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

• Question 121:

  For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management:

  A. Wants to use equity funding exclusively.

  B. Believes bank loans are riskier than capital investments.

  C. Believes capital investment proposals involve average risk.

  D. Wants to factor risk into its consideration of projects.

  Correct Answer: D

  Choice "d" is correct. Management would select a high hurdle rate for certain projects to factor risk into its consideration of projects. The higher hurdle rate discounts future cash flows more, creating a smaller present value. By "devaluing" the cash flows of certain projects, risk has been compensated for. Choices "a" and "b" are incorrect. The method and cost of funding are independent of the hurdle rate for screening investments. Choice "c" is incorrect. If capital investment proposals involve average risk, no adjustment upward is needed for risk.

• Question 122:

  All of the following are the rates used in net present value analysis, except for the:

  A. Cost of capital.

  B. Hurdle rate.

  C. Discount rate.

  D. Accounting rate of return.

  Correct Answer: D

  Choice "d" is correct. The accounting rate of return is a capital budgeting technique, not a rate. Choices "a", "b", and "c" are incorrect. All of these are rates used in net present value analysis:

  ?Cost of capital ?Hurdle rate ?Discount rate ?Required rate of return

  Cost of capital is the cost of borrowing. The hurdle rate, the discount rate, and the required rate of return are synonymous terms for an arbitrary rate set by management.

• Question 123:

  When determining net present value in an inflationary environment, adjustments should be made to:

  A. Increase the discount rate, only.

  B. Increase the estimated cash inflows and increase the discount rate.

  C. Increase the estimated cash inflows but not the discount rate.

  D. Decrease the estimated cash inflows and increase the discount rate.

  Correct Answer: B

  Choice "b" is correct. Rule: In an inflationary environment, future cash flows (except for cash flows generated from the tax effect of depreciation) should be increased to the extent of predicted inflation. For internal consistency, an inflationary factor should also be added to the discount rate. Choices "a", "c", and "d" are incorrect, per the above Explanation.

• Question 124:

  A company has unlimited capital funds to invest. The decision rule for the company to follow in order to maximize shareholders' wealth is to invest in all projects having a (n):

  A. Present value greater than zero.

  B. Net present value greater than zero.

  C. Internal rate of return greater than zero.

  D. Accounting rate of return greater than the hurdle rate used in capital budgeting analyses.

  Correct Answer: B

  Choice "b" is correct. Rule: If the net present value is positive (greater than zero), a project should be accepted, unless there is a better project. If, however, a company has unlimited funds, all projects with a net present value greater than zero should be accepted in order to maximize shareholder wealth. Choice "a" is incorrect. Considering only present value greater than zero accounts for future net cash inflows, but it ignores cash outflows from the initial capital investment. Choice "c" is incorrect. Considering only internal rate of return greater than zero may result in the acceptance of a project with an internal rate of return less than the company's minimum desired rate of return. Choice "d" is incorrect. Considering only accounting rate of return greater than hurdle rate ignores the time value of money.

• Question 125:

  In order to increase production capacity, Gunning Industries is considering replacing an existing production machine with a new technologically improved machine effective January 1, 1997. The following information is being considered by Gunning Industries.

  •

  The new machine would be purchased for $160,000 in cash. Shipping, installation, and testing would cost

  an additional $30,000.

  •

  The new machine is expected to increase annual sales by 20,000 units at a sales price of $40 per unit.

  Incremental operating costs are comprised of $30 per unit in variable costs and total fixed costs of $40,000

  per year.

  •

  The investment in the new machine will require an immediate increase in working capital of $35,000.

  •

  Gunning uses straight-line depreciation for financial reporting and tax reporting purposes. The new

  machine has an estimated useful life of five years and zero salvage value.

  •

  Gunning is subject to a 40 percent corporate income tax rate.

  Gunning uses the net present value method to analyze investments and will employ the following factors

  and rates.

  

  Gunning Industries' net cash outflow in a capital budgeting decision would be:

  A. $190,000

  B. $195,000

  C. $204,525

  D. $225,000

  Correct Answer: D

  Choice "d" is correct. $225,000 net cash outflow.

  

  Choices "a", "b", and "c" are incorrect, per the above calculation.

  Note: This question is the first from a series of questions on a prior exam. The last in the series is

  presented for you in the regular homework questions (not the supplemental questions) for this chapter.

• Question 126:

  The method that recognizes the time value of money by discounting the after-tax cash flows over the life of a project, using the company's minimum desired rate of return is the:

  A. Accounting rate of return method.

  B. Net present value method.

  C. Internal rate of return method.

  D. Payback method.

  Correct Answer: B

  Choice "b" is correct. The net present value method recognizes the time value of money and discounts

  cash flows over the life of a project, using the minimum desired (hurdle) rate.

  Choice "a" is incorrect. The accounting rate of return is the accrual accounting increase compared to the

  initial investment.

  Choice "c" is incorrect. IRR is similar to NPV, but does not assume a desired rate of return. The rate is

  calculated that produces a NPV of zero.

  Choice "d" is incorrect. Payback method does not recognize the time value of money.

• Question 127:

  All of the following items are included in discounted cash flow analysis, except:

  A. Future operating cash savings.

  B. The current asset disposal price.

  C. The future asset depreciation expense.

  D. The tax effects of future asset depreciation.

  Correct Answer: C

  Choice "c" is correct. The future asset depreciation expense is not included in discounted cash flow

  analysis.

  Choices "a", "b", and "d" are incorrect. All of these are included in discounted cash flow analysis:

  ?Future operating cash savings

  ?Current asset disposal price ?Tax effects of future asset depreciation ?Future asset disposal price

• Question 128:

  Lawson Inc. is expanding its manufacturing plant, which requires an investment of $4 million in new equipment and plant modifications. Lawson's sales are expected to increase by $3 million per year as a result of the expansion. Cash investment in current assets averages 30 percent of sales; accounts payable and other current liabilities are 10 percent of sales. What is the estimated total investment for this expansion?

  A. $3.4 million.

  B. $4.3 million.

  C. $4.6 million.

  D. $4.9 million.

  Correct Answer: C

  Rule: The expansion of working capital (WC = CA-CL) is treated as an increase in investment. Choice "c" is correct. $4.6 million estimated total investment for this expansion.

  

  Choices "a", "b", and "d" are incorrect, per the above calculation.

• Question 129:

  Which one of the following is most relevant to a manufacturing equipment replacement decision?

  A. Original cost of the old equipment.

  B. Disposal price of the old equipment.

  C. Gain or loss on the disposal of the old equipment.

  D. A lump-sum write-off amount from the disposal of the old equipment.

  Correct Answer: B

  Rule: Relevant costs are only those costs that will differ among many alternatives.

  Choice "b" is correct. The disposal price of the old equipment is most relevant because it is an expected future inflow that will differ among alternatives. If this old equipment is replaced, there will be a cash inflow from the sale of the old equipment. If the old equipment is kept, there will be no cash inflow from the sale of the old equipment. Choice "a" is incorrect. The original cost of the old equipment is a sunk cost and, therefore, not relevant. Choice "c" is incorrect. The gain or loss on the disposal of the old equipment is not relevant. The gain or loss is an accounting computation that combines the book value, which is always not relevant, and the disposal value, which is relevant. The result is meaningless to future decisions and, therefore, is not relevant. Choice "d" is incorrect. The book value is not relevant to future decisions because the undepreciated sunk cost of an asset will only reduce net income in the future as either depreciation expense or as a loss on disposal.

• Question 130:

  Kore Industries is analyzing a capital investment proposal for new equipment to produce a product over the next eight years. The analyst is attempting to determine the appropriate "end-of-life" cash flows for the analysis. At the end of eight years, the equipment must be removed from the plant and will have a net book value of zero, a tax basis of $75,000, a cost to remove of $40,000, and scrap salvage value of $10,000. Kore's effective tax rate is 40 percent. What is the appropriate "end-of-life" cash flow related to these items that should be used in the analysis?

  A. $27,000

  B. $12,000

  C. $(18,000)

  D. $(30,000)

  Correct Answer: B

  Choice "b" is correct. $12,000 "end-of-life" cash flow.

  The $75,000 loss on disposal is a non-cash reduction in taxable income that will reduce taxes paid by

  $30,000 (75,000 ?40%).

  The cost to remove the equipment is a cash expense that will reduce taxable income by $40,000 and

  reduce taxes paid by $16,000 (40,000 ?40%), resulting in a net cash expense of $24,000 ($40,000 minus

  $16,000, or $40,000 ?60%).

  The $10,000 salvage value will increase after-tax cash flow by $6,000 (10,000 ?60%).

  

  Choices "a", "c", and "d" are incorrect, per the above calculation.