Chapter 14 Capital Budgeting Decisions True/False Questions When cash flows are uneven and vary from year to year, the internal rate of return method is easier to use than the net present value method Ans: False AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Hard For capital budgeting decisions, the net present value method is superior to the simple rate of return method Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,6 Level: Easy Depreciation is included as a cash flow in capital budgeting decisions to ensure that the original cost of the asset is fully recovered Ans: False AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Medium Even when done properly, the total-cost and incremental-cost approaches to choosing between alternatives will sometimes yield different answers Ans: False AACSB: Analytic AICPA FN: Reporting LO: AICPA BB: Critical Thinking Level: Medium An increase in the expected salvage value at the end of a capital budgeting project will have no effect on the internal rate of return for that project Ans: False AACSB: Analytic AICPA FN: Reporting LO: AICPA BB: Critical Thinking Level: Medium The intangible benefits of automation cannot be estimated with any accuracy and therefore should be ignored in capital budgeting decisions Ans: False AACSB: Analytic AICPA FN: Reporting LO: AICPA BB: Critical Thinking Level: Medium When making preference decisions about competing investment proposals, the project profitability index is superior to the internal rate of return Ans: True AACSB: Analytic AICPA FN: Reporting LO: AICPA BB: Critical Thinking Level: Medium Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition 14-7 Chapter 14 Capital Budgeting Decisions The project profitability index is computed by dividing the net present value of the project by the investment required by the project Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Easy In calculating the “investment required” for the project profitability index, the amount invested should be reduced by any salvage recovered from the sale of old equipment Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Medium 10 The payback method is most appropriate for projects whose cash flows extend far into the future Ans: False AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Medium 11 When using the payback method, any cash flows for a project that occur after the payback period are not considered in computing the payback period for that project Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Medium 12 The present value of a given future cash flow will increase as the discount rate decreases Ans: False AACSB: Analytic AICPA FN: Reporting LO: AICPA BB: Critical Thinking Level: Medium 13 If a company is operating at a profit, the cash inflow resulting from the depreciation tax shield is computed by multiplying the depreciation deduction by one minus the tax rate Ans: False AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: Level: Medium 14 All cash inflows are taxable Ans: False AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: Level: Easy 14-8 Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 15 The after-tax benefit, or net cash inflow, realized from a particular taxable cash receipt can be obtained by multiplying the cash receipt by one minus the tax rate Ans: True AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: Level: Easy Multiple Choice Questions 16 Suture Corporation's discount rate is 12% If Suture has a 5-year investment project that has a project profitability index of zero, this means that: A) the net present value of the project is equal to zero B) the internal rate of return of the project is equal to the discount rate C) the payback period of the project is equal to the project's useful life D) both A and B above are true Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2,4,5 Level: Hard 17 Amster Corporation has not yet decided on the required rate of return to use in its capital budgeting This lack of information will prevent Amster from calculating a project's: A) B) C) D) Payback Net Present Value Internal Rate of Return No No No Yes Yes Yes No Yes Yes No Yes No Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2,5 Level: Medium Source: CMA, adapted 18 If income taxes are ignored, how is depreciation used in the following capital budgeting techniques? A) B) C) D) Internal Rate of Return Net Present Value Excluded Excluded Excluded Included Included Excluded Included Included Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Medium Source: CPA, adapted Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition 14-9 Chapter 14 Capital Budgeting Decisions 19 If the net present value of a project is zero based on a discount rate of 16%, then the internal rate of return is: A) equal to 16% B) less than 16% C) greater than 16% D) cannot be determined from this data Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Medium 20 Three potential investment projects (A, B, and C) at Nit Corporation all require the same initial investment, have the same useful life (3 years), and have no expected salvage value Expected net cash inflows from these three projects each year is as follows: A B C Year $1,000 $2,000 $3,000 Year $2,000 $2,000 $2,000 Year $3,000 $2,000 $1,000 What can be determined from the information provided above? A) the net present value of project C will be the highest B) the internal rate of return of projects A and C cannot be computed C) the net present value and the internal rate of return will be the same for all three projects D) both A and B above Ans: A AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Hard 21 A project's net present value, ignoring income taxes, is affected by: A) the net book value of an asset that is replaced B) the depreciation on an asset that is replaced C) the depreciation to be taken on assets used directly on the project D) proceeds from the sale of an asset that is replaced Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Easy Source: CPA, adapted 14-10 Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 22 A company has unlimited funds to invest at its discount rate The company should invest in all projects having: A) an internal rate of return greater than zero B) a net present value greater than zero C) a simple rate of return greater than the discount rate D) a payback period less than the project's estimated life Ans: B AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Easy Source: CMA, adapted 23 When the cash flows are the same every period after the initial investment in a project, the payback period is equal to: A) the net present value B) the simple rate of return C) the factor of the internal rate of return D) the payback rate of return Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 2,5 Level: Hard Source: CMA, adapted 24 The internal rate of return method assumes that a project's cash flows are reinvested at the: A) internal rate of return B) simple rate of return C) required rate of return D) payback rate of return Ans: A AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Medium Source: CMA, adapted 25 (Ignore income taxes in this problem.) Which of the following would be used in the calculation of the internal rate of return of an investment in new machinery to replace old machinery? A) The annual depreciation expense on the new machinery B) The cost of an overhaul that would be needed on the old machinery in three years C) The salvage value of the old machinery in ten years D) both B and C above Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Medium Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition 14-11 Chapter 14 Capital Budgeting Decisions 26 The project profitability index and the internal rate of return: A) will always result in the same preference ranking for investment projects B) will sometimes result in different preference rankings for investment projects C) are less dependable than the payback method in ranking investment projects D) are less dependable than net present value in ranking investment projects Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 4,5 Level: Medium 27 Zonifugal Corporation needs to purchase a new conveyor system for its factory Four different conveyor systems have been proposed Which calculation would be the best one for Zonifugal to use to determine which system to purchase? A) payback period B) simple rate of return C) net present value D) project profitability index Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Medium 28 A preference decision: A) is concerned with whether a project clears the minimum required rate of return hurdle B) comes before the screening decision C) is concerned with determining which of several acceptable alternatives is best D) responses A, B, and C are all correct Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Easy 29 In an equipment investment decision, which of the following amounts would be unaffected by a change in the tax rate? A) the present value of the initial investment in the equipment B) the present value of the increase in working capital needed C) the present value of the salvage value of the equipment D) both A and B above Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: Level: Medium 14-12 Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 30 When evaluating a project, the portion of the fixed corporate headquarters expense that would be allocated to the project should be: A) included as a cash outflow on an after-tax basis by multiplying the expense by one minus the tax rate B) included as a cash outflow on an after-tax basis by multiplying the expense by the tax rate C) included as a cash outflow on a before-tax basis D) ignored Ans: D AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting Appendix: 14C LO: Level: Hard 31 (Ignore income taxes in this problem.) Given the following data: Cost of equipment Annual cash inflows Internal rate of return $55,750 $10,000 16% The life of the equipment must be: A) it is impossible to determine from the data given B) 15 years C) 12.5 years D) 5.75 years Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Hard Solution: The internal rate of return factor is 5.575, or $55,750 ÷ $10,000 In the table for the Present Value of an Annuity of $1 in Arrears, the factor of 5.575 can be found in the 16% column in the 15th row; 15 then represents the life of the equipment Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition 14-13 Chapter 14 Capital Budgeting Decisions 32 (Ignore income taxes in this problem.) Heap Company is considering an investment in a project that will have a two year life The project will provide a 10% internal rate of return, and is expected to have a $40,000 cash inflow the first year and a $50,000 cash inflow in the second year What investment is required in the project? A) $74,340 B) $77,660 C) $81,810 D) $90,000 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Hard Source: CMA, adapted Solution: st Cash inflow−1 year Cash inflow−2nd year Net present value Year(s) Amount 40,000 50,000 10% Factor 0.909 0.826 PV $36,360 41,300 $77,660 For the net present value of this project to be zero, the initial investment should be equal to the present value of the cash inflows, or $77,660 33 (Ignore income taxes in this problem.) Congener Beverage Corporation is considering an investment in a capital budgeting project that has an internal rate of return of 20% The only cash outflow for this project is the initial investment The project is estimated to have an year life and no salvage value Cash inflows from this project are expected to be $100,000 per year in each of the years Congener's discount rate is 16% What is the net present value of this project? A) $5,215 B) $15,464 C) $50,700 D) $55,831 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Hard 14-14 Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions Solution: Internal rate of return factor = Initial investment ÷ Annual inflows Look up the factor in the table Present Value of an Annuity of $1 in Arrears for periods, 20% column; the factor is 3.837 Substituting into the above equation, 3.837 = Initial investment ÷ $100,000 Initial investment = $383,700 Initial investment Annual net cash receipts Net present value Year(s) Amount 16% Factor PV Now ($383,700) 1.000 ($383,700) 1-8 $100,000 4.344 434,400 $ 50,700 34 (Ignore income taxes in this problem.) The Able Company is considering buying a new donut maker This machine will replace an old donut maker that still has a useful life of years The new machine will cost $2,500 a year to operate, as opposed to the old machine, which costs $2,700 per year to operate Also, because of increased capacity, an additional 10,000 donuts a year can be produced The company makes a contribution margin of $0.02 per donut The old machine can be sold for $5,000 and the new machine costs $25,000 The incremental annual net cash inflows provided by the new machine would be: A) $200 B) $400 C) $5,200 D) $5,400 Ans: B AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Hard Solution: Operating cost savings per year ($2,700 − $2,500) Additional contribution margin provided by the new donut maker ($0.02 × 10,000) Incremental annual net cash inflows provided by new machine Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition $200 200 $400 14-15 Chapter 14 Capital Budgeting Decisions 35 (Ignore income taxes in this problem.) Given the following data: Initial investment Annual cash inflow Salvage value Net present value Life of the project Discount rate $80,000 ? $0 $13,600 years 16% Based on the data given above, the annual cash inflow from the project after the initial investment is closest to: A) $50,116 B) $21,710 C) $25,400 D) $38,376 Ans: C AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting LO: Level: Hard Solution: First, set up table: Initial investment Annual cash inflows Net present value Year(s) Now 1-6 Amount 16% Factor $80,000 1.000 ? 3.685 PV ($80,000) ? $13,600 Second, solve for the present value of the annual cash inflow: PV of annual cash inflow = $13,600 − (-$80,000) = $93,600 Finally, solve for the annual cash inflow: Annual cash inflow × 3.685 = $93,600 Annual cash inflow = $25,400 14-16 Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 140 (Ignore income taxes in this problem.) Maxcy Limos, Inc., is considering the purchase of a limousine that would cost $187,335, would have a useful life of years, and would have no salvage value The limousine would bring in cash inflows of $45,000 per year in excess of its cash operating costs Required: Determine the internal rate of return on the investment in the new limousine Show your work! Ans: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $187,335 ÷ $45,000 = 4.163 The factor of 4.163 for years represents an internal rate of return of 19% AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy AICPA FN: Reporting 141 (Ignore income taxes in this problem.) The management of Zachery Corporation is considering the purchase of a automated molding machine that would cost $203,255, would have a useful life of years, and would have no salvage value The automated molding machine would result in cash savings of $65,000 per year due to lower labor and other costs Required: Determine the internal rate of return on the investment in the new automated molding machine Show your work! Ans: Factor of the internal rate of return = Investment required ÷ Net annual cash inflow = $203,255 ÷ $65,000 = 3.127 The factor of 3.127 for years represents an internal rate of return of 18% AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition AICPA FN: Reporting 14-83 Chapter 14 Capital Budgeting Decisions 142 (Ignore income taxes in this problem.) The management of an amusement park is considering purchasing a new ride for $60,000 that would have a useful life of 15 years and a salvage value of $8,000 The ride would require annual operating costs of $26,000 throughout its useful life The company's discount rate is 10% Management is unsure about how much additional ticket revenue the new ride would generateparticularly since customers pay a flat fee when they enter the park that entitles them to unlimited rides Hopefully, the presence of the ride would attract new customers Required: How much additional revenue would the ride have to generate per year to make it an attractive investment? Ans: Cost of asset Annual operating costs Salvage value Net present value Years Amount 10%Factor Present Value Now $(60,000) 1.000 ($ 60,000) 1-15 $(26,000) 7.606 ( 197,756) 15 $8,000 0.239 1,912 ($255,844) $255,844 ÷ 7.606 = $33,637 additional revenue per year would be necessary to justify the investment This much additional revenue would result in a zero net present value Any less than this and the net present value would be negative Any more than this and the net present value would be positive AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Hard AICPA FN: Reporting 143 (Ignore income taxes in this problem.) Devon Corporation uses a discount rate of 8% in its capital budgeting Partial analysis of an investment in automated equipment with a useful life of years has thus far yielded a net present value of -$496,541 This analysis did not include any estimates of the intangible benefits of automating this process nor did it include any estimate of the salvage value of the equipment Required: a Ignoring any salvage value, how large would the additional cash flow per year from the intangible benefits have to be to make the investment in the automated equipment financially attractive? b Ignoring any cash flows from intangible benefits, how large would the salvage value of the automated equipment have to be to make the investment in the automated equipment financially attractive? 14-84 Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions Ans: a Minimum annual cash flows from the intangible benefits = Negative net present value to be offset ÷ Present value factor = $496,541 ÷ 5.747 = $86,400 b Minimum salvage value = Negative net present value to the offset ÷ Present value factor = $496,541 ÷ 0.540 = $919,520 AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy AICPA FN: Reporting 144 (Ignore income taxes in this problem.) The management of Crosson Corporation is investigating the purchase of a new satellite routing system with a useful life of years The company uses a discount rate of 17% in its capital budgeting The net present value of the investment, excluding its intangible benefits, is -$173,055 Required: How large would the additional cash flow per year from the intangible benefits have to be to make the investment in the automated equipment financially attractive? Ans: Minimum annual cash flows from the intangible benefits = Negative net present value to be offset ÷ Present value factor = $173,055 ÷ 4.451 = $38,880 AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy AICPA FN: Reporting 145 (Ignore income taxes in this problem.) Chipps Corporation uses a discount rate of 9% in its capital budgeting Management is considering an investment in telecommunications equipment with a useful life of years Excluding the salvage value of the equipment, the net present value of the investment in the equipment is $530,985 Required: How large would the salvage value of the telecommunications equipment have to be to make the investment in the telecommunications equipment financially attractive? Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition 14-85 Chapter 14 Capital Budgeting Decisions Ans: Minimum salvage value = Negative net present value to the offset ÷ Present value factor = $530,985 ÷ 0.650 = $816,900 AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy AICPA FN: Reporting 146 (Ignore income taxes in this problem.) Choudhury Corporation is considering the following three investment projects: Investment required Present value of cash inflows Project H Project I Project J $11,000 $53,000 $89,000 $12,980 $61,480 $96,120 Required: Rank the investment projects using the project profitability index Show your work Ans: Investment required (a) Present value of cash inflows Net present value (b) Project profitability index (b) ÷ (a) Ranked by project profitability index Project H Project I Project J ($11,000) ($53,000) ($89,000) 12,980 61,480 96,120 $ 1,980 $ 8,480 $ 7,120 0.18 0.16 0.08 AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy AICPA FN: Reporting 147 (Ignore income taxes in this problem.) The management of Winstead Corporation is considering the following three investment projects: Investment required Present value of cash inflows Project Q Project R Project S $14,000 $48,000 $74,000 $14,140 $54,720 $82,140 The only cash outflows are the initial investments in the projects Required: Rank the investment projects using the project profitability index Show your work 14-86 Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions Ans: Project Q Project R Project S Investment required (a) ($14,000) ($48,000) ($74,000) Present value of cash inflows 14,140 54,720 82,140 Net present value (b) $ 140 $ 6,720 $ 8,140 Project profitability index (b) ÷ (a) 0.01 0.14 0.11 Ranked by project profitability index AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy AICPA FN: Reporting 148 (Ignore income taxes in this problem.) Hady Company is considering purchasing a machine that would cost $688,800 and have a useful life of years The machine would reduce cash operating costs by $118,759 per year The machine would have no salvage value Required: a Compute the payback period for the machine b Compute the simple rate of return for the machine Ans: a Payback period = Investment required ÷ Net annual cash flow = $688,800 ÷ $118,759 = 5.80 years b The simple rate of return is computed as follows: Cost of machine, net of salvage value (a) Useful life (b) Annual depreciation (a) ÷ (b) $688,800 years $98,400 Annual cost savings Less annual depreciation Annual incremental net operating income $118,759 98,400 $ 20,359 Simple rate of return = Annual incremental net operating income ÷ Initial investment = $20,359 ÷ $688,800 = 2.96% AACSB: Analytic AICPA BB: Critical Thinking LO: 5,6 Level: Easy Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition AICPA FN: Reporting 14-87 Chapter 14 Capital Budgeting Decisions 149 (Ignore income taxes in this problem.) Ramson Company is considering purchasing a machine that would cost $756,000 and have a useful life of years The machine would reduce cash operating costs by $132,632 per year The machine would have a salvage value of $151,200 at the end of the project Required: a Compute the payback period for the machine b Compute the simple rate of return for the machine Ans: a Payback period = Investment required ÷ Net annual cash flow = $756,000 ÷ $132,632 = 5.70 years In this case the salvage value plays no part in the payback period since all of the investment is recovered before the end of the project b The simple rate of return is computed as follows: Cost of machine, net of salvage value (a) Useful life (b) Annual depreciation (a) ÷ (b) $604,800 years $75,600 Annual cost savings Less annual depreciation Annual incremental net operating income $132,632 75,600 $ 57,032 Simple rate of return = Annual incremental net operating income ÷ Initial investment = $57,032 ÷ $756,000 = 7.54% AACSB: Analytic AICPA BB: Critical Thinking LO: 5,6 Level: Medium 14-88 AICPA FN: Reporting Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 150 (Ignore income taxes in this problem.) Ostermeyer Corporation is considering a project that would require an initial investment of $247,000 and would last for years The incremental annual revenues and expenses for each of the years would be as follows: Sales Variable expenses Contribution margin Fixed expenses: Salaries Rents Depreciation Total fixed expenses Net operating income $198,000 46,000 152,000 22,000 32,000 33,000 87,000 $ 65,000 At the end of the project, the scrap value of the project's assets would be $16,000 Required: Determine the payback period of the project Show your work! Ans: Net operating income Add noncash deduction for depreciation Net annual cash inflow $65,000 33,000 $98,000 Payback period = Investment required ÷ Net annual cash inflow = $247,000 ÷ $98,000 = 2.52 years AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition AICPA FN: Reporting 14-89 Chapter 14 Capital Budgeting Decisions 151 (Ignore income taxes in this problem.) The management of Truelove Corporation is considering a project that would require an initial investment of $321,000 and would last for years The annual net operating income from the project would be $28,000, including depreciation of $42,000 At the end of the project, the scrap value of the project's assets would be $27,000 Required: Determine the payback period of the project Show your work! Ans: Net operating income Add noncash deduction for depreciation Net annual cash inflow $28,000 42,000 $70,000 Payback period = Investment required ÷ Net annual cash inflow = $321,000 ÷ $70,000 = 4.59 years AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy AICPA FN: Reporting 152 (Ignore income taxes in this problem.) Ducey Corporation is contemplating purchasing equipment that would increase sales revenues by $79,000 per year and cash operating expenses by $27,000 per year The equipment would cost $150,000 and have a year life with no salvage value The annual depreciation would be $25,000 Required: Determine the simple rate of return on the investment to the nearest tenth of a percent Show your work! Ans: Simple rate of return = Annual incremental net operating income ÷ Initial investment = [Incremental revenues − (Cash operating expenses + Depreciation)] ÷ Initial investment =79,000 − ($27,000 + $25,000) ÷ $150,000 = 27,000 ÷ $150,000 = 18.0% AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy 14-90 AICPA FN: Reporting Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 153 (Ignore income taxes in this problem.) The management of Nixon Corporation is investigating purchasing equipment that would cost $518,000 and have a year life with no salvage value The equipment would allow an expansion of capacity that would increase sales revenues by $364,000 per year and cash operating expenses by $211,000 per year Required: Determine the simple rate of return on the investment to the nearest tenth of a percent Show your work! Ans: Simple rate of return = Annual incremental net operating income ÷ Initial investment = [Incremental revenues − (Cash operating expenses + Depreciation)] ÷ Initial investment = 364,000 − ($211,000 + $74,000) ÷ $518,000 = 79,000 ÷ $518,000 = 15.3% AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy AICPA FN: Reporting 154 (Ignore income taxes in this problem.) Russnak Corporation is investigating automating a process by purchasing a new machine for $198,000 that would have a year useful life and no salvage value By automating the process, the company would save $68,000 per year in cash operating costs The company's current equipment would be sold for scrap now, yielding $18,000 The annual depreciation on the new machine would be $22,000 Required: Determine the simple rate of return on the investment to the nearest tenth of a percent Show your work! Ans: Simple rate of return = Annual incremental net operating income ÷ Initial investment = (Cost savings - Depreciation) ÷ Initial investment = ($68,000 − $22,000) ÷ ($198,000 − $18,000) = $46,000 ÷ $180,000 = 25.6% AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition AICPA FN: Reporting 14-91 Chapter 14 Capital Budgeting Decisions 155 (Ignore income taxes in this problem.) The management of Schenk Corporation is investigating automating a process by replacing old equipment by a new machine The old equipment would be sold for scrap now for $13,000 The new machine would cost $648,000, would have a year useful life, and would have no salvage value By automating the process, the company would save $186,000 per year in cash operating costs Required: Determine the simple rate of return on the investment to the nearest tenth of a percent Show your work! Ans: Depreciation on the new machine = $648,000 ÷ = $72,000 Simple rate of return = Annual incremental net operating income ÷ Initial investment = (Cost savings − Depreciation) ÷ Initial investment = ($186,000 − $72,000) ÷ ($648,000 - $13,000) = $114,000 ÷ $635,000 = 18.0% AACSB: Analytic AICPA BB: Critical Thinking LO: Level: Easy 14-92 AICPA FN: Reporting Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 156 A company is considering purchasing an asset for $70,000 that would have a useful life of years and would have a salvage value of $12,000 For tax purposes, the entire original cost of the asset would be depreciated over years using the straight-line method and the salvage value would be ignored The asset would generate annual net cash inflows of $22,000 throughout its useful life The project would require additional working capital of $8,000, which would be released at the end of the project The company's tax rate is 40% and its discount rate is 9% Required: What is the net present value of the asset? Ans: Cost of asset Working capital needed Net annual cash inflows Depreciation tax shield Salvage value Working capital released Net present value Cost of asset Working capital needed Net annual cash inflows Depreciation tax shield Salvage value Working capital released Net present value Years Amount Now ($70,000) Now ($8,000) 1-5 $22,000 1-5 $14,000 $12,000 $8,000 After-Tax Cash Flows ($70,000) ($8,000) $13,200 $5,600 $7,200 $8,000 Tax Effect 9% Factor 1.000 1.000 3.890 3.890 0.650 0.650 AACSB: Analytic AICPA BB: Critical Thinking Appendix: 14C LO: Level: Medium Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition 0.60 0.40 0.60 Present Value ($70,000) (8,000) 51,348 21,784 4,680 5,200 $ 5,012 AICPA FN: Reporting 14-93 Chapter 14 Capital Budgeting Decisions 157 Management is considering purchasing an asset for $40,000 that would have a useful life of years and no salvage value For tax purposes, the entire original cost of the asset would be depreciated over years using the straight-line method The asset would generate annual net cash inflows of $20,000 throughout its useful life The project would require additional working capital of $5,000, which would be released at the end of the project The company's tax rate is 40% and its discount rate is 12% Required: What is the net present value of the asset? Ans: Cost of asset Working capital needed Net annual cash inflows Depreciation tax shield Working capital released Net present value Cost of asset Working capital needed Net annual cash inflows Depreciation tax shield Working capital released Net present value Tax Years Amount Effect Now ($40,000) Now ($5,000) 1-8 $20,000 0.60 1-8 $5,000 0.40 $5,000 After-Tax Cash Present Flows 12%Factor Value ($40,000) 1.000 ($40,000) ($5,000) 1.000 (5,000) $12,000 4.968 59,616 $2,000 4.968 9,936 $5,000 0.404 2,020 $26,572 AACSB: Analytic AICPA BB: Critical Thinking Appendix: 14C LO: Level: Medium 14-94 AICPA FN: Reporting Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 158 Belling Inc has provided the following data concerning a proposed investment project: Initial investment Annual cash receipts Life of the project Annual cash expenses Salvage value $168,000 $126,000 years $50,000 $8,000 The company's tax rate is 30% For tax purposes, the entire initial investment without any reduction for salvage value will be depreciated over years The company uses a discount rate of 14% Required: Compute the net present value of the project Ans: Annual cash receipts $126,000 Annual cash expenses 50,000 Annual net cash receipts $ 76,000 Initial investment (a) $168,000 Tax life (b) years Annual depreciation deduction (a) ÷ (b) $24,000 Initial investment Annual net cash receipts Salvage value Annual depreciation deductions Initial investment Annual net cash receipts Salvage value Annual depreciation deductions Net present value Year(s) Amount Now ($168,000) 1-9 $76,000 $8,000 1-7 $24,000 After-Tax Cash Flows ($168,000) $53,200 $5,600 $7,200 AACSB: Analytic AICPA BB: Critical Thinking Appendix: 14C LO: Level: Medium Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition 14% Factor 1.000 4.946 0.308 4.288 Tax Effect 0.70 0.70 0.30 After-Tax Cash Flows ($168,000) $53,200 $5,600 $7,200 PV ($168,000) 263,127 1,725 30,874 $127,726 AICPA FN: Reporting 14-95 Chapter 14 Capital Budgeting Decisions 159 Camel Inc is considering a project that would require an initial investment of $210,000 and would have a useful life of years The annual cash receipts would be $126,000 and the annual cash expenses would be $57,000 The salvage value of the assets used in the project would be $32,000 The company's tax rate is 30% For tax purposes, the entire initial investment without any reduction for salvage value will be depreciated over years The company uses a discount rate of 10% Required: Compute the net present value of the project Ans: Annual cash receipts $126,000 Annual cash expenses 57,000 Annual net cash receipts $ 69,000 Initial investment (a) $210,000 Tax life (b) years Annual depreciation deduction (a) ÷ (b) $42,000 Initial investment Annual net cash receipts Salvage value Annual depreciation deductions Initial investment Annual net cash receipts Salvage value Annual depreciation deductions Net present value Year(s) Amount Now ($210,000) 1-6 $69,000 $32,000 1-5 $42,000 After-Tax Cash Flows ($210,000) $48,300 $22,400 $12,600 AACSB: Analytic AICPA BB: Critical Thinking Appendix: 14C LO: Level: Medium 14-96 10% Factor 1.000 4.355 0.564 3.791 Tax Effect 0.70 0.70 0.30 After-Tax Cash Flows ($210,000) $48,300 $22,400 $12,600 PV ($210,000) 210,347 12,634 47,767 $ 60,747 AICPA FN: Reporting Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions Garrison/Noreen/Brewer, Managerial Accounting, Twelfth Edition 14-97 ... profitability index (b) ÷ (a) 0.16 0.13 0 .14 Ranked by project profitability index 14- 28 Garrison/ Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 56 (Ignore... Critical Thinking AICPA FN: Reporting Appendix: 14C LO: Level: Medium 14- 12 Garrison/ Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions 30 When evaluating... Critical Thinking AICPA FN: Reporting LO: 1,2 Level: Hard 14- 14 Garrison/ Noreen/Brewer, Managerial Accounting, Twelfth Edition Chapter 14 Capital Budgeting Decisions Solution: Internal rate of