978-0077826482 Chapter 11 Part 1

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Chapter 11 Capital Budgeting Answer Key

True / False Questions

1. Preference decisions compare an investment with some minimum criteria.

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Capital investment decisions

2. Independent projects are unrelated to one another, so that investing in one project does not

affect the choice about investing in another project.

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Capital investment decisions

3. The accounting rate of return is the only method that focuses on net income rather than cash

flow.

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4. The payback period is defined as the average net income divided by the initial investment.

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Topic: Payback period

5. The payback period method ignores the time value of money.

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

6. The net present value method compares a project’s future net income to the initial investment.

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Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

7. The internal rate of return is the rate of return that yields a zero net present value.

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Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

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8. The internal rate of return method uses cash flows rather than net income.

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Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

9. The profitability index is calculated as the present value of future cash flows divided by the

initial investment.

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Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Profitability index

10. Sensitivity analysis helps determine whether changing the underlying assumptions would

affect the decision.

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Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

11. When deciding between mutually exclusive investments, a manager should choose the option

with the lowest depreciation.

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Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

12. When managers must choose among independent projects, they should prioritize projects

according to their net present value.

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Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

13. An example of a future value of a single amount problem would be finding how much the right

to receive a certain amount in the future would be worth today.

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Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

14. To find the present value of a single amount, you only need to know the amount to be received

in the future, the interest rate and the number of periods until the amount will be received.

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Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

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15. An annuity is a series of consecutive payments that are equal in dollar amount, have interest

periods of equal length, and earn an equal interest rate each period.

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Topic: Time value of money

Multiple Choice Questions

16. Which of the following statements is correct about capital assets?

A. For managerial accounting purposes, “capital assets” are defined more narrowly than for

financial accounting purposes.

B. Human capital and research and development are both considered capital assets for

financial accounting purposes, but not for managerial accounting purposes.

C. Capital assets are only those that can be depreciated, whether using managerial or

financial accounting.

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Topic: Capital budgeting process

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17. A decision that occurs when managers evaluate a proposed capital investment to determine

whether it meets some minimum criteria is a(n):

A. preference decision.

B. capital decision.

D. incremental decision.

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Topic: Capital investment decisions

18. A decision that requires managers to choose from among a set of alternative capital

investment opportunities is a(n):

B. capital decision.

C. screening decision.

D. incremental decision.

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19. Projects that are unrelated to one another, so that investing in one project does not preclude or

affect the choice about investing in the other alternatives, are:

A. mutually exclusive projects.

B. screening projects.

D. preference projects.

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Capital investment decisions

20. Projects that involve a choice among competing alternatives, where selection of one project

implies rejection of all the other alternatives, are:

B. screening projects.

C. independent projects.

D. preference projects.

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Capital investment decisions

21. Which of the following capital budgeting methods does not use discounted cash flows?

A. Net present value

B. Internal rate of return

D. Profitability index

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

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22. The accounting rate of return is calculated as:

A. initial investment divided by annual net income.

B. initial investment divided by required rate of return.

D. annual net income divided by required rate of return.

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Accounting rate of return

23. The accounting rate of return is also called all of the following except:

A. annual rate of return.

C. simple rate of return.

D. unadjusted rate of return.

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Accounting rate of return

24. Which of the following methods is calculated as annual net income as a percentage of the

original investment in assets?

B. Payback period

C. Net present value

D. Internal rate of return

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Topic: Accounting rate of return

25. Which of the following is the formula for accounting rate of return?

A. Initial investment/net income

B. Annual net cash flow/Initial investment

C. Initial investment/Annual net cash flow

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Accounting rate of return

26. Which of the following capital budgeting methods focuses on net income rather than cash

flows?

A. Payback period

C. Net present value

D. Internal rate of return

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27. How does the accounting rate of return differ from the return on investment formula?

A. They are not different; both are calculated by dividing net operating income by initial

investment.

B. The numerator in each formula differs; accounting rate of return divides net operating

income by initial investment, and return on investment divides gross operating income by

initial investment.

C. The numerator in each formula differs; accounting rate of return divides net operating

income by average invested assets, while return on investment divides gross operating

income by average invested assets.

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Accounting rate of return

28. Palmer Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in net income after tax of $100,000. The

equipment will have an initial cost of $400,000 and have a 7-year life. If the salvage value of

the equipment is estimated to be $75,000, what is the accounting rate of return?

A. 14.28%

C. 42.11%

D. 147.37%

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29. Belmont Corp. is considering the purchase of a new piece of equipment. The cost savings

from the equipment would result in an annual increase in net income after tax of $200,000.

The equipment will have an initial cost of $1,000,000 and have an 8-year life. If there is no

salvage value of the equipment, what is the accounting rate of return?

A. 12.5%

C. 40%

D. 15%

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Accounting rate of return

30. Nelson Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in cash flow of $100,000. The equipment will

have an initial cost of $400,000 and have a 5-year life. If the salvage value of the equipment is

estimated to be $75,000, what is the accounting rate of return? Ignore income taxes.

A. 6.25%

C. 25.00%

D. 26.67%

First, calculate the increase in net income from the equipment. Depreciation expense equals

$65,000 per year [($400,000 – $75,000)/5 = $65,000] and cash flow increase is $100,000. The

effect of these two things on net income is a $35,000 increase. [$100,000 increase – $65,000

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31. Newport Corp. is considering the purchase of a new piece of equipment. The cost savings

from the equipment would result in an annual increase in cash flow of $200,000. The

equipment will have an initial cost of $900,000 and have a 6-year life. There is no salvage

value for the equipment. What is the accounting rate of return? Ignore income taxes.

B. 16.67%

C. 22.22%

D. 44.44%

First, calculate the increase in net income from the equipment. Depreciation expense equals

$150,000 per year [($900,000 – $0)/6 = $150,000] and cash flow increase is $200,000. The

effect of these two things on net income is a $50,000 increase. [$200,000 increase – $150,000

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Accounting rate of return

32. Fletcher Corp. is considering the purchase of a new piece of equipment. The equipment will

have an initial cost of $400,000, a 5-year life, and a salvage value of $75,000. If the

accounting rate of return for the project is 10%, what is the annual increase in net cash flow?

Ignore income taxes.

A. $25,000

B. $40,000

C. $65,000

Work backwards to solve for the increase in cash flows. First calculate annual depreciation

expense to be $65,000. [($400,000 – $75,000)/5 = $65,000] Net income ($400,000) multiplied

by the accounting rate of return (10%) is $40,000. [$400,000 × 10% = $40,000] Thus, the

annual increase in net cash flow equals $105,000, the sum of depreciation expense and the

increase in net income. [$65,000 + $40,000 = $105,000]

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Accounting rate of return

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33. Addison Corp. is considering the purchase of a new piece of equipment. The equipment will

have an initial cost of $900,000, a 6-year life, and no salvage value. If the accounting rate of

return for the project is 5%, what is the annual increase in net cash flow? Ignore income

taxes.

A. $45,000

B. $105,000

C. $150,000

Work backwards to solve for the increase in cash flows. First calculate annual depreciation

expense to be $150,000. [($900,000 – $0)/6 = $150,000] Net income ($900,000) multiplied by

the accounting rate of return (5%) is $45,000. [$900,000 × 5% = $45,000] Thus, the annual

increase in net cash flow equals $195,000, the sum of depreciation expense and the increase

in net income. [$150,000 + $45,000 = $195,000]

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Accounting rate of return

34. Which of the following is not a limitation of using the accounting rate of return method for

capital budgeting?

A. The accounting rate of return method does not incorporate time value of money.

B. The accounting rate of return method is based on accounting income, rather than cash

flow.

than cash flow.

D. The accounting rate of return method is subject to potential manipulation based on

accounting choices made by management (e.g., the method used to depreciate a capital

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35. Which of the following would be included in net income but not in annual cash flows?

A. Sales revenue

C. Initial investment

D. Direct labor

Depreciation is a non-cash expense, so it would not be included as part of annual cash flows;

however, it is included in computing net income.

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Net cash flow versus net income

36. Homer Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in net income after tax of $100,000. The

equipment will have an initial cost of $400,000 and have a 5-year life. If the salvage value of

the equipment is estimated to be $75,000, what is the annual net cash flow?

A. $25,000

B. $35,000

D. $175,000

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Topic: Net cash flow versus net income

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37. Cortland Corp. is considering the purchase of a new piece of equipment. The cost savings

from the equipment would result in an annual increase in net cash flows of $100,000. The

equipment will have an initial cost of $400,000 and have a 5-year life. If the salvage value of

the equipment is estimated to be $75,000, what is the annual net income? Ignore income

taxes.

A. $25,000

C. $165,000

D. $175,000

Annual depreciation expense is $65,000. [($400,000 – $75,000)/5 = $65,000] Subtract this

annual depreciation expense (a non-cash item) from annual net cash flow ($100,000) to

determine annual net income. [$100,000 – $65,000 = $35,000]

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Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Net cash flow versus net income

38. The total time to recover an original investment is the:

A. net present value.

B. internal rate of return.

C. accounting rate of return.

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

39. When cash flows are equal each year, the payback period is calculated as:

A. Initial investment × Annual net cash flow.

C. Annual net cash flow/Initial investment.

D. Annual net cash flow – Initial investment/Project life.

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

40. If cash flows are not equal each year, the payback period:

A. cannot be calculated.

B. is calculated by dividing the initial investment by the average cash flows.

reached.

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

41. Nelson Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in cash flow of $100,000. The equipment will

have an initial cost of $400,000 and have a 5-year life. If the salvage value of the equipment is

estimated to be $75,000, what is the payback period? Ignore income taxes.

A. 3.25 years

C. 4.75 years

D. 7.00 years

Initial investment divided by the annual increase in cash flow equals the payback period.

[$400,000/$100,000 = 4 years] (Ignore depreciation in the computation because it is a non-

cash expense.)

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

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42. Newport Corp. is considering the purchase of a new piece of equipment. The cost savings

from the equipment would result in an annual increase in cash flow of $200,000. The

equipment will have an initial cost of $900,000 and have a 6-year life. There is no salvage

value for the equipment. What is the payback period?

A. 1.33 years

B. 2.57 years

D. 6.00 years

Initial investment divided by the annual increase in net cash flows equals the payback period.

[$900,000/$200,000 = 4.5 years] (Ignore depreciation in the computation because it is a non-

cash expense.)

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

43. Wright Corp. is considering the purchase of a new piece of equipment, which would have an

initial cost of $1,000,000 and a 5-year life. There is no salvage value for the equipment. The

increase in cash flow each year of the equipment’s life would be as follows:

Year 1 $375,000

Year 2 $350,000

Year 3 $285,000

Year 4 $230,000

Year 5 $185,000

What is the payback period?

A. 2.39 years

C. 3.00 years

D. 3.51 years

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44. Patterson Corp. is considering the purchase of a new piece of equipment, which would have

an initial cost of $500,000, a 7-year life, and $150,000 salvage value. The increase in cash

flow each year of the equipment’s life would be as follows:

Year 1 $99,000

Year 2 $91,000

Year 3 $89,000

Year 4 $78,000

Year 5 $75,000

Year 6 $70,000

Year 7 $64,000

What is the payback period?

A. 5.51 years

C. 6.00 years

D. 6.18 years

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

45. Palmer Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in net income after tax of $100,000. The

equipment will have an initial cost of $400,000 and have a 7-year life. If the salvage value of

the equipment is estimated to be $75,000, what is the payback period?

B. 4.00 years

C. 4.75 years

D. 7.00 years

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Topic: Payback period

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46. Belmont Corp. is considering the purchase of a new piece of equipment. The cost savings

from the equipment would result in an annual increase in net income after tax of $200,000.

The equipment will have an initial cost of $1,000,000 and have an 8-year life. If there is no

salvage value of the equipment, what is the payback period?

A. 1.6 years

C. 5 years

D. 8 years

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

47. Wright Corp. is considering the purchase of a new piece of equipment, which would have an

initial cost of $1,000,000 and a 5-year life. There is no salvage value for the equipment. The

increase in net income each year of the equipment’s life would be as follows:

Year 1 $375,000

Year 2 $350,000

Year 3 $285,000

Year 4 $230,000

Year 5 $185,000

What is the payback period?

B. 2.06 years

C. 2.96 years

D. 3.51 years

0.77 = 1.77 years.

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Topic: Payback period

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48. Patterson Corp. is considering the purchase of a new piece of equipment, which would have

an initial cost of $500,000, a 7-year life, and $150,000 salvage value. The increase in net

income each year of the equipment’s life would be as follows:

Year 1 $99,000

Year 2 $91,000

Year 3 $89,000

Year 4 $78,000

Year 5 $75,000

Year 6 $70,000

Year 7 $64,000

What is the payback period?

B. 3.82 years

C. 5.97 years

D. 6.18 years

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

49. The payback method:

A. is a complex method of analysis.

B. is infrequently used.

C. incorporates the time value of money.

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

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50. Which of the following statement regarding the payback method is incorrect?

A. The payback period is the amount of time it takes for a capital investment to “pay for itself.“

shorter payback periods.

C. When cash flows are equal each year, the payback period is calculated by dividing the

initial investment in the project by its annual cash flow.

D. The payback method is often used as a screening tool for potential investments.

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Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

51. The method that compares the present value of a project’s future cash flows to the initial

investment is:

A. accounting rate of return.

B. payback period.

D. internal rate of return.

The net present value method compares the present value of a project’s future cash flows to

the initial investment; the difference between the two is the net present value.

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Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

52. Which of the following statements is correct about the net present value method?

A. It is a discounted cash flow method based on net income.

B. It is a non-discounted method based on net income.

D. It is a non-discounted method based on cash flow.

11-21

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Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

53. If a project has a positive net present value, it means the project is expected to provide returns

that are ___________ the cost of capital.

B. less than

C. equal to

D. not connected to

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Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

54. The minimum required rate of return for a project is the:

A. annual rate of return.

B. accounting rate of return.

D. internal rate of return.

The rate used to compute the net present value is called the required rate of return, the

minimum rate of return, or the hurdle rate.

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Topic: Net present value

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55. If the hurdle rate is greater than the internal rate of return, the net present value will be:

A. positive.

C. zero.

D. equal to the hurdle rate.

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Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

56. A positive net present value indicates that a project will:

B. generate more cash than is initially invested.

C. generate more cash than alternative projects.

D. generate a return in excess of alternative projects.

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Difficulty: 1 Easy

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

57. When making screening decisions using the net present value method, a project is acceptable

if:

A. the NPV is greater than the hurdle rate.

B. the NPV is greater than the IRR.

D. the NPV is negative.

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11-23

McGraw-Hill Education.

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

58. Newport Corp. is considering the purchase of a new piece of equipment. The cost savings

from the equipment would result in an annual increase in cash flow of $200,000. The

equipment will have an initial cost of $900,000 and have a 6-year life. There is no salvage

value for the equipment. If the hurdle rate is 10%, what is the approximate net present value?

Ignore income taxes.

B. Positive $28,940

C. Zero

D. Positive $300,000

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Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

59. Newport Corp. is considering the purchase of a new piece of equipment. The cost savings

from the equipment would result in an annual increase in cash flow of $200,000. The

equipment will have an initial cost of $900,000 and have a 6-year life. There is no salvage

value for the equipment. If the hurdle rate is 8%, what is the approximate net present value?

Ignore income taxes.

A. $924,580

C. $900,000

D. $300,000

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Difficulty: 2 Medium

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

11-24

McGraw-Hill Education.

60. Byron Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in cash flow of $100,000. The equipment will

have an initial cost of $400,000 and have a 5-year life. The salvage value of the equipment is

estimated to be $75,000. If the hurdle rate is 10%, what is the approximate net present value?

Ignore income taxes.

B. $100,000

C. $175,000

D. ($20,291)

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Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

61. Byron Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in cash flow of $100,000. The equipment will

have an initial cost of $400,000 and have a 5-year life. The salvage value of the equipment is

estimated to be $75,000. If the hurdle rate is 15%, what is the approximate net present value?

Ignore income taxes.

B. Zero

C. Positive $400,000

D. Positive $75,000

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Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

11-25

McGraw-Hill Education.

62. Wilson Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in net income after tax of $50,000. The

equipment will have an initial cost of $600,000 and have an 8-year life. The salvage value of

the equipment is estimated to be $100,000. If the hurdle rate is 10%, what is the approximate

net present value?

A. Less than zero

B. $100,000

C. $500,000

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Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

63. A profitability index greater than ____________ means that a project has a positive NPV.

A. negative one

B. zero

D. the hurdle rate

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Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Profitability index

64. The discount rate that would return a net present value equal to zero is the:

A. annual rate of return.

B. accounting rate of return.

C. hurdle rate.

D. internal rate of return.

Internal rate of return is calculated as the discount rate that would return a net present value

equal to zero.

11-26

McGraw-Hill Education.

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Difficulty: 2 Medium

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Difficulty: 2 Medium

Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

11-27

McGraw-Hill Education.

67. Grace Corp., whose required rate of return is10%, is considering the purchase of a new piece

of equipment. The internal rate of return of the project, which has a life of 8 years, is 12%. The

project would have:

A. an accounting rate of return greater than 10%.

B. a payback period more than 8 years.

C. a net present value of zero.

If the internal rate of return is greater than the required rate of return, the net present value will

be positive.

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Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

68. Newport Corp. is considering the purchase of a new piece of equipment. The cost savings

from the equipment would result in an annual increase in cash flow of $200,000. The

equipment will have an initial cost of $900,000 and have a 6-year life. There is no salvage

value for the equipment. If the hurdle rate is 10%, what is the internal rate of return? Ignore

income taxes.

A. Between 6% and 8%

C. Between 10% and 12%

D. Less than zero

The net present value at 10% is ($200,000 × 4.3553) – $900,000 = ($28,940), so the internal

rate of return is less than 10% since NPV is negative. The net present value at 8% is

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Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

11-28

McGraw-Hill Education.

69. Olive Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in cash flow of $250,000. The equipment will

have an initial cost of $1,300,000 and have an 8-year life. There is no salvage value for the

equipment. If the hurdle rate is 10%, what is the internal rate of return? Ignore income taxes.

A. Between 6% and 8%

B. Between 8% and 10%

D. Less than zero

The net present value at 10% is ($250,000 × 5.3349) – $1,300,000 = $33,725 so the internal

rate of return is more than 10% since NPV is positive.

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Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

70. Byron Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in cash flow of $100,000. The equipment will

have an initial cost of $400,000 and have a 5-year life. The salvage value of the equipment is

estimated to be $75,000. If the hurdle rate is 10%, what is the internal rate of return?

A. Between 6% and 8%

B. Between 8% and 10%

C. Between 10% and 12%

The net present value at 12% is ($100,000 × 3.6048) + ($75,000 × 0.5674) – $400,000 =

$3,035, so the internal rate of return is more than 12% since NPV is positive. The net present

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Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

11-29

McGraw-Hill Education.

71. Wilson Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in net income after tax of $50,000. The

equipment will have an initial cost of $600,000 and have an 8-year life. The salvage value of

the equipment is estimated to be $100,000. If the hurdle rate is 10%, what is the internal rate

of return?

A. Less than zero

B. Between zero and 10%

D. More than 15%

Depreciation = ($600,000 – $100,000)/8 = $62,500. Annual cash flow = $50,000 + $62,500 =

$112,500. Net present value at 10% = ($112,500 × 5.3349) + ($100,000 × 0.4665) – $600,000

= $46,826, so the internal rate of return is more than 10% since NPV is positive. Net present

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Difficulty: 3 Hard

Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

72. When comparing mutually exclusive capital investments, managers should:

B. choose the option with the lowest undiscounted cost.

C. not use net present value because it cannot be used to compare investments.

D. not use sensitivity analysis.

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Difficulty: 1 Easy

Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

11-30

McGraw-Hill Education.

73. An analysis that reveals whether changing the underlying assumptions would affect the

decision is a:

A. net present value analysis.

B. internal rate of return analysis.

C. payback period analysis.

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Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

74. Heidi Inc. is considering whether to lease or purchase a piece of equipment. The total cost to

lease the equipment will be $120,000 over its estimated life, while the total cost to buy the

equipment will be $75,000 over its estimated life. At Heidi’s required rate of return, the net

present value of the cost of leasing the equipment is $73,700 and the net present value of the

cost of buying the equipment is $68,000. Based on financial factors, Heidi should:

A. lease the equipment, saving $45,000 over buying.

B. buy the equipment, saving $45,000 over leasing.

C. lease the equipment, saving $5,700 over buying.

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Difficulty: 2 Medium

Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

11-31

McGraw-Hill Education.

75. Devon Corp. is trying to decide whether to lease or purchase a piece of equipment. The total

cost lease the equipment will be $150,000 over its estimated life, while the total cost to buy the

equipment will be $120,000 over its estimated life. At Devon’s required rate of return, the net

present value of the cost of leasing the equipment is $108,000 and the net present value of the

cost of buying the equipment is $119,000. Based on financial factors, Devon should:

A. lease the equipment, saving $30,000 over buying.

B. buy the equipment, saving $30,000 over leasing.

D. buy the equipment, saving $11,000 over leasing.

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Difficulty: 2 Medium

Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

76. Foster Inc. is trying to decide whether to lease or purchase a piece of equipment needed for

the next ten years. The equipment would cost $45,000 to purchase, and maintenance costs

would be $5,000 per year. After ten years, Foster estimates it could sell the equipment for

$20,000. If Foster leases the equipment, it would pay $12,000 each year, which would include

all maintenance costs. If the hurdle rate for Foster is 10%, Foster should:

A. lease the equipment, as net present value of cost is about $5,700 less.

C. lease the equipment, as net present value of cost is about $2,000 less.

D. buy the equipment, as net present value of cost is about $45,000 less.

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Difficulty: 2 Medium

Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

11-32

McGraw-Hill Education.

77. Randall Corp. is trying to decide whether to lease or purchase a piece of equipment needed

for the next five years. The equipment would cost $100,000 to purchase, and maintenance

costs would be $10,000 per year. After five years, Randall estimates it could sell the

equipment for $30,000. If Randall leases the equipment, it would pay $30,000 each year,

which would include all maintenance costs. If the hurdle rate for Randall is 12%, Randall

should:

B. buy the equipment, as net present value of cost is about $11,000 less.

C. lease the equipment, as net present value of cost is about $30,000 less.

D. buy the equipment, as net present value of cost is about $30,000 less.

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Difficulty: 2 Medium

Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

78. Frank Inc. is trying to decide whether to lease or purchase a piece of equipment needed for

the next ten years. The equipment would cost $45,000 to purchase, and maintenance costs

would be $5,000 per year. After ten years, Frank estimates it could sell the equipment for

$20,000. If Frank leased the equipment, it would pay a set annual fee that would include all

maintenance costs. Frank has determined after a net present value analysis that at its hurdle

rate of 10%, it would be better off by $5,700 if it buys the equipment. What would the

approximate annual cost be if Frank were to lease the equipment?

A. $9,000

B. $7,000

D. $13,250

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Difficulty: 3 Hard

Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

11-33

McGraw-Hill Education.

79. Dallas Corp. is trying to decide whether to lease or purchase a piece of equipment needed for

the next five years. The equipment would cost $100,000 to purchase, and maintenance costs

would be $10,000 per year. After five years, Dallas estimates it could sell the equipment for

$30,000. If Dallas leased the equipment, it would pay a set annual fee that would include all

maintenance costs. Dallas has determined after a net present value analysis that at its hurdle

rate of 12% it would be better off by $11,000 if it leases the equipment. What would the

approximate annual cost be if Dallas were to lease the equipment?

A. $21,800

B. $27,800

D. $34,700

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Difficulty: 3 Hard

Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

80. Independent projects should be prioritized according to their:

B. net present value.

C. payback period.

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Difficulty: 1 Easy

Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

11-34

McGraw-Hill Education.

81. When a project has a positive net present value, it has a profitability index:

A. greater than zero.

B. less than zero.

D. less than one.

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Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

82. Carmen, Inc. is considering three different independent investment opportunities. The present

value of future cash flows, initial investment, net present value, and profitability index for each

of the projects are as follows:

Project A Project B Project C

Present value of

future cash flows $300,000 $250,000 $275,000

Initial investment 150,000 105,000 140,000

Net present value $150,000 $145,000 $135,000

Profitability index 2.00 2.38 1.96

In what order should Carmen prioritize investment in the projects?

A. A, C, B

B. B, C, A

C. A, B, C

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Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

11-35

McGraw-Hill Education.

83. Norwood, Inc. is considering three different independent investment opportunities. The present

value of future cash flows, initial investment, net present value, and profitability index for each

of the projects are as follows:

Project A Project B Project C

Present value of

future cash flows $600,000 $550,000 $500,000

Initial investment 320,000 300,000 230,000

Net present value $280,000 $250,000 $270,000

Profitability index 1.88 1.83 2.17

In what order should Norwood prioritize investment in the projects?

A. A, B, C

B. C, B, A

C. A, C, B

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Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

11-36

McGraw-Hill Education.

84. Carol, Inc. is considering three different independent investment opportunities. The present

value of future cash flows, initial investment, and net present value for each of the projects are

as follows:

Project A Project B Project C

Present value of

future cash flows $300,000 $250,000 $275,000

Initial investment 150,000 105,000 140,000

Net present value $150,000 $145,000 $135,000

In what order should Carol prioritize investment in the projects?

A. A, C, B

B. B, C, A

C. A, B, C

2.38, and for C is $275,000/$140,000 = 1.96. Independent capital investment projects should

be prioritized according to their profitability index. The ranking from highest to lowest would be

B, A, C.

AACSB: Analytical Thinking

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Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

11-37

McGraw-Hill Education.

85. Boxwood, Inc. is considering three different independent investment opportunities. The

present value of future cash flows, initial investment, and net present value for each of the

projects are as follows:

Project A Project B Project C

Present value of

future cash flows $600,000 $550,000 $500,000

Initial investment 320,000 300,000 230,000

Net present value $280,000 $250,000 $270,000

In what order should Boxwood prioritize investment in the projects?

A. A, B, C

B. C, B, A

C. A, C, B

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Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

11-38

McGraw-Hill Education.

86. Iron, Inc., which has a hurdle rate of 10%, is considering three different independent

investment opportunities. Each project has a five-year life. The annual cash flows and initial

investment for each of the projects are as follows:

Project A Project B Project C

Annual cash flows $79,150 $65,950 $72,540

Initial investment 150,000 105,000 140,000

In what order should Iron prioritize investment in the projects?

A. A, C, B

B. B, C, A

C. A, B, C

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Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

11-39

McGraw-Hill Education.

87. Ironwood, Inc., which has a hurdle rate of 12%, is considering three different independent

investment opportunities. Each project has a seven-year life. The annual cash flows and initial

investment for each of the projects are as follows:

Project A Project B Project C

Annual cash flows $131,470 $120,520 $109,560

Initial investment 320,000 300,000 230,000

In what order should Ironwood prioritize investment in the projects?

A. A, B, C

B. C, B, A

C. A, C, B

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Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

88. The value today of cash flow to be received in the future is called:

B. cash value.

C. future value.

D. accounting value.

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Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

11-40

McGraw-Hill Education.

89. A problem in which you must calculate how much money you will have in the future as a result

of investing a certain amount in the present is a:

B. present value of a single amount problem.

C. future value of an annuity problem.

D. present value of an annuity problem.

A future value of a single amount problem is one in which you calculate the amount of an

investment in the future.

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Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

90. If you invest $10,000 today in a savings account that earns 5% interest, compounded annually,

how much would be in the account at the end of ten years?

A. $6,139

C. $77,217

D. $125,779

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Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

91. You purchase a home for $200,000 that you expect to appreciate 6% in value on an annual

basis. How much will the home be worth in ten years?

A. $111,680

C. $1,472,020

D. $2,636,160

11-41

McGraw-Hill Education.

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Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

92. You have $10,000 that you can invest in a savings account that earns 7% interest,

compounded annually. If you want to withdraw at least $18,000 at some point in the future,

how long will you need to keep the money invested?

B. 10 years

C. 11 years

D. 12 years

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Difficulty: 2 Medium

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

93. A problem in which you must calculate the worth to you today of receiving a certain amount at

some time in the future is a:

A. future value of a single amount problem.

C. future value of an annuity problem.

D. present value of an annuity problem.

A present value of a single amount problem is one in which you must calculate the worth to

you today of receiving a certain amount at some point in the future.

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Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

11-42

McGraw-Hill Education.

94. How much would you need to deposit in a savings account that earns 7%, compounded

annually, to withdraw $20,000 eight years from now?

B. $18,600

C. $18,692

D. $34,364

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Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

95. You are saving for a car that costs $28,000 that you hope to purchase in five years. How much

will you need to deposit today in a savings account that earns 8%, compounded annually, to

withdraw enough for the purchase?

A. $16,800

C. $25,760

D. $41,140

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Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

11-43

McGraw-Hill Education.

96. Your grandmother has told you she can either give you $4,000 now or $5,000 when you

graduate from college in three years. Your savings account earns 7% interest, compounded

annually. Which option would be worth more to you now, and how much more?

A. The $4,000 now is worth $81.50 more than the $5,000 in the future.

B. The $4,000 now is worth $100.00 more than the $5,000 in the future.

D. The $5,000 in the future is worth $100.00 more than the $4,000 now.

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Difficulty: 3 Hard

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

97. Which of the following is not a characteristic of an annuity?

A. It is a series of equal payments.

B. It earns an equal interest rate each interest period.

D. Interest periods are of equal length.

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Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

11-44

McGraw-Hill Education.

98. A problem in which you must calculate how much money you will have in the future as a result

of depositing a fixed amount of money each period is a:

A. future value of a single amount problem.

B. present value of a single amount problem.

D. present value of an annuity problem.

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Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

99. How much will you have in a savings account in ten years, if you deposit $1000 in the account

at the end of each year and the account earns 6% interest, compounded annually?

A. $10,000

B. $10,600

D. $17,906

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Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

11-45

McGraw-Hill Education.

100. You are saving for a car that you plan to purchase in five years. You plan to put $3,000 in

savings (which earns 8%, compounded annually) at the end of each year until then. How much

will you have saved for the car at the end of the five years?

A. $15,000

B. $16,200

D. $22,040

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Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

101. You will need at least $5,000 in four years and your friend says she can either loan you $5,000

all at once four years from now or she can deposit $1,200 in your savings account at the end

of each year for the next four years. Your savings account earns 7% interest, compounded

annually. Which option would be worth more to you four years from now, and how much

more?

A. The $5,000 in four years will be worth $328 more than the annual deposits.

C. The $5,000 in four years will be worth $136 more than the annual deposits.

D. The annual deposits will be worth $136 more than the $5,000 in four years.

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Difficulty: 3 Hard

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

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McGraw-Hill Education.

102. A problem in which you must calculate the value now of a series of equal amounts to be

received for some specified number of periods in the future is a:

A. future value of a single amount problem.

B. present value of a single amount problem.

C. future value of an annuity problem.

AICPA: FN Measurement

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

103. How much would you need to deposit now in a savings account that earns 5% interest,

compounded annually, in order to withdraw $5,000 at the end of every year for ten years?

B. $47,500

C. $47,619

D. $50,000

AICPA: FN Measurement

Accessibility: Keyboard Navigation

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

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104. You have a savings account that earns 5% interest, compounded annually. A friend has offered

you an investment opportunity; he says that if you invest in his new business, he will pay you

$10,000 a year for the next five years. What is the maximum amount you would be willing to

invest in your friend’s business?

B. $47,500

C. $47,619

D. $50,000

Identify the multiplier (4.3295) to calculate the present value of a future annuity. The most you

would be willing to invest based on the outlined terms is the investment’s present value.

AICPA: FN Measurement

Accessibility: Keyboard Navigation

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

105. You invest $13,420 in an annuity contract that earns 8% interest, compounded annually. You

are to receive annual payments for the next ten years. How much will each of the payments

be?

A. $1,342

B. $1,449

C. $1,459

AICPA: FN Measurement

Accessibility: Keyboard Navigation

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

Essay Questions

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106. Fargo Corp. is considering the purchase of a new piece of equipment. The equipment costs

$50,000, and will have a salvage value of $5,000 after nine years. Using the new piece of

equipment will increase Fargo’s annual cash flows by $6,000. Fargo has a hurdle rate of 12%.

a. How much is Fargo’s annual depreciation on the equipment?

b. What is Fargo’s projected annual increase in net income?

c. What is the accounting rate of return for purchasing the new piece of equipment?

d. Based on financial factors, should Fargo purchase the new equipment? Why or why not?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Topic: Accounting rate of return

107. Fire Corp. is considering the purchase of a new piece of equipment. The equipment costs

$50,000, and will have a salvage value of $5,000 after nine years. Using the new piece of

equipment will increase Fire’s annual cash flows by $6,000.

a. What is the payback period for the new piece of equipment?

b. Suppose that the increase in cash flows were $10,000 in the first year, then decreased by

$1,000 each year over the life of the equipment. What is the payback period for the

equipment?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Payback period

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108. Dobson Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in net income of $50,000. The equipment will

have an initial cost of $500,000 and have an 8-year life. There is no salvage value of the

equipment. The hurdle rate is 10%. Ignore income taxes. Calculate the following:

a. Accounting rate of return

b. Payback period

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Accounting rate of return

Topic: Payback period

109. Lexington Corp. is considering the purchase of a new piece of equipment. The cost savings

from the equipment would result in an annual increase in cash flow of $100,000. The

equipment will have an initial cost of $500,000 and have an 8-year life. There is no salvage

value of the equipment. The hurdle rate is 8%. Ignore income taxes. Calculate the following:

a. Accounting rate of return

b. Payback period

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Topic: Accounting rate of return

Topic: Payback period

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110. Grady Corp. is considering the purchase of a new piece of equipment. The equipment costs

$50,000, and will have a salvage value of $5,000 after nine years. Using the new piece of

equipment will increase Grady’s annual cash flows by $6,000. Grady has a hurdle rate of 12%.

a. What is the present value of the increase in annual cash flows?

b. What is the present value of the salvage value?

c. What is the net present value of the equipment purchase?

d. Based on financial factors, should Grady purchase the equipment? Why?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Topic: Net present value

111. Cloud Corp. is considering the purchase of a new piece of equipment. The equipment costs

$30,000, and will have a salvage value of $4,000 after nine years. Using the new piece of

equipment will increase Cloud’s annual cash flows by $6,000. Cloud has a hurdle rate of 12%.

a. What is the net present value?

b. What would the net present value be with a 15% hurdle rate?

c. Based on the NPV calculations, in what range would the equipment’s internal rate of return

fall?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

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112. Major Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in cash flow of $100,000. The equipment will

have an initial cost of $500,000 and have an 8-year life. The equipment has no salvage value.

The hurdle rate is 8%. Ignore income taxes. Answer the following:

a. What is the net present value?

b. What would the net present value be with a 12% hurdle rate?

c. Based on the NPV calculations, in what range would the equipment’s internal rate of return

fall?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

Topic: Net present value

113. Mindy Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in net income after tax of $50,000. The

equipment will have an initial cost of $500,000 and have an 8-year life. The equipment has no

salvage value. The hurdle rate is 10%. Answer the following:

a. What is the net present value?

b. What would the net present value be with a 15% hurdle rate?

c. Based on the NPV calculations, in what range would the equipment’s internal rate of return

fall?

AICPA: FN Measurement

Blooms: Apply

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McGraw-Hill Education.

Difficulty: 3 Hard

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Internal rate of return

Topic: Net present value

114. Grove Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in net income of $200,000. The equipment

will have an initial cost of $1,200,000 and have an 8 year life. The salvage value of the

equipment is estimated to be $200,000. The hurdle rate is 10%. Ignore income taxes. Answer

the following:

a. What is the accounting rate of return?

b. What is the payback period?

c. What is the net present value?

d. What would the net present value be with a 15% hurdle rate?

e. Based on the NPV calculations, in what range would the equipment’s internal rate of return

fall?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Accounting rate of return

Topic: Internal rate of return

Topic: Net present value

Topic: Payback period

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115. Briar Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in cash flow of $200,000. The equipment will

have an initial cost of $1,200,000 and have an 8-year life. The salvage value of the equipment

is estimated to be $200,000. The hurdle rate is 8%. Ignore income taxes. Answer the following:

a. What is the accounting rate of return?

b. What is the payback period?

c. What is the net present value?

d. What would the net present value be with a 12% hurdle rate?

e. Based on the NPV calculations, in what range would the equipment’s internal rate of return

fall?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Accounting rate of return

Topic: Internal rate of return

Topic: Net present value

Topic: Payback period

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116. Surf Corp. is considering the purchase of a new piece of equipment. The cost savings from the

equipment would result in an annual increase in net income of $50,000. The equipment will

have an initial cost of $600,000 and have an 8-year life. The equipment has no salvage value.

The hurdle rate is 10%. Ignore income taxes. Answer the following:

a. What is the accounting rate of return?

b. What is the payback period?

c. What is the net present value?

d. What would the net present value be with a 15% hurdle rate?

e. Based on the NPV calculations, in what range would the equipment’s internal rate of return

fall?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Accounting rate of return

Topic: Internal rate of return

Topic: Net present value

Topic: Payback period

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117. Clyde Corp. is considering the purchase of a new piece of equipment. The cost savings from

the equipment would result in an annual increase in cash flow of $100,000. The equipment will

have an initial cost of $600,000 and have an 8-year life. The equipment has no salvage value.

The hurdle rate is 8%. Ignore income taxes. Answer the following:

a. What is the accounting rate of return?

b. What is the payback period?

c. What is the net present value?

d. What would the net present value be with a 12% hurdle rate?

e. Based on the NPV calculations, in what range would the equipment’s internal rate of return

fall?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Learning Objective: 11-01 Calculate the accounting rate of return and describe its major weaknesses.

Learning Objective: 11-02 Calculate the payback period and describe its major weaknesses.

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Learning Objective: 11-04 Predict the internal rate of return and describe its relationship to net present value.

Topic: Accounting rate of return

Topic: Internal rate of return

Topic: Net present value

Topic: Payback period

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118. Emerson Corp. is trying to decide whether to lease or purchase a piece of equipment needed

for the next five years. The equipment would cost $500,000 to purchase, and maintenance

costs would be $20,000 per year. After five years, Emerson estimates it could sell the

equipment for $100,000. If Emerson leases the equipment, it would pay $150,000 each year,

which would include all maintenance costs. Emerson’s hurdle rate is 12%.

a. What is the net present value of the cost of purchasing the equipment?

b. What is the net present value of the cost of leasing the equipment?

c. Based on financial factors, should Emerson purchase or lease the equipment? Why?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

119. York Inc. is trying to decide whether to lease or purchase a piece of equipment needed for the

next ten years. The equipment would cost $90,000 to purchase, and maintenance costs would

be $10,000 per year. After ten years, York estimates it could sell the equipment for $40,000. If

York leases the equipment, it would pay $24,000 each year, which would include all

maintenance costs. The hurdle rate for York is 10%.

a. What is the net present value of the cost of purchasing the equipment?

b. What is the net present value of the cost of leasing the equipment?

c. Based on financial factors, should York purchase or lease the equipment? Why?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-05 Use the net present value method to analyze mutually exclusive capital investments.

Topic: Evaluating mutually exclusive projects

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120. Norwood, Inc., which has a hurdle rate of 12%, is considering three different independent

investment opportunities. Each project has a seven-year life. The annual cash flows and initial

investment for each of the projects are as follows:

Project A Project B Project C

Annual cash flows $131,470 $120,520 $109,560

Initial investment 320,000 300,000 230,000

a. What is the present value of the annual cash flows for each of the three projects?

b. What is the net present value of each of the projects?

c. What is the profitability index of each of the projects? (Round to two decimal places.)

d. In what order should Norwood prioritize investment in the projects?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

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121. Carmen, Inc., which has a hurdle rate of 10%, is considering three different independent

investment opportunities. Each project has a five-year life. The annual cash flows and initial

investment for each of the projects are as follows:

Project A Project B Project C

Annual cash flows $79,150 $65,950 $72,540

Initial investment 150,000 105,000 140,000

a. What is the present value of the annual cash flows for each of the three projects?

b. What is the net present value of each of the projects?

c. What is the profitability index of each of the projects? (Round to two decimal places.)

d. In what order should Carmen prioritize investment in the projects?

3.7908

b. A $150,042 = $300,042 – $150,000; B $145,003 = $250,003 – $105,000; C $134,985 =

$274,985 – $140,000

c. A 2.00 = $300,042/$150,000; B 2.38 = $250,003/105,000; C 1.96 = $274,985/$140,000

d. B, A, C

Feedback: Net present value is calculated by discounting the annual cash flows and

subtracting the initial investment. Profitability index = Present value of future cash flows/Initial

investment. Investment in projects should be prioritized by their profitability indexes. The

higher the indexed amount, the better the investment.

AACSB: Analytical Thinking

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

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122. Imagine you are a managerial accountant in charge of operations for an architectural firm

whose work focuses on green building initiatives. To be consistent with the firm’s principles,

you propose three separate green initiatives to the board. The first proposal is to install low-

water plumbing throughout the building. The second proposal is to install solar panels on the

south-facing side of the building to reduce electric costs. The third proposal is to eliminate food

and package waste from the break area by partnering with a sustainable food pantry. All three

initiatives would include educational materials for clients, architects, and staff of the firm to

underscore the firm’s commitment to environmental matters. To convince the board of directors

of the viability of these options, you prepare the following analysis.

Clean

Water

Solar

Energy

Food

Waste

Initial Cost $1,000,000 $1,000,000 $800,000

Present

Value of

Future Cash

Flows

1,220,000 800,000 1,000,000

NPV a. b. c.

Profitability

Index d. e. f.

Cost of

Capital 6% 8% 6%

IRR 7.5% 7% 8%

Payback

Period 5 years 10 years 4 years

a-f. Fill in the missing spaces within the table above.

Which project would the board of directors choose if it values:

g. a fast payback period?

h. internal rate of return?

i. net present value?

j. initial cost outlay?

k. If you make your recommendation based on the profitability index, in which order would you

recommend the projects be prioritized?

AICPA: BB Critical Thinking

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-03 Calculate net present value and describe why it is superior to other capital budgeting techniques.

Learning Objective: 11-06 Use the profitability index to prioritize independent capital investment projects.

Topic: Prioritizing independent projects

123. You want to invest $10,000 in a business opportunity. If you keep the money invested in the

business for two years, you will receive $11,000 back. If you keep the money invested in the

business for five years, you will receive $13,000 back. Currently, the money is in your savings

account, which earns 5% interest, compounded annually.

a. What is the future value of the money if it remains in your savings account for two years?

b. What is the future value of the money if it remains in your savings account for five years?

c. Is it better to invest in the business for two years, five years, or not at all? Why?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

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124. An acquaintance of yours owes you $1,000, but only has $800 to pay you now. He says he

can either give you the $800 now in full settlement of the debt, or he can give you $1,000 one

year from now. If you would let him keep the money for two years, though, he would give you

$1,100 at that point. You have a savings account that earns 12% interest.

a. What is the present value of the payment now?

b. What is the present value of the payment a year from now?

c. What is the present value of the payment two years from now?

d. Which option would be best for you financially?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

125. You are saving for a car and have decided you can afford to deposit $5,000 into a savings

account at the end of each of the next five years, at which point you will withdraw the money to

purchase the car. You can deposit the money in a savings account that earns 8% interest with

no annual fee, or you can choose a savings account that earns 10% interest, but has an

annual fee of $100.00 that would come out of your deposits.

a. If you choose the free savings account, how much money will you be able to withdraw five

years from now?

b. If you choose the savings account with a fee, how much money will you be able to withdraw

five years from now?

c. Which option would be best for you financially?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

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126. You won the lottery, and the jackpot was $12,000,000. You can either receive the $12,000,000

in equal installments over 20 years, or you can receive a lump sum today. The amount of the

lump sum you’ll receive today is based on the present value of the equal installment

payments.

a. What is the present value of the lottery winnings taken in equal installments over 20 years at

8% interest?

b. What is the present value of the lottery winnings taken in equal installments over 20 years at

10% interest?

c. Which interest rate yields the greatest amount of cash today?

AICPA: FN Measurement

Blooms: Apply

Difficulty: 2 Medium

Learning Objective: 11-S1 Use present value and future value tables to incorporate the time value of money.

Topic: Time value of money

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