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

The further into the future the investment cash flows extend, the more likely it is that actual results will differ from the initial predictions.

Which of the following best describes the profitability index?

Sun Company is considering purchasing new equipment costing $350,000. Sun's management has estimated that the equipment will generate cash inflows as follows: Year 1 \ 100,000 Year 2 \ 100,000 Year 3 \ 125,000 Year 4 \ 125,000 Year 5 \ 75,000 Using the table below, please calculate the profitability index of the project using a discount rate of 10%. Please round all calculations to the nearest whole dollar. Prefent 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

If $1,000 is invested in an account with 4% interest compounding yearly, what will the balance of the account be after 4 years? (You may ignore small differences that result from rounding.)

The rate of return is the only capital budgeting method that uses accrual accounting.

Which of the following capital budgeting models is most likely to be used if a company's goal is to maximize their operating book income?

The rate of return calculations ignores the time value of money, but the payback period does include consideration of the time value of money.

You are currently 25 and would like to retire at age 45. You plan to save by making equal investments of $10,000 at the end of each year for the next 20 years. If you are able to earn 8% per year on your investments, how much will you have at the end of the 20 years? Please refer to the table below: Future Value of an Annuity of $1 Periods 8\% 12 18.98 13 21.5 14 24.21 15 27.15 16 30.32 17 33.75 18 37.45 19 41.45 20 45.76

The payback method uses discounted cash flows to make investment decisions.

Julio has just received a legal judgment in a civil court case which awards him a settlement of $24,000 to be received two years from now. He would like to sell the rights to the settlement money to a financial institution, so that he can have the cash now. In order to estimate the present value of the settlement, he will use a discount rate of 6%. What is the present value of the settlement? 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 0.79 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 0.51 8 0.677 0.627 0.582 0.540 0.502 0.467 9 0.645 0.59 0.544 0.500 0.460 0.424 10 0.614 0.558 0.508 0.463 0.422 0.386

Pearl Manufacturing is considering an investment in equipment costing $660,000. The equipment will be depreciated on the straight-line basis over an eight-year period with an estimated residual value of $120,000. The investment is expected to generate annual net cash inflows of $135,000 for 8 years. Using the rate of return model, what is the minimum average annual operating income that must be generated from this investment in order to achieve a 14% rate of return?

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 year Estimated annual net cash inflows for years \ 130,000 \ 80,000 Residual value \ 0 \ 0 Depreciation method Straight-line Straight-line Discount rate 9\% 10\% What is the total present value of future cash inflows from Proposal X? Prefent 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 2.83 1.808 1.783 1.759 1.736 4 3.546 3.465 2.624 2.577 2.531 2.487 5 4.329 4.21 4.100 3.312 3.240 3.170 6 5.076 4.917 4.767 4.623 3.890 3.79 7 5.786 5.58 5.389 5.206 5.033 4.355 8 6.463 6.210 5.971 5.747 5.535 5.335 9 7.108 6.80 6.515 6.247 5.995 5.759 10 7.722 7.360 7.024 6.710 6.418 6.145

Which of the following MOST accurately describes the term annuity?

Landmark Company is considering an investment in new equipment costing $360,000. The equipment will be depreciated on a straight-line basis over a five-year life and is expected to generate net cash inflows of $70,000 the first year, $80,000 the second year, and $120,000 every year thereafter until the fifth year. What is the payback period for this investment? The residual value is zero.

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 \ 0 \ 0 Depreciation method Straight-line Straight-line Discount rate 9\% 10\% Present Value of an Annuity of \1 1 5\% 6\% 7\% 8\% 9\% 10\% 2 1.952 0.943 0.935 0.926 0.917 0.909 3 2.723 2.83 1.808 1.783 1.759 1.736 4 3.546 3.465 2.624 2.577 2.531 2.487 5 4.329 4.21 4.100 3.312 3.240 3.170 6 5.076 4.917 4.767 4.623 3.890 3.79 7 5.786 5.58 5.389 5.206 5.033 4.355 8 6.463 6.210 5.971 5.747 5.535 5.335 9 7.108 6.80 6.515 6.247 5.995 5.759 10 7.722 7.360 7.024 6.710 6.418 6.145 After calculating the net present value of the two alternatives, Proposal Y appears to deliver the most favorable results.

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 year Estimated annual net cash inflows for years \ 130,000 \ 80,000 Residual value \ 0 \ 0 Depreciation method Straight-line Straight-line Discount rate 9\% 10\% What is the net present value of Proposal X, taking into consideration the initial outlay and the subsequent Cash inflows? Prefent 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 2.83 1.808 1.783 1.759 1.736 4 3.546 3.465 2.624 2.577 2.531 2.487 5 4.329 4.21 4.100 3.312 3.240 3.170 6 5.076 4.917 4.767 4.623 3.890 3.79 7 5.786 5.58 5.389 5.206 5.033 4.355 8 6.463 6.210 5.971 5.747 5.535 5.335 9 7.108 6.80 6.515 6.247 5.995 5.759 10 7.722 7.360 7.024 6.710 6.418 6.145

Net present value is defined as the difference between the present value of the project's cash inflows and the investment's cost.

Which of the following is the rate of return, based on discounted cash flows, that a company can expect to earn by investing in a capital asset?

The term net present value means the difference between:

Most capital budgeting methods focus on cash flows rather than book income.