Exam 12: Strategy and the Analysis of Capital Investments

GuSont Inc. was considering an investment in the following project: Required initial investment \ 990,000 Net annual after-tax cash inflow \ 165,000 Annual depreciation expense (\ 990,000-\ 165,000)/15 years \ 55,000 Estimated salvage value \ 165,000 Life of the project in years 15 The internal rate of return (IRR) is (Note: to solve this problem students will need access either to Appendix C, Table 2 (Chapter 12) or to Excel):

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 accounting (book) rate of return (ARR) based on initial investment for this proposed investment (to two decimal places) is:

When the net present value (NPV) of a project is calculated based on the assumption that the after-tax cash inflows occur at the end of the year when they actually occur uniformly throughout each year, the NPV will:

Madson Company is analyzing several proposed investment projects. The firm has resources only for one project. The company uses the payback period method for making capital investment decisions. Based on this decision model, which project should be selected? (Ignore taxes and assume that cash inflows occur evenly throughout the year. Carry calculations out to two decimal places.)

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. The hurdle rate for accepting new capital investment projects is 4%, after-tax. The estimated accounting rate of return (ARR) on this project (rounded to two decimal points), based on the initial investment is:

Research has shown that in framing capital investment decisions past (i.e., "sunk") costs or losses tend to:

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 internal rate of return (IRR) on this proposed investment is: (Note: the PV annuity factor from Table 2, Appendix C, 10%, 10 years is 6.145.)

In capital budgeting, the accounting rate of return (ARR) decision model:

The Zone Company is considering the purchase of a new machine at a cost of $1,040,000. The machine is expected to improve productivity and thereby increase cash inflows by $250,000 per year for 7 years. It will have no salvage value. The company requires a minimum rate of return of 12 percent on this type of capital investment. (Ignore income taxes for this problem.) Required: 1. Determine the net present value (NPV) of the proposed investment. (The PV annuity factor for 12%, 7 years is 4.564.) Round your answer to the nearest whole number. 2. Determine the project's estimated internal rate of return (IRR), rounded to the nearest tenth of a percent. (Note: PV annuity factors for 7 years: @ 10% = 4.868; @ 11% = 4.712; @ 12% = 4.564; @ 13% = 4.423; @ 14% = 4.288; @ 15% = 4.160; and, @ 20% = 3.605.) 3. What is the estimated payback period for the proposed investment, under the assumption that cash inflows occur evenly throughout the year? Round your answer to 2 decimal places. 4. What is the present value payback period for the proposed investment (rounded to two decimal places)? 5. What is the estimated accounting rate of return (ARR) (on initial investment) for the proposed project? Round your answer to 1 decimal place, e.g., 0.1224 = 12.2%.

The term "breakeven after-tax cash flow" represents:

Under conditions of capital rationing (i.e., limited capital funds are available), the optimal allocation of funds to capital investment projects occurs when management uses which one of the following decision models?

The annual tax depreciation expense on an asset reduces income taxes by an amount equal to

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 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 for depreciation. The machine is considered 3-year property and is not expected to have any significant residual value at the end of its useful life. The company is subject to a 40% combined income tax rate, t. Management uses a 10% weighted-average cost of capital (WACC) to evaluate proposed capital expenditures. 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 payback period for the new machine (rounded to the nearest tenth of a year)? Assume for purposes of this calculation that the cash inflows occur evenly throughout the year. 2. What is the accounting (book) rate of return (ARR) (rounded to two decimal places) based on the initial investment and on average after-tax income over the five-year period? 3. What is the accounting (book) rate of return (ARR) (rounded to two decimal places), based on the average investment, where the latter is determined as a simple average of beginning-of-project and end-of-project book value of the asset?

Slumber Company is considering two mutually exclusive investment alternatives.Its estimated weighted-average cost of capital, used as the discount rate for capital budgeting purposes, is 10%.Following is information regarding each of the two projects: Required: 1.Compute the estimated net present value of each project and determine which alternative, based on NPV, is more desirable.(The PV annuity factor for 10%, 5 years, is 3.7908.) 2.Compute the profitability index (PI) for each alternative and state which alternative, based on PI, is more desirable. 3.Why do the project rankings differ under the two methods of analysis? Which alternative would you recommend, and why?

In situations where a firm specifies different required rates of return (i.e., discount rates) over the years, it is advantageous to use:

Within the context of capital budgeting, a primary goal-congruency problem exists when discounted cash flow (DCF) models are used for decision-making purposes, but accrual-based earnings figures are used for subsequent performance-evaluation purposes. Which of the following items is not likely to be useful for addressing this goal-congruency problem?

Which of the following is not used to deal with uncertainty in the capital budgeting process?

All of the following capital budgeting decision models, except for this one, use cash flows as the primary basis for the calculation.

Nelson Inc.is considering the purchase of a $600,000 machine to manufacture a specialty tap for electrical equipment.The tap is in high demand and Nelson can sell all that it could manufacture for the next ten years, the government exempts taxes on profits from new investments.This legislation will most likely remain in effect in the foreseeable future.The equipment is expected to have ten years of useful life with no salvage value.The firm uses the double-declining-balance depreciation method and switches to the straight-line depreciation method in the last four years of the asset's 10-year life.Nelson uses a rate of 10% in evaluating its capital investments.The net cash inflows are expected to be as follows: Note: PV $1 factors, at 10%: year 1 = 0.909; year 2 = 0.826; year 3 = 0.751; year 4 = 0.683; year 5 = 0.621; year 6 = 0.564; year 7 = 0.513; year 8 = 0.467; year 9 = 0.424; year 10 = 0.386. The PV annuity factor for 10 years, 10% = 6.145. Required: 1. What is the estimated net present value (NPV) of this proposed investment, rounded to the nearest thousand (e.g., $34,480 = $34,000)? 2. What is the estimated internal rate of return (IRR) on this project, rounded to the nearest whole % (e.g., 20.34% = 20%; 20.52% = 21%, etc.)? (Note: Students would have to have access to Excel to answer this question.) 3. What is the present value payback period for this proposed investment, in years (rounded to one decimal place)?

Tyson Company has a pre-tax net cash inflow of $1,200,000. The company can claim depreciation expense of $500,000 this year, and is subject to a combined income tax rate of 26%. What is the after-tax cash inflow for the year?