MANAGERIAL ACCOUNTING

SECTION 2

STRATEGIC CHOICES AND DECISIONS

CONCEPT REVIEW AND PRACTICE

PROF. H. AMIRASLANI
INSEAD MBA PROGRAMME 23D
ASIA CAMPUS
MARCH-APRIL 2023

(For internal use only – Not for external distribution)

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CONCEPT REVIEW

SESSION 7

1. What are the three main characteristics of relevant cost information?

• Information that is relevant for a decision differs between the decision
options and affects future cash flows
2. Are opportunity costs relevant or irrelevant?
• Always relevant
3. Are sunk costs relevant or irrelevant?
• Always irrelevant
4. Can variable costs be irrelevant?
• Yes, if they do not differ between the decision options (e.g., consider the cost
of burger patties in the Wendy’s Chili case study which were essentially
variable in nature but were deemed as being irrelevant for purposes of by-
product costing)
5. Can fixed costs be relevant?
• Yes, if they differ between the decision options. For example, if a firm has no
excess capacity and needs to incur additional fixed costs to accommodate an
order, the fixed cost incurred for this purpose is a relevant cost. Conversely,
if a strategic choice means that the firm can avoid certain fixed costs, then
they will also be deemed as being relevant costs

SESSION 8

1. What are the three stages in capital investment analysis?

• Investment stage
• Operating stage
• Terminal/divestiture stage
2. What are the relevant cash flows in each of these three stages?
• Net cash outflows from initial investment in equipment, working capital, …
• After-tax net cash inflows from incremental revenues and cost savings
• After-tax proceeds from divestiture; recouping working capital
3. How can you determine whether the outcome of your analysis changes
dramatically with the assumptions that you make?
• Sensitivity/scenario analysis: Change one estimated model input parameter at
a time to see which estimates have the biggest effect on the NPV
• Note that projects need to be systematically monitored: the follow-up on a
capital project to see how the project actually turns out is commonly known as
a post-audit
4. If the tax code allowed companies to use straight line depreciation and
accelerated depreciation, which one should be used?
• Accelerated depreciation because it leads to higher depreciation tax shields in
the earlier years of the projects. Earlier tax shields are more valuable than
later tax shields because of the time value of money
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5. What are the alternative approaches to incorporating ESG (environmental, social,

and governance) factors in capital budgeting decisions?
• Company responses to ESG issues, and specifically to environmental and
social issues, have been diverse. These usually range from a “compliance”
approach, where the focus is merely on ticking the regulatory box, to
integration with strategy. Increasingly, stakeholder pressures, cost
containment, and potential product development opportunities increase the
motivation for companies to address environmental issues proactively. This
was one of the main takeaways from the Moulder Company case study:
should the company adopt the project that leads to mere compliance or
should it opt for the project that goes beyond compliance and signals a shift in
the company’s strategy in relation to environmental considerations?
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RELEVANT COSTS

Question 1.

St. Luke’s Hospital has been hit with a number of complaints about its food service from
patients, employees, and cafeteria customers. These complaints, coupled with a very
tight local labor market, have prompted the organization to contact Nationwide
Institutional Food Service (NIFS) about the possibility of an outsourcing arrangement.
The hospital's business office has provided the following information for food service for
the year just ended: food costs, $890,000; labor, $85,000; variable overhead, $35,000;
allocated fixed overhead, $60,000; and cafeteria net income, $80,000.
Conversations with NIFS personnel revealed the following information:
· NIFS will charge St. Luke’s Hospital $14 per day for each patient served. Note: This
figure has been "marked up" by NIFS to reflect the firm's cost of operating the hospital
cafeteria.
· St. Luke’s 250-bed facility operates throughout the year and typically has an average
occupancy rate of 70%.
· Labor is the primary driver for variable overhead. If an outsourcing agreement is
reached, hospital labor costs will drop by 90%. NIFS plans to use St. Luke’s facilities for
meal preparation.
· Cafeteria net income is expected to increase by 15% because NIFS will offer an
improved menu selection.

Required:
1. What is meant by the term "outsourcing"?
2. Should St. Luke’s outsource its food-service operation to NIFS?
3. What factors, other than dollars, should St. Luke’s consider before making the final
decision?

Solution:
1. Outsourcing is essentially a make-or-buy decision that is, producing a product or
service in-house or purchasing it from an external supplier.
2. The hospital would be better off to outsource its food-service operation, benefiting by
$115,750 ($930,000 - $814,250). Note: The allocated overhead is not a relevant
decision factor.

St. Luke NIFS

Food Cost $890,000 $ ---
Labor ($85,000; $85,000 × 10%) 85,000 8,500
Variable overhead ($35,000; $35,000 × 10%) 35,000 3,500
Cafeteria net income ($80,000; $80,000 × 115%) (80,000) (92,000)
NIFS charges (250 beds × 70% × 365 days × $14) --- 894,250
Net cost $930,000 $814,250

3. Factors to consider would include improvement in food quality, reliability of NIFS,

elimination of labor problems, and data validity in future years.
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Question 2.

Drew Mellow builds custom homes in Miami. Mellow was approached not too long ago
by a client about a potential project, and he submitted a bid of $590,000, derived as
follows:

Land $90,000
Construction materials 120,000
Subcontractor labor costs 150,000
$360,000
Construction overhead: 20% of direct costs 72,000
Allocated corporate overhead 40,000
Total cost $472,000

Mellow adds a 25% profit margin to all jobs, computed on the basis of total cost. In this
client's case the profit margin amounted to $118,000 ($472,000 × 25%), producing a bid
price of $590,000. Assume that 60% of construction overhead is fixed.

Required:
1. Suppose that business is presently very slow, and the client countered with an offer
on this home of $455,000. Should Mellow accept the client's offer? Why?
2. If Mellow has more business than he can handle, how much should he be willing to
accept for the home? Why?
Solution:

Solution:
1. A relevant cost analysis shows that the home is still profitable at $455,000, and the
offer should be accepted. Keep in mind that business is very slow.

Land $90,000
Construction materials 120,000
Subcontractor labor costs 150,000
Variable Construction overhead: $72,000 x 40% 28,800
Total relevant costs $388,800

2. Since demand is very strong, Mellow should hold firm to the $590,000 price. This way
he can cover all of his costs and make his normal 25% profit margin.
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Question 3.

Platinum Manufacturers Inc. (PM), which is located in Canada, is approached by an

Australian customer to fulfill a one-time-only special order. Since the customer
approached PM, fulfilling this order would not require any incremental marketing costs
for PM. The company has excess capacity. The following per unit data apply for sales of
the same product to the company’s regular customers in Canada:
Variable costs:
Direct materials $150
Direct labor $70
Manufacturing support $100
Marketing costs $35
Fixed costs:
Manufacturing support $140
Marketing costs $45
Total costs $540
Markup (50%) $270
Targeted selling price $810

Required:
a) What are the characteristics that determine whether certain costs and revenues
are relevant or irrelevant for decision making?
b) What is the minimum acceptable price of this special order?
c) How would you adapt your analysis if the firm could instead use its excess
capacity to produce a new product?
d) What qualitative considerations should Platinum Manufacturers take into account
when pricing this special order?

Solution:
a) (i) Differential (incremental – varies across the options) and (ii) affects future
cash flows
b) Since the company has excess capacity to fill the order, the relevant cost, and
therefore, the minimum selling price, is the sum of the variable costs:

Direct materials $150

Direct labor $70
Manufacturing support $100
Variable costs $320

c) The contribution margin of that new product would be the opportunity cost for
filling the special order.

d) Would our regular customers find out about us offering a reduced price to one
customer and pressure us to reduce prices across the board? Would it decrease
loyalty of our regular customers?
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Question 4.

Lansing Camera Company has received a special order for photographic equipment it
does not normally produce. The company has excess capacity, and the order could be
manufactured without reducing production of the firm’s regular products. Discuss the
relevance of each of the following items in computing the cost of the special order.

Equipment to be used in producing the order has a book value of $2,000. The equipment
has no other use for Lansing Camera Company. If the order is not accepted, the
equipment will be sold for $1,500. If the equipment is used in producing the order, it can
be sold in three months for $800.

If the special order is accepted, the operation will require some of the storage space in
the company’s plant. If the space is used for this purpose, the company will rent storage
space temporarily in a nearby warehouse at a cost of $18,000. The building depreciation
allocated to the storage space to be used in producing the special order is $12,000.

If the special order is accepted, it will require a subassembly. Lansing Camera can
purchase the subassembly for $24 per unit from an outside supplier or make it for $30
per unit. The $30 cost per unit was determined as follows:

Direct material $10.00

Direct labor 6.00
Variable overhead 6.00
Allocated fixed overhead 8.00
Total unit cost of subassembly $30.00

Solution:

The book value of the equipment is a sunk cost, irrelevant to the decision. The relevant
cost of the equipment is $700, determined as follows:

Sales value of equipment now $1,500

Sales value after producing special order 800
Differential cost $700

The $12,000 portion of building depreciation allocated to the storage space to be used
for the special order is irrelevant. First, it is a sunk cost. Second, any costs relating to the
company’s factory building will continue whether the special order is accepted or not. The
relevant cost is the $18,000 rent that will be incurred only if the special order is accepted.

Lansing Camera should make the subassembly. The subassembly’s relevant cost is $22
per unit ($30.00 - $8.00).
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Relevant Cost of Making Subassembly Relevant Cost of Purchasing Subassembly

(per unit) (per unit)
Direct material $10.00 Purchase price $24.00
Direct labor 6.00
Variable overhead 6.00
Total $22.00

Notice that the unitized fixed overhead, $8, is not a relevant cost of the subassembly.
Lansing Camera Company’s total fixed cost will not change, whether the special order is
accepted or not.
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CAPITAL BUDGETING

Question 1.

Randi Corp. is considering the replacement of some machinery that has zero book
value and a current market value of $2,800. One possible alternative is to invest in new
machinery that costs $30,000. The new equipment has a four-year service life and an
estimated salvage value of $3,500, will produce annual cash operating savings of
$9,400, and will require a $2,200 overhaul in year 3. The company uses straight-line
depreciation.

FV of an PV of an
Year FV of $1 at 8% PV of $1 at 8%
annuity at 8% annuity at 8%
1 1.080 1.000 0.926 0.926
2 1.166 2.080 0.857 1.783
3 1.260 3.246 0.794 2.577
4 1.361 4.506 0.735 3.312
5 1.469 5.867 0.681 3.993
6 1.587 7.336 0.630 4.623

Required:
Prepare a net-present-value analysis of Randi’s replacement decision, assuming an 8% hurdle
rate and no income taxes. Should the machinery be acquired? Note: Round calculations to the
nearest dollar.

Solution:

Purchase of net machine $(30,000) x 1.0 $(30,000)

Sale of old machine $2,800 x 1.0 2,800
Cash operating savings $9,400 x 3.312 31,133
Overhaul $(2,200) x 0.794 (1,747)
Salvage value $3,500 x 0.735 2,573
Total $4,759

The machinery should be acquired because the investment has a positive net present
value.
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Question 2.

At the beginning of the year 2017, Capitol Inc. is considering replacing one of its
machines. Information regarding the old machine and the new machine is provided
below:

Old Machine New Machine

Price at time of purchase 350000 330000
Current market value 200000
Book value in 3 years 0 0
Market value in 3 years 0 50000
Total useful life of machine (in years) 5 3
Age of machine (in years) 2
Remaining useful life of machine (in years) 3 3
Working capital requirement 10000 20000
Annual pre-tax operating cost savings 60000

Both machines have to be straight-line depreciated to a final book value of $0 for tax
and financial accounting purposes. The tax rate for income and capital gains/losses is
40%. Tax effects occur in the same time period as the transactions or cash flows that
cause the tax effects. The company is profitable and can be expected to remain
profitable in the future. Inflation can be neglected. The company’s discount rate for such
investments is 10%. All pre-tax operating cost savings are cash-related. Working capital
is invested when machines are purchased and recovered in full when machines are
sold.

What is the total net cash outflow that Capitol Inc. would incur at the beginning of
the year 2017 if it decided to replace the machine?

Solution:

Cash flow: -330,000 + 200,000 + 10,000 – 20,000 + 40% × [-200,000 + (350,000 – 2 ×

70,000)] = -136,000
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Question 3.

Racer Industries is currently purchasing Part No. 76 from an outside supplier for $80 per
unit. Because of supplier reliability problems, the company is considering producing the
part internally in an idle manufacturing plant. Annual volume over the next six years is
expected to total 300,000 units at variable manufacturing costs of $75 per unit.
Racer must acquire $80,000 of new equipment if it reopens the plant. The equipment
has a six-year service life, a $14,000 salvage value, and will be depreciated by the
straight-line method. Repairs and maintenance are expected to average $5,200 per
year in years 4-6, and the equipment will be sold at the end of its life.

Year FV of $1 at 12% FV of an PV of $1 at 12% PV of an

annuity at 12% annuity at 12%

1 1.120 1.000 0.893 0.893

2 1.254 2.120 0.797 1.690
3 1.405 3.374 0.712 2.402
4 1.574 4.779 0.636 3.037
5 1.762 6.353 0.567 3.605
6 1.974 8.115 0.507 4.111

Required:
Rounding to the nearest dollar, use the net-present-value method (total-cost approach)
and a 12% hurdle rate to determine whether Mark should make or buy Part No. 76.
Ignore income taxes.

Solution:

Racer is better off making Part No. 76.

Buy:
Purchase (300,000 units x $80) $(24,000,000) x 4.111 $ 98,664,000
Make:
Variable manufacturing costs
(300,000 units x $75) $(22,500,000) x 4.111 $(92,497,500)
New Equipment $(80,000) x 1.0 (80,000)
Repairs and maintenance $(5,200) x (4.111 - 2.402) (8,887)
Equipment sale $14,000 x 0.507 7,098
Total $(92,579,289)
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Question 4.

SportsOne operates a chain of fitness centers across the UK. Corporate executives
have realized that in response to lifestyle changes in recent years, the number of
players in the sector has been increasing. This has now become a source of concern
for both shareholders and the firm’s lenders. As a result, they called on the firm’s CFO
to assess options in terms of upgrading the fitness equipment so as to maintain or even
increase the firm’s market share.

During a recent meeting in London, the CFO proposed to replace the existing machines
with a new range that will be designed in Poland and manufactured in China. The
quoted cost for acquiring the machines is £98m, with an expected economic life of 10
years and a disposal value of 10m. The CFO further indicated that the new equipment
would potentially reduce utilities costs by 30% and cut the maintenance cost in half.

A majority of the executives, however, were not convinced and wanted to evaluate the
replacement plan in some more detail. Towards the end of the meeting, one of the
executives proposed that the existing equipment should be retained and used for
another 10 years (after which it will probably have no salvage value). Due to the lack of
consensus on the matter, the CEO proposed that they obtain an independent opinion
from a financial consultant on this matter, after which they could reconvene and discuss
further.

The firm’s accounting records show that the existing machines have a historical cost of
£50m with an accumulated depreciation of £46m. Assessments of the second-hand
market suggests that these machines can be liquidated for £5m. It currently costs
£1.2m per month in utilities and another £10m a year in maintenance to run the centers
across the UK. SportsOne currently charges its customers £10 per hour to use the
fitness centers. Replacing the fitness machines will not affect the price of service or the
number of customers the firm can serve.

In the days following the meeting, you were approached by the firm to evaluate the
situation and offer your expert opinion on the firm’s capital budgeting problem.
Assuming an average tax rate of 40%, a cost of capital of 8%, and straight-line
depreciation over remaining useful life of machines, should the company order the new
fitness equipment?
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Solution:

Partitioning relevant cash flows into categories:

1. Net initial investment cash flows:

- The £98m cost of the new equipment

- The disposal value of the old machine, £5,000,000 is a cash inflow
- The book value of the old machine £4,000,000 (£50m − £46m), relative to the disposal
value of £5,000,000, yields a taxable gain of £1,000,000 (£5m − £4m) that leads to a
cash outflow for taxes of £1,000,000 × Tax Rate

2. Cash flow savings from operations:

- The 30% savings in utilities cost per year of £4,320,000 (30% × £1.2m per month × 12
months) results in cash inflow from operations after tax of £4,320,000 × (1 − Tax Rate)
- The savings of half the maintenance costs per year of £5,000,000 (50% × £10m)
results in a cash inflow from operations after tax of £5,000,000 (1 − Tax Rate)
- Annual depreciation of (£98m − £10m)/10 years = £8,800,000 on the new machines,
relative to the
(£4m − £0)/10 years = £400,000 depreciation on current equipment leads to additional
tax savings of $8,400,000 × Tax Rate

3. Cash flows from terminal disposal of investment:

- The £10,000,000 salvage value of the new equipment minus the $0 salvage value of
the old equipment is a terminal cash flow at the end of Year 10. There are no tax effects
because both machines are planned to be disposed of at book value (i.e., no gains or
losses on disposal).

4. Data not relevant to the capital budgeting decision:

- The £10 charge for customers, since it would not change whether or not the firm
acquires the new machines

- The $50,000,000 original cost of the existing machines (sunk cost)

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Net present value of the investment: Net initial investment (in thousands)

Initial investment in the new equipment £(98,000)

Current disposal value of the old equipment 5,000
Tax on gain on sale of the old equipment (40% × £1m) (400)
Net initial investment £(93,400)

Annual after-tax cash flow from operations (in thousands)

After-tax savings in utilities costs, £4,320 × (1−0.40) £2,592
After-tax savings in maintenance costs, £5,000 × (1−0.40) 3,000
Annual after-tax cash flow from operations £5,592

Tax (cash) savings from annual additional depreciation ($8,800 − $400) × £3,360
40%

After-tax cash flow from terminal disposal of machines £10,000

These four amounts can be combined to determine the NPV at an 8% discount rate.

1. Present value of net initial investment, £(93,400) × 1.000 £(93,400)

2. Present value of 10-year annuity of annual after-tax cash flow from 37,522
operations (excl. depreciation. effects), £5,592 × 6.710
3. Present value of 10-year annuity of income-tax cash savings from 22,546
annual depreciation deductions, £3,360 × 6.710
4. Present value of after-tax cash flow from terminal disposal of machines, 4,630
(£10,000 × 0.463)
Net present value £(28,702)

At a cost of capital of 8%, the net present value of the investment in the new equipment
is substantially negative (£28.7m). The firm should not make the investment.
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MULTIPLE CHOICE QUESTIONS

- Cornerstone, Inc. has $125,000 of inventory that suffered minor smoke damage from a
fire in the warehouse. The company can sell the goods "as is" for $45,000; alternatively,
the goods can be cleaned and shipped to the firm's outlet center at a cost of $23,000.
There the goods could be sold for $80,000. What alternative is more desirable and what
is the relevant cost for that alternative?
(A) Sell "as is," $125,000.
(B) Clean and ship to outlet center, $23,000.
(C) Clean and ship to outlet center, $103,000.
(D) Clean and ship to outlet center, $148,000.
(E) Neither alternative is desirable, as both produce a loss for the firm.
KEY: (B)
- In early July, Colin Marks purchased a $70 ticket to the December 15 game of the
Chicago Bears. Parking for the game was expected to cost approximately $22, and
Marks would probably spend another $15 for a souvenir program and food. It is now
December 14. The Bears were having a miserable season and the temperature was
expected to peak at 5 degrees on game day. Marks therefore decided to skip the game
and took his wife to the movies, with tickets and dinner costing $50. The sunk cost
associated with this decision situation is:
(A) $20. (B) $50. (C) $70. (D) $107. (E) None of the answers is correct.
KEY: (C)
- A special order “generally” should be accepted if:
(A) its revenue exceeds allocated fixed costs, regardless of the variable costs
associated with the order.
(B) the revenue exceeds variable costs, regardless of available capacity.
(C) excess capacity exists and the revenue exceeds allocated fixed costs.
(D) the revenue exceeds total costs, regardless of available capacity.
(E) excess capacity exists and the revenue exceeds all variable costs associated with
the order.
KEY: (E)
- McAlister Company is operating at capacity and desires to add a new service to its
expanding business. The service should be added as long as service revenues exceed:
(A) variable costs.
(B) fixed costs.
(C) the sum of variable costs and fixed costs.
(D) the sum of variable costs and any related opportunity costs.
(E) the sum of variable costs, fixed costs, and any related opportunity costs.
KEY: (D)
 15

- Two months ago, Air-tite Corp. purchased 4,500 pounds of Hydrol, paying $15,300.
Demand for this product has been strong since the acquisition, with the market price
jumping to $4.05 per pound. (Air-tite can buy or sell Hydrol at this price.) The company
recently received a special-order inquiry, one that would require the use of 4,200
pounds of Hydrol. Which of the following is (are) relevant in deciding whether to accept
the special order?
(A) The $3.40 purchase price. (D) 4,500 pounds of Hydrol.
(B) The $4.05 market price. (E) Two or more factors are relevant.
(C) The 300-pound inventory of Hydrol.
KEY: (B)
- Flavor Enterprises has been approached about providing a new service to its clients.
The company will bill clients $140 per hour; the related hourly variable and fixed
operating costs will be $75 and $18, respectively. If all employees are currently working
at full capacity on other client matters, the per-hour opportunity cost of being unable to
provide this new service is:
(A) $0. (B) $47. (C) $65. (D) $93. (E) $140.
KEY: (C)
Brilliant, Inc. reported the following results from the sale of 24,000 units of IT-54:
Sales $528,000
Variable manufacturing costs 288,000
Fixed manufacturing costs 120,000
Variable selling costs 52,800
Fixed administrative costs 35,200
Extra Company has offered to purchase 3,000 IT-54s at $16 each. Brilliant has
available capacity, and the president is in favor of accepting the order. She feels it
would be profitable because no variable selling costs will be incurred. The plant
manager is opposed because the "full cost" of production is $17. Which of the following
correctly notes the change in income if the special order is accepted?
(A) $3,000 decrease. (D) $12,000 increase.
(B) $3,000 increase. (E) None of the answers is correct.
(C) $12,000 decrease.
KEY: (D)
- Which of the following statements regarding costs and decision making is correct?
(A) Fixed costs must be considered only on a per-unit basis.
(B) Per-unit fixed cost amounts are valid only for make-or-buy decisions.
(C) Per-unit fixed costs can be misleading because such amounts appear to behave as
variable costs when, in actuality, the amounts are related to fixed expenditures.
(D) Sunk costs can be misleading in make-or-buy decisions because these amounts
appear to be relevant differential costs.
(E) Opportunity costs should be ignored when evaluating decision alternatives.
KEY: (C)
 16

- A company that is operating at full capacity should emphasize those products and
services that have the:
(A) lowest total per-unit costs.
(B) highest contribution margin per unit.
(C) highest contribution margin per unit of scarce resource.
(D) highest operating income.
(E) highest sales volume.
KEY: (C)
- A company has been asked to quote a price for a job that must be completed within a
week. The job requires 100 skilled labor hours and 50 unskilled labor hours. The current
employees are paid a guaranteed minimum wage of $525 for skilled workers and $280
for unskilled workers for a 35-hour week. Currently, skilled and unskilled labor have
spare capacity of 75 and 100 labor hours each week, respectively. Additional workers
can be employed and paid by the hour at rates based on the wages paid to current
workers. What is the relevant labor cost of this job?
(A) $0. (B) $375. (C) $775. (D) $1,540. (E) None of the above
KEY: (B)
- A company has been asked to provide a quote for a job. The company aims to make a
profit of 30% on all sales. The estimated cost for the job is as follows: Direct materials of
10 kg at £10 per kg, Direct labor of 20 hours at £5 per hour. Variable production
overheads are allocated at the rate of £2 per labor hour. Fixed production overheads for
the company are budgeted to be £100,000 each year and are allocated on the basis of
labor hours. There are 10,000 budgeted labor hours each year. Other costs in relation
to selling, distribution and administration are allocated at the rate of £50 per job. The
company’s quote for the job should be:
(A) £572. (B) £637. (C) £700. (D) £833. (E) £490.
KEY: (C)
- The Hackney division of GB Enterprises currently performs computer services for
various departments of the firm. One of the services has created a number of operating
problems, and divisional managers are exploring whether to outsource the service to a
consultant. Traceable variable and fixed operating costs total £80,000 and £25,000,
respectively, in addition to £18,000 of corporate administrative overhead allocated from
GB. If Hackney were to use the outside consultant, fixed operating costs would be
reduced by 70%. The irrelevant costs in Hackney’s outsourcing decision total:
(A) £17,500 (B) £25,500 (C) £18,000 (D) £43,000 (E) £25,000
KEY: (B)
 17

- Which of the following choices correctly states the rules for project acceptance under
the net-present-value method and the internal-rate-of-return method?
Net Present Value Internal Rate of Return
(A) Positive total Greater than hurdle rate
(B) Positive total Less than hurdle rate
(C) Negative total Greater than hurdle rate
(D) Negative total Less than hurdle rate
(E) Greater than hurdle rate Positive number
KEY: (A)
- A company that is using the internal rate of return (IRR) to evaluate projects should
accept a project if the IRR:
(A) is greater than the project's net present value.
(B) equates the present value of the project's cash inflows with the present value of the
project's cash outflows.
(C) is greater than zero.
(D) is greater than the hurdle rate.
(E) is less than the firm's cost of investment capital.
KEY: (D)
- Higgins & Co. plans to incur $350,000 of salaries expense if a capital project is
implemented. Assuming a 30% tax rate, the salaries should be reflected in the analysis
by a:
(A) $105,000 inflow. (B) $105,000 outflow.
(C) $245,000 inflow. (D) $245,000 outflow.
(E) $350,000 outflow.
KEY: (D)
- If income taxes are ignored, which of the following choices correctly notes how a
project's depreciation is treated under the net-present-value method and the internal-
rate-of-return method?
Net Present Value Internal Rate of Return
(A) Considered Considered
(B) Considered Ignored
(C) Ignored Considered
(D) Ignored Ignored
(E) The correct answer depends on the depreciation
method (straight line or accelerated) that is used.
KEY: (D)
 18

- Carlin Company, which uses net present value to analyze investments, requires a 10%
minimum rate of return. A management accounting assistant recently calculated a
$500,000 machine's net present value to be $86,400, excluding the impact of straight-
line depreciation.
FV of 1 (i=10%, n=5): 1.611
FV of a series of $1 cash flows (i=10%, n=5): 6.105
PV of $1 (i=10%; n = 5): 0.621
PV of a series of $1 cash flows (i=10%, n=5): 3.791
If Carlin ignores income taxes and the machine is expected to have a five-year service
life, the correct net present value of the machine would be:
(A) $(13,600). (D) $292,700.
(B) $86,400. (E) $465,500.
(C) $186,400.
KEY: (B) Nothing to calculate here – the answer has already been given to you.
- Twilight Corporation will evaluate a potential investment in an advanced manufacturing
system by use of the net-present-value (NPV) method. Which of the following system
benefits is least likely to be omitted from the NPV analysis?
(A) Savings in operating costs.
(B) Greater flexibility in the production process.
(C) Improved product quality.
(D) Shorter manufacturing cycle time.
(E) Ability to fill customer orders more quickly.
KEY: (A)
- A new asset is expected to provide service over the next four years. It will cost
$500,000, generates annual cash inflows of $150,000, and requires cash operating
expenses of $30,000 each year. In addition, a $10,000 overhaul will be needed in year
3.
Period FV of $1 FV of a series of $1 PV of $1 PV of a series of $1
(i=10%) cash flows (i=10%) (i=10%) cash flows (i=10%)
1 1.100 1.000 0.909 0.909
2 1.210 2.100 0.826 1.736
3 1.331 3.310 0.751 2.487
4 1.464 4.641 0.683 3.170
If the company requires a 10% rate of return, the net present value of this machine
would be:
(A) $(127,110), and the machine meets the company's rate-of-return requirement.
(B) $(129,600), and the machine does not meet the company's rate-of-return
requirement.
(C) $(127,110), and the machine does not meet the company's rate-of-return
requirement.
(D) $(151,700), and the machine meets the company's rate-of-return requirement.
(E) None of the answers is correct.
 19

(C) ($150,000 - $30,000) x 3.170 = $380,400; $380,400 - $500,000= $(119,600)

$(119,600) + ($10,000 x 0.751)= $(127,110); as a negative amount, it does not meet the
company’s rate of return requirement.
- The mayor of Trenton is considering the purchase of a new computer system for the
city's tax department. The system costs $75,000 and has an expected life of five years.
The mayor estimates the following savings will result if the system is purchased:
Period Savings PV of $1 at 10% PV of an annuity at 10%
1 $20,000 0.909 0.909
2 25,000 0.826 1.736
3 30,000 0.751 2.487
4 15,000 0.683 3.170
5 12,000 0.621 3.791
If Trenton uses a 10% discount rate for capital-budgeting decisions, the net present
value of the computer system would be:
(A) $489. (B) $4,057. (C) $11,658. (D) $63,342. (E) $79,057.
KEY: (B) [($20,000 x 0.909) + ($25,000 x 0.826) + ($30,000 x 0.751) + ($15,000 x
0.683) + ($12,000 x 0.621)] - $75,000 = $4,057.
- Bowers Company plans to incur $190,000 of salaries expense and produce $320,000
of additional sales revenue if a capital project is implemented. Assuming a 30% tax rate,
these two items collectively should appear in a capital budgeting analysis as:
(A) a $39,000 inflow. (B) a $39,000 outflow.
(C) a $91,000 inflow. (D) a $91,000 outflow.
(E) None of the answers is correct.
KEY: (C)
- Dapper Company received $7,000 cash from the sale of a machine that had an
$11,000 book value. If the company is subject to a 30% income tax rate, the net cash
flow to use in a discounted-cash-flow analysis would be:
(A) $2,100. (B) $4,900. (C) $5,800. (D) $7,000. (E) $8,200.
KEY: (E)