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CHAPTER 13

PLANNING FOR CAPITAL INVESTMENTS


SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOMS TAXONOMY
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True-False Statements

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Multiple Choice Questions

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K
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AP
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C

42.
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3
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AN
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58.
59.
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64.
65.
66.
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70.
71.
72.
73.

104
105
106.
.

2
3
3

AP
E
AP

107
108
109.
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3,5
7
8

E
E
AP

110.
111.

112
113
..
114
115.

2,3,
2,3,
8
2,3,
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2,3,
8

E
AP
AP
E

116
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2,3,
3,5
3,5,
7
3,5,
7

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Brief Exercises

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Exercises

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(i)
3,6
3,4
3

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Completion Statements

132
3
K
133
4
K
. Matching
Short Answer Essay

139

1-8

(i) 2,3,5,7,8

AN

140

AN

141

AP

134
135
.

Planning for Capital Investments

13-2

SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE


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73.
78.
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TF
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42.
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69.
72.

MC
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74.
87.
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92.
105.
106.

10.
11.

TF
TF

12.
47.

TF
MC

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49.

13.
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15.
43.

TF
TF
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MC

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MC
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16.
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TF
TF

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60.

TF
MC

61.
62.

19.
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21.

TF
TF
TF

64.
65.
66.

MC
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MC

67.
68.
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Study Objective 1
MC
94. MC
124.
MC
95. MC
128.
MC
101. MC
138.
Study Objective 2
MC
97. MC
113.
MC
104. BE
114.
MC
111. BE
115.
MC
112. Ex
116.
MC
Study Objective 3
MC
107. BE
117.
MC
112. Ex
118.
MC
113. Ex
119.
MC
114. Ex
120.
BE
115. Ex
121.
BE
116. Ex
122.
Study Objective 4
MC
50. MC
122.
MC
51. MC
133.
Study Objective 5
MC
70. MC
118.
MC
93. MC
119.
MC
107. BE
120.
MC
117. Ex
134.
Study Objective 6
MC
63. MC
135.
MC
121. Ex
138.
Study Objective 7
MC
76. MC
108.
MC
86. MC
112.
MC
91. MC
116.

79.
80.
81.

Study Objective 8
MC
84. MC
113.
MC
85. MC
114.
MC 109. BE
115.

22.
23.
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TF
TF
TF

25.
75.
77.

TF
MC
MC

Note: TF = True-False
MC = Multiple Choice

C = Completion
Ex = Exercise

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BE = Brief Exercise

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

Planning for Capital Investments

13-3

CHAPTER STUDY OBJECTIVES


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.

Identify the challenges presented by intangible benefits in capital budgeting.


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.

Indicate the benefits of performing a post-audit. A post-audit is an evaluation of a


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.

Test Bank for Managerial Accounting, Third Canadian Edition

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.

Planning for Capital Investments

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.

By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate


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

Test Bank for Managerial Accounting, Third Canadian Edition

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.

A well-run organization should perform an evaluation, called a post-audit, of its investment


projects before their completion.

17.

Post-audits create an incentive for managers to make accurate estimates, since


managers know that their results will be evaluated.

18.

A post-audit is an evaluation of how well a project's actual performance matches the


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.

Planning for Capital Investments

13-7

ANSWERS TO TRUE-FALSE STATEMENTS


Item

1.
2.
3.
4.

Ans
.

T
F
T
F

Item

5.
6.
7.
8.

Ans
.

T
T
T
F

Item

9.
10.
11.
12.

Ans
.

F
T
F
T

Item

13.
14.
15.
16.

Ans
.

F
T
T
F

Item

17.
18.
19.
20.

Ans
.

T
T
T
T

Item

21.
22.
23.
24.

Ans.

F
T
F
F

Item

25.

Ans.

13-8

Test Bank for Managerial Accounting, Third Canadian Edition

MULTIPLE CHOICE QUESTIONS


26.

The capital budget for the year is approved by a company's


a. board of directors.
b. capital budgeting committee.
c. officers.
d. shareholders.

27.

Which of the following describes the capital budgeting evaluation process?


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.

Which of the following represents a cash inflow?


a. the initial investment
b. sale of old equipment
c. repairs and maintenance
d. increased operating costs

29.

Which of the following represents a cash outflow?


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.

The capital budgeting decision depends in part on the


a. availability of funds.
b. relationships among proposed projects.
c. risk associated with a particular project.
d. all of these.

31.

Capital budgeting is the process


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.

Planning for Capital Investments

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.

The cash payback technique


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 disadvantage of the cash payback technique is that it


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

Test Bank for Managerial Accounting, Third Canadian Edition

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.

The higher the risk element in a project, the


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.

Planning for Capital Investments

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.

Intangible benefits in capital budgeting


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.

To avoid rejecting projects that actually should be accepted,


1.
2.
3.
a.
b.
c.
d.

50.

intangible benefits should be ignored.


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

Test Bank for Managerial Accounting, Third Canadian Edition

51.

In evaluating high-tech projects


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.

The profitability index is calculated by dividing the


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.

The profitability index


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.

Planning for Capital Investments

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.

The potential investments profitability index is


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.

Post-audits of capital projects


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 post-audit should be performed using


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.

Performing a post-audit is important because


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

Test Bank for Managerial Accounting, Third Canadian Edition

b.
c.
d.

it provides a formal mechanism by which the company can determine whether


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.

The internal rate of return is the interest rate that results in a


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.

Use the following table for questions 6972.


Periods
1

Present Value of an Annuity of 1


8%
9%
10%
.926
.917
.909

Planning for Capital Investments

2
3

1.783
2.577

1.759
2.531

13-15

1.736
2.487

69.

A company has a minimum required rate of return of 9% and is considering investing in a


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.

A company has a minimum required rate of return of 9% and is considering investing in a


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.

A company has a minimum required rate of return of 8% and is considering investing in a


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

Use the following information for questions 7376.


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

Test Bank for Managerial Accounting, Third Canadian Edition

The company requires a 10% rate of return on all new investments.


Periods
5
6

Present Value of an Annuity of 1


9%
10%
11%
3.890
3.791
3.696
4.486
4.355
4.231

12%
3.605
4.111

73.

The cash payback period for Project Soup is


a. 13.5 years.
b. 5 years.
c. 3.9 years.
d. 3 years.

74.

The net present value for Project Nuts is


a. $618,410.
b. $182,912.
c. $100,000.
d. $18,410.

75.

The annual rate of return for Project Soup is


a. 13.3%.
b. 10%.
c. 33.3%.
d. 30%.

76.

The internal rate of return for Project Nuts is approximately


a. 10%.
b. 11%.
c. 12%.
d. 9%.

Use the following information for questions 77 and 78.


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.

The cash payback period on the equipment is

Planning for Capital Investments

a.
b.
c.
d.

13-17

8.89 years.
5.0 years.
3.2 years.
2.67 years.

79.

The annual rate of return method is also referred to as:


a. simple rate of return method.
b. accounting rate of return method.
c. unadjusted rate of return method.
d. all of the above.

80.

The annual rate of return method is based on


a. accounting data.
b. the time value of money data.
c. market values.
d. cash flow data.

81.

What is the main disadvantage of the annual rate of return method?


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.

Use the following information for questions 82 to 84.


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.

What is the net annual cash flow?


a. $40,000
b. $90,000
c. $130,000
d. $140,000

83.

What is the cash payback period?


a. 12.5 years
b. 5.56 years
c. 3.85 years
d. 3.57 years

84.

What is the annual rate of return?


a. 8%

13-18

Test Bank for Managerial Accounting, Third Canadian Edition

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

Planning for Capital Investments

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

Present Value of an Annuity of 1


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

Test Bank for Managerial Accounting, Third Canadian Edition

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

Present Value of an Annuity of 1


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.

The cash payback method is useful because


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.

The major difficulty of the cash payback method is


a. it ignores any salvage values at the end of a project.
b. it ignores the time value of money in the calculations.

Planning for Capital Investments

c.
d.

13-21

it ignores the overall cash flow of the project.


it ignores the overall profitability of the project.

98.

When evaluating a project, companies should always use


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.

An intangible benefit of a project would best be described as?


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.

When accepting large capital projects, a company should


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.

Sensitivity analysis on a potential project


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.

In using the Internal Rate of Return method


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

Test Bank for Managerial Accounting, Third Canadian Edition

c.
d.

the ARR method focuses on overall profitability of a project.


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

Planning for Capital Investments

13-23

ANSWERS TO MULTIPLE CHOICE QUESTIONS


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

Test Bank for Managerial Accounting, Third Canadian Edition

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.)

Present value of annual cash flows

Cash
Flows
$60,000

12% Discount
Factor

Present
Value

4.56376

$273,826

Planning for Capital Investments

Present value of salvage value

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

EXPN Co. uses a discount rate of 8% to evaluate both projects.


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

Profitability index = $926,944/$810,000 = 1.144


Project Rooster

Present value of annual cash flows


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

Test Bank for Managerial Accounting, Third Canadian Edition

$73,592

Net present value


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

Therefore, its annual rate of return is:


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

Planning for Capital Investments

13-27

Brief Exercise 110


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

Net Present Value


1
2
3
4

$150,000
140,000
130,000
60,000

$25,000
25,000
35,000
15,000

Using the profitability index approach, rank the four projects


Solution 110 (5 min.)
3
165130 = 1.27

4
7560 = 1.25

2
165140 = 1.18

1
175150 = 1.17

Brief Exercise 111


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

Test Bank for Managerial Accounting, Third Canadian Edition

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:

$30,000 $5,000 = 6 years

(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

Planning for Capital Investments

13-29

(b) Present value of cash flow ($8,000 5.58238) = $44,659.04


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

Test Bank for Managerial Accounting, Third Canadian Edition

Annual net income


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)

(c) Annual rate of return:

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:

Planning for Capital Investments

Utility cost
Supplies
Labour
Depreciation
Other
Net income

28,000
7,500
110,000
38,500
23,000

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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

(b) Internal rate of return of the investment:


$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

Present Value of an Annuity of 1


Period
9%
1
.917
2
1.759
3
2.531

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Test Bank for Managerial Accounting, Third Canadian Edition

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

Present value of cash inflows


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

Present Value of an Annuity of 1


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

Planning for Capital Investments

(2)
(b)

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Profitability index: $77,888 $67,000 = 1.163


Capital Investment

Net Annual Cash Inflow

= Internal Rate of Return Factor

$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

Present Value of an Annuity of 1


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)

(2) Profitability index

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

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Test Bank for Managerial Accounting, Third Canadian Edition

(3)
Internal rate of return factor

Internal rate of return

Machine 1
$152,000
= 4.34
$35,000

Machine 2
$170,000
= 4.25
$40,000

10% (4.355 factor)

11% (4.231 factor)

(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.

Present value of cash inflows ($62,000 5.535)


Capital investment
Net present value

$343,170
320,000
$ 23,170

3.

Profitability index: $343,170 $320,000 = 1.07

4.

Internal rate of return factor: $320,000 $62,000 = 5.16


Internal rate of return = 11% (5.146 factor)

5.

Annual rate of return: $22,000 [($320,000 + $0) 2] = 13.75%

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,

Planning for Capital Investments

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.

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Test Bank for Managerial Accounting, Third Canadian Edition

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.

(b) Present value of annual cash flows [($4,300 + $500) 5.335]


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.

Planning for Capital Investments

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

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Test Bank for Managerial Accounting, Third Canadian Edition

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%.

The company uses the straight-line method of depreciation.


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

Planning for Capital Investments

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

Salvage value of old scales, now


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

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Test Bank for Managerial Accounting, Third Canadian Edition

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.

A projects ________________, such as increased quality or safety, are often incorrectly


ignored in capital budgeting decisions.

134.

The _______________ is a method of comparing alternative projects that takes into


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

135.

A well-run organization should perform an evaluation, called a _____________, of its


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.

Planning for Capital Investments

ANSWERS TO COMPLETION STATEMENTS


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

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Test Bank for Managerial Accounting, Third Canadian Edition

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.

Annual rate of return method


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.

____

7. The determination of the profitability of a capital expenditure by dividing expected


annual net income by the average investment.

____

8. The process of making capital expenditure decisions in business.

Planning for Capital Investments

ANSWERS TO MATCHING
1.

5.

2.

6.

3.

7.

4.

8.

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Test Bank for Managerial Accounting, Third Canadian Edition

SHORT-ANSWER ESSAY QUESTIONS


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.

It is ethical, in general, to adjust projections to compensate for risk. However, it should be


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.

Planning for Capital Investments

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.

Short Answer Essay 141 (Communication)


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.