Exam 21: Capital Investment Decisions and the Time Value of Money

Simms Manufacturing is considering two alternative investment proposals with the following data: Proposal X Proposal Y Investment \ 620,000 \ 400,000 Useful life 8 years 8 years Estimated annual net cash inflows for 8 years \ 130,000 \ 80,000 Residual value \ 60,000 \ 0 Depreciation method Straight-line Straight-line Required rate of return 14\% 10\% - How long is the payback period for Proposal X?

The rate of return method and the payback method are often used as preliminary screening measures, but are insufficient to fully evaluate a capital investment.

Billy Pierce invests $8,000 at the end of each year for 5 years at 6%. What is the future value of the investment? Future Value of an Annuity of \ 1 4\% 5\% 6\% 7\% 8\% 9\% 1 1.000 1.000 1.000 1.000 1.000 1.000 2 2.040 2.050 2.060 2.070 2.080 2.090 3 3.122 3.153 3.184 3.215 3.246 3.278 4 4.246 4.310 4.379 4.440 4.506 4.573 5 5.416 5.526 5.637 5.751 5.867 5.985 6 6.631 6.802 6.976 7.153 7.336 7.523 7 7.898 8.142 8.394 8.654 8.929 9.200 8 9.214 9.549 9.897 10.26 10.64 11.03 9 10.58 11.03 11.49 11.98 12.49 13.02 10 12.01 12.58 13.18 13.82 14.49 15.19

If an investment project's IRR is higher than the company's hurdle rate, the company should go forward with the investment.

Natick Products is evaluating an investment in new production machinery. The initial investment is $700,000 and will yield cash flows of $120,000 per year for an 8 year period. At the end of 8 years, the machinery will be sold and has expected residual value of $90,000. Natick uses a discount rate of 6%. What is the net present value of the investment? Present Value of an Annuity of \1 5\% 6\% 7\% 8\% 9\% 10\% 1 0.952 0.943 0.935 0.926 0.917 0.909 2 1.859 1.833 1.808 1.783 1.759 1.736 3 2.723 2.673 2.624 2.577 2.531 2.487 4 3.546 3.465 3.387 3.311 3.240 3.170 5 4.329 4.212 4.100 3.993 3.890 3.791 6 5.07d 4.917 4.767 4.623 4.480 4.355 7 5.786 5.582 5.389 5.206 5.033 4.868 8 6.463 6.210 5.971 5.747 5.535 5.759 9 7.108 6.802 6.515 6.247 5.995 5.759 10 7.722 7.360 7.024 6.710 6.418 6.145 Present Value of an Annuity of \1 5\% 6\% 7\% 8\% 9\% 10\% 1 0.952 0.943 0.935 0.926 0.917 0.909 2 0.907 0.890 0.873 0.857 0.847 0.826 3 0.864 0.840 0.816 0.794 0.771 0.751 4 0.823 0.792 0.763 0.735 0.708 0.683 5 0.784 0.747 0.713 0.681 0.650 0.621 6 0.746 0.705 0.666 0.630 0.596 0.564 7 0.711 0.665 0.623 0.583 0.547 0.513 8 0.677 0.627 0.582 0.540 0.50 0.467 9 0.645 0.592 0.544 0.500 0.469 0.424 10 0.614 0.558 0.508 0.463 0.422 0.386

Which capital budgeting method uses accrual accounting, rather than net cash flows, as a basis for calculations?

The payback period and rate of return (ROR) methods are more suitable to investments with a shorter time span.

When projecting the cash flows of an investment, the inflows are netted against the outflows.

Capital rationing is when a company has limited resources, and it must find ways to reduce operating expenses in all of its divisions and units.

Marsh Products is evaluating an investment in new production machinery. The initial investment is $250,000 and will yield cash flows of $60,000 per year for a 5 year period. At the end of 5 years, the machinery will be sold and has expected residual value of $40,000. Marsh uses a discount rate of 7%. What is the net present value of the investment? Present Value of an Anuuity of \1 5\% 6\% 7\% 8\% 9\% 10\% 1 0.952 0.943 0.935 0.92 0.917 0.909 2 1.859 1.833 1.808 1.78 1.759 1.736 3 2.723 2.673 2.624 2.577 2.531 2.487 4 3.546 3.465 3.387 3.31 3.240 3.170 5 4.329 4.212 4.100 3.99 3.89 3.791 Present Value of \ 1 5\% 6\% 7\% 8\% 9\% 10\% 1 0.952 0.943 0.935 0.926 0.917 0.909 2 0.907 0.890 0.873 0.857 0.842 0.826 3 0.864 0.840 0.816 0.794 0.772 0.751 4 0.823 0.792 0.763 0.735 0.708 0.683 5 0.784 0.747 0.713 0.681 0.650 0.621

ABC Company is adding a new product line that will require an investment of $1,500,000. The product line is estimated to generate cash inflows of $300,000 the first year, $250,000 the second year, and $200,000 each year thereafter for ten more years. What is the payback period?

If $5,000 is invested in an account with 7% interest compounding yearly, what will the balance of the account be after 3 years? Please refer to the following Future Value table: Future Value of \1 4\% 5\% 6\% 7\% 1 1.040 1.050 1.060 1.070 2 1.082 1.103 1.124 1.145 3 1.125 1.158 1.191 1.225 4 1.170 1.210 1.262 1.311 5 1.217 1.270 1.338 1.403 6 1.265 1.340 1.419 1.50

Which of the following best describes capital rationing?

Centurion Company is considering a mineral extraction project which requires an initial investment of $2,000,000 and will yield annual cash flows of $300,000 for 8 years. Centurion has an 8% hurdle rate. If Centurion uses the NPV method of evaluation investments, this would be considered a good investment opportunity. Present Value of an Annuity of \ 1 5\% 6\% 7\% 8\% 9\% 10\% 1 0.952 0.943 0.939 0.92 0.917 0.909 2 1.859 1.833 1.809 1.78 1.759 1.736 3 2.723 2.673 2.624 2.577 2.531 2.487 4 3.546 3.465 3.387 3.31 3.240 3.170 5 4.329 4.212 4.10 3.99 3.890 3.791 6 5.076 4.917 4.767 4.623 4.486 4.355 7 5.780 5.582 5.389 5.206 5.033 4.355 8 6.463 6.210 5.971 5.747 5.535 5.335 9 7.108 6.802 6.513 6.247 5.995 5.759 10 7.722 7.360 7.024 6.710 6.418 6.145

When comparing several investments with the same initial outlay, the decision should be made on the basis of which of the following?

Clapton Corporation is considering an investment in new equipment costing $900,000. The equipment will be depreciated on a straight-line basis over a ten-year life and is expected to have a salvage value of $90,000. The equipment is expected to generate net cash flows of $140,000 for each of the first five years and $100,000 for each of the last five years. What is the accounting rate of return associated with the equipment investment?

If Teddy Godfried invests $400,000 today at a rate of 9% compounding yearly, his investment will grow to $1,000,000 in 10 years. Future Value of \1 4\% 5\% 6\% 7\% 8\% 9\% 1 1.040 1.050 1.069 1.07 1.080 1.090 2 1.082 1.103 1.124 1.14 1.160 1.188 3 1.125 1.158 1.191 1.22 1.260 1.295 4 1.170 1.216 1.26 1.311 1.360 1.412 5 1.217 1.276 1.33 1.40 1.469 1.539 6 1.265 1.340 1.419 1.501 1.587 1.677 7 1.316 1.407 1.504 1.606 1.714 1.828 8 1.369 1.477 1.594 1.719 1.851 1.993 9 1.423 1.551 1.689 1.839 1.999 2.172 10 1.480 1.629 1.791 1.967 2.159 2.367

Please review the information on 4 potential investments: Project A Project B Project C Project D Initial investment \ 200,000 \ 250,000 \ 300,000 \ 90,000 PV of cash inflows \ 285,000 \ 295,000 \ 420,000 \ 94,000 Payback period (years) 7.2 6.0 9.5 2.0 NPV of project \ 85,000 \ 45,000 \ 120,000 \ 4,000 Profitability inclex 1.43 1.18 1.40 1.04 - Under conditions of capital rationing, which project would be favored?

Which of the following methods ignores the time value of money?

If Teddy Godfried invests $10,000 today in an account compounding yearly, and he wants his money to at least double within 10 years, what interest rate is needed? Future Value of \ 1 4\% 5\% 6\% 7\% 8\% 9\% 1 1.040 1.050 1.060 1.070 1.080 1.090 2 1.082 1.103 1.124 1.145 1.166 1.188 3 1.125 1.158 1.191 1.225 1.260 1.295 4 1.170 1.216 1.261 1.311 1.360 1.412 5 1.217 1.276 1.338 1.403 1.469 1.539 6 1.265 1.340 1.410 1.501 1.587 1.677 7 1.316 1.407 1.504 1.606 1.714 1.828 8 1.369 1.477 1.594 1.718 1.851 1.993 9 1.423 1.551 1.689 1.838 1.999 2.172 10 1.480 1.629 1.791 1.967 2.159 2.367