Exam 25: Capital Budgeting and Managerial Decisions

Capital budgeting decisions are risky because the outcome is uncertain, large amounts of money are usually involved, the investment involves a long-term commitment, and the decision could be difficult or impossible to reverse.

A new manufacturing machine is expected to cost $278,000, have an eight-year life, and a $30,000 salvage value. The machine will yield an annual incremental after-tax income of $35,000 after deducting the straight-line depreciation. Compute the payback period for the purchase.

After-tax net income divided by the average amount invested in a project, is the:

Dracor Company is considering the purchase of equipment that would allow the company to add a new product to its line. The equipment is expected to cost $280,000 with a 7-year life, no salvage value, and will be depreciated using straight-line depreciation. The expected annual income related to this equipment follows. Compute the (a) payback period and (b) accounting rate of return for this equipment. Sales \ 900,000 Costs: Manufacturing \ 545,000 Depreciation on machine 40,000 Selling and administrative expenses 249,000 (834,000) Income before taxes 66,000 Income tax (30\%) ) Net income \ 46,200

Neither the payback period nor the accounting rate of return methods of evaluating investments considers the time value of money.

The ________ is the rate that yields a net present value of zero for an investment.

Alfarsi Industries uses the net present value method to make investment decisions and requires a 15% annual return on all investments. The company is considering two different investments. Each require an initial investment of $15,000 and will produce cash flows as follows: End of Investment Year A B 1 \ 8,000 \ 0 2 8,000 0 3 8,000 24,000 The present value factors of $\$ 1$ each year at $15 \%$ are: 1 0.8696 2 0.7561 3 0.6575 - The present value of an annuity of $1 for 3 years at 15% is 2.2832 Which investment should Alfarsi choose?

Goodfellow Company had the following results of operations for the past year: Sales (8,000 units at \6 .80) \ 54,400 Materials and direct labor (20,000) Overhead (40\% variable) (10,000) Selling and administrative expenses (all fixed) (6,000) Operating income \ 18,400 A foreign company (whose sales will not affect Goodfellow's regular sales) offers to buy 2,000 units at $5.00 per unit. In addition to variable manufacturing costs, there would be shipping costs of $1,200 in total on these units. Prepare an analysis of this additional business to show whether Goodfellow should take this order.

Maxim manufactures a cat food product called Green Health. Maxim currently has 10,000 bags of Green Health on hand. The variable production costs per bag are $1.80 and total fixed costs are $10,000. The cat food can be sold as it is for $9.00 per bag or be processed further into Premium Green and Green Deluxe at an additional $2,000 cost. The additional processing will yield 10,000 bags of Premium Green and 3,000 bags of Green Deluxe, which can be sold for $8 and $6 per bag, respectively. - If Green Health is processed further into Premium Green and Green Deluxe, the total gross profit would be:

The time value of money is considered when calculating the payback period of an investment.

Soar Incorporated is considering eliminating its mountain bike division, which reported an operating loss for the recent year of $3,000. The division sales for the year were $1,050,000 and the variable costs were $860,000. The fixed costs of the division were $193,000. If the mountain bike division is dropped, 30% of the fixed costs allocated to that division could be eliminated. The impact on operating income for eliminating this business segment would be:

Presented below are terms preceded by letters a through g and followed by a list of definitions 1 through 7. Match the letter of the term with the definition. Use the space provided preceding each definition. (a) Internal Rate of Return (b) Hurdle Rate (c) Accounting Rate of Return (d) Net Cash Flow (e) Capital Budgeting (f) Payback Period (g) Net Present Value ________ (1) Equals the discount rate that results in a net present value of zero. ________ (2) Cash inflows minus cash outflows for the period. ________ (3) A minimum acceptable rate of return. ________ (4) The time expected to pass before the net cash flows from an investment equals its initial cost. ________ (5) Annual after-tax net income divided by annual average investment. ________ (6) A process of analyzing alternative long-term investments and deciding which assets to acquire or sell. ________ (7) Initial cost of an investment subtracted from discounted future cash flows from the investment.

A company buys a machine for $76,000 that has an expected life of 6 years and no salvage value. The company anticipates a yearly after tax net income of $1,805. What is the accounting rate of return?

The following data concerns a proposed equipment purchase: Cost \ 144,000 Salvage value \ 4,000 Estimated useful life 4 years Annual net cash flows \ 46,100 Depreciation method Straight-line - The annual average investment amount used to calculate the accounting rate of return is:

Marshall Company currently manufactures one of its parts at a cost of $3.25 per unit. This cost is based on a normal production rate of 50,000 units. Variable costs are $2.10 per unit, fixed costs related to making this part are $40,000 per year, and allocated fixed costs are $45,000 per year. Allocated fixed costs are unavoidable whether the company makes or buys the part. Marshall is considering buying the part from a supplier for a quoted price of $2.80 per unit guaranteed for a three-year period. Should the company continue to manufacture the part, or should it buy the part from the outside supplier? Support your answer with analyses.

A company must decide between scrapping or rebuilding units that do not pass inspection. The company has 15,000 such units that cost $6 per unit to manufacture. The units were built to satisfy a special order, which must still be satisfied if the defective units are scrapped. The units can be sold as scrap for $2.50 each or they can be reworked for $4.50 each and sold for the full price of $9.00 each. If the units are sold as scrap, the company will have to build 15,000 replacement units and sell them at the full price. Required: (1) What is the net return from selling the units as scrap? (2) What is the net return from reworking and selling the units? (3) Should the company sell the units as scrap or rework them?

When the amount invested differs substantially across projects, NPV is of limited value for comparison purposes. You have evaluated three projects of substantially different investment amounts using the net present value (NPV) method. How would you decide which one of the projects to select?

Poe Company is considering the purchase of new equipment costing $80,000. The projected net cash flows are $35,000 for the first two years and $30,000 for years three and four. The revenue is to be received at the end of each year. The machine has a useful life of 4 years and no salvage value. Poe requires a 10% return on its investments. The present value of an annuity of $1 and present value of an annuity for different periods is presented below. Compute the net present value of the machine. Periods Present Value of \ 1 at 10\% Present Value of an Annuity of \ 1 at 10\% 1 0.9091 0.9091 2 0.8264 1.7355 3 0.7514 2.4869 4 0.6830 3.1699

The concept of incremental cost is the same as the concept of differential cost.