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Answer Key KinneyAISE14IM

Answer Key KinneyAISE14IM

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Published by: maro. on Feb 21, 2009
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09/11/2013

 
 
311
This edition is intended for use outside of the U.S. only, with content that may be
 
different from the U.S. Edition. This may not beresold, copied, or distributed without the prior consent
 
of the publisher.
Chapter 14
Capital BudgetingQuestions
 
1. Capital assets are the long-lived assetsthat are acquired by a firm. Capital assetsprovide the essential production anddistributional capabilities required by allorganizations.2. Cash flows are the final objective of capitalbudgeting investments just as cash flowsare the final objective of any investment.Accounting income ultimately becomescash flow but is reported based on accrualsand other accounting assumptions andconventions. These accounting practicesand assumptions detract from the purity ofcash flows and, therefore, are not used incapital budgeting.3. Timelines provide clear visual models ofthe expected cash inflows and outflows foreach point in time for a project. Theyprovide an efficient and effective means tohelp organize the information needed toperform capital budgeting analyses.4. The payback method measures the timeexpected for the firm to recover itsinvestment. The method ignores thereceipts expected to occur after theinvestment is recovered and ignores thetime value of money.5. Return of capital means the investor isreceiving the principal that was originallyinvested. Return on capital means theinvestor is receiving an amount earned onthe investment.6. The NPV of a project is the present value ofall cash inflows less the present values of alloutflows associated with a project. If theNPV is zero, it is acceptable because, inthat case, the project will exactly earn therequired cost of capital rate of return. Also,when NPV equals zero, the project’sinternal rate of return equals the cost ofcapital.7. It is highly unlikely that the estimated NPVwill exactly equal the actual NPV achievedbecause of the number of estimatesnecessary in the original computation.These estimates include the project life,the discount rate chosen and the timingand amounts of cash inflows and outflows.The original investment may also includean estimate of the amount of workingcapital that is needed at the beginning ofthe project life.8. The NPV method subtracts the initialinvestment from the discounted net cashinflows to arrive at the net present value.The profitability index is calculated bydividing the discounted cash inflows bythe initial investment. Thus, eachcomputation uses the same set ofamounts in different ways. The PI modelattempts to measure the plannedefficiency of the use of the money (i.e.,output/input) in that it reflects the expecteddollars of discounted cash inflows perdollar of investment in the project. A PIequal or greater than 1.00 is equivalent toa NPV equal to or greater than zero andindicates that the investment will provide areturn on capital.9. The IRR is the rate that would cause theNPV of a project to equal zero. A project isconsidered potentially successful (all otherfactors being acceptable) if the calculatedIRR exceeds the company's cost ofcapital.10. The amount of depreciation for a year is onefactor that helps determine the amount ofcash outflow for income taxes. Therefore,although depreciation is not a cash flowitem itself, it does affect the size of anotheritem (income taxes) that is a cash flow.11. The four questions are:1. Is the activity worthy of aninvestment?2. Which assets can be used for theactivity?
 
Chapter 14
This edition is intended for use outside of the U.S. only, with content that may be
 
different from the U.S. Edition. This may not beresold, copied, or distributed without the prior consent
 
of the publisher.
312
3. Of the assets available for eachactivity, which is the best investment?4. Of the best investments for allworthwhile activities, in which onesshould the company invest?12. Risk is defined as the likely variabilityof the future returns of an asset.Aspects of a project for which risk isinvolved are:
Life of the asset
Amount of cash flows
Timing of cash flows
Salvage value of the asset
Tax ratesWhen risk is considered in capitalbudgeting analysis, the NPV of a project islowered.13. Sensitivity analysis is used to determinethe limits of value for input variables (e.g.,discount rate, cash flows, asset life, etc.)beyond which the project's outcome willbe significantly affected. This processgives the decision maker an indication ofhow much room there is for error inestimates for input variables and whichinput variables need special attention.14. Post-investment audits are performed todetermine whether the realized return.matches the expected return on a projectPost-investment audits are performed ator near the end of a project’s life.15. The time value of money refers to theconcept that money has time-basedearnings power. Money can be loaned orinvested to earn an expected rate ofreturn. Present value is always less thanfuture value because of the time value ofmoney. A future value must bediscounted to determine its equivalent (butsmaller) present value. The discountingprocess strips away the imputed rate ofreturn in future values, thus resulting insmaller present values.16. ARR = Average annual profits ÷ AverageinvestmentUnlike the rate used to discount cashflows or to compare to the cost of capitalrate, the ARR is not a discount rate toapply to cash flows. It is measured fromaccrual-based accounting information andis not intended to be associated with cashflows.
Exercises
 
1 7. a. Payback = $375,000 ÷ $75,000 per year = 5.00 yearsb. Year Amount Cumulative Amount
 
1 $ 37,500 $ 37,5002 37,500 75,0003 37,500 112,5004 37,500 150,0005 37,500 187,5006 50,000 237,5007 50,000 287,5008 50,000 337,5009 50,000 387,500Payback = 8 + ($37,500 ÷ $50,000) years= 8.75 years, or 8 years and 9 months
 
Chapter 14
18. a.
313
This edition is intended for use outside of the U.S. only, with content that may be
 
different from the U.S. Edition. This may not beresold, copied, or distributed without the prior consent
 
of the publisher.
313
 Year Amount Cumulative Amount1 $35,000 $ 35,0002 39,000 74,0003 36,000 110,0004 28,000 138,0005 25,000 163,0006 24,000 187,0007 22,000 209,000Payback = 5 years + ($7,000 ÷ $24,000) = 5.29 yearsBased on the payback criterion, Cottonwood should not invest in theproposed product line.b. Yes. Cottonwood should also use a discounted cash flow technique for two reasons: (1) to take into account the time value of money and (2) toconsider those cash flows that occur after the payback period.19. Point in Time Cash Flows PV Factor Present Value
 
0 $(800,000) 1.0000 $(800,000)1 140,000 0.8929 125,0062 140,000 0.7972 111,6083 170,000 0.7118 121,0064 170,000 0.6355 108,0355 170,000 0.5674 96,4586 144,400 0.5066 73,1537 144,400 0.4524 65,3278 144,400 0.4039 58,3239 130,000 0.3606 46,87810 130,000 0.3220 41,860NPV $ 47,654Based on the NPV, this is an acceptable investment.20. a. The contribution margin of each part is $17 ($30 - $13)Contribution margin per year = $17 x 25,000 = $425,000Point in Time Cash Flows PV Factor Present Value0 $ (250,000) 1.0000 $ (250,000)1 - 8 (20,000) 5.5348 (110,696)1 - 8 425,000 5.5348 2,352,290NPV $1,991,594b. Based on the NPV, this is a very acceptable investment.

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