Solved by verified expert :Chapter 21

Review Questions and Exercises

1.

The ______ method of capital budgeting is based on income rather than cash

flows.

2.

The discount rate that makes the net present value of a project equal to zero

is called the __ 3. In a capital-budgeting project, the investment required for

accounts receivable and inventories is called _ ____.

4.

(Appendix) __ ___ is the decline in the general purchasing power of the

monetary unit.

True-False

___

1. The planning and control tools used for year-to-year operating decisions are

well suited for capital-budgeting decisions.

___

2. The present value of $1 million to be received ten years from now is lower

if computed at a discount rate of 10% rather than 14%.

___

3. Assume a required rate of return of 12% is used to compute the NPV of a

project. If NPV is negative, IRR is less than 12%.

___

4. The payback method does not consider a project’s cash flows after the payback

period.

__

5. If the income tax rate for a profitable company is 30%, a depreciation

deduction of $10,000 results in a tax savings of $7,000 (before considering

time value of money).

___

6. For a profitable company, the gain or loss on the recovery of working

capital in a capital-budgeting project is subject to income tax.

____

7. It is consistent to use NPV as best for capital-budgeting decisions and then

use AARR to evaluate a manager’s performance over short time horizons.

Multiple Choice

____

1. (CMA) Amster Corporation has not yet decided on its required rate of return

for use in the evaluation of capital budgeting projects for the current year. This

lack of information prohibits Amster from calculating a project’s

___

2. (CPA adapted) Brewster Co. is reviewing the following data relating to an

energy- saving investment proposal:

Net initial investment

$50,000

After-tax cash flow from disposal of the investment at the end

of 5 years

10,000

Present value of an annuity of $1 at 12% for 5 years

3.60

Present value of $1 at 12% in 5 years

0.57

What

is the amount of after-tax annual savings (including the depreciation effects) needed

for the investment to provide a 12% return?

___

3. (CMA) Making the common assumption in capital-budgeting analysis that cash inflows

occur in a lump sum at the end of individual years during the life of an investment

project when, in fact, they flow more or less continuously during those years:

___

4. (CPA adapted) Apex Corp. is considering the purchase of a machine costing $100,000.

The machine’s expected useful life is five years. The estimated annual after-tax

cash flow from operations is: $60,000 in year 1, $30,000 in year 2, $20,000 in

year 3, $20,000 in year 4, and $20,000 in year 5. Assuming these cash flows

will be received evenly during each year, the payback is:

___

5. (CMA) Fast Freight Inc. is planning to purchase equipment to make its operations

more efficient. The equipment has an estimated life of six years. At the time

of acquiring the equipment, a $9,000 investment in working capital is required.

In a discounted cash-flow analysis, this investment in working capital:

_D___

6. Assume in the current year that a profitable company pays $10,000 for

advertising and has depreciation of $10,000. If the income tax rate is 40%, the

after-tax effects on cash flow before considering time value of money are a net

outflow of:

____

7. (CMA) Garfield Inc. is considering a 10-year capital investment project with

forecasted cash revenues of $40,000 per year and forecasted cash operating

costs of $29,000 per year. The initial cost of the equipment for the project is

$23,000, and Garfield expects to sell the equipment for $9,000 at the end of

the tenth year. The equipment will be depreciated on a straight-line basis over

seven years for tax purposes. The project requires a working capital investment

of $7,000 at its inception and another $5,000 at the end of year 5. The working

capital is fully recoverable at the end of the life of the project. Assuming a

40% tax rate, expected net after-tax cash flow from the project for the tenth

year is:

___

8. (CMA) Superstrut is considering replacing an old press that cost $80,000 six

years ago with a new one with a purchase cost of $225,000. Shipping and installation

cost an additional $20,000. The old press has a book value of $15,000 and can

be sold currently for $5,000. The increased production of the new press would

increase inventories by $4,000, accounts receivable by $16,000, and accounts

payable by $14,000. Superstrut’s net initial investment for analyzing the

acquisition of the new press, assuming a 40% income tax rate

___

9. (CMA) Brownel Inc. currently has annual cash revenues of $240,000 and annual

operating costs of $185,000 (all cash items except depreciation of $35,000).

The company is considering the purchase of a new mixing machine costing

$120,000 that would increase cash revenues to $290,000 per year and operating

costs (including depreciation) to $205,000 per year. The new machine would increase

depreciation to $50,000 per year. Using a 40% income tax rate, Brownel’s annual

incremental after-tax cash flow from the new mixing machine is:

Items

Present Situation

Proposed Situation

Cash-flow Difference

Cash

revenues

$240,000

$290,000

$50,000

Operating

Cost:

Cash operating costs (excludes

depreciation)

$185,000 – 35,000

150,000

$205,000 – 50,000

155,000

(5,000)

Depreciation

35,000

50,000

Total operation Cost

185,000

205,000

Operating

income

55,000

85,000

____

10. (Appendix) If the nominal rate of interest is 16% and the inflation rate is

5%, the real rate of interest (rounded to the nearest tenth of a percent) is:

Review Exercises

1.

The following information pertains to a machine recently sold by Powers

Enterprises:

Net initial investment

$300,000

Estimated useful life for tax purposes

8 years

Terminal disposal value for tax purposes

zero

Age at the time of sale

6 years

Cash received from the sale

$60,000

Income tax rate

30%

Assuming

Powers uses straight-line depreciation and is a profitable company, calculate

the after-tax cash flow from the sale of the machine.

2.

(CMA adapted) Jasper Company has a payback requirement of three years on new

equipment acquisitions. A new sorter is being evaluated that costs $450,000 and

has an estimated useful life of five years. Straight-line depreciation will be

used with a zero terminal disposal value. Jasper is subject to a 40% income tax

rate.

Calculate

the amount of savings in after-tax annual cash operating costs that must be

generated by the new sorter to meet the company’s payback requirement.

3.

(Appendix) Massey Company’s nominal rate of return for capital-budgeting projects

is 20%, which includes a 10% inflation rate. The present value of $1 at 20% for

one year is 0.833. Assume a 40% income tax rate.

Calculate

the after-tax present value (expressed in nominal dollars) of:

a.

Before-tax cash operating savings of $100,000 (expressed in year 0 dollars) to

be received at the end of year 1.

b. Year 1 depreciation of $70,000.