B3-1 Flashcards
Carter Co. paid $1,000,000 for land three years ago. Carter estimates it can sell the land for $1,200,000, net of selling costs. If the land is not sold, Carter plans to develop the land at a cost of $1,500,000. Carter estimates net cash flow from the development in the first year of operations would be $500,000. What is Carter’s opportunity cost of the development?
a.
$500,000
b.
$1,200,000
c.
$1,000,000
d.
$1,500,000
Choice “b” is correct. Opportunity cost is the potential benefit lost by selecting a particular course of action. In this question, opportunity cost is the revenue that will not occur ($1,200,000) if Carter develops the land instead of selling it.
Choice “d” is incorrect. The cost of development is not an opportunity cost of development.
Choice “c” is incorrect. The book value of the property is not an opportunity cost of development. The fair value that Carter can receive for the land is considered, not what the land originally cost.
Choice “a” is incorrect. The cash flow in the first year of operations is not an opportunity cost of development. It’s an opportunity cost of selling the land.
In equipment-replacement decisions, which one of the following does not affect the decision-making process?
a.
Original fair market value of the old equipment.
b.
Cost of the new equipment.
c.
Current disposal price of the old equipment.
d.
Operating costs of the new equipment.
Choice “a” is correct. The original FMV of the old equipment is a sunk cost that does not affect equipment-replacement decisions.
All of the following items affect the decision process:
c.
Current disposal price of the old equipment.
b.
Cost of the new equipment.
d.
Operating costs of the new equipment.
A characteristic of the payback method (before taxes) is that it:
a.
Neglects total project profitability.
b.
Incorporates the time value of money.
c.
Uses accrual accounting inflows in the numerator of the calculation.
d.
Uses the estimated expected life of the asset in the denominator of the calculation.
Choice “a” is correct. The payback method neglects total project profitability. It simply looks at the time required to recover the initial investment; subsequent cash flows are ignored.
Choice “b” is incorrect. Payback does not incorporate the time value of money.
Choice “c” is incorrect. Payback uses cash flow, not accrual accounting income.
Choice “d” is incorrect. The denominator is the annual cash inflows.
Egan Co. owns land that could be developed in the future. Egan estimates it can sell the land for $1,200,000, net of all selling costs. If it is not sold, Egan will continue with its plans to develop the land. As Egan evaluates its options for development or sale of the property, what type of cost would the potential selling price represent in Egan’s decision?
a.
Variable.
b.
Future.
c.
Sunk.
d.
Opportunity.
Choice “d” is correct. Opportunity cost is the potential benefit lost by selecting a particular course of action. If the land is developed rather than sold, the potential selling price foregone is an opportunity cost.
Choice “c” is incorrect. Sunk costs are those costs that have already been incurred, are unavoidable in the future and will not vary with the course of action taken. The potential selling price is not a sunk cost.
Choice “b” is incorrect. This is a distracter option.
Choice “a” is incorrect. Variable costs are costs of production that change in total with changes in volume. The potential selling price is not a variable cost.
Which of the following limitations is common to the calculations of payback period, discounted cash flow, internal rate of return, and net present value?
a.
They rely on the forecasting of future data.
b.
They require multiple trial and error calculations.
c.
They require knowledge of a company’s cost of capital.
d.
They do not consider the time value of money.
Choice “a” is correct. The common disadvantage of all capital budgeting models is their reliance on future data. Capital financing relates to longer periods of time that are subject to greater levels of uncertainty than other short-term budgeting and financing decisions.
Choice “d” is incorrect. While the failure to consider the time value of money is a shortcoming of the payback method, it is not a common weakness in NPV and IRR methods or other discounted cash flow methods that do consider the time value of money.
Choice “b” is incorrect. While the IRR method may require multiple trial-and-error computations, other methods do not. This weakness is not common to all of the capital budgeting methods mentioned.
Choice “c” is incorrect. The cost of capital is a typical hurdle rate used in discounting future cash flows in capital budgeting, but it is not used for the payback method. Cost of capital considerations are not common to all of the capital budgeting methods mentioned.
The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?
a.
Depreciation increases cash flow by reducing income taxes.
b.
The decline in the value of the investment should be reflected in the determination of net present value.
c.
Depreciation adjusts the book value of the investment.
d.
Depreciation represents a cash outflow that must be added back to net income.
Choice “a” is correct. Although depreciation is not directly relevant to net present value computations, the depreciation tax shield (reduced income taxes) results in increased cash flows from an investment and is used in the determination of net present value.
Choice “b” is incorrect. Depreciation is an accounting method of cost allocation, not a method of valuation that would be considered in determining the initial investment.
Choice “c” is incorrect. The reductions in the book value associated with depreciation expense are not relevant to net present value calculations.
Choice “d” is incorrect. Depreciation is not a cash outflow, rather it is a noncash expense.
Which of the following events would decrease the internal rate of return of a proposed asset purchase?
a.
Use accelerated, instead of straight-line depreciation.
b.
Decrease tax credits on the asset.
c.
Decrease related working capital requirements.
d.
Shorten the payback period.
Rule: The internal rate of return is computed as follows:
Investment / Cash Flows = Present Value Factor
The higher the present value factor, the lower the computed rate (internal rate of return). Increases to the investment or decreases to the cash flows serve to increase the present value factor.
Choice “b” is correct. A decrease in tax credits associated with an asset would increase the initial investment. That increase would cause the present value factor to increase and would result in a decline in internal rate of return.
Choice “c” is incorrect. A decrease in working capital requirements decreases the initial investment amount, thereby decreasing the present value factor and, by extension, increasing the internal rate of return.
Choice “d” is incorrect. A reduced payback period correlates to a decrease in the present value factor. Decreases in the present value factor is in an increase in the internal rate of return.
Choice “a” is incorrect. An accelerated depreciation method would initially increase the tax shield and, by extension, the cash flows. The increase in cash flow serves to reduce the present value factor, which indicates an increase in the internal rate of return. [Please note that, while this was the exact wording of the released question from the AICPA, it does not appear to be perfectly worded, as the IRR cannot typically be calculated with uneven cash flows (as in accelerated depreciation). We have provided the best explanation of the question considering the provided wording.]
Which of the following metrics equates the present value of a project’s expected cash inflows to the present value of the project’s expected cash outflows?
a.
Return on assets.
b.
Economic value-added.
c.
Internal rate of return.
d.
Net present value.
Choice “c” is correct. The internal rate of return (IRR) focuses the decision maker on the discount rate at which the present value of a project’s cash inflows equals the present value of the cash outflows. The IRR is the rate used to arrive at a net present value of zero.
Choice “d” is incorrect. Net present value is the difference in the amount of an investment and its related discounted cash inflows. Although the values are compared, they are not expected to be equal. They do not equate.
Choice “a” is incorrect. Return on assets (ROA) is the product of gross margin and asset turnover. The ROA does not equate the investment with discounted cash inflows.
Choice “b” is incorrect. Economic value added is a residual income measure that compares income with required return on investment. Positive amounts indicate objectives have been met, negative amounts indicate that objectives have not been met. The method does not equate investment cash outflows and cash inflows.
The profitability index is a variation of which of the following capital budgeting models?
a.
Internal rate of return.
b.
Economic value-added.
c.
Net present value.
d.
Discounted payback.
Choice “c” is correct. The profitability index is a variation of the net present value capital budgeting model.
RULE: The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability index is also referred to as the “excess present value index” or simply the “present value index.” Companies hope that this ratio will be over 1.0, which means that the present value of the inflows is greater than the present value of the outflows.
Present value of net future cash inflows
Present value of net initial investment
=Profitability index
Choice “a” is incorrect. The profitability index is a companion computation to net present value, not internal rate of return, which measures percentage return.
Choice “b” is incorrect. The profitability index is a companion computation to net present value, not economic value added.
Choice “d” is incorrect. The profitability index is a companion computation to net present value, not the discounted payback method, which measures years to payback.
Which of the following statements is correct regarding the payback method as a capital budgeting technique?
a.
An advantage of the payback method is that it indicates if an investment will be profitable.
b.
Payback is calculated by dividing the annual cash inflows by the net investment.
c.
The payback method considers the time value of money.
d.
The payback method provides the years needed to recoup the investment in a project.
Choice “d” is correct. The formula for calculating the payback period is:
Net Initial Investment / Increase in annual net after-tax cash flow
The payback method computes the years needed to recoup an investment. The net cash inflows are generally assumed to be constant for each period during the life of the project. It is often used for risky investments, since it shows how quickly the initial investment will be recouped.
Choice “c” is incorrect. The payback method does not consider the time value of money although a discounted payback method (which discounts the cash inflows) can be computed.
Choice “a” is incorrect. The payback method does not measure profitability.
Choice “b” is incorrect. The payback formula is not computed as the ratio of annual cash flows to net investment.
At the beginning of Year 1, $10,000 is invested at 8% interest, compounded annually. What amount of interest is earned for Year 2?
a.
$800.00
b.
$806.40
c.
$933.12
d.
$864.00
Choice “d” is correct. This question is a compound interest question because the interest is to be determined at the end of the second year. The calculation is as follows and uses different symbols than the SI = PIN formula in the text to show candidates the PRT formula as well (the CPA exam often uses different terminology):
Interest = PRT (for the first year)
Interest = $10,000 × .08 × 1 = $800 and adding the $800 to the beginning principal
Interest = PRT (for the second year)
Interest = $10,800 × .08 × 1 = $864
It is obvious from the answer that the interest earned in Year 2 is interest earned on the original principal ($10,000 × .08 = $800) plus interest on the Year 1 interest ($800 × .08 = $64).
Choice “a” is incorrect. This answer is interest only on the original principal, and not on the Year 1 interest.
Choice “b” is incorrect. This answer has a decimal point error in calculating the Year 2 interest on Year 1 interest.
Choice “c” is incorrect. This answer is simply a distractor with no calculation logic.
Under which one of the following conditions is the internal rate of return method less reliable than the net present value technique?
a.
When income taxes are considered in the analysis.
b.
When there are several alternating periods of net cash inflows and net cash outflows.
c.
When the net present value of the project is equal to zero.
d.
When both benefits and costs are included, but each is separately discounted to the present.
Choice “b” is correct. The internal rate of return (IRR) method is less reliable than the net present value (NPV) technique when there are several alternating periods of net cash inflows and net cash outflows or the amounts of cash flows differ significantly. The IRR is strictly a percentage measure of return, while the NPV is an absolute measure. Due to this difference, the timing or amount of cash flows under IRR can be misleading when compared to the NPV method.
Example:
If an investment of $50 earns $100. Then, 100/50 = 200% return
If an investment of $50,000 earns $25,000 then, 25,000/50,000 = 50% return
IRR suggests it is best to invest $50 to earn $100 and a 200% return while the NPV method will favor a larger NPV for the $50,000 investment.
Choices “c”, “a”, and “d” are incorrect. These conditions do not make the IRR method less reliable than the NPV method.
Which of the following statements about investment decision models is true?
a.
The discounted payback rate takes into account cash flows for all periods.
b.
The payback rule ignores all cash flows after the end of the payback period.
c.
The internal rate of return rule is to accept the investment if the opportunity cost of capital is greater than the internal rate of return.
d.
The net present value model says to accept investment opportunities when their rates of return exceed the company’s incremental borrowing rate.
Choice “b” is correct. The payback period computation ignores cash flows after the initial investment has been recovered. The payback method focuses on liquidity and the time it takes to recover the initial investment.
Choice “a” is incorrect. The discounted payback period considers the time value of money but, like any other payback method, it ignores cash flows after the initial investment has been recovered.
Choice “d” is incorrect. The net present value method measures the amount of absolute return and not a rate. Although a positive net present value would confirm that the entity’s investment exceeds the hurdle rate established by management, it neither measures the rate specifically nor assumes a hurdle rate equal to the incremental borrowing rate.
Choice “c” is incorrect. When using the internal rate of return, the analyst recommends acceptance of the investment in the event that the IRR is greater than the hurdle rate established by management.
The factor for present value of an annuity for five years at 10% is 3.791. The factor for present value of $1 for five years at 10% is 0.621. The factor for future value of $1 at 10% for five years is 1.611. The factor for future value of an annuity for five years at 10% is 6.1053.
Given a 10% discount rate with cash inflows of $3,000 at the end of each year for five years and an initial investment of $11,000, what is the net present value?
a.
$(9,500)
b.
$370
c.
$4,000
d.
$11,370
Choice “b” is correct. The present value of the cash inflows of $3,000 per year for five years at 10% is $3,000 × 3.791 = $11,373. The original investment is $11,000. The net present value (NPV) is the difference of $373. The closest answer is $370.
Choices “a”, “c”, and “d” are incorrect based on the above explanation.
Which of the following statements is true regarding the payback method?
a.
The salvage value of old equipment is ignored in the event of equipment replacement.
b.
It is the time required to recover the investment and earn a profit.
c.
It does not consider the time value of money.
d.
It is a measure of how profitable one investment project is compared to another.
Choice “c” is correct. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. The payback method does not consider the time value of money.
Choice “b” is incorrect. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. Although the payback method focuses on liquidity, project cash flows after the initial investment are not considered; thus, profitability is ignored.
Choice “d” is incorrect. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. Although the payback method focuses on liquidity, project cash flows after the initial investment are not considered; thus, profitability is ignored.
Choice “a” is incorrect. Salvage value is specifically considered as part of payback computations because it contributes to the incoming cash flow when the asset is sold.
Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?
a.
Payback period.
b.
Accounting rate of return.
c.
Internal rate of return.
d.
Cost-benefit ratio.
Choice “c” is correct. The internal rate of return method computes the rate of return where net present value equals zero. The method equates the initial investment with the present value of the future cash inflows.
Choice “b” is incorrect. The accounting rate of return anticipates changes in net income and does not consider present value.
Choice “a” is incorrect. The payback period computes the period of time necessary to recover an initial investment generally based on undiscounted cash flows.
Choice “d” is incorrect. The cost-benefit ratio does not equate investment and the present value of cash flow.
In evaluating costs for decision-making, a company would always consider each of the following as relevant,except:
a.
Incremental costs.
b.
Differential costs.
c.
Avoidable costs.
d.
Variable costs.
Choice “d” is correct. Variable costs change with the level of output but may not change purely in response to different selected alternatives. Although variable costs are frequently relevant, they are not always relevant. Relevant costs are those costs that will change in response to the selection of different courses of action.
Choice “a” is incorrect. Incremental costs represent the change in cost associated with different alternatives and are considered synonymous with relevant.
Choice “b” is incorrect. Differential costs represent the change in costs associated with two separate courses of action and are considered synonymous with relevant.
Choice “c” is incorrect. Avoidable costs represent the costs that can be averted by selecting different courses of action and are considered synonymous with relevant.
Which of the following inputs would be most beneficial to consider when management is developing the capital budget?
a.
Profit center equipment requests.
b.
Wage trends.
c.
Supply/demand for the company’s products.
d.
Current product sales prices and costs.
Choice “a” is correct. In developing its capital budget, management would find the employee input associated with equipment requests from various profit centers most helpful. Departmental requests, appropriately justified, would provide key insights into the capital requirements of the business that are not otherwise known.
Choice “c” is incorrect. Supply and demand for company products is a crucial strategic input in forecasting the future capital requirements. Current year capital budgeting would not benefit as directly from this information, however, as profit center equipment requests.
Candidate Note:
Some candidates may question why the correct answer is not choice “c.” However, the answer to the question is very clear.
The question really is what are the best (most beneficial to consider) inputs to a capital budget. The “supply and demand for the company’s products” is very indirect. The demand for the company’s products may or may not result in the company spending any capital money because the demand may be able to be satisfied with the current capital equipment. But, equipment requests, if approved, will most likely result in spending money (assuming that the money in the budget is actually spent) and thus should go into the capital budget. The supply and demand might affect future capital budgets if the demand is not able to be satisfied with the current capital equipment. But the question asks for the best inputs for presumably the current capital budget.
Choice “d” is incorrect. Current product sales prices and costs represent operating data most relevant to operating rather than capital budgeting.
Choice “b” is incorrect. Wage trends represent operating data most relevant to operating than capital budgeting.
In evaluating a capital budget project, the use of the net present value model is generally not affected by the:
a.
Initial cost of the project.
b.
Method of funding the project.
c.
Amount of the project’s associated depreciation tax allowance.
d.
Amount of added working capital needed for operations during the term of the project.
Choice “b” is correct. The method of funding the project has no effect on the net present value model. NPV uses a hurdle rate to discount cash flows. If the NPV is positive, the project is acceptable. The method of financing the project, and the cost, are independent of the process of screening the project for acceptability.
Choice “a” is incorrect. The initial cost is one of the most important items in the calculation of NPV.
Choice “d” is incorrect. Added working capital requirements and salvage value affect cash flow. All cash flows are used in the NPV model.
Choice “c” is incorrect. The tax depreciation allowance will provide a “tax shield” or tax savings that impacts cash flow and must be considered in NPV analysis.
