CAPITAL BUDGETING

PAGE 636Chapter 14 Capital Budgeting

MULTIPLE CHOICE - 2

Traditional evaluation models

1.The payback capital budgeting technique considers

Income over entire Time value

life of project

of money

A. No

No

B. No

Yes

C. Yes

Yes

D. Yes

No

(aicpa)

1.A

?The one considered by the payback capital budgeting technique.(Payback period measures the length of time over which the cost of investment is recovered. It is determined by dividing the net cost of investment over annual net cash inflows. Payback period does not consider the net income and time value of money, choice-letter a is correct.

2.Which one of the following statements about the payback method of investments analysis is correct? The payback method

A. Does not consider the time value of money.

B. Considers cash flows after the payback has been reached.

C. Uses discounted cash flow techniques.

D. Is rarely used in practice.

(cma)

2.A

?A correct statement about payback period.(Payback period estimates the stretch of time before the cost of investment is recouped. It is the point in time where the cumulative cash inflows equal cost of investment. Payback period does not consider the time value of money, choice-letter a is correct.

Choice-letters b, c, and d are incorrect statements regarding payback period. Payback period considers cash flows before and after the payback period; it does not use discounted cash flows techniques; and is popularly used in practice.

3.A machine costing P1,000 produces total cash inflows of P1,400 over 4 years. Determine the payback period given the following cash flows:

After-tax

Cumulative

Year Cash FlowsCash Flows

1

P400

P 400

2

300

700

3

500

1,200

4

200

1,400

A. 2 years.C. 2.86 years.

B. 2.60 years.

D. 3 years.

(cma)

3.B

?The payback period.(Payback period is where the cumulative cash flows equal the cost of investment. It is the breakeven time. The cost of investment is P1,000, and by end of second year the cumulative cash is already P700, while the total cash be the end of third year is already P1,200. The payback period is between second year and third year. The get the exact payback period, the fraction in the third year is 0.60 [i.e., (P1,000 P700) / P500]. Therefore, the payback period is 2.6 years.

4.Nakane Company is planning to purchase a new machine for P500,000. The new machine is expected to produce cash flows from operations, before income taxes, of P135,000 a year in each of the next five years. Depreciation of P100,000 a year will be charged to income for each of the next five years. Assume that the income tax rate is 40%. The payback period would be approximately

A. 2.2 years.C. 3.7 years.

B. 3.4 years.

D. 4.1 years.

(aicpa)

4.D

?The payback period.(When cash flows are uniform, payback period is computed by dividing cost of investment over net cash inflows. The given cash flows are before taxes. The net cash inflows are still to be calculated as follows:

Cash flows before taxes

P135,000

- Depreciation expense

100,000

Income before income tax

35,000

- Income tax (40%)

14,000

Net income

21,000

+ Depreciation expense

100,000

Net cash inflows

P121,000

The payback period is 4.1 years (i.e., P500,000/P121,000).

5. An investment project is expected to yield P10,000 in annual revenues, will incur P2,000 in fixed cost per year, and requires an initial inventory of P5,000. Given a cost of goods sold of 60% of sales and ignoring taxes, what is the payback period in years?

A. 2.50C. 2.00

B. 5.00D. 1.25

(cia)

5.A

?The payback period.(The cash flows from operations is determined as follows:

Sales

P10,000

Cost of goods sold (P10,000 x 50%)( 6,000)

Fixed costs

( 2,000)

Cash flows from operations

P 2,000The payback period is 2.50 yrs (i.e., P5,000/P2,000).

6.Sweets, Etc., Inc. plans to undertake a capital expenditure requiring P2 million cash outlay. Below are the projected after-tax cash inflows for the five-year period covering the useful life. The companys tax rate is 35%

YearP000

1600

2700

3480

4400

5400

The founder and president of the company believes that the best gauge for capital expenditures is cash payback period and that the recovery period should not be more than 75% of the useful life of the project or the asset. Should the company undertake the project?

A. No, since the payback period is 4 years or 80% of the useful life of the project.

B. Yes, since the payback period is 3.55 years or 71% of the useful life of the project

C. No, since the payback period extends beyond the life of the project.

D. Yes, since the payback period is 4 years and still shorter than the useful life of the project.

(rpcpa)

6.B

?The decisions as to whether undertake the project or not using the payback period as criterion.(Payback period (also called as breakeven time) indicates the length of time before an investment cost is fully recovered. The problem gives an unequal (irregular) cash inflows after tax. Payback period is then determined by getting the cumulative cash inflows until such time that it equals the net cost of investment (P2 million):

Annual net cash

Cumulative

Payback

Year

Inflow, after tax

Cash flows

Period

1

P600,000

P 600,000

1.0

2

700,000

1,300,000

1.0

3

480,000

1,780,000

1.0

4

400,000

2,000,000

0.55 *

Payback Period

3.55 years

* [(P2,000,000 P1,780,000) / 400,000)]The remaining P220,000 cash (P2 million - P1,780,000) is expected to come from the cash flows in the 4th year. That is why the fraction of a year after the 3rd year but before the 4th year is P220,000 divided by P400,000 or 0.55. Hence, the payback period is 3.55 years.

7.Mary Company recently acquired a machine at a cost of P64,000. It will be depreciated on a straight-line basis over eight years with no estimated salvage value. Mary estimates that this machine will produce an annual net cash inflow (before income taxes) of P18,000. Assuming an income tax rate of 35%, what is the approximate payback period on the investment?

A.4.4 years.

C. 7.1 years

B. 12.8 years.

D. 3.6 years

(rpcpa)

7.A

?The approximate payback period.(Payback period (breakeven time) indicates the length of time before an investment could be recouped. At this period of time, the total cash flows is already equal to the net cost of investment. Let us determine then annual cash inflows, then later, the payback period.Annual cash inflows before tax

P18,000

- Depreciation expense (P64,000/8 yrs.)

( 8,000)Income before income tax

10,000

- Tax

3,500Net income

6,500

+ Depreciation expense

8,000Net cash inflows

P14,500Therefore, payback period is:

Payback period= Net cost of investment / Annual cash inflows

= P64,000 / P14,500 = 4.4 years

8.Which of the following is necessary in order to calculate the payback period for a project?

A. Useful life.

B. Minimum desired rate of return.

C. Net present value.

D. Annual cash flow.

(aicpa)

8.D

?An item necessary in computing the payback period.(Payback period is cost of investment divided by net cash inflows. Hence, choice-letter d is correct. Choice-letter a is incorrect because useful life is not needed in the computation of net cash inflows. Choice-letter b is incorrect because the concept of minimum desired rate of return is not relevant since payback period speaks of time of return and not rate of return. Choice-letter c is incorrect because payback period does not consider the time value of money.

9. Given these data:

Net after tax inflows are: P24,000 for year 1, P30,000 for year 2, P36,000 for year 3, and P30,000 for year 4.

Initial investment outlay is P60,000.

Cost of capital is 18%.

Determine the payback period for this investment:

A. 2.5 years.

C. 3.00 years.

B. 2.17 years.

D. 3.17 years.

(rpcpa)

9.B

?The payback period.(Payback period (or the breakeven time) is the point in time where the cost of investment is equal to the cumulative cash inflows. It indicates on low long should an investor wait before his investment is recovered. The shorter the payback period, the better it would be.If the annual cash inflows are even (or uniform, equal), the payback period is net cost investment divided by the annual cash inflows. In this problem, however, the annual cash inflows are uneven or unequal. The payback period is determined as follows:

YearAnnual cash InflowsCash to datePayback

years

1P24,000P24,0001.0

230,00054,0001.0

336,00060,000 0.17*

Total2.17

* [(P60,000 P54,000) / P36,000)]

10.Jasper Company has a payback goal of 3 years on new equipment acquisitions. A new sorter is being evaluated that cost P450,000 and has a 5-year life. Straight-line depreciation will be used; no salvage is anticipated. Jasper is subject to a 40% income tax rate. To meet the companys payback goal, the sorter must generate reductions in annual cash operating costs of

A. P60,000C. P150,000

B. P100,000D. P190,000

(cma)

10.D

?The amount of reductions in annual cash operating costs.(The cash savings from operations, (or the cash flows before taxes) shall be determined backwards following the normal computations of the net cash inflows, as follows:Cash flows before taxes

P190,000

- Depreciation expense

90,000Income before income taxes (P60,000/60%) 100,000

- Income taxes (P100,000 x 40%)

40,000Net income

60,000

+ Depreciation expense P(450,000 / 5 yrs.) 90,000Net cash inflows(P450,000/3 yrs.)

P150,000The net cash inflows are computed using the payback period of 3 years. The net income is computed backward by deducting from the net cash inflows the amount of depreciation expense. The income before income taxes is determined by dividing the net income over 60% (i.e., 1 tax rate).

11.The payback reciprocal is an estimate of the internal rate of return. The Bravo, Inc. is considering the acquisition of a merchandise picking system to improve customer service. Annual cash returns on investment cost of P1.2 million is P220,000. Useful life is estimated at 8 years. The companys cost of capital is 14% and income tax rate is 35%. Calculate Bravo, Inc.s payback reciprocal for this investment:

A. 20.5%C. 11.9%

B. 18.3%D. 22.2%

(rpcpa)

11.B

?The payback reciprocal.(Payback reciprocal (PR) is a capital budgeting technique that measures the rate of return on investment, cash-wise. It does not consider the time value of money and is computed as follows:Payback Reciprocal = 1/ Payback period.The PR rate indicates the percentage of annual cash return of the investment made. The higher the PB rate, the better it would be.

First, let us compute the payback period then, the payback reciprocal. Payback period is net cost of investment divided by annual cash inflows. The payback period in this problem is 5.45 yrs. (i.e., P1,200,000/P220,000). The payback reciprocal is 18.3% (i.e., 1/5.45).

12. The payback reciprocal can be used to approximate a projects

A. Net present value.

B. Accounting rate of return if the cash flow pattern is relatively stable.

C. Payback period.

D. Internal rate of return if the cash flow pattern is relatively stable.

(cma)

12.D

?The use of payback reciprocal.(Payback reciprocal is determined by dividing 1 over the payback period. It is a measure of liquidity rate of return provided by an investment. With the payback reciprocal, the payback period may be derived, which is the first step needed in computing the internal rate of return (IRR). Therefore, with the payback reciprocal the IRR may be approximated. Hence, choice-letter d is correct. Another, it has been shown that the payback reciprocal approximates a projects IRR especially when cash inflows are relatively stable.

Choice-letter a is incorrect because net present value needs a discount rate that incorporates business risk and this cannot be derived from the payback reciprocal. Choice-letter b is incorrect because accounting rate of return uses net income while payback uses net cash inflows. Choice-letter c is incorrect because payback period is a measure of time while payback reciprocal is a measure of rate of return on a cash basis. Payback reciprocal does not approximate but may serve as a basis in precisely computing the payback period.

13.The bailout payback method

A. Incorporates the time value of money.

B. Equals the recovery period from normal operations.

C. Eliminates the disposal value from the payback calculation.

D. Measures the risk if a project is terminated.

(cma)

13.D

?A statement about bailout payback method.(Payback bailout method considers the salvage value as cash inflows of a project in determining the payback period. This means that the project is considered terminated at the end of each year; hence, choice-letter d is correct. Payback bailout method is applicable when a project is dependent on grants and gratuities of fund providers or dependent on the appropriations made by the government.

Choice-letter a is incorrect because it does not incorporate the time value of money. Choice-letter b is incorrect because it refers to payback period, not payback bailout period. Choice-letter c is incorrect because payback bailout method considers the disposal value of the investment.

14. Mark Company purchased a new machine on January 1 of this year for an amount of P90,000, with an estimated useful life of 5 years and a salvage value of P10,000. The machine will be depreciated using the straight-line method. The machine is expected to produce cash flows from operations, net of income taxes, of P36,000 a year in each of the next 5 years. The new machines salvage value is P20,000 in years 1 and 2, and P15,000 in years 3 and 4 What will be the bailout period (rounded) for this new machine?

A. 1.4 years.C. 1.9 years.

B. 2.2 years.D. 3.4 years.

(aicpa)

14.C

?The bailout period.(The payback bailout period is computed as follows:

Net cash Cash to Salvage

Payback

Period inflows date

value

Total cashbailout years

01P36,000 P36,000P20,000P56,000 1

02 36,000 72,000 20,000 90,000 0.9Total

1.9 yrs. The fraction of the payback period in the second year of operations is computed as [(P90,000 P36,000 P20,000)/P36,000]. This indicates that the needed cash in the second year amounting to P54,000 (i.e., P90,000 P36,000) is taken first from the salvage value, then the balance of P34,000 (i.e., P54,000-P20,000) is recovered from the cash generated in the second year.

15.The following statements refer to the accounting rate of return (ARR):

1. The ARR is based on the actual basis, not cash basis.

2. The ARR does not consider the time value of money.

3. The profitability of the project is not considered.

From the above statements, which at considered limitations of the ARR concept?

A. Statements 2 and 3 only.

C. All the 3 statements .

B. Statements 3 and 1 only.

D. Statements 1 and 2 only.

(rpcpa)

15.D

?The statement describing limitations of the accounting rate of return (ARR) concept.(ARR uses net income, rather than net cash inflows, in evaluating the desirability of capital expenditures. This is its first limitation if we consider cash inflows as a superior concept of net return than the net income. Second, ARR does not consider the time value of money.

The third statement could be considered as an advantage of ARR over the other capital budgeting techniques that use cash inflows in their product evaluation because using net income assists the evaluator to determine the profitability of a project. Choice-letter d is correct, statements 1 and 2 are considered limitations of the accounting rate of return.

16. A capital budgeting method that provides a rough approximation of an investments profitability as measured with net income from the income statement is known as:

A. Average rate of return method.C. Payback period method.

B. Net present value method.

D. Internal rate of return method.

(rpcpa)

16.A

?A capital budgeting method that provides a rough approximation of an investments profitability as measured with net income.(Choice-letter a is correct because accounting rate of return is the only capital expenditure evaluation technique that measures investment proposal based on its profitability. Choice-letters b, c, and d are incorrect because they all measure capital investments projects based on their liquidity (i.e., ability to generate cash inflows).

17.The Hablot Inc. is planning to spend P600,000 for a machine that it will depreciate on a straight-line basis over a ten-year period with no terminal disposal price. The machine will generate cash flow form operations of P120,000 a year. Ignoring income taxes, what is the accounting rate of return on the net initial investment?

A. 5%

C. 10%

B. 12%

D. 15%

(rpcpa)

17.C

?The accounting rate of return (ARR) on the net initial investment.(ARR is equal to net income over original investment. The net income is not readily given but the annual cash flows from operations of P120,000 is given. Income tax is ignored. The ARR on original investment is:

Annual cash flows

P120,000

Less: Depreciation expense (P600,000 / 10 yrs.) 60,000

Net income

60,000

Divided by Original Investment

600,000Accounting rate of return

10%18.The Folk Company is planning to purchase a new machine, which it will depreciate on a straight-line basis over a ten-year period with no salvage value and a full years depreciation in the year of acquisition. The new machine is expected to produce cash flow from operations, net of income taxes, of P66,000 a year in each of the next ten years. The accounting (book value) rate of return on the initial investment is expected to be 12%. How much will the new machine cost?

A. P300,000C. P660,000

B. P550,000D. P792,000

(aicpa)

18.A

?The cost of the new machine.(The cost of the new machine may be derived using the accounting rate of return (ARR) of 12%. Since, ARR is net income over cost of investment, then, cost of investment is net income over ARR, as follows:

If:

x = cost of investment

.

10x = Depreciation expense

Then, Net income = .12x

And, Net income = 66,000 - .10x

Therefore,

.12x = 66,000 - .10x

x = 66,000/.22 = P300,00019. The method that divides a projects annual after tax net income by the average investment cost to measure the estimated performance of a capital investment is the

A. Internal rate of return method.

B. Accounting rate of the return method.

C. Payback method.

D. Net present value (NPV) method.

(cma)

19.B

?The method that divides net income by the average investment.(Accounting rate of return (ARR) is the only project evaluation method that uses net income (i.e., profitability) to measure the attractiveness of an investment. The ARR on average investment equals net income over average investment. The ARR on original investment is net income over original investment.

Choice-letters a, c, and d are incorrect because all of these methods use net cash inflows in measuring a projects attractiveness, desirability and acceptability.

Discounted cash flows model general concepts

20.Which of the following methods measures the cash inflows and outflows of a project as if they occurred at a single point in time?

A. Cash flow based payback method.

B. Capital budgeting.

C. Payback method.

D. Discounted cash flow.

(rpcpa)

20.D

?A method that measures cash inflows and outflows of a project as if they occurred at a single point in time.(Discounted cash flow method considers the time value of money. It measures the equivalent values of cash inflows and outflows as if they occurred at a single point in time. The amount of expected cash inflows is converted at present values before comparing with cost of investment, which is an outflow that occurred at the present time (choice-letter d is correct).

Choice-letters a and c, payback period, does not consider the time value of money. Choice-letter b capital budgeting is a strategic planning and evaluation technique used to screen off proposed project proposals as to their acceptability and priority. The requirement is to identify the specific method of capital budgeting that measures the relation of cash inflows and outflows as if they occurred at a single point in time.

21.The method of project selection which considers the time value of money in a capital budgeting decision is accomplished by computing the

a. Accounting rate of return on initial investment.

b. Payback period.

c. Accounting rate of return on average investment.

d. Discounted cash flow.

(rpcpa)

21.D

?The capital budgeting project evaluation method which considers the time value of money.(Capital budgeting project evaluation techniques may be classified as to those that do not consider the time value of money (e.g., payback period, accounting rate of return, payback reciprocal, payback bailout method) and those that consider the time value of money or the discounted cash flow method (e.g., net present value, internal rate of return, profitability index, net present value index, present value payback method).

Choice-letter d is correct because discounted cash flow model considers the time value of money. Choice-letter a, b, and c are incorrect because they do not consider the time value of money.

22. The capital budgeting model that is ordinarily 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.

(cma)

22.D

?The capital budgeting model that is considered the best in the long-range decision-making.(Long-range decision-making extends over a stretch of many years. This condition suggests to consider in the analysis the time value of money and effects of taxes. These factors are considered in the discounted cash flow model (or, simply, discounted model), where future cash inflows are discounted on their present values and compared with the present value of cash outflows (i.e., cost of investment) to assess the liquidity potential of a proposed project.

Choice-letters a, b, and c are incorrect because these methods do not consider the time value of money.

23. All of the following items are included in discounted cash flow analysis except

A. Future operating cash savings.

B. The disposal prices of the current and future assets.

C The future assets depreciation.

D.The tax effects of future assets depreciation.

(cma)

23.C

?The item not included in the discounted cash flow analysis.(Discounted cash flow analysis uses net cash inflows in evaluating projects. The depreciation expense, whether past, present, or future, is not considered in the determination of net cash inflows.

Choice-letters a, b, and d are incorrect answers because they affect cash flows and are all considered in the computation of net cash inflows.

24.When using one of the discounted cash flow methods to evaluate the desirability of a capital budgeting project, which of the following factors generally is not important?

a. The method of financing the project under consideration.

b. The impact of the project on income taxes to be paid.

c. The timing of cash flows relating to the project.

d. The amount of cash flows relating to the project.

(rpcpa)

24.A

?The one that is not important in evaluating the desirability of a capital budgeting project using the discounted cash flow method.(In using the discounted cash flow method of evaluating project proposals in capital budgeting, the following factors are important: the cost of investment, amount of cash inflows, and present value factor at a given discount rate and time. Choice-letter a is the correct answer because the method of financing the project is not a consideration in the discounted cash flow method. The method of financing affects the determination of cost of capital but not capital budgeting.

Choice-letter b, c, and d are all important in the discounted cash flow technique.

25.If income tax considerations are ignored, how is depreciation expense used in the following capital budgeting techniques?

Internal rate of return

Payback

A. Excluded

Excluded

B. Excluded

Included

C. Included

Excluded

D. Included

Included

(aicpa)

25.A

?The use of depreciation expense in the internal rate of return and payback techniques in capital budgeting.(The internal rate of return and payback method use net cash inflows in evaluating project investment opportunities. Net cash inflows computation disregards depreciation expense, per se. What is considered is the tax effects of depreciation expense. Hence, depreciation expense is excluded both in the computation of internal rate of return and payback techniques. Choice-letter a is correct.

26.A proposed project has an expected economic life of eight years. In the calculation of the net present value of the proposed project, salvage value would be

A. Excluded from the calculation of the net present value.

B. Included in a cash inflow at the estimated salvage value.

C. Included as a cash inflow at the present value of the estimated salvage value.

D. Included as a cash inflow at the future amount of the estimated salvage value. (aicpa)

26.C

?The treatment of salvage value in the computation of net present value.(Salvage value is an inflow at the end of the proposed project life, and should be discounted to their present values using the net present value method.

Choice-letter a is incorrect because salvage value is included, not excluded, in the calculation of net present value. Choice-letters b and d are incorrect because under the net present value method all future cash inflows should be discounted to their present values, including that of salvage value.

27. It is assumed that cash flows are reinvested at the rate earned by the investment in which of the following capital budgeting techniques?

Internal rate of return Net present value

A. Yes

Yes

B. Yes

No

C. No

No

D.

No

Yes

(aicpa)

27.A

?The assumption regarding cash inflows.(Future cash inflows derived from the investment are assumed to be reinvested in the projects operations and earn interests thereon. This assumption is true to all discounted methods used in capital budgeting. The only difference in this assumption between internal rate of return (IRR) and net present value (NPV) methods is the rate at which the reinvested capital earns its returns. Under the NPV method, the reinvested cash produces returns equal to the discount rate used in computing the net present value. Under the IRR method, the reinvested cash produces returns equal to the internal rate of return. The better assumption is the NPV model.

Choice-letter a is correct because both the IRR and NPV assume that cash flows are reinvested at the rate earned by the investment.

28. Your company is purchasing a transport equipment as part of its territorial expansion strategy. The technical services department indicated that this equipment needs overhauling in year 4 or year 5 of its useful life. The overhauling cost will be expected during the year the overhauling is done. The Finance Officer insists that the overhauling be done in year 4, not in year 5. The most likely reason is:

A. There is lower tax rate in year 5.

B. There is higher tax rate in the year 5.

C. The time value of money is considered.

D. Due to statements A and C above.

(rpcpa)

28.D

?The most likely reason why the Finance Officer insists on doing the equipment overhauling in year 4 instead of year 5.(Choice-letter d is correct. The Finance Officer insists on doing the equipment overhauling in year 4 instead of year 5 because probably the tax rate is greater in year 4 than in year 5 and the time value of money is considered. The overhauling cost shall be charged to expense, which will reduce the income subject to tax. A higher tax rate during a lower income before income tax would mean greater tax savings on the part of the company. Considering the time value of money in year 4 compared to year 5, the net benefit in the part of the company would be even greater.

29.Several proposed capital projects, which are economically acceptable, may have to be ranked due to constraints in financial resources. In ranking those projects, the least pertinent is this statement.

A. If the internal rate of return method is used in the capital rationing problem, the higher the rate, the better the project.

B. In selecting the required rate of return, one may either calculate the organizations cost of capital or use a rate generally acceptable in the industry.

C. A ranking procedure on the basis of quantitative criteria may be established by specifying a minimum desired rate of return, which rate is used in calculating the net present value of each project.

D. If the net present value method is used, the profitability index is calculated to rank the projects. The lower the index, the better the project.

rpcpa)

29. D

?The least pertinent statement in ranking capital projects.(Choice-letter d is an incorrect statement, and therefore the least pertinent, because in the profitability index calculation, the higher the index, the better the project is.

Choice-letter a is a pertinent statement, the higher the internal rate of return, the better the project is. Choice-letter b is also a pertinent statement because the cost of capital or the rate generally acceptable in the industry serves as the minimum required rate of return for a project to generate and become acceptable. Choice-letter c is also a pertinent statement because the minimum required rate of return could be used as the discount rate in determining the net present value of a project.

30.The inflation element refers to the

A. Impact that future price increases will have on the original cost of capital expenditure.

B. Fact that the real purchasing power of a monetary unit usually increases over time.

C. Future deterioration of the general purchasing power of the monetary unit.

D. Future increases in the general purchasing power of the monetary unit.(rpcpa)

30. C

?A statement that refers to inflation element.(Inflation element relates to the increases in the value of commodities or deterioration of the general purchasing power of the monetary unit. Choice-letter c is correct.

Choice-letter a is incorrect because future price increases are adjustments in prices and not necessarily relate to inflation. Choice-letter b is incorrect because real purchasing power of a monetary unit usually decreases, not increases, over time. Choice-letter d is incorrect because it refers to the appreciation in the purchasing power of the monetary unit.

31.All of the following refer to the discount rate used by a firm in capital budgeting except

A. Hurdle rate.

C. Opportunity cost.

B. Required rate of return.

D. Opportunity cost of capital.

(rpcpa)

31. C.

?The one that does not refer to the discount rate.(Discount rate may refer to cost of capital, required rate or return, hurdle rate, or minimum rate of return, but not opportunity cost. Opportunity cost, is not a rate, but is a gain or benefit foregone in favor of the chosen alternative.

32.You are the treasurer of Mayaman Corporation. The company is considering a proposed project, which has an expected economic life of seven years. Net present value is the capital budgeting technique the president wants you to use. Salvage value of the project would be.

A. Treated as cash inflow at estimated salvage value.

B. Treated as cash inflow at its present value.

C. Irrelevant cash flow item.

D. Treated as cash inflow at the future value.

(rpcpa)32. B

?The treatment of salvage value in the net present value analysis.(Net present value is a discounted method of evaluating investment proposals. Net present value is the difference between the present value of cash inflows and the cost of investment. There are at least three (3) cash inflows that are considered: one is the cash inflow from regular operations, the remaining two are cash inflows recovered at the end of the project. They are the cash inflows recovered from the salvage value and the working capital. In the net present value model, the salvage value is a future inflow to be adjusted at present values. Choice-letter d is correct.33.Depreciation tax shield is

A. The expense caused by depreciation.

B. The cash provided by recording depreciation.

C. A reduction in income tax.

D. A after-tax cash flow.

(rpcpa)

33. C

?A statement with regard to depreciation tax shield.(Depreciation tax shield refers to the amount of tax savings generated out of recording depreciation expense; choice-letter c is correct. Choice-letter a is incorrect because tax shield is not an expense but is a savings. Choice-letters b and d are incorrect because there is no cash inflow generated from tax savings but rather a restrain from cash expenditures arising from reduction in tax payments.

34.Sensitivity analysis, if applied in capital budgeting evaluation,

A. Is used extensively when cash flows are known with certainty.

B. Is what if techniques that ask how a given outcome will change if the original estimates of the capital budgeting model are changed.

C. Measures the amount of time it will take for a project to recover its initial capital outflow.

D. Is a technique used to rank capital expenditures request.

(rpcpa)

34. B

?A description of sensitivity analysis as applied to capital budgeting.(Sensitivity analysis is a simulation technique where predicted outcomes are determined by analyzing the effects of the changes in one or more of the relevant variables affecting the predicted outcome. Choice-letter b is the most appropriate answer because sensitivity analysis is a what if technique that asks how a given outcome will change if the original estimates of the capital budgeting model are changed.

Choice-letter a is incorrect because sensitivity analysis, just like any other forecasting model is used more extensively when uncertainties abound. Choice-letter c is incorrect because it refers to payback period. Choice-letter d is incorrect because it refers to a project evaluation technique used to rank investment proposals (such as profitability index, NPV index, IRR, payback period, net present value, etc.).

35.You just passed the CPA licensure examination and took your oath. As you started your practice, Kon Fuse Inc. came you for help in establishing a minimum desired rate of return to be used in the evaluation of a capital project with a five-year life. The following data were provided:

Inflation rate for the past 5 years13%

Expected inflation rate for the next 5 years9%

Risk-free element5%

Risk premium demanded for the project7%

You will advice the client to consider a minimum desired rate of return of

A. 20%

C. 16%

B. 21%

D. 25%

(rpcpa)

35. B

?The minimum desired rate of return to be considered.(The concept of minimum rate of return could either be the cost of capital, the internal rate of return, or desired rate of return. All of them could be referred to as the hurdle rate. The cost of capital is the required rate of return of an investment so not to impair the interests of the common shareholders. The internal rate of return is the minimum rate that a project must earn to breakeven.

A discount rate is basically determined as follows:Risk-free rate

x %

Risk-premium rate

xBasic discount rate at a given level of risk x The risk-free rate is the prevailing market rate of securities or investments which gives convincing assurance as to their ability to provide return based on their tract record or because it is supported by the government or by a wide range of financial backup (e.g., treasury bills). The risk-free rate is normally represented by the Treasury bill rate being considered as a risk-free investment. The risk-premium rate measures the level of return that an investor is willing to accept for a given investment after considering an investment business risk. It is the compelling factor that entices the investor to invest in a more risky opportunity with the objective of earning more.

The inflation rate is added to the basic discount rate to get the adjusted or final discount rate to be used in analyzing an investment proposal. Specifically, the inflation rate is added to the risk-free rate. In this problem, the discount rate is 21%, computed as follows:

Risk-free rate

5%

Risk-premium rate

7%

Expected inflation rate

9%

Minimum desired rate of return21%

36.The common assumption in capital budgeting analysis that cash inflows occur in lump sums at the end of individuals years during the life of an investment project when in fact they flow more or less continuously during those years

A. Results in understated estimates of NPV.

B. Is done because present value tables for continuous flows cannot be constructed.

C. Will result in inconsistent errors being made on estimating NPVs such that project cannot be evaluated reliably.

D. Results in higher estimates for the IRR on the investment.

(rpcpa)

36. A

?The effect of an assumption in capital budgeting analysis about the timing of cash inflows.(Choice-letter a is correct. In capital budgeting cash inflows are commonly assumed to have been received in lump sum at the end of each year wherein in reality cash is received more or less continuously during the year. This assumption result in an understatement of net present value as cash is considered received in a later period, which means lower present value factor applied in the same amount of cash.

Choice-letter b is incorrect because present value tables may be constructed for continuous flows. Choice-letter c is also incorrect because even with assumed timing of cash inflows, projects can be reasonably evaluated with relevance and reliability. Choice-letter d is incorrect since an assumption that cash inflows are received at the end of the year reduces the net present value, then the IRR would be reduced as well.

37.You have determined the profitability of a planned project by finding the present value of all cash flows from that project. Which of the following would cause the project to look less appealing, that is, have a lower present value?

A. The discount rate increases.

B. The cash flows are extended over a longer period of time.

C. The investment cost decreases without affecting the expected income and life of the project.

D. The cash flows are accelerated and the project life is correspondingly shortened.

(rpcpa)37. A

?A situation that would cause the project look less appealing.(A project will look less appealing if its net present value (NPV) is reduced. The NPV decreases when the present value of cash inflows (PVCI) decreases or the cost of investment is increased. The following causes a decrease in PVCI: (a) an increase in discount rate, or, (b) the same amount of cash is received at a longer period of time.

Choice-letter a is correct. If the discount rate increases, the present value factor decreases and the PVCI also decreases. Choice-letter b will increase the PVCI because cash flows are extended overtime thereby increasing the nominal amount of cash received and its NPV. Choice letters c and d (decrease in the cost of investment and acceleration of cash flows, respectively) will increase the NPV.

39.Anton Corporation is planning to buy a new machine with the expectation that this investment should earn a discounted rate of return of at least 15%. This machine, which costs P150,000, would yield an estimated net cash flow of P30,000 a year for 10 years, after income taxes. In order to determine the net present value of buying the new machine, Anton should first multiply the P30,000 by what amount of the following factors?

A. 20.304 (Future amount of an ordinary annuity of P1).

B. 5.019 (Present value of an ordinary annuity of P1).

C. 4.046 (Future amount of P1).

D. 0.247 (Present value of P1).

(aicpa)

39. B

?The time value factor used in determining the net present value of buying the new machine.(Under the discounted value technique, the cash inflows and cash outflows should be compared at the same point in time, particularly at time zero, at the time the new asset is acquired. To this, future cash inflows should be discounted at their present values.

The present values to be used depend on whether future cash inflows are even or uneven. If the cash inflows are even, the present value factor of annuity is to be used for easy (i.e., short-cut) computations. For uneven cash inflows, the present value of single payment should be used. Since the future cash inflows are evenly received at P30,000, then the present value of ordinary annuity is to be used. Hence, choice-letter b is correct.

Choice-letters a and c are not correct because the present values should be used, not the future values. Choice-letter d is an inferior answer because the cash flows are even, and therefore, for easy computation, the present value factor of annuity should be used in discounting future cash inflows.

40.Essex Corporation is evaluating a lease that takes effect on March 1, 2006. The Company must make eight equal payments, with the first payment due on March 1, 2006. The concept most relevant to the evaluation of the lease is

A. The present value of an annuity due.

B. The present value of an ordinary annuity.

C. The future value of an annuity due.

D. The future value of an ordinary annuity.

(cma)

40. A

?The concept that is most relevant to the evaluation of the lease.(Future lease payments should be discounted at their present values to determine their true worth at the present time. The lease payments should be multiplied by the present value factor of annuity due, since the first payment is made at the start of the lease period. Hence, choice-letter a is correct.

If the payment is made at the end of each lease year, the present value factor of ordinary annuity should be used; hence, choice-letter b is incorrect. Choice-letters c and d are incorrect because the proper time value to be determined is the present value, not the future value.

41.An actuary has determined that a company should have P90 million accumulated in its pension fund 20 years from now for the fund to be able to meet its obligations. An interest rate of 8% is considered appropriate for all pensions fund calculations. The company wishes to know how much it should contribute to the pension fund at the end of each of the next 20 years. Which set of instructions correctly describes the procedures necessary to compute the annual contribution?

A. Divide P90,000,000 by the factor for present value of an ordinary annuity.

B. Multiply P90,000,000 by the factor for present value of a n ordinary annuity.

C. Divide P90,000,000 by the factor for future value of an ordinary annuity.

D. Multiply P90,000,000 by the factor for future value of an ordinary annuity. (cia)

41. C

?The set of instructions that correctly describes the procedures necessary to compute the annual contribution.(Annual contributions have to be made to establish the P90 million future pension fund balance to meet pension obligations. The annual contributions are to be made every end of the year, therefore an ordinary annuity case. By derivation, we cash say that:

If :P90 million = Annual contribution x Future value factor of ordinary annuity

Then :Annual contribution = P90 million / Future value factor of ordinary annuity

Questions 42 through 44 are based on the following information. Tranx Corporation has agreed to sell some used computer equipment to Rod Santos, one of the companys employees, for P5,000. Tranx and R. Santos have been discussing alternative financing arrangements for the sale. The information in the opposite column is pertinent to these discussions.

Present Value of an Ordinary Annuity of P1

Payments 5% 6%

7% 8%

1 0.952 0.943 0.935 0.926

2 1.859 1.833 1.808 1.783

3 2.723 2.673 2.624 2.577

4 3.546 3.465 3.387 3.312

5 4.329 4.212 4.100 3.993

6 5.076 4.917 4.767 4.623

7 5.786 5.582 5.389 5.206

8 6.463 6.210 5.971 5.747

42. Tranx Corporations has offered to accept a P1,000 down payment and set up a note receivable for R. Santos that calls for a P1,000 payment at the end of each of the next 4 years. If Tranx uses a 6% discount rate, the present value of the note receivable would be

A. P2,940C. P4,212

B. P4,465

D. P3465

(cma)

42. D

?The present value of the notes receivable.(The notes receivable is equal to four P1,000 payments which should be discounted to its present value. Therefore, the present value of the notes receivable is P3,465 (i.e., P1,000 x 3.465).

43. Rod Santos has agreed to the immediate down payment of P1,000 but would like the note for P4,000 to be payable in full at the end of the fourth year. Because of the increased risk associated with the terms of this note, Tranx Corporation would apply an 8% discount rate. The present value of this note would be

A. P2,940C. P3,940

B. P3,312

D. P2,557

(cma)

43. A

?The present value of the note.(The note, with a face value of P4,000, will be received in sum at the end of the fourth year. Therefore, the present value of the note is P2,940 (i.e., P4,000 x 0.7350). The 0.7350 is the present value of single payment at 8%, at the end of fourth year. This value may be computed using your calculator or by deriving it from the present value factor of annuity table at 8% as given in the problem (i.e., 3.312 2.577).

44.If Rod Santos borrowed the P5,000 at 8% interest for 4 years from his bank and paid Tranx Corporation the full price of the equipment immediately, Tranx could invest the P5,000 for 3 years at 7%. The future value of this investment (rounded) would be

A. P6,297C. P6,553

B. P6,127

D. P6,803

(cma)

44.B

?The future value of the investment.(The P5,000 investment earns 7% for 3 years. Therefore, the future value of the investment is P6,125 (i.e., P5,000 x 1.225). The 1.225 is the future value factor of annuity for 3 years at 7% rate (i.e., 1.07 x 1.07 x 1.07).

Another way to determine the future value of the P5,000 investment at 7% return rate for 3 years is by dividing the P5,000 by the present value factor of 7% at 3 years, computed to be 0.816. This (e.g., 0.816) may be also calculated using your calculator or by getting the difference in the present value factor of annuity at 7% between third year and second year (i.e., 2.624 1.808). Therefore, the future value of the investment is P6,127 (i.e., P5,000/0.816).

45.Snow Company plans to invest P2,000 at the end of the next ten years. Assume that Snow will earn interest at an annual rate of 6% compounded annually. The future amount of an ordinary annuity of P1 for 10 periods at 6% is 13.181. The present value of P1 for ten periods at 6% is 0.558. The present value of an ordinary annuity of P1 for ten periods at 6% is 7.360. The investment after the end of ten years would be

A.P26,362

C. P14,720

B. P21,200

D. P27,478

(rpcpa)

45.A

?The amount of investment after ten years.(The future value of investment is the amount of yearly investment times the future value factor annuity. The answer is P26,362 (that is , P2,000 x 13.181). The future value factor of annuity is used because the constant amount of investment made at the end of every year is the same and in an annual series.

46.Girl Casual Wear has P75,000 in a bank account as of December 31, 2005. If the company plans on depositing P4,000 in the account at the end of each of the next 3 years (2006 ,2007, and 2008) and all amounts in the account balance earn 8% per year, what will the account balance be at December 31, 2008? Ignore the effect of income taxes.

8% Interest Rate Factors

Future value Future value of

Period

of P1 an annuity of P1

1

1.08

1.00

2

1.17

2.08

3

1.26

3.25

4

1.36

4.51

A. P87,000

C. P 96,070

B. P88,000

D. P107,500

(cma)

46.D

?The amount of investment balance at December 31, 2008(The investment is made in two streams P75,000 and P4,000. The P75,000 is to be deposited at the beginning of 2006. The P4,000 investment is to be deposited at the end of the next 3 years. The total future value of investments shall be:

Single deposit (P75,000 x P1.26)P 94,500

Annuity deposit (P4,000 x 3.25)

13,000

Future value of investments

P107,500

Annuity deposit refers to the series of equal deposits to be made in the next 3 years.

47. If a firm identifies (or creates) an investment opportunity with a present value < List A> its cost, the value of the firm and the price of its common stock will .

List A

List B

A. Greater thanIncrease

B. Greater thanDecrease

C. Equal to

Increase

D. Equal to

Decrease

(cia)

47.A

?The effects of investment opportunity to the present value and price of common stock.(If the present value of an investment opportunity is greater than its cost, meaning, the investment opportunity is attractive or acceptable, profit shall increase and the price of the common stock would increase.

Choice-letter b is incorrect because it is in contrast with the right answer. Choice-letters c and d are incorrect because if the present value of investment opportunity is equal to its cost, then the price of the common stock will remain unchanged.

48. The proper discount rate to use in calculating certainty equivalent net present value is the

A. Risk-adjusted discount rate.

C. Cost of equity capital

B. Risk-free rate.

D. Cost of debt

(cma)

48.B

?The proper discount rate to be used in calculating certain equivalent net present value.(The discount rate used in the discounted models is composed of the risk-free rate and the risk-premium rate. The risk-free rate, or certainty rate, represents the rate of return on relatively risk-free investments (e.g., treasury bills).

Choice-letter a is incorrect because risk-adjusted discount rate incorporates the business risk associated to a given investment opportunity. Choice-letters c and d are incorrect because they refer to cost of funds, which are not used in calculating certainty equivalent rate.

49. A projects net present value, ignoring income tax considerations, is normally affected by the

A. Proceeds from the sale of the assets to be replaced.

B. Carrying amount of the assets to be replaced by the project.

C. Amount of annual depreciation on the asset to be replaced.

D. Amount of annual depreciation on fixed assets used directly on the project.

(aicpa)

49.A

?The item that affects the projects net present value.(Net present value is the difference between present value of cash inflows and cost of investment. Cash inflows may come from incremental sales, savings, or even proceeds from the sale or disposal of old asset. Choice-letter a is correct.

Choice-letter b is incorrect because the carrying amount of the old asset is a sunk cost, not a future cash inflow, and not considered in the net present value computation. Choice-letters c and d are incorrect because depreciation expense is not considered in the computation of net cash inflows, and is, therefore, disregarded in the net present value computation.

Net present value

50.The discount (hurdle) rate of return must be determined in advance for the

A. Internal rate of return method.

B. Net present value method.

C. Payback period method.

D. Time adjusted rate of return method.

(aicpa)

50.B

?The capital budgeting evaluation method affected by the advance determination of the discount (hurdle) rate of return.(The capital budgeting evaluation methods needing a discount rate to be made known in advance are the net present value, profitability index, net present value index, and the discounted payback period.

Choice-letter a is incorrect because the internal rate of return computes the true discount rate where the present value of cash inflows equals the cost of investment. Internal rate of return does not need a discount rate to be given in advance. Choice-letter c is incorrect because payback period does not consider the time value of money. Choice-letter d is incorrect because the time-adjusted rate of return is the same as the internal rate of return.

51.The net present value capital budgeting technique can be used when cash flows from period to period are

Uniform Uneven

A. No

Yes

B. No

No

C. Yes

No

D. Yes

Yes

(aicpa)

51.D

?The applicability of net present value model under uniform and uneven cash flows.(Net present value is applicable regardless of cash flows situations be it even or uneven. If the cash flows are even (uniform), the present value of cash inflows are determined using the present value factor of annuity. When cash flows are uneven, the present value of cash inflows are computed using the present value factor of single payment.

52.Velasquez & Company is considering an investment proposal for P10 million yielding a net present value of P450,000. The project has a life of 7 years with salvage value of P200,000. The company uses a discount rate of 12%. Which of the following would decrease the net present value?

A. Extend the project life and associated cash inflows.

B. Increase the discount rate to 15%.

C. Decrease the initial investment amount to P9.0 million.

D. Increase the salvage value.

(rpcpa)

52.B

?The one that would decrease the net present value.(Increasing the discount rate to 15% would lower the present value factor, would decrease the present value of cash inflows, and eventually would decrease the net present value of an investment. Choice-letter b is correct.

Choice-letter a is incorrect because extending the project life and associated cash inflows would increase the future cash inflows on top of the regular cash inflows and would therefore increase the net present value of an investment. Choice-letter c is also incorrect because decreasing the cost of investment would have an increasing impact on the net present value of the project. Choice-letter d is incorrect because increasing the salvage value, other things being the same, would also increase the net present value of the investment.

53.A disadvantage of the net present value method of capital expenditure evaluation is that it

A.Is difficult to apply because it uses a trial-and-error approach.

B.Does not provide the true rate of return on investment.

C.Is calculated using sensitivity analysis.

D.Computes the true rate of return.

(rpcpa)

53.B

?A disadvantage of the net present value method.(Choice-letter b is the correct answer. Net present value method does not provide the true rate of return on investment. This is determined using the internal rate of return.

Choice-letter a is incorrect because NPV model is not difficult to apply and does not use a trial-and-error approach in its procedure. Choice-letter c is incorrect because NPV model is definite in amount after the discount rate is determined. Choice-letter d is incorrect because NPV model does not compute the true rate of return.

54.Garfield Company purchased a machine, which will be depreciated on the straight-line basis over an estimated useful life of seven years and no salvage value. This machine is expected to generate cash flow from operations, net of income taxes, of P80,000 in each of the seven years. Garfields expected rate of return is 12%. Information on present value factors is as follows:

Present value of P1 at 12% for seven periods

0.452

Present value of an ordinary annuity of P1 at 12% for 7 periods4.564

Assuming a positive net present value of P12,720, what was the cost of the machine?

A. P240,000

C. P352,400

B. P253,120

D. P377,840

(aicpa)

54.C

?The cost of the machine given a positive net present value.(Using the net present value method (NPV), the cost of machine is the difference between the present value of cash inflows and positive net present value, as follows:Present value of cash inflows (P80,000 x 4.564)P365,120

- Net present value positive

( 12,720)

Cost of investment

P352,400A positive NPV indicates that the present value of cash inflows is greater than the cost of investment. As such, the positive NPV is deducted from present value of cash inflows to get the cost of investment.

Questions 96 and 97 are based on the following data: Apex Corporation is planning to buy production machinery costing P100,000. The machinerys expected useful life is five years, with no residual value. Apex required a rate of return of 20%, and has calculated the following data pertaining to the purchase and operation of this machinery.

Estimated

Annual

Present value

Year Cash Inflow

of P1 at 20%

1

P 60,000

.91

2

30,000

.76

3

20,000

.63

4

20,000

.53

5

20,000

.44Total P150,000

3.27Assuming that the cash inflow was received evenly during the year.

55.The payback period is

A. 2.50 years

C. 3.00 years

B. 2.75 years

D. 5.00 years

(aicpa)

55.A

?The payback period.(The cost of investment is P100,000. At the end of second year, the cumulative cash inflows already hit the P90,000 total (i.e., P60,000 + P30,000). In short, only P10,000 more in cash inflows are needed to be generated in the third year. The fraction of a year in the third year to generate the needed additional P10,000 out of the total third year cash inflows of P20,000 is 0.50 (i.e., P10,000/P20,000). Therefore, the payback period is 2.5 years.

56.The net present value is

A. P 9,400

C. P 80,000

B. P 54,128

D. P109,400

(aicpa)

56.A

?The net present value (NPV).(The NPV is the difference between the present value of cash inflows and cost of investment, as follows:

Estimated

Annual

Present Value Present Value of

YearCash Inflow

of P1 at 20% Cash Inflows

01

P 60,000

.91

P 54,600

02

30,000

.76

22,800

03

20,000

.63

12,600

04

20,000 .53

10,600

05

20,000 .44

8,800Total

109,400

Less: Cost of investment

100,000Net present value

P 9,40057.How are the following used in the calculation of the net present value of a proposed project? Ignore income tax considerations.

Depreciation Salvage

Expense

Value

A. Include

Include

B. Include

Exclude

C. Exclude

Include

D. Exclude

Exclude

(aicpa)

57.C

?The effects of depreciation expense and salvage value in the calculation of net present value.(Net present value (NPV) is the difference between present value of cash inflows and cost of investment. This model uses net cash inflows in assessing the acceptability of an investment opportunity. Depreciation expense is not included in the determination of net cash inflows. However, the salvage value is treated as a cash inflow to be discounted at present value. Hence, choice-letter c is correct.

58.The net present value of a proposed project represents the

A. Cash flows less the present value of the cash flows.

B. Cash flows less the original investment.

C. Present value of the cash flows plus the present value of the original investment less the original investment.

D. Present value of the cash flows less the original investment.

58.D

?A representation of the net present value (NPV).(Net present value (NPV) is the difference between present value of cash inflows and the original cost of investment, choice-letter d is correct. This model uses net cash inflows in assessing the acceptability of an investment opportunity. It measures the ability of an investment opportunity to provide liquidity more than or less than the cost of investment.

Choice-letter a is incorrect because it refers to the effects of present value analysis with cash flows. Choice-letter b is incorrect because it is a nominal net cash flow calculation without regard to the time value of money. Choice-letter c is incorrect because it does not provide a rational treatment of cash flows.

59.It is the start of the year and St. Tropez Company plans to replace its old sing-along equipment. These information are available:

OldNew

Equipment costP70,000P120,000

Current salvage value10,000

Salvage value, end of useful life2,00016,000

Annual operating costs56,00038,000

Accumulated depreciation55,300

Estimated useful life10 years10 years

The companys income tax rate is 35% and its cost of capital is 12%. What is the present value of all the relevant cash flows at time zero?

A. (P 54,000)

C. (P120,000)

B. (P110,000)

D. (P124,000)

(rpcpa)

59.B

?The present value of all relevant cash flows at time zero.(The company is considering to replace its old sing-along equipment. The relevant cash flows at present time (i.e., time zero) include the following:Purchase price new

P120,000

Current salvage value old

(10,000)Relevant cash flows (time zero)

P110,000The old equipment has a book value of P14,700 (i.e., P70,000 P55,300). The disposal of the old equipment will result to a loss of P4,700 (that is, salvage value of P10,000 less the book value of P14,700). This loss of P4,700 gives rise to a tax savings of P1,645 (i.e., P4,700 x 35%). This tax saving is irrelevant in this computation because this tax savings (an inflow) will be realized at the end of the year and not at the present time (time-zero). The book value of the old machine and the loss on disposal of old machine do not affect cash flows, and are also irrelevant in this decision situation.

60The net present value of a proposed project is negative therefore, the discount rate must be

A.Less than the project s internal rate or return.

B.Less than the risk free rate.

C.Greater than the firms cost of equity.

D.Greater than the projects internal rate or return.

(rpcpa)

60.D

?The discount rate if the net present value (NPV) of a proposed project is negative.(Net present value is the difference in the present value of cash inflows (PVCI) and the cost of investment. If the NPV is negative, the PVCI is less than the cost of investment. A low PVCI is caused by a low present value factor of annuity brought about by a higher discount rate.

Choice-letter d is correct because a negative NPV indicates that the internal rate of return (IRR) is less than the discount rate or the discount rate is greater than the IRR. To be accepted, the IRR must be higher than the discount rate. Since the project has negative NPV, then it is not acceptable, and the IRR is lower than the discount rate. (This makes choice-letter a incorrect).

Choice-letter b is incorrect because risk-free rate is only a part of the discount rate. Choice-letter c is incorrect because cost of equity (or cost of capital) is normally the same as the discount rate used in capital budgeting techniques The cost of equity is compared with the return on proposed investment to produce meaningful information.

61.You have been consulted to advice CPA Corporation on the projected acquisition of another production line costing P1 million. The line has an expected useful life of 5 years without any salvage value. The companys hurdle rate is 20% and the following additional information were made available to you.

YearEstimated Annual CashflowPresent Value of P1 at 20%

1P 600,0000.91

2300,000.76

3200,000.63

4200,000.53

5200,000.44

P1,500,0003.27

Assuming that the cash flow is generated evenly during the year, your advice is

A. To invest due to net present value of P94,000.

B. To invest due to net present value of P541,280.

C. To invest due to net present value of P635,000.

D. To invest due to net advantage of P500,000.

(rpcpa)

61.A

?The net present value (NPV) of the project.(The NPV computation is presented below:

Annual

PV of P1

YearCash Inflows at 20% Present values

1

P600,000

.91

P P546,000

2

300,000

.76

228,000

3

200,000

.63

126,000

4

200,000

.53

106,000

5

200,000

.44

88,000

Present value of inflows

1,094,000

Less: Cost of investment

1,000,000Net present value

P 94,00062.J Corporation is considering the purchase of a new machine that will cost P320,000. It has an estimated useful life of 30% in the first year, 40% in the second year, and 30% in the third year. It has a resale value of P20,000 at the end of its economic life. Savings are expected from the use of machine estimated at P170,000 annually. The company has an effective tax rate of 40%. It uses 16% as hurdle rate in evaluating capital projects. Should the company proceed with the P320,000 capital investment?

Discount factors at 16%

Present value of 1Present value of an ordinary annuity of P1

Year 1.862 .862

Year 2.743 1.605

Year 3.641 2.246

A. Yes, due to NPV of P6,556.

B. Yes, due to NPV of P11,684.

C. Yes, due to NPV of P61,820.

D. No, due to negative NPV of P1,136.

(rpcpa)

62.B

?The decision whether the company should proceed with the proposed investment.(The capital budgeting technique used in evaluating the desirability of the proposed investment is the net present value (NPV) as implied in the choice given. The NPV is the difference between the present value of cash inflows and the cost of investment. The annual cash inflows after tax are not given and are initially determined as follows:

1st year2nd year3rd year

Cash savings before tax

Less: Depreciation expense

(P300,000 x 30%)

(P300,000 x 40%)

IBIT

Less: Tax (40%)

Net Income

Add: Depreciation expense

Annual cash inflowsP170,000

( 90,000)

_______

80,000

32,000

48,000

90,000

P138,000P170,000

( 20,000)

50,000

20,000

30,000

120,000 P150,000P170,000

( 90,000)

_______

80,000

32,000

48,000

90,000 P138,000

The net present value is:

Present value of cash inflows:

1st year (P138,000 x 0.862)

P118,956

2nd year (P150,000 x 0.743)

111,450

3rd year (P138,000 x 0.641)

88,458

Salvage value (P20,000 x 0.641)

12,820P331,684

Less: Cost of investment

320,000

Net present value

P 11,684

Alternatively, cash flows after tax may be determined as:

1st year 2nd year 3rd year

Cash flows before tax

P170,000P170,000P170,000

- Tax {[(P170,000 (P300,000 x 30%)] x 40%} (32,000) (32,000)

{[(P170,000 (P300,000 x 40%)] x 40%}

(20,000)

Cash flows after tax

P138,000 P150,000 P138,000 The proposed project may be accepted as its net present value is positive which means that the expected cash inflows is greater than the cash outflows (or cost of investment).

63.Annette Tay has P750,000 in a bank account as of the end of the last year. If she deposits P10,000 in the account at the end of each of the next three years, and all amounts in the account can earn 8% per annum, will she become a millionaire by the end of the said period? (Disregard income tax implications).

Below are the factors that may be used:

8% Interest rate factors

PeriodFuture value of P1Future value on annuity of P1

11.081.00

21.172.08

31.263.25

41.364.51

A. Yes, with P1,075,000.

C. Yes, with P1,200,000.

B. No, with only P870,000.

D. No with only P880,000.

(rpcpa)

63.A

?Determine the future value of investments.(Future value equals cash deposited today multiplied by the future value factor. If the cash deposit is in series (in annuity), then the future value of annuity is to be used. If the deposit is made at the end of the period, there is an ordinary annuity. If the deposit is made at the beginning of the period, there is an annuity due. In this problem, we have ordinary annuity.The future value of investments is computed below:

Initial deposit (P750,000 x 1.26)P 945,000

Serial deposits (P40,000 x 3.25) 130,000

Total investments after 3 years

P1,075,000

64.The net present value method of investment analysis assumes that the projects cash flows are invested at the

A. Computed internal rate of return.

B. Discounted rate in the NPV calculation.

C. Firms average rate of return.

D. Risk free interest rate.

(rpcpa)

64.B

?The assumption used by the net present value (NPV) method with regard to cash flows reinvestment analysis.(Choice-letter b is correct where under the NPV method cash flows are assumed to be reinvested using the discount rate used in the NPV calculations. This separates NPV from the internal rate of return (IRR) where the cash inflows are assumed to be reinvested at the internal rate of return. The NPV method is considered to have the better treatment of cash inflows reinvestment assumption. (Choice-letter a is incorrect.)

Choice-letter c, firms average rate of return, is not the discount rate but could be considered as a factor in determining the discount rate. Choice-letter d is incorrect because the risk-free interest rate is only one of the two basic factors in computing the discount rate. The other factor in computing the discount rate is the risk-premium rate, which encompasses the business risk of venturing into a given investment.

65.Alang-alang sa Lahat Foundation, Inc., a non stock, nonprofit and tax exempt foundation, invested P1 million is a five-year project at the beginning of the year. The foundation estimates that the annual savings from the project will amount to P325,000. The P1 million asset is depreciable over five (5) years on a straight-line basis. The foundations hurdle rate is 12%. To facilitate computations, below are present value factors:

12%14%16%

Present value of P1 for 5 periods0.570.520.48

Present value of an annuity of P1 for 5 period3.63.43.3

The net present value of the project is

A. P170,000

C. P182,000

B. P625,000

D. P450,000

(rpcpa)

65.A

?The net present value of the project.(The annual savings of P325,000 shall be discounted using the present value of ordinary annuity and, then, compute the net present value as follows:

Present value of cash inflows (P325,000 x 3.6)P1,170,000

- Cost of investment

1,000,000

Net present value

P 170,00066.McIndon Corporation bought a major equipment which is depreciable over 7 years on a straight line basis without any salvage value. It is estimated that it would generate cash flow from operations, net of income taxes, of P800,000 in each of the seven years. The companys expected rate of return is 12%. Based on estimates, the project has a net present value of P127,200. What is the cost of the equipment?

To facilitate computation, below are present value factors:

Present value of P1 and 12% for seven periods is

0.452

Present value of an ordinary annuity of P1 at 12% for seven years is

4.564

A. P3,651,200

C. P2,404,000

B. P3,524,000

D. P3,778,400

(rpcpa)

66.B

?The cost of the equipment.(To compute the cost of investment, the present value of cash inflows (PVCI) is deducted by the cost of investment. Ergo, the cost of investment is PVCI less NPV as shown below:PV of cash inflows (P800,000 x 4.564)P3,651,200

Less: Net present value (given)

127,200Cost of the equipment

P3,524,000The present value of cash inflows is the annual cash inflows times the present value factor of annuity. Annuity is used because the cash inflows are expected to be received in the next seven years with a constant amount at P800,000.

67.The General Manager of Tela Mills Inc. is considering the purchase of some new machines. The machine would cost P4,000,000 with an economic life of 8 years without any salvage value. Once set up, they would generate P12,500,000 additional revenues but yearly expenses for additional labor and materials would also increase by P11,500,000. Assume the company uses straight-line depreciation for taxes and that the appropriate tax rate is 35%. The required after-tax rate or return is 14%.

The following data are an interest rate of 15% and 8 periods:

Present value of P10.3506

Failure value of P12.8526

Present value of annuity of P14.6389

Future value of annuity of P113.2328

The company should

A. Purchase the machines due to positive NPV of P638,900.

B. Not purchase the machines due to negative NPV of P984,715.

C. Not purchase the machines due to negative NPV of P172,907.50.

D. Be indifferent as the option does not bring about any advantage nor disadvantage.

(rpcpa)

67.C

?The decision to make whether to purchase or not to purchase a machine using the NPV method.(The tax rate is 35% and the machine is to be depreciated in 8 years. The incremental annual net cash inflows after-tax is:

Revenues

P 12,500,000

Materials and labor costs

(11,500,000)

Depreciation expense (4 million / 8 yrs.) ( 500,000)Income before income tax

500,000

Less: Tax (35%)

175,000Net income

325,000

Add back: Depreciation expense

500,000

Annual net cash inflows

P 825,000

The net present value is:

PV of cash inflows (P825,000 x 4.6389)

P 3,827,092.50

Less: Cost of investment

4,000,000.00

Net present value negative

P ( 172,907.50)

The machine should not be purchased because its net present value is negative. Meaning, its cash inflows are not enough to recover the cost of investment at present values.

68.Junio Assembly Inc. is considering the purchase automatic wirebonder which costs P750,000. It has ten-year life without any salvage value. Junio would save P200,000 in labor cost annually as a result of the use of the new machine. Power cost would however increase by P25,000 annually. The cost of capital is 16%. The present value factor for 10 years at 16% is 4.8332. The present value of the net annual cost savings is:

A. P845,810

C. P745,810

B. P575,000D. P966,640

(rpcpa)

69.A

?The present value of the net annual savings.(Present value of savings is equal to amount of savings (or net cash inflows) times the present value factor at a given discount rate. The annual savings is computed below:

Operating Income

Decrease in labor costsP200,000

Increase in power costs(25,000)

Annual cash savingsP175,000

Present value of cash savings (P175,000 x 4.8332)P845,810

There is no tax rate given, hence, depreciation expense is not considered anymore in the analysis of cash flows.

69.The technique that recognizes the time value of money by discounting the after-tax cash flows for a project over its life to time period zero using the companys minimum desired rate of return is the

A. Net present value method.

C. Payback method.

B. Capital rationing method.

D. Accounting rate return method.

(cma)

69.A

?The technique that discounts cash flows to time zero.(The discounted cash flow models convert future cash inflows to present values (or at time zero) and compare it with the cost of investment to get the net present value. Choice-letter a is correct.

Choice-letter b is incorrect because capital-rationing method refers to the distribution or allocation of available funds to the best projects, which are ranked according to their ability to produce liquidity or profitability. The methods used to rank acceptable projects are the profitability index and the net present value index. Choice-letters c and d are incorrect because payback period and accounting rate of return do not consider the time value of money.

70.The net present value method of capital budgeting assumes that cash flows are reinvested at

A. The risk-free rate.

B. The cost of debt.

C. The internal rate of return.

D. The discount rate used in the analysis.

(cma)

70.D

?The assumption used by net present value with regard to cash flows.(The net cash inflows generated by the project are assumed to be reinvested in the project and earn appropriate return thereof. This is true to all discounted cash flows models. There is, however, a difference between net present value (NPV) method and internal rate of return (IRR) with regard to their assumption on how the cash reinvested to operations earns interest. Under the NPV model, the reinvested cash is expected to earn the same discount rate used in computation. Choice-letter d is correct. Under the IRR model, the reinvested cash is expected to earn a rate equal to the internal rate of return. Here lies the big difference. The discount rate used in the NPV computation carries with it a fair return on investment, while the IRR is the breakeven rate. The NPV assumption is better because it factors in a reasonable profit-return in a given business risk.

Choice-letter a is incorrect because the risk-free rate, or certainty rate, which represents the return of those considered risk-free investment, is only a component of the discount rate, and is not related to internal rate of return. Choice-letter b is incorrect because the cost of debt is an isolated cost of financing and is not used in the NPV model. Choice-letter c is incorrect because internal rate of return uses the breakeven rate (or true rate) in estimating the earning potential of cash reinvestments.

71.The capital budgeting techniques known as net present value uses:

Cash flow over

Time value

life of project

of money

A. No

Yes

B. No

No

C. Yes

No

D. Yes

Yes

(aicpa)

71.D

?The items used in net present value (NPV) technique.(The NPV model considers both the time value of money and the cash flows. Choice-letter d is correct. Net present value (NPV) is the difference between present value of cash inflows and cost of investment. This model uses net cash inflows in assessing the acceptability of an investment opportunity.

72.A disadvantage of the net present value method of capital expenditure is that it

A. Is calculated using sensitivity analysis.

B. Computes the true interest rate.

C. Does not provide the true rate of return on investment.

D. Is difficult to adapt for risk.

(cma)

72.C

?A disadvantage of NPV method.(The NPV model considers the time value of money, cash flows, and relative business risk of an investment opportunity. It is easy to use in sensitivity analysis and is easy to adapt for risk. If a business risk is high, the discount is adjusted higher to reflect it in the project evaluation. A disadvantage of NPV is that it does not provide the true rate of return on investment Choice-letter c is correct.

Choice-letter a is incorrect because NPV uses sensitivity analysis. Choice-letter b is incorrect because NPV does not compute the true interest rate (or the internal rate of return). Choice-letter d is incorrect because NPV model is easy to adapt for risk.

73.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 projects.

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

D. Computes the maximum interest rate that can be used over life of the project to break even.

(cma)

73.B

?An advantage of NPV over IRR.(The NPV can be used when there is no constant rate of return required for each year of the projects. This model may be used when cash flows vary from a year to another. And also, NPV may be reasonably applied when business risk varies from year to year.

Choice-letters a, c, and d are incorrect because they all relate to internal rate of return.

74.Palafox and Company is considering an investment proposal for P10 million yielding a net present value of P450,000. The project has a life of 7 years with salvage value of P200,000. The company uses a discount rate of 12%. Which of the following would decrease the net present value?

A. Extend the project life and associated cash inflows.

B. Increase the discount rate to 15%.

C. Decrease the initial investment amount to P9.0 million.

D. Increase the salvage value.

(rpcpa)

74.B

(The item that would decrease the net present value.(Increasing the discount rate to 15% would lower the present value factor, would decrease the present value of cash inflows, and eventually would decrease the net present value of an investment. Choice-letter b is correct.

Choice-letter a is incorrect because extending the project life and associated cash inflows would increase the future cash inflows on top of the regular cash inflows and would therefore increase the net present value of an investment. Choice-letter c is also incorrect because decreasing the cost of investment would have an increasing impact on the net present value of the project. Choice-letter d is incorrect because increasing the salvage value, other things being the same, would also increase the net present value of the an investment.

75.The treasurer of a firm has an opportunity to purchase a secured 15% mortgage with 5 years remaining for P10,000. If the firm purchases the mortgage, it will receive five annual payments of P3,000 each. If the Treasurer wants no less than a 12% return on long-term cash investments, the NPV of the mortgage will be

Years:

1 2 3 4 5

Present value of P1 at 12%:

.89.80.71.64.57

Present value of P1 at 15%:

.87.76.66.57.50

A. P 80.

C. P5,000.

B. P830.

D. not enough information.

(cia)

75.B

?The NPV of the mortgage.(The cash inflows of the mortgage is P3,000 for each of the next 5 years. The present value factor of annuity is 3.61 (i.e., .89 + .80 + .71 + .64 +.57). The NPV is determined as follows:Present value of cash inflows (P3,000 x 3.61)P10,830

- Cost of investment

10,000Net present value

P 83076.Each of three mutually exclusive projects costs P200. Using the table provided, rank the project in descending NPV order.

Present Value

Interest FactorProjects Cash Flow

Year 10%

A B

C

1

.91

P300 P200 P 0

2

.83

200 100 100

3

.75

100 0 100

4

.68

0 100 200

5

.62

0 200 300

A. A, B, C.

C. C, B, A.

B. B, A, C.

D. A, C, B.

(cia)

76.D

?The rank of the projects in descending NPV order.(The projects should be ranked accounting to their NPVs. Net present value is the difference between present value of cash inflows and cost of investment. The present value of cash inflows are computed by multiplying cash inflows with their related present value factors. The NPVs are determined as follows:

A

B

C

Present value of cash inflows

Year 1 (cash inflows x 0.91)P273P182P 0

Year 2 (cash inflows x 0.83) 166 83 83

Year 3 (cash inflows x 0.75) 75 0 75

Year 4 (cash inflows x 0.68) 0 68 136

Year 5 (cash inflows x 0.62) 0 124 186Totals

514 457 480

- Cost of investment

200 200 200Net present value

P314P257P280Rank

(1) (3) (2)

Choice-letter d is correct. Using the NPV model, the projects attractiveness and acceptability is ranked as project A, C, and B in descending order.

77.On January 1, Studley Company purchased a new machine for P100,000 to be depreciated over 5 years. It will have no salvage value at the end of 5 years. For book and tax purposes, depreciation will be P20,000 per year. The machine is expected to produce annual cash flow from operations, before income taxes, of P40,000. Assume that Studley uses a discount rate of 12% and that its income tax rate will be 40% for all years. The present value of P1 at 12% for five periods is 0.57, and the present value of an ordinary annuity of P1 at 12% for five periods is 3.61. The NPV of the machine should be

A. P15,52