Exam 16: Capital Expenditure Decisions

A profitability index can be used to rank investment proposals. Required: A.Define the profitability index. A.The profitability index equals the present value of a project's cash inflows divided by the initial investment. B.Both projects provide a return greater than the hurdle rate and both are acceptable.It is not possible to say which one is better.The profitability index provides a ratio that is not influenced by the size of the project-a limitation of net-present-value (NPV)analysis.Thus,a project that has a greater NPV and a greater profitability index generally will be more attractive than another project against which it is being compared. B.Two projects are under consideration.Project I has a net present value of $20,000 whereas project II has a net present value of $200,000.Which project is better? Explain.What weakness in a net-present-value analysis does the profitability index address?

Pinero is considering a $600,000 investment in new equipment that is anticipated to produce the following net cash inflows: If cash flows occur evenly throughout a year,the equipment's payback period is:

A new machine that costs $172,100 is expected to save annual cash operating costs of $40,000 over each of the next nine years.The machine's internal rate of return is:

The hurdle rate that is used in a net-present-value analysis is the same as the firm's:

Consider the following statements about the investment in working capital in a capital budgeting analysis: I.Working capital often increases as the result of higher balances in accounts receivable or inventory necessary to support a project. II.Working capital increases are sources of cash and should be included in a discounted-cash-flow analysis. III.The time 0 cash investment in working capital is included in a discounted-cash-flow analysis as a cash outflow. Which of the above statements is (are)correct?

The Modified Accelerated Cost Recovery System (MACRS)assumes that,on average,assets will be placed in service:

A company that is using the internal rate of return (IRR)to evaluate projects should accept a project if the IRR:

Schille Company is considering a $5.4 million asset investment that has a four-year service life and a $400,000 salvage value.The investment is expected to produce annual savings in cash operating costs of $860,000 and will require a $250,000 overhaul in year 3,which is fully-deductible for tax purposes. Schille uses the net-present-value method to analyze investments.Asset investments are depreciated by the straight-line method,ignoring salvage values in related computations. Required: A.Asset acquisition: $(5,400,000) Annual savings in cash operating costs: $860,000 Annual straight-line depreciation: $0 Year 3 overhaul: $(250,000) Year 4 asset disposal: $400,000 A.Ignoring income taxes,determine the (pre-discounted)cash-flow amounts that would be used in a net-present-value analysis for (1)the asset acquisition,(2)annual savings in cash operating costs,(3)annual straight-line depreciation,(4)the overhaul in year 3,and (5)disposal of the asset in year 4.Note cash outflows in parentheses. B.Asset acquisition: $(5,400,000) Annual savings in cash operating costs: $860,000 * 0.7 = $602,000 Depreciation should be: Year 1: $675,000 x.3 = $202,500 Year 2: $1,350,000 x.3 =$405,000 Year 3: $1,350,000 x.3 =$405,000 Year 4: $1,350,000 x.3 =$405,000 Year 5: $675,000 x.3 = $202,500 Year 3 overhaul: $(250,000)* 0.7 = $(175,000) Year 4 asset disposal: $5,400,000 _- $5,400,000 accumulated depreciation = $0 book value;$0 book value _- $400,000 salvage value = $400,000 gain;$400,000 gain * 0.3 = $(120,000)added tax;$400,000 salvage value _- $(120,000)added tax = $280,000 B.Repeat requirement "A," assuming the company is subject to a 30% income tax rate.Assume the company depreciates the asset using the optional straight-line methoD.Additionally,it depreciates it over the asset's service life (not its MACRS life).

Wrikeman evaluates future projects by using the profitability index.The company is currently reviewing five similar projects and must choose one of the following: Which project should Wrikeman select if the decision is based entirely on the profitability index?

Paige Company is contemplating the acquisition of a machine that costs $50,000 and promises to reduce annual cash operating costs by $11,000 over each of the next six years.Which of the following is a proper way to evaluate this investment if the company desires a 12% return on all investments?

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

In a net-present-value analysis,the discount rate is often called the:

A machine was sold in December 20x3 for $9,000.It was purchased in January 20x1 for $15,000,and depreciation of $12,000 was recorded from the date of purchase through the date of disposal.Assuming a 40% income tax rate,the after-tax cash inflow at the time of sale is:

The net after-tax cash flow of the disposal is:

The mayor of Statesville is considering the purchase of a new computer system for the city's tax department.The system costs $75,000 and has an expected life of five years.The mayor estimates the following savings will result if the system is purchased: Statesville uses a 10% discount rate for capital-budgeting decisions. A salesperson from a different computer company claims that his machine,which costs $85,000 and has an estimated service life of four years,will generate annual savings for the city of $32,000.If the discount rate is 10%,the net present value of this system would be:

The internal rate of return equates the present value of a project's cash inflows with the present value of the cash outflows.

The payback period can only be used if net cash inflows are uniform throughout a project's life.

Consider the following statements about taxes and after-tax cash flows: I.Capital budgeting analyses should incorporate after-tax cash flows rather than before-tax cash flows. II.Added company revenues will result in lower taxes for a firm. III.Operating expenses may actually provide a tax benefit for an organization. Which of the above statements is (are)correct?

Hightower Company plans to incur $350,000 of salaries expense if a capital project is implemented.Assuming a 30% tax rate,the salaries should be reflected in the analysis by a:

Consider the following statements about the total-cost and the incremental-cost approaches of investment evaluation: I.Both approaches will yield the same conclusions. II.Choosing between these approaches is a matter of personal preference. III.The incremental approach focuses on cost differences between alternatives. Which of the above statements is (are)true?