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

• Question 201:

  Wendy's Sandwich Shop purchased an asset for $100,000 that has no salvage value and a 10-year life. Wendy's effective income tax rate is 40 percent, and it uses the straight-line depreciation method for income tax reporting purposes. Wendy's annual depreciation tax shield from the asset would be:

  A. $10,000

  B. $6,000

  C. $4,000

  D. $2,000

  Correct Answer: C

  Choice "c" is correct. $4,000 annual depreciation tax shield.

  

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

• Question 202:

  Which of the following statements is true regarding the payback method?

  A. It does not consider the time value of money.

  B. It is the time required to recover the investment and earn a profit.

  C. It is a measure of how profitable one investment project is compared to another.

  D. The salvage value of old equipment is ignored in the event of equipment replacement.

  Correct Answer: A

  Choice "a" is correct. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. The payback method does not consider the time value of money. Choice "b" is incorrect. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. Although the payback method focuses on liquidity and measures risk, project cash flows after the initial investment are not considered; thus, profitability is ignored. Choice "c" is incorrect. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. Although the payback method focuses on liquidity and measures risk, project cash flows after the initial investment are not considered; thus, profitability is ignored. Choice "d" is incorrect. Salvage value is specifically considered as part of payback computations because it contributes to the incoming cash flow when the asset is sold.

• Question 203:

  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' discounted annual depreciation tax shield for the year 1997 would be:

  A. $13,817

  B. $15,200

  C. $16,762

  D. $20,725

  Correct Answer: A

  Choice "a" is correct. $13,817 discounted annual depreciation tax shield for the year 1997.

  

  Choices "b", "c", and "d" are incorrect based on the above Explanation.

• Question 204:

  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.

  

  The acquisition of the new production machine by Gunning Industries will contribute a discounted net-oftax contribution margin of:

  A. $242,624

  B. $303,280

  C. $363,936

  D. $454,920

  Correct Answer: D

  Choice "d" is correct. $454,920 discounted net-of-tax contribution margin.

  

  Choices "a", "b", and "c" are incorrect based on the above Explanation.

• Question 205:

  A divisional manager receives a bonus based on 20% of the residual income from the division. The results of the division include: Divisional revenues, $1,000,000; divisional expenses, $500,000; divisional assets, $2,000,000; and the required rate of return is 15%. What amount represents the manager's bonus?

  A. $200,000

  B. $140,000

  C. $100,000

  D. $40,000

  Correct Answer: D

  Choice "d" is correct as shown in the computation below:

  

  Choice "a" is incorrect. The amount of the residual income itself is not the amount of the bonus.

  Choice "b" is incorrect. The difference between revenues (before consideration of divisional expenses) and

  the hurdle amount is not residual income. The bonus would be improperly calculated if residual income

  were to be inflated by divisional expenses as suggested by this answer.

  Choice "c" is incorrect. The difference between the hurdle amount and the residual income ($100,000) is

  not the bonus amount.

• Question 206:

  A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?

  A. Less than the company's weighted average cost of capital.

  B. Less than the project's internal rate of return.

  C. Greater than the company's weighted average cost of capital.

  D. Greater than the project's internal rate of return.

  Correct Answer: B

  Choice "b" is correct. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV. Choice "a" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). A positive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likely equal. Choice "c" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). A positive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likely equal. Choice "d" is incorrect. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.

• Question 207:

  A project's net present value, ignoring income tax considerations, is normally affected by the:

  A. Proceeds from the sale of the asset to be replaced.

  B. Carrying amount of the asset to be replaced by the project.

  C. Amount of annual depreciation on the asset to be replaced.

  D. Amount of annual depreciation on fixed assets used directly on the project.

  Correct Answer: A

  Choice "a" is correct. A project's net present value is a function of current and future cash flows, including

  proceeds from the sale of the old asset. Choice "b" is incorrect. A project's net present value is a function

  of current and future cash flows. The carrying amount of the asset does not affect cash flows.

  Choice "c" is incorrect. A project's net present value is a function of current and future cash flows.

  Depreciation is a noncash item and does not affect cash flows.

  Choice "d" is incorrect. A project's net present value is a function of current and future cash flows.

  Depreciation is a noncash item and does not affect cash flows.

• Question 208:

  Managers that anticipate greater return for greater risk are referred to as having what attitude toward risk?

  A. Risk indifferent.

  B. Risk averse.

  C. Risk seeking.

  D. Cautious.

  Correct Answer: B

  Choice "b" is correct. Risk averse behavior describes managers who demand more return on an investment as risk increases. These managers expect to be compensated for increased risk. Choice "a" is incorrect. Risk indifferent behavior describes a manager who is neutral with regard to the return associated with a particular investment. Typically, the amount of a risk free rate of return associated with an investment of a given amount compared to a higher return associated with higher risk is viewed as having equal value. Choice "c" is incorrect. Risk seeking behavior describes managers who seek reduced return for higher risk. Choice "d" is incorrect. The term "cautious" is a distracter. Although caution is an attitude, it is not a technical term.

• Question 209:

  The profitability index is a variation on which of the following capital budgeting models?

  A. Internal rate of return.

  B. Economic value-added.

  C. Net present value.

  D. Discounted payback.

  Correct Answer: C

  Choice "c" is correct. The profitability index is a variation on the net present value capital budgeting model. RULE: The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability index is also referred to as the "excess present value index" or simply the "present value index." Companies hope that this ratio will be over 1.0, which means that the present value of the inflows is greater than the present value of the outflows.

  

  Choice "a" is incorrect. The profitability index is a companion computation to net present value, not internal

  rate of return, which measures percentage return.

  Choice "b" is incorrect. The profitability index is a companion computation to net present value, not

  economic value added.

  Choice "d" is incorrect. The profitability index is a companion computation to net present value, not the

  discounted payback method, which measures years to payback.

• Question 210:

  In evaluating a capital budget project, the use of the net present value model is generally not affected by the:

  A. Method of funding the project.

  B. Initial cost of the project.

  C. Amount of added working capital needed for operations during the term of the project.

  D. Amount of the project's associated depreciation tax allowance.

  Correct Answer: A

  Choice "a" is correct. The method of funding the project has no effect on the net present value model. NPV uses a hurdle rate to discount cash flows. If the NPV is positive, the project is acceptable. The method of financing the project, and the cost, are independent of the process of screening the project for acceptability. Choice "b" is incorrect. The initial cost is one of the most important items in the calculation of NPV. Choice "c" is incorrect. Added working capital requirements and salvage value affect cash flow. All cash flows are used in the NPV model. Choice "d" is incorrect. The tax depreciation allowance will provide a "tax shield" or tax savings that impacts cash flow and must be considered in NPV analysis.