Hilton 2222
Hilton 2222
Hilton 2222
present-value calculations.
Future Value of $1
Present Value of $1
A. emergency situations.
B. long-term decisions.
E. Whether a pro football team should trade for and sign a star quarterback to a long-term
contract.
3. The decision process that has managers select from among several acceptable
investment proposals to make the best use of limited funds is known as:
A. capital rationing.
B. capital budgeting.
D. cost analysis.
E. project planning.
A. revenues.
B. costs.
C. cost centers.
E. allocation tools.
A. payback rate.
B. hurdle rate.
C. minimal value.
7. The hurdle rate that is used in a net-present-value analysis is the same as the firm's:
A. discount rate.
A. Yes No No
B. Yes Yes No
D. No Yes Yes
E. No Yes No
A. I only.
B. II only.
C. I and II.
D. II and III.
10. The true economic yield produced by an asset is summarized by the asset's:
C. future value.
B. if the asset's cash flows are identical to the future value of a series of cash flows.
C. if the future value of a series of cash flows can be arrived at by the annuity accumulation
factor.
D. equates the present value of a project's cash inflows with the present value of the cash
outflows.
E. equates the present value of a project's cash flows with the future value of the project's
cash flows.
13. Page Company is contemplating the acquisition of a machine that costs $50,000 and
promises to reduce annual cash operating costs by $11,000 over each of the next six years. Which of the
following is a proper way to evaluate this investment if the company desires a 12% return on all
investments?
14. Adams Company can acquire a $750,000 machine now that will benefit the firm over the
next 8 years. Annual savings in cash operating costs are expected to total $140,000. If the hurdle rate is
10%, the investment's net present value is:
A. $(226,960).
B. $(3,100).
C. $65,150.
D. $370,000.
E. some other amount.
15. Reeder Company, which uses net present value to analyze investments, requires a 10%
minimum rate of return. A staff assistant recently calculated a $500,000 machine's net present value to
be $86,400, excluding the impact of straight-line depreciation. If Reeder 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).
B. $86,400.
C. $186,400.
D. $292,700.
E. $465,500.
16. 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. If the company requires a 10% rate
of return, the net present value of this machine would be:
B. $(127,110), and the machine does not meet the company's rate-of-return requirement.
C. $(129,600), and the machine does not meet the company's rate-of-return requirement.
A. approximately 14%.
B. approximately 16%.
C. approximately 18%.
D. approximately 20%.
18. Paulsen is considering the acquisition of a $217,750 machine that is expected to produce
annual savings in cash operating costs of $50,000 over the next six years. If Paulsen uses the internal
rate of return (IRR) to evaluate new investments and the firm has a hurdle rate of 12%, which of the
following statements is correct?
A. The machine's IRR is less than 4%, and the machine should not be acquired.
B. The machine's IRR is approximately 10%, and the machine should not be acquired.
C. The machine's IRR is approximately 10%, and the machine should be acquired.
D. The machine's IRR is approximately 12%, and the machine should be acquired.
A. $(3,840).
B. $(3,370).
C. $0.
D. $21,630.
E. $28,840.
20. Which of the following statements about the machine's internal rate of return is true?
E. There is insufficient information to make any judgment about the internal rate of return.
The mayor of Smalltown 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:
Year Savings
1 $20,000
2 25,000
3 30,000
4 15,000
5 12,000
21. If Smalltown 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.
22. What can be said about the computer system's internal rate of return if the net present
value at 12% is positive?
E. There is insufficient information to make any judgment about the internal rate of return.
Answer: A LO: 1 Type: N
23. A salesperson from a different computer company claims that his machine, which costs
$85,000 and has an estimated service life of four years, will generate annual savings for the city of
$32,000. If the discount rate is 10%, the net present value of this system would be:
A. $16,440.
B. $23,175.
C. $63,512.
D. $101,440.
24. A company that is using the internal rate of return (IRR) to evaluate projects should
accept a project if the IRR:
B. equates the present value of the project's cash inflows with the present value of the
project's cash outflows.
26. The net-present-value method assumes that project funds are reinvested at the:
A. hurdle rate.
27. The internal-rate-of-return method assumes that project funds are reinvested at the:
A. hurdle rate.
28. Which of the following choices correctly states how funds are assumed to be reinvested
under the net-present-value method and the internal-rate-of-return method?
D. project risk.
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.
31. Consider the following statements about the total-cost and the incremental-cost
approaches of investment evaluation:
A. I only.
B. II only.
C. III only.
D. II and III.
32. The systematic follow-up on a capital project to see how the project actually turns out is
commonly known as:
B. a postaudit.
II. Postaudits can be used to detect undesirable projects that were accepted.
III. Postaudits may reveal shortcomings in cash-flow projections, providing insights that allow a firm
to improve future predictions.
A. I only.
B. II only.
C. III only.
D. II and III.
34. Generally speaking, which of the following would not directly affect a company's income
tax payments?
A. Advertising expense.
C. Sales revenue.
35. A company's cash flows from income taxes are normally affected by:
A. revenues.
B. operating expenses.
36. Consider the following statements about taxes and after-tax cash flows:
I. Capital budgeting analyses should incorporate after-tax cash flows rather than before-tax cash
flows.
II. Added company revenues will result in lower taxes for a firm.
III. Operating expenses may actually provide a tax benefit for an organization.
A. I only.
B. II only.
C. III only.
D. I and II.
E. I and III.
37. When income taxes are considered in capital budgeting, the cash flows related to a
company's advertising expense would be correctly figured by taking the cash paid for advertising and:
38. Of the five expenses that follow, which one is most likely treated differently than the
others when income taxes are considered in a discounted-cash-flow analysis?
A. Salaries expense.
B. Advertising expense.
C. Depreciation expense.
D. Utilities expense.
E. Office expense.
39. Assume that a capital project is being analyzed by a discounted-cash-flow approach, and
an employee first assumes no income taxes and then later assumes a 30% income tax rate. How would
depreciation expense be incorporated in the analysis?
Tax Rate
A. Considered Considered
B. Considered Ignored
C. Ignored Considered
D. Ignored Ignored
A. should be ignored.
41. When income taxes are considered in capital budgeting, the cash flows related to a
company's depreciation expense would be correctly figured by taking the cash paid for depreciation
and:
E. doing none of the above because there is no cash paid for depreciation.
42. Jester plans to generate $650,000 of sales revenue if a capital project is implemented.
Assuming a 30% tax rate, the sales revenue should be reflected in the analysis by a:
A. $195,000 inflow.
B. $195,000 outflow.
C. $455,000 inflow.
D. $455,000 outflow.
E. $650,000 inflow.
A. $105,000 inflow.
B. $105,000 outflow.
C. $245,000 inflow.
D. $245,000 outflow.
E. $350,000 outflow.
44. Penn Company plans to incur $180,000 of salaries expense and produce $300,000 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 $36,000 inflow.
B. a $36,000 outflow.
C. an $84,000 inflow.
D. an $84,000 outflow.
45. Brookside Company has $70,000 of depreciation expense and is subject to a 30% income
tax rate. On an after-tax basis, depreciation results in a:
A. $21,000 inflow.
B. $21,000 outflow.
C. $49,000 inflow.
D. $49,000 outflow.
E. neither an inflow nor an outflow because depreciation is a noncash expense.
46. Crossland Company is studying a capital project that will produce $600,000 of added
sales revenue, $400,000 of additional cash operating expenses, and $50,000 of depreciation. Assuming
a 30% income tax rate, the company's after-tax cash inflow (outflow) is:
A. $105,000.
B. $125,000.
C. $155,000.
D. $175,000.
47. Which of the following is the proper calculation of a company's depreciation tax shield?
C. noncash factor.
II. A depreciation tax shield should be ignored when doing a net-present-value analysis.
III. A depreciation tax shield can occur in more than one year.
A. I only.
B. II only.
C. III only.
D. I and II.
E. I and III.
A. would write off a larger portion of an asset's cost sooner than under the straight-line
method.
B. would find that depreciation speeds up, with a small portion taken in early years and
larger amounts taken in later years.
C. would find that more tax benefits occur earlier than under the straight-line method.
D. would find itself out of compliance with generally accepted accounting principles
(GAAP).
51. David Company is considering the use of accelerated depreciation rather than straight-
line depreciation for a new asset acquisition. Which of the following choices correctly shows when the
majority of depreciation would be taken (early or late in the asset's life), when most of the tax savings
occur (early or late in the asset's life), and which depreciation method would have the higher present
value?
When Majority
of Depreciation
of Tax Savings
Value
A. $(200,000).
B. $(140,000).
C. $(35,000).
D. $15,000.
E. $50,000.
53. If a company desires to be in compliance with current income tax law and write off the
cost of its assets rapidly, the firm would use:
A. straight-line depreciation.
B. sum-of-the-years'-digits depreciation.
C. accelerated depreciation.
E. annuity depreciation.
54. The Modified Accelerated Cost Recovery System (MACRS) assumes that, on average,
assets will be placed in service:
55. A company used the net-present-value method to analyze an investment and found the
investment to be very attractive. If the firm used straight-line depreciation and changes to the Modified
Accelerated Cost Recovery System (MACRS), the investment's net present value will:
A. increase.
C. decrease.
D. change, but the direction cannot be determined based on the data presented.
56. Pick Company received $18,000 cash from the sale of a machine that had a $13,000
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. $3,500.
B. $6,500.
C. $12,600.
D. $16,500.
E. $19,500.
A. $2,100.
B. $4,900.
C. $5,800.
D. $7,000.
E. $8,200.
58. A machine was sold in December 20x3 for $9,000. It was purchased in January 20x1 for
$15,000, and depreciation of $12,000 was recorded from the date of purchase through the date of
disposal. Assuming a 40% income tax rate, the after-tax cash inflow at the time of sale is:
A. $3,600.
B. $6,600.
C. $8,400.
D. $9,000.
E. $11,400.
59. Rogers Company purchased equipment for $30,000 in December 20x1. The equipment
is expected to generate $10,000 per year of additional revenue and incur $2,000 per year of additional
cash expenses, beginning in 20x2. Under MACRS, depreciation in 20x2 will be $3,000. If the firm's
income tax rate is 40%, the after-tax cash flow in 20x2 would be:
A. $3,200.
B. $3,600.
C. $4,800.
D. $6,000.
James Company has an asset that cost $5,000 and currently has accumulated depreciation of $2,000.
Suppose the firm sold the asset for $2,500 and is subject to a 30% income tax rate.
A. $350.
B. $500.
C. $650.
D. $2,500.
A. $2,100.
B. $2,350.
C. $2,500.
D. $2,650.
62. Wright Company is considering a five-year project that requires a typical investment in
working capital, in this case, $100,000. Consider the following statements about this situation:
II. Wright should include separate $100,000 outflows in each year of the project's five-year life.
III. Wright should include a $100,000 recovery of its working-capital investment in year 5 of a
discounted-cash-flow analysis.
A. I only.
B. II only.
C. III only.
D. I and II.
E. I and III.
63. A machine is expected to produce annual savings in cash operating costs of $400,000 for
the next six years. If the firm has a 10% after-tax hurdle rate and is subject to a 30% income tax rate, the
correct discounted net cash flow would be:
A. $522,600.
B. $947,520.
C. $1,219,400.
D. $1,742,000.
64. A machine is expected to produce increases in cash operating costs of $200,000 for the
next six years. If the firm has a 14% after-tax hurdle rate and is subject to a 30% income tax rate, the
correct discounted net cash flow would be:
A. $(233,340).
B. $(544,460).
C. $(777,800).
D. $(1,011,140).
65. A new machine is expected to produce a MACRS deduction in three years of $50,000. If
the firm has a 12% after-tax hurdle rate and is subject to a 30% income tax rate, the correct discounted
net cash flow to include in an acquisition analysis would be:
A. $0.
B. $10,680.
C. $24,920.
D. $46,280.
E. some other amount.
66. In 10 years, Hopkins Company plans to receive $9,000 cash from the sale of a machine
that has a $5,000 book value. If the company is subject to a 30% income tax rate and has an 8% after-
tax hurdle rate, the correct discounted net cash flow would be:
A. $2,916.90.
B. $3,611.40.
C. $4,167.00.
D. $4,722.60.
67. In eight years, Larson Company plans to receive $11,000 cash from the sale of a machine
that has a $16,000 book value. If the company is subject to a 30% income tax rate and has a 12% after-
tax hurdle rate, the correct discounted net cash flow would be:
A. $606.
B. $1,414.
C. $3,838.
D. $5,050.
68. Which of the following tools is sometimes used to rank investment proposals?
A. Profitability index.
B. Annuity index.
D. none of the above, because the net present value cannot be gauged by the profitability
index.
70. St. Andrews ranks investments by using the profitability index (PI). The following data
relate to Project X and Project Y:
Project X Project Y
71. Wakefield evaluates future projects by using the profitability index. The company is
currently reviewing five similar projects and must choose one of the following:
Project Initial
of Cash Inflows
1 $100,000 $ 97,000
2 50,000 80,000
3 75,000 110,000
4 60,000 100,000
5 150,000 200,000
Which project should Wakefield select if the decision is based entirely on the
profitability index?
A. Project 1.
B. Project 2.
C. Project 3.
D. Project 4.
E. Project 5.
D. present value of the cash flows, exclusive of the initial investment, ÷ initial investment.
E. initial investment ÷ present value of the cash flows, exclusive of the initial investment.
I. As shown in your text, the payback period considers the time value of money.
II. The payback period can only be used if net cash inflows are uniform throughout a project's life.
III. The payback period ignores cash inflows that occur after the payback period is reached.
A. I only.
B. II only.
C. III only.
D. I and II.
74. A piece of equipment costs $30,000, and is expected to generate $8,500 of annual cash
revenues and $1,500 of annual cash expenses. The disposal value at the end of the estimated 10-year
life is $3,000. Ignoring income taxes, the payback period is:
A. 3.53 years.
B. 3.86 years.
C. 4.29 years.
D. 6.98 years.
75. Portland is considering the acquisition of new machinery that will produce uniform benefits over
the next eight years. The following information is available:
If the company is subject to a 30% tax rate, what denominator should be used to compute the
machinery's payback period?
A. $70,000.
B. $170,000.
C. $245,000.
D. $320,000.
1 $120,000
2 250,000
3 110,000
4 80,000
5 160,000
If cash flows occur evenly throughout a year, the equipment's payback period is:
A. 4 years, 2 months.
B. 4 years, 3 months.
C. 4 years, 4 months.
D. 5 years.
D. Payback period.
79. Which of the following choices correctly depicts whether discounted cash flows are used by the
method noted when evaluating long-term investments?
Net
of Return Accounting
Rate of Return
A. No No Yes
B. Yes No Yes
C. Yes No No
D. Yes Yes No
80. Consider the following statements about the accounting rate of return:
I. The accounting rate of return focuses on a project's income rather than its cash flows.
II. Companies can figure the accounting rate of return on either the initial investment figure or an
average investment figure.
III. The accounting rate of return considers the time value of money.
A. I only.
B. II only.
C. III only.
D. I and II.
E. II and III.
A. 16%.
B. 18%.
C. 26%.
D. 28%.
82. San Remo has a $4,000,000 asset investment and is subject to a 30% income tax rate.
Cash inflows are expected to average $600,000 before tax over the next few years; in contrast, average
income before tax is anticipated to be $500,000. The company's accounting rate of return is:
A. 8.75%.
B. 10.50%.
C. 12.50%.
D. 15.00%
B. often gives rise to net-present-value figures that are negative despite a manager's belief
that the investment is beneficial for the firm.
C. is not recommended.
D. often omits a number of factors that are difficult to quantify (e.g., greater manufacturing
flexibility, improved product quality, and so forth).
B. is the actual cash flow adjusted for a change in the dollar's purchasing power.
87. Consider the following statements about the accounting for inflation in a capital
budgeting analysis:
I. An analyst can use nominal dollars in conjunction with a nominal interest rate.
II. An analyst can use real dollars in conjunction with a real interest rate.
III. An analyst can use nominal dollars in conjunction with a real interest rate.
A. I only.
B. II only.
C. III only.
D. I and II.
E. II and III.
EXERCISES
88. Green 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.
Required:
LO: 1 Type: A
Answer:
Total $ 4,759
The machinery should be acquired because the investment has a positive net
present value.
Required:
A. Prepare a dated listing of the cash inflows and outflows related to Rebecca's stock investment.
Ignore income taxes.
B. Assume that Rebecca has a 10% hurdle rate for all investments. Rounding to the nearest dollar,
compute the net present value of her investment in Bazooka and determine whether she achieved her
10% goal.
LO: 1 Type: A, N
Answer:
B. Rebecca achieved her goal, as indicated by the positive net present value.
Total $ 1,671
90. Mark 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 a currently 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.
Mark must acquire $80,000 of new equipment if it reopens the plant. The equipment
has a six-year service life and 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.
Required:
Answer:
Buy:
Make:
$(22,500,000) x 4.111
$(92,497,500)
Total $(92,579,289)
91. The Airways Company is planning a project that is expected to last for six years and
generate annual net cash inflows of $75,000. The project will require the purchase of a $280,000
machine, which is expected to have a salvage value of $10,000 at the end of the six-year period. In
addition to annual operating costs, the machine will require a $50,000 overhaul at the end of the fourth
year. The company presently has a 12% minimum desired rate of return.
The accountant recommends that the project be rejected because it does not meet the
company's minimum desired rate of return. Ignore income taxes.
Required:
B. Use the net-present-value method and determine whether the project should be accepted.
C. Based on your answer in requirement "B," is the internal rate of return greater or less than 12%?
Explain.
LO: 1 Type: A, N
Answer:
A. The accountant is focusing on income rather than cash flows. The cash flows should be
discounted to reflect the time value of money, and depreciation should be omitted because of the
absence of taxes.
B. Purchase price $(280,000) x 1.0 $(280,000)
Total $ 1,595
The project should be accepted because the net present value is positive.
C. The net present value is positive using a discount rate of 12%. Thus, the internal rate of return is
greater than 12%.
92. Harrison Township is studying a 700-acre site for a new landfill. The new site will save
$70,000 in annual operating costs for 10 years, as Harrison currently uses the landfill of a neighboring
municipality. Other data are:
Hurdle rate: 6%
Required:
A. Use the net-present-value method and determine whether the landfill should be acquired.
B. Determine the landfill's approximate internal rate of return.
LO: 1 Type: A
Answer:
Total $ 20,200
Yes, the landfill should be acquired because it has a positive net present value.
X = 7.071
A review of annuity factors for 10 years finds an internal rate of return that falls between 6% (7.360) and
8% (6.710).
93. Gotham Corporation is considering the acquisition of a new machine that costs
$149,040. The machine is expected to have a four-year service life and will produce annual savings in
cash operating costs of $45,000. Gotham evaluates investments by using the internal rate of return and
ignores income taxes.
Required:
B. What relationship holds true at the internal rate of return with respect to discounted cash
inflows and discounted cash outflows? With respect to net present value?
LO: 1 Type: A, N
Answer:
A. The internal rate of return is the true economic yield on a project, taking the time value of
money into consideration.
B. At the internal rate of return, the present value of the cash inflows equals the present value of
the cash outflows. Thus, the net present value is zero.
C. $149,040 ÷ $45,000 = 3.312, which corresponds with the factor of an 8% return on a four-year
project.
94. Simon Company is considering a $5.4 million asset investment that has a four-year service life
and a $400,000 salvage value. The investment is expected to produce annual savings in cash operating
costs of $860,000 and will require a $250,000 overhaul in year 3, which is fully-deductible for tax
purposes.
Simon uses the net-present-value method to analyze investments. Asset investments are depreciated
by the straight-line method, ignoring salvage values in related computations.
Required:
A. Ignoring income taxes, determine the (pre-discounted) cash-flow amounts that would be used in
a net-present-value analysis for (1) the asset acquisition, (2) annual savings in cash operating costs, (3)
annual straight-line depreciation, (4) the overhaul in year 3, and (5) disposal of the asset in year 4. Note
cash outflows in parentheses.
B. Repeat requirement "A," assuming the company is subject to a 30% income tax rate.
LO: 2, 4, 6 Type: A
Answer:
Year 4 asset disposal: $5,400,000 - $5,400,000 accumulated depreciation = $0 book value; $0 book value
- $400,000 salvage value = $400,000 gain; $400,000 gain x 0.3 = $(120,000) added tax; $400,000 salvage
value - $(120,000) added tax = $280,000
Depreciation as a Tax Shield, MACRS, Discounted Cash Flow
95. Smith Corporation recently purchased a $1,200,000 asset that has a three-year service
life and no salvage value. The company is subject to a 30% income tax rate and employs a 12% after-tax
hurdle rate in capital investment decisions.
Required:
A. Calculate the total depreciation expense that will be taken by each of the methods under
consideration.
B. Calculate the total tax savings that will occur with each method.
C. On the basis of your calculations in part "B," which of the two methods will management likely
prefer? Explain your answer.
D. Calculate the present value of the tax savings under each method. Round to the nearest dollar.
LO: 4, 5, 6 Type: A, N
Answer:
A. Both methods will result in the total asset cost of $1,200,000 being written off as depreciation
expense.
B. Straight-line:
$1,200,000 ÷ 3 years = $400,000 per year; $400,000 x 0.30 = $120,000 annual tax
$360,000
C. Although the total dollar amounts are the same, the timing differs, with MACRS producing
greater savings in the earlier part of the asset's life. These dollar savings can be reinvested by the
business to generate additional returns, as verified by the present value calculations in requirement "D."
D. Straight-line:
MACRS:
$289,677
96. Morgan Corporation plans to purchase $1.5 million of equipment in the not-too-distant
future. The equipment will have a $300,000 salvage value and will be depreciated over a six-year service
life by the straight-line method. Morgan is subject to a 40% income tax rate.
The company's accountant is about to perform a net-present-value analysis, assuming a
12% after-tax hurdle rate.
Required:
A. Determine the discounted cash flows that would be reflected in the analysis in year 0 and year 1.
B. Determine the discounted cash flow that would be reflected in the analysis in year 6, assuming
that Morgan sells the equipment for only $250,000 because of a recent change in market conditions.
LO: 4, 6 Type: A
Answer:
B. Cost $1,500,000
97. You are reviewing some material that deals with investment analysis, preparing for your
first day on the job at Franklin Enterprises. Consider the cash flows that follow.
3. Annual savings in cash operating costs of $50,000 over the next eight years.
4. Sale of a machine for $35,000 at the end of its six-year service life. The machine has a book
value of $25,000.
5. A $6,000 equipment overhaul in year 5 that is fully deductible for income tax purposes.
Required:
Calculate the discounted cash flow that is appropriate for each of the preceding items.
Assume a 10% after-tax hurdle rate and a 30% income tax rate, and round to the nearest dollar.
LO: 4, 6 Type: A
Answer:
98. The Warren Machine Tool Company is considering the addition of a computerized lathe
to its equipment inventory. The initial cost of the equipment is $600,000, and the lathe is expected to
have a useful life of five years and no salvage value. The cost savings and increased capacity attributable
to the machine are estimated to generate increases in the firm's annual cash inflows (before considering
depreciation) of $180,000. The machine will be depreciated as follows for tax purposes: $200,000 in
year 1, $266,700 in year 2, $88,860 in year 3, and $44,440 in year 4.
Warren is currently in the 40% income tax bracket. A 10% after-tax rate of return is
desired.
Required:
A. What is the net present value of the investment? Round to the nearest dollar.
C. Assume that the equipment will be sold at the end of its useful life for $100,000. If the
depreciation amounts are not revised, calculate the dollar impact of this change on the total net present
value.
LO: 4, 5, 6 Type: A, N
Answer:
and capacity
409,428
MACRS:
Total $ 9,101
B. Yes, the machine should be acquired because it has a positive net present value.
C. Cost $600,000
Book value $ --
99. Worrell Industries is currently purchasing part no. 456 from an outside supplier for $90
per unit. Because of supplier reliability problems, the company is considering producing the part
internally in a currently idle manufacturing plant. Annual volume over the next five years is expected to
total 400,000 units at variable manufacturing costs of $88 per unit.
Worrell must acquire $200,000 of new equipment if it reopens the plant. The
equipment has a five-year service life and a $20,000 salvage value, and will be depreciated by the
straight-line method. (Note: Worrell ignores salvage values in depreciation calculations.) Normal
equipment maintenance is expected to total $12,000 in year 4, and the equipment will be sold at the
end of its life.
Required:
Rounding to the nearest dollar, use the net-present-value method (total-cost approach)
and a 12% after-tax hurdle rate to determine whether Worrell should make or buy part no. 456. The
company is subject to a 30% income tax rate.
LO: 3, 4, 6 Type: A
Answer:
Buy:
$(24,640,000) x 3.605
$(88,827,200)
$12,000 x 3.605
43,260
Equipment sale ($20,000 - $0 book value = $20,000 gain; $20,000 x 0.30 = $6,000 tax; $20,000 - $6,000)
$14,000 x 0.567
7,938
Total $(88,981,344)
100. Wexler Corporation is considering the acquisition of a new machine that costs $350,000. The
machine is expected to have a four-year service life and will produce annual savings in cash operating
costs of $100,000. Wexler uses straight-line depreciation, is subject to a 30% income tax rate, has an
after-tax hurdle rate of 12%, and rounds calculations to the nearest dollar.
Required:
A. Determine the annual after-tax cash flows that result from acquisition of the machine.
B. Assuming that your answer in requirement "A" totaled $110,410, calculate the machine's:
3. Payback period.
Answer:
B. 1. Initial investment
$(350,000) x 1.0
335,315
$ (14,685)
2.
3. The machine is not considered an attractive investment because it has a negative net present
value.
$350,000 ÷ $110,410 = 3.170, which corresponds with the factor of a 10% return on a four-year project.
Given the hurdle rate of 12%, the machine is not considered an attractive investment.
101. Ivory Corporation is reviewing an investment proposal that has an initial cost of $52,500.
An estimate of the investment's end-of-year book value, the yearly after-tax net cash inflows, and the
yearly net income are presented in the schedule below. The investment's salvage value at the end of
each year is equal to book value, and there will be no salvage value at the end of the investment's life.
Ivory uses a 14% after-tax target rate of return for new investment proposals.
Required:
C. Calculate the proposal's net present value. Round to the nearest dollar.
LO: 6, 8 Type: A
Answer:
A. The project's payback is 3 years. By the conclusion of this time period, Ivory will have recovered
the investment's cost of $52,500 ($20,000 + $17,500 + $15,000 = $52,500).
$ 1,213
Payback, Accounting Rate of Return, Net Present Value, Cash-Flow Determination
102. Lorax Corporation is considering the acquisition of a new machine that is expected to
produce annual savings in cash operating costs of $30,000 before income taxes. The machine costs
$100,000, has a useful life of five years, and no salvage value. Lorax uses straight-line depreciation on all
assets, is subject to a 30% income tax rate, and has an after-tax hurdle rate of 8%.
Required:
LO: 4, 6, 8 Type: A
Answer:
103. Custard Treats, which sells frozen custard and sandwiches, is considering a new site that
will require a $1 million investment for land acquisition and construction costs. The following operating
results are expected:
Utilities 10,000
Required:
A. If management requires a payback period of four years or less, should the new site be opened?
Why?
C. What significant limitation of payback and the accounting rate of return is overcome by the net-
present-value method?
LO: 8 Type: A, N
Answer:
C. Payback and the accounting rate of return ignore the time value of money, which is the
foundation of the net-present-value method.
DISCUSSION QUESTIONS
Comparisons Between Net Present Value and the Internal Rate of Return
104. Both net present value (NPV) and the internal rate of return (IRR) have a reinvestment
assumption.
Required:
B. One of the advantages of the NPV method is that users can adjust for risk considerations.
Explain how this is done.
LO: 2 Type: RC
Answer:
A. In the NPV method, cash flows are assumed to be reinvested at the hurdle rate. With the IRR,
cash flows are assumed to be reinvested at the same rate as the project's return.
B. In the NPV method, a higher hurdle rate can be used, either for the entire analysis or for the
estimated cash inflows (savings) that occur late in the project's life.
Postaudits
Required:
C. A manager prepared an unsuccessful proposal for a capital project, as her firm decided not to
fund and pursue the project. The manager observed, "The company's postaudit process will show that
this project should have been funded." Comment on the manager's understanding of the postaudit
process.
LO: 3 Type: RC
Answer:
A. A postaudit is a review of the actual cash flows generated by a project and a comparison of the
actual net present value with the original, anticipated net present value (or IRR).
C. The manager's understanding of the postaudit process is incorrect. The postaudit is applied to
projects that are funded/implemented. It is not a mechanism to show what might have happened if a
rejected project had been accepted.
Required:
B. MACRS is an accelerated depreciation system. Explain how an accelerated system can provide a
more beneficial tax shield than, say, a straight-line depreciation system.
LO: 4, 5 Type: RC
Answer:
A. Depreciation does not require a cash outlay. (The cash outlay occurred when the asset was
acquired.) However, depreciation reduces taxable income and consequently, reduces the cash outflow
for income taxes. Thus, depreciation provides a reduction in cash outflows for income taxes, or in other
words, shields some of a firm's income.
B. Under an accelerated depreciation system, the asset's cost is written off more rapidly than
under the straight-line system. This leaves funds for re-investment sooner, thus allowing a firm to
generate greater returns because the money is invested for a longer period of time.
Profitability Index
Required:
B. Two projects are under consideration. Project I has a net present value of $20,000 whereas
project II has a net present value of $200,000. Which project is better? Explain. What weakness in a
net-present-value analysis does the profitability index address?
LO: 7 Type: RC
Answer:
A. The profitability index equals the present value of a project's cash inflows divided by the initial
investment.
B. Both projects provide a return greater than the hurdle rate and both are acceptable. It is not
possible to say which one is better. The profitability index provides a ratio that is not influenced by the
size of the project—a limitation of net-present-value (NPV) analysis. Thus, a project that has a greater
NPV and a greater profitability index generally will be more attractive than another project.
Required:
A. Explain how the payback period is determined. Generally speaking, from a payback perspective,
which projects are viewed to be the most attractive?
B. Does the payback method take income taxes into consideration? Explain.
LO: 8 Type: RC
Answer:
A. The payback period is the time required to recover the initial investment. Projects with the
shortest payback are generally viewed as being the most attractive.
B. Yes, the payback period is based on net cash inflows to the firm (i.e., those after taxes).
C. There are two major deficiencies. The payback method completely ignores cash flows that occur
after the payback point has been reached. This method also ignores the time value of money.
Required:
A. Many proposed advanced manufacturing systems have a negative net present value when
discounted-cash-flow analysis is used. Explain several reasons behind this situation.
B. Two major benefits of advanced systems are greater flexibility in the manufacturing process and
improvements in product quality. Explain how these benefits can create problems when performing
discounted-cash-flow analysis.
A. Negative net present values may arise from several factors: the investments are very costly; the
hurdle rate may be very high to compensate for project risk; the time horizon may be too short; and a
number of benefits associated with the project may have been excluded from the analysis because of
related quantification problems.
B. Greater flexibility in the manufacturing process and improvements in product quality are very
difficult to quantify. As a result, these items may be excluded from a discounted-cash-flow analysis,
decreasing an investment's attractiveness.