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Flashcards in FinMgmt-Hard Qs Deck (37):
1

Whipco has determined that its pre-tax cost of preferred stock is 12%. If its tax rate is 30%, which one of the following is its after-tax cost of preferred stock?
A. 15.6%
B. 12.0%
C. 8.4%
D. 3.6%

B. 12.0%

Since dividends on preferred stock are not tax deductible, no adjustment to the pre-tax cost needs to be made. Therefore, the after-tax cost of preferred stock is the same as the pre-tax cost, 12%.

2

A company recently issued 9% preferred stock. The preferred stock sold for $40 a share, with a par of $20. The cost of issuing the stock was $5 a share. What is the company's cost of preferred stock?
A. 4.5%
B. 5.1%
C. 9.0%
D. 10.3%

B. 5.1%

The current cost of capital for newly issued preferred stock is computed as the net proceeds per share divided into the annual cost (dividends) of the newly issued shares. In this question, the net proceeds per share is given as $40 sales price less $5 per share issue cost, or $35 per share net proceeds. The annual cost of the newly issued shares is the par value, $20, multiplied by the preferred dividend rate, 9%, or $20 x .09 = $1.80 annual dividend per share. Therefore, the cost of capital for the newly issued preferred stock is $1.80/$35.00 = 5.1%.

3

Allen issues $100 par value preferred stock that is selling for $101 per share, on which the firm has to pay an underwriting fee of $5 per share sold. The stock is paying an annual dividend of $10 per share. Allen's tax rate is 40%. Which one of the following is the cost of preferred stock financing to Allen?
A. 4.2%
B. 6.2%
C. 9.9%
D. 10.4%

D. 10.4%

The correct calculation is the annual dividend divided by the net proceeds of the stock issuance. Therefore, the calculation would be $10 annual dividend/$101 selling price - $5 underwriter's fee = $96 proceeds, or $10/$96 = 10.4%

4

Which of the following statements concerning common stock is/are generally correct?
I. Requires dividends be paid.
II. Grants ownership interest.
III. Grants voting rights.
A. I only.
B. II only.
C. II and III only.
D. I, II and III.

C. II and III only.

Common stock grants both an ownership interest and a voting right. It does not require the payment of dividends, which are at the discretion of the Board of Directors and require profitable operations.

5

The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What percentage represents the firm's cost of common equity?
A. 12.0%
B. 8.4%
C. 7.0%
D. 5.0%

A. 12.0%

The firm's cost of common equity is the rate of return currently expected by potential investors in the firm's common stock. When it is assumed that the dividends are expected to grow at a constant rate, that rate of return is calculated as:

Common Stock Expected Return (CSER) = (Dividend in 1st Year/Market Price) + Growth Rate

Using the values given: CSER = ($4.25/$85.00) + .07
CSER = .05 + .07 = .12 (or 12%)

The CSER of 12% is the cost of capital through common stock financing.

6

Bander Co. is determining how to finance some long-term projects. Bander has decided it prefers the benefits of no fixed charges, no fixed maturity date, and an increase in the credit-worthiness of the company. Which of the following would best meet Bander's financing requirements?
A. Bonds.
B. Common stock.
C. Long-term debt.
D. Short-term debt.

B. Common stock.


Issuing common stock to finance its projects would best meet Bander's financing strategy. Specifically, issuing common stock would (1) not result in fixed charges, since dividends are at the discretion of the Board of Directors, (2) not result in a fixed maturity date, since common stock does not mature, and (3) would likely increase the credit-worthiness of the company because the issuance of additional common stock would reduce its debt to equity ratio by increasing equity.

7

Which of the following formulas should be used to calculate the historic economic rate of return on common stock?
A. (Dividends + change in price) divided by beginning price.
B. (Net income - preferred dividend) divided by common shares outstanding.
C. Market price per share divided by earnings per share.
D. Dividends per share divided by market price per share.

A. (Dividends + change in price) divided by beginning price.


For common stock, expected returns are from dividends and stock price appreciation. Thus, the rate of return on the common stock would be (dividends paid during the period + change in the stock price)/price of the stock at beginning of the period.

8

Green, Inc., a financial investment-consulting firm, was engaged by Maple Corp. to provide technical support for making investment decisions. Maple, a manufacturer of ceramic tiles, was in the process of buying Bay, Inc., its prime competitor. Green's financial analyst made an independent detailed analysis of Bay's average collection period to determine which of the following?
A. Financing.
B. Return on equity.
C. Liquidity.
D. Operating profitability.

C. Liquidity.

A detailed analysis of average collection period most likely would be used to assess or determine liquidity. An analysis of average collection period would measure how long, on average, it takes an entity to collects its receivables – how long it takes to convert accounts receivable to cash.

9

A company has income after tax of $5.4 million, interest expense of $1 million for the year, depreciation expense of $1 million, and a 40% tax rate. What is the company's times-interest-earned ratio?
A. 5.4
B. 6.4
C. 7.4
D. 10.0

D. 10.0

The company's times-interest-earned ratio is 10.0. The times-interest-earned ratio measures the ability of current earnings to cover interest payments for a period. It is measured as:

Times-Interest-Earned Ratio = (Net Income + Interest Expense + Income Tax Expense) / Interest Expense
Therefore:
Times-Interest-Earned Ratio = ($5.4M + $1M + $3.6M*)/$1M
= $10M/$1M = 10.0 times

Income before taxes is computed as: .6X = $5.4M (i.e., 60% of taxable income equals $5.4M). Therefore: X (income before taxes) = $5.4M/.6 = $9.0M. Income before taxes = $9.0M - income after taxes = $5.4M = income taxes = $3.6M.)

The $10M also can be determined as $9.0 income before taxes + $1M interest expense= $10M.

10

A company has cash of $100 million, accounts receivable of $600 million, current assets of $1.2 billion, accounts payable of $400 million, and current liabilities of $900 million. What is its acid-test (quick) ratio?
A. 0.11
B. 0.78
C. 1.75
D. 2.11

B. 0.78

The acid-test ratio (also known as the quick ratio) is computed as the relationship between highly liquid assets and current liabilities. Highly liquid assets include cash, accounts receivable, and marketable securities. In this case, the company has only cash and accounts receivable. Therefore, the correct calculation is $100m (cash) + $600m (accounts receivable) = $700m/$900 (current liabilities) = 0.777 (or 0.78).

11

Farrow Co. is applying for a loan in which the bank requires a quick ratio of at least 1. Farrow's quick ratio is 0.8. Which of the following actions would increase Farrow's quick ratio?
A. Purchasing inventory through the issuance of a long-term note.
B. Implementing stronger procedures to collect accounts receivable at a faster rate.
C. Paying an existing account payable.
D. Selling obsolete inventory at a loss.

D. Selling obsolete inventory at a loss.

Selling obsolete inventory at a loss (or at a gain) would increase Farrow's quick ratio. The quick ratio (also known as the acid test ratio) measures the number of times that cash and assets that can be converted quickly to cash cover current liabilities. It is calculated as: (Cash + Current Receivables + Marketable Securities)/Current Liabilities. Selling obsolete inventory would increase cash, in the numerator, without changing current liabilities, the denominator, which would increase the quick ratio.

12

Would the following accounts be included in the computation of the quick ratio?
Accounts Receivable Marketable Securities Inventories
Yes Yes Yes
Yes Yes No
Yes No Yes
Yes No No

Yes Yes No

The quick ratio (also called the acid-test ratio) measures the relationship between current assets that are cash or can be converted to cash quickly and the total of current liabilities.
Current assets that can be converted to cash quickly include (in addition to cash) accounts receivable and marketable securities (expected to be sold in the near term). Inventories are not included in the quick ratio because normally they cannot be converted to cash quickly.

By excluding inventories (and other current assets that cannot be converted to cash quickly – e.g., prepaid assets), the measure of assets available to pay current liabilities in the quick ratio is more conservative than the measure of assets used in working capital (or current) ratio, thus the quick ratio also is called the acid-test ratio.

13

Information that relates to a firm's solvency is used primarily to assess a firm's ability to
A. Convert assets to cash.
B. Pay its debts.
C. Generate profits.
D. Collect its receivables in a timely manner.

B. Pay its debts.

Measures related to the solvency of a firm are primarily concerned with the ability of a firm to pay its debts as they become due.

14

Which combination of changes in asset turnover and income as a percentage of sales will maximize the return on investment?
Asset turnover Income as a percentage of sales
Increase Decrease
Increase Increase
Decrease Increase
Decrease Decrease

Increase Increase

Return on investment = income/investment = (sales/investment x [income/sales]) = (asset turnover) x (income as a percent of sales). This disaggregation of return on investment allows an analysis of the effect of turnover and income as a percent of sales on return on investment. An increase in either or both of the component ratios will result in an increase in return on investment. This makes intuitive sense. The more times assets "turn over" or produce sales in the amount of assets in a period, the higher will be the return on those assets. Similarly, the larger percentage of sales kept by the firm as income, the higher will be return to investment.

15

A company has two divisions. Division A has operating income of $500 and total assets of $1,000. Division B has operating income of $400 and total assets of $1,600. The required rate of return for the company is 10%. The company's residual income would be which of the following amounts?
A. $0
B. $260
C. $640
D. $900

C. $640

Residual income is the difference between the actual income and the required return on investment. For the facts given actual income is $900 ($500 + $400) and the required return is of $260 [($1,000 + $1,600) * 10%], resulting in residual income of $640 ($900 - $260).

16

The following selected data pertain to the Darwin Division of Beagle Co. for Year 1:

Sales $400,000
Operating income 40,000
Capital turnover 4
Imputed interest rate 10%
What was Darwin's Year 1 residual income?
A. $0
B. $4,000
C. $10,000
D. $30,000

D. $30,000

Residual income is the excess of the division's income over the income that would be required based on the 10% imputed interest rate and the amount invested in divisional assets. This question requires a determination of divisional assets. The division's assets turned over four times, meaning, with sales of $400,000, the division has $100,000 of assets. The expected income for this division is then 10% of that amount, or $10,000. Thus, residual income is: Operating income ($40,000) - expected income ($10,000) = $30,000. This amount represents the excess of actual operating income of the division over the minimum amount that is required for a division with $100,000 worth of assets invested.

17

Spar Co. calculated the following ratios for one of its profit centers:

Gross margin 30%
Return on sales 25%
Capital turnover .5 times
What is Spar's return on investment for this profit center?
A. 7.5%
B. 12.5%
C. 15.0%
D. 25.0%

B. 12.5%


Rate of return on investment (ROI) is computed as: ROI = Net income/Total investment. Since net income and total investment are not given, an alternative formulation must be used. That alternative recognizes that ROI can be derived as: ROI = Asset turnover x Profit margin on sales. Asset turnover = Sales/Investment and Profit margin on sales = Net income/Sales. Therefore,

ROI = (Sales/Investment) x (Net income/ Sales), or

Using the facts given: ROI = .5 x .25 = .125 or 12.5%, Spar's return on investment.

18

SkBound Airlines provided the following information about its two operating divisions:

Passenger Cargo
Operating profit $ 40,000 $ 50,000
Investment 250,000 500,000
External borrowing rate 6% 8%

Measuring performance using return on investment (ROI), which division performed better?
A. The Cargo division, with an ROI of 10%.
B. The Passenger division, with an ROI of 16%.
C. The Cargo division, with an ROI of 18%.
D. The Passenger division, with an ROI of 22%.

B. The Passenger division, with an ROI of 16%.

The Passenger division with an ROI of 16% is the better performing division. Return on investment (ROI) measures the rate of return earned on total assets invested and is computed as operating profit divided by total investment. The greater the ROI, the better the performance. For the facts given:

Passenger division = $40,000/$250,000 = 16% = Greater ROI

Cargo division = $50,000/$500,000 = 10%

19

Para Co. is reviewing the following data relating to an energy saving investment proposal:

Cost $50,000
Residual value at the end of 5 years 10,000
Present value of an annuity of 1 at 12% for 5 years 3.60
Present value of 1 due in 5 years at 12% 0.57
What would be the annual savings needed to make the investment realize a 12% yield?
A. $8,189
B. $11,111
C. $12,306
D. $13,889

C. $12,306


To solve this problem, let "A" equal the unknown annual savings needed to realize a 12% annual yield. Recall that the net present value (NPV) is the difference between the present value of cash inflows from the investment and the cost of the investment, and that NPV would be zero (0) when the project earns 12%. Since the unknown "A" is an annual cash savings, it must be "measured" by applying an annuity factor. In addition, the $10,000 residual value is a single cash inflow, that must be converted to present value. The cost of the investment, $50,000, is a present value. Thus, the formula for solving for a NPV of zero (0) is:

"A" (3.60) + $10,000 (.57) - $50,000 = 0
Rearranged: "A" (3.60) = $50,000 - $5,700, or "A" = $44,300/3.60; "A" = $12,306.

Thus, an annual savings of $12,306 would yield a 12% return on the project investment.

20

Based on potential sales of 500 units per year, a new product has estimated traceable costs of $990,000. What is the target price to obtain a 15% profit margin on sales?
A. $2,329
B. $2,277
C. $1,980
D. $1,935

A. $2,329

Two steps are involved in getting the solution. First, the total sales have to be determined using the given "cost" margin (100% - 15% profit margin = 85% cost margin) and the given cost amount. Once the total sales are determined, the given number of units (500) can be used to determine the per unit selling price. Total sales can be computed as:

Total Sales - Cost = 15% Total Sales.
Rearranged: Total Sales - .15 Total Sales = Cost.

Therefore, .85 Total Sales = $990,000, or Total Sales = $990,000/.85 = $1,164,706.

Target Price = $1,164,706/500 units (given) = $2,329 sales price per unit.

Proof: Profit Margin = Net Income/Sales

Net Income = Sales ($1,164,705) - Cost ($990,000) = $174,706 Net Income.

Profit Margin = $174,706/$1,164,705 = 15% (the desired profit on sales).

21

Managers of the Doggie Food Co. want to add a bonus component to their compensation plan. They are trying to decide between return on investment (ROI) and residual income (RI) as the performance measure they will use. If Doggie adopts the RI performance measure, the relevant required rate of return would be 18%. One segment of Doggie is the Good Treats division, where the manager has invested in new equipment. The operating results from this equipment are as follows:

Revenues $80,000
Cost of goods sold 45,000
General and administrative expenses 15,000

Assuming that there are no income taxes, what would be the ROI and RI, respectively, for this equipment, which has an average value of $100,000?
A. $2,000, 20%
B. 35%, $3,600
C. $3,600, 35%
D. 20%, $2,000

D. 20%, $2,000

The ROI is computed as: Net Income/Average Total Assets. Substituting the values provided, the calculation would be: Net Income ($80,000 - $45,000 - $15,000) = $20,000/Average Equipment Value = $100,000 = $20,000/$100,000 = .20 (or 20%). RI is computed as: Net Income - Required $ Return. Substituting the values provided, the calculation would be: Net Income ($80,000 - $45,000 - $15,000) = $20,000 - (Average Investment ($100,000) x Required or Hurdle Rate (.18)) = $20,000 - ($100,000 x .18) = $20,000 - $18,000 = $2,000. Thus, ROI = 20% and RI = $2,000.

22

Return on assets is computed as Net Income (as appropriately adjusted)/Average Total Assets.
DuPont Company developed a method of separating the return on assets computation into two component ratios.

Which one of the following sets identifies the two component ratios that make up the DuPont return on assets approach?
A. Gross profit margin (ratio) and average total asset turnover ratio.
B. Net profit margin (ratio) and average total asset turnover ratio.
C. Gross profit margin (ratio) and average fixed asset turnover ratio.
D. Net profit margin (ratio) and average fixed asset turnover ratio

B. Net profit margin (ratio) and average total asset turnover ratio.


The basic return on assets (ROA) calculation is: ROA = Net Income/Total Assets That formula is separated into two components in the DuPont return on assets: ROA = Net Profit Margin (Ratio) x Average Total Asset Turnover Ratio Each of these ratios is defined as: Net Profit Margin Ratio = Net Income/Net Sales and Average Total Asset Turnover Ratio = Net Sales/Average Total Assets. Thus, in its most detailed form the DuPont ROA is:


Net Income


Net Sales
ROA =

__________

x

________________

Net Sales


Average Total Assets

23

The following data was derived from Delta Corp.'s financial statement:

Sales
$ 100,000
Pretax Income
20,000
Average Total Assets
200,000
Average Total Debt
40,000
Income Tax Rate
40%

Which one of the following is Delta's return on total equity?
A. 6.0%
B. 7.5%
C. 10.0%
D. 12.5%

B. 7.5%

The return on total equity (ROE) is computed as: ROE = Net income/Average owners' equity. For Delta the calculation of net income would be pretax income minus tax expense, or $20,000 - ($20,000 x .40) = $20,000 - $8,000 = $12,000 net income. Average owners' equity would be calculated as Assets - Debt = Owners' equity, or $200,000 - $40,000 = $160,000. With those values, ROE can be computed as: ROE = $12,000/$160,000 = .075, or 7.5%

24

A company's return on investment is the

A. Profit margin percentage divided by the capital turnover.
B. Profit margin percentage multiplied by the capital turnover.
C. Capital turnover divided by invested capital.
D. Capital turnover multiplied by invested capital.

B. Profit margin percentage multiplied by the capital turnover.

Return on investment = Income/Investment

Profit margin percentage = Income/Sales
Capital turnover = Sales/Investment

Therefore: Return on investment = (Income/Sales) x (Sales/Investment) = Profit margin percentage x capital turnover.
This answer correctly states: Profit margin percentage MULTIPLIED by the capital turnover.

25

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

B. $370

The net present value is $370. The present value (PV) of expected cash inflows is determined by discounting those flows to their present value using the firm's discount rate (also called the hurdle rate). The difference between the resulting PV of cash inflows and the initial cost (which is at present value) is the net present value of the project. Cash inflows are $3,000 at the end of each year for five years, which is an ordinary annuity. If (in the absence of a PV table of factors) you know the formula for the PV of an ordinary annuity it can be used. That would be:

PVoa = C x [(1 - (1 / (1 + i)n)) / i]

Where: C = Cash flow per year; i = interest rate; and n = number of years.

Substituting: PV = $3,000 x [(1 - (1/(1 + .10)5))/.10]; PV = $3,000 x 3.79; PV of cash inflows = $11,370 - initial investment $11,000 = $370 net present value.

Even if you don't have PV factors or don't know the formula for PVoa, you can compute the answer (even easier than using the formula). For each year, discount the $3,000 by the discount rate times the number of years, as follows:

26

Oak Company bought a machine that they will depreciate on a straight-line basis over an estimated life of seven years. The machine has no salvage value. They expect the machine to generate after-tax net cash inflows from operations of $110,000 in each of the seven years. Oak's minimum rate of return is 12%. Information on present value factors is as follows:

Present value of $1 at 12% at the end
of 7 periods 0.0452
Present value of an ordinary annuity
of $1 at 12% for 7 periods 4.564

Assuming a positive net present value of $12,000, what was the cost of the machine?
A. $480,000
B. $490,040
C. $502,040
D. $514,040

B. $490,040

B is correct.
The net present value of a project is determined by subtracting the cost of the investment from the present value of future cash inflows (or savings), using a hurdle rate of return as the discount rate. In this case, the hurdle rate is expressed as Oak's minimum rate of return, 12%. Thus, the equation for solution would be:

NPV = ($110,000 x PV of an annuity @ 12% for 7 years) - Investment Cost
$12,000 = ($110,000 x 4.564) - Investment Cost
$12,000 = $502,040 - Investment
Investment = $502,040 - $12,000 = $490,040

27

The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?
A. The decline in the value of the investment should be reflected in the determination of net present value.
B. Depreciation adjusts the book value of the investment.
C. Depreciation represent cash outflow that must be added back to net income.
D. Depreciation increases cash flow by reducing income taxes.

D. Depreciation increases cash flow by reducing income taxes.

Determining the net present value of an investment is done by comparing the present value of the expected cash inflows (revenues or savings) of the project with the initial cash investment in the project (outflows). Since the amount of depreciation expense taken reduces taxes due, it reduces cash outflow by the amount of taxes saved. The present value of that saving enters into the determination of present values for net present value assessment purposes.

28

Tam Co. is negotiating for the purchase of 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 is 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 is
A. $5,760
B. $6,440
C. $12,200
D. $13,000

D. $13,000

The computation of net present value (NPV) is:

NPV = Present value of cash inflows - Present value of cash outflows.
For the facts given, the calculation would be: NPV = ($20,000 x 5.65) - $100,000 = $113,000 - $100,000 = $13,000.

With positive NPV of $13,000, the decision should be to accept the project.

29

Smarti Co. has determined the following data in connection with its evaluation of a capital investment project:

Initial cost of project
$75,000
Estimated periods benefited
10 years
Estimated annual savings
$15,000
Estimated residual value
$ 5,000
Cost of capital
10%

Smarti uses straight-line depreciation for capital investments of this type. Excerpts from present value tables showed the following:

Using the above information, which one of the following is the present value of total estimated future cash inflows and savings? (Ignore income taxes.)
A. $92,175
B. $94,105
C. $97,175
D. $122,900

B. $94,105

B is correct. The total present value is the sum of the present value of a series (annuity) of savings plus the present value of the one-time residual value. The calculation of these elements is:

PV of savings = $15,000 x PV of an annuity at 10% for 10 years
PV of savings = $15,000 x 6.145 = $92,175
PV of residual value = $5,000 x PV of $1.00 at 10% for 10 years
PV of residual value = $5,000 x .386 = $1,930
Total PV = $92,175 + $1,930 = $94,105
$94,105 = Present value of total estimated future cash inflows and savings.

30

Salem Co. is considering a project that yields annual net cash inflows of $420,000 for years 1 through 5, and net cash inflow of $100,000 in year 6. The project will require an initial investment of $1,800,000. Salem's cost of capital is 10%. Present value information is present below:

Present value of $1 for 5 years at 10% is .62.
Present value of $1 for 6 years at 10% is .56.
Present value of an annuity of $1 for 5 years at 10% is 3.79.

What was Salem's expected net present value for this project?
A. $ 83,000
B. ($108,200)
C. ($152,200)
D. ($442,000)

C. ($152,200)

The expected net present value for this project is $152,200. The calculation would be the net present value for the first 5 years using the annuity factor ($420,000 x 3.79) plus the present value for year 6 using the present value of $1 factor ($100,000 x .56), both subtracted from the initial investment to get the net present value. Thus, the computation would be $1,591,800 (which is $420,000 x 3.79) + $56,000 (which is $100,000 x .56) equals $1,647,800 (the present value of future cash inflows), subtracted from the present value of the initial investment of $1,800,000, resulting in a net present value of $152,200. In summary, the calculation is $1,800,000 - ($1,591,800 + $56,000) = $152,200, the expected net present value.

31

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

B. $370

The net present value is $370. The present value (PV) of expected cash inflows is determined by discounting those flows to their present value using the firm's discount rate (also called the hurdle rate). The difference between the resulting PV of cash inflows and the initial cost (which is at present value) is the net present value of the project. Cash inflows are $3,000 at the end of each year for five years, which is an ordinary annuity. If (in the absence of a PV table of factors) you know the formula for the PV of an ordinary annuity it can be used. That would be:

PVoa = C x [(1 - (1 / (1 + i)n)) / i]

Where: C = Cash flow per year; i = interest rate; and n = number of years.

Substituting: PV = $3,000 x [(1 - (1/(1 + .10)5))/.10]; PV = $3,000 x 3.79; PV of cash inflows = $11,370 - initial investment $11,000 = $370 net present value.

Even if you don't have PV factors or don't know the formula for PVoa, you can compute the answer (even easier than using the formula). For each year, discount the $3,000 by the discount rate times the number of years, as follows:

32

Tam Co. is negotiating for the purchase of 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 is acquired. The equipment's estimated useful life is 10 years, with no residual value, and it 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.

In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns closest to
A. 0.65
B. 1.30
C. 5.00
D. 5.65

C. 5.00

The IRR is the rate of return that equates the present value of inflows with the present value of outflows. Expressed mathematically it is: Present value of inflows using IRR = present value of outflows using IRR. The calculation for the facts given would be:

$20,000 x (PV of annuity factor for 10 years at IRR percent) = $100,000
Rearranged: (PV of annuity factor for 10 years at IRR percent) = $100,000/$20,000 = 5.00

Using the present value of an annuity table, for n = 10, the factors nearest to 5.00 would be used to determine the IRR.

33

How are the following used in the calculation of the internal rate of return of a proposed project? Ignore income tax considerations.
Residual sales value of project Depreciation expense
Exclude Include
Include Include
Exclude Exclude
Include Exclude

Include Exclude

The IRR is the rate that equates the present value of net cash inflows with a project's investment cost. Depreciation expense is not a cash flow and does not affect cash flows when income taxes are ignored; it should be excluded. The residual value of an asset at the end of a project is a cash flow, is discounted, and affects the present value of net cash inflows; it should be included.

34

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

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


The payback (period) rule or approach to assessing investments (e.g., capital projects) determines the number of years or other periods needed for future cash flows from an investment to recover the initial cost of the investment. It does not take into account cash flows for all periods, but measures only the present value of cash flows needed to recover the initial investment; cash flows received in periods after the initial investment is recovered (the payback period) are ignored.

35

Which of the following events would decrease the internal rate of return of a proposed asset purchase?
A. Decrease tax credits on the asset.
B. Decrease related working capital requirements.
C. Shorten the payback period.
D. Use accelerated, instead of straight-line depreciation.

A. Decrease tax credits on the asset.

The internal rate of return method (also called the time adjusted rate of return) evaluates a project by determining the discount rate that equates the present value of the project's future cash inflows with the present value of the project's cash outflows. The first step in the calculation is to divide the initial cost of the project (numerator) by the annual savings of the project (denominator) to get a present value factor. Decreases in the tax credits on an asset, which means that tax savings on the purchase of the asset are reduced, serve to increase the effective initial cost of the asset. Increasing the initial cost of the asset (numerator) results in a higher present value factor and, therefore, a lower discount (interest) rate, which is the internal rate of return.

36

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 costs?
A. Net present value.
B. Return on assets.
C. Internal rate of return.
D. Economic value-added.

C. Internal rate of return.

The internal rate of return metric equates the present value of a project's expected cash inflows to the present value of the project's expected costs. It does so by determining the discount (interest) rate that equates the present value of the project's future cash inflows with the present value of the project's cash outflows. The rate so determined is the rate of return earned on the project.

37

Which of the following phrases defines the internal rate of return on a project?
A. The number of years it takes to recover the investment.
B. The discount rate at which the net present value of the project equals zero.
C. The discount rate at which the net present value of the project equals one.
D. 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 zero.

The internal rate of return on a project is defined as the discount rate at which the net present value of the project equals zero. Specifically, the internal rate of return assesses a project by determining the discount rate that equates the present value of the project's future cash inflows with the present value of the project's future cash outflows.