Exam 12: Strategy and the Analysis of Capital Investments

When ranking two mutually exclusive investments with different initial amounts but approximately the same useful life, and assuming no capital rationing, management should give priority to the project:

A characteristic of the payback method is that it

Which of the following statements regarding cost of capital is not true?

The capital budgeting decision technique that reflects the time value of money and is calculated as the present value of the future after-tax cash inflows divided by the initial cash outlay for the investment is called the:

Results from the net present value (NPV) method and the internal rate of return (IRR) method may differ between projects if the projects differ in all the following except:

In a discounted cash flow (DCF) analysis, a required incremental investment in net working capital:

Which one of the following capital budgeting decision models consists of dividing the total initial investment outlay by annual after-tax cash inflows (when such inflows are assumed equal over time)?

Marc Corporation wants to purchase a new machine for $400,000. Management predicts that the machine can produce sales of $275,000 each year for next 5 years. Expenses are expected to include direct materials, direct labor, and factory overhead (excluding depreciation) totaling $80,000 per year. The company uses MACRS (modified accelerated cost recovery system) for depreciation. The machine is considered 3-year property and is not expected to have any significant residual at the end of its useful life. Marc's income tax rate, t, is 40%. Management estimates that the weighted-average cost of capital (WACC) is 10%. A partial MACRS depreciation table is reproduced below. Year 3-year property 5-year property 1 33.33 20.00 2 44.45 32.00 3 14.81 19.20 4 7.41 11.52 5 11.52 6 5.76 Required: 1. What is the estimated net present value (NPV) of the investment (rounded to the nearest whole dollar)? (Note: PV $1 factors for 10% are as follows: year 1 = 0.909; year 2 = 0.826; year 3 = 0.751; year 4 = 0.683; year 5 = 0.621; the PV annuity factor for 10%, 5 years = 3.791.) Assume that all estimated cash flows occur at year-end. 2. What is the present value payback period (rounded to two decimal places)?

Which of the following is not a characteristic of the payback method for making capital budgeting decisions?

If a company is faced with limited capital funds for investment (i.e., the company faces capital rationing), the best general method to employ to assess individual project profitability is:

Which one of the following is true for the internal rate of return (IRR) method?

Fritz Company is planning to acquire a $250,000 machine to improve manufacturing efficiencies, thereby reducing annual cash operating costs (before taxes) by a projected $80,000 for each of the next five years. The company requires a minimum rate of return of 8% on all capital investments. The machine will be depreciated using straight-line method over a five-year period with no salvage value at the end of five years. Fritz is subject to a combined 40% income tax rate. Required: 1. What is the machine's payback period, in years (rounded to one decimal place, e.g., 4.2483 years = 4.2 years), under the assumption that cash flows occur evenly throughout the year? 2. What is the accounting (book) rate of return (ARR), based on the initial investment amount (rounded to one decimal place, that is, rounded to the nearest one-tenth of a percent, e.g., 12.342% = 12.3%)?

Quip Corporation wants to purchase a new machine for $300,000. Management predicts that the machine will produce sales of $200,000 each year for the next 5 years. Expenses are expected to include direct materials, direct labor, and factory overhead (excluding depreciation) totaling $80,000 per year. The firm uses straight-line depreciation with an assumed residual (salvage) value of $50,000. Quip's combined income tax rate, t, is 40%. Management requires a minimum of 10% return on all investments. What is the approximate present value payback period, rounded to one-tenth of a year? (Note: PV $1 factors for 10% are as follows: year 1 = 0.909; year 2 = 0.826; year 3 = 0.751; year 4 = 0.683; year 5 = 0.621; the PV annuity factor for 10%, 5 years = 3.791.) Assume that annual after-tax cash inflows occur evenly throughout the year.

Brandon Company is contemplating the purchase of a new piece of equipment for $45,000. Brandon is in the 30% income tax bracket. Predicted annual after-tax cash inflows from this investment are $18,000, $15,000, $9,000, $6,000 and $3,000 for years 1 through 5, respectively. The firm uses straight-line depreciation with no residual value at the end of five years. Assume that the hurdle rate for accepting new capital investment projects for the company is 4%, after-tax. (Note: PV $1 factors for 4% are as follows: for year 1 = 0.962, for year 2 = 0.925, for year 3 = 0.889, for year 4 = 0.855, for year 5 = 0.822; the PV annuity factor for 4%, 5 years = 4.452.) At an after-tax discount rate of 4%, the estimated net present value (NPV) of the proposed investment is (rounded to the nearest hundred dollars):

For capital budgeting purposes, a depreciation tax shield

Omaha Plating Corporation is considering purchasing a machine for $1,500,000. The machine is expected to generate a constant after-tax income of $100,000 per year for 15 years. The firm will use straight-line (SL) depreciation for the new machine over 10 years with no residual value. Its estimated weighted-average cost of capital (WACC) for evaluating capital expenditure proposals is 10%. Note: the PV $1 factor for 10 years, 10% is 0.386; the PV annuity factor for 10%, 10 years is 6.145; and, the PV annuity factor for 10%, 5 years is 3.791. Required: Using a discount rate of 10%, what is the estimated net present value (NPV) of the proposed investment (rounded to the nearest thousand)?

Which of the following is an example of a sunk cost in a capital budgeting decision regarding the replacement of an existing piece of equipment for a profitable business that pays taxes?

Olsen Inc. purchased a $600,000 machine to manufacture a specialty tap for electrical equipment. The tap is in high demand and Olsen can sell all that it could manufacture for the next 10 years. To encourage capital investments, the government exempts taxes on profits from new investments in this type of machinery. This legislation most likely will remain in effect in the foreseeable future. The equipment is expected to have 10 years of useful life and no salvage value at the end of this 10-year period. The firm uses straight-line depreciation. The net cash inflow is expected to be $144,000 each year. Olsen uses a discount rate of 10% in evaluating its capital investments. The estimated net present value (NPV) of this proposed investment (rounded to the nearest thousand) is: (Note: the PV annuity factor from Table 2, Appendix C, 10%, 10 years is 6.145.)

Harris Corporation provides the following data on a proposed capital project:Harris uses straight-line depreciation method with no salvage value. Required: Compute for the proposed investment project: 1. The project's estimated NPV (the PV annuity factor for 12%, 4 years is 3.037). Round your answer to nearest whole number (dollar). 2. The project's IRR (to the nearest tenth of a percent). Note: PV annuity factors for 4 years: @ 8% = 3.312; @ 9% = 3.240; @ 10% = 3.170; @ 11% = 3.102; @ 12% = 3.037; and, @ 13% = 2.974). 3. Payback period (assume that cash inflows occur evenly throughout the year); round answer to two decimal places (e.g., 4.459 years = 4.46 years, rounded). 4. Accounting rate of return (ARR) on the net initial investment, rounded to two decimal places (e.g., 10.4233% = 10.42%). 5. Discounted payback period (assume that the cash inflows occur evenly throughout the year; round your answer to 2 decimal places). The appropriate PV factors for 12% are as follows: year 1 = 0.893; year 2 = 0.797; year 3 = 0.712; year 4 = 0.636.

Kravitz Company is planning to acquire a $250,000 machine to improve manufacturing efficiencies, thereby reducing annual cash operating costs (before taxes) by an estimated $80,000 for each of the next five years. The company's estimated weighted-average cost of capital (WACC) is 8%. The machine will be depreciated using straight-line method over a five-year period with no salvage value. Fritz is subject to a combined 40% income tax rate, t. Note: at 8%, the PV annuity factor for five years is 3.993; at 8%, PV $1 factors are as follows: for year 1 = 0.926; for year 2 = 0.857; for year 3 = 0.794; for year 4 = 0.735; and, for year 5 = 0.681. Required: 1. What is the estimated net present value (NPV) of the proposed investment, rounded to the nearest whole number? 2. What is the present value payback period, in years (rounded to one decimal place, that is, to tenth of a year, e.g., 4.085 years = 4.1 years)? 3. What is the estimated internal rate of return (IRR) on the proposed investment? Round your answer to one decimal place (i.e., tenth of a percent, e.g., 13.4%). (Note: to answer this question, you will need access to the tables presented in Chapter 12, Appendix C or to Excel.)