STUDY UNIT NINE SHORT-TERM FINANCING AND CAPITAL BUDGETING I Flashcards
Both the Net Present Value (NPV) method and the Internal Rate of Return (IRR) method assume that cash flows will be reinvested at the internal rate of return.
True
False
False
Your answer is correct.
The IRR method assumes that cash flows will be reinvested at the internal rate of return. The NPV method assumes the cash flows can be reinvested at the particular project’s discount rate, that is, the desired rate of return.
Companies using the payback method set a maximum length of time within which projects must generate a predetermined profit to be considered acceptable.
True
False
False
Your answer is correct.
Companies using the payback method set a maximum length of time within which projects must pay for themselves to be considered acceptable.
The internal rate of return for a project can be determined
A If the internal rate of return is greater than the firm’s cost of capital.
B Only if the project cash flows are constant.
C By subtracting the firm’s cost of capital from the project’s profitability index.
D By finding the discount rate that yields a net present value of zero for the project.
D By finding the discount rate that yields a net present value of zero for the project.
This answer is correct.
The IRR is a capital budgeting technique that calculates the interest rate that yields a net present value equal to $0. It is the interest rate that will discount the future cash flows to an amount equal to the initial cost of the project. Thus, the higher the IRR, the more favorable the ranking of the project.
Capital investment projects include proposals for all of the following except
A The acquisition of government mandated pollution control equipment.
B The expansion of existing product offerings.
C Additional research and development facilities.
D Refinancing existing working capital agreements.
D Refinancing existing working capital agreements.
This answer is correct.
Working capital consists of the most liquid of current assets. Capital budgeting techniques are appropriate for long-term projects.
Net present value as used in investment decision-making is stated in terms of which of the following options?
A Net income.
B Cash flow.
C Earnings before interest, taxes, and depreciation.
D Earnings before interest and taxes.
B Cash flow.
This answer is correct.
Net present value is defined as the difference between (1) the present value of the estimated net cash inflows provided by the investment and (2) the present value of the estimated net cash outflows. If the net present value is positive, the investment should be undertaken.
Fact Pattern: Tam Co. is negotiating to purchase equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment’s estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of $1 at 12% for 10 periods is 5.65. Present value of $1 due in 10 periods at 12% is .322. Net present value to Tam Co. is A $13,000 B $5,760 C $12,200 D $6,440
A $13,000
This answer is correct.
The net present value of this investment can be calculated as follows:
PV of after-tax cash savings ($20,000 × 5.65)
$ 113,000
Cost of new equipment
(100,000)
Net present value
$ 13,000
The ABC Company is trying to decide between keeping an existing machine and replacing it with a new machine. The old machine was purchased just 2 years ago for $50,000 and had an expected life of 10 years. It now costs $1,000 a month for maintenance and repairs due to a mechanical problem. A new machine is being considered to replace it at a cost of $60,000. The new machine is more efficient, and it will only cost $200 a month for maintenance and repairs. The new machine has an expected life of 10 years. In deciding to replace the old machine, which of the following factors, ignoring income taxes, should ABC not consider?
A The lower maintenance cost on the new machine.
B The estimated useful life of the new machine.
C Any estimated salvage value on the old machine.
D The original cost of the old machine.
D The original cost of the old machine.
This answer is correct.
The original cost of the old machine is a sunk cost. Sunk costs have already been incurred or committed to be incurred. Because they do not vary with the decision chosen, they are not relevant to the quantitative analysis.
A company uses its company-wide cost of capital to evaluate new capital investments. What is the implication of this policy when the company has multiple operating divisions, each having unique risk attributes and capital costs?
A High-risk divisions will over-invest in new projects and low risk divisions will under-invest in new projects.
B Low-risk divisions will over-invest in low-risk projects.
C High-risk divisions will under-invest in high-risk projects.
D Low-risk divisions will over-invest in new projects and high risk divisions will under-invest in new projects.
A High-risk divisions will over-invest in new projects and low risk divisions will under-invest in new projects.
This answer is correct.
When the divisions of a large, complex firm have their own specific risk attributes and capital costs, using a single company-wide hurdle rate may lead to suboptimal decisions. The managers of a high-risk division will be tempted to over-invest in new projects and those of low-risk divisions will tend to under-invest.
View Subunit 9.3 Outline
Colter Corp. is conducting an analysis of a potential capital investment. The project is expected to increase sales by $100,000 and reduce costs by $50,000 annually. Depreciation expense is $30,000 per year. Colter’s marginal tax rate is 40%. What is the annual operating cash flow for the project?
A. $90,000
B. $42,000
C. $72,000
D. $102,000
D. $102,000
Answer (D) is correct.
The first step in assessing the desirability of a potential capital project is to identify the relevant cash flows, which are the future revocable cash flows. They include (1) the cost of new equipment, (2) annual after-tax cash savings or inflows, (3) proceeds from disposal of old equipment (salvage value), and (4) adjustment for depreciation expense on new equipment (called the depreciation tax shield since it reduces taxable income and thereby reduces cash outflow for tax expense). Therefore, the annual operating cash flow for the project is calculated as follows:
After-tax increase in sales [$100,000 × (1 – 0.4)]
$ 60,000
After-tax cost savings [$50,000 × (1 – 0.4)]
30,000
Depreciation tax shield ($30,000 × 0.4)
12,000
Annual operating cash flows
$102,000
(9.2.50)
Fact Pattern: Tam Co. is negotiating to purchase equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment’s estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of $1 at 12% for 10 periods is 5.65. Present value of $1 due in 10 periods at 12% is .322.
Accrual accounting rate of return based on initial investment to Tam Co. is
A. 10%
B. 30%
C. 20%
D. 12%
Answer (A) is correct.
The accounting rate of return is a capital budgeting technique that ignores the time value of money. It is calculated by dividing the increase in average annual accounting net income by the required investment.
Annual cash savings
$ 20,000
Less: annual depreciation expense ($100,000 ÷ 10 years)
(10,000)
Annual increase in accounting net income
$ 10,000
Divided by: purchase price of new equipment
÷100,000
Accounting rate of return
(9.2.42)
10%
Fitzgerald Company is planning to acquire a $250,000 machine that will provide increased efficiencies, thereby reducing annual operating costs by $80,000. The machine will be depreciated by the straight-line method over a 5-year life with no salvage value at the end of 5 years. Assuming a 40% income tax rate, the machine’s payback period is
A. 8.33 years.
B. 5.21 years.
C. 3.13 years.
D. 3.68 years.
3.68 years.
Answer (D) is correct.
The payback period is the number of years required to complete the return of the original investment. This measure is computed by dividing the net investment required by the average expected net cash inflow to be generated. The first step is to determine the annual cash flow. The $80,000 cost reduction will be offset by the tax expense on the savings. The full $80,000, however, will not be taxable because depreciation can be deducted before computing income taxes. Allocating the $250,000 cost evenly over 5 years produces an annual depreciation expense of $50,000. Thus, taxable income will be $30,000 ($80,000 – $50,000). At a 40% tax rate, the tax on $30,000 is $12,000. The net annual cash inflow is therefore $68,000 ($80,000 – $12,000), and the payback period is 3.68 years ($250,000 investment ÷ $68,000).
(9.6.119)
A company purchased property that it expects to sell for $14,000 next year. The net present value of the investment is $1,000. The company is guaranteed an interest rate of 12% by the bank. What amount did the company pay for the property?
A. $11,500
B. $13,500
C. $13,000
D. $12,500
Answer (A) is correct.
The net present value of an investment is the difference between the present value of the inflows expected over the life of the investment and the initial amount of the investment. The present value of the inflow expected from this property is $12,500 ($14,000 ÷ 1.12). Thus, using the formula NPV = PV of cash inflows – Initial investment, the initial investment is $11,500 ($12,500 – $1,000).
Fact Pattern: Morton Company needs to pay a supplier’s invoice of $50,000 and wants to take a cash discount of 2/10, net 40. The firm can borrow the money for 30 days at 12% per annum plus a 10% compensating balance.
The amount Morton Company must borrow to pay the supplier within the discount period and cover the compensating balance is
A. $54,444
B. $55,000
C. $55,556
D. $55,056
Answer (A) is correct.
Morton’s total borrowings can be calculated as follows:
Total borrowings
=
Amount needed ÷ (1.0 – Compensating balance %)
=
($50,000 × 98%) ÷ (100% – 10%)
=
$49,000 ÷ 90%
=
$54,444
(9.1.4)
In equipment replacement decisions, which one of the following does not affect the decision-making process?
A. Operating costs of the new equipment.
B. Original fair value of the old equipment.
C. Current disposal price of the old equipment.
D. Operating costs of the old equipment.
B. Original fair value of the old equipment.
Answer (B) is correct.
All relevant costs should be considered when evaluating an equipment replacement decision. These include the initial investment in the new equipment, any required investment in working capital, the disposal price of the new equipment, the disposal price of the old equipment, the operating costs of the old equipment, and the operating costs of the new equipment. The original cost or fair value of the old equipment is a sunk cost and is irrelevant to future decisions.
(9.2.40)
A corporation is considering purchasing a machine that costs $100,000 and has a $20,000 salvage value. The machine will provide net annual cash inflows of $25,000 per year and has a 6-year life. The corporation uses a discount rate of 10%. The discount factor for the present value of a single sum 6 years in the future is 0.564. The discount factor for the present value of an annuity for 6 years is 4.355. What is the net present value of the machine?
A. $(2,405)
B. $8,875
C. $28,875
D. $20,155
D. $20,155
Answer (D) is correct.
The net present value calculation is as follows:
PV of annual cash inflows ($25,000 × 4.355)
$108,875
PV of salvage value ($20,000 × 0.564)
11,280
Less: initial investment
(100,000)
Net PV of the machine
$ 20,155
(9.4.77)
