Exam 26: Capital Budgeting

Capital budgeting Carry-Along is debating whether or not to invest in new equipment to manufacture a line of high-quality luggage. The new equipment would cost $850,000, with an estimated four-year life and no salvage value. The estimated annual operating results with the new equipment are as follows: All revenue from the new luggage line and all expenses (except depreciation) will be received or paid in cash in the same period as recognized for accounting purposes. You are to compute the following for the investment in the new equipment to produce the new luggage line: (a) Annual cash flow: $___________ (b) Payback period: __________ years (c) Return on average investment: ___________% (d) Total present value of the expected future annual cash flows, discounted at an annual rate of 12% (an annuity table shows that the present value of $1 received annually for four years discounted at 12% is 3.037): $___________ (e) Net present value of the proposed investment: $___________ Revenue from sales of new luggage line \9 25,000 Expenses other than depreciation \ 625,000 Depreciation (straight-line basis) 250,000 (875,000) Increase in net income from the new line \5 0,000

A weakness in the usefulness of the return on average investment is that it fails to consider the present value of an investment.

If the net present value of an investment proposal is positive, what conclusions can be drawn? (Identify all correct answers.)

The present value of money is always:

The future value of a future cash flow is always less than the present amount.

A short payback period is preferred so that the investment's costs can be put to other uses.

What is the net present value of the cutting machine discounted at an annual rate of 10%, if the present value of a ten-year $1 annuity discounted at 10% is 6.145? $_____________

If all revenue generated by an investment is immediately received in cash, and all of the investment's expenses (other than depreciation) are immediately paid in cash, annual net cash flow of the investment may be determined by:

The payback period of this investment is:

The payback period for the investment in equipment is:

A failure of the return on investment method is that no consideration is given to the time value of money.

The management of Salem Corporation is considering the purchase of equipment costing $109,000 which has an estimated life of 3 years and no salvage value. The net after tax cash flow from the project for each of the three years is expected to be $45,000. The company's cost of capital is 10%. Compute the net present value of the equipment. (Present value of $1 due in three years, discounted at 10%, is 0.751; present value of $1 received annually for three years, discounted at 10%, is 2.487.)

Which of the following factors does the payback method does NOT ignore?

Non financial considerations are not accounted for in capital budgeting decisions.

Return on average investment vs. discounting cash flows The computation of return on average investment ignores one characteristic of the earnings stream which is considered in discounting cash flows. What is this characteristic? Why is it important?

Results of capital budgeting processes may have serious implications for employees.

Payback period: ____________ years

The acquiring of a subsidiary company by a publicly traded company would be an example of a capital expenditure.

Capital investment proposals may not be evaluated by using:

When straight-line depreciation is used, the average carrying value of an asset with no salvage value is equal to the asset's original cost divided by its estimated useful life.