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Exam 11: Capital Budgeting and Investment Analysis

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Question 1

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Nebraska Co. is reviewing a capital investment of $100,000. This project's projected cash flows over a five-year period are estimated at $35,000 each year. Required: (a) Calculate the payback period. (b) Calculate the break-even time. Assume a 12% hurdle rate and use the table below: Present Value Periods of 1 at 12% 1…… 0.8929 2…… 0.7972 3…… 0.7118 4…… 0.6355 5…… 0.5674 (c) Using the results in (a) and (b), make a recommendation for the project.

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(a) Payback period = $100,000/$35,000 pe...

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Question 2

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Watson Corporation is considering buying a machine for $25,000. Its estimated useful life is 5 years, with no salvage value. Watson anticipates annual net income after taxes of $1,500 from the new machine. What is the accounting rate of return assuming that Watson uses straight-line depreciation and that income is earned uniformly throughout each year?

A) 6.0%.
B) 8.0%.
C) 8.5%.
D) 10.0%.
E) 12.0%.

F) B) and C)
G) A) and B)

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Question 3

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A company is considering the purchase of a new piece of equipment for $90,000. Predicted annual cash inflows from this investment are $36,000 (year 1) , $30,000 (year 2) , $18,000 (year 3) , $12,000 (year 4) and $6,000 (year 5) . The payback period is:

A company is considering a 5-year project. It plans to invest $62,000 now and it forecasts cash flows for each year of $16,200. The company requires a hurdle rate of 12%. Calculate the internal rate of return to determine whether it should accept this project. Selected factors for a present value of an annuity of 1 for five years are shown below: Interest rate Present value of an annuity of 1 factor 10% 3.7908 12% 3.6048 14% 3.4331

What is capital budgeting? Why are capital budgeting decisions often difficult and risky?

The following data concerns a proposed equipment purchase: Cost $144,000 Salvage value $ 4,000 Estimated useful life 4 years Annual net cash flows $ 46,100 Depreciation method Straight-line Ignoring income taxes, the annual net income amount used to calculate the accounting rate of return is:

Two investments with exactly the same payback periods are not equally valuable to an investor because the timing of net cash flows may be different.

An estimate of an asset's value to the company, calculated by discounting the future cash flows from the investment at the project's required rate of return and then subtracting the initial amount of the investment, is known as:

A given project requires a $28,000 investment and is expected to generate end-of-period annual cash inflows as follows: $\begin{array} { l l l } \text { Year 1 } & \text { year 2 } & \text { year } 3 \\\$ 12,000 & \$ 13,000 & \$ 12,000\end{array}$ Assuming a discount rate of 10%, what is the net present value of this investment? Selected present value factors for a single sum are shown in the table below. $\begin{array} { c c c } i = 10\% & i = 10 \% & i = 10\% \\n = 1 & n = 2 & n = 3 \\.9091 & .8264 & .7513\end{array}$

The minimum acceptable rate of return on an investment, often the company's cost of capital, is called the ________.

A company is trying to decide which of two new product lines to introduce in the coming year. The predicted revenue and cost data for each product line follows: $\begin{array}{lcc}&\underline{\text { Product A}} &\underline{\text {Product B }}\\ \text { Sales } & \$ 80,000 & \$ 96,000 \\\text { Direct materials } & 3,000 & 6,000 \\\text { Direct labor } & 30,000 & 45,000 \\\text { Other cash operating expenses } & 7,500 & 9,000 \\\text { New equipment costs } & 75,000 & 100,000 \\\text { Estimated useful life (no salvage } & 5 \text { years } & 5 \text { years }\end{array}$ The company has a 30% tax rate, it uses the straight-line depreciation method, and it predicts that cash flows will be spread evenly throughout each year. Calculate each product's payback period. If the company requires a payback period of three years or less, which, if either, product should be chosen?

A given project requires a $28,500 investment and is expected to generate end-of-period annual cash inflows of $12,000 for each of three years. Assuming a discount rate of 10%, what is the net present value of this investment? Selected present value factors for a single sum are shown in the table below: $\begin{array} { c c c } i = 10\% & i = 10 \% & i = 10\% \\n = 1 & n = 2 & n = 3 \\.9091 & .8264 & .7513\end{array}$

Projects with a profitability index of greater than 1 have a return that is greater than the hurdle rate.

A company is considering the purchase of new equipment for $45,000. The projected annual net cash flows are $19,000. The machine has a useful life of 3 years and no salvage value. Management of the company requires a 12% return on investment. The present value of an annuity of $1 for various periods follows: $\begin{array} { c c } \text { Period } & \text { Presert value of ary annuity of } \$ 1 \text { at } 12 \% \\1 & 0.8929 \\2 & 1.6901 \\3 & 2.4018\end{array}$ What is the net present value of this machine assuming all cash flows occur at year-end?

There is only one method of evaluating capital budgeting decisions.

Briefly describe the time value of money. Why is the time value of money important in capital budgeting?

A new manufacturing machine is expected to cost $278,000, have an eight-year life, and a $30,000 salvage value. The machine will yield an annual incremental after-tax income of $35,000 after deducting the straight-line depreciation. Compute the payback period for the purchase.

Which methods of evaluating a capital investment project ignore the time value of money?

The payback period method of evaluating an investment fails to consider cash inflows after the point where an investment's costs are fully recovered.

Nestor Company is considering the purchase of an asset for $100,000. It is expected to produce the following net cash flows. The cash flows occur evenly throughout each year. Compute the break-even time (BET) period for this investment. $\begin{array} { | l | l | l | } \hline & \begin{array} { c } \text { Annual Net } \\\text { Cash Flows }\end{array} & \begin{array} { c } \text { Present Value } \\\text { of } \$ 1 \text { at } \mathbf { 1 0 } \%\end{array} \\\hline \text { Year 0 } & & 1.0000 \\\hline \text { Year 1 } & \$ 40,000 & .9091 \\\hline \text { Year 2 } & \$ 40,000 & .8264 \\\hline \text { Year 3 } & \$ 35,000 & .7513 \\\hline \text { Year 4 } & \$ 35,000 & .6830 \\\hline \text { Year 5 } & \$ 30,000 & .6209 \\\hline\end{array}$