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Exam 24: Capital Budgeting and Investment Analysis

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Question 21

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Use of the internal rate of return method cannot be used with uneven cash flows.

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B) False

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Question 22

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The __________________________ is the rate that yields a net present value of zero for an investment.

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A company produces two boat models,Montauk and Orient.Both products are being considered for major investment projects next year.Relevant data follow: $\begin{array}{l}&\underline{\text{Montauk}}&\underline{\text{Orient}}\\\text{New investment}&\$ 400,000&\$ 300,000\\\text{Expected 3-year net cash flows:}\\\text{Year 1}&150,000&130,000\\\text{Year 2}&160,000&130,000\\\text{Year 3}&170,000&130,000\end{array}$ $\begin{array} { c c } \underline{\text { Year }} & \underline{\text { PV factor of } \$ 1} \\1 & 0.8929 \\2 & 0.7972 \\3 & 0.7118\end{array}$ Required: a.Calculate the net present value and the profitability index of the Montauk (assuming a discount rate of 12%). b.Calculate the net present value and the profitability index of the Orient. c.Which boat should the company acquire and why?

The payback method of evaluating an investment fails to consider how long the investment will generate cash inflows beyond the payback period.

The following data concerns a proposed equipment purchase: $\begin{array}{lr}\text{Cost} & \quad & \$ 144,000 \\\text{Salvage value} & \quad& \$ 4,000 \\\text{Estimated useful life} & \quad & 4 \text { years } \\\text{Annual net cash flows} & \quad & \$ 46,100\\\text{Depreciation method} & \quad & \text{Straight-line}\end{array}$ Assuming that net cash flows are received evenly throughout the year,the accounting rate of return is:

A company wishes to buy new equipment for $85,000.The equipment is expected to generate an additional $35,000 in cash inflows for four years.All cash flows occur at year-end.A bank will make an $85,000 loan to the company at a 10% interest rate so that the company can purchase the equipment.Use the table below to determine break-even time for this equipment. $\begin{array} { c c } \text { Year } & \text { Present Value } \\& \text { of 1 at } 10 \% \\0 & 1.0000 \\1 & 0.9091 \\2 & 0.8264 \\3 & 0.7513 \\4 & 0.6830\end{array}$

Capital budgeting is the process of analyzing alternative long-term investments and deciding which assets to acquire or sell.

A given project requires a $25,000 investment and is expected to generate end-of-period annual cash inflows as follows: $\begin{array} { c c c c } \text { Year 1 } & \text { Year 2 } & \text { Year 3 } & \text { Total } \\\hline \$ 4,000 & \$ 15,000 & \$ 6,000 & \$ 25,000\end{array}$ Assuming a discount rate of 10%,what is the net present value of this investment? Selected present value factors for a single sum are shown in the table below: $\begin{array} { c c c } i = 10 \% & i = 10 \% / 4 & i = 10 \% / 1 \\n = 1 & n = 2 & n = 3 \\\hline .9091 & .8264 & .7513\end{array}$

Holder Manufacturing is considering purchasing two machines.Each machine costs $8,000 and will produce cash flows as follows: $\begin{array} { c c } \begin{array}{l}\text {End of}\\ \text {Year}\\1\\2\\3\end{array}\begin{array} { }& \text { Machine } \\&\begin{array} { }&\text { A } & \text { B } \\&\$ 5,000 & \$ 1,000 \\&4,000 & 2,000 \\&2,000 & 11,000\end{array}\end{array}\end{array}$ Holder Manufacturing uses the net present value method to make the decision,and it requires a 15% annual return on its investments.The present value factors of 1 at 15% are: 1 year,0.8696; 2 years,0.7561; 3 years,0.6575.Which machine should Holder purchase?

A company is trying to decide which of two new product lines to introduce in the coming year.The company requires a 12% return on investment.The predicted revenue and cost data for each product line follows: $\begin{array} { l rr } &\underline{\text { Product A }} & \underline{ \text { Product B } }\\\text {Unit sales}&25,000&20,000 \\\text {Unit sales price}&\$ 30 &\$ 30 \\\text {Direct materials}&\$15,000&\$ 8,000\\\text {Direct labor}&\$120,000 &\$ 80,000\\\text {Other cash operating expenses}&\$ 30,000&\$ 25,000\\\text {New equipment costs}&\$2,500,000 &\$ 1,500,000\\\text {Estimated useful life (no salvage)}&5 \text { years }&5 \text { years }\end{array}$ The company has a 30% tax rate and it uses the straight-line depreciation method.The present value of an annuity of 1 for 5 years at 12% is 3.6048.Compute the net present value for each piece of equipment under each of the two product lines.Which,if either,of these two investments is acceptable?

Neither the net present value nor the internal rate of return methods of evaluating investments consider the time value of money.

The time value of money concept works on the principle that a dollar today is worth more than a dollar tomorrow.

A company has a decision to make between two investment alternatives.The company requires a 10% return on investment.Predicted data is provided below: $\begin{array} { l rr } &\underline{\text { Investment Y}} & \underline{\text { Investment Z}} \\\text {Projected after-tax net income}&\$ 40,000&\$ 43,000\\\text {Investment costs}&\$ 600,000&\$ 672,000\\\text {Estimated life}&6 \text { years }&6 \text { years }\end{array}$ The present value of an annuity for six years at 10% is 4.3553.This company uses straight-line depreciation. Required: a.Calculate the net present value for each investment. b.Calculate the profitability index for each investment. c.Which investment should this company select? Explain.

A company is trying to decide which of two new product lines to introduce in the coming year.The predicted revenue and cost data for each product line follows: $\begin{array}{lrr}&\underline{\text{Product A}}&\underline{\text{Product B}}\\\text{Sales}&\$ 80,000&\$ 96,000\\\text{Direct materials}&3,000&6,000\\\text{Direct labor}&30,000&45,000\\\text{Other cash operating expenses}&7,500&9,000\\\\\text{New equipment costs}&75,000&100,000\\\text{Estimated useful life (no salvage)}&5 \text { years }&5 \text { years }\end{array}$ The company has a 30% tax rate,uses the straight-line depreciation method,and predicts that cash flows will be spread evenly throughout each year.Calculate each product's payback period.If the company requires a payback period of three years or less,which,if either,product should be chosen?

The process of restating future cash flows in terms of their present values is called:

A company is considering the purchase of a new piece of equipment for $90,000.Predicted annual cash inflows from this investment are $36,000 (year 1) ; $30,000 (year 2) ; $18,000 (year 3) ; $12,000 (year 4) ; and $6,000 (year 5) .The payback period is:

If net present values are used to evaluate two investments that have equal costs and equal total cash flows,the one with more cash flows in the early years has the higher net present value.

Reference: 24_01 A company is planning to purchase a machine that will cost $24,000, have a six-year life, and be depreciated using the straight-line method with no salvage value. The company expects to sell the machine's output of 3,000 units evenly throughout each year. A projected income statement for each year of the asset's life appears below. $\begin{array}{llr}\text{Sales} & & \$ 90,000 \\\text{Costs:} & & \\\text{Manufacturing} & \$ 52,000 \\ \text{Depreciation on machine} & 4,000 \\ \text{Selling and administrative expenses} & 30,000 & \underline{(86,000) }\\\text{Income before taxes} & & \$ 4,000 \\\text{Income tax 50 \%} & & \underline{(2,000) }\\\text{Net income} & & \bold{\underline{\$ 2,000}}\end{array}$ -What is the accounting rate of return for this machine?

Monterey Corporation is considering the purchase of a machine costing $36,000 with a six-year useful life and no salvage value.Monterey uses straight-line depreciation and assumes that the annual cash inflow from the machine will be received uniformly throughout each year.In calculating the accounting rate of return,what is Monterey's average investment?

A company is considering purchasing a machine for $123,000.The machine is expected to generate a net after-tax income of $8,200 per year.Depreciation expense would be $12,300.What is the payback period for this machine?