Capital Investments

Medium Practice Test

Introduction to Accounting

Things You Must Know

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Self Test

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Easy Practice Test

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Medium Practice Test

Medium Practice Test

Click the “Check Your Answer” box below each question to reveal the correct answer and explanation.

1. When the first investment has a payback of 5 years and a second investment has a payback period of 4 years, the first investment will be

a. less profitable than the second investment
b. more profitable than the second investment
c. equally profitable to the second investment
d. can’t tell, payback is not an indication of the level of profitability
Answer
D. Payback is not an indication of profitability. It is a measure of liquidity. A return of cash is not a profit. It does not consider the time value of money.

2. When the discount rate decreases

a. net present value of future cash flows increases
b. net present value of future cash flows decreases
c. indicates a higher risk or return
d. the internal rate of return decreases
Answer
A. The net present value of future cash flows moves opposite of the discount rate. As the discount rate decreases, present value increases. You must have more now to earn an amount in the future if the rate you earn is less.

3. The decision regarding an acceptable investment under the net present value method is based on

a. net present value is higher than additional operating expenses
b. net present value must be equal or less than the internal rate of return
c. net present value must be positive relative to cost of capital
d. net present value must be less than the cost of capital
Answer
C. Under the net present value method, a positive net present value means that the investment will return more than the discount rate or cost of capital. A higher return than required means it is an acceptable investment. Net present value is not ever compared to operating expenses or a rate of return such as cost of capital.

4.The relationship between internal rate of return and payback period

a. payback period of 5 will give an internal rate of return of 5%
b. payback period is the factor used to determine the rate
c. a payback period that is shorter than desired will also give an internal rate of return that is lower than desired
d. all of the above
Answer
B. Payback period and internal rate of return use the same formula. Payback period uses the result as the number of years to recover the cash invested. Internal rate of return uses the result as a factor to use in the present value table to determine the rate of return. Payback period does not discount cash flows and the internal rate of return does consider the discount (interest earned). They are not comparable methods.

5. Which will increase the net present value of an investment in a new product line?

a. an increase in cash outflows
b. a decrease in the life of the equipment
c. an increase in the estimated variable incremental expenses
d. an increase in the volume of units sold

Answer
D. An increase in the net present value can be accomplished by an increase in net cash flows or a decrease in the discount rate. Increasing the volume of units sold should increase revenues which is a cash inflow. All others will decrease net cash flows.

6. An investment with a positive net present value using a discount rate of 10% will also have

a. an internal rate of return of higher than 10%
b. an internal rate of return equal to 10%
c. a payback period of 10%
d. an accounting rate of return of more than 10%

Answer
A. A positive net present value means the investment is earning more than the discount rate of 10%. The internal rate of return is what the investment earns. Payback has nothing to do with net present value. Accounting rate of return is not comparable to net present value because it considers non cash expenses and will most likely give a lower rate of return.

7. The method used for capital investment decisions that does not use only cash flows is

a. payback
b. accounting rate of return
c. net present value
d. internal rate of return 

Answer
B. The accounting rate of return considers depreciation expense and other non cash expenses. All other methods use only cash inflows and cash outflows.

8. When all other factors remain the same and the cost of capital increases materially

a. fewer capital investments will be acceptable
b. more capital investments will be acceptable
c. internal rate of return will increase for most projects
d. accounting rate of return will increase for most projects 

Answer
A. An acceptable investment means the investment will return more than the required rate of return or cost of capital. A higher required return will mean that less investments will return that required rate. The internal rate of return is a function of net cash flows and the cost of the initial investment. Internal rate of return will not change when the cost of capital changes. The accounting rate of return does not change with the required rate or cost of capital. Internal rate of return and accounting rate of return are compared to the cost of capital and are not affected by the cost of capital.

9. Which of the following is generally not important when making a capital investment decision using discounted cash flow methods?

a. the timing of the cash flows associated with the investment
b. the amount of cash outflows associated with the investment
c. the method of financing that will be used for the investment
d. the cost of capital 

Answer
C. The method of financing is not important when determining whether or not the investment should be made. This is a separate decision. The timing and amount of all cash flows and the discount rate associated (the cost of capital) are very important when determining if the investment will return more than the cost of capital.

10. When total cash inflows of an investment are higher than total cash outflows of the investment

a. the investment should always be made
b. the internal rate of return will always be greater than 0
c. the payback period is always acceptable
d. none of the above is correct 

Answer
B. Internal rate of return is computed using the investment divided by annual cash flows. As long as the net cash flows are positive, the rate of return will be greater than zero, even though it may be a very, very small return. Positive cash flows does not mean that the investment will yield a return higher than required or that the net cash inflows will occur within an acceptable time frame.

11. A company has a mainframe/server computer system that it is considering replacing for a more efficient system. The company’s cost of capital is 12%. If the current system is not replaced, it will be used for another 5 years. The new system is expected to be used for 5 years. The following data has been gathered:

 

                                                                           Current  System               New  System

Purchase cost                                                  $150,000                           $250,000
Accumulated depreciation System              $100,000
Annual operating costs                                 $ 40,000                             $ 28,000
Salvage value now                                         $ 20,000
Salvage – 5 years from now                         $ 10,000                              $ 40,000
Required working capital – expensed 1st year                                     $ 10,000
Additional annual efficiency savings                                                      $ 65,000

A. Compute the net present value for the two alternatives. Keep the old system or replace the old system with a new system

B. Compute the internal rate of return for investing in the new system

Answer

A. Compute the net present value of both alternatives:

Keep the current system:

                                                                                                                  12%                                                         
                                                                                                                   PV                             Present
Cash flow descr.           Years          Amount of cash           x           Factor           =           Value of CF
Net annual cash
flows                              1-5             ($40,000)                                     3.605                          ($144,200)
Salvage value                Yr. 5          $10,000                                       .567                             $ 5,670
                                        Total Net Present Value                                                                  ($138,530)

Ignore the old cost and the depreciation. They are sunk costs and not future cash flows. Ignore the salvage value now, because if you keep the computer you won’t be selling now, you will be selling in 5 years. Use the salvage value 5 years from now.

Purchase the new system:

 

                                                                                                        
                                                                                                                                                     
Cash flow descr.            Years          Amount of cash           x         12% PV Factor           =         Present Value of CF

Purchase                          0                ($250,000)                                1.0                                          ($250,000)

Cash outflow                  1-5              ($ 28,000)                                  3.605                                     ($100,940)

Cash savings                  1-5              $ 65,000                                     3.605                                     $ 234,325

Working capital              0                 ($ 10,000)                                  1.0                                         ($ 10,000)

Sell old computer          0                 $ 20,000                                     1.0                                         $ 20,000

Salvage value               yr 5               $ 40,000                                     0.567                                    $ 22,680

                                                 Total Net Present Value                                                                   ($83,935)

Working capital is expensed and is not turned into cash inflow at the end of 5 years.

This is an example of a decision to reduce costs as much as possible.

The company incurs a better return compared to the 12% required if they purchase the new computer system than if they keep the old system.

Therefore, the company should purchase the new computer system.

B. Compute the internal rate of return for investing in the new system

PV Factor = 6.756           Investment required           $250,000           Inflows                       $65,000
                                          Net annual cash flows         $ 37,000           – Outflows                 $28,000
                                                                                                                   = Net Annual CFs       $37,000

Go to the present value of an annuity table and go down to period 5 and across until you get closest to 6.756 The return will be less than 1%.

The decision is how to minimize the cost to the company.

Even though the computer does not meet the 12% required rate of return it should be considered because it will reduce costs below current costs.

12. A company is considering adding a new product line that would require significant long-term investment. Machines costing $200,000 that would be used for 10 years and sold for $30,000 will have to be purchased. The company will incur $60,000 per year in annual operating expenses to support the product line. Other fixed manufacturing costs would increase $37,000 per year. Revenues are very difficult to estimate as this is a product line that is new to the market place. The company’s required rate of return is 16% for capital investments.

How much revenue would the product line have to generate in order for the product line to meet the 16% required rate of return?

Answer

Cash flow descr.          Years        Amount of cash      x    16% PV  Factor      =     Present Value of CF

Purchase                        0               ($200,000)                     1.0                                  ($200,000)

Cash outflow                1-10          ($60,000)                        4.833                              ($289,980)

Cash outflow                1-10          ($20,000)                        4.833                             ($ 96,660)

Salvage value               yr 10         $ 30,000                         .227                                $ 6,810

Subtotal                                                                                                                         ($ 579,830)

Required Revenues
cash flow in                1-10             ?                                      4.833                             $         ?
__________________________________________________________________________________________________
Total Net Present Value                                                                                                       $0

Depreciation expense is $200,000 – $30,000 = $170,000 / 10 = $17,000

Cash outflow = Fixed manufacturing overhead expenses of
$37,000 – $17,000 depreciation = $20,000

Net present value (NPV) equal 0 gives an internal rate of return of 16%.
Revenues generated have to equal a positive present value of 579,830
to make NPV = 0.

Annual cash inflows required:

$579,830 / 4.833 = $119,973 each year.

13. A company is considering the purchase of an asset that would cost $80,000, be used for 8 years, and have a salvage value of $20,000 at the end of use. The asset would generate cash inflows of $38,000 annually and the company would incur $36,000 of annual expenses which includes depreciation. Additional working capital required initially in the amount of $24,000 would be recovered at the end of 8 years. Extensive maintenance on the asset costing $60,000 would be required at the end of 6 years. The company’s cost of capital is 10% and the required rate of return is 12%.

 

A. Compute the net present value of investing in the asset
B. Compute the internal rate of return of investing in the asset
C. Compute the payback period of the investment in the asset.
D. Compute the accounting rate of return for investing in the asset.

Answer

A. Compute the net present value of investing in the asset

Use the required rate of return (RR) for the NPV table. It is common that the RR is higher than the cost of capital in order to give profits.

Cash flow descr.             Years            Amount of cash        x         12% PV Factor        =        Present Value of CF

Purchase                          0                   ($80,000)                               1.0                                      ($80,000)

Cash outflow                  1-8                ($28,500)                               4.9676                                ($141,577)

Cash inflow                    1-8                 $38,000                                 4.9676                                $188,769

Salvage value                yr 8                $ 20,000                                .4039                                   $ 8,078

Working Cap                  0                    ($24,000)                               1.0                                       ($24,000)

Work Cap Rec.              8                     $24,000                                  .4039                                  $9,694

Maintenance                6                      ($60,000)                              .5066                                   ($30,396)

                        Net Present Value                                                                                                   ($69,432)

Depreciation = $80,000 – $20,000 = $60,000 / 8 = $7,500 each year
Annual expenses – depreciation = $36,000 – $7,500 = $28,500 cash outflows

The asset will earn less than 12%.

 

B. Compute the internal rate of return for investing in the asset

PV Factor = 8.421             Investment required           $80,000             Cash Inflows              $38,000
                                            Net annual cash flows        $ 9,500              – Cash Outflows       $28,500
                                                                                                                        = Annual CFs            $ 9,500

Go to the present value of an annuity table and go down to period 8 and across until you get closest to 8.421 The return will be less than 1%.

 

C. Compute the payback period of the investment in the asset.

Investment required                   $80,000
Net annual cash flows                $ 9,500 =

8.421 years to get cash investment back at 0% interest

You should notice this is longer than the asset will be used.

 

D. Compute the accounting rate of return for investing in the asset.

Annual net cash flows – Annual depreciation
                     Initial Investment

38,000 – 28,500 – 7,500 = 2.5%
                  80,000