Chapter 26 Review

Managerial Accounting

1. List and describe the 4 methods of analyzing potential capital investments. Are these an exact
science? Why or Why not?
a. Payback Period- Amount invested/estimated annual net cash inflows, measures
how long in years it takes an investment to pay itself off.
Strength- easy to calculate.
Weakness- It only accounts for the cash flows until the asset pays itself back. Any
capital investment model that doesn’t take into account the time value of Money is
a poor model.
b. Accounting Rate of Return- Average Annual Operating Income from an
asset/average amount needed in an asset, this is a superior model because it takes
into account actual factors, cash in and cash out, denominator is just (cost + salvage
value)/2
Strength: Well-rounded measurement, measures income, not just cash flows,
measures them for the entire useful life.
Weakness: only cash outflow considered is depreciation, it doesn’t take into account
the time value of money, therefore it’s a poor model.
c. NPV (Net Present Value)- Total cash inflows – amount invested
Strengths- It is a time value based calculation. We can guess if it will return us a
profit or not, but not all too confident.
Weakness- It doesn’t take into account depreciation. It’s only net cash flows. The
dollar value bias is built in, we think if it’s a positive value its good or negative its
bad.
d. Profitability Index- Total Cash inflows/Investment. Or NPV of FC/Investment.
Strength- It gives us a score. It removes a dollar value bias. Need a minimum of 1.0
to breakeven and higher than 1.0 is profit.
Weakness- It is not certain and has built in risk because we are working on
estimated cash flows.
(Not an exact science, estimating future cash flows)
2. Describe the capital budgeting process from start to finish. Which step would be considered to
be the most valuable and why?
1. Identify potential investments
2. Estimate cash inflows- looked at what the asset did for us.
3. Analyze investment using method(s)- Apply the Payback period, AROR, NPR, Profitability
index methods.
4. Capital rationing to choose options- Which one pays back in shortest amount of
time/highest return percentage is the best. If asset doesn’t payback, disqualify asset. Drop
the asset right there if it doesn’t meet the Rate of Return. Pick a winner from the
Profitability index. NPV method: If positive NPV, it’s good, choose highest dollar amount for
 superior model. Disqualify NPV is negative or doesn’t breakeven. Profitability index: 1.0 or
greater is good profitability index.
5. Post-audits to compare outcomes- Did it workout like I wanted it to? Learn to cut things off
before it breaks you, if it’s not working for what it’s worth, toss it.

3. Logan, Inc. is evaluating two possible investments in depreciable plant assets. The company uses
the straight-line method of depreciation. The following information is available:
 All Annuities in this problem

Investment A Investment B Investment C

Initial capital investment $60,000 $90,000 $250,000
Estimated useful life 3 years 3 years 3 years
Estimated residual value —0— —0— 0
Estimated annual net cash inflow for 3 $91,000
years $25,000 $40,000
Required rate of return 10% 12% 12.75%
a. What is the payback period for all of the investments?
b. Which is superior and why?

4. Dylan Company is considering an investment in new equipment costing $720,000. The

equipment will be depreciated on a straight-line basis over a five-year life and is expected to
have a salvage value of $45,000. The equipment is expected to generate net cash flows totaling
$970,000 during the five years.
a. What is the rate of return associated with the equipment investment?
b. What are the strengths and weaknesses of the ROR measurement?
5. Simms Manufacturing is considering two alternative investment proposals with the following data:

Proposal X Proposal Y
Investment $620,000 $400,000
Useful life 8 years 8 years
Estimated annual net cash inflows for 8
years $130,000 $80,000
Residual value $0 $0
Depreciation method Straight-line Straight-line
Discount rate 9.75% 10.85%
a. What type of cash flows are these?
b. What formula should we use to calculate the factor for this problem?
c. Which is a superior method? Show all work!
6. Sun Company is considering purchasing new equipment costing $350,000. Sun's management
has estimated that the equipment will generate cash inflows as follows:
 These are Lump Sums

Investment X Y Z
Discount Rate 10.25% 9.75% 12.65%
Year 1 $100,000 200,000 150,000
Year 2 $100,000 95000 150000
Year 3 $125,000 85000 90000
Year 4 $125,000 80000 75000
Year 5 $75,000 65000 60000
a. What is the net present value of each investment?
b. Which is superior and why?

7. Carte Blanco Company is evaluating an investment of $1,000,000 which will yield cash flows of
$257,000 per year for 5 years with no residual value. What is the internal rate of return?
(Please choose the rate that is closest to the actual solution.)

Present Value
of an Annuity
of $1
5% 6% 7% 8% 9% 10%
1 0.952 0.943 0.935 0.926 0.917 0.909
2 1.859 1.833 1.808 1.783 1.759 1.736
3 2.723 2.673 2.624 2.577 2.531 2.487
4 3.546 3.465 3.387 3.312 3.240 3.170
5 4.329 4.212 4.100 3.993 3.890 3.791