Professional Documents
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$3,500
$7,400
16%
Project B
4,000
9,950
12%
14%
15%
16%
18%
20%
22%
Using the net-present-value (NPV) method, project A's net present value is
A. $(265,460)
B. $23,140
C. $316,920
D. $(316,920)
A. There is only one cash inflow to this project, and it occurs 5 years after the initial cash outflow. The firm's
cost of capital is 18%. Therefore, the correct Present Value of $1 factor (from the table given) to use in
discounting the cash inflow is .4371. The present value of the cash inflow is .4371 $7,400,000, or $3,234,540.
Subtracting the initial investment of $3,500,000 from the present value of the cash inflow of $3,234,540, we get
$(265,460).
(c) HOCK international, page 1
$3,500
$7,400
16%
Project B
4,000
9,950
12%
14%
15%
16%
18%
20%
22%
Annual Net
After-Tax
Cash Flows
$
Annual
Net Income
$105,000
70,000
50,000
15,000
42,000
45,000
17,000
21,000
40,000
19,000
7,000
35,000
21,000
30,000
23,000
Yipann uses a 24% after-tax target rate of return for new investment proposals. The discount figures for a 24% rate of
return are given.
Present Value of
Present Value of
Annuity of $1
$1 Received at Received at End
Year the End of Period of Each Period
1
.81
.81
.65
1.46
.52
1.98
.42
2.40
.34
2.74
.28
3.02
.22
3.24
Year 0
Year 1
Year 2
Initial Investment in Equipment (105,000)
After-Tax Cash Flow
50,000
45,000
------------ ----------------Total After-Tax Cash Flows (105,000) 50,000
45,000
Cumulative Cash Flow
(105,000) (55,000) (10,000)
35,000
--------35,000
65,000
30,000
--------30,000
95,000
The cumulative cash flow from the project becomes positive during Year 3. Assuming that the cash flows occur
evenly throughout the year, the payback period is 2.25 years, calculated as follows:
Number of the project year in the final year when cash flow is negative: 2
Plus: a fraction consisting of
Numerator = the positive value of the negative cumulative inflow amount from the final negative year, which is
10,000
Denominator = cash flow for the following year, which is 40,000
or: 2 + 10,000/40,000 = 2.25
Note that the present value factors given are irrelevant to answering this question, because the payback
method is not a discounted cash flow technique.
C. The note calls for four annual payments of $1,000. This is an ordinary annuity, since the payments are due at
the end of each period. Therefore, the factor in the present value of an annuity table can be used as it is given,
without adjustment. The present value of a four-year ordinary annuity of $1,000, discounted at 6%, is $1,000
3.465, or $3,465.
D. An answer of $4,212 results from using the present value of an annuity factor for 6% for 5 years. However, the note is
for four years.
$105,000
0
(c) HOCK international, page 9
70,000
50,000
15,000
42,000
45,000
17,000
21,000
40,000
19,000
7,000
35,000
21,000
30,000
23,000
Yipann uses a 24% after-tax target rate of return for new investment proposals. The discount figures for a 24% rate of
return are given.
Present Value of
Annuity of $1
Present Value of
$1 Received at Received at End
Year the End of Period of Each Period
1
.81
.81
.65
1.46
.52
1.98
.42
2.40
.34
2.74
.28
3.02
.22
3.24
The average annual cash inflow at which Yipann would be indifferent to the investment (rounded to the nearest dollar) is
A. $38,321.
B. $40,000.
C. $21,000.
D. $46,667.
A.
The question is asking for an average annual after-tax cash flow amount that will result in a net present value of
zero for the project, because that will be the average annual cash flow level at which Yipann will be indifferent
to the investment. We need to look at this as a present value of an annuity problem, because since we are
looking for an average annual cash flow amount, all the annual cash flow amounts after year 0 will be the same
average amount.
The annual cash flows given in the problem are irrelevant, because we are looking for the average annual
after-tax cash flow amount that will result in an NPV of zero, given the initial investment in Year 0.
Since the initial investment is $105,000 and the project's life is 5 years, we need to know what annuity amount
will produce a present value of $105,000 when discounted at 24% for 5 years. Recall that the present value of an
annuity is the annuity amount PV of an annuity factor. We don't know the annuity amount, but we do know the
PV of an annuity factor and the present value amount of $105,000. The PV of an annuity factor for 5 years at 24%
is given in the problem: 2.74.
Thus, the formula is: Annuity Amount 2.74 = $105,000. Therefore, the Annuity Amount = $105,000 2.74, which
is equal to $38,321.
This means that if the annual after-tax cash flows are all the same and they are $38,321, the NPV will be zero
and the company will be indifferent to the investment.
B. $40,000 is the average of the five net after tax cash flows already given.
$105,000
$0
70,000
50,000
15,000
42,000
45,000
17,000
21,000
40,000
19,000
7,000
35,000
21,000
30,000
23,000
Yipann uses a 24% after-tax target rate of return for new investment proposals. The discount figures for a 24% rate of
return are given.
Present Value of
Annuity of $1
Present Value of
$1 Received at Received at End
Year the End of Period of Each Period
1
.81
.81
.65
1.46
.52
1.98
.42
2.40
.34
2.74
.28
3.02
.22
3.24
The accounting rate of return for the investment proposal over its life using the initial value of the investment is
A. 38.1%.
B. 28.1%.
C. 18.1%.
D. 36.2%.
A. An answer of 38.1% results from the average of the after-tax cash flows divided by the net initial investment. However,
the after-tax cash flows are not used in calculating the accounting rate of return.
B. An answer of 28.1% results from averaging the annual after-tax cash flows and then averaging the annual net
incomes, then taking the average of the two averages and dividing it by the net initial investment. However, the after-tax
(c) HOCK international, page 11
$93,000
$90,000
$45,000
$40,000
Year 2
93,000
85,000
55,000
50,000
Year 3
93,000
75,000
65,000
60,000
Year 4
55,000
70,000
65,000
Year 5
50,000
75,000
75,000
$23,370
$29,827
$27,333
$(7,854)
18.7%
17.6%
17.2%
10.6%
1.12
1.13
1.14
0.96
C. The internal rate of return is the rate at which a project's net present value is zero. Since the IRR is a rate and the
NPV is a monetary amount, the two are not comparable.
D. The profitability index for an investment project is its discounted annual net cash inflows divided by its initial
cash investment. If a project profitability index is greater than 1.00, we know that its discounted annual net cash
inflows are greater than its initial cash investment. Since the net present value is the monetary gain (loss) of the
project's cumulative net cash flows, the net present value of a project with a P.I. of greater than 1.00 must be
positive.
$120,000
0.91
60,000
0.76
40,000
0.63
40,000
0.53
40,000
0.44
Totals
$300,000
3.27
Assuming that the estimated cash inflows occur evenly during each year, the payback period for the investment is
A. 1.50 years.
B. 1.67 years.
C. 2.50 years.
D. 3.94 years.
A. 1.5 years results from dividing the total undiscounted cash flows of $300,000 by the initial cash outflow of $200,000.
However, this is not the correct way to calculate the payback period.
B. A payback period of 1.67 years would result if the second year's cash flow were the same as the first year's cash flow.
However, that is not the case.
C. The payback period is, first, the number of the project year in the final year when cumulative cash flow
(including the initial investment) is negative, plus a fraction consisting of the positive value of the negative
cumulative cash inflow amount from the final negative year divided by the cash flow for the following year. In
this case, the final year in which the cumulative cash flow is zero is Year 2, because $(200,000) + $120,000 +
$60,000 = $(20,000). In the third year, the cash flow is $40,000. So $20,000 $40,000 = .5, and the payback period
is 2 + .5, or 2.5 years.
D. This is the discounted payback period, in which all cash flows are discounted and the cumulative discounted cash
flow is used to calculate the payback period. Although the discount factors are given in this problem, the problem does
not ask for the discounted payback period.
$120,000
0.91
60,000
0.76
40,000
0.63
40,000
0.53
40,000
0.44
Totals
$300,000
3.27
The capital budgeting model that is generally considered the best model for long-range decision making is the
A. Unadjusted rate of return model.
B. Accounting rate of return model.
C. Discounted cash flow model.
D. Payback model.
A. The unadjusted rate of return model, or accounting rate of return model, is not generally considered the best model
for long-range decision making, because it does not incorporate time value of money concepts.
B. The accounting rate of return model, or unadjusted rate of return model, is not generally considered the best model
for long-range decision making, because it does not incorporate time value of money concepts.
C. Discounted cash flow methods of capital budgeting, including net present value, internal rate of return, and
profitability index, are generally considered the best model for long-range capital budgeting decision making.
D. The payback method is not generally considered the best model for long-range decision making, because it does not
incorporate time value of money concepts.
Net Year
1
2
3
4
5
Period
1
2
3
4
5
After-Tax
Earnings
$100,000
100,000
100,000
100,000
200,000
Cash Flow
$160,000
140,000
100,000
100,000
100,000
Net Year
1
2
3
4
5
Period
1
2
3
4
5
Cash Flow
$160,000
140,000
100,000
100,000
100,000
.88
.88
33%
.77
1.65
45
.68
2.33
15
.59
2.92
The present value of the depreciation tax shield for the fourth year MACRS depreciation of Crane Company's new asset
is
A. $16,520.
B. $6,112.
C. $6,608.
D. $0.
A. An answer of $16,520 results from discounting the fourth year's depreciation amount to year 0. The question asks for
the present value of the fourth year's depreciation tax shield, not the present value of the fourth year's depreciation.
B. An answer of $6,112 results from using the gross asset cost less the salvage value to calculate the depreciation.
However, under MACRS, the depreciation rate is applied to the gross asset cost, not the depreciable base.
C. Although this question involves replacing one asset with another asset, we are not given information that
would enable us to do an incremental analysis of the difference (if any) between the depreciation on the new
asset versus the depreciation on the old asset. Thus, we will analyze this as if it were a new asset purchase, not
a replacement of an existing asset. Since depreciation under MACRS is applied to the gross purchase price of
the asset ($400,000) and the fourth year's depreciation will be 7% of $400,000, the fourth year's depreciation will
be $28,000. Crane's tax rate is 40%, so the depreciation tax shield is $28,000 .40, or $11,200. Since the
question asks for the present value of the depreciation tax shield for the fourth year, we will discount it using
.59 from the table (the PV of $1 at 14% for 4 years). $11,200 .59 = $6,608, which is the present value of the
depreciation tax shield for the fourth year of MACRS depreciation.
D. An answer of $0 results from failing to recognize that under MACRS, the "half-year convention" is normally used.
Under the half-year convention, one-half of one year's depreciation is taken in the first year the asset is placed in service.
For an asset with a three-year life, one year's depreciation would then be taken in each of years 2 and 3; and one-half of
one year's depreciation would be taken in year 4. Thus, the present value of the depreciation tax shield for the fourth
(c) HOCK international, page 32
.88
.88
33%
.77
1.65
45
.68
2.33
15
.59
2.92
The discounted net-of-tax amount that should be factored into Crane Company's analysis for the disposal transaction is
A. $60,000.
B. $67,040.
C. $68,000.
D. $45,760.
A. $60,000 is the cash flow from the disposition of the old asset, but that is not the only component of the discounted
net-of-tax amount that should be factored into Crane Company's analysis for the disposal transaction. The tax savings
from the loss on the disposition must also be considered.
B. We are told in the question, "Assume that any gain or loss affects the taxes paid at the end of the year in
which it occurred." Therefore, the tax savings that results from the $20,000 loss on the sale of the old
equipment that occurs in year 0 must be discounted for one year. The tax savings is $8,000 ($20,000 .40).
Discounted for one year at 14%, it is $8,000 .88, or $7,040. Cash flow from the disposal in year 0 is $60,000,
and no discounting is necessary. Thus, the discounted net of tax amount to factor into Crane Company's
analysis for the disposal transaction is $60,000 + $7,040, or $67,040.
C. An answer of $68,000 results from using the tax savings from the loss on the disposition at its gross, undiscounted
value. We are told in the question, "Assume that any gain or loss affects the taxes paid at the end of the year in which it
occurred." Therefore, the tax savings from the loss on the disposition should be discounted for one year.
D. An answer of $45,760 results from two errors: One, discounting the $60,000 cash that is received in year 0 for one
year, which is incorrect because the cash received in year 0 needs no discounting. And two, the answer results from
subtracting the present value of the tax savings from the present value of the cash received in the disposition, which is
incorrect. The tax savings is an increase to cash, not a decrease.
A. No Yes No
B. Yes Yes Yes
C. No Yes Yes
D. No No No
Period
0.89
0.89
33%
0.80
1.69
45
0.71
2.40
15
0.64
3.04
The discounted cash flow for the fourth year MACRS depreciation on the new asset is
A. $17,920.
B. $0.
C. $26,880.
D. $21,504.
A. Under MACRS depreciation using the half-year convention, 100% of an asset's cost is depreciated. A fourth year cash
flow of $17,920 results from subtracting the salvage value from the cost to determine the depreciable base. However,
under MACRS, salvage value is not used because 100% of the asset's cost is depreciated.
B. Under MACRS depreciation using the half-year convention, 100% of an asset's cost is depreciated. One-half of one
year's depreciation is taken in the first year the asset is owned, one-half of one year's depreciation is taken in the last
year it is depreciated, and one year's depreciation is taken in each of the other years of the asset's life. According to the
(c) HOCK international, page 36
Period
0.89
0.89
33%
0.80
1.69
45
0.71
2.40
15
0.64
3.04
The discounted, net-of-tax amount that relates to disposal of the existing asset is
A. $180,000.
B. $168,000.
C. $169,320.
D. $190,680.
A. $180,000 is the amount of cash to be received for the existing asset, but it does not include the effect of taxes due on
the gain. It also is not discounted.
Period
0.89
0.89
33%
0.80
1.69
45
0.71
2.40
15
0.64
3.04
The expected incremental sales will provide a discounted, net-of-tax contribution margin over 4 years of
A. $273,600.
B. $92,160.
C. $437,760.
D. $57,600.
A. $273,600 results from subtracting both the incremental fixed cost and the incremental variable cost from the
incremental revenue, netting out the tax effect, and discounting the resulting amount as an annuity for four years.
However, the $90,000 in incremental fixed cost should not be included in the calculation of a contribution margin. The
(c) HOCK international, page 38
Period
0.89
0.89
33%
0.80
1.69
45
0.71
2.40
15
0.64
3.04
The overall discounted-cash-flow impact of the working capital investment on Metro's project is
A. $(50,000).
B. $(18,000).
C. $(59,200).
(c) HOCK international, page 39
D. The cost of capital is frequently used as the required rate of return in discounting future cash flows to their present
value. Thus, it is used in net present value analysis.
.862
.862
Year 2
.743
1.605
Year 3
.641
2.246
Year 1
Year 2
Year 3
(160,000)
(160,000)
48,000
19,200
64,000
25,600
85,000
(34,000)
70,200
.862
60,512
85,000
(34,000)
76,600
.743
56,914
48,000
19,200
6,000
85,000
(34,000)
76,200
.641
48,844
.862
.862
Year 2
.743
1.605
Year 3
.641
2.246
Year 1 Year 2
Year 3
Initial Investment
(160,000)
Depreciation
48,000 64,000 48,000
Depreciation Tax Shield (Depr. * .40)
19,200 25,600 19,200
Cash from disposition RECD @ YEAR END (after
6,000
tax)
Operating cash flows
85,000 85,000 85,000
Tax on operating cash flow at 40%
(34,000) (34,000) (34,000)
Net Cash Flow excluding cash from disposition
(160,000) 70,200 76,600 70,200
Cumulative Cash Flow excluding cash from
disposition (undiscounted)
(160,000) (89,800) (13,200) 57,000
When calculating the payback period, operating cash flows are usually assumed to be received evenly
throughout each year of the project's life. However, the $6,000 received from disposition of the asset is not
received until the end of the project, which is at the end of Year 3. Therefore, it is handled differently from
operating cash flows. It is not included in the calculation of the payback period in this case, because it occurs
at the end of the year, while operating cash flows are assumed to occur evenly throughout the year. Thus, the
payback period would end before the disposition occurs. Note that it is not a part of the net cash flow used to
calculate the payback period. The cumulative cash flow from the project becomes positive during year 3. The
payback period is 2.19 years, calculated as follows:
Number of the project year in the final year when cash flow is negative, which is 2
Plus: a fraction consisting of
Numerator = the positive value of the negative cumulative inflow amount from the final negative year - 13,200
Denominator = cash flow (excluding disposition) for the following year: 70,200
OR : 2 + (13,200/70,200) = 2.19
Since the disposition of the asset occurs after the payback period, it is not a part of the payback period
calculation.
$65,000 $100,000
$80,000
$95,000
Year 2
70,000
135,000
95,000
125,000
Year 3
80,000
90,000
90,000
90,000
Year 4
40,000
65,000
80,000
60,000
(3,798)
4,276
14,064
14,662
Profitability Index
98%
101%
106%
105%
11%
13%
14%
15%
Which project(s) should Capital Invest Inc. undertake during the upcoming year assuming it has no budget restrictions?
A. Projects 1, 3, and 4.
B. Projects 2, 3, and 4.
C. Projects 1, 2, and 3.
D. All of the projects.
A. No project with a negative NPV should be accepted, and Project 1 has a negative NPV.
B. When a company has no restrictions on its capital investments, it should undertake all projects with positive
NPVs, because any project with a positive NPV will increase shareholder wealth. Projects 2, 3 and 4 all have
positive NPVs, so all should be accepted. Note also that the Internal Rates of Return for Projects 2, 3 and 4 are
all greater than Capital Invest's 12% hurdle rate; and the Profitability Indices for Projects 2, 3 and 4 are greater
than 100%.
C. No project with a negative NPV should be accepted, and Project 1 has a negative NPV.
D. No project with a negative NPV should be accepted, and Project 1 has a negative NPV.
$65,000 $100,000
$80,000
$95,000
Year 2
70,000
135,000
95,000
125,000
Year 3
80,000
90,000
90,000
90,000
Year 4
40,000
65,000
80,000
60,000
(3,798)
4,276
14,064
14,662
Profitability Index
98%
101%
106%
105%
11%
13%
14%
15%
Which project(s) should Capital Invest Inc. undertake during the upcoming year if it has only $600,000 of funds available?
A. Projects 3 and 4.
B. Projects 2 and 3.
(c) HOCK international, page 48
$80,000
$95,000
Year 2
$65,000 $100,000
70,000
135,000
95,000
125,000
Year 3
80,000
90,000
90,000
90,000
Year 4
40,000
65,000
80,000
60,000
(3,798)
4,276
14,064
14,662
Profitability Index
98%
101%
106%
105%
11%
13%
14%
15%
Which project(s) should Capital Invest Inc. undertake during the upcoming year if it has only $300,000 of capital funds
available?
A. Project 3.
B. Project 1.
C. Projects 3 and 4.
D. Projects 2, 3, and 4.
A. The Profitability Index represents the ratio of the benefits (net cash inflows) to the costs (net initial
investment). Thus, it can identify the project with the greatest return per dollar of investment. The Profitability
Index enables us to rank different sized investments, since the Profitability Index expresses profitability on a
percentage basis rather than a total dollar amount basis. It is very useful for comparing multiple investments
that are of different investment amounts. In this case, we can accept only one project because of the limitation
in capital. The project with the highest Profitability Index is Project 3, even though it does not have the highest
NPV or IRR. Although its NPV is lower than the NPV of Project 4, Project 3 requires only $248,000 of capital
outlay compared with $272,000 required for Project 4.
B. No project with a negative NPV should be accepted, and Project 1 has a negative NPV.
C. Capital Invest has only $300,000 to invest, and Projects 3 and 4 require more capital than the amount available.
Annual Net
After-Tax
Cash Flow
$
Annual
Net
Income
$250,000
168,000
120,000
35,000
100,000
108,000
39,000
50,000
96,000
43,000
18,000
84,000
47,000
72,000
51,000
.89
.89
.80
1.69
.71
2.40
.64
3.04
.57
3.61
.51
4.12
Annual Net
After-Tax
Cash Flows
$
Annual
Net
Income
$250,000
168,000
120,000
35,000
100,000
108,000
39,000
50,000
96,000
43,000
18,000
84,000
47,000
72,000
51,000
.89
.89
.80
1.69
.71
2.40
.64
3.04
.57
3.61
.51
4.12
$250,000
168,000
120,000
100,000
108,000
39,000
50,000
96,000
43,000
18,000
84,000
47,000
72,000
51,000
35,000
.89
.89
.80
1.69
.71
2.40
.64
3.04
.57
3.61
.51
4.12
Which one of the following correctly identifies the methods that utilize discounted cash-flow (DCF) techniques?
A. IRR and NPV.
B. IRR and ARR only.
C. IRR and Payback only.
D. Payback and NPV only.
For tax purposes, the depreciable base is 100% of an asset's cost, regardless of which depreciation method is
used and regardless of whether salvage value is expected.
D. This answer results from multiplying the pre-tax net cash flow by the tax rate, .40, to calculate the after-tax net cash
flow. The pre-tax cash flow should be multiplied by 1 the tax rate to calculate after-tax cash flow.
For tax purposes, the depreciable base is 100% of an asset's cost, regardless of which depreciation method is
used and regardless of whether salvage value is expected.
Accordingly, the revised NPV for the tax shield (rounded to the nearest thousand) should be
A. $109,000
(c) HOCK international, page 60