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L. The remaining useful life of an asset

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.



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