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

• Question 211:

  The capital budgeting model that is generally considered the best model for long-range decision making is the:

  A. Payback model.

  B. Accounting rate of return model.

  C. Unadjusted rate of return model.

  D. Discounted cash flow model.

  Correct Answer: D

  Choice "d" is correct. The discounted cash flow model is the best for long-term decisions. Discounted cash flow methods include NPV, IRR, and profitability index. Choice "a" is incorrect. Payback and bailout payback do not consider the time value of money or the return after the initial investment is recovered. The difference between the two methods is that bailout payback takes salvage value into account in calculating cash flows. Choice "b" is incorrect. Accounting rate of return is based on accrual income rather than cash flows. It does not consider the time value of money and is considered inferior to the discounted cash flow methods. Choice "c" is incorrect. There is no unadjusted rate of return model.

• Question 212:

  Para Co. is reviewing the following data relating to an energy saving investment proposal:

  

  What would be the annual savings needed to make the investment realize a 12% yield?

  A. $8,189

  B. $11,111

  C. $12,306

  D. $13,889

  Correct Answer: C

  Choice "c" is correct. The annual savings needed to make the investment realize a 12% yield is where the present value of the cash savings/inflows equals the present value of the net cash outflows. Use algebra to calculate the annual savings, as follows:

  

  Choice "a" is incorrect. The annual savings needed to make the investment realize a 12% yield is where

  the present value of the cash savings/inflows equal the present value of the net cash outflows. Choice "b"

  is incorrect. Subtract the present value of $10,000 due in 5 years at 12%, or $10,000 ?.57 = $5,700. Don't

  subtract the entire $10,000.

  Choice "d" is incorrect. Subtract the present value of the $10,000 residual value from the $50,000 cost.

• Question 213:

  For the next 2 years, a lease is estimated to have an operating net cash inflow of $7,500 per annum, before adjusting for $5,000 per annum tax basis lease amortization, and a 40% tax rate. The present value of an ordinary annuity of $1 per year at 10% for 2 years is $1.74. What is the lease's after-tax present value using a 10% discount factor?

  A. $2,610

  B. $4,350

  C. $9,570

  D. $11,310

  Correct Answer: D

  Choice "d" is correct. Present value is based on the cash flows of an activity. Amortization is a non-cash expense that is considered only for its tax shield; therefore, the only relevant amounts are the $7,500 operating net cash inflow and the tax paid.

  

  After-tax PV $11,310 Choice "a" is incorrect. Amortization expense of $5,000 is a non-cash expense and is not used to compute after-tax present value. It is used to determine the cash paid for taxes. Choice "b" is incorrect. Amortization is a non-cash expense. It is not considered in the calculation, expecpt to the extent it creates a tax shield. The tax shield reduces the amount of taxes paid out by the company. Choice "c" is incorrect. Present value is based on the cash flows of an activity. Amortization is a noncash expense that is considered only for its tax shield; therefore, the only relevant amounts are the $7,500 operating net cash inflow and the tax paid.

• Question 214:

  Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are:

  

  Using a 14% cost of capital, what is the present value of these future savings?

  A. $59,600

  B. $60,800

  C. $62,900

  D. $69,500

  Correct Answer: C

  Choice "c" is correct. The facts of the question provide annuity factors, yet the question only provides one "annuity" - the $30,000 for the first two years. Therefore, to calculate the present value of the savings for years 1 and 2, the factor for the present value of an annuity of $1 for two periods (1.65) is used. To calculate the present value of the savings for year 3, the factor for the lump sum of a present value of $1 for three periods is required; however, it is not directly provided. The factor must be calculated as the difference between the factors for the present value of an annuity of $1 for three periods (2.32) and for two periods (1.65), or .67.

  

  Review your knowledge of how the annuity and lump sum factors work together, as follows:

  

• Question 215:

  An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method:

  A. Computes a desired rate of return for capital projects.

  B. Can be used when there is no constant rate of return required for each year of the project.

  C. Uses a discount rate that equates the discounted cash inflows with the outflows.

  D. Uses discounted cash flows whereas the internal rate of return model does not.

  Correct Answer: B

  Choice "b" is correct. When using the net present value method of capital budgeting, different hurdle rates can be used for each year of the project. Choice "a" is incorrect. The desired rate of return for capital projects is established by management. Choice "c" is incorrect. The internal rate of return determines the discount rate that will equate the discounted cash inflows with the outflows, thus resulting in no gain or loss (breakeven). Choice "d" is incorrect. Both the net present value method and the internal rate of return model are discounted cash flow methods.

• Question 216:

  The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40 percent.

  What is the net cash flow for the third year that Moore Corporation should use in a capital budgeting analysis?

  A. $68,400

  B. $64,200

  C. $53,700

  D. $47,400

  Correct Answer: A

  Choice "a" is correct. $68,400 net cash flow for the third year.

  

  Alternate Computation:

  In year 3, Moore will generate a $100,000 profit from the incremental sales (2000 units ?($500 - $450)). This profit will be taxed at 40%, so the net after-tax increase in cash flow is $60,000 BEFORE the depreciation tax shield is considered. Depreciation is not a cash outflow, but it will reduce the amount of tax the company has to pay (by 40% of the depreciation), and this has an effect on the cash-flow for the company. Depreciation, as calculated above, is $21,000 per year ($105,000 cost of the machine divided by 5 years). The depreciation tax shield is $8,400 ($21,000 ?40%), so the total after-tax cash flows in year 3 for the new machine is $60,000 + $8,400 = $68,400.

• Question 217:

  The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40 percent.

  What is the net cash flow for the tenth year of the project that Moore Corporation should use in a capital budgeting analysis?

  A. $81,000

  B. $68,400

  C. $63,000

  D. $60,000

  Correct Answer: C

  Choice "c" is correct. $63,000 net cash flow for the tenth year.

  

  Alternate Computation:

  In year 10, Moore will generate a $100,000 profit from the incremental sales (2000 units ?($500 - $450)). This profit will be taxed at 40%, so the net after-tax increase in cash flow is $60,000. The machine is fully depreciated in year 10 because it was depreciated over a 5-year life. The tax basis of the machine is zero on the date Moore receives a $5,000 salvage value for the machine. The gain on the machine of $5,000 ($5,000 SV - $0 Basis) is taxed at 40%, or $2,000 in total tax outflow for the gain, so the net inflows on the salvage is $3,000. Therefore, the total after-tax cash flows in year 10 for the new machine is $60,000 + $3,000 = $63,000.

• Question 218:

  Under which one of the following conditions is the internal rate of return method less reliable than the net present value technique?

  A. When the net present value of the project is equal to zero.

  B. When income taxes are considered in the analysis.

  C. When both benefits and costs are included, but each is separately discounted to the present.

  D. When there are several alternating periods of net cash inflows and net cash outflows.

  Correct Answer: D

  Choice "d" is correct. The internal rate of return (IRR) method is less reliable than the net present value (NPV) technique when there are several alternating periods of net cash inflows and net cash outflows or the amounts of cash flows differ significantly. The IRR is strictly a percentage measure of return, while the NPV is an absolute measure. Due to this difference, the timing or amount of cash flows under IRR can be misleading when compared to the NPV method. Example: If an investment of $50 earns $100. Then, 100/50 = 200% return If an investment of $50,000 earns $25,000 then, 25,000/50,000 = 50% return IRR suggests it is best to invest $50 to earn $100 and a 200% return while the NPV method will indicate a larger NPV for the $50,000 investment. Choices "a", "b", and "c" are incorrect. These conditions do not make the IRR method less reliable than the NPV method.

• Question 219:

  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 overall discounted cash flow impact of Gunning Industries' working capital investment for the new production machine would be:

  A. $(7,959)

  B. $(10,680)

  C. $(13,265)

  D. $(35,000)

  Correct Answer: C

  Choice "c" is correct. $(13,265) overall discounted cash flow impact of working capital investment.

  

• Question 220:

  The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40 percent. What is the net cash outflow at the beginning of the first year that Moore Corporation should use in a capital budgeting analysis?

  A. $(85,000)

  B. $(90,000)

  C. $(96,000)

  D. $(105,000)

  Correct Answer: D

  Choice "d" is correct. $(105,000) net cash outflow at the beginning of the first year.