Cornerstones of Managerial Accounting Study Set 5

Business

Quiz 14 :

Capital Investment Decisions

Quiz 14 :

Capital Investment Decisions

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and discuss three possible reasons that the payback period is used to help make capital investment decisions.
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Payback period is the time required for a firm to recover its original or initial investment.
The three possible reasons that the payback period is used to make capital investment decisions are:
a) Some analyst suggest that the payback period can be used as a rough measure of risk, with a perceived notion that the longer it takes for a project to pay for itself, the riskier it is.
b) Another critical concern is obsolescence. If the risk of obsolescence is high then the firm would want to recover funds quickly.
c) Many managers would choose payback period out of self-interest. If a manager's performance is measured using short run criteria as annual net income, project with quick pay back may be chosen to show improve net income and cash flow as quickly as possible.

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ARR has one specific advantage not possessed by the payback period in that it
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E. Considers the profitability of a project beyond the payback period.
Accounting rate of return measures the return on a project in terms of income, as opposed to using a project's cash flow. It is the average income divided by the original or average investment.
One of the specific advantages of ARR which is not possessed by the payback period is that ARR considers the profitability of a project beyond the payback period. The payback period ignores the financial performance of a project beyond the payback period.

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Describe at least one qualitative factor that NoFat should consider, in addition to the financial factors, in making its final decision regarding the acceptance or rejection of the special sales offer.
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One important qualitative factor is product reputation , the perception of the public about olestra's safety. In particular, a large percentage of NoFat's customers might be concerned that olestra is not a safe ingredient for human ingestion given its apparent effectiveness in cleaning up toxic waste sites.
As a result, the acceptance of PU's special sales offer might significantly decrease NoFat's regular sales of olestra.

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time value of money is ignored by the payback period and the ARR. Explain why this is a major deficiency in these two models.
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Explain the difference between independent projects and mutually exclusive projects.
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Mutually exclusive capital budgeting projects are those that
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Based solely on financial factors, explain why NoFat should accept or reject PU's special sales offer.
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is the accounting rate of return? Compute the ARR for an investment that requires an initial outlay of $300,000 and promises an average net income of $100,000.
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Allyson decides to use NoFat's 10% mark-up pricing method to set the price for PU's special sales offer, a. Calculate the price that NoFat would charge PU for each pound of olestra. b. Calculate the relevant profit that NoFat would earn if it set the special sales price by using its mark-up pricing method. (Hint: Use the estimate of relevant costs that you calculated in response to Requirement 1b.) c. Explain why NoFat should accept or reject the special sales offer if it uses its mark-up pricing method to set the special sales price.
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payback period suffers from which of the following deficiencies?
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Capital investments should
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NPV is the same as the profit of a project expressed in present dollars. Do you agree? Explain.
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Conduct a relevant analysis of the special sales offer by calculating the following: a. The relevant revenues associated with the special sales offer b. The relevant costs associated with the special sales offer c. The relevant profit associated with the special sales offer
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Explain why the timing and quantity of cash flows are important in capital investment decisions.
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Explain the relationship between NPV and a firm's value.
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is the payback period? Compute the payback period for an investment requiring an initial outlay of $80,000 with expected annual cash inflows of $30,000.
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make a capital investment decision, a manager must
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investment of $6,000 produces a net annual cash inflow of $2,000 for each of 5 years. What is the payback period?
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investment of $1,000 produces a net cash inflow of $500 in the first year and $750 in the second year. What is the payback period?
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Assume that NoFat pays for all costs with cash. Also, assume a 10% discount rate, a 5-year time horizon, and all cash flows occur at the end of the year. Using an NPV approach to discount future cash flows to present value, a. Calculate the NPV of accepting the special sale with the assumed positive relevant profit of $10,000 per year (i.e., the special sales alternative). b. Calculate the NPV of downsizing capacity as previously described (i.e., the down sizing alternative). c. Based on the NPV of Calculations a and b, identify and explain which of these two alternatives is best for NoFat to pursue in the long term.
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