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Exam 11: Capital Budgeting and Investment Analysis

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Question 1

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The accounting rate of return (ARR) is computed by dividing a project's after-tax net income by the amount of the initial investment.

A) True
B) False

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Question 2

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The accounting rate of return (ARR) is computed by dividing a project's after-tax net income by the average annual investment.

A) True
B) False

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Question 3

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Which methods of evaluating a capital investment project use cash flows as a measurement basis?

The accounting rate of return is based on cash flows rather than net income in its calculation.

An advantage of the break-even time (BET) method over the payback period method is that it recognizes the time value of money.

Dracor Company is considering the purchase of equipment that would allow the company to add a new product to its line. The equipment is expected to cost $280,000 with a 7-year life, no salvage value, and will be depreciated using straight-line depreciation. The expected annual income related to this equipment follows. Compute the (a) payback period and (b) accounting rate of return for this equipment.

When computing payback period, the date the initial capital investment is made is year 1.

A company is considering two alternative investment opportunities, each of which requires an initial cash outlay of $110,000. The expected net cash flows from the two projects follow:

Briefly describe the time value of money. Why is the time value of money important in capital budgeting?

Which methods of evaluating a capital investment project ignore the time value of money?

Capital budgeting decisions are not affected by return on investment considerations.

A company purchases a machine for $800,000. The machine has an expected life of 9 years and no salvage value. The company anticipates a yearly after-tax net income of $60,000 to be received uniformly throughout each year. What is the accounting rate of return?

A shorter payback period reduces the company's ability to respond to unanticipated changes and increases the risk of having to keep an unprofitable investment.

A company is considering the purchase of new equipment for $45,000. The projected annual net cash flows are $19,000. The machine has a useful life of 3 years and no salvage value. Management of the company requires a 12% return on investment. The present value of an annuity of $1 for various periods follows: What is the net present value of this machine assuming all cash flows occur at year-end?

Presented below are terms preceded by letters a through f and followed by a list of definitions 1 through 6. Match the letter of the terms with the definitions.

Coffer Co. is analyzing two potential investments. If the company is using the payback period method and it requires a payback of three years or less, which project(s) should be selected?

A company is considering purchasing a machine for $21,000. The machine will generate an after-tax net income of $2,000 per year. Annual depreciation expense would be $1,500. What is the payback period for the new machine?

A company is considering purchasing a machine for $21,000. The machine will generate an after-tax net income of $2,000 per year. Annual depreciation expense would be $1,500. The machine has no salvage value. What is the accounting rate of return?

A company is considering a 5-year project. It plans to invest $62,000 now and it forecasts cash flows for each year of $16,200. The company requires a hurdle rate of 12%. Calculate the internal rate of return to determine whether it should accept this project. Selected factors for a present value of an annuity of 1 for five years are shown below:

The internal rate of return method of evaluating capital investments cannot be used with uneven cash flows.