CHAPTER 12 PLANNING FOR CAPITAL INVESTMENTS SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOM’S TAXONOMY Item SO BT Item SO BT Item S BT Item SO BT 6 7 K C K K K 7 6 7 7 7 7 7 7 AP AP AP AP AP AP AP AP AP AP K K C K C AP K C K C C K AP AP C Item SO BT 21 22 23 24 25 8 8 C C K K C 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 7 7 7 8 8 8 8 8 8 8 8 C C C K C K K K K AN AN AN AP AP AP K K C AP C K C True-False Statements 1 2 K K C C K 10 3 C K C C K 11 12 13 14 15 4 5 C C K K C 16 17 18 19 20 Multiple Choice Questions 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 1 1 1 1 1 1 2 2 2 2 2 2 K K K K K K C K K K K C C K K AP AP AP C K K AP C C K 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 2 3 3 3 3 3 3 3 3 3 3 K C AP K K C C AN K C K C K C C C K K K C AN AP AP AN K 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 4 4 4 5 5 5 5 5 5 5 5 5 AN K K C C K K C K K C K AP K C C C AP AP AP AP C C C C 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 Brief Exercises 148 149 AP E 150 151 3,5 AP E 152 153 E AP Exercises 154 155 156 * 2,3,8 2,3,7 E AP AN 157 2,3,8 158 2,3,8 159 ** AP E E 160 3,4 161 3,5 162 3,5,7 E E E 163 3,5,8 164 3,6 165 3,7 E E E 12-2 Test Bank for ISV Managerial Accounting, Fourth Edition Completion Statements 166 167 K K 168 169 3 K K 170 171 K K 172 173 K K 174 175 K K *1,2,3,5,7 **2,3,5,7,8 SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE Item Type Item Type Item TF TF TF 26 27 28 MC MC MC 29 30 31 38 TF TF TF MC 39 40 41 42 MC MC MC MC 43 44 45 46 54 55 56 57 TF TF TF MC MC MC MC 58 59 60 61 62 63 64 MC MC MC MC MC MC MC 65 66 67 68 69 70 71 10 11 TF TF 12 75 TF MC 76 77 13 14 15 82 83 TF TF TF MC MC 84 85 86 87 88 MC MC MC MC MC 89 90 91 92 93 16 17 TF TF 18 111 TF MC 112 113 19 20 21 103 106 TF TF TF MC MC 109 114 115 116 117 MC MC MC MC MC 118 119 120 121 122 Type Item Type Item Study Objective MC 32 MC 35 MC 33 MC 36 MC 34 MC 37 Study Objective MC 47 MC 51 MC 48 MC 52 MC 49 MC 53 MC 50 MC 107 Study Objective MC 72 MC 150 MC 73 MC 151 MC 74 MC 154 MC 101 MC 155 MC 104 MC 156 MC 108 MC 157 MC 149 BE 158 Study Objective MC 78 MC 80 MC 79 MC 81 Study Objective MC 94 MC 99 MC 95 MC 100 MC 96 MC 102 MC 97 MC 105 MC 98 MC 151 Study Objective MC 164 Ex MC 173 C Study Objective MC 123 MC 128 MC 124 MC 129 MC 125 MC 130 MC 126 MC 131 MC 127 MC 152 Type Item Type Item Type MC MC MC 154 166 Ex C MC MC MC MC 148 154 155 156 BE Ex Ex Ex 157 158 159 167 Ex Ex Ex C BE BE Ex Ex Ex Ex Ex 159 160 161 162 163 164 165 Ex Ex Ex Ex Ex Ex Ex 168 169 170 C C C MC MC 160 171 Ex C MC MC MC MC BE 154 159 161 162 163 Ex Ex Ex Ex Ex 172 C MC MC MC MC BE 154 156 159 162 165 Ex Ex Ex Ex Ex 174 C Planning for Capital Investments 22 23 24 25 TF TF TF TF 110 132 133 134 MC MC MC MC 135 136 137 138 Note: TF = True-False MC = Multiple Choice Study Objective MC 139 MC 143 MC 140 MC 144 MC 141 MC 145 MC 142 MC 146 MC MC MC MC C = Completion BE = Brief Exercise 147 153 155 157 MC BE Ex Ex 158 159 163 175 12-3 Ex Ex Ex C Ex = Exercise The chapter also contains one set of eight Matching questions and three Short-Answer Essay questions CHAPTER STUDY OBJECTIVES Discuss capital budgeting evaluation and explain inputs used in capital budgeting Management gathers project proposals from each department; a capital budget committee screens the proposals and recommends worthy projects Company officers decide which projects to fund, and the board of directors approves the capital budget In capital budgeting, estimated cash inflows and outflows, rather than accrual-accounting numbers, are the preferred inputs Describe the cash payback technique The cash payback technique identifies the time period required to recover the cost of the investment The formula when net annual cash flows are equal is: Cost of capital investment ÷ Estimated net annual cash flow = Cash payback period The shorter the payback period, the more attractive the investment Explain the net present value method The net present value method compares the present value of future cash inflows with the capital investment to determine net present value The NPV decision rule is: Accept the project if net present value is zero or positive Reject the project if net present value is negative Identify the challenges presented by intangible benefits in capital budgeting Intangible benefits are difficult to quantify, and thus are often ignored in capital budgeting decisions This can result in incorrectly rejecting some projects One method for considering intangible benefits is to calculate the NPV, ignoring intangible benefits; if the resulting NPV is below zero, evaluate whether the benefits are worth at least the amount of the negative net present value Alternatively, intangible benefits can be incorporated into the NPV calculation, using conservative estimates of their value Describe the profitability index The profitability index is a tool for comparing the relative merits of alternative capital investment opportunities It is computed as: Present value of net cash ÷ Initial investment The higher the index, the more desirable the project Indicate the benefits of performing a post-audit A post-audit is an evaluation of a capital investment’s actual performance Post-audits create an incentive for managers to make accurate estimates Post-audits also are useful for determining whether a company should continue, expand, or terminate a project Finally, post-audits provide feedback that is useful for improving estimation techniques 12-4 Test Bank for ISV Managerial Accounting, Fourth Edition Explain the internal rate of return method The objective of the internal rate of return method is to find the interest yield of the potential investment, which is expressed as a percentage rate The IRR decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return Reject the project when the internal rate of return is less than the required rate of return Describe the annual rate of return method The annual rate of return uses accrual accounting data to indicate the profitability of a capital investment It is calculated as: Expected annual net income ÷ Amount of the average investment The higher the rate of return, the more attractive the investment TRUE-FALSE STATEMENTS Capital budgeting decisions usually involve large investments and often have a significant impact on a company's future profitability The capital budgeting committee ultimately approves the capital expenditure budget for the year For purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision tools The cash payback technique is a quick way to calculate a project's net present value The cash payback period is computed by dividing the cost of the capital investment by the annual cash inflow The cash payback method is frequently used as a screening tool but it does not take into consideration the profitability of a project 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 Using the net present value method, a net present value of zero indicates that the project would not be acceptable 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 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 Planning for Capital Investments 12-5 13 The profitability index is calculated by dividing the total cash flows by the initial investment 14 The profitability index allows comparison of the relative desirability of projects that require differing initial investments 15 Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns 16 A well-run organization should perform an evaluation, called a post-audit, of its investment projects before their completion 17 Post-audits create an incentive for managers to make accurate estimates, since managers know that their results will be evaluated 18 A post-audit is an evaluation of how well a project's actual performance matches the projections made when the project was proposed 19 The internal rate of return method is, like the NPV method, a discounted cash flow technique 20 The interest yield of a project is a rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows 21 Using the internal rate of return method, a project is rejected when the rate of return is greater than or equal to the required rate of return 22 Using the annual rate of return method, a project is acceptable if its rate of return is greater than management's minimum rate of return 23 The annual rate of return method requires dividing a project's annual cash inflows by the economic life of the project 24 A major advantage of the annual rate of return method is that it considers the time value of money 25 An advantage of the annual rate of return method is that it relies on accrual accounting numbers rather than actual cash flows Answers to True-False Statements Item Ans T F T F Item Ans T T T F Item 10 11 12 Ans F T F T Item 13 14 15 16 Ans F T T F Item 17 18 19 20 Ans T T T T Item 21 22 23 24 Ans F T F F Item 25 Ans F 12-6 Test Bank for ISV Managerial Accounting, Fourth Edition MULTIPLE CHOICE QUESTIONS 26 The capital budget for the year is approved by a company's a board of directors b capital budgeting committee c officers d 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 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 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 Net annual cash flow can be estimated by a deducting credit sales from net income b adding depreciation expense to net income c deducting credit purchases from net income d adding advertising expense to net income 33 Which of the following is not a typical cash flow related to equipment purchase and replacement decisions? a Increased operating costs b Overhaul of equipment c Salvage value of equipment when project is complete d Depreciation expense Planning for Capital Investments 12-7 34 Capital expenditure proposals are initially screened by the a board of directors b executive committee c capital budgeting committee d stockholders 35 Capital budgeting decisions depend in part on all of the following except the a relationships among proposed projects b profitability of the company c company’s basic decision making approach d risks associated with a particular project 36 The corporate capital budget authorization process consists of how many steps? a b c d 37 Which of the following is not a capital budgeting decision? a Constructing new studios b Replacing old equipment c Scrapping obsolete inventory d Remodeling an office building 38 Which of the following is a disadvantage of the cash payback technique? a It is difficult to calculate b It relies on the time value of money c It can only be calculated when there are equal annual net cash flows d It ignores the expected profitability of a project 39 The payback period is often compared to an asset’s a estimated useful life b warranty period c net present value d internal rate of return 40 Which of the following ignores the time value of money? a Internal rate of return b Profitability index c Net present value d Cash payback 41 Brady Corp is considering the purchase of a piece of equipment that costs $23,000 Projected net annual cash flows over the project’s life are: Year Net Annual Cash Flow $ 3,000 8,000 15,000 9,000 The cash payback period is 12-8 Test Bank for ISV Managerial Accounting, Fourth Edition a b c d 42 2.63 years 2.80 years 2.20 years 2.37 years Bradshaw Inc is contemplating a capital investment of $85,000 The cash flows over the project’s four years are: Expected Annual Year Expected Annual Cash Inflows $30,000 45,000 60,000 50,000 Cash Outflows $12,000 20,000 25,000 30,000 The cash payback period is a 2.17 years b 3.35 years c 2.30 years d 3.47 years 43 Jordan Company is considering the purchase of a machine with the following data: Initial cost One-time training cost Annual maintenance costs Annual cost savings Salvage value $130,000 12,000 15,000 75,000 20,000 The cash payback period is a 2.37 years b 2.17 years c 1.89 years d 1.73 years 44 If project A has a lower payback period than project B, this may indicate that project A may have a a lower NPV and be less profitable b higher NPV and be less profitable c higher NPV and be more profitable d lower NPV and be more profitable 45 Which of the following does not consider a company’s required rate of return? a Net present value b Internal rate of return c Annual rate of return d Cash payback 46 The cash payback technique a considers cash flows over the life of a project b cannot be used with uneven cash flows c is superior to the net present value method d may be useful as an initial screening device Planning for Capital Investments 12-9 47 If an asset costs $210,000 and is expected to have a $30,000 salvage value at the end of its ten-year life, and generates annual net cash inflows of $30,000 each year, the cash payback period is a years b years c years d years 48 If a payback period for a project is greater than its expected useful life, the a project will always be profitable b entire initial investment will not be recovered c project would only be acceptable if the company's cost of capital was low d project's return will always exceed the company's cost of capital 49 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 50 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 51 When using the cash payback technique, the payback period is expressed in terms of a a percent b dollars c years d months 52 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 53 Bark Company is considering buying a machine for $180,000 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 $12,000 each year The cash payback period on this investment is a 15 years b 10 years c years d years 54 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 12-10 Test Bank for ISV Managerial Accounting, Fourth Edition 55 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 56 The higher the risk element in a project, the a more attractive the investment b higher the net present value c higher the cost of capital d higher the discount rate 57 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% 58 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 59 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 60 When the annual cash flows from an investment are unequal, the appropriate table to use is the a future value of table b future value of annuity table c present value of table d present value of annuity table 61 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 Planning for Capital Investments 12-27 BE 152 (cont.) Instructions What is the approximate internal rate of return associated with this investment? Solution 152 (5 min.) When net annual cash inflows are expected to be equal, the internal rate of return can be approximated by dividing the capital investment by the net annual cash inflows to determine the discount factor and then locating this discount factor on the present value of an annuity table $90,000 ÷ $18,150 = 4.96 By tracing across on the 8-year row, we see that the discount factor of 12% is 4.96764 Thus the internal rate of return on this project is approximately 12% BE 153 Salt Company is considering investing in a new facility to extract and produce salt The facility will increase revenues by $250,000, but it will also increase annual expenses by $160,000 The facility will cost $980,000 to build, and it will have a $20,000 salvage value at the end of its useful life Instructions Calculate the annual rate of return on this facility Solution 153 (5 min.) The annual rate of return is calculated by dividing expected annual income by the average investment The company’s annual income is $250,000 – $160,000 = $90,000 Its average investment is ($980,000 + $20,000) ÷ = $500,000 Therefore, it annual rate of return is $90,000 ÷ $500,000 = 18% EXERCISES Ex 154 Corn Doggy, Inc produces and sells corn dogs The corn dogs are dipped 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 $40,300 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? 12-28 Test Bank for ISV Managerial Accounting, Fourth Edition Solution 154 (13–18 min.) (a) Cash payback period: $262,000 ÷ $40,300 = 6.50124 years (b) Internal rate of return: Scanning the 12-year line, a factor of 6.50124 represents an internal rate of return of approximately 11% (c) Net present value using a discount rate of 10%: Time Period -01-12 Cash Flow PV Factor $(262,000) 1.00000 40,300 6.81369 Net Present Value Present Value $(262,000) 274,592 $ 12,592 (d) Yes, the investment is acceptable Indications are that the investment will earn a greater return than 10% The internal rate of return is estimated to be 11%, and the net present value is positive Ex 155 Top Growth Farms, a farming cooperative, is considering purchasing a tractor for $455,500 The machine has a 10-year life and an estimated salvage value of $32,000 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 $350 Fuel is $50 for each use of the tractor The present value of an annuity of 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 Solution 155 (16–22 min.) (a) Cost of the tractor: $455,500 + $12,100 + $400 = $468,000 Annual Cash Flow: Number of uses: 52 × = 260 Contribution margin per use: $350 – $50 = $300 Total annual cash flow: 260 × $300 = $78,000 $468,000 Cash payback: ———— = years $78,000 (b) Present value of cash flow ($78,000 × 6.418) = Capital investment Net present value (c) $500,604 468,000 $ 32,604 $468,000 + $32,000 Average Investment: ————————— = $250,000 Planning for Capital Investments Solution 155 12-29 (cont.) $468,000 – $32,000 Annual Depreciation: ————————— = $43,600 10 years Annual Net Income: $78,000 – $43,600 = $34,400 $34,400 Average Annual Rate of Return: ———— = 13.76% $250,000 Ex 156 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 building 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 10% (present value factor of 6.8137) Estimated annual net income and cash flows are as follows: Revenue Less: Utility cost Supplies Labor Depreciation Other Net income $329,000 40,000 8,000 141,000 52,500 38,500 280,000 $ 49,000 Instructions For this investment, calculate: (a) The net present value (b) The internal rate of return (c) The cash payback period Solution 156 (12–16 min.) (a) Net present value of the investment: Item Initial Investment Revenue $329,000 Expense (227,500)* Present Value Cash Flow $(630,000) 101,500 Factor 1.0000 6.8137 Net Present Value Present Value $(630,000) 691,591 $ 61,591 *$40,000 + $8,000 + $141,000 + $38,500 (b) Internal rate of return of the investment: $630,000 ÷ $101,500 = 6.2069 Scanning the 12-year line, a factor of 6.2069 represents an IRR of approximately 12% (c) Cash payback period of the investment: $630,000 ÷ $101,500 = 6.21 years 12-30 Test Bank for ISV Managerial Accounting, Fourth Edition Ex 157 Mimi Company is considering a capital investment of $250,000 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 $25,000 and $75,000, respectively Mimi's minimum required rate of return is 10% The present value of for periods at 10% is 621 and the present value of an annuity of for 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 Solution 157 (10–15 min.) (a) Cash payback period = $250,000 ÷ $75,000 = 3.33 years (b) Present value of cash inflows ($75,000 × 3.791) = $284,325 Capital investment 250,000 Net present value $ 34,325 (c) Annual rate of return = $25,000 ÷ [($250,000 + $0) ÷ 2] = 20% Ex 158 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 50,000 80,000 Estimated useful life years 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 for periods at 8% is 540 and the present value of an annuity of for 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? Solution 158 (14–18 min.) (a) Annual net income Annual depreciation Annual cash inflow *($400,000 ÷ 8) Project Red $ 50,000 50,000* $100,000 **($560,000 ÷ 8) Project Blue $ 80,000 70,000** $150,000 Planning for Capital Investments Solution 158 12-31 (cont.) Cash payback period: $400,000 ———— = 4.0 years $100,000 (b) Present value of cash inflows: Capital investment Net present value *($100,000 × 5.747) (c) Annual rate of return: Project Red $574,700* 400,000 $174,700 $560,000 ———— = 3.7 years $150,000 Project Blue $862,050** 560,000 $302,050 **(150,000 × 5.747) Project Red $50,000 ————————— = 25% ($400,000 + $0) ÷ Project Blue $80,000 ————————— = 28.6% ($560,000 + $0) ÷ (d) Savanna should select Project Blue because it has a larger positive net present value and a higher annual rate of return In addition, Project Blue has a slightly shorter cash payback period Ex 159 Yappy Company is considering a capital investment of $320,000 in additional equipment The new equipment is expected to have a useful life of 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 $25,000 and $65,000, respectively Yappy requires a 10% return on all new investments Period 8% 5.747 Present Value of an Annuity of 9% 10% 11% 12% 5.535 5.335 5.146 4.968 Instructions (a) Compute each of the following: Cash payback period Net present value Profitability index Internal rate of return Annual rate of return (b) Indicate whether the investment should be accepted or rejected Solution 159 (a) (15–20 min.) Cash payback period: $320,000 ÷ $65,000 = 4.92 years Present value of cash inflows ($65,000 × 5.335) Capital investment Net present value $346,775 320,000 $ 26,775 Profitability index: $346,775 ÷ $320,000 = 1.08 Internal rate of return factor: $320,000 ÷ $65,000 = 4.92 Internal rate of return = 12% (4.968 factor) 15% 4.487 Test Bank for ISV Managerial Accounting, Fourth Edition 12-32 Solution 159 (cont.) Annual rate of return: $25,000 ÷ [($320,000 + $0) ÷ 2] = 15.63% (b) Yappy should accept the investment, since its net present value is positive and its internal rate of return of 12% is greater than the company's required rate of return of 10% In addition, its cash payback period of 4.92 years is significantly shorter than the equipment's useful life of years Ex 160 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 Annual net cash flows Salvage value Estimated useful life Cost of capital Present value of an annuity of Present value of $25,000 4,000 3,000 years 10% 5.335 467 Sophie's assistant manager is trying to convince Sophie that the van has other benefits that she hasn't considered in the initial estimates These additional benefits, including the free advertising the store's name painted on the van's doors will provide, are expected to increase net cash flows by $500 each year Instructions (a) Calculate the net present value of the van, based on the initial estimates Should the van be purchased? (b) Calculate the net present value, incorporating the additional benefits suggested by the assistant manager Should the van be purchased? (c) Determine how much the additional benefits would have to be worth in order for the van to be purchased Solution 160 (15–19 min.) (a) Present value of annual cash flows ($4,000 × 5.335) Present value of salvage value ($3,000 × 467) Capital investment Net present value $21,340 1,401 $22,741 25,000 $( 2,259) Based on the negative net present value of $2,259, the van should not be purchased (b) Present value of annual cash flows [($4,000 + $500) × 5.335] Present value of salvage value ($3,000 × 467) Capital investment Net present value $24,008 1,401 $25,409 25,000 $ 409 Planning for Capital Investments Solution 160 12-33 (cont.) Incorporating the additional benefits of $500/year into the calculation produces a positive net present value of $409 Therefore, the van should be purchased (c) The additional benefits would need to have a total present value of at least $2,259 in order for the van to be purchased Ex 161 Vista Company is considering two new projects, each requiring an equipment investment of $95,000 Each project will last for three years and produce the following cash inflows: Year Cool $ 38,000 42,000 48,000 $128,000 Hot $ 42,000 42,000 42,000 $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: Present Value of Period 12% 893 797 712 Present Value of an Annuity of Period 12% 893 1.690 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? Solution 161 (a) Year (12–16 min.) Project Cool Annual Cash Inflows Present Value of $ 38,000 893 42,000 797 48,000 712 $128,000 Present value of cash inflows Capital investment Net present value Present Value $ 33,934 33,474 34,176 $101,584 $101,584 95,000 $ 6,584 Test Bank for ISV Managerial Accounting, Fourth Edition 12-34 Solution 161 (cont.) Project Hot Present value of cash inflows ($42,000 × 2.402) Capital investment Net present value (b) Profitability index: Cool $101,584 ÷ $95,000 = 1.07 $100,884 95,000 $ 5,884 Hot ($100,884 ÷ $95,000) = 1.06 (c) Both projects are acceptable because both show a positive net present value Project Cool is the preferred project because its net present value is greater than project Hot's net present value and it has a slightly higher profitability index Ex 162 Santana Company is considering investing in a project that will cost $110,000 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 $30,000 each year The company requires a 10% rate of return and uses the following compound interest table: Present Value of an Annuity of Period 6% 4.212 8% 3.993 9% 3.890 10% 3.791 11% 3.696 12% 3.605 15% 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? Solution 162 (a) (1) (2) (b) (10–18 min.) Present value of cash inflows ($30,000 × 3.791) Capital investment Net present value $113,730 110,000 $ 3,730 Profitability index: $113,730 ÷ $110,000 = 1.03 Capital Investment —————————— Net Annual Cash Inflow = Internal Rate of Return Factor $110,000 ———— = 3.67 $30,000 Since the calculated internal rate of return factor of 3.67 is very near the factor 3.696 for five periods and 11% interest, this project has an approximate interest yield of 11% (c) Santana should invest in this project because it has a positive net present value, a profitability index above 1, and its internal rate of return of 11% is greater than the company's 10% required rate of return Planning for Capital Investments 12-35 Ex 163 Johnson Company is considering purchasing one of two new machines The following estimates are available for each machine: Machine $148,000 50,000 15,000 years Initial cost Annual cash inflows Annual cash outflows Estimated useful life Machine $165,000 60,000 20,000 years The company's minimum required rate of return is 10% Period 8% 4.623 Present Value of an Annuity of 9% 10% 11% 12% 4.486 4.355 4.231 4.111 15% 3.784 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? Solution 163 (12–16 min.) (a) (1) Present value of net cash flows Capital investment Net present value *($35,000 × 4.355) **($40,000 × 4.355) Machine $152,425* 148,000 $ 4,425 Machine $174,200** 165,000 $ 9,200 Machine $152,425 ———— = 1.03 $148,000 Machine $174,200 ———— = 1.06 $165,000 Internal rate of return factor Machine $148,000 ———— = 4.23 $35,000 Machine $165,000 ———— = 4.13 $40,000 Internal rate of return 11% (4.231 factor) 12% (4.111 factor) (2) Profitability index (3) (b) Both machines are acceptable because both show a positive net present value, have a profitability index above 1, and have an internal rate of return greater than the company's minimum required rate of return Machine is preferred because its net present value, profitability index, and internal rate of return are all greater than Machine 1's amounts Ex 164 Platoon Company is performing a post-audit of a project that was estimated to cost $300,000, have a useful life of years with a zero salvage value, and result in net cash inflows of $75,000 per year After the investment was in operation for a year, revised figures indicate that it actually cost $345,000, will have a 9-year useful life, and will produce net cash inflows of $58,000 The present value of an annuity of for years at 10% is 4.355 and for years is 5.759 12-36 Ex 164 Test Bank for ISV Managerial Accounting, Fourth Edition (cont.) Instructions Determine whether the project should have been accepted based on (a) the original estimates and then on (b) the actual amounts Solution 164 (8–12 min.) (a) Present value of the estimated net cash inflows ($75,000 × 4.355) Estimated capital investment Net present value $326,625 300,000 $ 26,625 Yes, Platoon Company should have invested in the project based on the original estimates, since the net present value is positive (b) Present value of the actual net cash inflows ($58,000 × 5.759) Actual capital investment Net present value $334,022 345,000 $ (10,978) Platoon should not have invested in the project based on the actual amounts, since the net present value is negative The decrease of $37,603 in net present value was caused due to a decrease of $17,000 per year in net cash inflows and a $45,000 increase in the cost of the capital investment This more than offsets the 3-year increase in useful life Ex 165 Shilling 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 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, Shilling can sell the property for more than it was originally purchased for The following amounts have been estimated: Cost of land Cost to build dorm and dining facility Annual cash inflows assuming 100 players and 10 weeks Annual cash outflows Estimated useful life Salvage value Discount rate Present value of an annuity of Present value of $ 600,000 2,100,000 2,520,000 2,260,000 20 years 3,900,000 10% 8.514 149 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 $1,865,000 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 at 12% is 104 and the present value of an annuity of is 7.469 Planning for Capital Investments Solution 165 12-37 (15–20 min.) (a) Present value of net cash flows ($260,000 × 8.514) Present value of salvage value ($3,900,000 × 149) Capital investment ($600,000 + $2,100,000) Net present value (b) Present value of net cash flows ($220,000 × 8.514) Present value of salvage value Capital investment Net present value $2,213,640 581,100 $2,794,740 2,700,000 $ 94,740 $1,873,080 581,100 $2,454,180 2,700,000 $ (245,820) If the number of campers attending each week is only 80 instead of 100, the net present value decreases by $340,560 (from a positive $94,740 to a negative $245,820) This indicates that the camp should not be invested in unless the number attending is closer to 100 (c) Present value of net cash flows ($260,000 × 7.469) Present value of salvage value ($3,900,000 × 104) Capital investment Net present value $1,941,940 405,600 $2,347,540 2,700,000 $ (352,460) 12-38 Test Bank for ISV Managerial Accounting, Fourth Edition COMPLETION STATEMENTS 166 For purposes of capital budgeting, estimated and outflows are preferred for inputs into the capital budgeting decision tools 167 The technique which identifies the time period required to recover the cost of the investment is called the method 168 The two discounted cash flow techniques used in capital budgeting are (1) the _ method and (2) the method 169 Under the net present value method, the interest rate to be used in discounting the future cash inflows is the 170 In using the net present value approach, a project is acceptable if the project's net present value is or _ 171 A project’s , such as increased quality or safety, are often incorrectly ignored in capital budgeting decisions 172 The _ is a method of comparing alternative projects that takes into account both the size of the investment and its discounted future cash flows 173 A well-run organization should perform an evaluation, called a _, of its investment projects after their completion 174 The internal rate of return method differs from the net present value method in that it results in finding the _ of the potential investment 175 A major limitation of the annual rate of return approach is that it does not consider the _ of money Answers to Completion Statements 166 167 168 169 170 171 172 173 174 175 cash inflows cash payback net present value, internal rate of return required rate of return zero, positive intangible benefits profitability index post audit interest yield time value Planning for Capital Investments 12-39 MATCHING 176 Match the items below by entering the appropriate code letter in the space provided A B C D Profitability index Internal rate of return method Discounted cash flow techniques Capital budgeting E F G H Annual rate of return method Cash payback technique Cost of capital Net present value method 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 Capital budgeting techniques that consider both the estimated total cash inflows from the investment and the time value of money 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 A method of comparing alternative projects that take into account both the size of the investment and its discounted cash flows A method used in capital budgeting that results in finding the interest yield of the potential investment The average rate of return that the firm must pay to obtain borrowed and equity funds The determination of the profitability of a capital expenditure by dividing expected annual net income by the average investment The process of making capital expenditure decisions in business Answers to Matching F C H A B G E D 12-40 Test Bank for ISV Managerial Accounting, Fourth Edition SHORT-ANSWER ESSAY QUESTIONS S-A E 177 Management uses several capital budgeting methods in evaluating projects for possible investment Identify those methods that are more desirable from a conceptual standpoint, and briefly explain what features these methods have that make them more desirable than other methods Also identify the least desirable method and explain its major weaknesses Solution 177 From a conceptual standpoint, the discounted cash flow methods (net present value and internal rate of return) are considered more desirable because they consider both the estimated cash flows and the time value of money The time value of money is critical because of the long-term impact of capital budgeting decisions Capital budgeting methods which not consider the time value of money include annual rate of return and cash payback The cash payback method is the least desirable because it also ignores the expected profitability of the project S-A E 178 (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 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: Who are the stakeholders in this situation? Is it ethical to adjust the figures to compensate for risk? Explain Is it ethical to change the proposal before submitting it? Explain Solution 178 The stakeholders include: Ed Rhodes Canton Tile the engineer who submitted the proposal It is ethical, in general, to adjust projections to compensate for risk However, it should be clearly stated that the projections have been adjusted for risk, and the method used should be available for review Otherwise, the entire selection process is undermined, and it becomes entirely subjective Planning for Capital Investments 12-41 Solution 178 (cont.) It is probably not ethical to modify a proposal at all; certainly not in the way described The person submitting the proposal should have the right to know about any changes that were made, and should have the right to review those changes S-A E 179 (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 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 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 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: Initial Investment Returns Year Year Year Net present value Option #1 $(95,000) 55,000 30,000 10,000 Option #2 $(270,000) 90,000 90,000 90,000 Required: Prepare a brief report for management in which you make a recommendation for one system or the other, using the information given Solution 179 The company should accept Option #1, to purchase upgrades to its present system and to buy a more efficient printer In the first place, the changes will be easier to implement because the equipment is similar to that which is already in use Secondly, the company will have less money invested in the project, which decreases the risk of loss should the project fail Option #2 appears to be too risky ... Ans F T F F Item 25 Ans F 12-6 Test Bank for ISV Managerial Accounting, Fourth Edition MULTIPLE CHOICE QUESTIONS 26 The capital budget for the year is approved by a company's a board of directors... 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 12-10 Test Bank for ISV Managerial Accounting, Fourth... 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