Test Prep Test Prep Certifications BUSINESS-ENVIRONMENT-AND-CONCEPTS Questions & Answers

• Question 101:

  Whatney Co. is considering the acquisition of a new, more efficient press. The cost of the press is $360,000, and the press has an estimated six-year life with zero salvage value. Whatney uses straightline depreciation for both financial reporting and income tax reporting purposes and has a 40 percent corporate income tax rate. In evaluating equipment acquisitions of this type, Whatney uses a goal of a four-year payback period. To meet Whatney's desired payback period, the press must produce a minimum annual before-tax, operating cash savings of:

  A. $90,000

  B. $110,000

  C. $114,000

  D. $150,000

  Correct Answer: B

  Choice "b" is correct. $110,000 minimum annual before-tax operating cash savings.

  Step 1: Determine the after-tax annual cash savings. The question provides the cash outflow and the desired payback period (which is calculated using after-tax cash flows). The $90,000 annual after-tax cash flows is calculated as follows:

  

  Step 2: Determine the amount of the annual depreciation expense. Because the question asks for annual before-tax cash savings, we will need to convert the $90,000 after-tax cash savings we calculated in Step 1, above, to a before-tax amount. The depreciation tax shield plays a role in the after-tax cash flows, so the annual depreciation of $60,000 must be calculated, as follows:

  

  Step 3: Use algebra to determine the before-tax cash savings. Before-tax cash savings is equal to the after-tax cash savings plus the taxes paid. So:

  Let B = annual before-tax operating cash savings

  $90,000 after tax cash savings + [(B - $60,000 depreciation expense) (.40 tax rate)] = B $90,000 + [(B - $60,000) (.40)] = B $90,000 + [.40B - $24,000] = B $90,000 - $24,000 = .60B $66,000 = .60B $110,000 = B = annual before-tax operating cash savings

  

• Question 102:

  Willis, Inc. has a cost of capital of 15 percent and is considering the acquisition of a new machine, which costs $400,000 and has a useful life of five years. Willis projects that earnings and cash flow will increase as follows.

  

  What is the payback period of this investment?

  A. 1.50 years

  B. 3.00 years

  C. 3.33 years

  D. 4.00 years

  Correct Answer: B

  Choice "b" is correct. 3.00 year payback period.

  

  Note: After 3 years, the initial investment is recovered, as the cumulative cash inflows equal $400,000. The cash flows are not discounted when the payback method is used.

• Question 103:

  Which one or the following statements about the payback method of investment analysis is correct? The payback method:

  A. Does not consider the time value of money.

  B. Uses discounted cash flow techniques.

  C. Generally leads to the same decision as other methods for long-term projects.

  D. Is rarely used in practice.

  Correct Answer: A

  Choice "a" is correct. The payback method does not consider the time value of money.

  Choice "b" is incorrect. The payback method does not use discounted cash flow techniques. The time

  value of money is ignored.

  Choice "c" is incorrect. The payback method may or may not lead to the same decision as other methods

  for long-term projects.

  Choice "d" is incorrect. The payback method is frequently used in practice because of its simplicity.

• Question 104:

  McLean Inc. is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of three years. Assume for simplicity that the equipment will be fully depreciated 30, 40, and 30 percent in each of the three years, respectively. The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40 percent estimated income tax rate and a 16 percent hurdle rate to evaluate capital projects. Discount rates for a 16 percent rate are as follows:

  

  The payback period for this investment would be:

  A. 2.95 years

  B. 1.76 years

  C. 2.09 years

  D. 2.94 years

  Correct Answer: C

  Choice "c" is correct. 2.09 years payback period.

  

  

  At the beginning of year 3, $6,000 is needed to recover the investment. Because an inflow of $69,000 is expected throughout the year, only 6,000 ?69,000 = .09 years is needed to recover the $6,000. Thus, the payback is 2.09 years. The $6,000 in salvage is excluded from the totals for year 3. Amounts are not realized until the end of the year while savings and depreciation tax shield occur throughout the year and are relevant to the partial year payback.

• Question 105:

  A characteristic of the payback method (before taxes) is that it:

  A. Incorporates the time value of money.

  B. Neglects total project profitability.

  C. Uses accrual accounting inflows in the numerator of the calculation.

  D. Uses the estimated expected life of the asset in the denominator of the calculation.

  Correct Answer: B

  Choice "b" is correct. The payback method neglects total project profitability. It simply looks at the time

  required to recover the initial investment; subsequent receipts are ignored.

  Choice "a" is incorrect. Payback does not incorporate the time value of money.

  Choice "c" is incorrect. Payback uses cash flow, not accrual accounting income.

  Choice "d" is incorrect. The denominator is the annual cash inflows.

• Question 106:

  The length of time required to recover the initial cash outlay of a capital project is determined by using the:

  A. Discounted cash flow method.

  B. Payback method.

  C. Net present value method.

  D. Accounting rate of return method.

  Correct Answer: B

  Choice "b" is correct. The payback method measures the time required to recover the initial investment.

  Choice "a" is incorrect. Discounted cash flows are used for several methods of capital budgeting; this is a

  generic term.

  Choice "c" is incorrect. The NPV method does not measure the length of time required to recover the initial

  cash outlay.

  Choice "d" is incorrect. The accounting rate of return does not measure the time to recover the initial

  investment.

• Question 107:

  The method that divides a project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment is the:

  A. Internal rate of return method.

  B. Accounting rate of return method.

  C. Payback method.

  D. Net present value method.

  Correct Answer: B

  Choice "b" is correct. Accounting rate of return divides annual after-tax net income by average investment

  amount.

  Choices "a", "c", and "d" are incorrect. IRR, NPV and payback all use cash flows, not net income.

• Question 108:

  The internal rate of return (IRR) is the:

  A. Hurdle rate.

  B. Rate of interest where the net present value is greater than 1.0.

  C. Rate of interest where the net present value is equal to zero.

  D. Rate of return generated from the operational cash flows.

  Correct Answer: C

  Choice "c" is correct. IRR is the rate of interest where the NPV is zero.

  Choice "a" is incorrect. The hurdle rate is a desired or minimum rate of return, set by management, to

  evaluate investments.

  Choice "b" is incorrect. NPV will be greater than zero when the IRR is higher than the hurdle rate.

  Choice "d" is incorrect. IRR is the rate of return of all cash flows produced by the investment.

• Question 109:

  The internal rate of return is the:

  A. Rate of interest that equates the present value of cash outflows and the present value of cash inflows.

  B. Risk-adjusted rate of return.

  C. Required rate of return.

  D. Weighted average rate of return generated by internal funds.

  Correct Answer: A

  Choice "a" is correct. The internal rate of return is defined as the technique that determines the present value factor such that the present value of the after-tax cash flows equals the initial investment on the project. Alternately, the internal rate of return (IRR) is the discount rate that produces a NPV of zero. Choices "b", "c", and "d" are incorrect, per the above Explanation.

• Question 110:

  The internal rate of return for a project can be determined:

  A. Only if the project cash flows are constant.

  B. By finding the discount rate that yields a net present value of zero for the project.

  C. By subtracting the firm's cost of capital from the project's profitability index.

  D. Only if the project's profitability index is greater than one.

  Correct Answer: B

  Choice "b" is correct. The internal rate of return (IRR) is the discount rate that produces a NPV of zero.

  Choice "a" is incorrect. IRR valuation does not require cash flows that are constant.

  Choice "c" is incorrect. Cost of capital is a percentage, profitability index is a ratio; this won't work.

  Choice "d" is incorrect. IRR can be determined even if the profitability index is less than 1.0. A profitability

  index of less than 1.0 means a negative NPV, which means the IRR is less than the discount rate being

  used.