CHAPTER 12
PLANNING FOR CAPITAL INVESTMENTS
SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOM’S TAXONOMY
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True-False Statements
1.
1
K
6.
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11.
3
C
16.
3
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21.
4
C
2.
1
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7.
2
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12.
3
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17.
3
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22.
5
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1
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8.
2
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13.
3
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3
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23.
5
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4.
1
C
9.
2
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14.
3
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19.
4
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24.
5
K
5.
1
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10.
3
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15.
3
C
20.
4
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25.
5
C
Multiple Choice Questions
26.
1
K
53.
1
AP
80.
3
K
107.
3
AP
134.
4
K
27.
1
K
54.
1
AP
81.
3
AN
108.
4
AP
135.
4
C
28.
1
K
55.
1
AP
82.
3
K
109.
2
AP
136.
4
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29.
1
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56.
1
AP
83.
3
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110.
3
AP
137.
4
AP
30.
1
K
57.
2
AP
84.
3
C
111.
4
AP
138.
5
AP
31.
1
K
58.
2
AP
85.
3
C
112.
1
AP
139.
5
AP
32.
1
C
59.
2
K
86.
3
K
113.
2
AP
140.
5
C
33.
1
K
60.
2
K
87.
3
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114.
4
AP
141.
5
AP
34.
1
K
61.
2
C
88.
3
C
115.
5
AP
142.
5
K
35.
1
K
62.
2
C
89.
3
K
116.
3
K
143.
5
K
36.
1
K
63.
2
AN
90.
3
K
117.
3
K
144.
5
K
37.
1
C
64.
2
K
91.
3
C
118.
3
C
145.
5
AN
38.
1
C
65.
2
C
92.
3
K
119.
4
K
146.
5
AN
39.
1
K
66.
2
K
93.
3
AP
120.
4
C
147.
5
AN
40.
1
K
67.
2
C
94.
3
K
121.
4
AP
148.
5
AP
41.
1
AP
68.
2
K
95.
3
C
122.
4
K
149.
5
AP
42.
1
AP
69.
2
C
96.
3
C
123.
4
C
150.
1
AP
43.
1
AP
70.
2
C
97.
3
C
124.
4
K
151.
5
K
44.
1
C
71.
2
C
98.
3
AP
125.
4
C
152.
5
K
45.
1
K
72.
2
K
99.
3
AP
126.
4
C
153.
5
C
46.
1
K
73.
2
K
100.
3
AP
127.
4
K
154.
5
AP
47.
1
AP
74.
2
K
101.
3
AP
128.
4
AP
155.
5
C
48.
1
C
75.
2
C
102.
3
C
129.
4
AP
156.
5
K
49.
1
C
76.
2
AN
103.
3
C
130.
4
C
157.
5
C
50.
1
K
77.
2
AP
104.
3
C
131.
4
C
51.
1
K
78.
2
AP
105.
3
C
132.
4
C
52.
1
C
79.
2
AN
106.
2
AP
133.
4
C
Brief Exercises
158.
1
AP
160.
2
AP
162.
2, 3
AN
164.
4
E
159.
2
E
161.
2, 3
E
163.
3
E
165.
5
AP
Test Bank for Managerial Accounting, Seventh Edition
12-2
Exercises
166.
.
*
E
170.
1,2,4
AN
174.
1,5
AP
178.
1,3,4
E
182.
4
AP
167.
1,2
E
171.
1,2,5
AP
175.
2,3
E
179.
1,3,5
E
168.
1,2,5
AP
172.
1,2,5
E
176.
2,3
E
180.
2,3
E
169.
1,2,5
AP
173.
.
**
E
177.
2,3
E
181.
2,4
E
Completion Statements
183.
1
K
185.
2
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187.
2
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189.
3
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191.
4
K
184.
1
K
186.
2
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188.
3
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190.
3
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192.
5
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*1,2,3,4
**1,2,3,4,5
SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE
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Learning Objective 1
1.
TF
28.
MC
36.
MC
44.
MC
52.
MC
166.
Ex
174.
Ex
2.
TF
29.
MC
37.
MC
45.
MC
53.
MC
167.
Ex
178.
Ex
3.
TF
30.
MC
38.
MC
46.
MC
54.
MC
168.
Ex
179.
Ex
4.
TF
31.
MC
39.
MC
47.
MC
55.
MC
169.
Ex
183.
C
5.
TF
32.
MC
40.
MC
48.
MC
56.
MC
170.
Ex
184.
C
6.
TF
33.
MC
41.
MC
49.
MC
112.
MC
171.
Ex
26.
MC
34.
MC
42.
MC
50.
MC
150.
MC
172.
Ex
27.
MC
35.
MC
43.
MC
51.
MC
158.
BE
173.
Ex
Learning Objective 2
7.
TF
61.
MC
68.
MC
75.
MC
113.
MC
168.
Ex
176.
Ex
8.
TF
62.
MC
69.
MC
76.
MC
159.
BE
169.
Ex
177.
Ex
9.
TF
63.
MC
70.
MC
77.
MC
160.
BE
170.
Ex
180.
Ex
57.
MC
64.
MC
71.
MC
78.
MC
161.
BE
171.
Ex
181.
Ex
58.
MC
65.
MC
72.
MC
79.
MC
162.
BE
172.
Ex
185.
C
59.
MC
66.
MC
73.
MC
106.
MC
166.
Ex
173.
Ex
186.
C
60.
MC
67.
MC
74.
MC
109.
MC
167.
Ex
175.
Ex
187.
C
Learning Objective 3
10.
TF
18.
TF
87.
MC
95.
MC
103.
MC
161.
BE
178.
Ex
11.
TF
80.
MC
88.
MC
96.
MC
104.
MC
162.
BE
179.
Ex
12.
TF
81.
MC
89.
MC
97.
MC
105.
MC
163.
BE
180.
Ex
13.
TF
82.
MC
90.
MC
98.
MC
107.
MC
166.
Ex
188.
C
14.
TF
83.
MC
91.
MC
99.
MC
110.
MC
173.
Ex
189.
C
15.
TF
84.
MC
92.
MC
100.
MC
116.
MC
175.
Ex
190.
C
16.
TF
85.
MC
93.
MC
101.
MC
117.
MC
176.
Ex
17.
TF
86.
MC
94.
MC
102.
MC
118.
MC
177.
Ex
Learning Objective 4
19.
TF
114.
MC
123.
MC
128.
MC
133.
MC
164.
BE
179.
Ex
20.
TF
119.
MC
124.
MC
129.
MC
134.
MC
166.
Ex
182.
Ex
21.
TF
120.
MC
125.
MC
130.
MC
135.
MC
170.
Ex
191.
C
108.
MC
121.
MC
126.
MC
131.
MC
136.
MC
173.
Ex
111.
MC
122.
MC
127.
MC
132.
MC
137.
MC
178.
Ex
Planning for Capital Investments 12-3
Learning Objective 5
22.
TF
138.
MC
143.
MC
148.
MC
154.
MC
168.
Ex
174.
Ex
23.
TF
139.
MC
144.
MC
149.
MC
155.
MC
169.
Ex
179.
Ex
24.
TF
140.
MC
145.
MC
151.
MC
156.
MC
171.
Ex
192.
C
25.
TF
141.
MC
146.
MC
152.
MC
157.
MC
172.
Ex
115.
MC
142.
MC
147.
MC
153.
MC
165.
BE
173.
Ex
Note: TF = True-False C = Completion Ex = Exercise
MC = Multiple Choice BE = Brief Exercise
The chapter also contains one set of eight Matching questions and three Short-Answer Essay
questions.
CHAPTER LEARNING OBJECTIVES
1. Describe capital budgeting inputs and apply the cash payback technique. Management
gathers project proposals from each department; a capital budget committee screens the
proposals and recommends worthy projects. Company officers decide which projects to fund,
2. Use the net present value method. The net present value method compares the present
value of future cash inflows with the capital investment to determine net present value. The
3. Identify capital budgeting challenges and refinements. Intangible benefits are difficult to
quantify and thus are often ignored in capital budgeting decisions. This can result in
incorrectly rejecting some projects. One method for considering intangible benefits is to
calculate the NPV, ignoring intangible benefits. If the resulting NPV is below zero, evaluate
whether the benefits are worth at least the amount of the negative net present value.
Alternatively, intangible benefits can be incorporated into the NPV calculation using
conservative estimates of their value.
4. Use the internal rate of return method. The objective of the internal rate of return method
is to find the interest yield of the potential investment, which is expressed as a percentage
Test Bank for Managerial Accounting, Seventh Edition
12-4
5. Use the annual rate of return method. The annual rate of return uses accrual accounting
data to indicate the profitability of a capital investment. It is calculated as Expected annual
net income ÷ Amount of the average investment. The higher the rate of return, the more
attractive the investment.
TRUE-FALSE STATEMENTS
1. Capital budgeting decisions usually involve large investments and often have a significant
impact on a company’s future profitability.
2. The capital budgeting committee ultimately approves the capital expenditure budget for
the year.
3. For purposes of capital budgeting, estimated cash inflows and outflows are preferred for
inputs into the capital budgeting decision tools.
4. The cash payback technique is a quick way to calculate a project’s net present value.
5. The cash payback period is computed by dividing the cost of the capital investment by the
net annual cash inflow.
6. The cash payback method is frequently used as a screening tool but it does not take into
consideration the profitability of a project.
7. The cost of capital is a weighted average of the rates paid on borrowed funds, as well as
on funds provided by investors in the company‘s stock.
8. Using the net present value method, a net present value of zero indicates that the project
would not be acceptable.
9. The net present value method can only be used in capital budgeting if the expected cash
flows from a project are an equal amount each year.
Planning for Capital Investments 12-5
10. By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate
projects that could be financially beneficial to the company.
11. To avoid accepting projects that actually should be rejected, a company should ignore
intangible benefits in calculating net present value.
12. One way of incorporating intangible benefits into the capital budgeting decision is to
project conservative estimates of the value of the intangible benefits and include them in
the NPV calculation.
13. The profitability index is calculated by dividing the total cash flows by the initial
investment.
14. The profitability index allows comparison of the relative desirability of projects that require
differing initial investments.
15. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability
among potential returns.
16. A well-run organization should perform an evaluation, called a post-audit, of its investment
projects before their completion.
17. Post-audits create an incentive for managers to make accurate estimates, since
managers know that their results will be evaluated.
18. A post-audit is an evaluation of how well a project’s actual performance matches the
projections made when the project was proposed.
19. The internal rate of return method is, like the NPV method, a discounted cash flow
technique.
20. The interest yield of a project is a rate that will cause the present value of the proposed
capital expenditure to equal the present value of the expected annual cash inflows.
Test Bank for Managerial Accounting, Seventh Edition
12-6
21. Using the internal rate of return method, a project is rejected when the rate of return is
greater than or equal to the required rate of return.
22. Using the annual rate of return method, a project is acceptable if its rate of return is
greater than management’s minimum rate of return.
23. The annual rate of return method requires dividing a project’s annual cash inflows by the
economic life of the project.
24. A major advantage of the annual rate of return method is that it considers the time value
of money.
25. An advantage of the annual rate of return method is that it relies on accrual accounting
numbers rather than actual cash flows.
Answers to True-False Statements
Item
Ans.
Item
Ans.
Item
Ans.
Item
Ans.
Item
Ans.
Item
Ans.
Item
Ans.
MULTIPLE CHOICE QUESTIONS
26. The capital budget for the year is approved by a company‘s
a. board of directors.
b. capital budgeting committee.
c. officers.
d. stockholders.
27. All of the following are involved in the capital budgeting evaluation process except a
company’s
a. board of directors.
b. capital budgeting committee.
c. officers.
d. stockholders.
Planning for Capital Investments 12-7
28. Most of the capital budgeting methods use
a. accrual accounting numbers.
b. cash flow numbers.
c. net income.
d. accrual accounting revenues.
29. The first step in the capital budgeting evaluation process is to
a. request proposals for projects.
b. screen proposals by a capital budgeting committee.
c. determine which projects are worthy of funding.
d. approve the capital budget.
30. The capital budgeting decision depends in part on the
a. availability of funds.
b. relationships among proposed projects.
c. risk associated with a particular project.
d. All of these answers are correct.
31. Capital budgeting is the process
a. used in sell or process further decisions.
b. of determining how much capital stock to issue.
c. of making capital expenditure decisions.
d. of eliminating unprofitable product lines.
32. Net annual cash flow can be estimated by
a. deducting credit sales from net income.
b. adding depreciation expense to net income.
c. deducting credit purchases from net income.
d. adding advertising expense to net income.
33. Which of the following is not a typical cash flow related to equipment purchase and
replacement decisions?
a. Increased operating costs
b. Overhaul of equipment
c. Salvage value of equipment when project is complete
d. Depreciation expense
34. Capital expenditure proposals are initially screened by the
a. board of directors.
b. executive committee.
c. capital budgeting committee.
d. stockholders.
Test Bank for Managerial Accounting, Seventh Edition
12-8
35. Capital budgeting decisions depend in part on all of the following except the
a. relationships among proposed projects.
b. profitability of the company.
c. company’s basic decision making approach.
d. risks associated with a particular project.
36. The corporate capital budget authorization process consists of how many steps?
a. 4
b. 3
c. 2
d. 1
37. Which of the following is not a capital budgeting decision?
a. Constructing new studios
b. Replacing old equipment
c. Scrapping obsolete inventory
d. Remodeling an office building
38. Which of the following is a disadvantage of the cash payback technique?
a. It is difficult to calculate
b. It relies on the time value of money
c. It can only be calculated when there are equal annual net cash flows
d. It ignores the expected profitability of a project
39. The payback period is often compared to an asset’s
a. estimated useful life.
b. warranty period.
c. net present value.
d. internal rate of return.
40. Which of the following ignores the time value of money?
a. Internal rate of return
b. Profitability index
c. Net present value
d. Cash payback
Planning for Capital Investments 12-9
41. Brady Corp. is considering the purchase of a piece of equipment that costs $20,000.
Projected net annual cash flows over the project’s life are:
Year Net Annual Cash Flow
1 $ 3,000
2 8,000
3 15,000
4 9,000
The cash payback period is
a. 2.29 years.
b. 2.60 years.
c. 2.40 years.
d. 2.31 years.
42. Bradshaw Inc. is contemplating a capital investment of $88,000. The cash flows over the
project’s four years are:
Expected Annual Expected Annual
Year Cash Inflows Cash Outflows
1 $30,000 $12,000
2 45,000 20,000
3 60,000 25,000
4 50,000 30,000
The cash payback period is
a. 3.59 years.
b. 3.50 years.
c. 2.37 years.
d. 3.20 years.
43. Jordan Company is considering the purchase of a machine with the following data:
Initial cost $150,000
One-time training cost 12,000
Annual maintenance costs 15,000
Annual cost savings 75,000
Salvage value 20,000
The cash payback period is
a. 2.70 years.
b. 2.50 years.
c. 2.37 years.
d. 2.17 years.
Test Bank for Managerial Accounting, Seventh Edition
12–10
44. If project A has a lower payback period than project B, this may indicate that project A
may have a
a. lower NPV and be less profitable.
b. higher NPV and be less profitable.
c. higher NPV and be more profitable.
d. lower NPV and be more profitable.
45. Which of the following does not consider a company’s required rate of return?
a. Net present value
b. Internal rate of return
c. Annual rate of return
d. Cash payback
46. The cash payback technique
a. considers cash flows over the life of a project.
b. cannot be used with uneven cash flows.
c. is superior to the net present value method.
d. may be useful as an initial screening device.
47. If an asset costs $240,000 and is expected to have a $40,000 salvage value at the end of
its ten-year life, and generates annual net cash inflows of $40,000 each year, the cash
payback period is
a. 7 years.
b. 6 years.
c. 5 years.
d. 4 years.
48. If a payback period for a project is greater than its expected useful life, the
a. project will always be profitable.
b. entire initial investment will not be recovered.
c. project would only be acceptable if the company’s cost of capital was low.
d. project’s return will always exceed the company’s cost of capital.
49. The cash payback technique
a. should be used as a final screening tool.
b. can be the only basis for the capital budgeting decision.
c. is relatively easy to compute and understand.
d. considers the expected profitability of a project.
Planning for Capital Investments 12–11
50. The cash payback period is computed by dividing the cost of the capital investment by the
a. annual net income.
b. net annual cash inflow.
c. present value of the cash inflow.
d. present value of the net income.
51. When using the cash payback technique, the payback period is expressed in terms of
a. a percent.
b. dollars.
c. years.
d. months.
52. A disadvantage of the cash payback technique is that it
a. ignores obsolescence factors.
b. ignores the cost of an investment.
c. is complicated to use.
d. ignores the time value of money.
53. Bark Company is considering buying a machine for $240,000 with an estimated life of ten
years and no salvage value. The straight-line method of depreciation will be used. The
machine is expected to generate net income of $6,000 each year. The cash payback
period on this investment is
a. 20 years.
b. 10 years.
c. 8 years.
d. 4 years.
54. A company is considering purchasing a machine that costs $400,000 and is estimated to
have no salvage value at the end of its 8-year useful life. If the machine is purchased,
annual revenues are expected to be $100,000 and annual operating expenses exclusive
of depreciation expense are expected to be $38,000. The straight-line method of
depreciation would be used. The cash payback period on the machine is
a. 8.0 years.
b. 7.5 years.
c. 6.5 years.
d. 3.2 years.
Test Bank for Managerial Accounting, Seventh Edition
12–12
55. Nance Company is considering buying a machine for $90,000 with an estimated life of ten
years and no salvage value. The straight-line method of depreciation will be used. The
machine is expected to generate net income of $3,000 each year. The cash payback on
this investment is
a. 15 years.
b. 10 years.
c. 7.5 years.
d. 6 years.
56. Giraldi Company has identified that the cost of a new computer will be $48,000, but with
the use of the new computer, net income will increase by $5,000 a year. If depreciation
expense is $3,000 a year, the cash payback period is:
a. 24.0 years.
b. 16.0 years.
c. 9.6 years.
d. 6.0 years.
57. Richman Co. purchased some equipment 3 years ago. The company’s required rate of
return is 12%, and the net present value of the project was $(900). Annual cost savings
were: $10,000 for year 1; $8,000 for year 2; and $6,000 for year 3. The amount of the
initial investment was
Present Value PV of an Annuity
Year of 1 at 12% of 1 at 12%
1 .893 .893
2 .797 1.690
3 .712 2.402
a. $20,478.
b. $18,316.
c. $20,116.
d. $18,678.
58. Use the following table,
Present Value of an Annuity of 1
Period 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487
A company has a minimum required rate of return of 9%. It is considering investing in a
project which costs $350,000 and is expected to generate cash inflows of $140,000 at the
end of each year for three years. The net present value of this project is
a. $354,340.
b. $70,000.
c. $35,436.
d. $4,340.
Planning for Capital Investments 12–13
59. The discount rate is referred to by all of the following alternative names except the
a. accounting rate of return.
b. cutoff rate.
c. hurdle rate.
d. required rate of return.
60. The rate that a company must pay to obtain funds from creditors and stockholders is
known as the
a. hurdle rate.
b. cost of capital.
c. cutoff rate.
d. All of these answers are correct.
61. The higher the risk element in a project, the
a. more attractive the investment.
b. higher the net present value.
c. higher the cost of capital.
d. higher the discount rate.
62. If a company’s required rate of return is 10% and, in using the net present value method,
a project’s net present value is zero, this indicates that the
a. project’s rate of return exceeds 10%.
b. project’s rate of return is less than the minimum rate required.
c. project earns a rate of return of 10%.
d. project earns a rate of return of 0%.
63. Using the profitability index method, the present value of cash inflows for Project Flower is
$88,000 and the present value of cash inflows of Project Plant is $48,000. If Project
Flower and Project Plant require initial investments of $90,000 and $40,000, respectively,
and have the same useful life, the project that should be accepted is
a. Project Flower.
b. Project Plant.
c. Either project may be accepted.
d. Neither project should be accepted.
64. The primary capital budgeting method that uses discounted cash flow techniques is the
a. net present value method.
b. cash payback technique.
c. annual rate of return method.
d. profitability index method.
Test Bank for Managerial Accounting, Seventh Edition
12–14
65. When the annual cash flows from an investment are unequal, the appropriate table to use
is the
a. future value of 1 table.
b. future value of annuity table.
c. present value of 1 table.
d. present value of annuity table.
66. A company’s cost of capital refers to the
a. rate the company must pay to obtain funds from creditors and stockholders.
b. total cost of a capital project.
c. cost of printing and registering common stock shares.
d. rate of return earned on common stock.
67. When a capital budgeting project generates a positive net present value, this means that
the project earns a return higher than the
a. internal rate of return.
b. annual rate of return.
c. required rate of return.
d. profitability index.
68. A negative net present value indicates that the
a. project is acceptable.
b. wrong discount rate was used.
c. project’s annual rate of return exceeds the discount rate.
d. present value of the cash inflows was less than the present value of the cash out
flows.
69. A company’s discount rate is based on the
a. cost of capital and the internal rate of return.
b. cost of capital and the risk element.
c. cut-off rate and the risk element.
d. cut-off rate and the internal rate of return.
70. The discount rate that will result in the lowest net present value for a project is
a. any rate lower that the cost of capital.
b. any rate higher than the cost of capital.
c. the lowest rate used to evaluate the project.
d. the highest rate used to evaluate the project.
Planning for Capital Investments 12–15
71. The discount rate that will result in the highest net present value for a project is
a. any rate lower that the cost of capital.
b. any rate higher than the cost of capital.
c. the lowest rate used to evaluate the project.
d. the highest rate used to evaluate the project.
72. Which of the following will increase the net present value of a project?
a. An increase in the initial investment
b. A decrease in annual cash inflows
c. An increase in the discount rate
d. A decrease in the discount rate
73. A project with a zero net present value indicates that it is
a. unacceptable.
b. profitable.
c. acceptable.
d. going to have an acceptable cash payback period.
74. Companies often assume that the risk element in the discount rate is
a. zero.
b. greater that zero.
c. less than zero.
d. known with certainty.
75. If a project has a salvage value greater than zero, the salvage value will
a. have no effect on the net present value.
b. increase the net present value.
c. increase the payback period.
d. decrease the net present value.
76. Sloan Inc. recently invested in a project with a 3-year life span. The net present value was
$9,000 and annual cash inflows were $21,000 for year 1; $24,000 for year 2; and $27,000
for year 3. The initial investment for the project, assuming a 15% required rate of return,
was
Present Value PV of an Annuity
Year of 1 at 15% of 1 at 15%
1 .870 .870
2 .756 1.626
3 .658 2.283
a. $45,792.
b. $45,180.
c. $29,232.
d. $38,376.
Test Bank for Managerial Accounting, Seventh Edition
12–16
77. Mini Inc. is contemplating a capital project costing $47,019. The project will provide annual
cost savings of $18,000 for 3 years and have a salvage value of $3,000. The company’s
required rate of return is 10%. The company uses straight-line depreciation.
Present Value PV of an Annuity
Year of 1 at 10% of 1 at 10%
1 .909 .909
2 .826 1.736
3 .751 2.487
This project is
a. unacceptable because it earns a rate less than 10%.
b. acceptable because it has a positive NPV.
c. unacceptable because it has a negative NPV.
d. acceptable because it has a zero NPV.
78. Johnson Corp. has an 8% required rate of return. It’s considering a project that would
provide annual cost savings of $50,000 for 5 years. The most that Johnson would be
willing to spend on this project is
Present Value PV of an Annuity
Year of 1 at 8% of 1 at 8%
1 .926 .926
2 .857 1.783
3 .794 2.577
4 .735 3.312
5 .681 3.993
a. $125,910.
b. $165,600.
c. $199,650.
d. $34,050.
79. Benaflek Co. purchased some equipment 3 years ago. The company’s required rate of
return is 12%, and the net present value of the project was $(1,800). Annual cost savings
were: $20,000 for year 1; $16,000 for year 2; and $12,000 for year 3. The amount of the
initial investment was
Present Value PV of an Annuity
Year of 1 at 12% of 1 at 12%
1 .893 .893
2 .797 1.690
3 .712 2.402
a. $40,956.
b. $36,632.
c. $40,232.
d. $37,356.
Planning for Capital Investments 12–17
80. In capital budgeting, intangible benefits should be
a. excluded entirely.
b. included using optimistic estimated values.
c. included using conservative estimated values.
d. included only when benefits are known with certainty.
81. Miles, Inc. is considering the purchase of a new machine for $600,000 that has an
estimated useful life of 5 years and no salvage value. The machine will generate net
annual cash flows of $105,000. It is believed that the new machine will reduce downtime
because of its reliability. Assume the discount rate is 8%. In order to make the project
acceptable, the reduction in downtime must be worth
Present Value PV of an Annuity
Year of 1 at 8% of 1 at 8%
1 .926 .926
2 .857 1.783
3 .794 2.577
4 .735 3.312
5 .681 3.993
a. $23,958 per year.
b. $49,662 per year.
c. $18,264 per year.
d. $45,263 per year.
82. Intangible benefits in capital budgeting would include all of the following except increased
a. product quality.
b. employee loyalty.
c. salvage value.
d. product safety.
83. Intangible benefits in capital budgeting
a. should be ignored because they are difficult to determine.
b. include increased quality or employee loyalty.
c. are not considered because they are usually not relevant to the decision.
d. have a rate of return in excess of the company’s cost of capital.
Test Bank for Managerial Accounting, Seventh Edition
12–18
84. To avoid rejecting projects that actually should be accepted,
1. intangible benefits should be ignored.
2. conservative estimates of the intangible benefits’ value should be incorporated into
the NPV calculation.
3. calculate net present value ignoring intangible benefits and then, if the NPV is
negative, estimate whether the intangible benefits are worth at least the amount of
the negative NPV.
a. 1
b. 2
c. 3
d. both 2 and 3 are correct.
85. All of the following statements about intangible benefits in capital budgeting are correct
except that they
a. include increased quality and employee loyalty.
b. are difficult to quantify.
c. are often ignored in capital budgeting decisions.
d. cannot be incorporated into the NPV calculation.
86. In evaluating high-tech projects,
a. only tangible benefits should be considered.
b. only intangible benefits should be considered.
c. both tangible and intangible benefits should be considered.
d. neither tangible nor intangible benefits should be considered.
87. Using a number of outcome estimates to get a sense of the variability among potential
returns is
a. financial analysis.
b. post-audit analysis.
c. sensitivity analysis.
d. outcome analysis.
88. If a company’s required rate of return is 9%, and in using the profitability index method, a
project’s index is greater than 1, this indicates that the project’s rate of return is
a. equal to 9%.
b. greater than 9%.
c. less than 9%.
d. unacceptable for investment purposes.
89. The profitability index is computed by dividing the
a. total cash flows by the initial investment.
b. present value of cash flows by the initial investment.
c. initial investment by the total cash flows.
d. initial investment by the present value of cash flows.
Planning for Capital Investments 12–19
90. The capital budgeting method that takes into account both the size of the original
investment and the discounted cash flows is the
a. cash payback method.
b. internal rate of return method.
c. net present value method.
d. profitability index.
91. The profitability index
a. does not take into account the discounted cash flows.
b. is calculated by dividing total cash flows by the initial investment.
c. allows comparison of the relative desirability of projects that require differing initial
investments.
d. will never be greater than 1.
92. The capital budgeting method that allows comparison of the relative desirability of projects
that require differing initial investments is the
a. cash payback method.
b. internal rate of return method.
c. net present value method.
d. profitability index.
93. The following information is available for a potential investment for Panda Company:
Initial investment $95,000
Net annual cash inflow 20,000
Net present value 36,224
Salvage value 10,000
Useful life 10 yrs.
The potential investment’s profitability index is
a. 4.75.
b. 3.22.
c. 2.62.
d. 1.38.
94. An approach that uses a number of outcome estimates to get a sense of the variability
among potential returns is
a. the discounted cash flow technique.
b. the net present value method.
c. risk analysis.
d. sensitivity analysis.
Test Bank for Managerial Accounting, Seventh Edition
12–20
95. If a project’s profitability index is greater than 1, then the
a. project should always be accepted.
b. project’s net present value is negative.
c. project’s internal rate of return is less than the discount rate.
d. project should be accepted if funds are available.
96. If a project’s profitability index is less than 1, then
a. its net present value is zero.
b. its net present value is positive.
c. it should be rejected.
d. its internal rate of return is greater than the discount rate.
97. If a project’s profitability index is equal to 1, then
a. its net present value is zero.
b. its net present value is positive.
c. it should be rejected.
d. its internal rate of return is greater than the discount rate.
98. A project with an initial investment of $70,000 and a profitability index of 1.239 also has an
internal rate of return of 12%. The present value of net cash flows is
a. $78,400.
b. $86,730.
c. $56,497.
d. $70,000.
99. A project with a profitability index of 1.156 also has net cash flows with a present value of
$69,360. The project’s internal rate of return was 10%. The initial investment was
a. $66,000.
b. $80,180.
c. $60,000.
d. $62,424.
Planning for Capital Investments 12–21
Use the following information for questions 100 and 101.
Selma Inc. is comparing several alternative capital budgeting projects as shown below:
Projects
A B C
Initial investment $80,000 $120,000 $160,000
Present value of net cash flows 90,000 110,000 200,000
100. Using the profitability index, the projects rank as
a. A, C, B.
b. A, B, C.
c. C, A, B.
d. C, B, A.
101. Using the profitability index, how many of the projects are acceptable?
a. 3
b. 2
c. 1
d. 0
102. If a project has a negative net present value, its profitability index will be
a. one.
b. greater than one.
c. less than one.
d. undeterminable.
103. If a project has a positive net present value, its profitability index will be
a. one.
b. greater than one.
c. less than one.
d. undeterminable.
104. If a project has a zero net present value, its profitability index will be
a. one.
b. greater than one.
c. less than one.
d. undeterminable.
105. If a project has a profitability index of 1.20, then the project’s internal rate of return is
a. equal to the discount rate.
b. less than the discount rate.
c. greater than the discount rate.
d. equal to 20%.
Test Bank for Managerial Accounting, Seventh Edition
12–22
Use the following information for questions 106–108.
Cleaners, Inc. is considering purchasing equipment costing $60,000 with a 6-year useful life. The
equipment will provide cost savings of $14,600 and will be depreciated straight-line over its useful
life with no salvage value. Cleaners requires a 10% rate of return.
Present Value of an Annuity of 1
Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784
106. What is the approximate net present value of this investment?
a. $27,600
b. $3,583
c. $1,772
d. $5,496
107. What is the approximate profitability index associated with this equipment?
a. 1.23
b. 1.03
c. 1.06
d. .73
108. What is the approximate internal rate of return for this investment?
a. 9%
b. 10%
c. 11%
d. 12%
Use the following table for questions 109–111.
Present Value of an Annuity of 1
Periods 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487
109. A company has a minimum required rate of return of 9%. It is considering investing in a
project that costs $210,000 and is expected to generate cash inflows of $84,000 at the
end of each year for three years. The net present value of this project is
a. $212,604.
b. $42,000.
c. $21,261.
d. $2,604.
Planning for Capital Investments 12–23
110. A company has a minimum required rate of return of 10%. It is considering investing in a
project that costs $50,000 and is expected to generate cash inflows of $25,000 at the end
of each year for three years. The profitability index for this project is
a. .80.
b. 1.00.
c. 1.24.
d. 1.27.
111. A company has a minimum required rate of return of 8%. It is considering investing in a
project that costs $91,116 and is expected to generate cash inflows of $36,000 each year
for three years. The approximate internal rate of return on this project is
a. 8%.
b. 9%.
c. 10%.
d. less than the required 8%.
Use the following information for questions 112–115.
Carr Company is considering two capital investment proposals. Estimates regarding each project
are provided below:
Project Soup Project Nuts
Initial investment $400,000 $600,000
Annual net income 30,000 46,000
Net annual cash inflow 110,000 146,000
Estimated useful life 5 years 6 years
Salvage value -0- -0-
The company requires a 10% rate of return on all new investments.
Present Value of an Annuity of 1
Periods 9% 10% 11% 12%
5 3.890 3.791 3.696 3.605
6 4.486 4.355 4.231 4.111
112. The cash payback period for Project Nuts is
a. 13.3 years.
b. 6.7 years.
c. 5.0 years.
d. 4.1 years.
113. The net present value for Project Nuts is
a. $635,830.
b. $200,330.
c. $100,000.
d. $35,830.
Test Bank for Managerial Accounting, Seventh Edition
12–24
114. The internal rate of return for Project Nuts is approximately
a. 11%.
b. 12%.
c. 10%.
d. 9%.
115. The annual rate of return for Project Soup is
a. 7.5%.
b. 15.0%.
c. 27.5%.
d. 55%.
116. A post-audit should be performed using
a. a different evaluation technique than that used in making the original decision.
b. the same evaluation technique used in making the original decision.
c. estimated amounts instead of actual figures.
d. an independent CPA.
117. A thorough evaluation of how well a project’s actual performance matches the projections
made when the project was proposed is called a
a. pre-audit.
b. post-audit.
c. risk analysis.
d. sensitivity analysis.
118. Performing a post-audit is important because
a. managers will be more likely to submit reasonable data when they make investment
proposals if they know their estimates will be compared to actual results.
b. it provides a formal mechanism by which the company can determine whether existing
projects should be terminated.
c. it improves the development of future investment proposals because managers
improve their estimation techniques by evaluating their past successes and failures.
d. all of these.
119. A capital budgeting method that takes into consideration the time value of money is the
a. annual rate of return method.
b. return on stockholders’ equity method.
c. cash payback technique.
d. internal rate of return method.
Planning for Capital Investments 12–25
120. The internal rate of return is the interest rate that results in a
a. positive NPV.
b. negative NPV.
c. zero NPV.
d. positive or negative NPV.
121. In using the internal rate of return method, the internal rate of return factor was 4.0 and
the equal annual cash inflows were $18,000. The initial investment in the project must
have been
a. $18,000.
b. $4,500.
c. $72,000.
d. $36,000.
122. The capital budgeting technique that finds the interest yield of the potential investment is
the
a. annual rate of return method.
b. internal rate of return method.
c. net present value method.
d. profitability index method.
123. All of the following statements about the internal rate of return method are correct except
that it
a. recognizes the time value of money.
b. is widely used in practice.
c. is easy to interpret.
d. can be used only when the cash inflows are equal.
124. If the internal rate of return is used as the discount rate in the net present value calcula-
tion, the net present value will be
a. zero.
b. positive.
c. negative.
d. undeterminable.
125. If a project costing $80,000 has a profitability index of 1.00 and the discount rate was
12%, then the present value of the net cash flows was
a. $80,000.
b. less than $80,000.
c. greater than $80,000.
d. undeterminable.
Test Bank for Managerial Accounting, Seventh Edition
12–26
126. If a project costing $40,000 has a profitability index of 1.00 and the discount rate was 8%,
then the project’s internal rate of return was
a. less than 8%.
b. equal to 8%.
c. greater than 8%.
d. undeterminable.
127. The internal rate of return factor is equal to the
a. capital investment divided by the net cash flows.
b. present value of net cash flows divided by the capital investment.
c. present value of net cash flows divided by the profitability index.
d. capital investment divided by the present value of the net cash flows.
128. If a 2-year capital project has an internal rate of return factor equal to 1.690 and net
annual cash flows of $60,000, the initial capital investment was
a. $101,400.
b. $35,503.
c. $50,700.
d. $71,007.
129. If a 3-year capital project costing $77,310 has an internal rate of return factor equal to
2.577, the net annual cash flows assuming straight-line depreciation are
a. $25,770.
b. $30,000.
c. $10,000.
d. $38,655.
130. If the internal rate of return exceeds the discount rate, then the net present value of a
project is
a. positive.
b. negative.
c. zero.
d. one.
131. If the internal rate of return is less than the discount rate, then the net present value of a
project is
a. positive.
b. negative.
c. zero.
d. one.
Planning for Capital Investments 12–27
132. If a project has a negative net present value, the internal rate of return will be
a. less than the discount rate.
b. greater than the discount rate.
c. equal to the discount rate.
d. a negative rate of return.
133. If a project has a zero net present value, then the internal rate of return will be
a. less than the discount rate.
b. greater than the discount rate.
c. equal to the discount rate.
d. a negative rate of return.
134. Which of the following will cause the internal rate of return to increase?
a. An increase in the annual cash inflows
b. A decrease in the annual cash inflows
c. An increase in the discount rate
d. A decrease in the discount rate
135. If project A has a lower internal rate of return than project B, then project A will have a
a. lower NPV and a shorter payback period.
b. higher NPV and a longer payback period.
c. lower NPV and a longer payback period.
d. higher NPV and a shorter payback period.
136. The internal rate of return factor is also the
a. annual rate of return.
b. profitability index.
c. cash payback period.
d. present value factor for a single amount.
137. Use the following table,
Present Value of an Annuity of 1
Period 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487
A company has a minimum required rate of return of 8%. It is considering investing in a
project that costs $379,650 and is expected to generate cash inflows of $150,000 each
year for three years. The approximate internal rate of return on this project is
a. 8%.
b. 9%.
c. 10%.
d. The IRR on this project cannot be approximated.
Test Bank for Managerial Accounting, Seventh Edition
12–28
138. A company is considering purchasing a machine that costs $280,000 and is estimated to
have no salvage value at the end of its 8-year useful life. If the machine is purchased,
annual revenues are expected to be $100,000 and annual operating expenses exclusive
of depreciation expense are expected to be $38,000. The straight-line method of
depreciation would be used.
If the machine is purchased, the annual rate of return expected on this machine is
a. 22.1%.
b. 44.3%.
c. 9.6%.
d. 19.3%.
139. A company projects an increase in net income of $135,000 each year for the next five
years if it invests $900,000 in new equipment. The equipment has a five-year life and an
estimated salvage value of $300,000. What is the annual rate of return on this
investment?
a. 15.0%
b. 22.5%
c. 30.0%
d. 34.5%
140. Garza Company is considering buying equipment for $320,000 with a useful life of five
years and an estimated salvage value of $16,000. If annual expected income is $28,000,
the denominator in computing the annual rate of return is
a. $320,000.
b. $160,000.
c. $168,000.
d. $336,000.
141. Mussina Company had an investment which cost $250,000 and had a salvage value at
the end of its useful life of zero. If Mussina’s expected annual net income is $15,000, the
annual rate of return is:
a. 6.0%.
b. 10.2%.
c. 12.0%.
d. 15.0%.
142. Discounted cash flow techniques include all of the following except
a. profitability index.
b. annual rate of return.
c. internal rate of return.
d. net present value.
Planning for Capital Investments 12–29
143. Which of the following is based directly on accrual accounting data rather than cash
flows?
a. Profitability index
b. Internal rate of return
c. Net present value
d. Annual rate of return
144. When calculating the annual rate of return, the average investment is equal to
a. (initial investment plus $0) divided by 2.
b. initial investment divided by life of project.
c. initial investment divided by 2.
d. (initial investment plus salvage value) divided by 2.
145. A project has an annual rate of return of 15%. The project cost $120,000, has a 5-year
useful life, and no salvage value. Straight-line depreciation is used. The annual net
income, exclusive of depreciation, was
a. $42,000.
b. $33,000.
c. $47,700.
d. $18,000.
146. A project that cost $75,000 has a useful life of 5 years and a salvage value of $3,000. The
internal rate of return is 12% and the annual rate of return is 18%. The amount of the
annual net income was
a. $7,020.
b. $6,480.
c. $4,680.
d. $4,320.
147. A project has annual income exclusive of depreciation of $80,000. The annual rate of
return is 15% and annual depreciation is $20,000. There is no salvage value. The internal
rate of return is 12%. The initial cost of the project was
a. $400,000.
b. $500,000.
c. $1,000,000.
d. $800,000.
148. A project that cost $80,000 with a useful life of 5 years is being considered. Straight-line
depreciation is being used and salvage value is $5,000. The project will generate annual
cash flows of $21,375. The annual rate of return is
a. 15%.
b. 50.3%.
c. 16%.
d. 17%.
Test Bank for Managerial Accounting, Seventh Edition
12–30
Use the following information for questions 149 and 150.
A company is considering purchasing factory equipment that costs $480,000 and is estimated to
have no salvage value at the end of its 8-year useful life. If the equipment is purchased, annual
revenues are expected to be $135,000 and annual operating expenses exclusive of depreciation
expense are expected to be $39,000. The straight-line method of depreciation would be used.
149. If the equipment is purchased, the annual rate of return expected on this equipment is
a. 40.0%.
b. 7.5%.
c. 15.0%.
d. 20.0%.
150. The cash payback period on the equipment is
a. 13.3 years.
b. 8.0 years.
c. 5.0 years.
d. 2.5 years.
151. The capital budgeting technique that indicates the profitability of a capital expenditure is
the
a. profitability index method.
b. net present value method.
c. internal rate of return method.
d. annual rate of return method.
152. The annual rate of return method is based on
a. accounting data.
b. the time value of money data.
c. market values.
d. cash flow data.
153. Disadvantages of the annual rate of return method include all of the following except that
a. it relies on accrual accounting numbers instead of actual cash flows.
b. it does not consider the time value of money.
c. no consideration is given as to when the cash inflows occur.
d. management is unfamiliar with the information used in the computation.
Planning for Capital Investments 12–31
154. A company projects an increase in net income of $30,000 each year for the next five
years if it invests $300,000 in new equipment. The equipment has a five-year life and an
estimated salvage value of $100,000. What is the annual rate of return on this
investment?
a. 10%
b. 15%
c. 20%
d. 25%
155. Colaw Company is considering buying equipment for $240,000 with a useful life of five
years and an estimated salvage value of $12,000. If annual expected income is $21,000,
the denominator in computing the annual rate of return is
a. $240,000.
b. $120,000.
c. $126,000.
d. $252,000.
156. The annual rate of return is computed by dividing expected annual
a. cash inflows by average investment.
b. net income by average investment.
c. cash inflows by original investment.
d. net income by original investment.
157. All of the following statements about the annual rate of return method are correct except
that it
a. indicates the profitability of a capital expenditure.
b. ignores the salvage value of an investment.
c. does not consider the time value of money.
d. compares the annual rate of return to management’s minimum rate of return.
Test Bank for Managerial Accounting, Seventh Edition
12–32
Answers to Multiple Choice Questions
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BRIEF EXERCISES
BE 158
Diamond Company is considering investing in new equipment that will cost $1,400,000 with a 10-
year useful life. The new equipment is expected to produce annual net income of $90,000 over its
useful life. Depreciation expense, using the straight-line rate, is $140,000 per year.
Instructions
Compute the cash payback period.
BE 159
Madeline Company is proposing to spend $200,000 to purchase a machine that will provide
annual cash flows of $38,000. The appropriate present value factor for 10 periods is 5.65.
Instructions
Compute the proposed investment’s net present value and indicate whether the investment
should be made by Madeline Company.
Planning for Capital Investments 12–33
Solution 159 (5 min.)
BE 160
LakeFront Company is considering investing in a new dock that will cost $560,000. The company
expects to use the dock for 5 years, after which it will be sold for $300,000. LakeFront anticipates
annual cash flows of $110,000 resulting from the new dock. The company’s borrowing rate is 8%,
while its cost of capital is 10%.
Instructions
Calculate the net present value of the dock and indicate whether LakeFront should make the
investment.
BE 161
Mobil Company has hired a consultant to propose a way to increase the company’s revenues.
The consultant has evaluated two mutually exclusive projects with the following information
provided for each project:
Project Turtle Project Snake
Capital investment $1,105,000 $625,000
Annual cash flows 180,000 105,000
Estimated useful life 10 years 10 years
Mobil Company uses a discount rate of 9% to evaluate both projects.
Instructions
(a) Calculate the net present value of both projects.
(b) Calculate the profitability index for each project.
(c) Which project should Mobil accept?
Test Bank for Managerial Accounting, Seventh Edition
12–34
Solution 161 (10–15 min.)
Ex. 162
Carlson Bottling Corporation is considering the purchase of a new bottling machine. The machine
would cost $300,000 and has an estimated useful life of 8 years with zero salvage value.
Management estimates that the new bottling machine will provide net annual cash flows of
$52,500. Management also believes that the new bottling machine will save the company money
because it is expected to be more reliable than other machines, and thus will reduce downtime.
How much would the reduction in downtime have to be worth in order for the project to be
acceptable? Assume a discount rate of 9%
Ans: N/A, LO: 2, 3, Bloom: E, Difficulty: Medium, Min: 8, AACSB: Analytic, AICPA BB: Resource Management, AICPA FN: Decision Modeling, AICPA
PC: Problem Solving/Decision Making, IMA: Quantitative Methods
Solution 162 (8 min.)
Planning for Capital Investments 12–35
Ex. 163
Stanton Company is performing a post-audit of a project completed one year ago. The initial
estimates were that the project would cost $490,000, would have a useful life of 9 years, zero
salvage value, and would result in net annual cash flows of $90,000 per year. Now that the
investment has been in operation for 1 year, revised figures indicate that it actually cost
$510,000, will have a useful life of 11 years, and will produce net annual cash flows of $77,000
per year. Evaluate the success of the project. Assume a discount rate of 10%
BE 164
Mint Company is contemplating an investment costing $135,000. The investment will have a life
of 8 years with no salvage value and will produce annual cash flows of $25,305.
Instructions
What is the approximate internal rate of return associated with this investment?
Test Bank for Managerial Accounting, Seventh Edition
12–36
BE 165
Salt Company is considering investing in a new facility to extract and produce salt. The facility will
increase revenues by $220,000, but it will also increase annual expenses by $160,000. The
facility will cost $980,000 to build, and it will have a $20,000 salvage value at the end of its useful
life.
Instructions
Calculate the annual rate of return on this facility.
EXERCISES
Ex. 166
Corn Doggy, Inc. produces and sells corn dogs. The corn dogs are dipped by hand. Austin
Beagle, production manager, is considering purchasing a machine that will make the corn dogs.
Austin has shopped for machines and found that the machine he wants will cost $215,000. In
addition, Austin estimates that the new machine will increase the company’s annual net cash
inflows by $33,000. The machine will have a 12-year useful life and no salvage value.
Instructions
(a) Calculate the cash payback period.
(b) Calculate the machine’s internal rate of return.
(c) Calculate the machine’s net present value using a discount rate of 10%.
(d) Assuming Corn Doggy, Inc.’s cost of capital is 10%, is the investment acceptable? Why or
why not?
Planning for Capital Investments 12–37
(d) Yes, the investment is acceptable. Indications are that the investment will earn a greater
return than 10%. The internal rate of return is estimated to be 11%, and the net present
value is positive.
Ex. 167
Cepeda Manufacturing Company is considering three new projects, each requiring an equipment
investment of $22,000. Each project will last for 3 years and produce the following cash inflows.
Year AA BB CC
1 $ 7,000 $ 9,500 $11,000
2 9,000 9,500 10,000
3 15,000 9,500 9,000
Total $31,000 $28,500 $30,000
The equipment’s salvage value is zero. Cepeda uses straight-line depreciation. Cepeda will not
accept any project with a payback period over 2 years. Cepeda’s minimum required rate of return
is 12%.
Instructions
(a) Compute each project’s payback period, indicating the most desirable project and the least
desirable project using this method. (Round to two decimals.)
(b) Compute the net present value of each project. Does your evaluation change? (Round to
nearest dollar.)
Test Bank for Managerial Accounting, Seventh Edition
12–38
Ex. 168
Gantner Company is considering a capital investment of $300,000 in additional productive
facilities. The new machinery is expected to have a useful life of 5 years with no salvage value.
Depreciation is computed by the straight-line method. During the life of the investment, annual net
income and cash inflows are expected to be $27,000 and $87,000, respectively. Gantner has a
12% cost of capital rate, which is the minimum acceptable rate of return on the investment.
Instructions
(Round to two decimals.)
(a) Compute (1) the annual rate of return and (2) the cash payback period on the proposed
capital expenditure.
(b) Using the discounted cash flow technique, compute the net present value.
Planning for Capital Investments 12–39
Ex. 169
Top Growth Farms, a farming cooperative, is considering purchasing a tractor for $551,500. The
machine has a 10-year life and an estimated salvage value of $36,000. Delivery costs and set-up
charges will be $12,100 and $400, respectively. Top Growth uses straight-line depreciation.
Top Growth estimates that the tractor will be used five times a week with the average charge to
the individual farmers of $400. Fuel is $50 for each use of the tractor. The present value of an
annuity of 1 for 10 years at 9% is 6.418.
Instructions
For the new tractor, compute the:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.
Test Bank for Managerial Accounting, Seventh Edition
12–40
Ex. 170
Tom Bat became a baseball enthusiast at a very early age. All of his baseball experience has
provided him valuable knowledge of the sport, and he is thinking about going into the batting cage
business. He estimates the construction of a state-of-the-art building and the purchase of
necessary equipment will cost $840,000. Both the facility and the equipment will be depreciated
over 12 years using the straight-line method and are expected to have zero salvage values. His
required rate of return is 9% (present value factor of 7.1607). Estimated annual net income and
cash flows are as follows:
Revenue $350,500
Less:
Utility cost 40,000
Supplies 8,000
Labor 141,000
Depreciation 70,000
Other 38,500 297,500
Net income $ 53,000
Instructions
For this investment, calculate:
(a) The net present value.
(b) The internal rate of return.
(c) The cash payback period.
Planning for Capital Investments 12–41
Ex. 171
Mimi Company is considering a capital investment of $275,000 in new equipment. The equipment
is expected to have a 5-year useful life with no salvage value. Depreciation is computed by the
straight-line method. During the life of the investment, annual net income and cash inflows are
expected to be $25,000 and $80,000, respectively. Mimi’s minimum required rate of return is
10%. The present value of 1 for 5 periods at 10% is .621 and the present value of an annuity of 1
for 5 periods at 10% is 3.791.
Instructions
Compute each of the following:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.
Ex. 172
Savanna Company is considering two capital investment proposals. Relevant data on each
project are as follows:
Project Red Project Blue
Capital investment $440,000 $640,000
Annual net income 25,000 60,000
Estimated useful life 8 years 8 years
Depreciation is computed by the straight-line method with no salvage value. Savanna requires an
8% rate of return on all new investments. The present value of 1 for 8 periods at 8% is .540 and
the present value of an annuity of 1 for 8 periods is 5.747.
Instructions
(a) Compute the cash payback period for each project.
(b) Compute the net present value for each project.
(c) Compute the annual rate of return for each project.
(d) Which project should Savanna select?
Test Bank for Managerial Accounting, Seventh Edition
12–42
Solution 172 (14–18 min.)
Ex. 173
Yappy Company is considering a capital investment of $320,000 in additional equipment. The
new equipment is expected to have a useful life of 8 years with no salvage value. Depreciation is
computed by the straight-line method. During the life of the investment, annual net income and
cash inflows are expected to be $22,000 and $62,000, respectively. Yappy requires a 10% return
on all new investments.
Present Value of an Annuity of 1
Period 8% 9% 10% 11% 12% 15%
8 5.747 5.535 5.335 5.146 4.968 4.487
Instructions
(a) Compute each of the following:
1. Cash payback period.
2. Net present value.
3. Profitability index.
4 Internal rate of return.
5. Annual rate of return.
(b) Indicate whether the investment should be accepted or rejected.
Planning for Capital Investments 12–43
Solution 173 (15–20 min.)
Ex. 174
Laramie Service Center just purchased an automobile hoist for $16,900. The hoist has a 5-year
life and an estimated salvage value of $1,250. Installation costs were $3,770, and freight charges
were $960. Laramie uses straight-line depreciation.
The new hoist will be used to replace mufflers and tires on automobiles. Laramie estimates
that the new hoist will enable his mechanics to replace four extra mufflers per week. Each muffler
sells for $85 installed. The cost of a muffler is $46, and the labor cost to install a muffler is $13.
Instructions
(a) Compute the payback period for the new hoist.
(b) Compute the annual rate of return for the new hoist. (Round to one decimal.)
Test Bank for Managerial Accounting, Seventh Edition
12–44
Ex. 175
Sophie’s Pet Shop is considering the purchase of a new delivery van. Sophie Smith, owner of the
shop, has compiled the following estimates in trying to determine whether the delivery van should
be purchased:
Cost of the van $35,000
Annual net cash flows 6,000
Salvage value 4,000
Estimated useful life 8 years
Cost of capital 10%
Present value of an annuity of 1 5.335
Present value of 1 .467
Sophie’s assistant manager is trying to convince Sophie that the van has other benefits that she
hasn’t considered in the initial estimates. These additional benefits, including the free advertising
the store’s name painted on the van’s doors will provide, are expected to increase net cash flows
by $500 each year.
Instructions
(a) Calculate the net present value of the van, based on the initial estimates. Should the van be
purchased?
(b) Calculate the net present value, incorporating the additional benefits suggested by the
assistant manager. Should the van be purchased?
(c) Determine how much the additional benefits would have to be worth in order for the van to
be purchased.
Planning for Capital Investments 12–45
Ex. 176
Vista Company is considering two new projects, each requiring an equipment investment of
$97,000. Each project will last for three years and produce the following cash inflows:
Year Cool Hot
1 $ 38,000 $ 42,000
2 43,000 42,000
3 48,000 42,000
$129,000 $126,000
The equipment will have no salvage value at the end of its three-year life. Vista Company uses
straight-line depreciation and requires a minimum rate of return of 12%.
Present value data are as follows:
Present Value of 1 Present Value of an Annuity of 1
Period 12% Period 12%
1 .893 1 .893
2 .797 2 1.690
3 .712 3 2.402
Instructions
(a) Compute the net present value of each project.
(b) Compute the profitability index of each project.
(c) Which project should be selected? Why?
Test Bank for Managerial Accounting, Seventh Edition
12–46
Ex. 177
KSU Corp. is considering purchasing one of two new diagnostic machines. Either machine would
make it possible for the company to bid on jobs that it currently isn’t equipped to do. Estimates
regarding each machine are provided below.
Machine A Machine B
Original cost $106,000 $ 175,000
Estimated life 8 years 8 years
Salvage value -0- -0-
Estimated annual cash inflows $30,000 $45,000
Estimated annual cash outflows $10,000 $15,000
Instructions
Calculate the net present value and profitability index of each machine. Assume a 9% discount
rate. Which machine should be purchased?
Planning for Capital Investments 12–47
Ex. 178
Santana Company is considering investing in a project that will cost $151,000 and have no
salvage value at the end of its 5-year life. It is estimated that the project will generate annual cash
inflows of $40,000 each year. The company requires a 9% rate of return and uses the following
compound interest table:
Present Value of an Annuity of 1
Period 6% 8% 9% 10% 11% 12% 15%
5 4.212 3.993 3.890 3.791 3.696 3.605 3.352
Instructions
(a) Compute (1) the net present value and (2) the profitability index of the project.
(b) Compute the internal rate of return on this project.
(c) Should Santana invest in this project?
Test Bank for Managerial Accounting, Seventh Edition
12–48
Ex. 179
Johnson Company is considering purchasing one of two new machines. The following estimates
are available for each machine:
Machine 1 Machine 2
Initial cost $152,000 $169,000
Annual cash inflows 50,000 60,000
Annual cash outflows 15,000 20,000
Estimated useful life 6 years 6 years
The company’s minimum required rate of return is 9%.
Present Value of an Annuity of 1
Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784
Instructions
(a) Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for
each machine.
(b) Which machine should be purchased?
Planning for Capital Investments 12–49
Ex. 180
Platoon Company is performing a post-audit of a project that was estimated to cost $420,000,
have a useful life of 6 years with a zero salvage value, and result in net cash inflows of $100,000
per year. After the investment was in operation for a year, revised figures indicate that it actually
cost $470,000, will have a 9-year useful life, and will produce net cash inflows of $77,000. The
present value of an annuity of 1 for 6 years at 10% is 4.355 and for 9 years is 5.759.
Instructions
Determine whether the project should have been accepted based on (a) the original estimates
and then on (b) the actual amounts.
Ex. 181
Shilling Corp. is thinking about opening a baseball camp in Florida. In order to start the camp, the
company would need to purchase land, build five baseball fields, and a dormitory-type sleeping
and dining facility to house 100 players. Each year the camp would be run for 10 sessions of 1
week each. The company would hire college baseball players as coaches. The camp attendees
would be baseball players age 12-18. Property values in Florida have enjoyed a steady increase
in value. It is expected that after using the facility for 20 years, Shilling can sell the property for
more than it was originally purchased for. The following amounts have been estimated:
Cost of land $ 630,000
Cost to build dorm and dining facility 2,100,000
Annual cash inflows assuming 100 players and 10 weeks 2,520,000
Annual cash outflows 2,260,000
Estimated useful life 20 years
Salvage value 4,400,000
Discount rate 10%
Present value of an annuity of 1 8.514
Present value of 1 .149
Test Bank for Managerial Accounting, Seventh Edition
12–50
Ex. 181 (Cont.)
Instructions
(a) Calculate the net present value of the project.
(b) To gauge the sensitivity of the project to these estimates, assume that if only 80 campers
attend each week, revenues will be $2,085,000 and expenses will be $1,865,000. What is
the net present value using these alternative estimates? Discuss your findings.
(c) Assuming the original facts, what is the net present value if the project is actually riskier than
first assumed, and a 12% discount rate is more appropriate? The present value of 1 at 12%
is .104 and the present value of an annuity of 1 is 7.469.
Ex. 182
Ace Corporation recently purchased a new machine for its factory operations at a cost of
$950,000. The investment is expected to generate $250,000 in annual cash flows for a period of
five years. The required rate of return is 8%. The new machine is expected to have zero salvage
value at the end of the five-year period.
Instructions
Calculate the internal rate of return. (Table 4 from Appendix C is needed.)
Planning for Capital Investments 12–51
COMPLETION STATEMENTS
183. For purposes of capital budgeting, estimated ____________ and outflows are preferred
for inputs into the capital budgeting decision tools.
184. The technique which identifies the time period required to recover the cost of the
investment is called the ________________ method.
185. The two discounted cash flow techniques used in capital budgeting are (1) the
_______________________ method and (2) the ______________________ method.
186. Under the net present value method, the interest rate to be used in discounting the future
cash inflows is the ________________.
187. In using the net present value approach, a project is acceptable if the project’s net present
value is ____________ or_______________.
188. A project’s ________________, such as increased quality or safety, are often incorrectly
ignored in capital budgeting decisions.
189. The _______________ is a method of comparing alternative projects that takes into
account both the size of the investment and its discounted future cash flows.
190. A well-run organization should perform an evaluation, called a _____________, of its
investment projects after their completion.
Test Bank for Managerial Accounting, Seventh Edition
12–52
191. The internal rate of return method differs from the net present value method in that it
results in finding the ___________________ of the potential investment.
192. A major limitation of the annual rate of return approach is that it does not consider the
_______________ of money.
Answers to Completion Statements
Planning for Capital Investments 12–53
MATCHING
193. Match the items below by entering the appropriate code letter in the space provided.
A. Profitability index E. Annual rate of return method
B. Internal rate of return method F. Cash payback technique
C. Discounted cash flow techniques G. Cost of capital
D. Capital budgeting H. Net present value method
____ 1. A capital budgeting technique that identifies the time period required to recover the
cost of a capital investment from the annual cash inflow produced by the investment.
____ 2. Capital budgeting techniques that consider both the estimated total cash inflows from
the investment and the time value of money.
____ 3. A method used in capital budgeting in which cash inflows are discounted to their
present value and then compared to the capital outlay required by the capital
investment.
____ 4. A method of comparing alternative projects that takes into account both the size of the
investment and its discounted cash flows.
____ 5. A method used in capital budgeting that results in finding the interest yield of the
potential investment.
____ 6. The average rate of return that the firm must pay to obtain borrowed and equity funds.
____ 7. The determination of the profitability of a capital expenditure by dividing expected
annual net income by the average investment.
____ 8. The process of making capital expenditure decisions in business.
SHORT-ANSWER ESSAY QUESTIONS
S-A E 194
Management uses several capital budgeting methods in evaluating projects for possible
investment. Identify those methods that are more desirable from a conceptual standpoint, and
briefly explain what features these methods have that make them more desirable than other
methods. Also identify the least desirable method and explain its major weaknesses.
Test Bank for Managerial Accounting, Seventh Edition
12–54
Solution 194
S-A E 195
Manny Perez is trying to understand the term “cost of capital.” Define the term, and indicate its
relevance to the decision rule under the annual rate of return technique.
S-A E 196 (Ethics)
Sam Stanton is on the capital budgeting committee for his company, Canton Tile. Ed Rhodes is
an engineer for the firm. Ed expresses his disappointment to Sam that a project that was given to
him to review before submission looks extremely good on paper. “I really hoped that the cost
projections wouldn‘t pan out,” he tells his friend. “The technology used in this is pie in the sky kind
of stuff. There are a hundred things that could go wrong. But the figures are very convincing. I
haven’t sent it on yet, though I probably should.”
“You can keep it if it’s really that bad,” assures Sam. “Anyway, you can probably get it shot out of
the water pretty easily, and not have the guy who submitted it mad at you for not turning it in. Just
fix the numbers. If you figure, for instance, that a cost is only 50% likely to be that low, then
double it. We do it all the time, informally. Best of all, the rank and file don’t get to come to those
sessions. Your engineering genius need never know. He’ll just think someone else’s project was
even better than his.”
Required:
1. Who are the stakeholders in this situation?
2. Is it ethical to adjust the figures to compensate for risk? Explain.
3. Is it ethical to change the proposal before submitting it? Explain.
Planning for Capital Investments 12–55
Solution 196
S-A E 197 (Communication)
You are the general accountant for Word Systems, Inc., a typing service based in Los Angeles,
California. The company has decided to upgrade its equipment. It currently has a widely used
version of a word processing program. The company wishes to invest in more up-to-date software
and to improve its printing capabilities.
Two options have emerged. Option #1 is for the company to keep its existing computer system,
and upgrade its word processing program. The memory of each work station would be enhanced,
and a larger, more efficient printer would be used. Better telecommunications equipment would
allow for the electronic transmission of some documents as well.
Option #2 would be for the company to invest in an entirely different computer system. The
software for this system is impressive, and it comes with individual laser printers. However, the
company is not well known, and the software does not connect well with well-known software.
The net present value information for these options follows:
Option #1 Option #2
Initial Investment $(95,000) $(270,000)
Returns Year 1 55,000 90,000
Year 2 30,000 90,000
Year 3 10,000 90,000
Net present value 0 0
Required:
Prepare a brief report for management in which you make a recommendation for one system or
the other, using the information given.