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SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOMS TAXONOMY

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Brief Exercises

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Study Objective 1

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BE = Brief Exercise

The chapter also contains one set of eight Matching questions and three Short-Answer Essay

questions.

13-3

1.

Discuss the capital budgeting evaluation process and explain the inputs used in

capital budgeting. Project proposals are gathered from each department and submitted

to a capital budget committee, which screens the proposals and recommends worthy

projects. Company officers decide which projects to fund, and the board of directors

approves the capital budget. In capital budgeting, estimated cash inflows and outflows,

rather than accrual accounting numbers, are the preferred inputs.

2.

Describe the cash payback technique. The cash payback technique identifies the time

period it will take to recoverthe cost of the investment. The formula when net annual cash

flows are the same is as follows: Cost of capital expenditure estimated net annual cash

inflow = cash payback period. The shorter the payback period, the more attractive is the

investment.

3.

Explain the net present value method. Under the net present value method, the present

value of future cash inflows is compared with the capital investment to determine the net

present value. The decision rule is as follows: Accept the project if the net present value is

zero or positive. Reject the project if the net present value is negative.

4.

Intangible benefits are difficult to measure, and thus are often ignored in capital budgeting

decisions. This can result in incorrectly rejecting some projects. One method for

considering intangible benefits is to calculate the NPV, ignoring intangible benefits. If the

resulting NPV is below zero, evaluate whether the benefits are worth at least the amount

of the negative net present value. Alternatively, intangible benefits can be included in the

NPV calculation, using conservative estimates of their value.

5.

Describe the profitability index. The profitability index is a tool for comparing the relative

merits of two alternative capital investment opportunities. It is calculated by dividing the

present value of net cash flows by the initial investment. The higher the index, the more

desirable is the project.

6.

capital investments actual performance. Post-audits create an incentive for managers to

make accurate estimates. Post-audits are also useful for determining whether a project

should be continued, expanded, or terminated. Finally, post-audits provide feedback that

is useful for improving estimation techniques.

7.

Explain the internal rate of return method. The objective of the internal rate of return

method is to find the interest yield of the potential investment, which is expressed as a

percentage rate. The decision rule is this: Accept the project when the internal rate of

return is equal to or greater than the required rate of return. Reject the project when the

internal rate of return is less than the required rate of return.

13-4

8.

Describe the annual rate of return method. The annual rate of return uses accounting

data to indicate the profitability of a capital investment. It is calculated by dividing the

expected annual net income by the amount of the average investment. The higher the rate

of return, the more attractive is the investment.

13-5

TRUE-FALSE STATEMENTS

1.

Capital budgeting decisions usually involve large investments and often have a significant

impact on a company's future profitability.

2.

The capital budgeting committee ultimately approves the capital expenditure budget for

the year.

3.

For purposes of capital budgeting, estimated cash inflows and outflows are preferred for

inputs into the capital budgeting decision tools.

4.

The cash payback technique is a quick way to calculate a project's net present value.

5.

The cash payback period is calculated by dividing the cost of the capital investment by the

annual cash inflow.

6.

The cash payback method is frequently used as a screening tool but it does not take into

consideration the profitability of a project.

7.

The cost of capital is a weighted average of the rates paid on borrowed funds, as well as

on funds provided by investors in the company's shares.

8.

Using the net present value method, a net present value of zero indicates that the project

would not be acceptable.

9.

The net present value method can only be used in capital budgeting if the expected cash

flows from a project are an equal amount each year.

10.

projects that could be beneficial to the company.

11.

To avoid accepting projects that actually should be rejected, a company should ignore

intangible benefits in calculating net present value.

12.

One way of incorporating intangible benefits into the capital budgeting decision is to

project conservative estimates of the value of the intangible benefits and include them in

the NPV calculation.

13-6

13.

The profitability index is calculated by dividing the total cash flows by the initial

investment.

14.

The profitability index allows comparison of the relative desirability of projects that require

differing initial investments.

15.

Sensitivity analysis uses a number of outcome estimates to get a sense of the variability

among potential returns.

16.

projects before their completion.

17.

managers know that their results will be evaluated.

18.

projections made when the project was proposed.

19.

The internal rate of return method is, like the NPV method, a discounted cash flow

technique.

20.

The interest yield of a project is a rate that will cause the present value of the proposed

capital expenditure to equal the present value of the expected annual cash inflows.

21.

Using the internal rate of return method, a project is rejected when the rate of return is

greater than or equal to the required rate of return.

22.

Using the annual rate of return method, a project is acceptable if its rate of return is

greater than management's minimum rate of return.

23.

The annual rate of return method requires dividing a project's annual cash inflows by the

economic life of the project.

24.

A major advantage of the annual rate of return method is that it considers the time value of

money.

25.

An advantage of the annual rate of return method is that it relies on accrual accounting

numbers rather than actual cash flows.

13-7

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13-8

26.

a. board of directors.

b. capital budgeting committee.

c. officers.

d. shareholders.

27.

a. The capital budget committee submits its proposals to the officers of the

company who choose which projects will be forwarded to the shareholders for

ultimate approval.

b. The officiers of the company submit their proposals to the capital budget

committee who choose which projects will be forwarded to the shareholders for

ultimate approval.

c. The officiers of the company submit their proposals to the capital budget

committee who choose which projects will be forwarded to the board of directors

for ultimate approval.

d. The capital budget committee submits its proposal to the officers of the company

who choose which projects will be forwarded to the board of directors for ultimate

approval.

28.

a. the initial investment

b. sale of old equipment

c. repairs and maintenance

d. increased operating costs

29.

a. overhaul of equipment

b. increased cash received from customers

c. reduced cash flows for operating costs

d. salvage value of equipment when project is completed

30.

a. availability of funds.

b. relationships among proposed projects.

c. risk associated with a particular project.

d. all of these.

31.

a. used in sell or process further decisions.

b. of determining how many common shares to issue.

c. of making capital expenditure decisions.

d. of eliminating unprofitable product lines.

13-9

32.

If an asset costs $60,000 and is expected to have a $5,000 salvage value at the end of its

nine-year life, and generates annual net cash inflows of $10,000 each year, the cash

payback period is

a. 6.5 years.

b. 6 years.

c. 5.5 years.

d. 9 years.

33.

If a payback period for a project is greater than its expected useful life, the

a. project will always be profitable.

b. entire initial investment will not be recovered.

c. project would only be acceptable if the company's cost of capital was low.

d. project's return will always exceed the company's cost of capital.

34.

a. should be used as a final screening tool.

b. can be the only basis for the capital budgeting decision.

c. is relatively easy to calculate and understand.

d. considers the expected profitability of a project.

35.

The cash payback period is calculated by dividing the cost of the capital investment by the

a. annual net income.

b. net annual cash inflow.

c. present value of the cash inflow.

d. present value of the net income.

36.

When using the cash payback technique, the payback period is expressed in terms of

a. a percent.

b. dollars.

c. years.

d. months.

37.

a. ignores obsolescence factors.

b. ignores the cost of an investment.

c. is complicated to use.

d. ignores the time value of money.

38.

Bark Company is considering buying a machine for $120,000 with an estimated life of ten

years and no salvage value. The straight-line method of depreciation will be used. The

machine is expected to generate net income of $8,000 each year. The cash payback

period on this investment is

a. 15 years.

b. 10 years.

c. 6 years.

13-10

d.

3 years.

39.

The discount rate is referred to by all of the following alternative names except the

a. cost of capital.

b. cutoff rate.

c. hurdle rate.

d. required rate of return.

40.

The rate that a company must pay to obtain funds from creditors and shareholders s

known as the

a. hurdle rate.

b. cost of capital.

c. cutoff rate.

d. all of these.

41.

a. more attractive the investment.

b. higher the net present value.

c. higher the cost of capital.

d. higher the discount rate.

42.

If a company's required rate of return is 10% and, in using the net present value method,

a project's net present value is zero, this indicates that the

a. project's rate of return exceeds 10%.

b. project's rate of return is less than the minimum rate required.

c. project earns a rate of return of 10%.

d. project earns a rate of return of 0%.

43.

Using the profitability index method, the present value of cash inflows for Project Flower is

$88,000 and the present value of cash inflows of Project Plant is $48,000. If Project

Flower and Project Plant require initial investments of $90,000 and $40,000, respectively,

and have the same useful life, the project that should be accepted is

a. Project Flower.

b. Project Plant.

c. Either project may be accepted.

d. Neither project should be accepted.

44.

Which of the following assumptions is made in order to simplify the net present value

method?

a. All cash flows come at the end of the year.

b. All cash flows are immediately reinvested at the best rate available at the time.

c. All cash flows come at the beginning of the year.

d. All cash flows are not reinvested.

13-11

45.

When the annual cash flows from an investment are unequal, the appropriate table to use

is the

a. future value of 1 table.

b. future value of annuity table.

c. present value of 1 table.

d. present value of annuity table.

46.

If a company uses a 12% discount rate with the net present value method, and then does

the same analysis, but with a 15% discount rate, which of the following is likely to occur?

a. The 12% rate will show the project is more profitable than the 15% rate.

b. The 15% rate will show the project is more profitable than the 12% rate.

c. Both rates will produce the same net present value.

d. The relative profitability of the two studies depends only on the timing of the cash

flows, not on the discount rate.

47.

Intangible benefits in capital budgeting would include all of the following except increased

a. product quality.

b. employee loyalty.

c. salvage value.

d. product safety.

48.

a. should be ignored because they are difficult to determine.

b. include increased quality or employee loyalty.

c. are not considered because they are usually not relevant to the decision.

d. have a rate of return in excess of the companys cost of capital.

49.

1.

2.

3.

a.

b.

c.

d.

50.

conservative estimates of the intangible benefits' value should be incorporated

into the NPV calculation.

calculate net present value ignoring intangible benefits and then, if the NPV is

negative, estimate whether the intangible benefits are worth at least the amount

of the negative NPV.

1

2

3

both 2 and 3 are correct.

All of the following statements about intangible benefits in capital budgeting are correct

except that they

a. include increased quality and employee loyalty.

b. are difficult to quantify.

c. are often ignored in capital budgeting decisions.

d. cannot be incorporated into the NPV calculation.

13-12

51.

a. only tangible benefits should be considered.

b. only intangible benefits should be considered.

c. both tangible and intangible benefits should be considered.

d. neither tangible nor intangible benefits should be considered.

52.

Using a number of outcome estimates to get a sense of the variability among potential

returns is

a. financial analysis.

b. post-audit analysis.

c. sensitivity analysis.

d. outcome analysis.

53.

If a company's required rate of return is 9%, and in using the profitability index method, a

project's index is greater than 1, this indicates that the project's rate of return is

a. equal to 9%.

b. greater than 9%.

c. less than 9%.

d. unacceptable for investment purposes.

54.

a. total cash flows by the initial investment.

b. present value of cash flows by the initial investment.

c. initial investment by the total cash flows.

d. initial investment by the present value of cash flows.

55.

The capital budgeting method that takes into account both the size of the original

investment and the discounted cash flows is the

a. cash payback method.

b. internal rate of return method.

c. net present value method.

d. profitability index.

56.

a. does not take into account the discounted cash flows.

b. is calculated by dividing total cash flows by the initial investment.

c. allows comparison of the relative desirability of projects that require differing

initial investments.

d. will never be greater than 1.

57.

The capital budgeting method that allows comparison of the relative desirability of projects

that require differing initial investments is the

a. cash payback method.

b. internal rate of return method.

c. net present value method.

d. profitability index.

58.

13-13

The following information is available for a potential investment for Panda Company:

Initial investment

Net annual cash inflow

Net present value

Salvage value

Useful life

$40,000

10,000

18,112

5,000

10 yrs.

a. 4.00.

b. 2.85.

c. 2.50.

d. 1.45.

59.

An approach that uses a number of outcome estimates to get a sense of the variability

among potential returns is

a. the discounted cash flow technique.

b. the net present value method.

c. risk analysis.

d. sensitivity analysis.

60.

a. are usually foolproof.

b. are done using different evaluation techniques than were used in making the

original capital budgeting decision.

c. provide a formal mechanism by which the company can determine whether

existing projects should be supported or terminated.

d. all of these.

61.

a. a different evaluation technique than that used in making the original decision.

b. the same evaluation technique used in making the original decision.

c. estimated amounts instead of actual figures.

d. an independent advisor.

62.

A thorough evaluation of how well a project's actual performance matches the projections

made when the project was proposed is called a

a. pre-audit.

b. post-audit.

c. risk analysis.

d. sensitivity analysis.

63.

a. managers will be more likely to submit reasonable data when they make

investment proposals if they know their estimates will be compared to actual

results.

13-14

b.

c.

d.

existing projects should be terminated.

it improves the development of future investment proposals because managers

improve their estimation techniques by evaluating their past successes and

failures.

all of these.

64.

A capital budgeting method that takes into consideration the time value of money is the

a. annual rate of return method.

b. return on shareholders' equity method.

c. cash payback technique.

d. internal rate of return method.

65.

a. positive NPV.

b. negative NPV.

c. zero NPV.

d. positive or negative NPV.

66.

In using the internal rate of return method, the internal rate of return factor was 4.0 and

the equal annual cash inflows were $16,000. The initial investment in the project must

have been

a. $8,000.

b. $16,000.

c. $64,000.

d. $32,000.

67.

The capital budgeting technique that finds the interest yield of the potential investment is

the

a. annual rate of return method.

b. internal rate of return method.

c. net present value method.

d. profitability index method.

68.

All of the following statements about the internal rate of return method are correct except

that it

a. recognizes the time value of money.

b. is widely used in practice.

c. is easy to interpret.

d. can be used only when the cash inflows are equal.

Periods

1

8%

9%

10%

.926

.917

.909

2

3

1.783

2.577

1.759

2.531

13-15

1.736

2.487

69.

project that costs $50,000 and is expected to generate cash inflows of $30,000at the end

of each year for two years. The net present value of this project is

a. $20,000.

b. $10,000.

c. $6,920.

d. $2,770.

70.

project that costs $50,000 and is expected to generate cash inflows of $20,000 at the end

of each year for three years. The profitability index for this project is

a. .99.

b. 1.00.

c. 1.01.

d. 1.20.

71.

project that costs $67,145 and is expected to generate cash inflows of $27,000 each year

for three years. The approximate internal rate of return on this project is

a. 8%.

b. 10%.

c. 9%.

d. less than the required 8%.

72.

A company has a minimum required rate of return of 10% and is considering investing in a

project that requires an investment of $68,000 and is expected to generate cash inflows of

$30,000 at the end of each year for 3 years. The present value of future cash inflows for

this project is

a. $68,000.

b. $74,610.

c. $7,930.

d. $6,610

Carr Company is considering two capital investment proposals. Estimates regarding each project

are provided below:

Project Soup

Project Nuts

Initial investment

$270,000

$600,000

Annual net income

27,000

45,000

Net annual cash inflow

90,000

142,000

Estimated useful life

5 years

6 years

Salvage value

-0-0-

13-16

Periods

5

6

9%

10%

11%

3.890

3.791

3.696

4.486

4.355

4.231

12%

3.605

4.111

73.

a. 13.5 years.

b. 5 years.

c. 3.9 years.

d. 3 years.

74.

a. $618,410.

b. $182,912.

c. $100,000.

d. $18,410.

75.

a. 13.3%.

b. 10%.

c. 33.3%.

d. 30%.

76.

a. 10%.

b. 11%.

c. 12%.

d. 9%.

A company is considering purchasing factory equipment that costs $400,000 and is estimated to

have no salvage value at the end of its 5-year useful life. If the equipment is purchased, annual

revenues are expected to be $150,000 and annual operating expenses exclusive of depreciation

expense are expected to be $25,000. The straight-line method of depreciation would be used.

77.

If the equipment is purchased, the annual rate of return expected on this equipment is

a. 37.5%.

b. 31.25%.

c. 11.25%.

d. 6.25%.

78.

a.

b.

c.

d.

13-17

8.89 years.

5.0 years.

3.2 years.

2.67 years.

79.

a. simple rate of return method.

b. accounting rate of return method.

c. unadjusted rate of return method.

d. all of the above.

80.

a. accounting data.

b. the time value of money data.

c. market values.

d. cash flow data.

81.

a. It is only valid for investments with a one year time perspective.

b. It incorporates depreciation into the calculations, which increases the uncertainty

of the calculations associated with estimating the life and salvage value of the

investment.

c. No consideration is given as to when the cash inflows occur.

d. It does not consider the time value of money.

A company projects an increase in net income of $40,000 each year for the next five years if it

invests $500,000 in new equipment. The equipment has a five-year life and an estimated salvage

value of $50,000. The company uses the straight-line method of depreciation.

82.

a. $40,000

b. $90,000

c. $130,000

d. $140,000

83.

a. 12.5 years

b. 5.56 years

c. 3.85 years

d. 3.57 years

84.

a. 8%

13-18

b.

c.

d.

85.

14.5%

18%

26.7%

All of the following statements about the annual rate of return method are correct except

that it

a. indicates the profitability of a capital expenditure.

b. ignores the salvage value of an investment.

c. does not consider the time value of money.

d. compares the annual rate of return to managements minimum rate of return.

86.

Peanut Co. is planning on investing in a new 2-year project, Project Jelly. Project

Jelly is expected to produce cash flows of $100,000 and $120,000 in each of the 2 years,

respectively. Peanut requires an internal rate of return of 15%. What is the maximum

amount that Peanut should invest immediately in Project Jelly?

Present Value of 1

Period

15%

1

.870

2

.756

Future Value of 1

Period

1

2

15%

1.150

1.323

a. $191.400

b. $177,720

c. $220,000

d. $273,760

87.

Vault Company wants to purchase an asset with a 3-year useful life, which is expected to

produce cash inflows of $10,000 each year for two years, and $15,000 in year 3. Vault

has a 14% cost of capital, and uses the following factors. What is the present value of

these future cash flows?

Present Value of 1

Period

14%

1

.88

.77

.67

2

3

a.

b.

c.

d.

88.

$30,800

$30,400

$26,550

$34,750

Doris Co. is considering purchasing a new machine which will cost $200,000, but which

will decrease costs each year by $50,000. The useful life of the machine is 10 years. The

machine would be depreciated straight-line with no residual value over its useful life at the

rate of $20,000/year. The payback period is

a. 5.0 years

b. 4.5 years

13-19

c. 4.0 years

d. 10.0 years

89.

Tammy Co. is considering purchasing a machine that will produce annual savings of

$22,000 at the end of the year. Tammy requires a 12% rate of return and the asset has a

5-year useful life. What is the maximum Tammy would be willing to pay for this machine?

Present Value of Annuity of 1

Period

12%

5

3.605

a.

b.

c.

d.

Period

5

Present Value of 1

12%

.567

$43,386

$79,310

$110,000

$62,370

90.

Mystery Co. is considering purchasing a new piece of equipment that will cost $600,000.

The equipment has an estimated useful life of 8 years and no salvage value. The

equipment will produce cash inflows of $215,000 per year and net income of $90,000 per

year. Mystery requires a 10% rate of return. What is the payback period for this

equipment?

a. 8.0 years

b. 3.75 years

c. 2.79 years

d. 6.67 years

91.

Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful

life. The equipment will provide cost savings of $7,300 and will be depreciated straightline over its useful life with no salvage value. Cleaners, Inc. requires a 10% rate of return.

What is the approximate internal rate of return for this investment?

Period

6

a.

b.

c.

d.

92.

8%

4.623

9%

10%

11%

12%

4.486

4.355

4.231

4.111

15%

3.784

9%

10%

11%

12%

Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful

life. The equipment will provide cost savings of $7,300 and will be depreciated straightline over its useful life with no salvage value. Cleaners, Inc. requires a 10% rate of return.

What is the approximate net present value of this investment?

Present Value of an Annuity of 1

13-20

Period

6

a.

b.

c.

d.

93.

8%

4.623

9%

4.486

10%

4.355

11%

4.231

12%

4.111

15%

3.784

$13,800

$1,792

$886

$2,748

Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful

life. The equipment will provide cost savings of $7,300 and will be amortized using the

straight-line method over its useful life with no salvage value. Cleaners, Inc. requires a

10% rate of return. What is the approximate profitability index associated with this

equipment?

Period

6

a.

b.

c.

d.

8%

4.623

9%

10%

11%

12%

4.486

4.355

4.231

4.111

15%

3.784

1.23

1.03

1.06

.73

94.

Capital budgeting relies on cash inflows and outflows as preferred inputs for calculations

because

a. managers prefer to use cash figures rather than accounting figures.

b. GAAP does not apply to capital budgeting decisions.

c. projects require cash paid out and firms want to know when cash will be returned.

d. cash figures are easier to calculate than accounting figures.

95.

Which of the following would not be considered as an input into a capital budgeting

decision?

a. Scrap value of equipment sold at the end of a project

b. Labour savings as a result of mechanization of a process

c. Cost outlays many years after the project has started

d. Amortization on a straight line basis

96.

a. it gives a broad indication when outlays will be recovered by the firm.

b. it gives a specific date as to when outlays will be recovered by the firm.

c. it avoids using complicated accounting data in capital budgeting decisions.

d. it is easy to communicate the relation between cash received and ultimate

profitability of a project to everyone in the organization.

97.

a. it ignores any salvage values at the end of a project.

b. it ignores the time value of money in the calculations.

c.

d.

13-21

it ignores the overall profitability of the project.

98.

a. the Bank of Canada rate of interest.

b. the rate that is currently charged at its bank.

c. the current corporate borrowing rate.

d. the corporate borrowing rate adjusted for any perceived risk of the project.

99.

a. Goodwill will be increased on the balance sheet as a result of the project.

b. The companys bankers may offer a lower rate of interest for certain projects.

c. The companys presence in its market is enhanced by the project.

d. The company may be allowed deferred income tax payment terms as a result of

the project.

100.

a. pay strict attention to what the numbers indicate and accept or reject a project

accordingly.

b. pay close attention to trends in the marketplace before accepting or rejecting a

project.

c. assess the numbers on the project and then go with managements best

judgment.

d. assess the numbers on the project then review the intangible benefits before

accepting or rejecting a project

101.

a. is only useful to perform when there are firm calculations on the project available.

b. is useful to perform when uncertainty exists and calculations are based on

estimates.

c. is designed to ensure that management is aware of all possible outcomes of the

project.

d. is designed to provide an escape-hatch for management should the project not

succeed.

102.

a. management can ignore the cost of capital for the project.

b. management must understand its own required rate of return for projects.

c. the Net Present Value method can be ignored in assessing the project.

d. both the Net Present Value and Cash Payback methods can be ignored in

assessing the project.

103.

The major difference between the Net Present Value method and the Annual Rate of

Return method in evaluating a capital project is

a. the ARR method is easier for accountants to justify than the NPV method.

b. the NPV method is easier for managers to justify than the ARR method.

13-22

c.

d.

the NPV method focuses on the overall profitability of a project.

13-23

Item

26.

27.

28.

29.

30.

31.

32.

33.

34.

35.

36.

Ans

.

a

d

b

a

d

c

b

b

c

b

c

Item

37.

38.

39.

40.

41.

42.

43.

44.

45.

46.

47.

Ans

.

d

c

a

b

d

c

b

a

c

a

c

Item

48.

49.

50.

51.

52.

53.

54.

55.

56.

57.

58.

Ans

.

b

d

d

c

c

b

b

d

c

d

d

Item

59.

60.

61.

62.

63.

64.

65.

66.

67.

68.

69.

Ans

.

d

c

b

b

d

d

c

c

b

d

d

Item

70.

71.

72.

73.

74.

75.

76.

77.

78.

79.

80.

Ans

.

c

b

b

d

d

b

b

c

c

d

a

Item

81.

82.

83.

84.

85.

86.

87.

88.

89.

90.

91.

Ans

.

Item

Ans.

d

c

c

b

b

b

c

c

b

c

d

92.

93.

94.

95.

96.

97.

98.

99.

100.

101.

102.

103.

b

c

c

d

a

d

d

c

d

b

b

c

13-24

BRIEF EXERCISES

Brief Exercise104

Diamond Co. is considering investing in new equipment that will cost $800,000 with a 8-year

useful life. The new equipment is expected to produce annual net income of $25,000 over its

useful life. Depreciation expense, using the straight-line rate, is $100,000 per year.

Instructions

Calculate the payback period.

Solution 104 (5 min.)

$800,000 ($25,000 + $100,000) = 6.4 years

Brief Exercise105

Madeline Company is proposing to spend $170,000 to purchase a machine that will provide

annual cash flows of $37,000. The appropriate present value factor for 8 periods is 6.73.

Instructions

Calculate the proposed investments net present value, and indicate whether the investment

should be made by Madeline Company.

Solution 105 (5 min.)

Present Value

Cash inflows $37,000 X 6.73

Cash outflow investment $170,000 X 1.00

Net present value

$ 249,010

(170,000)

$79,010

The investment should be made because the net present value is positive.

Brief Exercise106

LeMo Co. is considering investing in a cottage that will cost $310,000. The company expects to

rent the cottage for 7 years, after which it will be sold for $400,000 at that time. LeMo anticipates

cash flows of $60,000 resulting from the cottage and the companys borrowing rate is 9%, while

its cost of capital is 12%.

Instructions

Calculate the net present value of the cottage and indicate whether LeMo should make the

investment.

Solution 106 (5 min.)

Cash

Flows

$60,000

12% Discount

Factor

Present

Value

4.56376

$273,826

400,000 X

0.45235

Capital investment

Net present value

13-25

180,940

454,766

(310,000)

$144,766

Since the net present value is positive, LeMo should accept the project.

Brief Exercise 107

EKPN Co. has hired a consultant to propose a way to increase the companys revenues. The

consultant has evaluated two mutually exclusive projects with the following information provided

for each project:

Capital investment

Annual cash flows

Estimated useful life

Estimated salvage value

Project Chicken

$810,000

210,000

5 years

$130,000

Project Rooster

$200,000

60,000

5 years

$50,000

Instructions

(a) Calculate the net present value of both projects.

(b) Calculate the profitability index for each project.

(c) Which project should EKPN accept?

Solution 107 (10-15 min.)

Project Chicken

Cash

Flows

Present value of annual cash flows

Present value of salvage value

$210,000 X

130,000 X

8% Discount

Factor

3.99271

0.68058

=

=

Capital investment

Net present value

Present

Value

$838,469

88,475

926,944

(810,000)

$116,944

Project Rooster

Present value of salvage value

Capital investment

Cash

Flows

$60,000

50,000

9% Discount

Factor

X

X

3.992711

0.68058

=

=

Present

Value

$239,563

34,029

273,592

(200,000)

13-26

$73,592

Profitability index = $273,592/$200,000 = 1.368

Project Rooster has a lower net present value than Project Chicken, but because of its lower capital

investment, it has a higher profitability index. Based on its profitability index, Project Rooster

should be accepted.

Brief Exercise108

An investment costing $72,000 is being contemplated by Mint Co. The investment will have a life

of 5 years with no salvage value and will produce annual cash flows of $19,481.

Instructions

What is the approximate internal rate of return associated with this investment?

Solution 108 (5 min.)

When net annual cash inflows are expected to be equal, the internal rate of return can be

approximated by dividing the capital investment by the net annual cash inflows to determine the

discount factor, and then locating this discount factor on the present value of an annuity table.

$72,000/$19,481 = 3.69591

By tracing across on the 5-year row we see that the discount factor for 11% is 3.69590. Thus, the

internal rate of return on this project is approximately 11%.

Brief Exercise109

Salt Co. is considering investing in a new facility to extract and produce salt. The facility will

increase revenues by $170,000, but will also increase annual expenses by $50,000 including

depreciation. The facility will cost $720,000 to build, but will have a $30,000 salvage value at the

end of its 15-year useful life.

Instructions

Calculate the annual rate of return on this facility.

Solution 109 (5 min.)

The annual rate of return is calculated by dividing expected annual income by the average

investment. The companys expected annual income is:

$170,000 $50,000 = $120,000

Its average investment is:

$720,000 + $30,000

2

= $375,000

$120,000/$375,000 = 32%

13-27

The manager of Induction Ltd. wants to evaluate the profitability of four potential new projects and

has provided you with the following information

Project

Investment

1

2

3

4

$150,000

140,000

130,000

60,000

$25,000

25,000

35,000

15,000

Solution 110 (5 min.)

3

165130 = 1.27

4

7560 = 1.25

2

165140 = 1.18

1

175150 = 1.17

Johnstown Ltd. wants to buy a new machine for its main product line. It costs $60,000 and will

save the company $9,000 per year for the next ten years.

Calculate the payback for the company on this machine.

Solution 111 (5 min.)

$60,000 $9,000 = 6.67 years

13-28

EXERCISES

Exercise 112

Myrnas Gardening is considering the purchase of new lawn equipment. A supplier has offered a

package that will replace Myrnas current equipment. The package price is $30,000. Myrna

believes the equipment will make her more efficient, and therefore it will increase her annual net

cashflow by $5,000. The equipment will have a 9-year useful life and have no salvage value.

Myrnas cost of capital is 8%.

Instructions

(a) Calculate the cash payback period.

(b) Calculate the machines internal rate of return.

(c) Calculate the machines net present value using a discount rate of 8%.

(d) Is the investment acceptable? Why or why not?

Solution 112 (1318 min.)

(a) Cash payback period:

(b) Internal rate of return: Scanning the 9-year line, a factor of 6 represents an internal rate of

return of approximately 9%. The factor at 9% is actually 5.99525.

(c) Net present value using a discount rate of 8%:

Time Period

Cash Flow

PV Factor

Present Value

-0($30,000)

1.0000

($30,000.00)

1-9

5,000

6.24689

31,234.45

Net Present Value

$ 1,234.45

(d) Yes, the investment is acceptable. Indications are that the investment will earn a return

greater than 8%. The internal rate of return is estimated to be 9%, and the net present value

is positive.

Exercise 113

M&H Inc. delivers groceries for seniors. The company is considering purchasing a new van for

$27,000. The van is expected to last 7 years and have a salvage value of $2,000. M&H will use

the straight-line depreciation method. M&H estimates the van will generate revenue of $15,000

per year, and incur expenses of $7,000 plus depreciation. M&Hs cost of capital is 6%.

Instructions

For the new van, calculate the:

(a) cash payback period.

(b) net present value.

(c) annual rate of return.

Solution 113 (1622 min.)

(a)

Total annual cash flow: $15,000 - $7,000 = $8,000

$27,000

Cash payback: = 3.375 years

$8,000

13-29

Present value of salvage ($2,000 x 0.66506) =

1,330.12

45,989.16

Capital investment

27,000.00

Net present value

$ 18,989.16

(c)

$27,000 + $2,000

Average Investment: = $14,500

2

$27,000 - $2,000

Annual Depreciation: = $3,571

7 years

Annual Net Income: $8,000 $3,571 = $4,429

$4,429

Average Annual Rate of Return: = 30.5%

$14,500

Exercise 114

Mimi Company is considering a capital investment of $570,000 in new equipment. The equipment

is expected to have a 15-year useful life with no salvage value. Depreciation is calculated by the

straight-line method. During the life of the investment, annual net income and cash inflows are

expected to be $63,000 and $101,000, respectively. Mimi's minimum required rate of return is

11%. The present value of 1 for 15 periods at 11% is .209 and the present value of an annuity of 1

for 15 periods at 11% is 7.191.

Instructions

Calculate each of the following:

(a) cash payback period.

(b) net present value.

(c) annual rate of return.

Solution 114 (1015 min.)

(a) Cash payback period = $570,000 $101,000 = 5.64 years

(b) Present value of cash inflows ($101,000 7.191)= $726,291

Capital investment

570,000

Net present value

$ 156,291

(c) Annual rate of return = $63,000 [($570,000 + $0) 2] = 22.1%

Exercise 115

Dog River Company is considering two capital investment proposals. Relevant data on each

project are as follows:

Project Red

Project Blue

Capital investment

$210,000

$980,000

13-30

Estimated useful life

15,000

7 years

90,000

7 years

Depreciation is calculated by the straight-line method with no salvage value. Dog River requires

a10% rate of return on all new investments. The present value of 1 for 7 periods at 10% is .513

and the present value of an annuity of 1 for 7 periods is 4.868.

Instructions

(a) Calculate the cash payback period for each project.

(b) Calculate the net present value for each project.

(c) Calculate the annual rate of return for each project.

(d) Which project should DogRiver select?

Solution 115 (1418 min.)

(a)

Annual net income

Annual depreciation

Annual cash inflow

*($210,000 7)

Cash payback period:

(b)

Project Red

$15,000

30,000*

$45,000

**($980,000 7)

$210,000

= 4.67 years

$45,000

Project Red

Present value of cash inflows:

$219,060*

Capital investment

210,000

Net present value

$ 9,060

*($45,000x4.868)

**(230,000 x 4.868)

Project Red

$15,000

= 14.3%

($210,000 + $0) 2

Project Blue

$90,000

140,000**

$230,000

$980,000

= 4.26 years

$230,000

Project Blue

$1,119,640**

980,000

$ 139,640

Project Blue

$90,000

= 18.4%

($980,000 + $0) 2

(d) DogRiver should select Project Blue because it has a larger positive net present value and a

higher annual rate of return. In addition, Project Blue has a slightly shorter cash payback

period.

Exercise 116

Tom Bat became a baseball enthusiast at a very early age. All of his baseball experience has

provided him valuable knowledge of the sport, and he is thinking about going into the batting cage

business. He estimates the construction of a state-of-the-art facility and the purchase of

necessary equipment will cost $539,000. Both the facility and the equipment will be depreciated

over 14 years using the straight-line method and are expected to have zero salvage values. His

required rate of return is 12% (present value factor of 6.6282). Estimated annual net income and

cash flows are as follows:

Revenue

$270,000

Less:

Utility cost

Supplies

Labour

Depreciation

Other

Net income

28,000

7,500

110,000

38,500

23,000

13-31

207,000

$63,000

Instructions

For this investment, calculate:

(a) The net present value.

(b) The internal rate of return.

(c) The cash payback period.

Solution116 (1216 min.)

(a) Net present value of the investment:

Item

Present Value Cash Flow Factor

Initial Investment

($539,000)

1.0000

Revenue

$270,000

Expense

(168,500)*

101,500

6.6282

Net Present Value

*$28,000 + $7,500 + $110,000 + $23,000

Present Value

($539,000)

$

672,762

133,762

$539,000 $101,500 = 5.310

Scanning the 14-year line, a factor of 5.310 represents an IRR of between 16 and 17%, well

above the required rate of return of 12%

(c) Cash payback period of the investment:

$539,000 $101,500 = 5.31 years.

Exercise 117

Vista Company is considering two new projects, each requiring an equipment investment of

$87,000. Each project will last for three years and produce the following cash inflows:

Year

1

2

3

Cool

$37,000

40,000

45,000

$122,000

Hot

$40,000

40,000

40,000

$120,000

The equipment will have no salvage value at the end of its three-year life. Vista Company

depreciates equipment using the straight-line method, and requires a minimum rate of return of

9%.

Present value data are as follows:

Present Value of 1

Period

9%

1

.917

2

.842

3

.772

Period

9%

1

.917

2

1.759

3

2.531

13-32

Instructions

(a) Calculate the net present value of each project.

(b) Calculate the profitability index of each project.

(c) Which project should be selected? Why?

Solution 117 (1216 min.)

(a)

Project Cool

Year

Annual Cash Inflows

Present Value of 1

1

$37,000

.917

2

40,000

.842

3

45,000

.772

$122,000

Present Value

$33,929

33,680

34,740

$102,349

Capital investment

Net present value

$102,349

87,000

$ 15,349

Project Hot

Present value of cash inflows ($40,000 2.531)

Capital investment

Net present value

$101,240

87,000

$ 14,240

(b)

Profitability index:

Cool

Hot

$102,349 $87,000 = 1.176 ($101,240 $87,000) = 1.164

(c) Both projects are acceptable because both show a positive net present value. Project Cool

is the preferred project because its net present value is greater than project Hot's net present

value and it has a slightly higher profitability index.

Exercise 118

Santana Company is considering investing in a project that will cost $67,000 and have no salvage

value at the end of its 7-year life. It is estimated that the project will generate annual cash inflows

of $16,000 each year. The company requires a 10% rate of return and uses the following

compound interest table:

Period

7

6%

5.582

8%

9%

10%

11%

5.206

5.033

4.868

4.712

12%

4.564

Instructions

(a) Calculate (1) the net present value and (2) the profitability index of the project.

(b) Calculate the internal rate of return on this project.

(c) Should Santana invest in this project?

Solution 118 (1018 min.)

(a) (1) Present value of cash inflows ($16,000 4.868)

Capital investment

Net present value

$77,888

67,000

$ 10,888

15%

4.160

(2)

(b)

13-33

Capital Investment

$67,000

= 4.188

$16,000

Since the calculated internal rate of return factor of 4.188 is very near the factor 4.160 for

seven periods and 15% interest, this project has an approximate interest yield of 15%.

(c) Santana should invest in this project because it has a positive net present value, a

profitability index above 1, and its internal rate of return of 15% is greater than the company's

10% required rate of return.

Exercise 119

Johnson Company is considering purchasing one of two new machines. The following estimates

are available for each machine:

Machine 1

Machine 2

Initial cost

$152,000

$170,000

Annual cash inflows

50,000

60,000

Annual cash outflows

15,000

20,000

Estimated useful life

6 years

6 years

The company's minimum required rate of return is 9%.

Period

6

8%

4.623

9%

10%

11%

12%

4.486

4.355

4.231

4.111

15%

3.784

Instructions

(a) Calculate the (1) net present value, (2) profitability index, and (3) internal rate of return for

each machine.

(b) Which machine should be purchased?

Solution119 (1216 min.)

(a)

(1) Present value of net cash flows

Capital investment

Net present value

*($35,000 4.486)

**($40,000 4.486)

Machine 1

$157,010*

152,000

$ 5,010

Machine 1

$157,010

= 1.03

$152,000

Machine 2

$179,440**

170,000

$ 9,440

Machine 2

$179,440

= 1.06

$170,000

13-34

(3)

Internal rate of return factor

Machine 1

$152,000

= 4.34

$35,000

Machine 2

$170,000

= 4.25

$40,000

(b) Both machines are acceptable because both show a positive net present value, have a

profitability index above 1, and have an internal rate of return greater than the company's

minimum required rate of return. Machine 2 is preferred because its net present value,

profitability index, and internal rate of return are all greater than Machine 1's amounts.

Exercise 120

Yappy Company is considering a capital investment of $320,000 in additional equipment. The

new equipment is expected to have a useful life of 8 years with no salvage value. Depreciation is

calculated by the straight-line method. During the life of the investment, annual net income and

cash inflows are expected to be $22,000 and $62,000, respectively. Yappy requires a 9% return

on all new investments.

Present Value of an Annuity of 1

Period

8%

9%

10%

11%

12%

15%

8

5.747

5.535

5.335

5.146

4.968

4.487

Instructions

(a) Calculate each of the following:

1. Cash payback period.

2. Net present value.

3. Profitability index.

4 Internal rate of return.

5. Annual rate of return.

(b) Indicate whether the investment should be accepted or rejected.

Solution 120 (1520 min.)

(a) 1. Cash payback period: $320,000 $62,000 = 5.16 years

(b)

2.

Capital investment

Net present value

$343,170

320,000

$ 23,170

3.

4.

Internal rate of return = 11% (5.146 factor)

5.

Yappy should accept the investment, since its net present value is positive and its internal

rate of return of 11% is greater than the company's required rate of return of 9%. In addition,

13-35

its cash payback period of 5.16 years is significantly shorter than the equipment's useful life

of 8 years.

Exercise 121

Platoon Company is performing a post-audit of a project that was estimated to cost $300,000,

have a useful life of 6 years with a zero salvage value, and result in net cash inflows of $70,000

per year. After the investment has been in operation for a year, revised figures indicate that it

actually cost $340,000, will have a 9-year useful life, and will produce net cash inflows of

$58,000. The present value of an annuity of 1 for 6 years at 10% is 4.355 and for 9 years is

5.759.

Instructions

Determine whether the project should have been accepted based on (a) the original estimates

and then on (b) the actual amounts.

Solution 121 (812 min.)

(a) Present value of the estimated net cash inflows ($70,000 4.355)

Estimated capital investment

Net present value

$304,850

300,000

$ 4,850

Yes, Platoon Company should have invested in the project based on the original estimates,

since the net present value is positive.

(b) Present value of the actual net cash inflows ($58,000 x 5.759)

Actual capital investment

Net present value

$334,022

340,000

($ 5,978)

Platoon should not have invested in the project based on the actual amounts, since the net

present value is negative. The decrease of $10,828 in net present value was caused due to

a decrease of $12,000 per year in net cash inflows and a $40,000 increase in the cost of the

capital investment. This more than offsets the 3-year increase in useful life.

Exercise 122

Sophies Pet Shop is considering the purchase of a new delivery van. Sophie Smith, owner of the

shop, has compiled the following estimates in trying to determine whether the delivery van should

be purchased:

Cost of the van

Annual net cash flows

Salvage value

Estimated useful life

Cost of capital

Present value of an annuity of 1

Present value of 1

$25,000

4,300

3,000

8 years

10%

5.335

.467

Sophie's assistant manager is trying to convince Sophie that the van has other benefits that she

hasn't considered in the initial estimates. These additional benefits, including the free advertising

the store's name painted on the van's doors will provide, are expected to increase net cash flows

by $500 each year.

13-36

Instructions

(a) Calculate the net present value of the van, based on the initial estimates. Should the van be

purchased?

(b) Calculate the net present value, incorporating the additional benefits suggested by the

assistant manager. Should the van be purchased?

(c) Determine how much the additional benefits would have to be worth in order for the van to be

purchased.

Solution 122 (1519 min.)

(a) Present value of annualnetcash flows ($4,300 5.335)

Present value of salvage value ($3,000 .467)

$22,941

1,401

$24,342

Capital investment

25,000

Net present value

($ 658)

Based on the negative net present value of $658, the van should not be purchased.

Present value of salvage value ($3,000 .467)

$25,608

1,401

$27,009

Capital investment

25,000

Net present value

$ 2,009

Incorporating the additional benefits of $500/year into the calculation produces a positive net

present value of $2,009. Therefore, the van should be purchased.

(c) The additional benefits would need to have a total present value of at least $658 in order for

the van to be purchased.

Exercise 123

Blue Jay Corp. is thinking about opening a baseball camp in Oakville. In order to start the camp,

the company would need to purchase land, build five baseball fields, and a dormitory-type

sleeping and dining facility to house 100 players. Each year the camp would be run for 10

sessions of 1 week each. The company would hire college baseball players as coaches. The

camp attendees would be baseball players age 12-18. Property values in Oakville have enjoyed

a steady increase in value. It is expected that after using the facility for 20 years, Blue Jay can

sell the property for more than it was originally purchased for. The following amounts have been

estimated:

Cost of land

$ 600,000

Cost to build dorm and dining facility

2,100,000

Annual cash inflows assuming 100 players and 10 weeks

2,520,000

Annual cash outflows

2,250,000

Estimated useful life

20 years

Salvage value

3,900,000

Discount rate

10%

Present value of an annuity of 1

8.514

Present value of 1

.149

Instructions

(a) Calculate the net present value of the project.

13-37

(b) To gauge the sensitivity of the project to these estimates, assume that if only 80 campers

attend each week, revenues will be $2,085,000 and expenses will be $1,875,000. What is the

net present value using these alternative estimates? Discuss your findings.

(c) Assuming the original facts, what is the net present value if the project is actually riskier than

first assumed, and a 12% discount rate is more appropriate? The present value of 1 at 12%

is .104 and the present value of an annuity of 1 is 7.469.

Solution 123 (1520 min.)

(a) Present value of net cash flows ($270,000 8.514)

Present value of salvage value ($3,900,000 .149)

Capital investment ($600,000 + $2,100,000)

Net present value

(b) Present value of net cash flows ($210,000 8.514)

Present value of salvage value

Capital investment

Net present value

$2,298,780

581,100

$2,879,880

2,700,000

$ 179,880

$1,787,940

581,100

$2,369,040

2,700,000

($330,960)

If the number of campers attending each week is only 80 instead of 100, the net present

value decreases by $510,840 (from a positive $179,880 to a negative $330,960). This

indicates that the camp should not be invested in unless the number attending is closer to

100.

(c) Present value of net cash flows ($270,000 7.469)

Present value of salvage value ($3,900,000 .104)

Capital investment

Net present value

$2,016,630

405,600

$2,422,230

2,700,000

($ 277,770)

Exercise 124

Explain what a capital investment decision is. In your answer, distinguish between independent

and mutually exclusive capital investment decisions.

Solution 124

Such decisions are the outcome of planning, setting goals and priorities, arranging financing and

using various selection criteria to choose amongst a variety of competing projects. Such projects

would be taken on with the view of furthering the company, with the purchase of some type of

asset which would generate an acceptable rate of return.

Independent projects are those that, once accepted or rejected, do not affect the cash flows of

other projects within the company.

Mutually exclusive projects are those that, once accepted or rejected, preclude the acceptance of

all other competing projects.

Exercise125

A certain investment proposal requires an initial outlay of $450,000, and has an expected useful

life of 6 years, with an annual cash inflow of $90,000 received at the end of each year. The

13-38

company uses the straight-line method of depreciation. Ignore income taxes. The company has a

12% incremental cost of borrowing.

Instructions

(a) Compute the payback for the proposal.

(b) Compute the net present value of the proposal.

(c) Would you recommend this proposal be accepted? Explain.

Solution 125

(a) 5 years = $450,000/$90,000

(b) NPV using 12%:

Initial outlay

PV of cash flows ($90,000 x 4.111)

NPV

($450,000)

$369,990

$(80,010)

(c) The company should not accept the proposal. The payback period of 5 years is less than the

expected life of the project, which is positive. However, the NPV is negative which suggests

that the proposal does not meet the companys desired rate of return.

Exercise126

Huttons Feed Supply wishes to purchase a new computerized weigh scales system which will

weigh and price the crops brought in by local farmers. Data on this new system are as follows:

Cost

Salvage value at end of 5 years

Useful life

Annual operating cost

$12,000

$1,000

5 years

$4,000

If the existing computerized weigh scales is kept and used, it would require the purchase and

installation of additional hardware, one year from now, costing $2,000. Management believes the

system will last another 5 years from today, at which time the salvage value is expected to be

$300. Additional information on the existing system is as follows:

Annual operating costs

Remaining book value

Current salvage value

Cost of capital

$9,000

$12,000

$3,000

12%.

Instructions

Should Huttons purchase the new system? Explain.

Solution 126

Buying New System Now:

Period

0

Cash Flow

($12,000)

PV Factor

1.0

Total

($12,000)

Notes

Initial purchase cost of weigh scales

0

1

$ 3,000

$ 2,000

1.0

0.893

1-5

5

$ 5,000

3.605

700

0.567

397

13-39

3,000

1,786

Savings from not purchasing new

hardware next year

18,025

Net savings in annual operating costs

Difference in salvage value in 5 years

$11,208

NPV of new weigh scales.

The positive NPV indicates that the new weigh scales savings are greater than the companys

cost of capital, so the new equipment should be purchased.

Note: the incremental analysis approach has been used here, rather than showing 2 separate

NPV calculations for the new and old systems. Had 2 separate NPV calculations been done, the

NPV for the new weigh scales would have been higher by $11,208.

Exercise 127

Jillian Grapes is thinking of purchasing a new grape-crushing machine for its factory. The cost of

the new equipment is $50,000. The current machine must be scrapped and will have no value.

The costs associated with operating the two machines are:

Current machine

New Machine

Labour

$7,000

$2,000

Maintenance

3,000

1,000

Utilities

2,000

1,500

Amortization

9,000

11,000

Calculate the payback period if the new machine is purchased

Solution 127

The new machine will have an outlay of $25,000 but will save the company the following money:

Labour

$7,000 $2,000 = $5,000

Maint.

3,000 1,000 = 2,000

Utilities

2,000 1,500 =

500

Amort.

0

Total

$7,500

Payback period $50,000 / $7,500 = 6.67 years

13-40

COMPLETION STATEMENTS

128.

For purposes of capital budgeting, estimated ____________ and outflows are preferred

for inputs into the capital budgeting decision tools.

129.

The technique which identifies the time period required to recover the cost of the

investment is called the ________________ method.

130.

The two discounted cash flow techniques used in capital budgeting are (1) the

_______________________ method and (2) the ______________________ method.

131.

Under the net present value method, the interest rate to be used in discounting the future

cash inflows is the ________________.

132.

In using the net present value approach, a project is acceptable if the project's net present

value is ____________ or_______________.

133.

ignored in capital budgeting decisions.

134.

account both the size of the investment and its discounted future cash flows.

135.

investment projects after their completion.

136.

The internal rate of return method differs from the net present value method in that it

results in finding the ___________________ of the potential investment.

137.

A major limitation of the annual rate of return approach is that it does not consider the

_______________ of money.

128.cash inflows

129.cash payback

130.net present value, internal rate of return

131.required rate of return

132.zero, positive

133.intangible benefits

134.profitability index

135.post audit

136.interest yield

137.time value

13-41

13-42

MATCHING

138.

Match the items below by entering the appropriate code letter in the space provided.

A.

B.

C.

D.

Profitability index

Internal rate of return method

Discounted cash flow techniques

Capital budgeting

E.

F.

G.

H.

Cash payback technique

Cost of capital

Net present value method

____

1. A capital budgeting technique that identifies the time period required to recover the

cost of a capital investment from the annual cash inflow produced by the investment.

____

2. Capital budgeting techniques that consider both the estimated total cash inflows from

the investment and the time value of money.

____

3. A method used in capital budgeting in which cash inflows are discounted to their

present value and then compared to the capital outlay required by the capital

investment.

____

4. A method of comparing alternative projects that take into account both the size of the

investment and its discounted cash flows.

____

5. A method used in capital budgeting that results in finding the interest yield of the

potential investment.

____

6. The average rate of return that the firm must pay to obtain borrowed and equity funds.

____

annual net income by the average investment.

____

ANSWERS TO MATCHING

1.

5.

2.

6.

3.

7.

4.

8.

13-43

13-44

Short Answer Essay139

Management uses several capital budgeting methods in evaluating projects for possible

investment. Identify those methods that are more desirable from a conceptual standpoint, and

briefly explain what features these methods have that make them more desirable than other

methods. Also identify the least desirable method and explain its major weaknesses.

Solution 139

From a conceptual standpoint, the discounted cash flow methods (net present value and internal

rate of return) are considered more desirable because they consider both the estimated cash

flows and the time value of money. The time value of money is critical because of the long-term

impact of capital budgeting decisions. Capital budgeting methods which do not consider the time

value of money include annual rate of return and cash payback. The cash payback method is the

least desirable because it also ignores the expected profitability of the project.

Short Answer Essay140 (Ethics)

Sam Stanton is on the capital budgeting committee for his company, Stanton Tile. Ed Rhodes is

an engineer for the firm. Ed expresses his disappointment to Sam that a project that was given to

him to review before submission looks extremely good on paper. "I really hoped that the cost

projections wouldn't pan out," he tells his friend. "The technology used in this is pie in the sky kind

of stuff. There are a hundred things that could go wrong. But the figures are very convincing. I

haven't sent it in yet, though I probably should."

"You can keep it if it's really that bad," assures Sam. "Anyway, you can probably get it shot out of

the water pretty easily, and not have the guy who submitted it mad at you for not turning it in. Just

fix the numbers. If you figure, for instance, that a cost is only 50% likely to be that low, then

double it. We do it all the time, informally. Best of all, the rank and file don't get to come to those

sessions. Your engineering genius need never know. He'll just think someone else's project was

even better than his."

Required:

1. Who are the stakeholders in this situation?

2. Is it ethical to adjust the figures to compensate for risk? Explain.

3. Is it ethical to change the proposal before submitting it? Explain.

Solution 140

1. The stakeholders include:

Ed Rhodes

Stanton Tile

the engineer who submitted the proposal.

2.

clearly stated that the projections have been adjusted for risk, and the method used should

be available for review. Otherwise, the entire selection process is undermined, and it

becomes entirely subjective.

3.

13-45

It is probably not ethical to modify a proposal at all; certainly not in the way described. The

person submitting the proposal should have the right to know about any changes that were

made, and should have the right to review those changes.

You are a general accountant for North Saskatchewan River Health Centre, a hospital based in a

northern Saskatchewan city. The hospital has decided to upgrade its health records system. The

hospital wishes to invest in electronic health records software and to improve its documentation

and retrieval of records capabilities.

Two options have emerged. Option #1 is for the hospital to keep its existing computer system,

and upgrade its scanning and retrieval software. The memory of each individual work station

would be enhanced, and larger, more efficient scanners would be used.

Better

telecommunications equipment would allow for the electronic transmission of some documents as

well.

Option #2 would be for the hospital to invest in an entirely different computer system. The

software for this system is extremely impressive, and it automatically creates a permanent

electronic health record which could be accessed by various health care providers. However, the

software provider is not well known, and the software does not connect well with other software

used by the hospital. The net present value information for these options follows:

Option #1

Initial Investment

($950,000)

Discounted Returns

Year 1

550,000

Year 2

300,000

Year 3

100,000

Net present value

0

Option #2

($2,700,000)

900,000

900,000

900,000

0

Required:

Prepare a brief report for management in which you make a recommendation for one system or

the other, using the information given.

Solution 141

I recommend that the hospital accept Option #1, to purchase upgrades to our present system and

to buy more efficient scanners. In the first place, the changes will be easier to implement

because the equipment is similar to that which we already use. Secondly, the hospital will have

less money invested in the project, which decreases our risk of loss should the project fail.

Option #2 appears to be too risky.

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