26–41
85.
The accuracy of capital budget decisions is critically dependent on:
Essay Questions
86.
Accounting terminology
Listed below are eight technical accounting terms introduced or emphasized in this
chapter.
Each of the following statements may (or may not) describe one of these technical terms.
In the space provided beside each statement, indicate the accounting term described, or
answer “None” if the statement does not correctly describe any of the terms.
____ (a) The process of analyzing investments in plant assets.
____ (b) The number of years required to recover the entire cost of an investment from its
net cash flows.
____ (c) A stream of equal cash flows to be received or paid.
____ (d) The estimated average annual income of an investment expressed as a percentage
of its average initial cost.
____ (e) The numerator in the return on average investment computation.
____ (f) The amount an investor should be willing to pay today for the right to receive a
specified amount of cash at a specified future date.
____ (g) The process of computing the present value of future cash flows.
87.
Appraising rate of return adequacy
What factors should be taken into consideration when appraising the adequacy of the rate
of return of a capital investment proposal?
88.
Carter & Co. is trying to decide which of two investments they should consider. The
following information is available:
Each investment is expected to have a useful life of 5 years. (Rounded)
(a) What is the rate of return on average investment of each investment?
(b) What is the payback period of each investment?
26–45
89.
Redman Company is considering an investment in new machinery. The details of the
investment are as follows:
The company uses straight-line depreciation for its machinery and requires a 12% rate of
return. The present value of $1 for 4 years at 12% is 0.636. The present value of an ordinary
annuity for $1 for 4 years at 12% is 3.037.
(1) What is the payback period? (Round your answer to one decimal place.)
(2) What is the rate of return on average investment? (Round your percentage to one
decimal place.)
(3) What is the net present value?
(4) Would you advise the company to invest in this machinery?
90.
Discounting cash flows
Determine the present value of the following cash flows discounted at an annual rate of
10%:
(a) $96,000 to be received five years from today (the present value of $1 at a 10%
compound interest rate for five years is 0.621): $__________
(b) $37,000 to be received annually for five years (the present value of $1 at 10% received
annually for five years is 3.791): $__________
(c) $58,000 to be received annually for six years, with an additional $16,000 salvage value
to be received at the end of the sixth year (the present value of $1 at 10% received
annually for six years is 4.355, and the present value of $1 due six years hence at 10% is
0.564): $__________
91.
The shortcomings of the payback method
What are the major shortcomings of relying too heavily upon the payback period in
evaluating capital investment decisions?
92.
Capital budgeting
Zhang Corporation is considering investing $190,000 in equipment to produce a new
product. Useful service life of the equipment is estimated to be 5 years, with zero salvage
value. Straight-line depreciation is used. The company estimates that production and sale
of the new product will increase net income by $65,000 a year. (Round your years and
percentage answers to one decimal place.)
(a) The payback period will be __________ years.
(b) The expected rate of return on average investment will be __________.
93.
Capital budgeting computations
A project costing $80,000 has an estimated life of 3 years and no salvage value. The
estimated net income and net after tax cash flows from the project are as follows:
The company’s minimum desired rate of return for discounted cash flow analysis is 10%.
The present value of $1 at compound interest of 10% at 1, 2, and 3 years is 0.909, 0.826,
and 0.751 respectively. The present value of a $1 annuity for three years at 10% is 2.487.
The company uses straight-line depreciation.
Compute
(a) Net present value of the project _________________________.
(b) The rate of return on average investment __________________.(rounded)
Calculations
94.
Capital budgeting
Golden Flights, Inc. is considering buying some specialized machinery which would enable
the company to obtain a six-year government contract for the design and engineering of a
futuristic plane. The machinery costs $975,000 and must be destroyed for security reasons
at the end of the six-year contract period. The estimated annual operating results of the
project are as follows:
All revenue from the contract and all expenses (except depreciation) will be received or
paid in cash in the same period as recognized for accounting purposes. You are to compute
the following three factors for this project:
(a) Payback period: __________ years
(b) Return on average investment: __________%
(c) Net present value of the investment in this machinery, discounted at an annual rate of
12% (an annuity table shows that the present value of $1 received annually for six years
discounted at 12% is 4.111): $__________
(a) 2.34
(b) 51.8
(c) 731,065
Feedback:
26–52
95.
Capital budgeting
Carry-Along is debating whether or not to invest in new equipment to manufacture a line of
high-quality luggage. The new equipment would cost $850,000, with an estimated four-year
life and no salvage value. The estimated annual operating results with the new equipment
are as follows:
All revenue from the new luggage line and all expenses (except depreciation) will be
received or paid in cash in the same period as recognized for accounting purposes. You are
to compute the following for the investment in the new equipment to produce the new
luggage line: (rounded)
(a) Annual cash flow: $__________
(b) Payback period: __________
(c) Return on average investment: __________%
(d) Total present value of the expected future annual cash flows, discounted at an annual
rate of 12% (an annuity table shows that the present value of $1 received annually for four
years discounted at 12% is 3.037): $__________
(e) Net present value of the proposed investment: $__________
26–54
96.
Capital budgeting
Flynn Corporation is debating whether to purchase a new computerized production system.
The system will cost $450,000, and have an estimated 10-year life with a salvage value of
$70,000. The estimated operating results from the new production system are as follows:
All revenue and expenses other than depreciation will be received and paid in cash.
Compute the following for this proposal: (rounded)
(a) Annual net cash flow: $__________
(b) Payback period: __________
(c) Return on average investment: __________
(d) Net present value, discounted at an annual rate of 6% (present value of $1 due in 10
years, discounted at 6%, is 0.558; present value of $1 received annually for 10 years,
discounted at 6%, is 7.360): $__________
26–56
97.
Capital budgeting
Mason Co. is evaluating two alternative investment proposals. Below are data for each
proposal:
The following information was taken from present value tables:
All revenue and expenses other than depreciation will be received and paid in cash. The
company uses a discount rate of 12% in evaluating all capital investments.
Compute the following for each proposal (round payback period to the nearest tenth of a
year and round return on average investment to the nearest tenth of a percent):
(f) Based on your analysis, which proposal appears to be the best investment?
(a) Proposal A = $24,200, Proposal B = $24,000
(b) Proposal A = 3.47 years, Proposal B = 4 years
(c) Proposal A = $44,000, Proposal B = $48,000
(d) Proposal A = 18.6%, Proposal B = 16.7%
(e) Proposal A = $5,509, Proposal B = $2,664
(f) Proposal A
98.
Return on average investment vs. discounting cash flows
The computation of return on average investment ignores one characteristic of the
earnings stream which is considered in discounting cash flows. What is this characteristic?
Why is it important?
99.
Capital budget audit
Briefly discuss the reasons that a company’s management would conduct a regular capital
budget audit.