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Exam 16: Planning for Capital Investments

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Question 51

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When the effect of income taxes is considered in a capital budgeting analysis, the amount of depreciation expense must be added back to after-tax income to calculate the annual cash inflow.

A) True
B) False

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Question 52

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Describe the decision rules management should use for accepting and rejecting capital projects under each of the following capital budgeting models: net present value model, internal rate of return model, payback period, and the unadjusted rate of return model.

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Management should accept projects whose ...

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Question 53

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Langdon Company is considering purchasing a capital investment that is expected to provide annual cash inflows of $10,000 per year for 3 years. Assuming that Langdon's required rate of return is 8%, what is the present value of these cash inflows? (Do not round PV factors and intermediate calculations. Round your final answer to the nearest dollar.)

Bruce Company is considering replacing one of its delivery trucks. The truck in question was purchased two years ago at a cost of $41,000. At the time of purchase the truck was expected to have a $5,000 salvage value at the end of its six-year life. Given the use of straight-line depreciation, the truck has a current book value of $29,000. If sold today, the company could get $22,000 for the truck. It costs $20,000 per year to operate the existing truck. The new truck would cost $46,000 and would cost only $14,000 per year to operate. The new truck would be depreciated on a straight-line basis over its four-year useful life to its expected salvage value of $10,000. The company's required rate of return is 14%. Ignore income taxes. Required: 1) Identify the cash flows for each alternative by completing the following table: $\begin{array} { | c | c | l | l | l | } \hline &{ \text { Keep Existing Truck } } &&{ \text { Replace Existing Truck } } \\\hline \text { Year } & \text { Cash Outflows } & \text { Cash Inflows } & \text { Cash Outflows } & \text { Cash Inflows } \\\hline 0 & & & & \\\hline 1 & & & & \\\hline 2 & & & & \\\hline 3 & & & & \\\hline 4 & & & & \\\hline\end{array}$ 2) The company's objective is to minimize costs. Complete the following table to determine whether the existing truck should be replaced. Ignore income taxes. What is your recommendation? $\begin{array} { | c | c | c | c | c | c | c | } \hline & & { \text { Keep Existing Truck } } & { \text { Replace Existing Truck } } \\\hline & & & \text { Present Value of } & & & \\\hline & 14 \% & \text { Net Cash } & \text { Net Cash } & & \text { Net Cash } & \text { Present Value of Net } \\\hline \text { Year } & \begin{array} { c } \text { PV } \\\text { Factor }\end{array} & \text { Outflows } & \text { Outflows } & & \text { Outflows } & \text { Cash Outflows } \\\hline 0 & & & & & \\\hline 1 & & & & & \\\hline 2 & & & & & & \\\hline 3 & & & & & & \\\hline 4 & & & & & & \\\hline\end{array}$

The payback method of evaluating capital investments measures the recovery of the investment, but it does not measure profitability.

Cash outflows from a capital investment project include:

Describe the general approaches companies may use in evaluating potential capital investments.

An investment that costs $40,000 will produce annual cash flows of $12,000 for a period of 4 years. Given a desired rate of return of 10%, the investment will generate a (Do not round your PV factors and intermediate calculations. Round your answer to nearest whole dollar) :

The cost of capital is called all of the following except:

The compensation a company receives for investing in capital assets is referred to as a return on investment.

When a capital investment is expected to provide unequal annual cash inflows, the payback period cannot be calculated.

A customary assumption in capital budgeting analysis is that:

Select the term from the list provided that best matches each of the following definitions or descriptions. Put the number of the term in the answer column.

Redmond Company is considering investing in one of the following two projects: $\begin{array}{l}\text {Annual Cash Inflows }\\\begin{array} {| l | l | l | } \hline \text {Year }&\text {Project A }&\text { Project B}\\\hline 1&\$2,000&\$4,000\\\hline 2&3,000&2,000\\\hline 3&3,000&2,000\\\hline 4&1,000&1,000\\\hline\text { Total}&\$9,000&\$9,000\\\hline\end{array}\end{array}$ Required: 1) Which project is more desirable strictly in terms of cash inflows? Why? 2) Compute the present value of each project's cash inflows assuming the company's required rate of return is 12%. 3) What is the maximum amount Redmond should be willing to pay for each project? 4) Suppose each project costs $7,000. Which project(s) should be accepted? Note that only one project can be accepted.

The assumption regarding ordinary annuities is that cash flows occur at the end of each period.

All of the following are capital investment decisions except:

The instantaneous computation power of spreadsheet software makes it ideal for answering "what-if" questions regarding present values.

The time value of money concept recognizes that a dollar today is worth more than a dollar tomorrow. Which of the following is not a factor in causing the present value of cash inflows to diminish over time?

Indicate whether each of the following statements is true or false. 1. When unequal cash inflows are expected from a capital investment, the payback period can be calculated by accumulating incremental cash inflows or by using average annual cash inflows. 2. The unadjusted rate of return is also called the simple rate of return. 3. The unadjusted rate of return can be calculated as average increase in cash inflows divided by net cost of the original investment. 4. The unadjusted rate of return does not take the time value of money into account. 5. The unadjusted rate of return should be calculated using the initial cost of the investment, rather than the average invested capital.

Mendez Company is considering a capital project that costs $16,000. The project will deliver the following cash flows: $\begin{array} { | l | c | c | c | c | } \hline \text { Year 1 } & \text { Year 2 } & \text { Year 3 } & \text { Year 4 } & \text { Year 5 } \\\hline \$ 8,000 & \$ 6,000 & \$ 5,000 & \$ 6,000 & \$ 5,000 \\\hline\end{array}$ Using the incremental approach, the payback period for the investment is: