Flashcards in STUDY UNIT NINE SHORT-TERM FINANCING AND CAPITAL BUDGETING I Deck (27):

1

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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.

2

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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.

3

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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.

4

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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.

5

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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.

6

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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

7

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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.

8

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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

9

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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)

10

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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%

11

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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)

12

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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).

13

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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)

14

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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)

15

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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)

16

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For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management

A. Believes too many proposals are being rejected.

B. Wants to factor risk into its consideration of projects.

C. Believes bank loans are riskier than capital investments.

D. Wants to use equity funding exclusively.

###
B. Wants to factor risk into its consideration of projects.

Answer (B) is correct.

Risk analysis attempts to measure the likelihood of the variability of future returns from the proposed investment. Risk can be incorporated into capital budgeting decisions in a number of ways, one of which is to use a hurdle rate (desired rate of return) higher than the firm’s cost of capital, that is, a risk-adjusted discount rate. This technique adjusts the interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment must be relatively larger or the increased discount rate will generate a negative net present value, and the proposed acquisition will be rejected.

(9.3.63)

17

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A corporation obtains a loan of $200,000 at an annual rate of 12%. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but normally does not have a cash balance account with the bank. What is the effective cost of the loan?

A. 16.0%

B. 12.0%

C. 15.0%

D. 13.3%

###
C. 15.0%

Answer (C) is correct.

The effective rate on a loan with a compensating balance equals the stated rate divided by 1 minus the compensating balance rate. Thus, the effective rate of the loan is 15.0% [12% ÷ (1 – 20%)].

(9.1.3)

18

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Jackson Corporation uses net present value techniques in evaluating its capital investment projects. The company is considering a new equipment acquisition that will cost $100,000, fully installed, and have a zero salvage value at the end of its 5-year productive life. Jackson will depreciate the equipment on a straight-line basis for both financial and tax purposes. Jackson estimates $70,000 in annual recurring operating cash income and $20,000 in annual recurring operating cash expenses. Jackson’s desired rate of return is 12% and its effective income tax rate is 40%.

The present value factors for 12% are as follows:

Present value of $1 at the end of five periods

.567

Present value of an ordinary annuity of $1 for five periods

3.605

What is the net present value of this investment on an after-tax basis?

A. $8,150

B. $28,840

C. $80,250

D. $36,990

###
D. $36,990

Answer (D) is correct.

Annual cash outflow for taxes is $12,000 {[$70,000 inflows – $20,000 cash operating expenses – ($100,000 ÷ 5) depreciation] × 40%}. The annual net cash inflow is therefore $38,000 ($70,000 – $20,000 – $12,000). The present value of these net inflows for a 5-year period is $136,990 ($38,000 × 3.605 present value of an ordinary annuity for 5 years at 12%), and the NPV of the investment is $36,990 ($136,990 – $100,000 investment).

(9.4.79)

19

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The net present value of an investment project represents the

A. Total after-tax cash flow including the tax shield from depreciation.

B. Total actual cash inflows minus the total actual cash outflows.

C. Cumulative accounting profit over the life of the project.

D. Excess of the discounted cash inflows over the discounted cash outflows.

###
D. Excess of the discounted cash inflows over the discounted cash outflows.

Answer (D) is correct.

The net present value of an investment project represents the excess of the discounted cash inflows over the discounted cash outflows.

(9.3.64)

20

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A company invests $100,000 in property. The company has a contract to sell it for $120,000 in one year. The bank has a guaranteed interest rate of 10%. What is the net present value of the company’s investment in the property?

A. $9,091

B. $109,091

C. $10,000

D. $110,000

###
A. $9,091

Answer (A) is correct.

A capital project’s net present value is the difference between the present value of the net cash savings or inflows expected over the life of the project and the required dollar investment. The present value of cash inflows expected from the sale of the property is $109,091 ($120,000 ÷ 1.1). The required investment is $100,000. Thus, the net present value of the company’s investment in the property is $9,091 ($109,091 – $100,000).

(9.3.67)

21

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A company obtained a short-term bank loan of $500,000 at an annual interest rate of 8%. As a condition of the loan, the company is required to maintain a compensating balance of $100,000 in its checking account. The checking account earns interest at an annual rate of 3%. Ordinarily, the company maintains a balance of $50,000 in its account for transaction purposes. What is the effective interest rate of the loan?

A. 7.77%

B. 8.56%

C. 8.22%

D. 9.25%

###
B. 8.56%

Answer (B) is correct.

The $100,000 compensating balance requirement is partially satisfied by the company’s practice of maintaining a $50,000 balance for transaction purposes. Thus, only $50,000 of the loan will not be available for current use, leaving $450,000 of the loan usable. At 8% interest, the $500,000 loan would require an interest payment of $40,000 per year. This is partially offset by the 3% interest earned on the $50,000 incremental balance, or $1,500. Subtracting the $1,500 interest earned from the $40,000 of expense results in net interest expense of $38,500 for the use of $450,000 in funds. Dividing $38,500 by $450,000 produces an effective interest rate of 8.56%.

(9.1.12)

22

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A company invested in a new machine that will generate revenues of $35,000 annually for 7 years. The company will have annual operating expenses of $7,000 on the new machine. Depreciation expense, included in the operating expenses, is $4,000 per year. The expected payback period for the new machine is 5.2 years. What amount did the company pay for the new machine?

A. $161,200

B. $182,000

C. $145,600

D. $166,400

###
D. $166,400

Answer (D) is correct.

The payback period is the number of years required for the net cash savings or inflows to equal the original investment. Payback period only considers direct cash flows, so it does not take into account the effect of depreciation or other non-cash expenses. This machine’s annual after-tax cash savings of $32,000 is calculated as the annual inflow of $35,000 decreased by the annual outflows (without regard to depreciation) of $3,000 ($7,000 – $4,000). The initial investment can be thus calculated as follows:

Initial investment ÷ Annual after-tax cash savings

=

Payback period

Initial investment ÷ $32,000

=

5.2 years

Initial investment

=

5.2 years × $32,000

Initial investment

=

$166,400

(9.6.125)

23

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A company has just borrowed $2 million from a bank. The stated rate of interest is 10%. If the loan is discounted and is repayable in 1 year, the effective rate on the loan is approximately

A. 11.11%

B. 9.09%

C. 10.00%

D. 8.89%

###
A. 11.11%

Answer (A) is correct.

The effective interest rate on a discounted loan can be calculated as follows:

Effective rate

=

Stated rate ÷ (1.0 – Stated rate)

=

10% ÷ (100% – 10%)

=

10% ÷ 90%

=

11.11%

Note that the amount of the loan is not needed to calculate the effective rate.

(9.1.18)

24

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The NPV of a project has been calculated to be $215,000. Which one of the following changes in assumptions would decrease the NPV?

A. Extend the project life and associated cash inflows.

B. Increase the discount rate.

C. Decrease the estimated effective income tax rate.

D. Decrease the initial investment amount.

###
B. Increase the discount rate.

Answer (B) is correct.

An increase in the discount rate would lower the net present value, as would a decrease in cash flows or an increase in the initial investment.

(9.3.60)

25

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Yarrow Co. is considering the purchase of a new machine that costs $450,000. The new machine will generate net cash flow of $150,000 per year and net income of $100,000 per year for 5 years. Yarrow’s desired rate of return is 6%. The present value factor for a 5-year annuity of $1, discounted at 6%, is 4.212. The present value factor of $1, at compound interest of 6% due in 5 years, is 0.7473. What is the new machine’s net present value?

A. $181,800

B. $110,475

C. $450,000

D. $373,650

###
Answer (A) is correct.

A capital project’s net present value is the difference between the present value of the net cash inflows expected over the life of the project and the required investment. The calculation is as follows:

PV of net cash inflows ($150,000 × 4.212)

$631,800

Cost of new machine

(450,000)

Net present value

$181,800

(9.4.76)

26

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

A. Shorten the payback period.

B. Decrease tax credits on the asset.

C. Use accelerated, instead of straight-line depreciation.

D. Decrease related working capital requirements.

###
B. Decrease tax credits on the asset.

Answer (B) is correct.

A decrease in tax credits on an asset purchase increases the company’s income tax expense and reduces the net cash inflow. The reduction of cash inflows from an asset decreases the internal rate of return.

(9.5.87)

27