Download Acct 2220 Zeigler - GQ #3 (Chp 10)

30-pt Solution - Acct 2220 Zeigler - GQ #3 (Chp 10) - Review for Exam #2
____ 1. A capital investment project may provide “cash inflows” (i.e. benefits) from:
A. incremental (new) revenues received as a result of the investment made.
B. cost savings realized due to the investment made.
C. the salvage value of the investment at the end of its useful life.
D. all of the above represent potential cash inflows (i.e. benefits).
____ 2. Which of the following statements best describes a firm’s “cost of capital”?
A. The return that a company must pay to attract investors and satisfy creditors. (Pg 302/303)
B. The maximum acceptable rate of return on investments.
C. The calculated internal rate of return on investments.
D. The interest rate the bank charges its best customers. (No, typically called the “Prime Rate”)
____ 3. The cost of capital is frequently referred to (i.e. called) all of the following except:
A. discount rate.
B. hurdle rate.
C. cutoff rate.
D. maximum rate. (See pg 303 for terminology discussion)
____ 4. For a capital investment project to be acceptable on a quantitative basis, it must generate a rate of return:
A. Less than the required rate of return.
B. Equal to or greater than the firm’s cost of capital.
C. Equal to or less than the initial investment.
D. Greater than the required rate of return, but less than the cost of capital.
____ 5. Vince & Palker, Inc. projects they can generate $300,000 of net cash benefits per year, for 7 years, on a
real estate investment project (i.e. after all expenses are deducted). If the company desires a pre-tax rate of
return of 7%, what is the maximum they should pay (rounded to the nearest dollar) for this real estate
investment? In essence, what is the present value of all expected benefits given the required rate of return?
A. $321,001
B. $642,653
C. $1,472,017
D. $1,616,787 (P.V of an annuity 7%, 7 yrs (Table 2) 5.389289 * $300,000 annual net cash inflow)
E. $2,100,000
____6. Two products from Wentling & Gaertner, Inc., X and Y, are alike in every way except that the sales of X
will start low and rise throughout its life, while those of Y will be the same each year. Total sales volume
over their five-year lives will be the same, as will selling prices, unit variable costs, cash fixed costs, and
initial investment. The Net Present Value (NPV) of product X:
A. will be less than that of product Y. (This will always be the case – make up numbers to confirm)
B. will be the same as that of product Y.
C. will be greater than that of product Y.
____ 7. Which of the following cash flow patterns represents an annuity?
A.
B.
C.
D.
“A” Above. (an annuity represents an equal payment per period)
“B” Above.
“C” Above.
None of the above can be described as an annuity.
Use the following for questions 8 & 9:
Wells, Smith and Walker, Inc. manufactures quality hockey sticks for professional competition. Mgmt is
considering the purchase of new machinery in order to improve its manufacturing process. This capital
investment is expected to provide net annual cash inflows (i.e. labor saving benefits due to improved
automation of the production process) of $10,000 per year for 3 years.
8. Assuming the firm’s required rate of return is 8%, and using your choice of Table 1 or 2 P.V. factors, what is
the present value of these annual cash inflows (i.e. net benefits) on a pre-tax basis? Show all computations and
round to the nearest whole dollar.
Using Table 1: (10,000 * .925926) + (10,000 * .857339) + (10,000 * .793832) = $25,771
Using Table 2: 10,000 * 2.577097 = $25,771 (we can use table 2 because we have an annuity)
9. Would the present value of the above cash inflows be higher if a required rate of return of 10% was used?
Show all computations to prove your position and EXPLAIN why or why not.
NO. Using Table 1 (or Table 2 since we have an annuity), the present value would be higher at a minimum
required rate of return of 8% ($25,771 at 8%, as compared to $24,869 at 10%). This is because we are
discounting (i.e. stripping away earnings) at 8% rather than 10%. As such, today’s (i.e. present) value of
the future cash flows would be higher at 8% (computations above). For 10%, 10,000 * 2.486852 = $24,869
____ 10. McConnell, Lydy & Imm, Inc. is considering the purchase of capital equipment that costs $5,000.
The equipment would be depreciated on a straight-line basis, with no expected salvage value, over its
5-year useful life. Assuming a tax rate of 30%, what would be the annual amount of cash tax savings
due to the depreciation deduction (i.e. “tax shield” or “tax shelter”) provided by this investment?
A. $1,000
B. $ 700
C. $ 300 (Taxes will be reduced by 30% of the $1,000 annual depreciation amount)
D. $ -0-
____ 11. Select the incorrect statement concerning the “Present Value Index” (PVI).
a. The PVI is computed by dividing the total present value of the cash inflows by the present value
of the cash outflows.
b. The PVI should be used to evaluate two or more projects whose initial investments differ.
c. A project whose PVI is greater than “1” will always have a positive net present value (NPV).
d. The lower the PVI, the lower the amount of investment required.
____ 12. Using Key Formula #2 (see handout #2), what would be the internal rate of return (IRR) for a $100,065
investment that provides a $9,000 annual benefit (i.e. annuity) for 15 years? Show your work AND
attach an Excel IRR template printout (see class website) to the end of this quiz to confirm your work.
A. ~2%
B. ~4%
C. ~6%
D. ~8%
E. More than 10%
Using formula #2, Investment / Periodic cash inflow = $100,065/$9,000 = 11.118333 (factor). Look on
Table #2 (Annuity table, because we have equal cash inflows) and search across the 15-period row.
Confirm this by using our Excel IRR Calculator as posted on the class website. (SEE END OF QUIZ)
____ 13. Which of the following Capital Budgeting techniques does not consider time value of money principles?
A. Payback Method.
B. Net Present Value Method.
C. Internal Rate of Return Method.
D. All of the above methods consider the time value of money.
____ 14. Which of the following statements concerning the “Payback” method of analysis is true?
A. An investment with a longer payback is preferable to an investment with a shorter payback.
B. The payback method must adjust for any depreciation as depreciation is not a cash flow itself.
C. The payback method and the unadjusted rate of return are different approaches that will consistently
lead to the same conclusion.
D. None of the above represent true statements.
____ 15. Przybylski & Clifton, Inc. has an opportunity to purchase an asset that costs $45,000. The asset is
expected to increase net income by $18,000 per year, but depreciation expense of $2,000 per year is
included in this projected net income increase. Based on this data, the cash “Payback” period would be:
A. 1.1 years
B. 2.25 years ($45,000 / $20,000). The non-cash depr amount must be added to net income.
C. 5.35 years
D. 9.0 years
16. (2 pts) What is a PostAudit of a capital investment decision, and how should the PostAudit be conducted?
Answer with a complete discussion, using full sentences.
A postaudit is a review of a capital investment project at the end of its life, performed to determine whether
the project lived up to expectations for it. The postaudit should be conducted using the same analysis
technique(s) used in making the investment decision, but will use actual results instead of estimated results
which were used in the planning process. The PostAudit also provides a basis for performance evaluation
of the decision maker(s)
Refer to H/W problem P10-18A - see me or our GA team with any questions
(1 pt each) Indicate whether each of the following statements relating to “PostAudits” is True or False:
F____ 17. A postaudit should be conducted at the time a capital investment is purchased/started.
T____ 18. The postaudit of a capital investment project should be made using the same analytical
technique that was used in deciding to make the initial investment.
T____ 19. The purpose of postaudits is to improve a company's capital investment decision process.
Use the following fact pattern for the five questions, #20-24, below (2 pts each = 10 pts total)
Bates & Dohalick (BD) Fine Dining, Inc. prepares quality meals for discriminating BGSU students. Company management
is considering the purchase of new machinery to lower variable costs and increase the production quality of its “Great
Accountant” brand of premium organic food products. Investment details are:
Cash cost of machine
$320,000
Expected life of the machine
10 Years
Expected annual savings in cash operating costs (i.e. net benefits)
$75,000
Straight-Line depreciation is used by the firm over the life of the asset and no salvage value is expected. The tax rate
is 30% and firm’s minimum desired rate of return is 12%.
20. Draw a timeline to document all relevant cash flows and then prepare an income statement to determine the after-tax
cash flows (benefits) expected per year. Next, determine the NPV of this investment opportunity and indicate whether
the company should purchase the machine on a quantitative basis.
Step One: Prepare a time line and detail/sketch the cash flows.
Step Two: Prepare an Income Statement to determine annual after-tax cash flows:
Annual benefit (savings)
$75,000
Less: Depr deduction
($32,000)
Taxable Income
$43,000
Taxes @30%
($12,900)
Income (Investment profit/yr)
$30,100
Add-back non-cash depr
$32,000
Annual after-tax cash flow
$62,100
Step Three: using the factor from Table 2 @ 12%
$62,100 x 5.650223 = $ 350,879 (Key Formula #1: periodic/annual Cash flow * PV factor)
Investment Cost =
$ 320,000
Net Present Value $30,879 Therefore, management should accept this project on a quantitative
basis. Certainly, any qualitative issues should be addressed before final approval of the investment.
21. Using a Key Formula, determine the approximate after-tax IRR of the investment. Show all work.
Key Formula 2:
Investment / periodic cash flow (see pg 308 or Key Formulas H/O & Excel template work) =
$320,000 / $62,100 = 5.152979 Table 2 factor = slightly > 14% (Per IRR Excel (see at end) = 14.313%)
22. IF the company had used the DDB depreciation method (rather than straight-line) in the above fact pattern:
a) The after-tax NPV would be lower.
b) The after-tax NPV would not change.
c) The after-tax NPV would be higher. (see P10-22A solution & class notes to confirm)
23. IF the machine was fully depreciated and then sold for $10,000 at the end of year 10:
a. The after-tax NPV would be higher.
b. The pre-tax NPV would be lower.
c. The pre-tax NPV would not change.
d. The after-tax NPV would not change.
NPV would be higher if any additional benefit was to be received (i.e. salvage value at the end of 10 yrs here).
Again, any additional cash inflow, either before or after-tax, would increase NPV (Pg 309 & 315). In this case,
the one-time $7,000 after-tax sales proceeds ($10,000*(1-30%)) would be multiplied by a Table 1 factor.
24. Considering the *original* facts only and using Key Formula #3, what annual net after-tax cash
inflow (i.e. benefit) would be required if the company desired a 10% rate of return? A 16% rate of return?
1) 10% return: The required periodic (annual) net after-tax cash inflow would be:
Formula 3 is used to determine required periodic payments to achieve an exact rate of return!
Investment ($320,000) / Table factor for a 10%, 10-yr annuity (6.144567) = $52,079 per period
2) 16% return: The required periodic (annual) net after-tax cash inflow would be:
Investment ($320,000) / Table factor for a 16%, 10-yr annuity (4.833227) = $66,208 per period
Note: The above required annual benefit (i.e. net cash inflow) can always be *proven* with IRR/Excel!
Note: For Exam #2, Table 1 & 2 PV factors will be provided, but Key Formulas will not.
IRR “Proof” for Question #12:
Acct 2220 Zeigler: Time Value of Money - Chp 10
HANDOUT #3
Internal Rate of Return: What actual rate of return are we earning?
IRR CALCULATOR: The Internal Rate of Return (IRR) calculations for BOTH equal and
unequal cash flows are easy with the use of the Excel template below!
"Key Formula" #2 can be used for equal cash flows, but Excel is needed for unequal cash flows *
STEP 1: BUILD YOUR OWN Internal Rate of Return (IRR) generic calculator:
Start Excel & enter the input format below FIRST, including labels as shown
and the annual net cash inflows (similar to below). Next, click on a cell where you want the answer
(output) to be (E45 in this example). Next, select "Formulas" from the drop down menus and choose the "Financial"
Function. Select the "IRR" option. Your entry choices will be "values" (i.e. cell ranges of E21 - E42 in my example).
There is no need to enter anything in the "guess" box. Enter the range of cells that will have
the required investment (outflow) and all the inflows (20 periods in my example). That is all there
is to it. Further help is available when you bring up the (fx) function.
Complete this 10-minute exercise to confirm your understanding of this process.
STEP 2: Compare YOUR Excel template results with my calculator below:
Your Input below:
Net Cash Flows
Initial (outflow) Investment
Period 0
Annual net cash inflows (benefits)
Period 1
Period 2
Period 3
Period 4
Period 5
Period 6
Period 7
Period 8
Period 9
Period 10
Period 11
Period 12
Period 13
Period 14
Period 15
Period 16
Period 17
Period 18
Period 19
Period 20
(Note: Net cash inflows
can be either equal or unequal)
Add periods if necessary
-$100,065 << (Enter as a negative number)
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
$9,000
Generic IRR Template
Handout #3
(i.e. Support for "Key Formula #2")
The percentage below is the only output of the Excel IRR function:
IRR = The Actual Rate of Return earned
(i.e. This is where NPV = Zero)
4.000% <<< EXCEL OUTPUT is ONLY ONE CELL
Note that the required rates of return are not addressed here as there is no rate to
"hurdle" (exceed) with this calculation. The question is simply; "What rate am I earning"?
The net cash inflows are compared to the investment over a given number of periods,
and if the rate to be earned exceeds the "Required Rate of Return", the project is desirable.
IRR “Proof” for Question #21:
Acct 2220 Zeigler: Time Value of Money - Chp 10
HANDOUT #3
Internal Rate of Return: What actual rate of return are we earning?
IRR CALCULATOR: The Internal Rate of Return (IRR) calculations for BOTH equal and
unequal cash flows are easy with the use of the Excel template below!
"Key Formula" #2 can be used for equal cash flows, but Excel is needed for unequal cash flows *
STEP 1: BUILD YOUR OWN Internal Rate of Return (IRR) generic calculator:
Start Excel & enter the input format below FIRST, including labels as shown
and the annual net cash inflows (similar to below). Next, click on a cell where you want the answer
(output) to be (E45 in this example). Next, select "Formulas" from the drop down menus and choose the "Financial"
Function. Select the "IRR" option. Your entry choices will be "values" (i.e. cell ranges of E21 - E42 in my example).
There is no need to enter anything in the "guess" box. Enter the range of cells that will have
the required investment (outflow) and all the inflows (20 periods in my example). That is all there
is to it. Further help is available when you bring up the (fx) function.
Complete this 10-minute exercise to confirm your understanding of this process.
STEP 2: Compare YOUR Excel template results with my calculator below:
Your Input below:
Net Cash Flows
Initial (outflow) Investment
Period 0
Annual net cash inflows (benefits)
Period 1
Period 2
Period 3
Period 4
$62,100
$62,100
$62,100
$62,100
Period 5
Period 6
Period 7
Period 8
Period 9
Period 10
Period 11
Period 12
Period 13
Period 14
Period 15
Period 16
Period 17
Period 18
Period 19
Period 20
$62,100
$62,100
$62,100
$62,100
$62,100
$62,100
(Note: Net cash inflows
can be either equal or unequal)
Add periods if necessary
-$320,000 << (Enter as a negative number)
Generic IRR Template
Handout #3
(i.e. Support for "Key Formula #2")
The percentage below is the only output of the Excel IRR function:
IRR = The Actual Rate of Return earned
(i.e. This is where NPV = Zero)
14.313% <<< EXCEL OUTPUT is ONLY ONE CELL
Note that the required rates of return are not addressed here as there is no rate to
"hurdle" (exceed) with this calculation. The question is simply; "What rate am I earning"?
The net cash inflows are compared to the investment over a given number of periods,
and if the rate to be earned exceeds the "Required Rate of Return", the project is desirable.