Financial and Managerial Accounting

Business

Quiz 26 :

Capital Budgeting

Quiz 26 :

Capital Budgeting

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Understanding Return on Average Investment Relationships Foz Co. is considering four investment proposals (A, B, C, and D). The following table provides data concerning each of these investments: img Solve for the missing information pertaining to each investment proposal.
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Evaluation of segment performance: Organization which is divided into different segments based on activities, functions or products, their performance is evaluated by preparing contribution format income statement. It provides classification of cost into variable and fixed expenses, direct and indirect expenses which is required to keep a check on expenses. Such detailed data provide support in controlling the expenses and improv performance accordingly.
Return on investment: Return on investment is the ratio which describe the relationship between the net income and amount invested. This ratio depicts the performance of the business unit or segment by measuring the profits earned by investing specific amount in the business.
img Fill the missing information in the table as given below:
img Compute each missing item in the table as given below:
Investment A:
Compute return on average investment as given below:
img Thus, return on average investment is 23.08%
Working note:
Compute average investment in proposal A as given below:
img Thus, average investment for proposal A is $26,000.
Investment B:
Compute average net income from formula of return on investment as given below:
img Thus, net income in proposal B is $7,000.
Working note:
Compute average investment for proposal B as given below:
img Thus, average investment for proposal B is $25,000.
Investment C:
Compute average investment value of proposal C from formula of return on investment as given below:
img Thus, average investment in proposal C is $27,000.
Compute estimated salvage value in proposal C as given below:
img Thus, estimated salvage value in proposal C is $4,000.
Investment D:
Compute average investment value of proposal D from formula of return on investment as given below:
img Thus, average investment in proposal D is $30,000.
Compute estimated salvage value in proposal D as given below:
img Thus, investment value in proposal D is $56,000.

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Analyzing Capital Investment Proposals Hibbing Technology is considering two alternative proposals for modernizing its production facilities. To provide a basis for selection, the cost accounting department has developed the following data regarding the expected annual operating results for the two proposals: img Instructions a. For each proposal, compute the (1) payback period, (2) return on average investment, and (3) net present value, discounted at an annual rate of 12 percent. (Round the payback period to the nearest tenth of a year and the return on investment to the nearest tenth of a percent.) Use Exhibits 26-3 and 26-4 where necessary. b. On the basis of your analysis in part a, state which proposal you would recommend and explain the reasons for your choice. EXHIBIT 26-3 Present Value of $1 Payable in n Periods img EXHIBIT 26-4 Present Value of a $1 Annuity Receivable Each Period for n Periods img
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a.
1.
Payback period:
• Payback period means the time period to get back the investment made in a project inform of returns. This is one of the most familiar techniques to compare investment alternatives.
• Generally, companies are interested in the projects having the shorter payback period because once the funds invested in the project were got back then the funds can be used for some other purpose which helps for the organization growth and development. In this method cash flows beyond payback period are not considered.
Payback period calculated using the formula:
Compute the Payback period of equipment:
img Payback period for Proposal A is
img and for Proposal B is
img .
2.
Return on average investment can be computed:
img Where,
img img Compute return on average investment:
img Return on average investment for Proposal A is
img and for Proposal B is
img .
3.
Compute the net present value of each proposal:
img Net present value for Proposal A is
img and for Proposal B is
img .
b.
It is better to invest in Proposal A and is because of following conditions:
• Payback period can't be considered singly, it is more useful only when we use other capital budgeting techniques.
• Average return on investment is more in case of Proposal A than Proposal B.
• Net present value of Proposal A is more than Proposal B.
Based on above points, it is better to invest in Proposal A.

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What is capital budgeting ? Why are capital budgeting decisions crucial to the long-run financial health of a business enterprise?
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Analyzing Capital Investment Proposals Jason Equipment Company is evaluating two alternative investment opportunities. The controller of the company has prepared the following analysis of the two investment proposals: img Instructions a. For each proposed investment, compute the (1) payback period, (2) return on average investment, and (3) net present value, discounted at an annual rate of 15 percent. (Round the payback period to the nearest tenth of a year and the return on investment to the nearest tenth of a percent.) Use Exhibits 26-3 and 26-4 where necessary. b. Based on your analysis in part a, which proposal do you consider to be the better investment? Explain. EXHIBIT 26-3 Present Value of $1 Payable in n Periods img EXHIBIT 26-4 Present Value of a $1 Annuity Receivable Each Period for n Periods img
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Heartland Paper Company is considering the purchase of a new high-speed cutting machine. Two cutting machine manufacturers have approached Heartland with proposals: (1) Toledo Tools and (2) Akron Industries. Regardless of which vendor Heartland chooses, the following incremental cash flows are expected to be realized: img a. If the machine manufactured by Toledo Tools costs $27,000. what is its expected payback period? b. If the machine manufactured by Akron Industries has a payback period of 66 months, what is its cost? c. Which of the machines is most attractive based on its respective payback period? Should Heartland base its decision entirely on this criterion? Explain your answer.
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Net Present Value Computations Landry's Tool Supply Corporation is considering purchasing a machine that costs $98,000 and will produce annual cash flows of $34,000 for six years. The machine will be sold at the end of six years for $5,000. What is the net present value of the proposed investment? Landry's requires a 12 percent return on all capital investments.
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Red Robin Gourmet Burgers is an upscale restaurant chain in the Northwest. The chain's former chairman, Michael Snyder, encouraged employees to be "unbridled" in everything they did. Unfortunately, Snyder was too unbridled with his use of some of the company's assets. The company reported the issue to the Securities and Exchange Commission, saying that the chairman's improprieties involved "use of chartered aircraft and travel and entertainment expenses, including charitable donations." After an audit of travel logs, Snyder repaid the company $1.25 million. In addition. Snyder owned a large stake in a company that was on opposite sides of transactions with R ed Robin a clear violation of the company's code of ethics governing conflicts of interest. Snyder has since stepped down and the company has moved to improve its corporate governance. Instructions a. Explain how governance violations such as those described as taking place at Red Robin Gourmet Burgers have an impact on capital budgeting outcomes. b. Do you believe that improved corporate governance practices can result in improved returns to capital investments in companies? Explain why or why not.
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Understanding Payback Period A company invests $175,000 in plant assets with an estimated 25-year service life and no salvage value. These assets contribute $28,000 to annual net income when depreciation is computed on a straight-line basis. Compute the payback period and explain your computation.
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Analyzing Capital Investment Proposals Welsh Industries is evaluating two alternative investment opportunities. The controller of the company has prepared the following analysis of the two investment proposals: img Instructions a. For each proposed investment, compute the (1) payback period, (2) return on average investment, and (3) net present value, discounted at an annual rate of 10 percent. (Round the payback period to the nearest tenth of a year and the return on investment to the nearest tenth of a percent.) Use Exhibits 26-3 and 26-4 where necessary. b. Based on your computations in part a, which proposal do you consider to be the better investment? Explain. EXHIBIT 26-3 Present Value of $1 Payable in n Periods img EXHIBIT 26-4 Present Value of a $1 Annuity Receivable Each Period for n Periods img
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A particular investment proposal has a positive net present value of $20 when a discount rate of 8 percent is used. The same proposal has a negative net present value of $2,000 when a discount rate of 10 percent is used. What conclusions can be drawn about the estimated return of this proposal?
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The management of Metro Printers is considering a proposal to replace some existing equipment with a new highly efficient laser printer. The existing equipment has a current book value of $2,200,000 and a remaining life (if not replaced) of 10 years. The laser printer has a cost of $ l.300.000 and an expected useful life of 10 years. The laser printer would increase the company's annual cash flows by reducing operating costs and by increasing the company's ability to generate revenue. Susan Mills, controller of Metro Printers, has prepared the following estimates of the laser printer's effect on annual earnings and cash flow: img Don Adams, a director of Metro Printers, makes the following observation: "These estimates look fine, but won't we take a huge loss in the current year on the sale of our existing equipment? After the invention of the laser printer. I doubt that our old equipment can be sold for much at all." In response Mills provides the following information about the expected loss on the sale of the existing equipment: img Adams replies. "Good grief, our loss would be almost as great as the cost of the laser itself. Add this $1,200,000 loss to the $1,300,000 cost of the laser, and we're into this new equipment for $2,500,000. I'd go along with a cost of $1,300,000, but $2,500,000 is out of the question." Instructions a. Use Exhibits 26-3 and 26-4 to help compute the net present value of the proposal to sell the existing equipment and buy the laser printer, discounted at an annual rate of 15 percent. In your computation, make the following assumptions regarding the timing of cash flows: 1. The purchase price of the laser printer will be paid in cash immediately. 2. The $200,000 sales price of the existing equipment will be received in cash immediately. 3. The income tax benefit from selling the equipment will be realized one year from today. 4. Metro uses straight-line depreciation in its income tax returns as well as its financial statements. 5. The annual net cash flows may be regarded as received at year-end for each of the next 10 years. b. Is the cost to Metro Printers of acquiring the laser printer $2,500,000, as Adams suggests? Explain fully.
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Toying With Nature wants to take advantage of children's current fascination with dinosaurs by adding several scale-model dinosaurs to its existing product line. Annual sales of the dinosaurs are estimated at 80.000 units at a price of $6 per unit. Variable manufacturing costs are estimated at. $2.50 per unit, incremental fixed manufacturing costs (excluding depreciation) at $45,000 annually, and additional selling and general expenses related to the dinosaurs at $55,000 annually. To manufacture the dinosaurs, the company must invest $350,000 in design molds and, special equipment. Since toy fads wane in popularity rather quickly, Toying With Nature anticipates the special equipment will have a three-year service life with only a $20,000 salvage value. Depreciation will be computed on a straight-line basis. Ail revenue and expenses other than depreciation will be received or paid in cash. The company 's combined federal and state income tax rate is 40 percent. Instructions a. Prepare a schedule showing the estimated increase in annual net income from the planned manufacture and sale of dinosaur toys. b. Compute the annual net cash flows expected from this project. c. Compute for this project the (l) payback period. (2) return on average investment, and (3) net present value, discounted at an annual rate of 15 percent. Round the payback period to the nearest tenth of a year and the return oil average investment to the nearest tenth of a percent. Use Exhibits 26-3 and 26-4 where necessary.
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Using Return on Investment to Evaluate Proposals Doug's Conveyor Systems, Inc., is considering two investment proposals (1 and 2). Data for the two proposals are presented here: img Calculate the return on average investment for both proposals.
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Dollars and Cents versus a Sense of Ethics Grizzly Community Hospital in central Wyoming provides health care services to families living within a 200-mile radius. The hospital is extremely well equipped for a relatively small, community facility. However, it does not have renal dialysis equipment for kidney patients. Those patients requiring dialysis must travel as far as 300 miles to receive care. Several of the staff physicians have proposed that the hospital invest in a renal dialysis center. The minimum cost required for this expansion is $4.5 million. The physicians estimate that the center will generate revenue of $1.15 million per year for approximately 20 years. Incremental costs, including the salaries of professional staff and depreciation, will average $850,000 annually. Grizzly is exempt from paying any income taxes. The only difference between annual net income and net cash flows is caused by depreciation expense. The center is not expected to have any salvage value at the end of 20 years. The administrators of the hospital strongly oppose the proposal for several reasons: (1) They do not believe that it would generate the hospital's minimum required return of 12 percent on capital investments; (2) they do not believe that kidney patients would use the facility even if they could avoid traveling several hundred miles to receive treatment elsewhere; (3) they do not feel that the hospital has enough depth in its professional staff to operate a dialysis center; and (4) they are certain that $4.5 million could be put to better use, such as expanding the hospital's emergency services to include air transport by helicopter. The issue has resulted in several heated debates between the physicians and the hospital administrators. One physician has even threatened to move out of the area if the dialysis center is not built. Another physician was quoted as saying, "All the administrators are concerned about is the almighty dollar. We are a hospital, not a profit-hungry corporation. It is our ethical responsibility to serve the health care needs of central Wyoming's citizens." Instructions Form small groups of four or five persons. Within each group, designate who will play the role of the hospital's physicians and who will play the role of the hospital's administrators. Then engage in a debate from each party's point of view. Be certain to address the following: a. Financial factors and measures. b. Nonfinancial factors such as (1) ethical responsibility, (2) quality of care issues, (3) opportunity costs associated with alternative uses of $4.5 million, (4) physician morale, and (5) whether a community hospital should be run like a business. c. Measures that could be taken to check for overly optimistic or pessimistic estimates.
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Monster Toys is considering a new toy monster called Garga. Annual sales of Garga are estimated at 100.000 units at a price of $8 per unit. Variable manufacturing costs are estimated at $3 per unit, incremental fixed manufacturing costs (excluding depreciation) at $60,000 annually, and additional selling and general expenses related to the monsters at $40,000 annually. To manufacture the monsters, the company must invest $400,000 in design molds and special equipment. Since to\ fails wane in popularity rather quickly. Monster Toys anticipates the special equipment will have a three-year service life with only a $ 10,000 salvage value. Depreciation will be computed on a straight-line basis. All revenue and expenses other than depreciation will be received or paid in cash. The company's combined federal and state income tax rate is 30 percent. Instructions a. Prepare a schedule showing the estimated increase in annual net income from the planned manufacture and sale of Garga. b. Compute the annual net cash Hows expected from this project. c. Compute for this project the (1) payback period, (2) return on average investment, and (3) net present value, discounted at an annual rate of 12 percent. Round the payback period to the nearest tenth of a year and the return on average investment to the nearest tenth of a percent. Use Exhibits 26-3 and 26-4 where necessary.
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Analyzing Capital Investment Proposals Virginia Technology is considering two alternative proposals for modernizing its production facilities. To provide a basis for selection, the cost accounting department has developed the following data regarding the expected annual operating results for the two proposals: img Instructions a. For each proposal, compute the (1) payback period, (2) return on average investment, and (3) net present value, discounted at an annual rate of 15 percent. (Round the payback period to the nearest tenth of a year and the return on investment to the nearest tenth of a percent.) Use Exhibits 26-3 and 26-4 where necessary. b. On the basis of your analysis in part a, state which proposal you would recommend and explain the reasons for your choice. EXHIBIT 26-3 Present Value of $1 Payable in n Periods img EXHIBIT 26-4 Present Value of a $1 Annuity Receivable Each Period for n Periods img
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Identify some conditions where upper management might allow some divisions to have a lower required rate of return.
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What is the major shortcoming of using the payback periodas the only criterion in making capital budgeting decisions?
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International Investments in Outsourcing What are the pitfalls to avoid when investing in overseas activities? The following key issues have been identified as important: • Lower cost offshore does not always mean gains in efficiency. • Choose your model carefully; either run your own offshore operation or outsource. • Get your current employees to be supportive; otherwise they can hinder the process. • Treat your overseas partners as equals in your business dealings. Instructions a. Explain how the above list of key issues in offshore investments can have an impact on future cash flows associated with an offshore investment. b. Discuss the ethical implications of encouraging current employees to help a company shift jobs overseas.
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The following are 10 technical accounting terms introduced or emphasized in this chapter: img Each of the following statements may (or may not) describe one of these technical terms. For each statement, indicate the accounting term described, or answer "None" if the statement does not correctly describe any of the terms. a. The examination of differences among revenue, costs, and cash flows under alternative courses of action. b. A cost incurred in the past that cannot be changed as a result of future actions. c. The process of planning and evaluating proposals for investments in plant assets. d. The average annual net income from an investment expressed as a percentage of the average amount invested. e. The length of time necessary to recover the entire cost of an investment from resulting annual net cash flows. f. The present value of an investment's expected future cash flows. g. The amount of money today that is considered equivalent to the cash flows expected to take place in the future. h. The required rate of return used by an investor to discount future cash flows to their present value. i. Often an investment's final cash flows to be considered in discounted cash flow analysis.
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