Question 1

McClaren Inc. is considering a $400,000 investment in new equipment that is anticipated to produce the following net cash inflows: $\begin{array}{lr}
\text { Year: } &\text { Net Cash} \
&\text { Inflows } \
1 & \$ 100,000 \
2 & 200,000 \
3 & 50,000 \
4 & 60,000 \
5 & 140,000
\end{array}$ If cash flows occur evenly throughout a year, the equipment's payback period is:

Accepted Answer

To calculate payback period, we need to determine how long it takes to recover the initial investment. We can determine this by adding up the net cash inflows each year until the sum equals the initial investment of $400,000.

Year 1: $100,000
Year 2: $200,000
Year 3: $50,000
Year 4: $60,000
Total cash inflows: $410,000

Therefore, the payback period would be 3 years and 10 months ($350,000 in 3 years + $60,000 in the 10th month of year 4).

Thus, the best choice is C with a payback period of 3 years, 10 months.

Question 2

Blueteeth Incorporated plans to incur $306,000 of salaries expense and produce $560,000 of additional sales revenue if a capital project is implemented. Assuming a 23% tax rate, these two items collectively should appear in a capital budgeting analysis as:

Accepted Answer

The net effect of the salaries expense and additional sales revenue is calculated as follows: Additional sales revenue ($560,000) minus salaries expense ($306,000) equals $254,000. After accounting for taxes (23%), the net inflow is $254,000 * (1 - 0.23) = $195,580.

Question 3

Reinhold Corporation has a $3,500,000 investment in equipment and is subject to a 20% income tax rate. Cash inflows are expected to average $320,000 before tax over the next few years; in contrast, average income before tax is anticipated to be $220,000. The company's accounting rate of return is:

Accepted Answer

The accounting rate of return is calculated by dividing the average annual income before tax by the investment. In this case, the average annual income before tax is $220,000 and the investment is $3,500,000. Therefore, the accounting rate of return is $220,000 / $3,500,000 = 6.3%.

Question 4

Which of the following tools is sometimes used to rank investment proposals?

Accepted Answer

The profitability index, also known as the profit investment ratio (PIR), is a financial tool used to evaluate the potential profitability of an investment proposal. It is calculated by dividing the present value of expected cash flows by the initial investment cost. A higher profitability index indicates a more favorable investment opportunity. Therefore, the profitability index can be used to rank investment proposals and select the most profitable one. The other options are either not commonly used or do not exist.

Question 5

Snaptile Company evaluates future projects by using the profitability index. The company is currently reviewing three projects similar in nature and must choose one of the following: $\begin{array} { l l l r } 
\text { Project } & \text { Initial Investment } && \begin{array} { l } 
\text { Present Value of Cash } \
\text { Inflows }
\end{array} \
1 & \$ 400,000 && \$ 300,000 \
2 & 200,000 & & 320,000 \
3 & 350,000 & & 430,000
\end{array}$ Which project should Snaptile select if the decision is based entirely on the profitability index?

Accepted Answer

The profitability index is calculated as the present value of cash inflows divided by the initial investment. Using this formula, we get the following profitability indices for each project:

Project 1: 300,000/400,000 = 0.75
Project 2: 320,000/200,000 = 1.60
Project 3: 430,000/350,000 = 1.23

Based on these results, project 2 has the highest profitability index and should be chosen. Therefore, the answer is (C).

Question 6

When income taxes are considered in capital budgeting, the cash flows related to a company's advertising expense would be correctly figured by taking the cash paid for advertising and:

Accepted Answer

Advertising expenses are tax-deductible, so the tax shield is calculated by multiplying the expense by the tax rate and subtracting it from the cash paid for advertising.

Question 7

When income taxes are considered in capital budgeting, the cash flows would be correctly figured by

Accepted Answer

The answer of When income taxes are considered in capital...

Question 8

When a company is analyzing a capital project by a discounted-cash-flow approach and income taxes are being considered, depreciation:

Accepted Answer

Depreciation should be considered because it results in a tax savings. Depreciation is a non-cash expense that can be subtracted from the taxable income, resulting in a lower tax bill. Therefore, depreciation helps to generate tax savings, which is an important consideration when analyzing a capital project by a discounted-cash-flow approach with income taxes being considered.

Question 9

The systematic follow-up on a capital project to see how the project actually turns out is commonly known as:

Accepted Answer

A post-audit is a formal review of a capital project after completion to determine whether or not projected benefits were actually realized. This is the most common term used to describe the systematic follow-up on a capital project. The other options listed do not accurately describe this process.

Question 10

The accounting rate of return focuses on the:

Accepted Answer

The accounting rate of return (ARR) focuses on the incremental accounting income generated by a project over its life, rather than total income or cash flows.

Question 11

The payback period is best defined as:

Accepted Answer

The answer of The payback period is best defined as:
...

Question 12

Which of the following choices correctly depicts whether discounted cash flows are used by the method noted when evaluating long-term investments? $$\begin{array} { | l | c | c | c | c | c |c| } 
\hline & &\begin{array} { c } 
\text { Net } \
\text { Present Value }
\end{array} & \begin{array} { c } 
\text { Internal Rate } \
\text { of Return }
\end{array} & &\begin{array} { c } 
\text { Accounting } \
\text { Rate of Return }
\end{array} \
\hline 1 && \text { No } &  \text { No } & &\text { Yes } \
\hline 2 && \text { Yes } &  \text { No } & &\text { Yes } \
\hline 3 && \text { Yes } &  \text { No } & & \text { No } \
\hline 4 && \text { Yes } &  \text { Yes } & & \text { No } \
\hline 5 && \text { Yes } &  \text { Yes } & & \text { Yes } \
\hline
\end{array}$$

Accepted Answer

The answer of Which of the following choices correctly depicts...

Question 13

MacEwen Brothers Ltd., which is subject to an 18% income tax rate, is considering investing in a $300,000 asset that will result in the following over its five-year life: Average revenue: $805,000
Average operating expenses (excluding depreciation): $620,000
Average depreciation: $80,000
The accounting rate of return on the initial investment is:

Accepted Answer

The accounting rate of return (ARR) is calculated as the average annual profit divided by the initial investment. The average annual profit is calculated as average revenue minus average operating expenses and depreciation, then adjusted for taxes. ARR = [(805,000 - 620,000 - 80,000) * (1 - 0.18)] / 300,000 = 28.70%.

Question 14

Bleeker Corporation plans to generate $450,000 of sales revenue if the implementation of their planned capital project moves forward. Assuming a 28% tax rate, the sales revenue should be reflected in the analysis by a:

Accepted Answer

Sales revenue is an inflow, and after-tax sales revenue is calculated as sales revenue minus taxes. Therefore, the sales revenue should be reflected in the analysis by a $324,000 inflow.

Question 15

Of the five expenses that follow, which one is most likely treated differently than the others when income taxes are considered in a discounted-cash-flow analysis?

Accepted Answer

Depreciation expense is treated differently than other expenses because it is a non-cash expense that reduces taxable income. When calculating income tax, companies can deduct the amount of depreciation from their taxable income, reducing the amount of tax they owe. Therefore, when using a discounted-cash-flow analysis that takes into account income taxes, the treatment of depreciation expense can have a significant impact on the analysis.

Question 16

A piece of equipment costs $50,000, and is expected to generate $2,500 of annual cash revenues and $500 of annual cash expenses. The disposal value at the end of the estimated 25-year life is $2,000. Ignoring income taxes, the payback period is:

Accepted Answer

The answer of A piece of equipment costs $50,000, and...

Question 17

If a proposal's profitability index is greater than one:

Accepted Answer

A profitability index greater than one indicates that the present value of the expected future cash flows is higher than the initial investment. This means that the net present value is positive, making the project profitable and worth pursuing. Therefore, the proposal should be accepted.

Question 18

In Canada, the allowable deduction for depreciation expense in the calculation of taxable income is called:

Accepted Answer

The allowable deduction for depreciation expense in the calculation of taxable income in Canada is called the capital cost allowance (CCA). This is the amount that can be claimed as an expense for tax purposes based on the depreciation of capital assets over time. The CCA is calculated based on the undepreciated capital cost of the asset, and varies depending on the type of asset and the rate of depreciation allowed.

Question 19

A company's after tax cash flows are not normally affected by:

Accepted Answer

The purchase of an asset is a capital expenditure and does not directly affect after-tax cash flows, which are typically influenced by revenues, operating expenses, and gains or losses on asset sales.

Question 20

Landau Spandex Inc. ranks investments by using the profitability index (PI). The following data relate to Product A and Product B: $\begin{array} { l r r } 
& \text { Product A } & \text { Product B } \
\text { Initial investment } & \$ 900,000 & \$ 1,500,000 \
\text { Present value of inflows } & 800,000 & 2,000,000
\end{array}$ Which Product would be more attractive as judged by its ranking, and why?

Accepted Answer

The profitability index (PI) determines the ratio of the present value of cash inflows to the initial investment. Thus, for Product A:

PI = (PV of inflows) / (Initial investment) = 800,000 / 900,000 = 0.89

For Product B:

PI = (PV of inflows) / (Initial investment) = 2,000,000 / 1,500,000 = 1.33

The higher the PI, the more attractive the investment. Thus, Product B is the better choice because it has a higher PI of 1.33, indicating that for every dollar invested, it generates $1.33 in present value of cash inflows.

Quiz 14: Capital Expenditure Decisions