Economic Concepts

Question 1

A price ceiling that is below the market equilibrium price would be expected to result in which one of the following sets of effects on demand and supply?

Answer 1

Shortage Excess

Question 2

If both demand and supply have traditional curves, a higher equilibrium price may be caused by which one of the following?

Answer 2

An increase in demand.

A higher equilibrium price (and quantity) would be caused by an increase in demand.

Question 3

A city ordinance that establishes a price ceiling on rent may cause

Answer 3

the quantity of rental space demanded to exceed the quantity supplied.

Correct!

A city ordinance that freezes rent prices will cause the quantity of rental space demanded to exceed the quantity supplied. Specifically, a freeze in rental prices would cause the actual price charged (the controlled price) to be less than the equilibrium price, resulting in a shortage of rentable space. Since suppliers (landlords) are prevented from raising prices to an equilibrium level, they will cease to invest in rentable space, causing a shortage.

Question 4

If the price for a good is fixed by government fiat below market equilibrium price, which one of the following will occur?

Answer 4

Excess demand.

If the price for a good is fixed by government fiat below market equilibrium price, an excess demand will result. Because the price that can be charged is limited (price ceiling), less supply will be provided, such that demand will exceed supply. There will be an excess demand.

Question 5

What is the effect on the quantity of a commodity supplied relative to demand as a result of a government-mandated price ceiling or price floor?

Answer 5

Quantity Shortage Quantity Surplus

A price ceiling is a government-mandated maximum price that can be charged for a good or service. Rent controls, for example, establish the maximum price that can be charged for rent.
Price ceilings result in a lower price than would otherwise occur in a free market and cause the quantity of a commodity supplied to be less than would be demanded at a free market price.
Thus, a shortage exists as the difference between quantity supplied at the price ceiling and the greater quantity demanded at that price. A price floor is a government-mandated minimum price for a good or service. The minimum wage law, for example, establishes the minimum wage that can be paid to employees.
Price floors result in a higher price than would otherwise occur in a free market and cause the quantity of a commodity supplied to be greater than would be demanded at a free market price.
Thus, a surplus exists as the difference between quantity supplied at the price floor and the lesser quantity demanded at that price.

Question 6

A project’s net present value, ignoring income tax considerations, is normally affected by the

Answer 6

Proceeds from the sale of the asset to be replaced.
The net present value approach is based on cash flows. Only the proceeds from sale of the asset to be replaced is a cash flow. The remaining alternatives are not cash flows, and do not cause cash flows to change when income tax effects are ignored. In the equipment replacement decision, the proceeds from the sale of the old asset (not its carrying value) increase the net present value of the replacement alternative.

Question 7

Yarrow Co. is considering the purchase of a new machine that costs $450,000. The new machine will generate net cash flow of $150,000 per year and net income of $100,000 per year for five years. Yarrow’s desired rate of return is 6%. The present value factor for a five-year annuity of $1, discounted at 6%, is 4.212. The present value factor of $1, at compound interest of 6% due in five years, is 0.7473. What is the new machine’s net present value?

Answer 7

$181,800
The net present value of the new machine is determined as the present value of future cash inflows less the present value of the current costs of the machine. Net income is not relevant in computing the net present value. In this question, the cash inflow is $150,000 per year for five years. The present value of that inflow is $150,000 x 4.212 (the present value of an annuity for five years) = $631,800. The present value of the cost of the new machine is $450,000. Thus, the net present value of the machine is $631,800 - $450,000 = $181,800.

Question 8

A corporation is considering purchasing a machine that costs $100,000 and has a $20,000 salvage value. The machine will provide net annual cash inflows of $25,000 per year and has a six-year life. The corporation uses a discount rate of 10%. The discount factor for the present value of a single sum six years in the future is 0.564. The discount factor for the present value of an annuity for six years is 4.355. What is the net present value of the machine?

Answer 8

$20,155
The net present value of the new machine is determined as the present value of future cash inflows less the present value of the current costs of the machine. The facts of this question contain two cash inflows: (1) the cash inflow of $25,000 per year for six years; and (2) the cash inflow from the salvage value of $20,000 at the end of the asset’s life. The present values of those inflows are $25,000 x 4.355 (the present value of an annuity for six years) = $108,875 and $20,000 x .564 (the present value of $1 discounted for six years) = $11,280, for a total of $108,875 + $11,280 = $120,155. The present value of the cost of the new machine is $100,000. Thus, the net present value of the machine is $120,155 - $100,000 = $20,155.

Question 9

Salem Co. is considering a project that yields annual net cash inflows of $420,000 for years 1 through 5, and net cash inflow of $100,000 in year 6. The project will require an initial investment of $1,800,000. Salem’s cost of capital is 10%. Present value information is present below:
Present value of $1 for 5 years at 10% is .62.
Present value of $1 for 6 years at 10% is .56.
Present value of an annuity of $1 for 5 years at 10% is 3.79.
What was Salem’s expected net present value for this project?

Answer 9

($152,200)
The expected net present value for this project is $152,200. The calculation would be the net present value for the first 5 years using the annuity factor ($420,000 x 3.79) plus the present value for year 6 using the present value of $1 factor ($100,000 x .56), both subtracted from the initial investment to get the net present value. Thus, the computation would be $1,591,800 (which is $420,000 x 3.79) + $56,000 (which is $100,000 x .56) equals $1,647,800 (the present value of future cash inflows), subtracted from the present value of the initial investment of $1,800,000, resulting in a net present value of $152,200. In summary, the calculation is $1,800,000 - ($1,591,800 + $56,000) = $152,200, the expected net present value.

Question 10

Net present value as used in investment decision-making is stated in terms of which of the following options?

Answer 10

Cash flow.
Net present value as used in investment decision-making is stated in terms of cash flow; specifically, in terms of the present value of cash flow. If the net present value of cash flow is zero or positive, an investment project is economically feasible.

Question 11

Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment is acquired. The equipment’s estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322.
Net present value is

Answer 11

$13,000
The computation of net present value (NPV) is:
NPV = Present value of cash inflows - Present value of cash outflows.

For the facts given, the calculation would be: NPV = ($20,000 x 5.65) - $100,000 = $113,000 - $100,000 = $13,000.
With positive NPV of $13,000, the decision should be to accept the project.

Question 12

Smarti Co. has determined the following data in connection with its evaluation of a capital investment project:

Initial cost of project	
$75,000
Estimated periods benefited	
10 years
Estimated annual savings	
$15,000
Estimated residual value	
$ 5,000
Cost of capital	
10%
Smarti uses straight-line depreciation for capital investments of this type. Excerpts from present value tables showed the following:

Using the above information, which one of the following is the present value of total estimated future cash inflows and savings? (Ignore income taxes.)

Answer 12

$94,105
B is correct. The total present value is the sum of the present value of a series (annuity) of savings plus the present value of the one-time residual value. The calculation of these elements is:
PV of savings = $15,000 x PV of an annuity at 10% for 10 years
PV of savings = $15,000 x 6.145 = $92,175
PV of residual value = $5,000 x PV of $1.00 at 10% for 10 years
PV of residual value = $5,000 x .386 = $1,930
Total PV = $92,175 + $1,930 = $94,105
$94,105 = Present value of total estimated future cash inflows and savings.

Question 13

The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?

Answer 13

Depreciation increases cash flow by reducing income taxes.
Determining the net present value of an investment is done by comparing the present value of the expected cash inflows (revenues or savings) of the project with the initial cash investment in the project (outflows). Since the amount of depreciation expense taken reduces taxes due, it reduces cash outflow by the amount of taxes saved. The present value of that saving enters into the determination of present values for net present value assessment purposes.

Question 14

A company is considering two projects, which have the following details:
Project A Project B
Expected sales $1,000 $1,500
Cash operating expense 400 700
Depreciation 150 250
Tax rate 30% 30%
Which project would provide the largest after-tax cash inflow?

Answer 14

Project B because after-tax cash inflow equals $635.
The project with the largest after-tax [net] cash inflow would be project B, with a net cash inflow of $635. The net cash inflow would be computed as: $1,500 - $700 = $800 x (1 - .30) = $800 x .70 = $560 + ($250 x .30) = $560 + $75 = $635. The ($250 x .30) is the tax savings from the deductibility of the depreciation for tax purposes.

Question 15

When estimating cash flow for use in capital budgeting, depreciation is

Answer 15

Utilized in determining the tax costs or benefit.
Depreciation may be used to determine the effect on tax costs or benefit from the recognition of depreciation expense for tax purposes. Specifically, depreciation expense recognized for tax purposes reduces taxable income and, therefore, the amount of tax paid (cash outflow).

Question 16

In evaluating the economic feasibility of a capital project, the discount rate (or hurdle rate of return) must be determined in advance when using the:

Answer 16

Net present value method.
The net present value method of evaluating capital projects uses a discount rate (also called hurdle rate or cost of capital rate) to discount future cash flows (or savings) to their present value. Thus, the discount rate or hurdle rate must be established in advance of using the method.
The present value of future cash inflows (or savings) is then subtracted from the cost (present values) of the project.
If the net present value is positive, the project is economically feasible.

Question 17

Which of the following characteristics represent an advantage of the internal rate of return technique over the accounting rate of return technique in evaluating a project?
I. Recognition of the project’s salvage value.

II. Emphasis on cash flows.

III. Recognition of the time value of money.

Answer 17

II and III.
Statements II and III are advantages of the IRR over ARR because ARR does not emphasize (use) cash flows, and does not consider the time value of money (discounted cash flow computations). ARR relates a project’s annual accrual-based income (as opposed to net cash inflow) to its investment. Furthermore, both approaches consider the project’s salvage value, although IRR uses the present value of the salvage amount.

Question 18

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 costs?

Answer 18

Internal rate of return.
The internal rate of return metric equates the present value of a project’s expected cash inflows to the present value of the project’s expected costs. It does so by determining the discount (interest) rate that equates the present value of the project’s future cash inflows with the present value of the project’s cash outflows. The rate so determined is the rate of return earned on the project.

Question 19

What is an internal rate of return?

Answer 19

A time-adjusted rate of return from an investment.
An internal rate of return is a time-adjusted rate of return from an investment. In capital budgeting an internal rate of return approach (also called a time adjusted rate of return) evaluates a project by determining the discount rate that equates the present value of the project’s future cash inflows with the present value of the project’s cash outflows. The rate so determined is the expected rate of return to be earned by the project.

Question 20

Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?

Answer 20

Internal rate of return.
The internal rate of return method (IRR - also called the time adjusted rate of return) evaluates a project by determining the discount rate that equates the present value of the project’s future cash inflows with the present value of the project’s cash outflows. The rate so determined is the rate of return earned by the project. The IRR uses both present value and cash flows.

Question 21

How are the following used in the calculation of the internal rate of return of a proposed project? Ignore income tax considerations.

Answer 21

Include Exclude
The IRR is the rate that equates the present value of net cash inflows with a project’s investment cost. Depreciation expense is not a cash flow and does not affect cash flows when income taxes are ignored; it should be excluded. The residual value of an asset at the end of a project is a cash flow, is discounted, and affects the present value of net cash inflows; it should be included.

Question 22

Neu Co. is considering the purchase of capital equipment that has a positive net present value based on Neu’s 12% hurdle rate.
The internal rate of return would be:

Answer 22

Greater than 12%
Since the internal rate of return determines the discount rate, which equates the present value of future cash inflows with the cost of the investment, if the project has a positive net present value, the discount rate (or internal rate of return) must be greater than the hurdle rate.

Question 23

Which of the following rates is most commonly compared to the internal rate of return to evaluate whether to make an investment?

Answer 23

Weighted-average cost of capital.
The weighted-average cost of capital is the cost of financing with each source of capital weighted by the proportion of total capital provided by each source, with the resulting weighted cost summed to get the total weighted-average cost of capital. The weighted-average cost also is the minimum rate of return that a firm must earn on its investments (i.e., uses of capital) and the calculated internal rate of return would be compared with the weighted-average cost of capital to determine whether or not an investment is economically feasible.

Question 24

Which of the following limitations is common to the calculations of payback period, discounted cash flow, internal rate of return, and net present value?

Answer 24

They rely on the forecasting of future data.
The calculation of payback period, discounted cash flow, internal rate of return and net present value all rely on the forecasting of future data. All of the listed calculations require that expected future cash flows be forecasted.

Question 25

Which of the following statements about investment decision models is true?

Answer 25

The payback rule ignores all cash flows after the end of the payback period.
The payback (period) rule or approach to assessing investments (e.g., capital projects) determines the number of years or other periods needed for future cash flows from an investment to recover the initial cost of the investment. It does not take into account cash flows for all periods, but measures only the present value of cash flows needed to recover the initial investment; cash flows received in periods after the initial investment is recovered (the payback period) are ignored.

Question 26

Polo Co. requires higher rates of return for projects with a life span greater than five years. Projects extending beyond five years must earn a higher specified rate of return. Which of the following capital budgeting techniques can readily accommodate this requirement?

Answer 26

Yes Yes
IRR is the rate that equates the present value of project net cash inflows and the cost of the investment. If the IRR, which is the expected compounded rate of return on a project, exceeds a specified return, the project is accepted. IRR can be compared to any specified rate for the purpose of accepting or rejecting projects. NPV is the difference between the present value of project inflows and the present value of outflows. The interest rate used to compute the present values is the rate that must be achieved. If the NPV is equal to or greater than 0, the project is accepted. NPV can accommodate any specified rate for the purpose of accepting or rejecting projects.

Question 27

Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment is acquired. The equipment’s estimated useful life is 10 years, with no residual value, and it would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322.
In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns closest to

Answer 27

5.00
The IRR is the rate of return that equates the present value of inflows with the present value of outflows. Expressed mathematically it is: Present value of inflows using IRR = present value of outflows using IRR. The calculation for the facts given would be:
$20,000 x (PV of annuity factor for 10 years at IRR percent) = $100,000

Rearranged: (PV of annuity factor for 10 years at IRR percent) = $100,000/$20,000 = 5.00
Using the present value of an annuity table, for n = 10, the factors nearest to 5.00 would be used to determine the IRR.

Question 28

Which of the following phrases defines the internal rate of return on a project?

Answer 28

The discount rate at which the net present value of the project equals zero.
The internal rate of return on a project is defined as the discount rate at which the net present value of the project equals zero. Specifically, the internal rate of return assesses a project by determining the discount rate that equates the present value of the project’s future cash inflows with the present value of the project’s future cash outflows.

Question 29

Which one of the following methods of evaluating potential capital projects would take into account depreciation expense that was non-deductible for tax purposes?

Answer 29

Accounting rate of return approach.
The accounting rate of return measures the expected annual incremental accounting income from a project as a percent of the initial (or average) investment in the project. Since it uses accounting income, it takes into account depreciation expense in computing the annual incremental income.

Question 30

Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment is acquired. The equipment’s estimated useful life is 10 years, with no residual value, and it would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322.
Accrual accounting rate of return based on initial investment is

Answer 30

10%
The accounting rate of return = (Change in) Annual accounting income/Initial Investment. For the facts given, the annual change in accounting income will be $20,000 - ($100,000/10 years) = $10,000. The accounting rate of return would be: $10,000/$100,000 = 10%.

Question 31

Phillips Company is considering the acquisition of a new machine that would cost $66,000, has an expected life of 6 years, and an expected salvage value of $16,000. The company expects the machine to provide annual incremental income before taxes of $7,200. Phillips has a tax rate of 30%. If Phillips uses average values in its calculations, which one of the following will be the average accounting rate of return on the machine?

Answer 31

12.29%
The (average) accounting rate of return is determined by dividing the average annual after-tax net income by the average cost of the investment. The after-tax income would be $7,200 x .70 = $5,040. The average cost of the investment would be beginning book value ($66,000) + ending book value of ($16,000), or $82,000/2 = $41,000. Therefore, the accounting rate of return is: $5,040/$41,000 = 12.29%.

Question 32

Lin Co. is buying machinery it expects will increase average annual operating income by $40,000. The initial increase in the required investment is $60,000, and the average increase in required investment is $30,000. To compute the accrual accounting rate of return, what amount should be used as the numerator in the ratio?

Answer 32

$40,000
The accounting rate of return (ARR) is calculated as:
ARR = Average annual incremental income/Initial (or Average) investment.

For the facts given, the equation would be: ARR = $40,000/$60,000 (or $30,000). Thus, the numerator is given as $40,000.

Question 33

Which of the following statements concerning the accounting rate of return approach to evaluating capital projects is/are correct?

I. It considers the entire life of a project.

II. It considers the time value of money.

III. It assumes that the incremental net income is the same each year.

Answer 33

I and III, only.
The accounting rate of return measures the expected annual incremental accounting income from a project as a percent of the initial (or average) investment in the project. It considers the entire life of the project and it assumes that the incremental net income is the same each year, including by using an average (Statements I and III, respectively).

Question 34

The war in Iraq substantially reduced the working population, as well as other economic resources, of that country. Which one of the following most likely occurred in the Iraqi economy as a result of the reduced working population?

Answer 34

The aggregate supply curve shifted inward.
Since labor is an economic resource, a decrease in labor would shift the aggregate supply curve inward (i.e., reduce aggregate supply).

Question 35

Which one of the following is not a limitation of the capital asset pricing model?

Answer 35

It fails to consider the time value of money.
The capital asset pricing model does consider the time value of money through the use of the risk-free rate of return. Therefore, failure to consider the time value of money is not a limitation of the model.

Question 36

When production levels are expected to decline within a relevant range, and a flexible budget is used, what effect would be anticipated with respect to each of the following?

Answer 36

Variable costs per unit Fixed costs per unit
No change Increase
Variable cost per unit in the relevant range is defined to be a constant. This assumption enables cost-volume-profit analysis and many other functions within cost accounting.
Total fixed cost is assumed to be constant in the relevant range. With declining production, fixed costs per unit would increase because the number of units produced is decreasing.

Question 37

The demand curve for a product reflects which of the following?

Answer 37

The impact that price has on the amount of a product purchased.
The demand curve reflects the impact that price has on the amount of a product purchased. A demand curve (or schedule) for a product shows the quantity of a commodity that will be demanded at various prices during a specified time, ceteris paribus (holding variables other than price constant).

Question 38

Which of the following statements is correct regarding the payback method as a capital budgeting technique?

Answer 38

The payback method provides the years needed to recoup the investment in a project.
The payback (period) approach determines the number of years (or other periods) needed to recover the initial cash investment in a project. It is calculated as the net investment in the project divided by the annual cash (net) inflows of the project. It uses undiscounted cash flows (i.e., does not consider the time value of money) and considers the project cash flows only up to the point at which the initial investment is recovered (i.e., does not measure whether or not the project will be profitable over its entire life).

Question 39

n which of the following market structures, if any, is a firm assured of making a profit in the short run?

Answer 39

Perfect Competition Monopolistic Competition Oligopoly Pure Monopoly
No No No No
A firm is not assured of making a short-run profit in any of the four basic market structures. Whether or not a firm makes a profit in any market structure depends on the firm’s ability to produce a good or service at a cost that is less than the price at which it can sell the product in the market.
A firm in any of the market structures can make a profit, break even, or suffer a loss, depending on the relationship between average cost to produce and sales price.

Question 40

Which one of the following statements concerning economic profit is true for a firm in a monopolistic competitive market?

Answer 40

Short run Long run
Yes No
While a firm in monopolistic competition can make an economic profit in the short run, it cannot do so in the long run because new firms will enter the market and/or consumers will switch to substitute products.

Question 41

Which one of the following would not cause an increase in demand for a commodity?

Answer 41

A reduction in the price of the commodity.
A reduction in price will not cause an increase in demand for a commodity, but rather will change (increase) the quantity demanded. An increase in demand causes a shift of the demand curve (up and to the right). A change in price causes movement along a specific demand curve.

Question 42

Which of the following changes in unemployment is most likely to be associated with a period of economic contraction?

Answer 42

Increase in the cyclical unemployment rate.
Cyclical unemployment results from a contraction in economic activity (i.e., a decrease in aggregate demand). During a period of economic contraction, the cyclical unemployment rate would be expected to increase.