likely to make capital investment decisions in the best interests of the firm. ANS: T A second benefit of the post-audit is its impact on the behavior of managers. If managers are held accountable for the results of a capital investment decision, they are more likely to make such decisions in the best interests of the firm. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 1 min. 35. Postaudits supply feedback to managers that should help improve future decision making. ANS: T Additionally, post-audits supply feedback to managers that should help improve future decision making. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 1 min. 36. Less objective results are obtainable if an independent party performs the postaudit of a capital investment. ANS: F Generally, more objective results are obtainable if the post-audit is done by an independent party. PTS: 1
DIF:
Difficulty: Easy
OBJ: LO: 14-5
NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 1 min. 37. The internal audit staff is usually the best choice for performing a postaudit of a capital investment. ANS: T Since considerable effort is expended to ensure as much independence as p ossible for the internal audit staff, that group is usually the best choice for this task. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 1 min. 38. An obvious problem with postaudits is that the assumptions driving the original analysis may often be invalidated by changes in the actual operating environment. ANS: T Most obvious is the fact that the assumptions driving the original analysis may often be invalidated by changes in the actual operating environment. Accountability must be qualified to some extent by the impossibility of foreseeing every possible eventuality. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 1 min. 39. Net present value analysis and internal rate of return analysis can sometimes produce erroneous choices because they ignore the time value of money. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 40. For independent projects, net present value analysis and internal rate of return analysis yield the same decision. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 41. The internal rate of return model does not consistently result in choices that maximize firm wealth. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 1 min.
MATCHING
Match each item with the correct statement below. a. Payback period b. Accounting rate of return c. Net present value d. Internal rate of return e. Discount rate f. Annuity g. Post-audit h. Compounding of interest
1. 2. 3. 4. 5. 6. 7. 8. 9.
can be used as a rough measure of risk and liquidity can be used to determine whether or not an investment will negatively affect key financial ratios interest rate used to discount future cash flows assumes that all future cash inflows earn the minimum rate of return assumes that all future cash inflows earn the same rate of return as the project itself a series of equal future cash flows comparison of actual benefits and costs of a project with the expected benefits and costs is the best method discounting model to use for mutually exclusive competing projects earning of interest on interest
1. ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 2. ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 1 min. 3. ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 4. ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 5. ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 6. ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 7. ANS: G PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 8. ANS: C PTS: 1 DIF: Difficulty: Moderate
OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. 9. ANS: H PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 1 min. COMPLETION
1. _______________________ are concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets. ANS: Capital investment decisions PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-25-Managerial Characteristics/Terminology KEY: Bloom's: Knowledge NOT: 2 min. 2. The process of making capital investment decisions often is referred to as ________________. ANS: capital budgeting PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-25-Managerial Characteristics/Terminology KEY: Bloom's: Knowledge NOT: 2 min. 3. The two types of capital budgeting projects are ________________ and _______________. ANS: independent projects, mutually exclusive projects. mutually exclusive projects, independent projects PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-25-Managerial Characteristics/Terminology KEY: Bloom's: Knowledge NOT: 2 min. 4. ______________________ are projects that, if accepted or rejected, do not affect the cash flows of other projects. ANS: Independent projects PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min.
5. _____________________ explicitly consider the time value of money. ANS: Discounting models PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 6. _______________________ ignore the time value of money. ANS: Nondiscounting models PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 7. The ______________ is the time required for a firm to recover its original investment. ANS: payback period PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 8. The _________________________ measures the return on a project in terms of income. ANS: accounting rate of return (ARR) ARR PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 9. _______________________ are the future cash flows expressed in terms of their present value. ANS: Discounted cash flows PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 10. The difference between the present value of the cash inflows and the outflows associated with a project is known as the ___________________.
ANS: Net present value PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 11. The ___________________ is the minimum acceptable rate of return. ANS: required rate of return discount rate hurdle rate cost of capital PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 12. The _______________________ is defined as the interest rate that sets the present value of a project’s cash inflows equal to the present value of the project’s cost. ANS: internal rate of return (IRR) IRR PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 13. If the internal rate of return (IRR) is greater than the required rate, the project is deemed ___________. ANS: acceptable PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 14. If the internal rate of return (IRR) is less than the required rate of return, the project is __________. ANS: rejected PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 15. A key element in the capital investment process is a follow-up analysis of a capital project once it is implemented; this analysis is a called a _____________.
ANS: postaudit PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 16. The major disadvantage of a postaudit is that it is ____________. ANS: costly PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 17. When choosing among competing projects, the ___________________ model correctly identifies the best investment alternative. ANS: net present value PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 18. When choosing among competing alternatives the ________________ model may choose an inferior project. ANS: internal rate of return (IRR) IRR PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 19. The amount that must be invested now to produce a future value is known as the ____________ of the future amount. ANS: present value PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 20. The value of an investment at the end of its life is called its ________________.
ANS: future value PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. MULTIPLE CHOICE
1. Which of the following is true of capital investment decision making? a. It is used only for independent projects. b. It is used only for mutually exclusive projects. c. It requires that funding for a project must come from sources with the same opportunity cost of funds. d. It is used to determine whether or not a firm should accept a special order. e. None of these. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 2 min. 2. In a. b. c. d. e.
general terms, a sound capital investment will earn back its original capital outlay. a return greater than existing capital investments. back its original capital outlay and provide a reasonable return on the original investment. back its original capital outlay by the midpoint of its useful life. None of these.
ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 2 min. 3. To a. b. c. d. e.
make a capital investment decision, a manager must estimate the quantity of cash flows. timing of cash flows. risk of the investment. impact of the investment on the firm's profitability. All of these.
ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 4. If the cash flows of a project are received evenly over the life of the project, the formula for the calculating the payback period is a. original investment/annual cash flow. b. original investment annual cash flow.
c. original investment + annual cash flow. d. original investment annual cash flow. e. (original investment + annual cash flow)/annual cash flow. ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 5. The payback period provides information to managers that can be used to help a. control the risks associated with the uncertainty of future cash flows. b. minimize the impact of an investment on a firm's liquidity problems. c. control the risk of obsolescence. d. control the effect of the investment on performance measures. e. All of these. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 6. Which of the following is a drawback of the payback period? a. It ignores a project's total profitability. b. It uses a set discount rate. c. It considers total profitability, requiring the forecasting of all future cash flows. d. It uses before-tax cash flows rather than after-tax cash flows. e. It uses operating income rather than cash flows. ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 7. A formula for the accounting rate of return is a. average income/initial investment. b. initial investment/annual cash flow. c. annual cash flow/initial investment. d. initial investment/average income. e. (average income + initial investment)/initial investment. ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 8. Managers may use the accounting rate of return to evaluate potential investment projects because a. debt contracts require that a firm maintain certain ratios that are affected by income and long-term asset levels. b. it serves as a screening measure to insure that new investments do not affect key financial ratios. c. bonuses to managers may be based on accounting income and/or return on assets. d. it can be tied to the manager's personal income. e. All of these. ANS: E
PTS: 1
DIF:
Difficulty: Easy
OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 2 min. 9. The time required for a firm to recover its original investment is the a. internal rate of return. b. net present value. c. life of the project. d. accounting rate of return. e. payback period. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Knowledge NOT: 2 min. 10. When the risk of obsolescence is high, managers will want a. a shorter payback period. b. a longer payback period. c. a payback period equal to the life of the investment. d. All of these. e. None of these. ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 2 min. 11. One disadvantage of the payback period is that a. it is sometimes used as a crude measure of risk. b. managers may choose investments with quick payback periods to maximize short term criteria on which their own bonuses, etc. may be based. c. it cannot be used for investments with unequal cash inflows. d. it cannot be used if the entire cost of the investment does not occur immediately. e. All of these. ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 2 min. 12. A division manager was considering a project that required a significant initial investment. If accepted, the project could have a negative impact on certain financial ratios that the firm was required to maintain to satisfy debt contracts. To ensure that the ratios would not be adversely affected by the investment, the manager would use which of the following capital investment models? a. payback period b. accounting rate of return c. net present value d. internal rate of return e. None of these. ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 2 min.
13. Greg Moss has just invested $120,000 in a coffee shop. He expects to receive cash income of $15,000 a year. What is the payback period? a. 5 years b. 7.7 years c. 4.5 years d. 6.5 years e. 8 years ANS: E Payback period = $120,000/$15,000 = 8 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 14. Carol Harrison is considering an investment in a retail shopping mall. The initial investment is $400,000. She expects to receive cash income of $80,000 a year. What is the payback period? a. 4 year b. 3.5 years c. 5 years d. 2.5 years e. 6 years ANS: C Payback period = $400,000/$80,000 = 5 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 15. Elena Wallace invested $150,000 in a project that pays her an even amount per year for 10 years. The payback period is 6 years. What are Elena's yearly cash inflows from the project? a. $150,000 b. $15,000 c. $25,000 d. $90,000 e. Cannot be determined from this information. ANS: C Cash inflows = $150,000/6 years = $25,000/year PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 16. Tessa Wilson invested in a project with a payback period of 6 years. The project brings $18,000 per year for a period of 9 years. What was the initial investment? a. $108,000 b. $107,500 c. $162,000 d. $240,000
e.
Cannot be determined from this information.
ANS: A 6 years x $18,000 = $108,000 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 17. Neil Morrison has just invested $130,000 in a restaurant. He expects to receive income of $24,000 a year, and to have the investment for 8 years. What is the accounting rate of return? a. 5.60% b. 18.46% c. 14.52% d. 12.41% e. 4.50% ANS: B ARR = $24,000/$130,000 = 18.46% PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 18. An investment of $5,000 provides an average net cash flows of $320 with zero salvage value. Depreciation is $35 per year. The accounting rate of return using the original investment is a. 4.0% b. 5.1% c. 5.7% d. 3.2% e. 2.4% ANS: C ARR = ($320 - $35)/$5,000 = .057 or 5.7% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 3 min. 19. Buster Evans is considering investing $20,000 in a project with the following annual cash revenues and expenses:
Year 1 Year 2 Year 3 Year 4 Year 5
Cash Revenues $ 8,000 $12,000 $15,000 $20,000 $20,000
Depreciation will be $4,000 per year.
Cash Expenses $ 8,000 $ 8,000 $ 9,000 $10,000 $10,000
What is the accounting rate of return on the investment? a. 15% b. 35% c. 70% d. 75% e. None of these. ANS: E
Year 1 Year 2 Year 3 Year 4 Year 5 Total Income
Cash Revenues $ 8,000 $12,000 $15,000 $20,000 $20,000
Less: Cash Expenses $ 8,000 $ 8,000 $ 9,000 $10,000 $10,000
Less: Depreciation $4,000 $4,000 $4,000 $4,000 $4,000
Operating Income $ (4,000) $ 0 $ 2,000 $ 6,000 $ 6,000 $10,000
Average annual income = $10,000/5 = $2,000 ARR = $2,000/$20,000 = 0.1 or 10% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. 20. Coriander Company is considering a project with an initial investment of $426,800 in new equipment that will yield annual net cash flows of $80,000, and will be depreciated at $53,350 per year over its eight year life. What is the accounting rate of return? a. 320% b. 18.74% c. 6.24% d. 31.27% e. 50.0% ANS: C ARR = ($80,000 $53,350)/$426,800 = 0.0624 or 6.24% PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 21. When comparing the payback method and the accounting rate of return methods, which of the following is true?
i ii iii iv
Profitability Ignored by both methods Ignored by both methods Considered by accounting method, not by payback Considered by accounting method, not by payback
Time Value of Money Ignored by both methods Used in accounting rate of return; ignored by payback method Ignored by both methods Considered by both methods
a. b. c. d.
i ii iii iv
ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 3 min. 22. Oakland Shop is considering the purchase of a used printing press costing $9,600. The printing press would generate a net cash inflow of $4,000 per year for three years. At the end of three years, the press would have no salvage value. The company's cost of capital is 10%. The company uses straight-line depreciation with no mid-year convention. What is the accounting rate of return on the original investment in the press to the nearest percent, assuming no taxes are paid? a. 41.67% b. 8.33% c. 75.00% d. 10.00% ANS: B SUPPORTING CALCULATIONS: [$4,000 ($9,600/3)]/$9,600 = 8.33% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 4 min. Figure 14-1. A company is considering two projects.
Initial investment Cash inflow Year 1 Cash inflow Year 2 Cash inflow Year 3 Cash inflow Year 4 Cash inflow Year 5
Project I Project II $120,000 $120,000 $40,000 $20,000 $40,000 $20,000 $40,000 $32,000 $40,000 $48,000 $40,000 $50,000
23. Refer to Figure 14-1. What is the payback period for Project I? a. 1 year b. 3 years c. 2.5 years d. 3.5 years e. 5 years ANS: B Payback period = $120,000/$40,000 = 3 years PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic
OBJ: LO: 14-2
STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 24. Refer to Figure 14-1. What is the payback period for Project II? a. 1 year b. 2 years c. 3.5 years d. 4 years e. 5 years ANS: D $20,000 + $20,000 + $32,000 + $48,000 = $120,000 4 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 4 min. Figure 14-2. A company is considering two projects.
Initial investment Cash inflow Year 1 Cash inflow Year 2 Cash inflow Year 3 Cash inflow Year 4 Cash inflow Year 5
Project A $200,000 $50,000 $50,000 $50,000 $50,000 $50,000
Project B $200,000 $90,000 $90,000 $40,000 $30,000 $30,000
25. Refer to Figure 14-2. What is the payback period for Project A? a. 4.5 year b. 2.5 years c. 5 years d. 3.5 years e. 4 years ANS: E Payback period = $200,000/$50,000 = 4 years PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 26. Refer to Figure 14-2. What is the payback period for Project B? a. 2 years b. 4.5 years c. 3.5 years d. 2.5 years e. 3 years ANS: D $90,000 + $90,000 + 0.5($40,000) = $200,000 = 2.5 years
PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. Figure 14-3. Davis Company is considering the purchase of a new piece of equipment that will cost $1,600,000 and have a life of five years with no expected salvage value. The expected cash flows associated with the project are as follows:
Year 1 2 3 4 5
Cash Revenues $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000
Cash Expenses & Depreciation $900,000 $900,000 $900,000 $900,000 $900,000
27. Refer to Figure 14-3. What is the average annual income for this project? a. $900,000 b. $1,500,000 c. $600,000 d. $700,000 e. $300,000 ANS: C Income per year = $1,500,000 - $900,000 = $600,000 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 2 min. 28. Refer to Figure 14-3. What is the accounting rate of return for the project? a. 83.33% b. 31.25% c. 47.00% d. 37.50% e. 43.75% ANS: D ARR = $600,000/$1,600,000 = 0.375 = 37.5% PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 3 min. Figure 14-4. Sony Lavery is considering investing $45,000 in a project with the following cash revenues and expenses:
Year Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Revenues $18,000 $22,000 $22,000 $24,000 $26,000 $28,000 $28,000 $28,000
Cash Expenses & Depreciation $8,000 $10,000 $9,000 $9,000 $9,000 $12,000 $11,000 $12,000
29. Refer to Figure 14-4. What is the average income for the project? a. $19,250 b. $30,000 c. $20,000 d. $14,500 e. $18,000 ANS: D Average income = (sum of revenues - sum of expenses)/years Average income = ($196,000 - $80,000)/8 Average income = $116,000/8 = $14,500 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Measurement | IMA: Investment Decisions | ACBSP: APC-33-Incremental analysis KEY: Bloom's: Application NOT: 4 min. 30. Refer to Figure 14-4. What is the accounting rate of return for the project? a. 32% b. 41% c. 20% d. 26% e. 35% ANS: A Average income = (sum of revenues - sum of expenses)/years Average income = ($196,000 - $80,000)/8 Average income = $116,000/8 = $14,500 ARR = Average income/Investment ARR = $14,500/$45,000 = 0.32 or 32% PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 3 min. 31. Refer to Figure 14-4. Assuming straight-line depreciation over 8 years, what is the payback period for the project? a. between 4 and 5 years b. between 2 and 3 years c. between 5 and 6 years
d. between 7 and 8 years e. between 6 and 7 years ANS: B Year
Year 1
Revenues Cash Expenses & Depreciation $18,000
Depreciation
Revenues - Cash Net cash flow expenses & depreciation (add back depreciation)
$8,000
$10,000
$15,625
$12,000
$17,625
$13,000
$18,625
$15,000
$20,625
$17,000
$22,625
$16,000
$21,625
$17,000
$22,625
$16,000
$21,625
5,625 Year 2
$22,000
$10,000 5,625
Year 3
$22,000
$9,000 5,625
Year 4
$24,000
$9,000
Year 5
$26,000
$9,000
5,625 5,625 Year 6
$28,000
$12,000 5,625
Year 7
$28,000
$11,000 5,625
Year 8
$28,000
$12,000
$196,000
$80,000
5,625
PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. Figure 14-5. Sara Turner is considering investing $60,000 in a project with the following cash revenues and expenses:
Year Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $16,000 $18,000 $17,000 $26,000 $26,000
Cash Expenses & Depreciation $16,000 $16,000 $17,000 $14,000 $14,000
32. Refer to Figure 14-5. Assuming straight-line depreciation over five years, what is the payback period for this investment? a. between 3 and 4 years b. between 2 and 3 years c. between 3 and 4 years d. between 4 and 5 years e. between 1 and 2 years ANS: A
Year
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues Cash Expenses & Depreciation $16,000 $18,000 $17,000 $26,000 $26,000
$16,000 $16,000 $17,000 $14,000 $14,000
Depreciation
Actual cash outflow
12,000 12,000 12,000 12,000 12,000
$4,000 $4,000 $5,000 $12,000 $12,000
Net cash flow (add back depreciation) $12,000 $14,000 $12,000 $24,000 $24,000
Net cash inflows for 4 years period is between 3 and 4 years. Net cash inflows $12,000 $14,000 $12,000 $22,000 $60,000 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. 33. Refer to Figure 14-5. What is the accounting rate of return for the project? a. 8.67% b. 15.60% c. 7.50% d. 3.10% e. Cannot be calculated with this information. ANS: A What is the accounting rate of return for the project? Average income = $26,000/5 years = $5,200 ARR = Average income/Investment ARR = $5,200/$60,000 = 0.0866 or 8.67% PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 4 min. Figure 14-7. Osler Company is considering an investment with the following data:
Initial cost Annual net cash inflows Expected life Salvage value
$200,000 $ 25,000 10 years none
Depreciation will be taken on a straight-line basis over the expected life of the investment. 34. Refer to Figure 14-7. What is the accounting rate of return for the investment? a. 10% b. 12.5% c. 25% d. 2.5% e. 20% ANS: D Depreciation = $200,000/10 years = $20,000/year Average annual income = $25,000 $20,000 = $5,000 ARR = $5,000/$200,000 = 0.025 or 2.5% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 4 min. 35. Refer to Figure 14-7. The company requires a minimum rate of return of 4%. What is the net present value of the investment? Period 4% a. b. c. d.
1 0.962
2 1.886
3 2.775
4 3.630
5 4.452
6 5.242
7 6.002
8 6.773
9 7.435
10 8.111
$2,775 $202,775 $118,170 ($81,830)
ANS: A NPV = (8.111 $25,000) $200,000 = $2,775 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. 36. Which of the following provides an absolute dollar measure? a. internal rate of return b. net present value c. payback period d. accounting rate of return e. None of these. ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 | LO: 14-3 | LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 37. The required rate of return used in the net present value model can also be called the a. hurdle rate. b. minimum acceptable rate of return.
c. cost of capital. d. discount rate. e. All of these. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 38. If net present value is negative, it means that the return on the investment is a. less than the discount rate. b. more than the discount rate. c. equal to the discount rate. d. acceptable. e. meaningless since the return on the investment bears no relationship to the discount rate. ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 39. A division manager is considering a project that requires a significant initial investment. The company's top management will not approve any project that does not return at least 12%. The manager will most likely use which of the following capital investment models? a. payback period b. accounting rate of return c. net present value d. internal rate of return e. None of these. ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 3 min. 40. A firm is evaluating a project that has a net present value of $0 when a discount rate of 8% is used. A discount rate of 6% will result in a a. negative net present value. b. positive net present value. c. net present value of $0. d. The question cannot be answered based upon the information provided. ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 2 min. 41. Jackson Company invests in a new piece of equipment costing $40,000. The equipment is expected to yield the following amounts per year for the equipment's four-year useful life: Cash revenues Cash expenses Depreciation expenses (straight-line) Income provided from equipment
$ 60,000 (32,000) (10,000) $ 18,000
Cost of capital
14%
What is the net present value of this investment in equipment? a. $81,592 b. $41,592 c. $(4,480) d. $52,452 ANS: B SUPPORTING CALCULATIONS: NPV = ($60,000 $32,000) 2.914 $40,000 = $41,592
(PVAF n = 4, 14%)
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 4 min. 42. The following information pertains to an investment: Investment Annual revenues Annual variable costs Annual fixed out-of-pocket costs Discount rate Expected life of project
$140,000 $ 96,000 $ 32,000 $ 20,000 12% 8 years
The present value of the annual cash flow (rounded) is a. $136,822. b. $152,538. c. $204,884. d. $218,592. ANS: D SUPPORTING CALCULATIONS: Revenues Less: Variable costs Fixed out-of-pocket costs Annual cash flow PVAF, n = 8, 12% Present value
$ 96,000 (32,000) (20,000) $ 44,000 4.968 $218,592
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. 43. A firm is considering a project with an annual cash flow of $200,000. The project would have a seven year life, and the company uses a discount rate of 10%. What is the maximum amount the company could invest in the project and have the project still be acceptable? a. $718,200 b. $1,400,000 c. $973,600 d. $200,000
ANS: C SUPPORTING CALCULATIONS: $200,000 4.868 (PVAF, n = 7, 10%) = $973,600 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. 44. A firm is considering a project with an annual cash flow of $80,000. The project would have a 10-year life, and the company uses a discount rate of 8%. What is the maximum amount the company could invest in the project and have the project still be acceptable (rounded)? a. $800,000 b. $536,800 c. $406,420 d. $727,208 ANS: B SUPPORTING CALCULATIONS: $80,000 6.710 (PVAF, n = 10, 8%) = $536,800 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. Figure 14-6. Present value of $1 Periods 4% 1 0.962 2 0.925 3 0.889 4 0.855 5 0.822 6 0.790 7 0.760 8 0.731 9 0.703 10 0.676
6% 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592 0.558
8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463
10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386
12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322
14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270
Present value of an Annuity of $1 Periods 4% 6% 1 0.962 0.943 2 1.886 1.833 3 2.775 2.673 4 3.630 3.465 5 4.452 4.212 6 5.242 4.917 7 6.002 5.582 8 6.733 6.210 9 7.435 6.802
8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247
10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759
12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328
14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946
10
8.111
7.360
6.710
6.145
5.650
5.216
45. Refer to Figure 14-6. Morgan Clinical Practice is considering an investment in new imaging equipment that will cost $400,000. The equipment is expected to yield cash inflows of $80,000 per year for a six year period. Morgan set a required rate of return at 10%. What is the net present value of the investment? ( Note: there may be a rounding error depending on the table you use to compute your answer. Choose the answer closest to the one you calculate.) a. $51,600 b. ($51,600) c. $348,400 d. ($348,600) e. $451,600 ANS: B Year 0 16 NPV
Cash Flow $(400,000) 80,000
Discount factor 1.000 4.355
Present Value $(400,000) 348,400 $ (51,600)
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. 46. Refer to Figure 14-6. Morgan Clinical Practice is considering an investment in new imaging equipment that will cost $400,000. The equipment is expected to yield cash inflows of $80,000 per year for a six year period. At the end of the sixth year, the firm expects to recover $150,000 from the sale of the equipment. Morgan set a required rate of return at 10%. What is the net present value of the investment? (Note: there may be a rounding error depending on the table you use to compute your answer. Choose the answer closest to the one you calculate.) a. ($33,000) b. $45,200 c. $433,000 d. $33,000 e. ($177,280) ANS: D Year 0 16 6 NPV
Cash Flow $(400,000) 80,000 150,000
Discount factor 1.000 4.355 0.564
Present Value $(400,000) 348,400 84,600 $ 33,000
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 4 min. 47. Refer to Figure 14-6. Roman Knoze is considering two investments. Each will cost $20,000 initially. Project 1 will return annual cash flows of $10,000 in each of three years. Project 2 will return $5,000 in year 1, $10,000 in year 2, and $15,000 in year 3. Roman requires a minimum rate of return of 10%. What is the net present value of Project 1? ( Note: there may be a rounding error depending on the table you use to compute your answer. Choose the answer closest to the one you calculate.) a. $20,000
b. c. d. e.
$25,670 $4,860 $22,530 $2,530
ANS: C Year 0 1 2 3 NPV
Cash Flow $(20,000) 10,000 10,000 10,000
Discount factor 1.000 0.909 0.826 0.751
Present Value $(20,000) 9,090 8,260 7,510 $ 4,860
PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. 48. Refer to Figure 14-6. Roman Knoze is considering two investments. Each will cost $20,000 initially. Project 1 will return annual cash flows of $10,000 in each of three years. Project 2 will return $5,000 in year 1, $10,000 in year 2, and $15,000 in year 3. Roman requires a minimum rate of return of 10%. What is the net present value of Project 2? a. $5,670 b. $20,000 c. $2,530 d. $24,070 e. $4,070 ANS: E Year 0 1 2 3 NPV
Cash Flow $(20,000) 5,000 10,000 15,000
Discount factor 1.000 0.909 0.826 0.751
Present Value $(20,000) 4,545 8,260 11,265 $ 4,070
PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. 49. Refer to Figure 14-6. Jan Rigby is considering an investment that will cost $20,000 initially, and return annual cash flows of $10,000 in each of three years. Jan requires a minimum rate of return of 8%. What is the present value of the cash inflows? ( Note: there may be a rounding error depending on the table you use to compute your answer. Choose the answer closest to the one you calculate.) a. $25,770 b. $20,000 c. $5,770 d. $45,770 e. $10,000 ANS: A Year 0
Cash Flow $(20,000)
Discount factor 1.000
Present Value $(20,000)
1 2 3 NPV
10,000 10,000 10,000
0.926 0.857 0.794
9,260 8,570 7,940 $ 5,770
PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. 50. The interest rate that sets the present value of a project's cash inflows equal to the present value of the project's cost is called the ____. a. present value b. discount rate c. company cost of capital d. payback period e. internal rate of return ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 51. Which of the following is true regarding the internal rate of return for a project? a. If the internal rate of return is less than the required rate of return, the project will be rejected. b. If the internal rate of return is equal to the required rate of return, the net present value of the project is zero. c. If the internal rate of return is more than the required rate of return, the project will be accepted. d. Managers may believe (in most cases, incorrectly) that the internal rate of return is the compounded rate of return earned by the initial investment. e. All of these. ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 52. Elizabeth Myers invested in a project that required an initial amount of $1,560, and returned one cash inflow of $12,000 at the end of the 18th year. A partial table of the present value of an annuity of $1 in arrears is as follows: Year 18
2% 0.700
4% 0.494
6% 0.350
8% 0.250
10% 0.180
What is the internal rate of return for this investment? a. 8% b. 10% c. 12% d. 14% e. 16% ANS: C
12% 0.130
14% 0.095
16% 0.069
To find the interest rate implied, set the present value of the initial investment equal to the present value of the cash inflow. $1,560 (1.00) = $12,000 (discount rate) discount rate = 0.130 This discount rate matches the one for an internal rate of return of 12%. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 2 min. 53. Jerry Hall invested in a project that required an initial amount of $52,160, and returned cash inflows of $10,000 per year for 10 years. A partial table of the present value of an annuity of $1 in arrears is as follows: Year 10
2% 7.983
4% 8.111
6% 7.360
8% 6.710
10% 6.145
12% 5.650
14% 5.216
16% 4.833
What is the internal rate of return for this investment? a. 8% b. 10% c. 12% d. 14% e. 16% ANS: D Discount factor = $52,160/$10,000 = 5.216 This discount factor matches the one for an internal rate of return of 14%. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 2 min. 54. Amatra Inc., has the opportunity to invest in new equipment that will cost $113,000. The net cash inflows for ten years equal $20,000 per year. What is the internal rate of return for the investment? A partial table of the present value of an annuity of $1 in arrears is as follows: Year 10 a. b. c. d. e.
2% 7.983
4% 8.111
6% 7.360
8% 6.710
10% 6.145
12% 5.650
14% 5.216
16% 4.833
8% 10% 12% 14% 16%
ANS: C Discount factor = $113,000/$20,000 = 5.650 This discount factor matches the one for an internal rate of return of 12%. PTS: 1
DIF:
Difficulty: Easy
OBJ: LO: 14-4
NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 2 min. 55. Shoring Company is considering a project with an internal rate of return of 14.5%. Shoring requires a minimum rate of return of 12%. The net present value of the project is a. negative. b. infinite. c. equal to zero. d. positive. e. None of these. ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 2 min. 56. The internal rate of return is defined as a. a blend of the costs of capital from all sources. b. the minimal acceptable interest rate on investments. c. the difference between the present value of the cash inflows and outflows associated with a project. d. the interest rate that sets the present value of a project's cash inflows equal to the present value of a project's cost. ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 2 min. 57. Jones Company is considering the purchase of a new machine for $57,000. The machine would generate an annual cash flow of $17,411 for 5 years. At the end of five years, the machine would have no salvage value. The company's cost of capital is 12%. The company uses straight-line depreciation. What is the internal rate of return for the machine rounded to the nearest percent? a. 12% b. 18% c. 14% d. 16% ANS: D SUPPORTING CALCULATIONS: $57,000/$17,411 = 3.274, which is the pv factor for n = 5, i = 16% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 2 min. 58. A firm is considering a project requiring an investment of $27,000. The project would generate an annual cash flow of $6,296 for the next seven years. The company uses the straight-line method of depreciation. The approximate internal rate of return for the project is a. 6%. b. 8%. c. 12%.
d. 14%. ANS: D SUPPORTING CALCULATIONS: $27,000/$6,296 = 4.288 PVAF of 4.288, n = 7, corresponds to 14% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 2 min. 59. Cooper Industries is considering a project that would require an initial investment of $101,000. The project would result in cost savings of $62,000 in year 1 and $70,000 in year two. The internal rate of return is a. between 16% and 17%. b. between 18% and 20%. c. under 15%. d. none of these. ANS: B Support: At 18%, the two discount factors would be .847 and .718 ($62,000 .847) + ($70,000 .718) = $102,774 At 20% the two discount factors would be .833 and .694 ($62,000 .833) + ($70,000 .694) = $100,226 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 4 min. Figure 14-8. Present value of an Annuity of $1 in Arrears Periods 4% 6% 8% 1 0.962 0.943 0.926 2 1.886 1.833 1.783 3 2.775 2.673 2.577 4 3.630 3.465 3.312 5 4.452 4.212 3.993 6 5.242 4.917 4.623 7 6.002 5.582 5.206 8 6.733 6.210 5.747 9 7.435 6.802 6.247 10 8.111 7.360 6.710
10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145
12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650
14% 0.877 1.647 2.322 2.914 4.433 3.889 4.288 4.639 4.946 5.216
60. Refer to Figure 14-8. Lucas Company is considering a project with an initial investment of $530,250 in new equipment that will yield annual net cash flows of $95,000, and will be depreciated at $75,750 per year over its seven year life. What is the internal rate of return? a. 8%
b. c. d. e.
6% 12% 10% 14%
ANS: B Discount rate = $530,250/$95,000 = 5.582 corresponding to a 6% IRR Salvage value is zero after depreciation. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. 61. Refer to Figure 14-8. Sawyer Company is considering a project with an initial investment of $226,000 that will yield annual net cash flows of $40,000, and will be depreciated at $22,600 per year over its ten year life. What is the internal rate of return? a. 6% b. 8% c. 10% d. 12% e. 14% ANS: D Discount factor = $226,000,/$40,000 = 5.650 corresponding to an IRR of 12% Salvage value is zero after depreciation. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 3 min. Figure 14-9. Kenner Company is considering two projects.
Initial investment Annual cash flows Life of the project Depreciation per year
Project A $85,000 $20,676 6 years $14,167
Project B $24,000 $6,011 5 years $4,800
Present value of an Annuity of $1 in Arrears Periods 8% 10% 12% 1 0.926 0.909 0.893 2 1.783 1.736 1.690 3 2.577 2.487 2.402 4 3.312 3.170 3.037 5 3.993 3.791 3.605 6 4.623 4.355 4.111 7 5.206 4.868 4.564
14% 0.877 1.647 2.322 2.914 4.433 3.889 4.288
8 9 10
5.747 6.247 6.710
5.335 5.759 6.145
4.968 5.328 5.650
4.639 4.946 5.216
62. Refer to Figure 14-9. Which of the two projects, A or B, is better in terms of internal rate of return? a. project A with an IRR of 12% b. project B with an IRR of 14% c. project A with an IRR of 10% d. project B with an IRR of 10% e. both projects have the same IRR ANS: A Project A: Discount factor = $85,000/$20,676 = 4.111, corresponding to an IRR of 12% Project B: Discount factor = $24,000/$6,011 = 3.993, corresponding to an IRR of 8% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-4 | LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 4 min. 63. Refer to Figure 14-9. Suppose that Kenner Company requires a minimum rate of return of 8%. Which project is better in terms of net present value? a. project A with NPV of $10,585 b. project B with NPV of $7,756 c. project A with NPV of $4,210 d. project B with NPV of $1,212 e. both projects have the same NPV ANS: A Project A NPV = ($20,676 x 4.623) - $85,000 = $10,585 Project B NPV = ($6,011 x 3.993) - $24,000 = -$1.92 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 | LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 4 min. 64. Which of the following compares the actual benefits from an investment with the estimated benefits, and the actual operating costs of the investment with estimated operating costs? a. internal rate of return b. discounted returns c. postaudit d. opportunity cost e. capital investment decision making ANS: C A post-audit compares the actual benefits with the estimated benefits and actual operating costs with estimated operating costs; it evaluates the overall outcome of the investment and proposes corrective action if needed. PTS: 1
DIF:
Difficulty: Moderate
OBJ: LO: 14-5
NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 65. Which of the following is a disadvantage of postaudits? a. They evaluate profitability rather than cash flows. b. They may point to the need for additional funding for the project. c. They tend to hold managers accountable for capital investment decision making. d. The assumptions driving the original analysis may be invalidated by changes in the actual operating environment. e. All of these. ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 66. Which of the following is not a benefit of postaudits of capital investments? a. Considers changes in the actual operating environment. b. Guides managers to make capital investment in the best interests of the firm. c. Ensures that resources are used wisely by evaluating profitability. d. Supplies feedback to managers that should help improve decision making. e. All of these are benefits. ANS: A Post-audits, however, are costly. Moreover, even though they may provide significant benefits, they have other limitations. Most obvious is the fact that the assumptions driving the original analysis may often be invalidated by changes in the actual operating environment. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 3 min. 67. A follow-up analysis of a capital investment after it is implemented is called a a. capital investment review. b. profitability analysis. c. postaudit. d. peer review. ANS: C A key element in the capital investment process is a follow-up analysis of a capital project once it is implemented. This analysis is called a post-audit. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 68. The best person/group in a firm to perform a postaudit of a capital investment is usually a. the manager of that investment.
b. c. d. e.
the CEO. the board of directors. the internal audit staff. an external auditor.
ANS: D Generally, more objective results are obtainable if the postaudit is done by an independent party. Since considerable effort is expended to ensure as much independence as possible for the internal audit staff, that group is usually the best choice for this task. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 2 min. 69. The capital investment decision making model that assumes that each cash inflow is reinvested at the required rate of return is a. net present value. b. internal rate of return. c. payback period. d. accounting rate of return. e. None of these. ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 70. The capital investment decision making model that assumes that each cash inflow is reinvested at the project's own rate of return is a. net present value. b. accounting rate of return. c. payback period. d. internal rate of return. e. None of these. ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 71. The best model for choosing the best of several competing projects is a. net present value. b. internal rate of return. c. payback period. d. accounting rate of return. e. None of these. ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min.
72. When investing in automated systems, which of the following intangible or indirect benefits may be important? a. improved customer satisfaction b. improved market share c. reduced support labor cost d. reduced lead time e. All of these. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: BB-Leveraging Technology | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 73. Which of the following is true regarding the measurement and use of indirect and intangible benefits in capital investment decision making? a. ABC has made identifying indirect benefits easier. b. Intangible benefits cannot be measured. c. Indirect and intangible benefits should not be considered, only direct costs and benefits are considered. d. Actions by competitors are not considered. e. None of these. ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Knowledge NOT: 2 min. 74. A division manager is choosing between two mutually exclusive projects.
Net present value Internal rate of return
Project A $235,000 13%
Project B $210,000 15%
The company requires any project to earn at least 12%. The manager believes that cash inflows from the project can be reinvested at the rate of 12%. Which project will the manager likely choose? a. Project B b. Project A c. both Projects A and B d. neither Project A nor B ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 3 min. 75. How do NPV and IRR differ? a. NPV measures profitability in absolute terms, whereas the IRR method measures profitability in relative terms. b. IRR should be used for choosing among competing, mutually exclusive projects. c. NPV considers the time value of money and IRR does not. d. Both NPV and IRR will generate the same decisions.
ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 2 min. 76. Five mutually exclusive projects had the following information:
NPV IRR
V $(6,000) 8%
W $40,000 11%
X $30,000 13%
Y $10,000 10%
Z $20,000 12%
Which project is preferred? a. Project V b. Project W c. Project X d. Project Y ANS: B SUPPORTING CALCULATIONS: Project W, because it has the highest NPV. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 2 min. 77. The earning of interest on interest is a. present value. b. future value. c. discount rate. d. compounding of interest. e. interest earned. ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 78. A series of equal future cash flows is a(n) a. future amount. b. future earnings. c. annuity. d. earnings to be discounted. e. insurance. ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. 79. The reason that a discount factor in Year 3 is less than a discount factor in Year 2 is that a. cash flows are uneven. b. compounding does not occur. c. cash flows are even. d. present value is positive.
e.
a dollar received in 3 years is worth less than a dollar received in 2 years.
ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Knowledge NOT: 2 min. PROBLEM
1. Mistral Manufacturing is considering an investment in a new, high-efficient machine. The new machine requires an initial investment of $1,750,000. The new system cash flows of either: a. Even cash flows of $350,000 per year or b. The following expected annual cash flows: $275,000, $420,000, $820,000, $470,000, and $150,000 Required: Calculate the payback period for each case.
ANS: A. Even cash flows: $1,750,000/$350,000 = 5 years
B. $275,000
1 year 275,000
420,000
1 year 420,000
820,000
1 year 820,000
470,000
.5 year 235,000
150,000
3.5 years 1,750,000
$2,135,000 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. 2. Brenning Company invested $3,000,000 in a new computer system. The following is the net income stream: Year 1 2 3 4 5
Net income stream $475,000 $375,000 $650,000 $900,000 $920,000
6
$800,000
Required: Calculate the accounting rate of return.
ANS: Average net income = ($475,000 +$375,000 + $650,000 + $900,000 + $920,000 + $800,000)/6 years Average net income = $686,667 ARR = Average net income/Investment $686,667/$3,000,000 = 0.23 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Application NOT: 5 min. 3. Billings Office Services is considering the purchase of a new computer system to replace the one in operation. Data on the new computer system are: Cost Salvage value at the end of 5 years Useful life, in years Annual operating cost
$12,000 $ 1,000 5 $ 4,000
If the existing computer system is kept and used, it would require the purchase of additional hardware a year from now costing $2,000. After using the system for five years, the salvage value would be $300. Additional information on the existing system is: Additional years of use Annual operating costs Remaining book value Current salvage value Cost of capital
5 $ 9,000 $12,000 $ 3,000 12%
The company uses the straight-line method of depreciation. Required: Should the new system be purchased? Why or why not?
ANS: New Computer Value Factor 1.000 1.000 0.893
System $(12,000) 3,000 1,786
5,000 3.605 15 5 700 0.567 Net present value of new computer system
18,025 397 $11,208
Period 0 0 1
Present Cash Flow $(12,000) 3,000 2,000
Comment Outlay cost Salvage of old Purchase of hardware avoided Lower operating Costs Difference in salvage value
Positive net present value indicates that the new computer system returns are gr eater than the company's cost of capital. Buy the new computer system. PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. 4. Dale Davis Company is evaluating a proposal to purchase a new machine that would cost $100,000 and have a salvage value of $10,000 in 4 years. It would provide annual operating cash savings of $10,000, as follows: Old Machine New Machine $40,000 $36,000 7,000 5,000 9,000 5,000 $56,000 $46,000
Salaries Supplies Maintenance Total
If the new machine is purchased, the old machine will be sold for its current salvage value of $20,000. If the new machine is not purchased, the old machine will be disposed of in 4 years at a predicted salvage value of $2,000. The old machine's present book value is $40,000. If kept, in 1 year the old machine will require repairs predicted to cost $35,000. Dale Davis's cost of capital is 14%. Required: Should the new machine be purchased? Why or why not?
ANS: Present Period Cash Flow Value 0 ($100,000) 0 20,000 1 35,000 10,000 14 4 8,000 Net present value of new machine
Factor 1.000 1.000 0.877 2.914 0.592
New Machine $(100,000) 20,000 30,695 29,140 4,736 $ (15,429)
Comment Outlay cost Salvage of old Repairs avoided Lower operating costs Difference in salvage value
Negative net present value indicates that the new machine returns are less than the company's cost of capital. Do not buy the new machine. PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. 5. Fill in the lettered blanks in the following table:
Amount of investment Economic life in years Annual cash flow
Investment A $40,000 10 $ 5,000
Investment B (A) 5 (B)
Investment C $20,000 8 $ 2,500
Payback period in years Present value of cash flows Net present value
(C) (E) $ 5,500
4 $33,000 $ 3,000
(D) (F) ($1,000)
ANS: A. B. C. D. E. F.
$33,000 $3,000 = $30,000 $30,000/4 = $7,500 $40,000/$5,000 = 8 $20,000/$2,500 = 8 $40,000 + $5,500 = $45,500 $20,000 $1,000 = $19,000
PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-2 | LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. 6. Barker Production Company is considering the purchase of a flexible manufacturing system. The annual cash benefits/savings associated with the system are: Decreased waste Increased quality Decrease in operating costs Increase in on-time deliveries
$ 75,000 100,000 62,500 12,500
The system will cost $750,000 and will last ten years. The company's cost of capital is 10%. Required: A. What is the payback period for the flexible manufacturing system? B. What is the NPV for the flexible manufacturing system?
ANS: A. B.
$750,000/$250,000 = 3 years 6.145 $250,000 $750,000 = $786,250
(PVAF n = 10, 10%)
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 | LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. Figure 14-10. Present value of $1 Periods 4% 1 0.962 2 0.925 3 0.889 4 0.855 5 0.822
6% 0.943 0.890 0.840 0.792 0.747
8% 0.926 0.857 0.794 0.735 0.681
10% 0.909 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
14% 0.877 0.769 0.675 0.592 0.519
6 7 8 9 10
0.790 0.760 0.731 0.703 0.676
0.705 0.665 0.627 0.592 0.558
Present value of an Annuity of $1 Periods 4% 6% 1 0.962 0.943 2 1.886 1.833 3 2.775 2.673 4 3.630 3.465 5 4.452 4.212 6 5.242 4.917 7 6.002 5.582 8 6.733 6.210 9 7.435 6.802 10 8.111 7.360
0.630 0.583 0.540 0.500 0.463
0.564 0.513 0.467 0.424 0.386
0.507 0.452 0.404 0.361 0.322
0.456 0.400 0.351 0.308 0.270
8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710
10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145
12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650
14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216
7. Refer to Figure 14-10. Jimmy Reynolds is considering investing $12,000 in a project with the following cash revenues and expenses: Revenues $20,000 $22,000 $22,000 $22,000 $25,000
Year 1 Year 2 Year 3 Year 4 Year 5
Expenses $18,000 $19,000 $20,000 $17,000 $17,000
Jimmy requires a minimum rate of return of 8%. A. B. C.
Calculate the net cash inflows in each of the 5 years. What is the payback period? What is the net present value of the investment?
ANS: A. Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $20,000 22,000 22,000 22,000 25,000
Expenses $18,000 19,000 20,000 17,000 17,000
B.
Payback period = ($2,000 + $3,000 + $2,000 + $5,000) = 4 years
C.
Net present value = $15,134 $12,000 = $3,134
Year 0 Year 1
Net Cash Inflows $(12,000) $ 2,000
Discount Factor 1.00 0.926
Net Cash Inflows $2,000 3,000 2,000 5,000 8,000
Present Value $(12,000) 1,852
Year 2 Year 3 Year 4 Year 5
3,000 2,000 5,000 8,000
0.857 0.794 0.735 0.681
2,571 1,588 3,675 5,448
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 | LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. 8. Refer to Figure 14-10. Jasmine Company is considering an investment costing $20,000. The investment would return $8,000 per year in each of three years. Jasmine requires a minimum rate of return of 6%. A. B. C.
What is the payback period for the investment? What is the net present value of the investment? The internal rate of return is greater than __________________ % and less than __________________ %.
ANS: A.
Payback period = $20,000/$8,000 = 2.5 years
B.
Net present value OR Net present value
C.
= $8,000(0.943) + $8,000(0.890) + $8,000(0.840) $20,000 = $1,384 = $8,000(2.673) $20,000 = $1,384
Discount factor = $20,000/$8,000 = 2.500 The internal rate of return for this discount factor lies between 8% and 10%
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 | LO: 14-3 | LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 5 min. 9. Refer to Figure 14-10. Geary Company is considering an investment costing $110,000. The investment would return $40,000 per year in each of three years. Geary requires a minimum rate of return of 10%. A. B. C. D.
What is the payback period for the investment? Using the Present Value of an Annuity of $1 table, calculate the net present value of the investment. The internal rate of return is greater than __________________ % and less than __________________ %. Now assume that the investment includes equipment that can be sold at the end of the third year for $10,000. What is the present value of this investment?
ANS: A.
Payback period = $110,000/$40,000 = 2.75 years
B.
Net present value = $40,000(2.487) $110,000 = ($10,520)
C.
Discount factor = $110,000/$40,000 = 2.75 The internal rate of return for this discount factor lies between 4% and 6%.
D.
Net present value
= $40,000(0.909) + $40,000(0.826) + $50,000(0.751) $110,000 = ($3,050)
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 | LO: 14-3 | LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. 10. Refer to Figure 14-10. Howard-Parr Company is considering an investment that will have an initial cost of $500,000 and yield annual net cash inflows of $130,000. Yearly depreciation will be $100,000. The equipment is expected to be useful for five years, at which point it will be scrapped with no salvage value. Howard-Parr requires a minimum rate of return of 10%. A. B. C. D.
What is the accounting rate of return? What is the net present value? Is the investment acceptable? Now suppose that Howard-Parr believes it can sell the equipment at the end of 5 years for $50,000. What is the net present value? Is the investment acceptable? What can you say about the IRR in the first case (no salvage value) versus the IRR in the second case ($50,000 salvage value)?
ANS: A.
ARR = ($130,000 $100,000)/$500,000 = 0.06 or 6%
B.
NPV = ($130,000 3.791) $500,000 = ($7,170) The investment is not acceptable because the NPV is negative.
C.
NPV = ($130,000 3.791) + ($50,000 0.621) $500,000 = $23,880 Now the investment is acceptable because the NPV is positive.
D.
In the first instance, the IRR must be lower than 10% but not by a great deal. We know this because the NPV in the first case is negative. In the second instance, the IRR is higher than 10% because the NPV is positive.
PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-2 | LO: 14-3 | LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. 11. Refer to Figure 14-10. A company is considering two modifications to its current manufacturing process. The after-tax cash flows associated with the two investments are:
Year 0 1 2
Project I $(37,500) --$50,460
Project II $(150,000) 91,075 91,075
The company's cost of capital is 12%. A. B. C.
Compute the net present value for each investment. Computer the internal rate of return for each investment. Which project is better? Explain your reasoning.
ANS: A.
NPV Project I = ($50,460 0.797) $37,500 = $2,717 NPV Project II = ($91,075 1.690) $150,000 = $3,917
B.
IRR Project I: discount factor = $37,500/$50,460 = 0.743* corresponding to IRR = 16%* IRR Project II: discount factor = $150,000/$91,075 = 1.647 corresponding to IRR = 14% * Estimate the approximate percentage by looking at the chart. A good guess is 16%. Check the number by the following calculation: To verify, df = [1/(1 + rate)] n
C.
Project II is better, even though it has a lower IRR, because its net present value is higher.
PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-3 | LO: 14-4 | LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. 12. Refer to Figure 14-10. Ray Corporation is looking to invest in a new piece of equipment. Two manufacturers of this type of equipment are being considered. After-tax inflows for the two competing projects are: Year 1 2 3 4 5
Fallon Equipment Inc. $275,000 225,000 185,000 140,000 65,000
Toller Equipment Inc. $70,000 70,000 285,000 330,000 390,000
Both projects require an initial investment of $400,000. In both cases, assume that the equipment has a life of 5 years with no salvage value. Required: A. Assuming a discount rate of 8%, compute the net present value of each piece of equipment. B. A third option is now available for a supplier outside of the country. The cost is also $400,000, but it will produce even cash flows over its 5 -year life. What must the annual cash flow be for this equipment to be selected over the other two? Assume an 8% discount rate.
ANS: A. Fallon Equipment Year 0 1 2 3 4 5
Cash Flow
Discount Factor
($400,000) 275,000 225,000 185,000 140,000 65,000
1 0.926 0.857 0.794 0.735 0.681
Present Value ($400,000) 254,650 192,825 146,890 102,900 $44,265 $341,530
Toller Equipment Inc. Year 0 1 2 3 4 5
Cash Flow
Discount Factor
($400,000) 70,000 70,000 285,000 330,000 390,000
1 0.926 0.857 0.794 0.735 0.681
Present Value ($400,000) 64,820 59,990 226,290 242,550 $265,590 $459,240
B. CF(3.993) - $400,000 = $459,240 (same as Toller Equipment) CF(3.993) = $859,240
CF = $859,240/3.993 CF = $215,187 Therefore in order for the supplier outside the country to be selected the cash flow would have to be higher than $215,187. PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-1 | LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. 13. Refer to Figure 14-10. Durrel Company is considering two different modifications to its current manufacturing process. The after-tax cash flows associated with the two investments are as follows: Year
Project A
Project B
0 ($220,000) 1
($220,000)
-
88,500
-
88,500
285,000
88,500
2 3
Durrel's cost of capital is 6%. Required: A. Compute the NPV for each investment and state which project should be chosen based on the NPV.
B. Compute the IRR for each investment and state which project should be chosen based on the IRR. ANS: A. Project A Year 0 1 2 3
Cash Flow ($220,000) 0 0 285,000
Discount Factor 1 0 0 0.840
Present Value ($220,000) 0 0 $239,400 $19,400
Year 0 1 2 3
Cash Flow ($220,000) 88,500 88,500 88,500
Discount Factor 1 0.943 0.890 0.840
Present Value ($220,000) 83,456 78,765 $74,340 $16,561
Project B
Project A should be chosen based on NPV
B. Project A $220,000/$285,000 = 0.77193
Project B $220,000/$88,500 = 2.485 From the table above, IRR is close to 10%.
From the table above, IRR is close to 8%. Project B should be chosen based on IRR. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 | LO: 14-4 | LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min.
Figure 14-11. Present value of an Annuity of $1 in Arrears Periods 4% 6% 8% 1 0.962 0.943 0.926 2 1.886 1.833 1.783 3 2.775 2.673 2.577 4 3.630 3.465 3.312 5 4.452 4.212 3.993 6 5.242 4.917 4.623 7 6.002 5.582 5.206 8 6.733 6.210 5.747 9 7.435 6.802 6.247 10 8.111 7.360 6.710
10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145
12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650
14% 0.877 1.647 2.322 2.914 4.433 3.889 4.288 4.639 4.946 5.216
14. Refer to Figure 14-11. Aragon Company is considering an investment in equipment that will have an initial cost of $560,290 and yield annual net cash inflows of $90,000. Yearly depreciation will be $56,000. The equipment is expected to be usef ul for 10 years and then it will be scrapped. Aragon requires a minimum rate of return of 10%. A. B. C. D.
What is the payback period? What is the accounting rate of return? What is the net present value? What is the approximate internal rate of return?
ANS: A. B. C. D.
Payback period = $560,290/$90,000 = 6.2 years ARR = ($90,000 $56,000)/$560,290 = 0.06068 or 6.07% NPV = ($90,000 6.145) $560,290 = ($7,240) Discount factor = $560,290/$90,000 = 6.225 corresponding to an IRR of slightly below 10%
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 | LO: 14-3 | LO: 14-4 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 5 min. 15. Refer to Figure 14-11. Cleves Company is considering two projects.
Initial investment Annual cash flows Life of the project Depreciation per year
Project X $500,000 $ 88,500 10 years $ 50,000
Cleves requires a minimum rate of return of 8%. A. B. C.
What is the accounting rate of return for each project? What is the net present value for each project? What is the internal rate of return for each project?
Project Y $100,000 $ 34,320 4 years $ 25,000
D.
Given that only one project can be selected, which project should be chosen? Explain your reasoning.
ANS: A.
Project X, ARR = ($88,500 $50,000)/$500,000 = 0.077 or 7.7% Project Y, ARR = ($34,320 $25,000)/$100,000 = 0.0932 or 9.32%
B.
Project X, NPV = ($88,500 6.71) $500,000 = $93,835 Project Y, NPV = ($34,320 3.312) $100,000 = $13,668
C.
Project X, Discount factor = $500,000/$88,500 = 5.650 corresponding to IRR of 12% Project Y, Discount factor = $100,000/$34,320 = 2.914 corresponding to IRR of 14%
D.
Project X should be chosen because it has the highest net present value. Even though Project Y has a higher internal rate of return, Project X will return a greater absolute dollar amount over the life of the project.
PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-2 | LO: 14-3 | LO: 14-4 | LO: 14-6 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 10 min. 16. Refer to Figure 14-11. Lyster Company wants to buy a new machine that will be able to perform many of the steps in the manufacturing process that they currently have to do manually. The hope is that it will reduce the amount of time it takes to create one unit and reduce the number of defective units. The machine requires an investment of $750,000. The machine will last six years with no expected salvage value. The expected after-tax cash flows associated with the project are as follows: Year 1
Cash revenues
Cash expenses
$825,000
$510,000
825,000
510,000
825,000
510,000
825,000
510,000
825,000
510,000
825,000
510,000
2 3 4 5 6
Required: A. Compute the payback period for the new machine. B. Compute the new machine's ARR. C. Compute the investment's NPV, assuming a required rate of return of 12%.
ANS:
A. Payback period = original investment/annual cash inflow $750,000/($825,000 - $510,000) = 2.38 years B. Annual depreciation = $750,000/6 years = $125,000 ARR = average annual income/investment ($315,000 - $125,000)/$750,000 = 0.253 or 25.3% C. $315,000 x 4.111 = $1,294,965 - $750,000 = $544,965 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 | LO: 14-3 NAT: BUSPROG: Analytic STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Application NOT: 5 min. ESSAY
1. What is a capital investment decision? Give an example. ANS: A capital investment decision is one that places large amounts of resources at risk for long periods of time. It affects the future development of the firm and is one of the largest decisions that managers make. Decisions to build a new factory, expand into another country, or upgrade the technical capacity of the company are examples of capital investment decisions. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-1 NAT: BUSPROG: Communication STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 5 min. 2. Name two nondiscounting capital investment models. What is meant by nondiscounting ? ANS: Two commonly used nondiscounting models are the payback period and the accounting rate of return. Nondiscounting means that the cash inflows and outflows are not adjusted for the time value of money. As a result, a dollar to be received today is weighted the same as one to be received in a year. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-2 NAT: BUSPROG: Communication STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 5 min. 3. What are some reasons why firms use the payback period model in capital investment decision making? ANS:
Commonly cited reasons include: 1.
2. 3. 4.
The payback period can be used to set a maximum payback period for all projects. Used in this way, it is a rough measure of risk, in that the longer it takes for a project to pay for itself, the riskier it is. Firms with liquidity problems would be more interested in projects with quicker paybacks. If the risk of obsolescence is high, firms might prefer a quicker payback. Managers may want a shorter payback period to increase the likelihood that the benefits of the project would accrue to their management tenure.
PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-2 NAT: BUSPROG: Communication STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-37-Payback/ARR Methods KEY: Bloom's: Comprehension NOT: 5 min. 4. Which model of capital investment decision making is most widely used? Why? ANS: Internal rate of return is the most widely used model. First, it is a rate of return, and this is a concept that managers are very comfortable with. Secondly, managers may believe that IRR is the true compounded rate of return being earned by the initial investment. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-4 NAT: BUSPROG: Communication STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-38-NPV/IRR Methods KEY: Bloom's: Comprehension NOT: 5 min. 5. What is a postaudit? What are the advantages and disadvantages of the postaudit? ANS: A postaudit compares the actual benefits with the estimated benefits and actual o perating costs with the estimated operating costs. It evaluates the overall outcome of the investment and proposes corrective action if necessary. Advantages: 1.
2. 3.
Postaudits help ensure that resources are wisely used. If the project is going well, it may be useful to add funds to the project. If the project is going poorly, then corrective action may be needed. Postaudits hold managers accountable for the results of a capital investment decision. It may make them more likely to act in the best interests of the firm. Postaudits provide feedback to managers to help future decision making.
Disadvantage postaudits are costly. In addition, it is necessary to consider changes in the operating environment from the time the decision was made to the time in which it was carried out. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-5 NAT: BUSPROG: Communication STA: AICPA: FN-Decision Modeling | IMA: Investment Decisions | ACBSP: APC-27-Managerial Accounting Features/Costs KEY: Bloom's: Comprehension NOT: 10 min.
