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Exam 16: Planning for Capital Investments

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Question 31

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Omicron Company is considering purchasing equipment that would cost $60,000 and have a useful life of 5 years. The equipment is expected to provide net cash inflows of $16,000 per year. Omicron's cost of capital is 12%. Required: Estimate the internal rate of return for this capital investment. Is this an acceptable investment?

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$60,000/$16,000 = 3.750 = present value ...

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Question 32

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A capital investment project may provide cash inflows from:

A) incremental revenues.
B) cost savings.
C) the salvage value of the investment.
D) all of these answers are correct.

E) A) and B)
F) C) and D)

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Question 33

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Mary needs to have $20,000 one year from today. The formula to compute the amount of money that must be invested today is future value/(1 - interest rate).

A project's net present value can be found by subtracting the cost of the project from the total present value of the future cash flows generated by the project.

Gordon Company is considering a three-year capital investment that will return $150,000 per year. The present value of this annuity at the company's required rate of return of 12% is $360,275. Required: Complete the table that has been started below to show the return on investment at 12% and the amount of investment recovered each year. Remember that the investment balance should be zero at the end of the three years. $\begin{array}{|c|c|c|c|c|c|}\hline& \text { a } & \text { b } & c & d & \\\hline& \text { Investment } & \text { Annual } & \text { Return on } & \text { Recovered } & \text { Year-end } \\\hline TIME&\text { Balance During } & \text { Cash } & \text { Investment } & \text { Investment } & \text { Investment } \\\hline period&\text { the Year } & \text { Inflow } & & & \text { Balance } \\\hline1& \mathrm{S} \quad 360,275 & & & & \\\hline2\\\hline3\\\hline\end{array}$

Indicate whether each of the following statements is true or false. 1. The net present value method provides a direct measure of the rate of return to be expected from a capital investment project. 2. Managers who want to know the rate of return to expect from a capital investment project should calculate the net present value. 3. The internal rate of return for a capital investment is the rate that would produce a net present value of zero. 4. For a capital investment project to be acceptable, the internal rate of return should be higher than the hurdle rate. 5. A capital investment project that has a positive net present value may have an internal rate of return that is lower than the hurdle or required rate of return.

Six years ago, Neighborhood Hardware paid a contractor $45,000 to expand the store. At that time, the company calculated a net present value of about $6,000 for the expansion. Now, the company believes that the investment increased annual cash inflows by $8,000 per year for each of the six years. The company has a desired rate of return of 10%. What was the net present value actually achieved for this capital investment? (Do not round your PV factors and intermediate calculations. Round to the nearest dollar.)

A capital investment with an internal rate of return equal to or greater than the required rate of return is considered to be an acceptable investment.

The unadjusted rate of return is found by dividing the average incremental increase in annual operating income by the cost of the investment.

What is a postaudit of a capital investment decision, and how should the postaudit be conducted?

Describe how the unadjusted rate of return for a capital investment is calculated. Should it be based on the net cost of the investment or the average investment?

Kerwin Company is considering purchase of equipment that costs $50,000. If the useful life is expected to be 5 years and Crown's required rate of return is 12%, what is the minimum annual cash inflow that the equipment must offer for the investment to be acceptable? (Do not round your PV factors and intermediate calculations. Round your final answer to the nearest dollar.)

Burgess Corporation is considering purchasing equipment that costs $235,000. The equipment has an estimated useful life of 5 years and no salvage value. Burgess believes that the annual cash inflows from using the equipment will be $65,000. Required: 1) Calculate the net present value of the equipment assuming that Burgess's cost of capital is 12%. Is the equipment an acceptable investment? 2) Calculate the net present value of the equipment assuming that Burgess's cost of capital is 10%. Is the equipment an acceptable investment? 3) Based on your results to parts 1) and 2), estimate the internal rate of return for the investment in the equipment.

Young Corporation is considering purchasing equipment that costs $80,000 and is expected to provide the following cash inflows over its five-year useful life: $\begin{array} { | l | l | } \hline \text { Year } & \text { Cash inflow } \\\hline 1 & \$ 18,000 \\\hline 2 & 22,000 \\\hline 3 & 24,000 \\\hline 4 & 16,000 \\\hline 5 & 9,000 \\\hline\end{array}$ What is the payback period of this investment project (rounded to the nearest year) ?

Bristles Hair Salon is considering installing spray tanning booths. The booths cost $220,000 and have an estimated five-year useful life. Ignore income taxes. The following pro forma income statement is provided: $\begin{array}{l}\begin{array}{|l|r|r|}\hline \text {Spray booth revenue }&&\$95,000\\\hline \text { Less expenses: }\\\hline \text { Supplies } & \$ 15,000 & \\\hline \text { Insurance } & 5,000 & \\\hline \text { Depreciation } & 44,000 & \\\hline \text { Maintenance } & \underline{6,000} & \underline{70,000} \\\hline \text { Net income } & & \$ 25,000 \\\hline\end{array}\end{array}$ Required: 1) Bristles would like to recoup its original investment in less than four years. Compute the payback period for the tanning booth investment. Would you recommend that the booths be purchased? Why or why not? 2) Bristles' minimum acceptable unadjusted rate of return is 11%. Compute the unadjusted rate of return on the original investment. Would you recommend that the booths be purchased? Why or why not?

Which of the following cash flow patterns represents of an annuity? $\begin{array} { | l | c | c | c | c | c | c | } \hline & \text { Year 1 } & \text { Year 2 } & \text { Year 3 } & \text { Year 4 } & \text { Year 5 } & { \text { Year 6 } } \\\hline \text { A) } & \$ 1,000 & \$ 1,000 & \$ 1,000 & \$ 1,000 & \$ 1,000 & \$ 1,000 \\\hline \text { B) } & \$ 500 & \$ - 0 - & \$ 500 & \$ 500 & \$ 500 & \$ - 0 - \\\hline \text { C) } & \$ 100 & \$ 200 & \$ 300 & \$ 400 & \$ 500 & \$ 600 \\\hline\end{array}$

Which one of the following statements describes an ordinary annuity?

Indicate whether each of the following statements is true or false. 1. The further into the future a cash receipt is expected to occur, the higher is its present value. 2. The return on investment measures the compensation a company expects to receive from investing in capital assets. 3. Most companies use their cost of capital to estimate the minimum return on investment required from capital investments. 4. When a company invests in capital assets, it sacrifices present dollars for the opportunity to receive future dollars. 5. The required rate of return on a capital investment is also referred to as the hurdle rate or discount rate.

A cash flow that only occurs in equal amounts each year is referred to as:

An annuity is a series of equal payments over equal time intervals that earn a constant rate of return.