DEVRY UNIVERSITY, KELLER GRADUATE

SCHOOL OF MANAGEMENT - BUSN 278FINALS2

CHAPTER 12
PLANNING FOR CAPITAL INVESTMENTS

SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOM’S TAXONOMY

Brief Exercises

CHAPTER STUDY OBJECTIVES

1. Discuss the capital budgeting evaluation process, and explain what inputs are used in
capital budgeting. Answers available at https://bit.ly/2X8N9zd
2. Describe the cash payback technique.
3. Explain the net present value method.. Answers available at https://bit.ly/2X8N9zd
4. Identify the challenges presented by intangible benefits in capital budgeting.
5. Describe the profitability index.
6. Indicate the benefits of performing a post-audit.
7. Explain the internal rate of return method. Answers available at https://bit.ly/2X8N9zd
8. Describe the annual rate of return method.

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. Answers available at https://bit.ly/2X8N9zd

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 computed 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. Answers available at https://bit.ly/2X8N9zd

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 stock.
12-2 Test Bank for Managerial Accounting, Third Edition

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 financially beneficial to the company. Answers available at
https://bit.ly/2X8N9zd

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. Answers available at https://bit.ly/2X8N9zd

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. Answers available at https://bit.ly/2X8N9zd

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. Answers available at https://bit.ly/2X8N9zd
 Planning for Capital Investments 12-3

25. An advantage of the annual rate of return method is that it relies on accrual accounting
numbers rather than actual cash flows.

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. stockholders.

27. All of the following are involved in the capital budgeting evaluation process except a
company's
a. board of directors.
b. capital budgeting committee.
c. officers.
d. stockholders. Answers available at https://bit.ly/2X8N9zd

28. Most of the capital budgeting methods use

a. accrual accounting numbers.
b. cash flow numbers.
c. net income.
d. accrual accounting revenues.

29. The first step in the capital budgeting evaluation process is to

a. request proposals for projects.
b. screen proposals by a capital budgeting committee.
c. determine which projects are worthy of funding.
d. approve the capital budget.

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. Answers available at https://bit.ly/2X8N9zd

31. Capital budgeting is the process

a. used in sell or process further decisions.
b. of determining how much capital stock to issue.
c. of making capital expenditure decisions.
d. of eliminating unprofitable product lines.

32. If an asset costs $70,000 and is expected to have a $10,000 salvage value at the end of
its ten-year life, and generates annual net cash inflows of $10,000 each year, the cash
payback period is
a. 8 years.
b. 7 years.
c. 6 years.
d. 5 years. Answers available at https://bit.ly/2X8N9zd

33. If a payback period for a project is greater than its expected useful life, the
a. project will always be profitable.
12-4 Test Bank for Managerial Accounting, Third Edition

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 compute and understand.
d. considers the expected profitability of a project.

35. The cash payback period is computed 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. Answers available at https://bit.ly/2X8N9zd

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. Answers available at https://bit.ly/2X8N9zd

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.
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. Answers available at https://bit.ly/2X8N9zd

40. The rate that a company must pay to obtain funds from creditors and stockholders is
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.
 Planning for Capital Investments 12-5

c. higher the cost of capital. Answers available at https://bit.ly/2X8N9zd

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. Answers available at https://bit.ly/2X8N9zd

44. The primary capital budgeting method that uses discounted cash flow techniques is the
a. net present value method.
b. cash payback technique.
c. annual rate of return method.
d. profitability index method.

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. Answers available at https://bit.ly/2X8N9zd

46. A company's cost of capital refers to the

a. rate the company must pay to obtain funds from creditors and stockholders.
b. total cost of a capital project.
c. cost of printing and registering common stock shares.
d. rate of return earned on common stock.

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. Answers available at https://bit.ly/2X8N9zd

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 company’s cost of capital.
12-6 Test Bank for Managerial Accounting, Third Edition

49. To avoid rejecting projects that actually should be accepted,

1. intangible benefits should be ignored.
2. conservative estimates of the intangible benefits' value should be incorporated
into the NPV calculation.
3. 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.
a. 1
b. 2 Answers available at https://bit.ly/2X8N9zd
c. 3
d. both 2 and 3 are correct.

50. 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.

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. Answers available at https://bit.ly/2X8N9zd

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 computed 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. Answers available at https://bit.ly/2X8N9zd
 Planning for Capital Investments 12-7

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. Answers available at https://bit.ly/2X8N9zd

58. The following information is available for a potential investment for Panda Company:
Initial investment $40,000
Net annual cash inflow 10,000
Net present value 18,112
Salvage value 5,000
Useful life 10 yrs.
The potential investment’s 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 CPA.
Answers available at https://bit.ly/2X8N9zd
12-8 Test Bank for Managerial Accounting, Third Edition

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.
b. it provides a formal mechanism by which the company can determine whether existing
projects should be terminated.
c. it improves the development of future investment proposals because managers
improve their estimation techniques by evaluating their past successes and failures.
d. all of these. Answers available at https://bit.ly/2X8N9zd

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 stockholders' 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 $12,000. The initial investment in the project must
have been
a. $12,000.
b. $3,000.
c. $48,000.
d. $24,000.

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.
 Planning for Capital Investments 12-9

Use the following table for questions 69–72.

Present Value of an Annuity of 1

Periods 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487

69. A company has a minimum required rate of return of 9% and is considering investing in a
project that costs $140,000 and is expected to generate cash inflows of $56,000 at the
end of each year for three years. The net present value of this project is
a. $141,736.
b. $28,000.
c. $14,174.
d. $1,736.

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 $68,337 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. 9%.
c. 10%.
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 $70,000 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. $70,000.
b. $74,610.
c. $82,070.
d. $4,610
12-10 Test Bank for Managerial Accounting, Third Edition

Use the following information for questions 73–76.

Carr Company is considering two capital investment proposals. Estimates regarding each project
are provided below:
Project Soup Project Nuts
Initial investment $400,000 $600,000
Annual net income 20,000 42,000
Net annual cash inflow 100,000 142,000
Estimated useful life 5 years 6 years
Salvage value -0- -0-

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

Present Value of an Annuity of 1

Periods 9% 10% 11% 12%
5 3.890 3.791 3.696 3.605
6 4.486 4.355 4.231 4.111

73. The cash payback period for Project Soup is

a. 20 years.
b. 10 years.
c. 5 years.
d. 4 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. 5%.
b. 10%.
c. 25%.
d. 50%.

76. The internal rate of return for Project Nuts is approximately

a. 10%.
b. 11%.
c. 12%.
d. 9%.
Answers available at https://bit.ly/2X8N9zd
 Planning for Capital Investments 12-11

Use the following information for questions 77 and 78.

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.

77. 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%.

78. The cash payback period on the equipment is

a. 13.3 years.
b. 8.0 years.
c. 6.2 years.
d. 3.1 years.

79. The capital budgeting technique that indicates the profitability of a capital expenditure is
the
a. profitability index method.
b. net present value method.
c. internal rate of return method.
d. annual rate of return method.

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. Disadvantages of the annual rate of return method include all of the following except that
a. it relies on accrual accounting numbers instead of actual cash flows.
b. it does not consider the time value of money.
c. no consideration is given as to when the cash inflows occur.
d. management is unfamiliar with the information used in the computation.

82. A company projects an increase in net income of $60,000 each year for the next five
years if it invests $300,000 in new equipment. The equipment has a five-year life and an
estimated salvage value of $100,000. What is the annual rate of return on this
investment?
a. 20%
b. 30%
c. 25%
d. 50% Answers available at https://bit.ly/2X8N9zd

83. Colaw Company is considering buying equipment for $80,000 with a useful life of five
years and an estimated salvage value of $4,000. If annual expected income is $7,000, the
denominator in computing the annual rate of return is
a. $80,000.
b. $40,000.
12-12 Test Bank for Managerial Accounting, Third Edition

c. $42,000.
d. $84,000.

84. The annual rate of return is computed by dividing expected annual

a. cash inflows by average investment.
b. net income by average investment.
c. cash inflows by original investment.
d. net income by original investment.

85. 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 management’s minimum rate of return.

86. Rod 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 $160,000 in each of the 2 years,
respectively. Rod requires an internal rate of return of 15%. What is the maximum
amount that Rod should invest immediately in Project Jelly?

Present Value of 1 Future Value of 1

Period 15% Period 15%
1 .870 1 1.150
2 .756 2 1.323

a. $163,340
b. $207,960
c. $260,000
d. $326,680

87. Vault Company wants to purchase an asset with a 3-year useful life, which is expected to
produce cash inflows of $15,000 each year for two years, and $10,000 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
2 .77
3 .67
a. $29,800
b. $30,400 Answers available at https://bit.ly/2X8N9zd
c. $31,450
d. $34,750

88. Doris 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 payback period is
a. 4.0 years
b. 4.5 years
 Planning for Capital Investments 12-13

c. 5.0 years
d. 10.0 years

89. Tammy Co. is considering purchasing a machine that will produce annual savings of
$24,600 at the end of the year. Tammy requires a 12% rate of return and the asset has a
5-year useful life. How much should Tammy agree to pay for this machine?

Present Value of Annuity of 1 Present Value of 1

Period 12% Period 12%
5 3.605 5 .567

a. $43,386
b. $88,683
c. $123,000
d. $69,741

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 $225,000 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. 4.44 years Answers available at https://bit.ly/2X8N9zd
c. 2.67 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 straight-
line 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?

Present Value of an Annuity of 1

Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784

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

92. 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 straight-
line 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

Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784

a. $13,800
12-14 Test Bank for Managerial Accounting, Third Edition

b. $1,792
c. $886
d. $2,748
93. 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 straight-
line 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?

Present Value of an Annuity of 1

Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784

a. 1.23
b. 1.03
c. 1.06
d. .73

Answers to Multiple Choice Questions

BRIEF EXERCISES
Ex. 94

Diamond 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 payback period. Answers available at https://bit.ly/2X8N9zd

Solution 94 (5 min.)

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

Ex. 95

Madeline Company is proposing to spend $140,000 to purchase a machine that will provide
annual cash flows of $25,000. The appropriate present value factor for 10 periods is 5.65.

Instructions
Compute the proposed investment’s net present value, and indicate whether the investment
should be made by Madeline Company.

Ex. 96

LakeFront Co. is considering investing in a new dock that will cost $280,000. The company
expects to use the dock for 5 years, after which it will be sold for $150,000 at that time.
 Planning for Capital Investments 12-15

LakeFront anticipates cash flows of $50,000 resulting from the new dock and the company’s
borrowing rate is 8%, while its cost of capital is 10%.

Instructions
Calculate the net present value of the dock and indicate whether LakeFront should make the
investment.

Ex. 97

Mobil Co. has hired a consultant to propose a way to increase the company’s revenues. The
consultant has evaluated two mutually exclusive projects with the following information provided
for each project:

Project Turtle Project Snake

Capital investment $790,000 $440,000
Annual cash flows 140,000 80,000
Estimated useful life 10 years 10 years

Mobil Co. uses a discount rate of 9% 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 Mobil accept?

Ex. 98

An investment costing $90,000 is being contemplated by Mint Co. The investment will have a life
of 8 years with no salvage value and will produce annual cash flows of $16,870.

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

Ex. 99

Salt 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.

Instructions
Calculate the annual rate of return on this facility.
12-16 Test Bank for Managerial Accounting, Third Edition

EXERCISES
Ex. 100
Corn Doggy, Inc. produces and sells corn dogs. The corn dogs are made by hand. Austin Beagle,
production manager, is considering purchasing a machine that will make the corn dogs. Austin
has shopped for machines and found that the machine he wants will cost $262,000. In addition,
Austin estimates that the new machine will increase the company’s annual net cash inflows by
$42,400. The machine will have a 12-year useful life and no salvage value.

Instructions
(a) Calculate the cash payback period.
(b) Calculate the machine’s internal rate of return.
(c) Calculate the machine’s net present value using a discount rate of 10%.
(d) Assuming Corn Doggy Inc.’s cost of capital is 10%, is the investment acceptable? Why or
why not?

Ex. 101
Top Growth Farms, a farming cooperative, is considering purchasing an tractor for $475,000. The
machine has a 10-year life and an estimated salvage value of $27,500. Delivery costs and set-up
charges will be $12,100 and $400, respectively. Top Growth uses straight-line depreciation.

Top Growth estimates that the tractor will be used five times a week with the average charge to
the individual farmers of $400. Gas is $25 for each use of the tractor. The present value of an
annuity of 1 for 10 years at 9% is 6.418.

Instructions
For the new tractor, compute the:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.

$257,500

Ex. 102
Mimi Company is considering a capital investment of $240,000 in new equipment. The equipment
is expected to have a 5-year useful life with no salvage value. Depreciation is computed by the
straight-line method. During the life of the investment, annual net income and cash inflows are
expected to be $30,000 and $78,000, respectively. Mimi's minimum required rate of return is
10%. The present value of 1 for 5 periods at 10% is .621 and the present value of an annuity of 1
for 5 periods at 10% is 3.791.

Instructions
Compute each of the following:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.
 Planning for Capital Investments 12-17

Ex. 103
Savanna Company is considering two capital investment proposals. Relevant data on each
project are as follows:
Project Red Project Blue
Capital investment $400,000 $560,000
Annual net income 30,000 50,000
Estimated useful life 8 years 8 years

Depreciation is computed by the straight-line method with no salvage value. Savanna requires
an 8% rate of return on all new investments. The present value of 1 for 8 periods at 8% is .540
and the present value of an annuity of 1 for 8 periods is 5.747.

Instructions
(a) Compute the cash payback period for each project.
(b) Compute the net present value for each project.
(c) Compute the annual rate of return for each project.
(d) Which project should Savanna select?

Answers available at https://bit.ly/2X8N9zd

Ex. 104
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 $630,000. Both the facility and the equipment will be depreciated
over 12 years using the straight-line method and are expected to have zero salvage values. His
required rate of return is 13% (present value factor of 5.9176). Estimated annual net income and
cash flows are as follows:
Revenue $329,000
Less:
Utility cost 40,000
Supplies 8,000
Labor 126,000
Depreciation 52,500
Other 38,500 265,000
Net income $64,000

Instructions
For this investment, calculate:
(a) The net present value.
(b) The internal rate of return.
(c) The cash payback period.
12-18 Test Bank for Managerial Accounting, Third Edition

Ex. 105
Vista Company is considering two new projects, each requiring an equipment investment of
$90,000. Each project will last for three years and produce the following cash inflows:

Year Cool Hot

1 $38,000 $42,000
2 42,000 42,000
3 48,000 42,000
$128,000 $126,000

The equipment will have no salvage value at the end of its three-year life. Vista Company uses
straight-line depreciation, and requires a minimum rate of return of 12%.

Present value data are as follows:

Answers available at https://bit.ly/2X8N9zd
Present Value of 1
Period 12%
1 .893
2 .797
3 .712
Present Value of an Annuity of 1
Period 12%
1 .893
2 1.690
3 2.402

Instructions
(a) Compute the net present value of each project.
(b) Compute the profitability index of each project.
(c) Which project should be selected? Why?

Ex. 106
Santana Company is considering investing in a project that will cost $73,000 and have no salvage
value at the end of its 5-year life. It is estimated that the project will generate annual cash inflows
of $20,000 each year. The company requires a 10% rate of return and uses the following
compound interest table:

Present Value of an Annuity of 1

Period 6% 8% 9% 10% 11% 12% 15%
5 4.212 3.993 3.890 3.791 3.696 3.605 3.352

Instructions
(a) Compute (1) the net present value and (2) the profitability index of the project.
(b) Compute the internal rate of return on this project.
(c) Should Santana invest in this project?

Instructions
(a) Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for
each machine.
(b) Which machine should be purchased?
 Planning for Capital Investments 12-19

Ex. 108
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
computed 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) Compute 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.

Ex. 109 Answers available at https://bit.ly/2X8N9zd

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.

Ex. 110
Sophie’s 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 $25,000

Annual net cash flows 4,300
Salvage value 3,000
Estimated useful life 8 years
Cost of capital 10%
Present value of an annuity of 1 5.335
Present value of 1 .467
12-20 Test Bank for Managerial Accounting, Third Edition

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.

Ex. 110 (cont.)

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.

Ex. 111
Schilling Corp. is thinking about opening a baseball camp in Florida. 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 Florida have enjoyed a
steady increase in value. It is expected that after using the facility for 20 years, Schilling 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
Ex. 111 (cont.)
Instructions
(a) Calculate the net present value of the project.
(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.
 Planning for Capital Investments 12-21

ANSWERS AVAILABLE AT HTTPS://BIT.LY/2X8N9ZD

12-22 Test Bank for Managerial Accounting, Third Edition

COMPLETION STATEMENTS

112. For purposes of capital budgeting, estimated ____________ and outflows are preferred
for inputs into the capital budgeting decision tools.

113. The technique which identifies the time period required to recover the cost of the
investment is called the ________________ method.

114. The two discounted cash flow techniques used in capital budgeting are (1) the
_______________________ method and (2) the ______________________ method.

115. Under the net present value method, the interest rate to be used in discounting the future
cash inflows is the ________________.

116. In using the net present value approach, a project is acceptable if the project's net present
value is ____________ or_______________.

117. A project’s ________________, such as increased quality or safety, are often incorrectly
ignored in capital budgeting decisions.

118. The _______________ is a method of comparing alternative projects that takes into
account both the size of the investment and its discounted future cash flows.

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

investment projects after their completion.

120. The internal rate of return method differs from the net present value method in that it
results in finding the ___________________ of the potential investment.

121. A major limitation of the annual rate of return approach is that it does not consider the
_______________ of money.
 Planning for Capital Investments 12-23

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

A. Profitability index E. Annual rate of return method

B. Internal rate of return method F. Cash payback technique
C. Discounted cash flow techniques G. Cost of capital
D. Capital budgeting H. 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.

12-24 Test Bank for Managerial Accounting, Third Edition

SHORT-ANSWER ESSAY QUESTIONS

S-A E 123
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.

S-A E 124 (Ethics)

Sam Stanton is on the capital budgeting committee for his company, Canton 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 on 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 124
1. The stakeholders include:
Ed Rhodes
Canton 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.

S-A E 125 (Communication)

You are the general accountant for Word Systems, Inc., a typing service based in Los Angeles,
California. The company has decided to upgrade its equipment. It currently has a widely used
version of a word processing program. The company wishes to invest in more up-to-date
software and to improve its printing capabilities.
 Planning for Capital Investments 12-25

Two options have emerged. Option #1 is for the company to keep its existing computer system,
and upgrade its word processing program. The memory of each individual work station would be
enhanced, and a larger, more efficient printer would be used. Better telecommunications
equipment would allow for the electronic transmission of some documents as well.

Option #2 would be for the company to invest in an entirely different computer system. The
software for this system is extremely impressive, and it comes with individual laser printers.
However, the company is not well known, and the software does not connect well with well-known
software. The net present value information for these options follows:

Option #1 Option #2
Initial Investment ($95,000) ($270,000)
Returns Year 1 55,000 90,000
Year 2 30,000 90,000
Year 3 10,000 90,000
Net present value 0 0

Required:
Prepare a brief report for management in which you make a recommendation for one system or
the other, using the information given.