Carter Co. paid $1,000,000 for land three years ago. Carter estimates it can sell the land for $1,200,000, net of selling costs. If the land is not sold, Carter plans to develop the land at a cost of $1,500,000. Carter estimates net cash flow from the development in the first year of operations would be $500,000. What is Carter's opportunity cost of the development?

a.

$500,000

b.

$1,200,000

c.

$1,000,000

d.

$1,500,000

Choice "b" is correct. Opportunity cost is the potential benefit lost by selecting a particular course of action. In this question, opportunity cost is the revenue that will not occur ($1,200,000) if Carter develops the land instead of selling it.

Choice "d" is incorrect. The cost of development is not an opportunity cost of development.

Choice "c" is incorrect. The book value of the property is not an opportunity cost of development. The fair value that Carter can receive for the land is considered, not what the land originally cost.

Choice "a" is incorrect. The cash flow in the first year of operations is not an opportunity cost of development. It's an opportunity cost of selling the land.

In equipment-replacement decisions, which one of the following does not affect the decision-making process?

a.

Original fair market value of the old equipment.

b.

Cost of the new equipment.

c.

Current disposal price of the old equipment.

d.

Operating costs of the new equipment.

Choice "a" is correct. The original FMV of the old equipment is a sunk cost that does not affect equipment-replacement decisions.

All of the following items affect the decision process:

c.

Current disposal price of the old equipment.

b.

Cost of the new equipment.

d.

Operating costs of the new equipment.

A characteristic of the payback method (before taxes) is that it:

a.

Neglects total project profitability.

b.

Incorporates the time value of money.

c.

Uses accrual accounting inflows in the numerator of the calculation.

d.

Uses the estimated expected life of the asset in the denominator of the calculation.

Choice "a" is correct. The payback method neglects total project profitability. It simply looks at the time required to recover the initial investment; subsequent cash flows are ignored.

Choice "b" is incorrect. Payback does not incorporate the time value of money.

Choice "c" is incorrect. Payback uses cash flow, not accrual accounting income.

Choice "d" is incorrect. The denominator is the annual cash inflows.

Egan Co. owns land that could be developed in the future. Egan estimates it can sell the land for $1,200,000, net of all selling costs. If it is not sold, Egan will continue with its plans to develop the land. As Egan evaluates its options for development or sale of the property, what type of cost would the potential selling price represent in Egan's decision?

a.

Variable.

b.

Future.

c.

Sunk.

d.

Opportunity.

Choice "d" is correct. Opportunity cost is the potential benefit lost by selecting a particular course of action. If the land is developed rather than sold, the potential selling price foregone is an opportunity cost.

Choice "c" is incorrect. Sunk costs are those costs that have already been incurred, are unavoidable in the future and will not vary with the course of action taken. The potential selling price is not a sunk cost.

Choice "b" is incorrect. This is a distracter option.

Choice "a" is incorrect. Variable costs are costs of production that change in total with changes in volume. The potential selling price is not a variable cost.

Which of the following limitations is common to the calculations of payback period, discounted cash flow, internal rate of return, and net present value?

a.

They rely on the forecasting of future data.

b.

They require multiple trial and error calculations.

c.

They require knowledge of a company's cost of capital.

d.

They do not consider the time value of money.

Choice "a" is correct. The common disadvantage of all capital budgeting models is their reliance on future data. Capital financing relates to longer periods of time that are subject to greater levels of uncertainty than other short-term budgeting and financing decisions.

Choice "d" is incorrect. While the failure to consider the time value of money is a shortcoming of the payback method, it is not a common weakness in NPV and IRR methods or other discounted cash flow methods that do consider the time value of money.

Choice "b" is incorrect. While the IRR method may require multiple trial-and-error computations, other methods do not. This weakness is not common to all of the capital budgeting methods mentioned.

Choice "c" is incorrect. The cost of capital is a typical hurdle rate used in discounting future cash flows in capital budgeting, but it is not used for the payback method. Cost of capital considerations are not common to all of the capital budgeting methods mentioned.

The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?

a.

Depreciation increases cash flow by reducing income taxes.

b.

The decline in the value of the investment should be reflected in the determination of net present value.

c.

Depreciation adjusts the book value of the investment.

d.

Depreciation represents a cash outflow that must be added back to net income.

Choice "a" is correct. Although depreciation is not directly relevant to net present value computations, the depreciation tax shield (reduced income taxes) results in increased cash flows from an investment and is used in the determination of net present value.

Choice "b" is incorrect. Depreciation is an accounting method of cost allocation, not a method of valuation that would be considered in determining the initial investment.

Choice "c" is incorrect. The reductions in the book value associated with depreciation expense are not relevant to net present value calculations.

Choice "d" is incorrect. Depreciation is not a cash outflow, rather it is a noncash expense.

Which of the following events would decrease the internal rate of return of a proposed asset purchase?

a.

Use accelerated, instead of straight-line depreciation.

b.

Decrease tax credits on the asset.

c.

Decrease related working capital requirements.

d.

Shorten the payback period.

Rule: The internal rate of return is computed as follows:

Investment / Cash Flows = Present Value Factor

The higher the present value factor, the lower the computed rate (internal rate of return). Increases to the investment or decreases to the cash flows serve to increase the present value factor.

Choice "b" is correct. A decrease in tax credits associated with an asset would increase the initial investment. That increase would cause the present value factor to increase and would result in a decline in internal rate of return.

Choice "c" is incorrect. A decrease in working capital requirements decreases the initial investment amount, thereby decreasing the present value factor and, by extension, increasing the internal rate of return.

Choice "d" is incorrect. A reduced payback period correlates to a decrease in the present value factor. Decreases in the present value factor is in an increase in the internal rate of return.

Choice "a" is incorrect. An accelerated depreciation method would initially increase the tax shield and, by extension, the cash flows. The increase in cash flow serves to reduce the present value factor, which indicates an increase in the internal rate of return. [Please note that, while this was the exact wording of the released question from the AICPA, it does not appear to be perfectly worded, as the IRR cannot typically be calculated with uneven cash flows (as in accelerated depreciation). We have provided the best explanation of the question considering the provided wording.]

Which of the following metrics equates the present value of a project's expected cash inflows to the present value of the project's expected cash outflows?

a.

Return on assets.

b.

Economic value-added.

c.

Internal rate of return.

d.

Net present value.

Choice "c" is correct. The internal rate of return (IRR) focuses the decision maker on the discount rate at which the present value of a project's cash inflows equals the present value of the cash outflows. The IRR is the rate used to arrive at a net present value of zero.

Choice "d" is incorrect. Net present value is the difference in the amount of an investment and its related discounted cash inflows. Although the values are compared, they are not expected to be equal. They do not equate.

Choice "a" is incorrect. Return on assets (ROA) is the product of gross margin and asset turnover. The ROA does not equate the investment with discounted cash inflows.

Choice "b" is incorrect. Economic value added is a residual income measure that compares income with required return on investment. Positive amounts indicate objectives have been met, negative amounts indicate that objectives have not been met. The method does not equate investment cash outflows and cash inflows.

The profitability index is a variation of which of the following capital budgeting models?

a.

Internal rate of return.

b.

Economic value-added.

c.

Net present value.

d.

Discounted payback.

Choice "c" is correct. The profitability index is a variation of the net present value capital budgeting model.

RULE: The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability index is also referred to as the "excess present value index" or simply the "present value index." Companies hope that this ratio will be over 1.0, which means that the present value of the inflows is greater than the present value of the outflows.

__Present value of net future cash inflows__

Present value of net initial investment

=Profitability index

Choice "a" is incorrect. The profitability index is a companion computation to net present value, not internal rate of return, which measures percentage return.

Choice "b" is incorrect. The profitability index is a companion computation to net present value, not economic value added.

Choice "d" is incorrect. The profitability index is a companion computation to net present value, not the discounted payback method, which measures years to payback.

Which of the following statements is correct regarding the payback method as a capital budgeting technique?

a.

An advantage of the payback method is that it indicates if an investment will be profitable.

b.

Payback is calculated by dividing the annual cash inflows by the net investment.

c.

The payback method considers the time value of money.

d.

The payback method provides the years needed to recoup the investment in a project.

Choice "d" is correct. The formula for calculating the payback period is:

Net Initial Investment / Increase in annual net after-tax cash flow

The payback method computes the years needed to recoup an investment. The net cash inflows are generally assumed to be constant for each period during the life of the project. It is often used for risky investments, since it shows how quickly the initial investment will be recouped.

Choice "c" is incorrect. The payback method does not consider the time value of money although a discounted payback method (which discounts the cash inflows) can be computed.

Choice "a" is incorrect. The payback method does not measure profitability.

Choice "b" is incorrect. The payback formula is not computed as the ratio of annual cash flows to net investment.

At the beginning of Year 1, $10,000 is invested at 8% interest, compounded annually. What amount of interest is earned for Year 2?

a.

$800.00

b.

$806.40

c.

$933.12

d.

$864.00

Choice "d" is correct. This question is a compound interest question because the interest is to be determined at the end of the second year. The calculation is as follows and uses different symbols than the SI = PIN formula in the text to show candidates the PRT formula as well (the CPA exam often uses different terminology):

Interest = PRT (for the first year)

Interest = $10,000 × .08 × 1 = $800 and adding the $800 to the beginning principal

Interest = PRT (for the second year)

Interest = $10,800 × .08 × 1 = $864

It is obvious from the answer that the interest earned in Year 2 is interest earned on the original principal ($10,000 × .08 = $800) plus interest on the Year 1 interest ($800 × .08 = $64).

Choice "a" is incorrect. This answer is interest only on the original principal, and not on the Year 1 interest.

Choice "b" is incorrect. This answer has a decimal point error in calculating the Year 2 interest on Year 1 interest.

Choice "c" is incorrect. This answer is simply a distractor with no calculation logic.

Under which one of the following conditions is the internal rate of return method less reliable than the net present value technique?

a.

When income taxes are considered in the analysis.

b.

When there are several alternating periods of net cash inflows and net cash outflows.

c.

When the net present value of the project is equal to zero.

d.

When both benefits and costs are included, but each is separately discounted to the present.

Choice "b" is correct. The internal rate of return (IRR) method is less reliable than the net present value (NPV) technique when there are several alternating periods of net cash inflows and net cash outflows or the amounts of cash flows differ significantly. The IRR is strictly a percentage measure of return, while the NPV is an absolute measure. Due to this difference, the timing or amount of cash flows under IRR can be misleading when compared to the NPV method.

Example:

If an investment of $50 earns $100. Then, 100/50 = 200% return

If an investment of $50,000 earns $25,000 then, 25,000/50,000 = 50% return

IRR suggests it is best to invest $50 to earn $100 and a 200% return while the NPV method will favor a larger NPV for the $50,000 investment.

Choices "c", "a", and "d" are incorrect. These conditions do not make the IRR method less reliable than the NPV method.

Which of the following statements about investment decision models is true?

a.

The discounted payback rate takes into account cash flows for all periods.

b.

The payback rule ignores all cash flows after the end of the payback period.

c.

The internal rate of return rule is to accept the investment if the opportunity cost of capital is greater than the internal rate of return.

d.

The net present value model says to accept investment opportunities when their rates of return exceed the company's incremental borrowing rate.

Choice "b" is correct. The payback period computation ignores cash flows after the initial investment has been recovered. The payback method focuses on liquidity and the time it takes to recover the initial investment.

Choice "a" is incorrect. The discounted payback period considers the time value of money but, like any other payback method, it ignores cash flows after the initial investment has been recovered.

Choice "d" is incorrect. The net present value method measures the amount of absolute return and not a rate. Although a positive net present value would confirm that the entity's investment exceeds the hurdle rate established by management, it neither measures the rate specifically nor assumes a hurdle rate equal to the incremental borrowing rate.

Choice "c" is incorrect. When using the internal rate of return, the analyst recommends acceptance of the investment in the event that the IRR is greater than the hurdle rate established by management.

The factor for present value of an annuity for five years at 10% is 3.791. The factor for present value of $1 for five years at 10% is 0.621. The factor for future value of $1 at 10% for five years is 1.611. The factor for future value of an annuity for five years at 10% is 6.1053.

Given a 10% discount rate with cash inflows of $3,000 at the end of each year for five years and an initial investment of $11,000, what is the net present value?

a.

$(9,500)

b.

$370

c.

$4,000

d.

$11,370

Choice "b" is correct. The present value of the cash inflows of $3,000 per year for five years at 10% is $3,000 × 3.791 = $11,373. The original investment is $11,000. The net present value (NPV) is the difference of $373. The closest answer is $370.

Choices "a", "c", and "d" are incorrect based on the above explanation.

Which of the following statements is true regarding the payback method?

a.

The salvage value of old equipment is ignored in the event of equipment replacement.

b.

It is the time required to recover the investment and earn a profit.

c.

It does not consider the time value of money.

d.

It is a measure of how profitable one investment project is compared to another.

Choice "c" is correct. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. The payback method does not consider the time value of money.

Choice "b" is incorrect. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. Although the payback method focuses on liquidity, project cash flows after the initial investment are not considered; thus, profitability is ignored.

Choice "d" is incorrect. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. Although the payback method focuses on liquidity, project cash flows after the initial investment are not considered; thus, profitability is ignored.

Choice "a" is incorrect. Salvage value is specifically considered as part of payback computations because it contributes to the incoming cash flow when the asset is sold.

Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?

a.

Payback period.

b.

Accounting rate of return.

c.

Internal rate of return.

d.

Cost-benefit ratio.

Choice "c" is correct. The internal rate of return method computes the rate of return where net present value equals zero. The method equates the initial investment with the present value of the future cash inflows.

Choice "b" is incorrect. The accounting rate of return anticipates changes in net income and does not consider present value.

Choice "a" is incorrect. The payback period computes the period of time necessary to recover an initial investment generally based on undiscounted cash flows.

Choice "d" is incorrect. The cost-benefit ratio does not equate investment and the present value of cash flow.

In evaluating costs for decision-making, a company would always consider each of the following as relevant,except:

a.

Incremental costs.

b.

Differential costs.

c.

Avoidable costs.

d.

Variable costs.

Choice "d" is correct. Variable costs change with the level of output but may not change purely in response to different selected alternatives. Although variable costs are frequently relevant, they are not always relevant. Relevant costs are those costs that will change in response to the selection of different courses of action.

Choice "a" is incorrect. Incremental costs represent the change in cost associated with different alternatives and are considered synonymous with relevant.

Choice "b" is incorrect. Differential costs represent the change in costs associated with two separate courses of action and are considered synonymous with relevant.

Choice "c" is incorrect. Avoidable costs represent the costs that can be averted by selecting different courses of action and are considered synonymous with relevant.

Which of the following inputs would be most beneficial to consider when management is developing the capital budget?

a.

Profit center equipment requests.

b.

Wage trends.

c.

Supply/demand for the company's products.

d.

Current product sales prices and costs.

Choice "a" is correct. In developing its capital budget, management would find the employee input associated with equipment requests from various profit centers most helpful. Departmental requests, appropriately justified, would provide key insights into the capital requirements of the business that are not otherwise known.

Choice "c" is incorrect. Supply and demand for company products is a crucial strategic input in forecasting the future capital requirements. Current year capital budgeting would not benefit as directly from this information, however, as profit center equipment requests.

Candidate Note:

Some candidates may question why the correct answer is not choice "c." However, the answer to the question is very clear.

The question really is what are the best (most beneficial to consider) inputs to a capital budget. The "supply and demand for the company's products" is very indirect. The demand for the company's products may or may not result in the company spending any capital money because the demand may be able to be satisfied with the current capital equipment. But, equipment requests, if approved, will most likely result in spending money (assuming that the money in the budget is actually spent) and thus should go into the capital budget. The supply and demand might affect future capital budgets if the demand is not able to be satisfied with the current capital equipment. But the question asks for the best inputs for presumably the current capital budget.

Choice "d" is incorrect. Current product sales prices and costs represent operating data most relevant to operating rather than capital budgeting.

Choice "b" is incorrect. Wage trends represent operating data most relevant to operating than capital budgeting.

In evaluating a capital budget project, the use of the net present value model is generally not affected by the:

a.

Initial cost of the project.

b.

Method of funding the project.

c.

Amount of the project's associated depreciation tax allowance.

d.

Amount of added working capital needed for operations during the term of the project.

Choice "b" is correct. The method of funding the project has no effect on the net present value model. NPV uses a hurdle rate to discount cash flows. If the NPV is positive, the project is acceptable. The method of financing the project, and the cost, are independent of the process of screening the project for acceptability.

Choice "a" is incorrect. The initial cost is one of the most important items in the calculation of NPV.

Choice "d" is incorrect. Added working capital requirements and salvage value affect cash flow. All cash flows are used in the NPV model.

Choice "c" is incorrect. The tax depreciation allowance will provide a "tax shield" or tax savings that impacts cash flow and must be considered in NPV analysis.

Which of the following phrases defines the internal rate of return on a project?

a.

The weighted-average cost of capital used to finance the project.

b.

The discount rate at which the net present value of the project equals one.

c.

The number of years it takes to recover the investment.

d.

The discount rate at which the net present value of the project equals zero.

Choice "d" is correct. Internal rate of return is defined as the discount rate at which the net present value of the project equals zero.

Choice "c" is incorrect. The number of years it takes to recover an investment is the payback period. Internal rate of return is defined as the discount rate at which the net present value of the project equals zero.

Choice "b" is incorrect. Internal rate of return is defined as the discount rate at which the net present value of the project equals zero, not one.

Choice "a" is incorrect. The weighted average cost of capital for financing a project is the financing cost weighted by the relative proportion of each source of funds for financing the total project. Internal rate of return is defined as the discount rate at which the net present value of the project equals zero.

The discount rate is determined in advance for which of the following capital budgeting techniques?

a.

Payback.

b.

Net present value.

c.

Accounting rate of return.

d.

Internal rate of return.

Choice "b" is correct. The discount or hurdle rate is determined in advance for computations of net present value. Project cash flows are discounted based upon a predetermined rate and compared to the investment in the project to arrive at a positive or negative net present value. Advance determination of management's required return is integral to the development and evaluation of net present value.

Choice "a" is incorrect. The payback method computes the period of time required to recover the cost of an investment and does not require a predetermined discount rate.

Choice "c" is incorrect. The accounting rate of return computes a percentage return based upon accrual basis data and does not require a predetermined discount rate.

Choice "d" is incorrect. The internal rate of return computes a rate of return that produces a net present value of zero and does not require a predetermined rate. The computed internal rate of return is evaluated in relation to management's required hurdle rate after the computation is done.

A client wants to know how many years it will take before the accumulated cash flows from an investment exceed the initial investment, without taking the time value of money into account. Which of the following financial models should be used?

a.

Net present value.

b.

Discounted payback period.

c.

Payback period.

d.

Internal rate of return.

Choice "c" is correct. The payback method typically ignores the time value of money and computes the number of years it will take for cash flows to equal (pay back) the initial investment.

Choice "b" is incorrect. The discounted payback method would take the time value of money into account.

Choice "d" is incorrect. The internal rate of return computes an expected rate of return and considers the time value of money.

Choice "a" is incorrect. The net present value method computes the amount by which an investment exceeds discounted cash flows or vice versa. The net present value method measures dollars, not years, and considers the time value of money.

Various methodologies can be used to develop the fair value of common shares. The most objective methodologies are considered to be:

a.

Price Earnings Growth (PEG) methods.

b.

Price Sales Ratio.

c.

Discounted Cash Flow (DCF) methods.

d.

Price Earnings (P/E) methods.

Choice "c" is correct. Discounted Cash Flow (DCF) methods are considered the most rigorous and objective of the valuation methods.

Choice "d" is incorrect. Price Earnings methods are considered less objective than DCF methods. PE methods require estimation of future earnings.

Choice "a" is incorrect. PEG methods are considered less objective than DCF methods. PEG methods require estimation of future earnings and growth rates.

Choice "b" is incorrect. Price sales ratio methods are considered less objective than DCF methods. Price sales methods require estimation of future sales.

Net present value as used in investment decision-making is stated in terms of which of the following options?

a.

Earnings before interest and taxes.

b.

Earnings before interest, taxes, and depreciation.

c.

Cash flow.

d.

Net income.

Choice "c" is correct. Net present value, like most capital budgeting techniques, focuses on cash flow. Cash flow is a pure measure of financial performance that isolates relevant information for decision making. The amount of cash the firm takes in and pays out for an investment affects the amount of cash the firm has available for operations and other activities.

Choice "d" is incorrect. Net present value focuses on cash flows. Net income distorts financial results useful for capital budgeting decisions with non-cash items, such as depreciation, as well as with sunk costs.

Choice "b" is incorrect. Net present value focuses on cash flows. Earnings before interest, taxes, and depreciation often approximates cash flow but still distorts financial results with earnings rather than the cash flow data most useful for capital budgeting.

Choice "a" is incorrect. Net present value focuses on cash flows. Earnings before interest and taxes distort financial results with non-cash data (depreciation) as well as earnings data rather than the cash flow data most useful for capital budgeting.

Which of the following statements is correct regarding financial decision making?

a.

The accounting rate of return considers the time value of money.

b.

Opportunity cost is recorded as a normal business expense.

c.

A strength of the payback method is that it is based on profitability.

d.

Capital budgeting is based on predictions of an uncertain future.

Choice "d" is correct. Capital budgeting involves the management's evaluation of an uncertain future since it involves long term commitments for asset acquisition and, often involves long term financing decisions as well. Management's decisions on the increased requirement for capital investment and the required return and the cost of capital require evaluation of an uncertain future.

Choice "b" is incorrect. Opportunity cost, while relevant in decision making, is not recorded as a normal business expense.

Choice "a" is incorrect. The accounting rate of return is based on GAAP basis net income and not cash flows and does not consider the time value of money.

Choice "c" is incorrect. The payback method measures risk (return of capital). A significant weakness of the payback method is that it does not consider profitability

Which of the following changes would result in the highest present value for a series of cash flows?

a.

A $100 increase in disposal value at the end of four years.

b.

A $100 increase in cash inflow each year for three years.

c.

A $100 decrease in taxes each year for four years.

d.

A $100 decrease in the cash outflow each year for three years.

Choice "c" is correct. A decrease in taxes for each year for four years causes increases in cash flow over a greater period of time than other alternatives and, therefore, a greater present value than any of the alternatives.

Choice "d" is incorrect. A decrease in cash outflow would improve present value but this alternative suggest a three rather than four year benefit. Choice "d" is not as beneficial to present value as choice "c".

Choice "a" is incorrect. A $100 increase in disposal value at the end of four years would increase present value but it would not increase present value as much as choice "c", a four-year annuity in the same amount each year.

Choice "b" is incorrect. An increase in cash inflow would improve present value but this alternative suggests a three, rather than four, year benefit. Choice "b" is not as beneficial to present value as choice "c".

A project's net present value, ignoring income tax considerations, is normally affected by the:

a.

Amount of annual depreciation on the asset to be replaced.

b.

Amount of annual depreciation on fixed assets used directly on the project.

c.

Proceeds from the sale of the asset to be replaced.

d.

Carrying amount of the asset to be replaced by the project.

Choice "c" is correct. A project's net present value is a function of current and future cash flows, including proceeds from the sale of the old asset.

Choice "d" is incorrect. A project's net present value is a function of current and future cash flows. The carrying amount of the asset does not affect cash flows.

Choice "a" is incorrect. A project's net present value is a function of current and future cash flows. Depreciation is a noncash item and does not affect cash flows.

Choice "b" is incorrect. A project's net present value is a function of current and future cash flows. Depreciation is a noncash item and does not affect cash flows.

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 two 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 notconsider?

a.

Any estimated salvage value on the old machine.

b.

The original cost of the old machine.

c.

The estimated useful life of the new machine.

d.

The lower maintenance cost on the new machine.

Choice "b" is correct. The original cost of the old machine is a sunk cost that will not change regardless of the decision that is made. Sunk costs are not relevant and would not be considered by ABC as part of their decision to keep or replace the current machine.

Choice "a" is incorrect. The estimated salvage value of the old machine is relevant to the decision to keep or replace the machine. The salvage value will be realized if the machine is replaced but not realized if the old machine is not replaced.

Choice "c" is incorrect. The estimated useful life of the new machine is relevant to the decision to keep or replace the old machine. The useful life of the new machine will impact the comparative productive capacity of the company and would be considered in the decision.

Choice "d" is incorrect. The lower maintenance cost of the new machine is relevant to the decision to keep or replace the old machine. The maintenance cost of the new machine will impact the comparative operating costs of the company and would be considered in the decision.

Which of the following is a limitation of the profitability index?

a.

It uses free cash flows.

b.

It is inconsistent with the goal of shareholder wealth maximization.

c.

It requires detailed long-term forecasts of the project's cash flows.

d.

It ignores the time value of money.

Choice "c" is correct. The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability ratio requires detailed long-term forecasts of project's cash flows. For longer term projects, cash flow projections might be either unavailable or unreliable.

Choice "a" is incorrect. Free cash flow contemplates cash flows that are available for distribution to securities holders such as debt or equity holders. Cash flows used for the profitability index specifically relate to project cash flows.

Choice "d" is incorrect. The time value of money is considered in both the numerator and the denominator of the profitability index. The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment.

Choice "b" is incorrect. The profitability index incorporates discounted cash flows based on hurdle rates that can be fully integrated with weighted average cost of capital or marginal cost of capital thresholds. Use of these concepts is fully compatible with maximization of shareholder value.

A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?

a.

Greater than the project's internal rate of return.

b.

Less than the project's internal rate of return.

c.

Less than the company's weighted average cost of capital.

d.

Greater than the company's weighted average cost of capital.

Choice "b" is correct. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.

Choice "c" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). A positive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likely equal.

Choice "d" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). A positive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likely equal.

Choice "a" is incorrect. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.

Which of the following is a strength of the payback method?

a.

It considers cash flows from all years of the project.

b.

It considers the time value of money.

c.

It is easy to understand.

d.

It distinguishes the sources of cash inflows.

Choice "c" is correct. One of the major strengths of the payback method is that it is easy to understand. The payback method takes the total investment in a project and divides it by its annual cash flows to determine the number of years it will take to gain a return of the initial investment. The technique does not consider time value of money concepts.

Choice "a" is incorrect. The payback method does not consider cash flows for the entire project, only the number years it takes to achieve a payback of the investment.

Choice "d" is incorrect. The payback method is a gross method that does not consider the sources of cash inflows.

Choice "b" is incorrect. The payback method does not consider the time value of money.

Preston Corporation is evaluating its potential investment in a $225,660 piece of equipment with a three-year life and no salvage value. The company anticipates that pre-tax cash flows in each of the three years will equal to 22%, 44%, and 66%, respectively, of the investment's face value. The tax rate is 28%. Pre-tax cash flows, discounted at 10 percent, are $427,697, undiscounted after-tax cash flows are $279,185, and after-tax cash flows, discounted at 10 percent, are $225,660. The internal rate of return is:

a.

22%

b.

23.7%

c.

44%

d.

10%

Choice "d" is correct. The internal rate of return is equal to the discount rate at which the net present value of the investment is equal to zero. The $225,660 present value of after-tax cash flows associated with the investment discounted at 10% is equal to the value of the investment. The internal rate of return is 10%.

Choice "a" is incorrect. The undiscounted return of the investment in the first year is not the internal rate of return. The internal rate of return is the rate that provides a zero net present value.

Choice "b" is incorrect. The ratio of the incremental difference between discounted and undiscounted after-tax cash flows is not the internal rate of return. The internal rate of return is the rate that provides a zero net present value.

Choice "c" is incorrect. The arithmetic average of the undiscounted annual returns of the investment is not internal rate of return. The internal rate of return is the rate that provides a zero net present value.

The capital budgeting model that is generally considered the best model for long-range decision making is the:

a.

Accounting rate of return model.

b.

Discounted cash flow model.

c.

Unadjusted rate of return model.

d.

Payback model.

Choice "b" is correct. The discounted cash flow model is the best for long-term decisions. Discounted cash flow methods include NPV, IRR, and profitability index.

Choice "d" is incorrect. Payback and bailout payback do not consider the time value of money or the return after the initial investment is recovered. The difference between the two methods is that bailout payback takes salvage value into account in calculating cash flows.

Choice "a" is incorrect. Accounting rate of return is based on accrual income rather than cash flows. It does not consider the time value of money and is considered inferior to the discounted cash flow methods.

Choice "c" is incorrect. There is no unadjusted rate of return model.

A depreciation tax shield is:

a.

The expense caused by depreciation.

b.

A reduction in income taxes.

c.

An after-tax cash outflow.

d.

Caused by the fact that depreciation does not affect cash flow.

Choice "b" is correct. Whenever depreciation protects income from taxation, it is known as a depreciation tax shield.

Choice "c" is incorrect. A depreciation tax shield may result in after-tax cash inflow, but not outflow.

Choice "a" is incorrect, per above.

Choice "d" is incorrect. A depreciation tax shield is caused by the tax deductibility of the depreciation expense, not by the fact that depreciation does not affect cash flow.

An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method:

a.

Uses a discount rate that equates the discounted cash inflows with the outflows.

b.

Uses discounted cash flows whereas the internal rate of return model does not.

c.

Computes a desired rate of return for capital projects.

d.

Can be used when there is no constant rate of return required for each year of the project.

Choice "d" is correct. When using the net present value method of capital budgeting, different hurdle rates can be used for each year of the project.

Choice "c" is incorrect. The desired rate of return for capital projects is established by management.

Choice "a" is incorrect. The internal rate of return determines the discount rate that will equate the discounted cash inflows with the outflows, thus resulting in no gain or loss (breakeven).

Choice "b" is incorrect. Both the net present value method and the internal rate of return model are discounted cash flow methods.

Management at MDK Corp. is deciding whether to replace a delivery van. A new delivery van costing $40,000 can be purchased to replace the existing delivery van, which cost the company $30,000 and has accumulated depreciation of $20,000. An employee of MDK has offered $12,000 for the old delivery van. Ignoring income taxes, which of the following correctly states relevant costs when making the decision whether to replace the delivery vehicle?

a.

Purchase price of new van, purchase price of old van, accumulated depreciation of old van, gain on sale of old van, disposal price of old van.

b.

Purchase price of new van, disposal price of old van.

c.

Purchase price of new van, purchase price of old van, and gain on sale of old van.

d.

Purchase price of new van, disposal price of old van, and gain on sale of old van.

Choice "b" is correct. Costs are deemed to be relevant if they change as a result of selecting different alternatives. The decision to replace the old van will result in the company paying the purchase price of the new van and receiving the disposal price of the old van. Neither the purchase price of the new van nor the disposal price of the old van will be incurred if the van is not replaced. Ignoring income taxes, the book value of the old van and any potential gain is not relevant.

Choice "d" is incorrect. The gain on the sale of the old van is not relevant absent any consideration of taxation.

Choice "c" is incorrect. Neither the purchase price of the old van (a sunk cost) nor the gain on the sale of the old van (ignoring tax consequences) are relevant to our decision.

Choice "a" is incorrect. Neither the purchase price/accumulated depreciation of the old van (a sunk cost) nor the gain on the sale of the old van (ignoring tax consequences) are relevant to our decision.

What is an internal rate of return?

a.

A net present value.

b.

A time-adjusted rate of return from an investment.

c.

An accounting rate of return.

d.

A payback period expected from an investment.

Choice "b" is correct. The internal rate of return is one of many capital budgeting techniques that utilize present value concepts to value both the investment and the related cash flows. These methods are generally referred to as using a time-adjusted rate of return.

Choice "a" is incorrect. Although the internal rate of return is the rate that yields a net present value of zero; the internal rate of return is not a net present value.

Choice "c" is incorrect. The accounting rate of return uses GAAP basis income to determine rate of return; it is not synonymous with internal rate of return.

Choice "d" is incorrect. The internal rate of return is not synonymous with the payback period of an investment. Payback measures return of capital in years on either a discounted or undiscounted basis.

Preston Corporation is evaluating its potential investment in a $240,000 piece of equipment with a three-year life and no salvage value. The company's hurdle rate is 10 percent and it anticipates that pre-tax cash flows in each of the three years will equal 20%, 40%, and 60%, respectively, of the investment's face value. The tax rate is 30%. Discounted pre-tax cash flows are $429,953, undiscounted after-tax cash flows are $273,600, and discounted after-tax cash flows are $221,414. The net present value of the investment is:

a.

$189,952

b.

$33,600

c.

$18,586

d.

($18,586)

Choice "d" is correct. The net present value of an investment is equal to the discounted after-tax cash flows associated with the investment minus the initial investment. In this case, the discounted cash flows are $221,414, and the investment was $240,000 yielding a negative (unsatisfactory) net present value of $18,586.

Choice "a" is incorrect. The difference between the present value of gross pre-tax cash flows and the initial investment does not represent the net present value.

Choice "b" is incorrect. The difference between the investment and the undiscounted after-tax cash flows represented by this computation is not the net present value.

Choice "c" is incorrect. The net present value is negative (unsatisfactory) because the amount of the investment is greater than the discounted after tax cash flows of the investment.

Which one of the following statements concerning cash flow determination for capital budgeting purposes isnot correct?

a.

Book depreciation is relevant since it affects net income.

b.

Relevant opportunity costs should be included in cash flow forecasts.

c.

Net working capital changes should be included in cash flow forecasts.

d.

Tax depreciation must be considered since it affects cash payments for taxes.

Choice "a" is correct. Book depreciation is not relevant to cash flow determination for capital budgeting purposes because depreciation is a "non-cash" expenditure. Further, the only cash flow effect of depreciation is the tax shield, and there is no "tax shield" for book depreciation − only for tax depreciation.

Choice "d" is incorrect. Tax depreciation must be considered because it reduces the taxable income and therefore reduces the cash payments for taxes.

Choice "c" is incorrect. Requirements for additional working capital are treated as immediate cash outflows that are recovered at the end of the investment's life for capital budgeting purposes.

Choice "b" is incorrect. Relevant opportunity costs should be included in cash flow forecasts.

Harvey Co. is evaluating a capital investment proposal for a new machine. The investment proposal shows the following information:

Initial cost $ 500,000

Life 10 years

Annual net cash inflows 200,000

Salvage value 100,000

If acquired, the machine will be depreciated using the straight-line method. The payback period for this investment is:

a.

2 years.

b.

3.25 years.

c.

2.67 years.

d.

2.5 years.

Choice "d" is correct. With even cash flows, payback period is calculated as initial cost / annual net cash inflows. That is, $500,000 / $200,000 = 2.5.

Choice "b" is incorrect. This answer was inserted as a distractor with no calculation logic.

Choice "c" is incorrect. This answer is calculated as follows: (initial cost − salvage value) / (annual net cash inflows − annual depreciation) or ($500,000 − $100,000) / ($200,000 − $50,000) = $400,000 / $150,000 = 2.67. With the payback period, depreciation should only be considered to the extent that it represents a tax shield.

Choice "a" is incorrect. This answer takes the initial cost less salvage value divided by the annual net cash inflows (($500,000 − $100,000) / $200,000 = 2.0). Salvage value is not included in the correct calculation.

When estimating cash flow for use in capital budgeting, depreciation is:

a.

Included as a cash or other cost.

b.

Utilized in determining the tax costs or benefit.

c.

Excluded for all purposes in the computation.

d.

Utilized to estimate the salvage value of an investment.

Choice "b" is correct. Depreciation is used in capital budgeting for determining tax costs or benefits of a decision. Asset value is determined based on the present value of its future after-tax cash flows. After-tax cash flows are the most relevant to cash flow decisions and consider the tax impact of depreciation deductions.

Choice "a" is incorrect. Depreciation is a noncash expense and is not included in cash or other costs. Depreciation is relevant from the standpoint of the cash flows it generates through its tax shielding effect.

Choice "c" is incorrect. Depreciation is not excluded from capital budgeting decisions. Its value in reducing taxes and impacting cash flows is included capital budgeting decisions.

Choice "d" is incorrect. Depreciation is not a component of salvage value.

What is the formula for calculating the profitability index of a project?

a.

Divide the present value of the annual after-tax cash flows by the original cash invested in the project.

b.

Subtract actual after-tax net income from the minimum required return in dollars.

c.

Divide the initial investment for the project by the net annual cash inflow.

d.

Multiply net profit margin by asset turnover.

Choice "a" is correct. The formula for the profitability index is:

__Present value of net future cash inflows__

Present value of net initial investment

= Profitability index

The profitability index is used to rank qualifying investments.

Note: The denominator maybe the "present value of the cash outflows" as opposed to "original cash invested" if the investment is not all made at the time of the initial investment.

Choice "b" is incorrect. Subtracting after tax net income from minimum required returns is an economic value added concept.

Choice "c" is incorrect. This is the formula for the payback period, not the profitability index.

Choice "d" is incorrect. Net profit times asset turnover is return on investment, not the profitability index.

Which of the following methods should be used if capital rationing needs to be considered when comparing capital projects?

a.

Profitability index.

b.

Net present value.

c.

Internal rate of return.

d.

Return on investment.

Choice "a" is correct. The profitability index is used for capital rationing. The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. Ranking and selection of investments is made by listing projects in descending order. Limited capital resources are applied in the order of the index until resources are either exhausted or the investment required by the next project exceeds remaining resources.

Choice "b" is incorrect. The net present value method is a technique to screen investments for compliance with capital investment policy or criteria, not a capital rationing method.

Choice "c" is incorrect. The internal rate of return method is a technique to screen investments for compliance with capital investment policy or criteria, not a capital rationing method.

Choice "d" is incorrect. The return on investment method is a technique to screen investments for compliance with capital investment policy or criteria, not a capital rationing method

In making capital budgeting decisions, management considers factors that are far broader than costs alone. Which one of the following factors is least likely to be considered a non-financial or qualitative factor?

a.

Less scrap and rework.

b.

Reduction in new product development time.

c.

Improved product delivery and service.

d.

Increase in manufacturing flexibility.

Choice "a" is correct. Less scrap and rework is least likely to be considered a non-financial or qualitative factor because it is the most easily quantifiable of the selections and therefore most likely to be included as a relevant avoidable cost in the capital budgeting analysis.

Choices "d", "c", and "b" are incorrect. All are important factors in a capital budgeting decision, but they can be difficult to quantify and therefore are more likely to be considered non-financial or qualitative factors.

If the net present value of a capital budgeting project is positive, it would indicate that the:

a.

Present value of cash outflows exceeds the present value of cash inflows.

b.

Rate of return for this project is greater than the discount percentage rate used in the net present value computation.

c.

Present value index would be less than 100 percent.

d.

Internal rate of return is equal to the discount percentage rate used in the net present value computation.

Choice "b" is correct. If the net present value of a project is positive, it would indicate that the rate of return for the project is greater than the discount percentage rate (hurdle rate) used in the net present value computation.

Choice "a" is incorrect. If the present value of cash outflows exceeds the present value of cash inflows, then the net present value is negative and the rate of return for the project is less than the discount percentage rate (hurdle rate).

Choice "d" is incorrect. If the internal rate of return is equal to the discount percentage rate (hurdle rate) used in the net present value computation, the net present value will be zero.

Choice "c" is incorrect. The present value index will be greater (not less) than 100 percent if the net present value of a project is positive.

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.

$13,500

b.

$12,500

c.

$13,000

d.

$11,500

Choice "d" is correct. The net present value is equal to the present value of cash inflows versus the present value of cash outflows. The inflow of $14,000 to be received next year is worth, at a discount rate of 12%, $12,500 in today's dollars. ($14,000 ÷ 1.12 = $12,500). If the net present value is $1,000, then the present value of cash outflows (which is typically just the initial investment) must be equal to $11,500:

NPV ($1,000) = Inflows ($12,500) – Outflows ($11,500)

Choice "b" is incorrect. $12,500 is just the present value of future inflows.

Choice "c" is incorrect. $13,000 as the outflow fails to take into account the present value of the $14,000 to be received one year in the future.

Choice "a" is incorrect. This answer choice incorrectly adds the present value of cash inflows to the net present value.

When the risks of the individual components of a project's cash flows are different, an acceptable procedure to evaluate these cash flows is to:

a.

Compare the internal rate of return from each cash flow to its risk.

b.

Compute the net present value of each cash flow using the firm's cost of capital.

c.

Discount each cash flow using a discount rate that reflects the degree of risk.

d.

Utilize the accounting rate of return.

Choice "c" is correct. Discount rates may be adjusted to factor differences in risk into cash flow analysis. For example, a 12% discount rate may be used for the first three years of a project and a 15% discount rate for subsequent years to reflect the greater risk associated with the cash flows in the later time periods. Discount rates may also be adapted to compensate for expected inflation.

Choices "b", "a", and "d" are incorrect, per above.

Which of the following is an advantage of net present value modeling?

a.

It uses the accounting rate of return.

b.

It is measured in time, not dollars.

c.

It accounts for compounding of returns.

d.

It uses accrual basis, not cash basis accounting for a project.

Choice "c" is correct. The net present value method assumes that positive cash flows are reinvested at the hurdle rate thereby considering compounding.

Choice "b" is incorrect. The net present value method measures the value of capital investments in dollars and considers the time value of money.

Choice "d" is incorrect. Net present value uses the cash basis not the accrual basis.

Choice "a" is incorrect. The accounting rate of return is a method of capital budgeting evaluation separate and apart from the net present value method.