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2) The annual rate of return technique requires dividing a project's annual cash inflows by the economic life of

the project. Answer: False

3) A hurdle rate is the rate of return set by applying ideal standards. Answer: False

4) A major advantage of the annual rate of return technique is that it considers the time value of money. Answer:

False

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

Answer: False

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

profitability of a project . Answer : True

7) The annual rate of return is computed by dividing expected annual net income by average investment. Answer

: True

8) The discounted cash flow technique considers estimated total cash inflows from the investment but not the

time value of money. Answer: False

A company is considering purchasing factory equipment that costs $320,000 and is estimated to have no

salvage value at the end of its 8-year useful life. If the equipment is purchased, annual revenues are

expected to be $90,000 and annual operating expenses exclusive of depreciation expense are expected to be

$38,000. The straight-line method of depreciation would be used. If the equipment is purchased, the

annual rate of return expected on this equipment is:

a. 32.5%. b. 3.8%.

c. 7.5%. d. 16.3%.

A company is considering purchasing factory equipment that costs $320,000 and is estimated to have no

salvage value at the end of its 8-year useful life. If the equipment is purchased, annual revenues are

expected to be $90,000 and annual operating expenses exclusive of depreciation expense are expected to be

$38,000. The straight-line method of depreciation would be used. The cash payback period on the

equipment is:

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

costs each year by $40,000. 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 cash payback period

is:

d. rate of return earned on total assets.

If an asset cost $210,000 and is expected to have a $30,000 salvage value at the end of its ten-year life, and

generates annual net cash inflows of $30,000 each year, the cash payback period is

a. 8 years.

b. 7 years.

c. 6 years.

d. 5 years.

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

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

A company is considering purchasing factory equipment which costs $480,000 and is estimated to have no

salvage value at the end of its 8-year useful life. If the equipment is purchased, annual revenues are

expected to be $225,000 and annual operating expenses exclusive of depreciation expense are expected to

be $95,000. The straight-line method of depreciation would be used. If the equipment is purchased, the

annual rate of return expected on this project is

a. 54.2%.

b. 14.6%.

c. 29.2%.

d. 27.1%.

b. Payback method

c. Discounted cash flow method

The rate that management expects to pay on borrowed or equity funds is known as

d. all of these.

a. accounting data.

c. market values.

d. replacement values.

A company projects an increase in net income of $225,000 each year for the next five years if it invests

$900,000 in new equipment. The equipment has a five-year life and an estimated salvage value of

$300,000. What is the annual rate of return on this investment?

a. 25.0%

b. 37.5%

c. 50.0%

d. 57.5%

a. a percent.

b. dollars.

c. time.

d. a discount factor.

c. is complicated to use.

Nance Company is considering buying a machine for $90,000 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 $6,000 each year. The cash payback on this investment is

a. 15 years.

b. 10 years.

c. 6 years.

d. 3 years.

Garza Company is considering buying equipment for $240,000 with a useful life of five years and an

estimated salvage value of $12,000. If annual expected income is $21,000, the denominator in computing

the annual rate of return is

a. $240,000. b. $120,000. c. $126,000. d. $252,000.

A capital budgeting technique which takes into consideration the time value of money is the

c. payback approach.

Mussina Company had an investment which cost $260,000 and had a salvage value at the end of its useful

life of zero. If Mussina's expected annual net income is $15,000, the annual rate of return is:

a. 5.8%. b. 9.8%.

c. 11.5%. d. 15%.

Giraldi Company has identified that the cost of a new computer will be $60,000, but with the use of the

new computer, net income will increase by $5,000 a year. If depreciation expense is $3,000 a year, the cash

payback period is:

a. 30 years.

b. 20 years.

c. 12 years.

d. 7.5 years.

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

provided below:

Salvage value 0 0

a. 5%.

b. 10%.

c. 25%.

d. 50%.

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

provided below:

Salvage value 0 0

a. 20 years. b. 10 years.

c. 5 years. d. 4 years.

The rate of return that management expects to pay on all borrowed and equity funds is the

a. cost of capital.

b. cutoff rate.

c. hurdle rate.

d. minimum rate.

BE 174

Lightle Co. is considering investing in new equipment that will cost $900,000 with a 10-year useful life. The new

equipment is expected to produce annual net income of $30,000 over its useful life. Depreciation expense, using

the straight-line rate, is $90,000 per year. Instructions

Compute the cash payback period.

Solution 174 (3 min.)

$900,000 ÷ ($30,000 + $90,000) = 7.5 years

BE 175

Holt Co. is considering investing in a new facility to extract and produce salt. The facility will increase revenues by

$240,000, but will also increase annual expenses by $160,000. The facility will cost $980,000 to build, but will have a

$20,000 salvage value at the end of its 20-year useful life.

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

company’s expected annual income is:

$240,000 – $160,000 = $80,000

$980,000 + $20,000

————————— = $500,000

2

$80,000 ÷ $500,000 = 16%

Ex. 197

Finney Company estimates the following cash flows and depreciation on a project that will cost

$200,000 and will last 10 years with no salvage value:

Revenues

Sales $70,000

Operating expenses

Salary expense $32,000

Depreciation expense 20,000

Miscellaneous expenses 8,000 60,000

Net Income $10,000

Instructions

(a) Calculate the expected annual rate of return on this project showing calculations to support your

answer.

(b) Calculate the cash payback on this project showing calculations to support your answer.

Ans: N/A, SO: 9, Bloom: AP, Difficulty: Medium, Min: 9, AACSB: Analytic, AICPA BB: Resource

Management, AICPA FN: Decision Modeling, AICPA PC: Problem Solving, IMA: Investment

Decisions

(a) Annual rate of return is 10%.

$200,000

Average investment = ———— = $100,000

2

$10,000

Annual rate of return = ———— = 10%

$100,000

Investment $200,000

Annual cash inflow ($10,000 + $20,000) $30,000 Cash

payback = $200,000 ÷ $30,000 = 6.67 years

Ex. 198

Wesley Medical Center is considering purchasing an ultrasound machine for $1,135,000. The machine has a 10-

year life and an estimated salvage value of $40,000. Installation costs and freight charges will be $24,200 and

$800, respectively. The Center uses straight-line depreci-ation.

The medical center estimates that the machine will be used five times a week with the average charge to the

patient for ultrasound of $850. There are $10 in medical supplies and $40 of technician costs for each

procedure performed using the machine.

Instructions

(a) Compute the payback period for the new ultrasound machine.

(b) Compute the annual rate of return for the new machine.

Number of procedures: 52 × 5 = 260

Contribution margin per procedure: $850 – $10 – $40 = $800

Total annual cash flow: 260 × $800 = $208,000

$1,160,000

Cash payback: ————— = 5.6 years

$208,000

Average Investment: —————————— = $600,000

2

$1,160,000 – $40,000

Annual Depreciation: —————————— = $112,000

10 years

$96,000

Average Annual Rate of Return: ———— = 16%

$600,000

Ex. 199

Laramie Service Center just purchased an automobile hoist for $13,000. The hoist has a 5-year life and an

estimated salvage value of $960. Installation costs were $2,900, and freight charges were $740. Laramie uses

straight-line depreciation.

The new hoist will be used to replace mufflers and tires on automobiles. Laramie estimates that the new

hoist will enable his mechanics to replace four extra mufflers per week. Each muffler sells for $65 installed.

The cost of a muffler is $35, and the labor cost to install a muffler is $10.

Instructions

(a) Compute the payback period for the new hoist.

(b) Compute the annual rate of return for the new hoist. (Round to one decimal.)

(a) Cost of hoist: $13,000 + $2,900 + $740 = $18,720.

Net annual cash flow:

Number of extra mufflers: 4 × 52 weeks (a) 208

Contribution margin per muffler ($65 – $35 – $10) (b) $ 20 Total

net annual cash flow: (a) × (b) $4,160

Cash payback = $18,720 ÷ $4,160 = 4.5 years.

depreciation: ($18,720 – $960) ÷ 5 = $3,528. Annual net income:

$4,160 – $3,528 = $632.

Average annual rate of return = $632 ÷ $9,900 = 6.4% (rounded).

Ex. 200

Cepeda Manufacturing Company is considering three new projects, each requiring an equipment investment of

$20,000. Each project will last for 3 years and produce the following cash inflows.

Year AA BB CC

1 $ 7,000 $ 9,500 $11,000

2 9,000 9,500 10,000

3 15,000 9,500 9,000

Total $31,000 $28,500 $30,000

The equipment's salvage value is zero. Cepeda uses straight-line depreciation. Cepeda will not accept any

project with a payback period over 2 years. Cepeda's minimum required rate of return is 12%.

Instructions

(a) Compute each project's payback period, indicating the most desirable project and the least desirable

project using this method. (Round to two decimals.)

(b) Compute the net present value of each project. Does your evaluation change? (Round to nearest

dollar.)

(a)

AA

Annual Net Cumulative Net

Year Cash Flow Cash Flow

1 $ 7,000 $ 7,000

2 9,000 16,000

3 15,000 31,000

$20,000 – $16,000 = $4,000

$4,000 ÷ $15,000 = .27

BB

20,000 ÷ (28,500 ÷ 3) = 2.11 years

CC

Year

1 $11,000 $11,000

2 10,000 21,000

3 9,000 30,000

$20,000 – 11,000 = $9,000

$9,000 ÷ $10,000 = .9

The most desirable project is CC because it has the shortest payback period. The least desirable project is AA

because it has the longest payback period. As indicated, only CC is acceptable because its cash payback is 1.9

years.

Ex. 201

Gantner Company is considering a capital investment of $200,000 in additional productive facilities. The new

machinery is expected to have a useful life of 5 years with no salvage value. Depreciation is by the straight-line

method. During the life of the investment, annual net income and cash inflows are expected to be $18,000 and

$58,000, respectively. Gantner has a 12% cost of capital rate, which is the minimum acceptable rate of return on the

investment.

Instructions

(Round to two decimals.)

(a) Compute (1) the annual rate of return and (2) the cash payback period on the proposed capital

expenditure.

(b) Using the discounted cash flow technique, compute the net present value.

(a) (1) Annual rate of return: $18,000 ÷ [(200,000 + $0) ÷ 2] = 18%

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