L. The remaining useful life of an asset
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Chapter 9 Capital Budgeting Decisions
9-29
EXERCISES
155.
How much is the present value of $6,500 to be received at the end of six years, if the required rate
of return is 15%?
Answer
$6,500 × 0.4323 = $2,809.95
156.
Maxwell Industries has a required rate of return of 8%. How much is the present value of
a.
$15,000 to be received at the end of 8 years?
b.
$12,000 to be received per year for 5 years?
Answer
a.
b.
157.
$15,000 × 0.5403 = $8,104.50
$12,000 × 3.9927 = $47,912.40
How much is the present value of $5,000 per year for four years. The required rate of return is
10%?
Answer
$5,000 × 3.1699 = $15,849.50
158.
Bouquet Florist is considering replacing an old refrigeration unit with a larger unit to store
flowers. Because the new refrigeration unit has a larger capacity, the company estimates that it
can sell an additional $14,000 of flowers a year at a cost of $5,000. Although it will cost an extra
$2,400 per year for maintenance, the new unit is energy efficient and will save $1,400 in
electricity cost each year. The new refrigeration unit costs $35,000 and has an expected life of 10
years. At the end of 10 years, the new unit has an expected residual value of $6,000. Determine
the net present value of the investment after taxes if the required rate of return is 8 percent.
Income taxes are 30%. Should the investment be undertaken?
Answer
Additional annual revenue ($14,000 – $5,000)
Annual electricity savings
Additional annual maintenance costs
Depreciation
Income before taxes
Income taxes expense
Net income
Add depreciation
Operating cash flows
$9,000
1,400
(2,400)
(2,900)
5,100
(1,530)
3,570
2,900
$6,470
Net Present Value
Cash Flow
PV Factor Present Value
Cost of new refrigeration unit
($35,000)
1.0000
($35,000)
Operating cash flows
6,470
6.7101
43,414
Salvage value
6,000
0.4632
2,779
Net present value
$11,193
The investment should be made as it generates a return that exceeds the required rate of return.
9-30
Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition
159.
Brown Shoe Company is considering investing in one of two machines that cut leather for shoes.
Machine A costs $55,000 and is expected to save the company $13,000 annual operating cash
flows for six years. Machine B costs $89,000 and is expected to save the company $22,000
annual cash flows for six years. Determine the net present value for each machine and decide
which machine should be purchased if the required rate of return is 10 percent.
Answer
Machine A
Cost of machine
Annual savings
Net present value
Cash Flow
($55,000)
13,000
PV Factor
1.0000
4.3553
PV Amounts
($55,000)
56,619
$ 1,619
Machine B
Cost of machine
Annual savings
Net present value
Cash Flow
($89,000)
22,000
PV Factor
1.0000
4.3553
PV Amounts
($89,000)
95,817
$ 6,817
Machine B should be purchased since it generates a higher return than the required rate of return.
160.
Sports & More is considering the development of an e-commerce business. The company
estimates that development will require an initial outlay of $350,000. Other cash flows are
estimated as follows:
Year 1
Year 2
Year 3
Year 4
($60,000)
$140,000
$210,000
$130,000
Assuming the company limits its analysis to four years due to economic uncertainties, determine
the net present value of the e-commerce business. Should the company develop the e-commerce
business if the required rate of return is 6 percent?
Answer
The e-commerce business should not be developed as the investment’s return will generate less
than the 6% required rate of return.
Cash Flow
($350,000)
(60,000)
140,000
210,000
130,000
Present value at 6%
161.
Factor
1.0000
0.9434
0.8900
0.8396
0.7921
Total
($350,000)
(56,604)
124,600
176,316
102,973
($ 2,715)
An investment of $185,575 is expected to generate returns of $65,000 per year for each of the
next four years. What is the investment’s internal rate of return?
Answer
$185,575 ÷ $65,000 = 2.855 at 4 years = 15%
Chapter 9 Capital Budgeting Decisions
162.
9-31
A project will require an initial investment of $620,000 and will return $165,000 of operating
cash flows each year for five years. The required rate of return is 9%. How much is the project’s
net present value? Based on this analysis, should the company proceed with the project?
Answer
($165,000 × 3.8897) – $620,000 = $21,801
Yes, since the net present value is greater than zero, the company should proceed with the project.
163.
The accountant of Fixer Depot prepared the following annual analysis of a $65,000 investment in
equipment that has a life of 4 years:
Cost savings
Taxes on savings
Depreciation tax shield
Operating cash flows
$ 4,000
(1,200)
19,500
22,300
After reviewing the calculation, the operations manager made the following observation: “You’ve
assumed that there won’t be inflation. I think it is reasonable to assume that labor and costs other
than depreciation will increase by 3% per year. Why don’t you redo the analysis with that
assumption?”
The accountant replied: “Inflation is built into our 8% required rate of return.”
a.
b.
Answer
a.
What does the accountant mean by “inflation is built into our 8% required rate of return?”
Redo the analysis assuming an inflation rate of 3%. Should the company make the
investment in the equipment?
The required rate of return includes an allowance for expected inflation. In periods where
expected inflation is high, the required rate of return will be high, and firms will demand
a high return on their investments.
b.
Cost savings
Taxes on savings
Depreciation tax shield
Operating cash flows
Year
Initial Investment
1
2
3
4
Year 1
$4,000
(1,200)
19,500
$22,300
Cash Flows
($65,000)
22,300
22,384
22,471
22,560
Year 2
$4,120
(1,236)
19,500
$22,384
Factor
1.0000
0.9259
0.8573
0.7938
0.7350
NPV
Year 3
$4,244
(1,273)
19,500
$22,471
Year 4
$4,371
(1,311)
19,500
$22,560
NPV
($65,000)
20,648
19,190
17,837
16,581
$ 9,256
Since the investment is expected to generate a higher return than the required rate of
return, the company should invest in the equipment.
9-32
Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition
Chapter 9 Capital Budgeting Decisions
164.
9-33
Saren Millworks is contemplating the purchase of a new casting oven. The oven will cost $40,000
but will generate additional revenue of $30,000 per year for ten years. Additional costs, other than
depreciation, will equal $15,000 per year. The oven has an expected life of ten years, at which
time it will have no residual value. Saren uses the straight-line method of depreciation. Determine
the net present value of the investment if the required rate of return is 14% and the tax rate is
40%. Should Saren Millworks make the investment in the boiler?
Answer
Revenue
Costs other than depreciation
Depreciation
Income before taxes
Less taxes at 40%
Net income
Add depreciation
Operating cash flows
$30,000
$15,000
4,000
19,000
11,000
4,400
6,600
4,000
$10,600
The oven should be purchased since it generates a higher return than the required rate of return.
Cash Flows
$10,600
(40,000)
Net present value
165.
Factor
5.2161
1.0000
Total
$55,291
(40,000)
$15,291
3-D Studios is evaluating a film project. The president estimates the film will cost $7,200,000 to
produce. In its first year, 2014, the film is expected to generate $5,800,000 in net revenue, after
which the film will be released to video. The video is expected to generate $900,000 in net
revenue 2014, $1,200,000 in 2015, and $400,000 in 2016. Amortization of the film cost will be
$5,500,000 in 2014 and $1,700,000 in 2015. The company’s tax rate is 30% and it requires an 8%
rate of return on its films. All outlays to produce the film occur at the beginning of January 2014.
How much is the net present value of the film project? Should the company produce the film?
Answer
Revenue
Amortization
Income before taxes
Income tax expense
Net income
Add amortization
Operating cash flows
Year
Initial Investment
1
2
3
2014
$6,700,000
(5,500,000)
1,200,000
(360,000)
840,000
5,500,000
$6,340,000
Cash Flows
($7,200,000)
6,340,000
1,350,000
280,000
2015
$1,200,000
(1,700,000)
(500,000)
150,000
(350,000)
1,700,000
$1,350,000
2016
$400,000
0
400,000
(120,000)
280,000
0
$280,000
Factor
NPV
1.0000
($7,200,000)
0.9259
5,870,206
0.8573
1,157,355
0.7938
222,264
NPV
$ 49,825
The company should produce the film since it generates a higher return than the required rate of
return.
9-34
Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition
166.
Sweet Thing Limo is considering an acquisition of an additional vehicle for its limo chauffeur
service. The model under consideration will cost $140,000, have a 5-year life, and a $25,000
residual value. The company anticipates that the effect on annual net income will be as follows:
Revenue
Expenses
Driver
Fuel
Maintenance
Insurance
Depreciation
Miscellaneous
Income before taxes
Income tax expense
Net income
$138,000
$49,000
9,000
2,000
1,800
23,000
2,000
86,800
51,200
20,480
$ 30,720
The company has a required rate of return of 14%. Calculate the net present value of the
investment. Should the company invest in the new limo?
Answer
Net income
Add depreciation
Annual cash flows
Cash Flow
$ 53,720
25,000
(140,000)
Net present value
$30,720
23,000
$53,720
PV Factor at 14%
3.4331
0.5194
1.0000
Total
$184,426
12,985
(140,000)
$ 57,411
The company should invest in the new limo since it is expected to generate a higher return than
the required rate of return.
167.
Recording Tunes is planning a $120,000 investment in microphones for its recording business.
The microphones has an expected 4-year life with a salvage value of $12,000. The company uses
the straight-line method of depreciation, has an income tax rate of 30%, and a required rate of
return of 9%. How much is the present value of the tax savings related to depreciation of the
equipment?
Answer
Annual depreciation: ($120,000 – $12,000) ÷ 4 years = $27,000
Annual tax savings: $27,000 30% = $8,100
Present value: $8,100 3.2397 = $26,242
168.
Chap Creations reported revenues of $540,000 and expenses of $480,000 last year, which
included depreciation expense totaling $62,000. The company pays income taxes at a 35% rate.
How much is the company’s annual operating cash flows?
Answer
$540,000 – $480,000 – [35% × ($540,000 – $480,000)] + $62,000 = $101,000
Chapter 9 Capital Budgeting Decisions
169.
9-35
U-Vision is deciding whether to buy a machine that packages products so that it can reduce labor
costs. The machine has an initial cost of $580,000. The company estimates the new machine will
speed up production and be able to generate annual revenues totaling $716,000 up from the
current revenue of $660,000. U-Vision estimates the machine can be sold at the end of its
estimated 8-year life for $60,000. Labor saved per year as a result of acquiring the machine is
expected to be $26,000. Additional maintenance and operating expenses as a result of the pending
acquisition are expected to be $12,000 per year. U-Vision’s required rate of return is 8% and its
income tax rate is 35%. Calculate annual operating cash flows for U-Vision.
Answer
Revenue ($716,000 – $660,000)
Labor savings
Maintenance and operating costs
Depreciation expense ($580,000 – $60,000) ÷ 8
Income before taxes
Income taxes expense
Net income
Add depreciation
Annual cash flows
170.
$56,000
26,000
(12,000)
(65,000)
5,000
(1,750)
3,250
65,000
$68,250
Deli Pizza is considering an investment that will generate cash revenues of $91,000 per year for 8
years, and have cash expenses of $80,000 per year for 8 years. The cost of the asset is $60,000,
and it will be depreciated using straight-line depreciation over its 8-year life. The company pays
income taxes at a rate of 30%. The required rate of return is 6%.
a.
Prepare a schedule showing the annual cash flows associated with this asset.
b.
Compute the net present value of this investment.
Answer
a.
Cash revenues
Cash expenses
Depreciation expense
Income before taxes
Income tax expense
Net income
Add depreciation
Annual cash flows
$91,000
$80,000
7,500
87,500
3,500
1,050
2,450
7,500
$9,950
b.
Year
Initial investment
Years 1-8
Cash Flows
($60,000)
9,950
Factor
1.0000
6.2098
NPV
NPV
($60,000)
61,788
$ 1,788
9-36
Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition
171.
Harry’s Seafood is considering the addition of a fish hatchery. Construction of the facility is
estimated to cost $1,100,000 and will be depreciated over 10 years using the straight-line method.
The hatchery is expected to have no estimated residual value. Harry’s Seafood has a required rate
of return of 12%. Incremental net income related to each year of the investment is as follows:
Revenue
Expenses:
Material cost
Labor
Depreciation
Other
Income before taxes
Income tax expense at 40%
Net income
a.
b.
c.
d.
Answer
a.
$450,000
$ 60,000
100,000
110,000
10,000
280,000
170,000
68,000
$102,000
Determine the net present value of the investment. Should Harry’s Seafood invest in the
hatchery?
Calculate the internal rate of return of the investment to the nearest ½ percent.
Calculate the payback period of the investment.
Calculate the accounting rate of return.
The company should invest in the hatchery because the investment will generate a return
greater than the company’s required minimum of 12%.
Net income
$102,000
Add depreciation
110,000
Annual cash flow
$212,000
Cash Flow
$212,000
(1,100,000)
Factor
5.6502
1.0000
Total
$1,197,842
(1,100,000)
$ 97,842
b.
PV of annuity factor = $1,100,000 ÷ 212,000 = 5.189
PVA factor of 5.189 implies an internal rate of return of approximately 14.5%.
c.
$1,100,000 ÷ $212,000 = 5.189 years
d.
$102,000 ÷ [($1,100,000 – $0) ÷ 2] = 18.55%
Chapter 9 Capital Budgeting Decisions
172.
9-37
A project will require an initial investment of $580,000 and is expected to generate the following
cash flows:
Year 1
$ 60,000
Year 2
250,000
Year 3
250,000
Year 4
200,000
Year 5
100,000
a.
b.
Answer
a.
b.
What is the project’s payback period?
If the required rate of return is 20% and taxes are ignored, what is the project’s net
present value?
$60,000 + $250,000 + $250,000 = $560,000
Portion of year 4: $20,000 ÷ $200,000 = 0.10
Payback period = 3.1 years
($580,000) × 1.000
$60,000 × 0.8333
$250,000 × 0.6944
$250,000 × 0.5787
$200,000 × 0.4823
$100,000 × 0.4019
Net present value
($580,000)
49,998
173,600
144,675
96,460
40,190
($75,077)
CHALLENGE EXERCISES
173.
Tow’em Away is considering the purchase of a tow truck with a cost of $54,400 to be acquired on
January 1, 2014. Tow’em estimates the truck can be sold for $10,400 at the end of its 5-year
estimated life. Tow’em has a cost of capital of 6% and a required rate of return of 8%. This
purchase would allow Tow’em to make 2,200 more tows per year. Annual cash basis net income
relating to the tow truck is estimated at $20,200. Income taxes are 32%.
a. Calculate the depreciation tax shield for 2014.
b.
What is the nature of the depreciation tax shield? Why is the depreciation tax shield a
component of analyzing investment decisions?
c.
Calculate Tow’em’s annual operating cash flows relating to the tow truck purchase.
Answer
a.
(($54,400 – $10,400) ÷ 5) × 32% = $2,816
b.
The tax shield represents the amount of cash saved from depreciation. Depreciation
expense lowers income tax expense to be paid, even though no cash flow occurs for the
depreciation amount.
c.
$20,200 + $2,816 = $23,016
9-38
Test Bank to accompany Jiambalvo Managerial Accounting, 5th edition
174.
For each capital budgeting project below, indicate whether management should Accept or Reject
by placing an A or R, respectively, in the space provided next to each project. Select the best
reason for the respective action from the list of reasons by printing a legible uppercase letter in
the space provided.
Possible Reasons
A. The investment’s return is less than the cost of capital.
B. The investment earns a return rate equal to the company’s hurdle rate.
C. The cash outflows equal the cash inflows.
D. The investment’s internal rate of return is greater than the required rate of return.
E. The investment generates a return on profit less than the required rate of return.
G. The investment generates a cash return greater than the required rate of return.
H. The investment generates a cash return less than the required rate of return.
J. The hurdle rate is greater than the required rate of return.
K. The hurdle rate is less than the required rate of return.
M. The total cash paid out is less than the total cash received.
Capital budgeting projects
Accept (A) or
Reject (R)?
Reason
Accept (A) or
Reject (R)?
Reason
R
C and H
A
B
A
D
R
H
1. JT Corp. has a cost of capital at 6.2% and a required rate of
return at 7.9%. The company evaluated an investment and
determined the IRR was zero.
2. Save Company evaluated a potential investment and determined
the NPV to be zero. Save Company’s required rate of return is
9.1% and its cost of capital is 6.4%.
3. An investment project has an internal rate of return of 10.8%.
The initial outlay for the investment is $91,000. The hurdle rate
is 10.2%.
4. An investment project has an NPV of ($5,200). The hurdle rate
is 10%.
Answer
Capital budgeting projects
1. The zero IRR indicates the investment will generate a return of
zero cents of cash per dollar of assets invested.
2. An NPV of zero means the investment’s present value of cash
inflows equal present value of cash outflows.
3. The investment’s IRR is higher than the required rate of return.
4. The investment earns a cash return that is less than the required
rate of return of 10%.
Chapter 9 Capital Budgeting Decisions
175.
9-39
A proposed acquisition of a forklift on January 1, 2014 will cost $86,000, and have an estimated
salvage value at the end of its estimated 5-year estimated life of $21,000.
Net income
Operating cash flows
2014
$ 7,300
20,300
2015
$ 8,700
21,700
2016
$ 8,000
21,000
2017
$ 5,100
18,100
2018
$ 1,400
14,400
The company’s required rate of return is 7% and its cost of capital is 6%. The income tax rate is
32%.
a.
b.
c.
d.
Determine the payback period of the proposed acquisition.
Interpret the meaning of your answer in part A.
Suppose that the amounts for 2018 are a loss of $9,000 and cash flows of $4,000 instead
of the amounts given. How will the payback period differ?
What are the criticisms against the payback period?
Answer
a.
Cost to recover
2014
2015
2016
2017
Amount to recover during 2018
Portion of 2018: $4,900 ÷ $14,400
Payback period = 4.34 years
$ 86,000
(20,300)
(21,700)
(21,000)
(18,100)
$ 4,900
0.3403
b.
In 4.34 years, the company will have recovered all of its cash investment it used to
purchase the forklift.
c. The $4,900 not recovered as of the end of 2017 will be recovered in two parts:
To be recovered through 2018 cash flows
$4,000
To be recovered through salvage value
900
The payback period will be 5 years.
d.
The payback period does not consider the time value of money, as money received today
is worth more than amounts received in the future. In addition, it does not consider all of
the cash flows that occur after the end of the payback period. It also does not consider the
time value of the cash flows within the payback period.