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Exam 25: Capital Budgeting and Managerial Decisions

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Question 31

True/False

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If the internal rate of return (IRR) of an investment is lower than the hurdle rate, the project should be accepted.

A) True
B) False

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Question 32

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A company's required rate of return, typically its cost of capital, is called the:

A) Internal rate of return.
B) Hurdle rate.
C) Average rate of return.
D) Maximum rate.
E) Payback rate.

F) B) and E)
G) All of the above

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Question 33

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The ________ is computed by discounting the future net cash flows from the investment at the project's required rate of return and then subtracting the initial amount invested.

Alfarsi Industries uses the net present value method to make investment decisions and requires a 15% annual return on all investments. The company is considering two different investments. Each require an initial investment of $15,000 and will produce cash flows as follows: $\begin{array}{c}\text {End of}&&\text {Investment}\\\text {Year}\\&\text {A}&\text {B}\\1 & \$ 8,000 & \$ 0 \\2 & 8,000 & 0 \\3 & 8,000 & 24,000\end{array}$ The present value factors of $\$ 1$ each year at $15 \%$ are: $\begin{array} { l l } 1 & 0.8696 \\ 2 & 0.7561 \\ 3 & 0.6575 \end{array}$ - The present value of an annuity of $1 for 3 years at 15% is 2.2832 The net present value of Investment A is:

A capital budgeting method that considers how quickly a project recovers costs is known as_________. An enhancement to this method that also considers the time value of money is called________.

A company is trying to decide which of two new product lines to introduce in the coming year. The company requires a 12% return on investment. The predicted revenue and cost data for each product line follows: $\begin{array} { l | l | l } &{ \text { Product A } } & \underline { \text { Product B } } \\\hline \text { Unit sales } & 25,000 & 20,000 \\\hline \text { Unit sales price } & \$ 30 & \$ 30 \\\hline \text { Direct materials } & \$ 15,000 & \$ 8,000 \\\hline \text { Direct labor } & \$ 120,000 & \$ 80,000 \\\hline \text { Other cash operating expenses } & \$ 30,000 & \$ 25,000 \\\hline \text { New equipment costs } & \$ 2,500,000 & \$ 1,500,000 \\\hline \text { Estimated useful life (no salvage) } & 5 \text { years } & 5 \text { years }\end{array}$ The company has a 30% tax rate and it uses the straight-line depreciation method. The present value of an annuity of $1 for 5 years at 12% is 3.6048. Compute the net present value for each piece of equipment under each of the two product lines. Which, if either of these two investments is acceptable?

A company has the choice of either selling 1,000 defective units as scrap or rebuilding them. The company could sell the defective units as they are for $4.00 per unit. Alternatively, it could rebuild them with incremental costs of $1.00 per unit for materials, $2.00 per unit for labor, and $1.50 per unit for overhead, and then sell the rebuilt units for $8.00 each. If the company rebuilds the units, rather than selling them as scrap, what is the incremental impact on income?

How does the calculation of break-even time (BET) differ from the calculation of payback period (PBP)?

If the straight-line depreciation method is used, the annual average investment amount used in calculating rate of return is calculated as (beginning book value + ending book value)/2.

When making capital budgeting decisions, companies usually prefer shorter payback periods. Explain why shorter payback periods are desirable.

A company is planning to introduce a new portable computer to its existing product line. Management must decide whether to make the computer case or buy it from an outside supplier. The lowest outside price is $90. If the case is produced internally, the company will have to purchase new equipment that will yield annual depreciation of $130,000. The company will also need to rent a new production facility at $200,000 a year. At 20,000 cases per year, a preliminary analysis of production costs shows the following: $\text { Per case }$ $\begin{array}{ll} \text { Dired materials. } & \$ 40.00 \\ \text { Dired labor... } & 32.00 \\ \text { Variable overhead. } & 10.00 \\ \text { Equipment depreciation . } & 6.50 \\\text { Building rental } & 10.00 \\ \text { Allocated fixed overhead } & 7.50 \\\end{array}$ Required: (1) Determine whether the company should make the cases or buy them from the outside supplier. (2) What other factors, besides cost, should the company consider?

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 $\begin{array} { lc} &\text { Present Value } \\\underline { \text { Periods } } &\underline { \text { of } \$ 1 \text { at } 12 \%}\\1 \ldots \ldots& 0.8929 \\2 \ldots \ldots & 0.7972 \\3 \ldots \ldots & 0.7118 \\4 \ldots \ldots & 0.6355 \\5 \ldots \ldots & 0.5674\end{array}$ (c) Using the results in (a) and (b), make a recommendation for the project.

In evaluating capital budgeting alternatives, there are two primary methods that do not consider the time value of money. These methods are ________ and ________. There are also two primary methods that consider the time value of money; these are ________ and ________.

An advantage of the break-even time (BET) method over the payback period method is that it recognizes the time value of money.

Maxim manufactures a hamster food product called Green Health. Maxim currently has 10,000 bags of Green Health on hand. The variable production costs per bag are $1.80 and total fixed costs are $10,000. The hamster food can be sold as it is for $9.00 per bag or be processed further into Premium Green and Green Deluxe at an additional $2,000 cost. The additional processing will yield 10,000 bags of Premium Green and 3,000 bags of Green Deluxe, which can be sold for $8 and $6 per bag, respectively. - The net advantage (incremental income) of processing Green Health further into Premium Green and Green Deluxe would be:

Identify at least three reasons for managers to favor the internal rate of return (IRR) over other capital budgeting approaches.

Factor Co. can produce a unit of product for the following costs: $\begin{array}{llr} \text { Direct material} &\$8\\ \text { Direct labor} &24\\ \text { Overhead } &40\\ \text {Total costs per unit } &\$72\end{array}$ An outside supplier offers to provide Factor with all the units it needs at $46 per unit. If Factor buys from the supplier, the company will still incur 60% of its overhead. Factor should choose to:

Epsilon Co. can produce a unit of product for the following costs: $\begin{array}{llr} \text { Direct material} &\$8\\ \text { Direct labor} &24\\ \text { Overhead } &40\\ \text {Total costs per unit } &\$72\end{array}$ An outside supplier offers to provide Epsilon with all the units it needs at $60 per unit. If Epsilon buys from the supplier, the company will still incur 40% of its overhead. Epsilon should choose to:

A company can buy a machine that is expected to have a three-year life and a $30,000 salvage value. It will be depreciated using the straight-line method. The machine will cost $1,800,000 and is expected to produce a $200,000 after-tax net income to be received at the end of each year. If a table of present values of $1 at 12% shows values of 0.8929 for one year, 0.7972 for two years, and 0.7118 for three years, what is the net present value of the cash flows from the investment, discounted at 12%?

Capital budgeting decisions are risky because all of the following are true except: