MANAGEMENT ACCOUNTING 2

HANDOUT #2

THEORIES

1. In capital budgeting decisions, the following items are considered among others:
1. Cash outflow for the investment.
2. Increase in working capital requirements.
3. Profit on sale of old asset
4. Loss on write-off of old asset.
For which of the above items would taxes be relevant?
A. Items 1 and 3 only. C. All items.
B. Items 3 and 4 only. D. Items 1, 3 and 4 only.

2. The payback method assumes that all cash inflows are reinvested to yield a return equal to
A. the discount rate. C. the internal rate of return.
B. the hurdle rate. D. zero.

3. 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.

4. When using the net present value method for capital budgeting analysis, the required rate of return is called
all of the following except the
A. Risk-free rate. B. Cost of capital. C. Discount rate. D. Cutoff rate.

5. When ranking two mutually exclusive investments with different initial amounts, management should give
first priority to the project
A. That generates cash flows for the longer period of time.
B. Whose net after-tax flows equal the initial investment.
C. That has the greater accounting rate of return.
D. That has the greater profitability index.

6. Which mutually exclusive project would you select, if both are priced at $1,000 and your discount rate is
15%; Project A with three annual cash flows of $1,000, or Project B, with 3 years of zero cash flow
followed by 3 years of $1,500 annually?
A. Project A.
B. Project B.
C. The IRRs are equal, hence you are indifferent.
D. The NPVs are equal, hence you are indifferent.

7. Capital budgeting techniques are least likely to be used in evaluating the

A. Acquisition of new aircraft by a cargo company.
B. Design and implementation of a major advertising program.
C. Trade for a star quarterback by a football team.
D. Adoption of a new method of allocating non-traceable costs to product lines.

8. To approximate annual cash inflow, depreciation is

A. Added back to net income because it is an inflow of cash.
B. Subtracted from net income because it is an outflow of cash.
C. Subtracted from net income because it is an expense.
D. Added back to net income because it is not an outflow of cash.

9. Which of the following methods measures the cash flows and outflows of a project as if they occurred at a
single point in time?
 A. Cash flow based payback period. C. Payback method.
B. Capital budgeting. D. Discounted cash flow.
10. A company had made the decision to finance next years capital projects through debt rather than additional
equity. The benchmark cost of capital for these projects should be
A. The before-tax cost of new-debt financing. C. The cost of equity financing.
B. The after-tax cost of new-debt financing. D. The weighted-average cost of
capital.
11. The discount rate that equates the present value of the expected cash flows with the cost of the investment
is the
A. Net present value C. Accounting rate of return
B. Internal rate of return D. Payback period.
12. When ranking two mutually exclusive investments with different initial amounts, management should give
first priority to the project
A. That generates cash flows for the longer period of time.
B. Whose net after-tax flows equal the initial investment.
C. That has the greater accounting rate of return.
D. That has the greater profitability index.
13. A company has analyzed seven new projects, each of which has its own internal rate of return. It should
consider each project whose internal rate of return is _____ its marginal cost of capital and accept those
projects in _____ order of their internal rate of return.
A. Below; decreasing. C. Above; increasing.
B. Above; decreasing. D. Below; increasing.
14. Which of the following characteristics represent an advantage of the internal rate of return techniques over
the accounting rate of return technique in evaluating a project?
I Recognition of the projects salvage value.
II Emphasis on cash flows.
III Recognition of the time value of money.
A. I only. B. I and II. C. II and III. D. I, II, and III.
15. Mahlin Movers, Inc. is planning to purchase equipment to make its operations more efficient. This
equipment has an estimated useful life of six years. As part of this acquisition, a P150,000 investment in
working capital is required. In a discounted cash flow analysis, this investment in working capital should
be
A. Amortized over the useful life of the equipment.
B. Disregarded because no cash is involved.
C. Treated as a recurring annual cash flow that is recovered at the end of six years.
D. Treated as an immediate cash outflow that is recovered at the end of six years.

PROBLEMS

1. Acme is considering the sale of a machine with a book value of $80,000 and 3 years remaining in its useful
life. Straight-line depreciation of $25,000 annually is available. The machine has a current market value of
$100,000. What is the cash flow from selling the machine if the tax rate 40%.

2. Hatchet Company is considering replacing a machine with a book value of $400,000, a remaining useful
life of 5 years, and annual straight-line depreciation of $80,000. The existing machine has a current market
value of $400,000. The replacement machine would cost $550,000, have a 5-year life, and save $75,000
per year in cash operating costs. If the replacement machine would be depreciated using the straight-line
method and the tax rate is 40%, what would be the net investment required to replace the existing machine?

3. Diliman Republic Publishers, Inc. is considering replacing an old press that cost P800,000 six years ago
with a new one that would cost P2,250,000. Shipping and installation would cost an additional P200,000.
The old press has a book value of P150,000 and could be sold currently for P50,000. The increased
 production of the new press would increase inventories by P40,000, accounts receivable by P160,000 and
accounts payable by P140,000. Diliman Republics net initial investment for analyzing the acquisition of
the new press assuming a 35% income tax rate would be?

4. A company is considering putting up P50,000 in a three-year project. The companys expected rate of
return is 12%. The present value of P1.00 at 12% for one year is 0.893, for two years is 0.797, and for
three years is 0.712. The cash flow, net of income taxes will be P18,000 (present value of P16,074) for the
first year and P22,000 (present value of P17,534) for the second year. Assuming that the rate of return is
exactly 12%, the cash flow, net of income taxes, for the third year would be?

5. A company is considering putting up P50,000 in a three-year project. The companys expected rate of
return is 12%. The present value of P1.00 at 12% for one year is 0.893, for two years is 0.797, and for
three years is 0.712. The cash flow, net of income taxes will be P18,000 (present value of P16,074) for the
first year and P22,000 (present value of P17,534) for the second year. Assuming that the rate of return is
exactly 12%, the cash flow, net of income taxes, for the third year would be?

6. Garfield Inc. is considering a 10-year capital investment project with forecasted revenues of $40,000 per
year and forecasted cash operating expenses of $29,000 per year. The initial cost of the equipment for the
project is $23,000, and Garfield expects to sell the equipment for $9,000 at the end of the tenth year. The
equipment will be depreciated over 7 years. The project requires a working capital investment of $7,000 at
its inception and another $5,000 at the end of year 5. Assuming a 40% marginal tax rate, the expected net
cash flow from the project in the tenth year is?

7. Metrejean Industries is analyzing a capital investment proposal for new equipment to produce a product
over the next 8 years. At the end of 8 years, the equipment must be removed from the plant and will have a
net book value of $0, a tax basis of $150,000, a cost to remove of $80,000, and scrap salvage value of
$20,000. Metrejeans effective tax rate is 40%. What is the appropriate end-of-life cash flow related to
these items that should be used in the analysis?

8. Umali Corporation is considering an investment in a new cheese cutting machine to replace its existing
cheese cutter. Information on the existing machine and the replacement machine follow:
Cost of the new machine 400,000
Net annual savings in operating costs 90,000
Salvage value now of the old machine 60,000
Salvage value of the old machine in 8 years 0
Salvage value of the new machine in 8 years 50,000
Estimated life of the new machine 8 years
What is the expected payback period of the new machine?

9. (Ignore income taxes in this problem.) Bugle's Bagel Bakery is investigating the purchase of a new bagel
making machine. This machine would provide an annual operating cost savings of $3,650 for each of the
next 4 years. In addition, this new machine would allow the production of one new type of bagel that would
result in selling 1,500 dozen more bagels each year. The company earns a contribution margin of $0.90 on
each dozen bagels sold. The purchase price of this machine is $13,450 and it will have a 4-year useful life.
Bugle's discount rate is 14%.
The total annual cash inflow from this machine for capital budgeting purposes is?
The internal rate of return for this investment is closest to?
The net present value of this investment is closest to

10. Information concerning two products or the Champaca Company is given below:
Catleya Company, a tax-exempt entity, 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. The new equipment costing P150,000 is
expected to produce cash savings of P33,000 per year in operating costs. Catleyas cost of capital is 16%.
For ten periods at 16%, the present value of P1 is 0.227, while the present value of an annuity of P1 is
P4.833.
Assuming that Catleya uses a discount rate of 15%, the net present value of the proposed investment is?
 Based on the Companys initial investment in the new equipment, the accounting rate of return is?

11. For 450,000, Maleen Corporation purchased a new machine with an estimated useful life of 5 years with no
salvage value. The machine is expected to product cash outflow from operations, net of 40% income taxes
as follows:
1st year 160,000
2nd year 140,000
3rd year 180,000
4th year 120,000
5th year 100,000
Maleen will use the sum-of-the-years digits method to depreciate the new machine as follows:
1st year 150,000
2nd year 120,000
3rd year 90,000
4th year 60,000
5th year 30,000
The present value of 1 for 5 periods at 12% is 3.60478. The present values of 1 at 12% at the end of each
period are:
Period 1 0.89280
Period 2 0.79719
Period 3 0.71178
Period 4 0.63552
Period 5 0.56743
Had Maleen used straight-line method of depreciation instead of declining balance method, what is the
difference in net present value provided by the machine at a discount rate of 12%?

12. The management of Queen Corporation is considering the purchase of a new machine costing 400,000. The
companys desired rate of return is 10%. The PV of P1 at compound interest of 10% for 1 through 5 years
are 0.909, 0.826, 0.751, 0.683, and 0.621, respectively, and the PV of annuity of 1 for 5 periods at 10% is
3079. In addition to the foregoing information, use the ff. data in determining the acceptability in this
situation:
Year Income from Ope. Net Cash Flow
1 100,000 180,000
2 40,000 120,000
3 20,000 100,000
4 10,000 90,000
5 10,000 90,000
What is the average rate of return?
The net present value for this investment is?
The present value index for this investment is?
What is the payback period for this investment?