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Capital Investment Decisions: an Overview
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Fundamentals of Cost Accounting Study Set 4

Business

Quiz 19 :
Capital Investment Decisions: an Overview

Quiz 19 :
Capital Investment Decisions: an Overview

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What are the two most important factors an accountant must estimate in the capital investment decision
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Capital investment decisions :
Capital investment decisions are also known as capital budgeting decisions. It involves the judgements relating to investment in any project with an expectation of deriving benefits in the future.
Capital investment decisions includes identification, analysis and selection of investment projects involving future cash inflows and outflows.
Capital expenditure is done to expand the business operations of any enterprise. Some examples are: Purchase of plants, buildings, or acquisition of new machinery to expand the production capacity.
Decisions relating to capital investment are generally made by the managers of finance department because it involves large amount of money and investment risk. Accountants and other finance experts assist managers in analyzing and evaluating various project proposals. They develop cash flow models to estimate the expected benefits of the project.
Accountants play a vital role in the capital investment decision. The two most important factors they estimate in the investment decision are:
1. The amount of cash inflows and outflows used in capital investment decision models.
2. The timing of cash flows used in capital investment decision models.

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What does the time value of money mean
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The term time value of money refers to the concept that money in hand currently is actually worth more than money received in the future.
•All capital investment decisions made by firms are based on the expected future cash flows of an investment opportunity.
•These future cash flows are calculated based on the amount of the investment, the interest rate, and the length of time of the investment.
•The timing of the future cash flows is very important. As cash is received from one investment, it can be immediately be reinvested , ensuring that money is not sitting idle but rather continuously earning more money.

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What is the difference between revenues and cash inflows
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It is important to understand the difference between revenues and cash inflows , as they are two different accounting concepts.
•Cash inflows refer to the physical receipt of cash. However, cash inflows are not always received at the same time the related revenues are recognized. All cash flows are not revenues. For example cash received for loan taken is a cash receipt but not a revenue.
•Revenues refer to the earning of money, but not necessarily the receipt of money. Remember, in accounting, revenues are recognized when they are earned (such as on the date of sale of a product) and not when they are received.
•In capital investment analysis, cash flows are used rather than revenues and costs. This is because capital investment uses actual cash received for investment purposes.

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What is the difference between expenses and cash outflows
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What is the difference between depreciation and the tax shield on depreciation
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Given two projects with equal cash flows but different timing, how can we determine which (if either) project should be selected for investment
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What are the four types of cash flows related to a capital investment project and why do we consider them separately
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Is depreciation included in the computation of net present value Explain.
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"The total tax deduction for depreciation is the same over the life of the project regardless of depreciation method. Why then would one be concerned about the depreciation method for capital investment analysis " Comment.
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"Working capital is just the temporary use of money during the life of the project. What is initially contributed is returned at the end, so it can be ignored in evaluating a project." Comment.
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Present Value of Cash Flows Star City is considering an investment in the community center that is expected to return the following cash flows: img This schedule includes all cash inflows from the project, which will also require an immediate $200,000 cash outlay. The city is tax-exempt; therefore, taxes need not be considered. Required a. What is the net present value of the project if the appropriate discount rate is 20 percent b. What is the net present value of the project if the appropriate discount rate is 12 percent
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Present Value of Cash Flows Rush Corporation plans to acquire production equipment for $600,000 that will be depreciated for tax purposes as follows: year 1, $120,000; year 2, $210,000; and in each of years 3 through 5, $90,000 per year. An 18 percent discount rate is appropriate for this asset, and the company's tax rate is 40 percent. Required a. Compute the present value of the tax shield resulting from depreciation. b. Compute the present value of the tax shield from depreciation assuming straight-line depreciation ($120,000 per year).
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Present Value Analysis in Nonprofit Organizations The Johnson Research Organization, a nonprofit organization that does not pay taxes, is considering buying laboratory equipment with an estimated life of seven years so it will not have to use outsiders' laboratories for certain types of work. The following are all of the cash flows affected by the decision: img Required Calculate the net present value of this decision. (Refer to Exhibit A.2 in formatting your answer.) Should the organization buy the equipment
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Sensitivity Analysis in Capital Investment Decisions Square Manufacturing is considering investing in a robotics manufacturing line. Installation of the line will cost an estimated $3 million. This amount must be paid immediately even though construction will take three years to complete (years 0, 1, and 2). Year 3 will be spent testing the production line and, hence, it will not yield any positive cash flows. If the operation is very successful, the company can expect after-tax cash savings of $2 million per year in each of years 4 through 7. After reviewing the use of these systems with the management of other companies, Square's controller has concluded that the operation will most probably result in annual savings of $1,400,000 per year for each of years 4 through 7. However, it is entirely possible that the savings could be as low as $600,000 per year for each of years 4 through 7. The company uses a 16 percent discount rate. Required Compute the NPV under the three scenarios.
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Compute Net Present Value Dungan Corporation is evaluating a proposal to purchase a new drill press to replace a less efficient machine presently in use. The cost of the new equipment at time 0, including delivery and installation, is $200,000. If it is purchased, Dungan will incur costs of $5,000 to remove the present equipment and revamp its facilities. This $5,000 is tax deductible at time 0. Depreciation for tax purposes will be allowed as follows: year 1, $40,000; year 2, $70,000; and in each of years 3 through 5, $30,000 per year. The existing equipment has a book and tax value of $100,000 and a remaining useful life of 10 years. However, the existing equipment can be sold for only $40,000 and is being depreciated for book and tax purposes using the straight-line method over its actual life. Management has provided you with the following comparative manufacturing cost data: img The existing equipment is expected to have a salvage value equal to its removal costs at the end of 10 years. The new equipment is expected to have a salvage value of $60,000 at the end of 10 years, which will be taxable, and no removal costs. No changes in working capital are required with the purchase of the new equipment. The sales force does not expect any changes in the volume of sales over the next 10 years. The company's cost of capital is 15 percent, and its tax rate is 45 percent. Required a. Calculate the removal costs of the existing equipment net of tax effects. b. Compute the depreciation tax shield. c. Compute the forgone tax benefits of the old equipment. d. Calculate the cash inflow, net of taxes, from the sale of the new equipment in year 10. e. Calculate the tax benefit arising from the loss on the old equipment. f. Compute the annual differential cash flows arising from the investment in years 1 through 10. g. Compute the net present value of the project.
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