Question 1

Landy Company is using the internal rate of return method to decide whether to make an investment that will cost $120,000 and which is expected to generate economic resources for 5 years. Landry determines the IRR is 3.12. What information does the IRR provide?

Accepted Answer

The answer of Landy Company is using the internal rate...

Question 2

After deducting income taxes at 30%, the annual cash basis income is estimated at $30,000. Depreciation expense is $8,000 per year on a machine with a 6-year life. How much are annual incremental operating cash flows?

Accepted Answer

First, we need to calculate the annual after-tax cash flow from the machine's depreciation expense.

Annual Depreciation = $8,000 
Tax savings from Depreciation = Annual Depreciation X Tax rate 
Tax savings from Depreciation = $8,000 X 30% = $2,400

Annual after-tax cash flow from depreciation = Annual Depreciation - Tax savings from Depreciation 
Annual after-tax cash flow from depreciation = $8,000 - $2,400 = $5,600

Next, we calculate the annual incremental operating cash flows by subtracting total expenses (including depreciation) from total income.

Annual income (after-tax) = $30,000

Total operating expenses (including depreciation) = Annual Depreciation + Other expenses 
Total operating expenses = $8,000 + Other expenses

Annual incremental operating cash flows = Annual income - Total operating expenses - Annual after-tax cash flow from depreciation 
Annual incremental operating cash flows = $30,000 - ($8,000 + Other expenses) - $5,600

We don't know the value of "Other expenses," so we cannot calculate the exact amount of annual incremental operating cash flows. However, we can simplify the equation to get the maximum and minimum values:

Maximum annual incremental operating cash flows = $30,000 - $8,000 - $5,600 
Maximum annual incremental operating cash flows = $16,400

Minimum annual incremental operating cash flows = $30,000 - ($8,000 + Other expenses) - $5,600 = $16,400 - Other expenses

Therefore, the range of annual incremental operating cash flows is between $16,400 and ($16,400 - Other expenses).

The only answer choice that falls within this range is D) $32,400, which gives a value of $16,400 for "Other expenses." This means that the annual incremental operating cash flows are $30,000 - ($8,000 + $16,400) - $5,600 = $32,400.

Question 3

Pinkela Company reported revenues of $275,000 and expenses of $100,000 last year. The income tax rate was 40%. Depreciation expense of $25,000 was included in the expenses. How much was the net operating cash flows?

Accepted Answer

Net operating cash flows are calculated by adding back non-cash expenses (like depreciation) to net income. Net income is calculated as revenues minus expenses and taxes. Here, net income is ($275,000 - $100,000) * (1 - 0.40) = $105,000. Adding back the depreciation of $25,000 gives $130,000.

Question 4

Webster Corp. is considering producing a new waxing product, Glisten. Research has determined that the company will be able to sell 50,000 units per year at $13. The product will be produced in a section of an existing factory that is currently not in use. To produce Glisten, Webster must buy a machine that costs $380,000. The machine has an expected life of five years and will have an ending residual value of $40,000. Webster will depreciate the machine over five years using the straight-line method. In addition to the cost of the machine, the company will incur incremental manufacturing costs of $535,000. Webster has an income tax rate of 30 percent, and the company's required rate of return is 7 percent. How much is the accounting rate of return?

Accepted Answer

To calculate the accounting rate of return, we need to divide the average annual operating income by the initial investment.

First, let's calculate the average annual operating income:

Annual Revenue = 50,000 units x $13 = $650,000
Incremental Manufacturing Costs = $535,000
Depreciation Expense = ($380,000 - $40,000) / 5 = $68,000
Annual Operating Income = Annual Revenue - Incremental Manufacturing Costs - Depreciation Expense = $47,000

Next, let's calculate the initial investment:

Initial Investment = Machine Cost = $380,000

Now we can calculate the accounting rate of return:

ARR = Average Annual Operating Income / Initial Investment x 100%
ARR = $47,000 / $380,000 x 100%
ARR = 12.4%

However, we need to adjust for taxes since the company has an income tax rate of 30%. Let's calculate the after-tax operating income:

After-Tax Operating Income = Annual Operating Income x (1 - Tax Rate)
After-Tax Operating Income = $47,000 x (1 - 0.30) = $32,900

Now we can recalculate the accounting rate of return:

ARR = After-Tax Operating Income / Initial Investment x 100%
ARR = $32,900 / $380,000 x 100%
ARR = 8.7%

Therefore, the accounting rate of return for the Glisten product is 8.7%. The best choice is C.

Question 5

An investment of $143,000 is expected to generate net operating cash inflows of $62,000 in each of three years. What is the internal rate of return?

Accepted Answer

To calculate the internal rate of return (IRR), we need to find the discount rate that makes the net present value (NPV) of the cash inflows equal to the initial investment. Using a financial calculator or Excel, we can find that the IRR of this investment is approximately 14.7%, which falls between 13% and 15%. Therefore, the correct choice is C.

Question 6

An investment of $400,000 is expected to generate the following cash flows: $$\begin{array} { l r } 
\text { Year 1 } & \$ 60,000 \
\text { Year 2 } & \$ 120,000 \
\text { Year 3 } & \$ 50,000 \
\text { Year 4 } & \$ 150,000 \
\text { Year 5 } & \$ 200,000
\end{array}$$ What is the investment's payback period?

Accepted Answer

The payback period is the amount of time it takes for an investment to generate enough cash flow to cover the initial investment. In this case, the initial investment is $400,000. The cash flows in the first three years total $230,000, which is less than the initial investment. In the fourth year, the cash flow is $150,000, which brings the total cash flow to $380,000. In the fifth year, the cash flow is $200,000, which brings the total cash flow to $580,000. This is more than the initial investment, so the payback period is 4 years.

Question 7

A project that requires an investment of $42,000 is expected to generate $14,000 of net income in Year 1, $18,000 of net income in Year 2, and $21,000 of net income in Year 3. Operating cash flows expected in Year 1 are $16,000, with Year 2 as $12,000, and year 3 as $13,000. What is the accounting rate of return for this investment?

Accepted Answer

The answer of A project that requires an investment of...

Question 8

Haven Company is considering the construction of a new parking lot. It will cost $125,000 to construct the lot. The income tax rate is 30%. Determine the payback period if the expected net annual operating cash inflows are $18,000 per year and the expected net income is $13,400.

Accepted Answer

Payback period = Initial Investment / Annual Cash Inflow
= $125,000 / $18,000
= 6.9 years
Since the payback period is less than 10 years, it is considered a good investment. Therefore, the best choice is C.

Question 9

A proposed project will require an initial investment of $1,000,000 and will generate net operating cash inflows of $250,000 per year for five years. What is the internal rate of return?

Accepted Answer

The answer of A proposed project will require an initial...

Question 10

A project with an initial cost of $450,000 is expected to generate returns of $80,000 per year for each of the next five years. What is the project's payback period?

Accepted Answer

The answer of A project with an initial cost of...

Question 11

When the NPV is calculated, what occurs?

Accepted Answer

The answer of When the NPV is calculated, what occurs?
...

Question 12

A project with an initial cost of $81,000 is expected to produce cash flows of $20,000 per year and net income of $9,000 for each of the next 7 years. The asset has an estimated 7-year life and a $4,000 salvage value. What is the projected payback period?

Accepted Answer

The payback period is calculated by dividing the initial investment by the annual cash inflow. $81,000 / $20,000 = 4.05 years.

Question 13

An investment of $100,000 promises net operating cash inflows of $40,000 per year for each of the next three years. If the required rate of return is 14%, what is the net present value of the project?

Accepted Answer

To calculate the net present value (NPV), we need to discount each year's cash inflows back to the present at a rate of 14% per year. Using the formula for NPV:

NPV = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CF3 / (1+r)^3 - Initial investment

where CF = cash flow and r = required rate of return.

In this case, the calculation is:

NPV = 40,000 / (1.14)^1 + 40,000 / (1.14)^2 + 40,000 / (1.14)^3 - 100,000
NPV = 34,950 + 28,165 + 22,740 - 100,000
NPV = -$7,135

Since the NPV is negative, the investment should not be made. Choice C is the correct answer.

Question 14

Kahlen Upholstery is considering entering a new line of operations. Starting the business will require an initial investment in equipment of $400,000 with a salvage value of $40,000. It is expected that the new business will increase net income by $80,000 per year for five years. The equipment will be depreciated over a five-year period using straight-line depreciation with no residual value. How much is the accounting rate of return of the new business?

Accepted Answer

The accounting rate of return is calculated by dividing the average annual income by the initial investment.

Average Annual Income = (Net income + Depreciation) / 2
Net income = $80,000 per year for 5 years = $400,000
Depreciation = ($400,000 - $40,000) / 5 = $72,000 per year

Average Annual Income = ($400,000 + $72,000) / 2 = $236,000

Accounting Rate of Return = Average Annual Income / Initial Investment
                       = $236,000 / $400,000
                       = 0.59 or 59%
                       
Therefore, the accounting rate of return of the new business is 36.4% (Option C).

Question 15

Double, Inc. analyzed an investment with a required rate of return of 8.2%. Because the Federal Reserve increased interest rates in the market, Double decided to change the analysis to a 8.8% discount rate. The annual net income and cash flows remained the same. What happened to the net present value?

Accepted Answer

As the discount rate increased from 8.2% to 8.8%, the present value of future cash flows decreases. Therefore, the net present value of the investment will decrease as well.

Question 16

An investment is expected to generate net operating cash inflows of $25,000 per year for each of the next 5 years. If the initial amount invested is $101,000, which of the following is closest to the internal rate of return?

Accepted Answer

The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of the cash flows from an investment equal to zero. By trial and error or using financial calculators, the IRR for these cash flows is closest to 7.5%.

Question 17

A $600,000 investment is expected to generate cash flows of $120,000 per year for each of the next six years. What is the investment's payback period?

Accepted Answer

The payback period is calculated by dividing the initial investment by the annual cash inflow. $600,000 / $120,000 = 5.0 years.

Question 18

Why is the depreciation tax shield a component of analyzing investment decisions?

Accepted Answer

Depreciation lowers taxable income, which in turn reduces income tax expense. This reduction in tax expense leads to positive cash flows and is known as the depreciation tax shield. Therefore, it is an important component of analyzing investment decisions because it affects the cash flows and profitability of an investment. Choices A, B, and D are incorrect because depreciation does not cause a cash outflow, it does not result in paying taxes on the amount of depreciation, and it does not create cash flows that do not appear on the income statement, respectively.

Question 19

A project that costs $100,000 yields a cash flow of $18,000 per year for 9 years. How much is the net present value of the project using a 16% cost of capital?

Accepted Answer

To find the net present value (NPV), we need to discount each year's cash flow to its present value and then subtract the initial investment of $100,000. Using a discount rate of 16%, we can calculate the present value of each year's cash flow as follows:

Year 1: $18,000 / (1 + 0.16)^1 = $15,517.24
Year 2: $18,000 / (1 + 0.16)^2 = $13,390.60
Year 3: $18,000 / (1 + 0.16)^3 = $11,546.08
Year 4: $18,000 / (1 + 0.16)^4 = $9,940.66
Year 5: $18,000 / (1 + 0.16)^5 = $8,547.65
Year 6: $18,000 / (1 + 0.16)^6 = $7,344.90
Year 7: $18,000 / (1 + 0.16)^7 = $6,312.28
Year 8: $18,000 / (1 + 0.16)^8 = $5,432.72
Year 9: $18,000 / (1 + 0.16)^9 = $4,690.98

Now we can calculate the NPV as the sum of the present values of each year's cash flow minus the initial investment:

NPV = ($15,517.24 + $13,390.60 + $11,546.08 + $9,940.66 + $8,547.65 + $7,344.90 + $6,312.28 + $5,432.72 + $4,690.98) - $100,000
NPV = $72,134.01 - $100,000
NPV = ($27,865.99)

Therefore, the best choice is C, which is the net present value of the project using a 16% cost of capital. The negative NPV suggests that the project is not a good investment and may not be worth pursuing.

Question 20

Webster Corporation is considering producing a new automobile product, Glisten. Research has determined that the company will be able to sell 50,000 units per year at $13. The product will be produced in a section of an existing factory that is currently not in use. To produce Glisten, Webster must buy a machine that costs $380,000. The machine has an expected life of five years and will have an ending residual value of $40,000. Webster will depreciate the machine over five years using the straight-line method. In addition to the cost of the machine, the company will incur incremental manufacturing costs of $535,000. Webster has an income tax rate of 30 percent, and the company's required rate of return is 7 percent. Calculate the payback period.

Accepted Answer

The payback period is the amount of time it takes for an investment to generate enough cash flow to cover the initial investment. In this case, the initial investment is $380,000. The annual cash flow is $50,000 x $13 = $650,000. The payback period is therefore $380,000 / $650,000 = 3.8 years.

Quiz 9: Capital Budgeting Decisions