Question 1

Brandon Company is contemplating the purchase of a new piece of equipment for $45,000. Brandon is in the 30% income tax bracket. Predicted annual after-tax cash inflows from this investment are $18,000, $15,000, $9,000, $6,000 and $3,000 for years 1 through 5, respectively. The firm uses straight-line depreciation with no residual value at the end of five years.

Assume that the after-tax hurdle rate for accepting new capital investment projects by the company is 4%, after-tax. (Note: To answer this question, students will have to be provided with the Tables provided in Appendix C, Chapter 12. Alternatively, the instructor can provide students with the following PV $1 factors for 4%: for year 1 = 0.962, for year 2 = 0.925, for year 3 = 0.889, for year 4 = 0.855, for year 5 = 0.822; the PV annuity factor for 4%, 5 years = 4.452.) The estimated internal rate of return (IRR) on this investment is:
A) Less than 4%.
B) 4%.
C) Slightly above 4%.
D) Greater than 6%.
E) Undeterminable with only the given information.

Accepted Answer

To determine the IRR, we need to calculate the present value (PV) of the after-tax cash inflows and compare it to the initial investment. Using the provided PV factors for a 4% discount rate, the calculation is as follows: ($18,000 * 0.962) + ($15,000 * 0.925) + ($9,000 * 0.889) + ($6,000 * 0.855) + ($3,000 * 0.822) = $17,316 + $13,875 + $8,001 + $5,130 + $2,466 = $46,788. Since the PV of the cash inflows ($46,788) is greater than the initial investment ($45,000), but without a detailed calculation for rates higher than 4%, we can infer that the IRR is slightly above 4%.

Question 2

The estimated value of a real option:
A) Is affected by essentially the same set of factors that affect the value of financial options.
B) Cannot be incorporated into a conventional DCF analysis of an investment project.
C) Is affected by the length of the expiration date of the option.
D) Decreases as the underlying risk of a project increases.
E) Is inversely related to estimated volatility of returns for a proposed project.

Accepted Answer

The answer of The estimated value of a real option:
A)...

Question 3

Flex Corporation is studying a capital investment proposal in which newly acquired assets will be depreciated using the straight-line (SL) method with no salvage value. Which one of the following statements about the proposal would be incorrect if, instead of SL, the Modified Accelerated Cost Recovery System (MACRS) is used for determining depreciation expense for income tax purposes? (Assume that income tax rates are constant over the life of the assets involved.)
A) The estimated net present value (NPV) of the project would increase.
B) The internal rate of return (IRR) of the project would likely increase.
C) The payback period for the investment would be shortened.
D) The total after-tax income from this project, over its life, would normally increase.
E) Total tax payments over the life of the project would be unaffected.

Accepted Answer

The total after-tax income from the project over its life would not increase with MACRS; it would remain the same as with SL because total depreciation is the same, only the timing differs.

Question 4

Which of the following statements regarding real options is not true?
A) Similar to financial options, real options are traded on an open exchange.
B) Their consideration in capital budgeting analysis is designed to complement conventional DCF models.
C) They refer to options on real assets (i.e., tangible and intangible property).
D) They can never reduce the NPV of a proposed investment; they can only increase its NPV.
E) They represent one way of handling risk and uncertainty in the capital budgeting process.

Accepted Answer

Real options are not traded on an open exchange like financial options. Real options refer to the potential opportunities or flexibility to make future decisions that can impact the value of an investment, and their consideration in capital budgeting analysis is designed to complement conventional DCF models. Real options can either increase or decrease the NPV of a proposed investment, depending on the nature of the option and the uncertainty involved in the investment decision. Therefore, option analysis is one way of handling risk and uncertainty in the capital budgeting process.

Question 5

Olsen Inc. purchased a $600,000 machine to manufacture a specialty tap for electrical equipment. The tap is in high demand and Olsen can sell all that it could manufacture for the next 10 years. To encourage capital investments, the government exempts taxes on profits from new investments in this type of machinery. This legislation most likely will remain in effect in the foreseeable future. The equipment is expected to have 10 years of useful life and no salvage value at the end of this 10-year period. The firm uses straight-line depreciation. The net cash inflow is expected to be $144,000 each year. Olsen uses a discount rate of 10% in evaluating its capital investments.

The accounting (book) rate of return (ARR) based on initial investment for this proposed investment (to two decimal places) is:
A) 12.73%.
B) 14.00%.
C) 25.46%.
D) 28.00%.

Accepted Answer

The accounting (book) rate of return (ARR) is calculated as the average annual profit divided by the initial investment. Since the machine has no salvage value and is depreciated over 10 years using straight-line depreciation, the annual depreciation is $600,000 / 10 = $60,000. The net cash inflow is $144,000, but for accounting purposes, we need to subtract the annual depreciation to find the profit. Thus, the annual profit is $144,000 - $60,000 = $84,000. The ARR is then ($84,000 / $600,000) * 100 = 14.00%.

Question 6

Olsen Inc. purchased a $600,000 machine to manufacture a specialty tap for electrical equipment. The tap is in high demand and Olsen can sell all that it could manufacture for the next 10 years. To encourage capital investments, the government exempts taxes on profits from new investments in this type of machinery. This legislation most likely will remain in effect in the foreseeable future. The equipment is expected to have 10 years of useful life and no salvage value at the end of this 10-year period. The firm uses straight-line depreciation. The net cash inflow is expected to be $144,000 each year. Olsen uses a discount rate of 10% in evaluating its capital investments.

The estimated net present value (NPV) of this proposed investment (rounded to the nearest thousand) is: (Note: the PV annuity factor from Table 2, Appendix C, 10%, 10 years is 6.145.)
A) ($105,000).
B) ($84,000).
C) $181,000.
D) $248,000.
E) $285,000.

Accepted Answer

To calculate the NPV, we need to find the present value of the net cash inflows for 10 years and subtract the initial investment of $600,000.

Using the PV annuity factor of 6.145 from Table 2, we can find the present value of the net cash inflows as:

$144,000 x 6.145 = $883,080

Therefore, the NPV is:

NPV = $883,080 - $600,000 = $283,080

Rounding to the nearest thousand, the estimated NPV is $285,000. Since the NPV is positive, the investment is expected to generate a return greater than the required rate of return of 10%. Therefore, Olsen should undertake the investment.

Question 7

Brandon Company is contemplating the purchase of a new piece of equipment for $45,000. Brandon is in the 30% income tax bracket. Predicted annual after-tax cash inflows from this investment are $18,000, $15,000, $9,000, $6,000 and $3,000 for years 1 through 5, respectively. The firm uses straight-line depreciation with no residual value at the end of five years.

Assume that the hurdle rate for accepting new capital investment projects for the company is 4%, after-tax. (Note: PV $1 factors for 4% are as follows: for year 1 = 0.962, for year 2 = 0.925, for year 3 = 0.889, for year 4 = 0.855, for year 5 = 0.822; the PV annuity factor for 4%, 5 years = 4.452.) At an after-tax discount rate of 4%, the estimated net present value (NPV) of the proposed investment is (rounded to the nearest hundred dollars): 
A) ($15,000).
B) ($12,300).
C) ($9,300).
D) ($6,000).
E) $1,800.

Accepted Answer

To calculate the NPV, we first find the present value (PV) of each year's after-tax cash inflow using the given PV factors, then subtract the initial investment. The calculation is as follows:- Year 1: $18,000 * 0.962 = $17,316- Year 2: $15,000 * 0.925 = $13,875- Year 3: $9,000 * 0.889 = $8,001- Year 4: $6,000 * 0.855 = $5,130- Year 5: $3,000 * 0.822 = $2,466Total PV of cash inflows = $17,316 + $13,875 + $8,001 + $5,130 + $2,466 = $46,788NPV = Total PV of cash inflows - Initial investment = $46,788 - $45,000 = $1,788, rounded to the nearest hundred dollars is $1,800.

Question 8

Olsen Inc. purchased a $600,000 machine to manufacture a specialty tap for electrical equipment. The tap is in high demand and Olsen can sell all that it could manufacture for the next 10 years. To encourage capital investments, the government exempts taxes on profits from new investments in this type of machinery. This legislation most likely will remain in effect in the foreseeable future. The equipment is expected to have 10 years of useful life and no salvage value at the end of this 10-year period. The firm uses straight-line depreciation. The net cash inflow is expected to be $144,000 each year. Olsen uses a discount rate of 10% in evaluating its capital investments.

The estimated accounting (book) rate of return (to two decimal places) based on average investment for this proposed investment is:
A) 12.73%.
B) 14.00%.
C) 25.45%.
D) 28.00%.
E) 50.90%.

Accepted Answer

The answer of Olsen Inc. purchased a $600,000 machine to...

Question 9

Brandon Company is contemplating the purchase of a new piece of equipment for $45,000. Brandon is in the 30% income tax bracket. Predicted annual after-tax cash inflows from this investment are $18,000, $15,000, $9,000, $6,000 and $3,000 for years 1 through 5, respectively. The firm uses straight-line depreciation with no residual value at the end of five years.

Assume that the hurdle rate for accepting new capital investment projects for the company is 4%, after-tax. (Note: PV $1 factors for 4% are as follows: for year 1 = 0.962, for year 2 = 0.925, for year 3 = 0.889, for year 4 = 0.855, for year 5 = 0.822; the PV annuity factor for 4%, 5 years = 4.452.) At an after-tax discount rate of 4%, the estimated PV (present value) payback period, in years (rounded to two decimal places) is:
A) 2.89 years.
B) 3.50 years.
C) 3.89 years.
D) 4.27 years.
E) More than 5 years.

Accepted Answer

The answer of Brandon Company is contemplating the purchase of...

Question 10

Brandon Company is contemplating the purchase of a new piece of equipment for $45,000. Brandon is in the 30% income tax bracket. Predicted annual after-tax cash inflows from this investment are $18,000, $15,000, $9,000, $6,000 and $3,000 for years 1 through 5, respectively. The firm uses straight-line depreciation with no residual value at the end of five years.

The hurdle rate for accepting new capital investment projects is 4%, after-tax. The estimated accounting rate of return (ARR) on this project (rounded to two decimal points), based on the initial investment is:
A) 2.67%.
B) 3.33%.
C) 6.67%.
D) 10.00%.
E) 12.00%.

Accepted Answer

The accounting rate of return (ARR) is calculated by dividing the average annual accounting income by the initial investment. The average annual accounting income is calculated by subtracting the annual depreciation expense from the annual after-tax cash inflows. The annual depreciation expense is calculated by dividing the initial investment by the number of years over which the asset is depreciated. In this case, the initial investment is $45,000 and the asset is depreciated over 5 years, so the annual depreciation expense is $9,000. The average annual accounting income is therefore calculated as follows:Average annual accounting income = ($18,000 + $15,000 + $9,000 + $6,000 + $3,000) / 5 - $9,000 = $6,000The ARR is then calculated as follows:ARR = Average annual accounting income / Initial investment = $6,000 / $45,000 = 13.33%Therefore, the estimated accounting rate of return (ARR) on this project, based on the initial investment, is 13.33%, which is closest to choice A, 2.67%.

Question 11

For dealing with uncertainty in the capital budgeting process, all of the following techniques can be used except:
A) What-if analysis.
B) Monte Carlo simulation.
C) Scenario analysis.
D) Linear programming.
E) Real options analysis.

Accepted Answer

Linear programming is not a technique for dealing with uncertainty in the capital budgeting process. It is used to optimize resource allocation and find the best solution to a problem given specific constraints. The other techniques listed (what-if analysis, Monte Carlo simulation, scenario analysis, and real options analysis) are all used to address uncertainty and risk in capital budgeting decisions.

Question 12

Jasper Company has a payback goal of three years on acquisitions of new equipment. A new piece of equipment that costs $450,000 and that has a five-year life is being considered. Straight-line (SL) depreciation will be used, with zero salvage value. Jasper is subject to a 40% combined income tax rate, t. To meet the company's payback goal, the equipment must generate reductions in annual cash operating costs of at least:
A) $60,000.
B) $114,000.
C) $150,000.
D) $190,000.
E) $285,000.

Accepted Answer

The payback period is calculated as the initial investment divided by annual cash inflows. To meet a 3-year payback, the equipment must generate $450,000 / 3 = $150,000 in annual after-tax cash savings. Depreciation tax shield is $450,000 / 5 * 0.4 = $36,000. Therefore, the required pre-tax savings is $150,000 + $36,000 = $186,000, rounded to $190,000.

Question 13

If a company must choose between two mutually exclusive investment projects, the best general method to employ for decision-making purposes is:
A) Cash-flow bailout.
B) Cash-flow break-even.
C) Net present value (NPV).
D) Discounted payback.
E) Accounting (book) rate of return (ARR), based on average investment over the life of each project.

Accepted Answer

Net present value (NPV) takes into account the time value of money and calculates the net present value of each investment project, allowing for an easy comparison between the two projects. The project with a higher NPV should be selected as it generates more value for the company.

Question 14

Which of the following is not one of the four general classes of real options?
A) Expansion option.
B) Exercise option.
C) Abandonment option.
D) Investment-timing option (e.g., delay)

Accepted Answer

The four general classes of real options are expansion option, abandonment option, investment-timing option, and option to switch. Exercise option is not one of them.

Question 15

If a company is faced with limited capital funds for investment (i.e., the company faces capital rationing), the best general method to employ to assess individual project profitability is:
A) Cash-flow bailout.
B) Net present value (NPV).
C) Payback.
D) Discounted payback.
E) Profitability index (PI).

Accepted Answer

The answer of If a company is faced with limited...

Question 16

Olsen Inc. purchased a $600,000 machine to manufacture a specialty tap for electrical equipment. The tap is in high demand and Olsen can sell all that it could manufacture for the next 10 years. To encourage capital investments, the government exempts taxes on profits from new investments in this type of machinery. This legislation most likely will remain in effect in the foreseeable future. The equipment is expected to have 10 years of useful life and no salvage value at the end of this 10-year period. The firm uses straight-line depreciation. The net cash inflow is expected to be $144,000 each year. Olsen uses a discount rate of 10% in evaluating its capital investments.

Assume that after-tax cash inflows occur evenly throughout the year. The estimated payback period for this proposed investment, in years, is (rounded to two decimal places):
A) 4.17 years.
B) 5.05 years.
C) 5.43 years.
D) 5.67 years.
E) 7.14 years.

Accepted Answer

The payback period is defined as the length of time it takes for the cash inflows from a capital investment to equal the initial investment. To calculate the payback period, we need to determine in which year the cumulative net cash inflows will equal the initial investment of $600,000.

Since the net cash inflow is $144,000 each year, we can divide the initial investment by the annual net cash inflow to get the payback period:

Payback period = Initial investment / Annual net cash inflow
Payback period = $600,000 / $144,000
Payback period = 4.17 years (rounded to two decimal places)

Therefore, the best choice is A) 4.17 years, since this represents the time it will take for the firm to recoup its initial investment.

Question 17

Olsen Inc. purchased a $600,000 machine to manufacture a specialty tap for electrical equipment. The tap is in high demand and Olsen can sell all that it could manufacture for the next 10 years. To encourage capital investments, the government exempts taxes on profits from new investments in this type of machinery. This legislation most likely will remain in effect in the foreseeable future. The equipment is expected to have 10 years of useful life and no salvage value at the end of this 10-year period. The firm uses straight-line depreciation. The net cash inflow is expected to be $144,000 each year. Olsen uses a discount rate of 10% in evaluating its capital investments.

The estimated internal rate of return (IRR) on this proposed investment is: (Note: the PV annuity factor from Table 2, Appendix C, 10%, 10 years is 6.145.)
A) Less than 10%.
B) 10%.
C) 12%.
D) Greater than 12%.
E) Indeterminable based on the information provided.

Accepted Answer

The net cash inflow for the next 10 years is $144,000 per year, therefore the total cash inflow is $1,440,000 ($144,000 x 10). The initial cost of the equipment is $600,000. The equipment's salvage value is zero. The straight-line depreciation expense per year is ($600,000/10 = $60,000).
Using the formula: 
IRR = Initial Investment / Annual Cash Inflow x PV Annuity factor.
IRR = $600,000 / $144,000 x 6.145
IRR = 25.29%
Since the IRR (25.29%) is greater than the required rate of return (10%), the investment is acceptable. Therefore, the answer is D) Greater than 12%.

Question 18

A widely used approach that managers use to recognize uncertainty about individual items and to obtain an immediate financial estimate of the financial consequences of possible prediction errors is:
A) Expected value analysis.
B) Learning curve analysis.
C) Capital budgeting analysis.
D) Sensitivity analysis.
E) Exponential distribution analysis.

Accepted Answer

Sensitivity analysis is the correct choice because it allows managers to understand how different values of an independent variable affect a particular dependent variable under a given set of assumptions. This method is particularly useful in assessing the impact of uncertainty and in estimating the potential financial consequences of various scenarios, making it a widely used approach for dealing with prediction errors and uncertainties in financial and business analysis.

Question 19

Which of the following statements regarding real options is true?
A) The farther away the expiration date, the less valuable the option is.
B) They can be incorporated into the capital budgeting decision process using decision trees.
C) They allow decision makers to react to unfavorable, but not favorable, future information/news.
D) Conventional DCF decision models (e.g., NPV) cannot incorporate the effects of real options.
E) It is not possible to handle multiple real options embedded in a proposed investment project.

Accepted Answer

Real options can be incorporated into the capital budgeting decision process using decision trees, which allow decision makers to consider the various possible outcomes and probabilities associated with an investment project. The value of a real option generally increases as the expiration date becomes further away, making option valuation more complex than conventional DCF models. Real options can also be affected by both favorable and unfavorable future information/news. It is possible to handle multiple real options embedded in a proposed investment project using decision trees or other quantitative methods.

Question 20

Amster Corporation has not yet decided on its discount rate for use in the evaluation of capital budgeting proposals.This lack of information will prohibit the company from calculating a proposed investment's: $$\begin{array}{l}
\begin{array} { l l l l } &\text { Accounting Rate of Return } &\text { Net Present Value }&\text { Internal Rate of Return }\
\text { A) } & \text { No } & \text { No } & \text { No } \
\text { B) } & \text { Yes } & \text { Yes } & \text { Yes } \
\text { C) } & \text { No } & \text { Yes } & \text { Yes } \
\text { D) } & \text { No } & \text { Yes } & \text { No } \
\text { E) } & \text { Yes } & \text { No } & \text { Yes }
\end{array}
\end{array}$$
A)Option A
B)Option B
C)Option C
D)Option D
E)Option E

Accepted Answer

The Net Present Value (NPV) and Internal Rate of Return (IRR) require a discount rate to be calculated, whereas the Accounting Rate of Return does not.

Quiz 12: Strategy and the Analysis of Capital Investments

The estimated value of a real option:

Which of the following statements regarding real options is not true?

For dealing with uncertainty in the capital budgeting process, all of the following techniques can be used except:

If a company must choose between two mutually exclusive investment projects, the best general method to employ for decision-making purposes is:

Which of the following is not one of the four general classes of real options?

If a company is faced with limited capital funds for investment (i.e., the company faces capital rationing) , the best general method to employ to assess individual project profitability is:

A widely used approach that managers use to recognize uncertainty about individual items and to obtain an immediate financial estimate of the financial consequences of possible prediction errors is:

Which of the following statements regarding real options is true?