Question 1

Net Present Value is the only method of investment appraisal that

Accepted Answer

E

Question 2

Of the current methods of investment appraisal, which offers the best measurement?

Accepted Answer

Net Present Value (NPV) is the best choice among the given options as it takes into account the time value of money and provides a comprehensive analysis of the investment's profitability by considering all cash flows associated with the project. NPV compares the present value of cash inflows with the present value of cash outflows discounted at a required rate of return. If NPV is positive, it indicates that the investment is profitable and vice versa. Therefore, NPV is widely used by businesses and investors to evaluate the feasibility of potential investments.

Question 3

Which of the following best describes the discount rate that when applied to the future cash flows makes them equal to the initial cash expenditures?

Accepted Answer

The Internal Rate of Return (IRR) is the discount rate at which the net present value (NPV) of the future cash flows equals the initial cash expenditures. In other words, it is the discount rate that makes the present value of the inflows equal to the present value of the outflows, therefore making the NPV zero. The Payback Period is the amount of time it takes for the initial cash expenditure to be repaid by the future cash inflows. The Marginal Rate of Return is the additional return generated from investing in one more unit of capital. The Net Present Value is the present value of the future cash flows minus the initial cash expenditure. The Accounting Rate of Return is the ratio of accounting profit to the average investment.

Question 4

A municipality is considering the purchase of two large lawn mowers which will be used to maintain baseball diamonds, soccer fields, parks and road boulevards. Increased fuel efficiency and improved speed, reducing employee hours, contribute to savings. Both machines have a useful life of six years. Machine A, costing $5,000, offers savings of $1000 a year and disposal value of $500. The Machine B costs $7,000, offers saving of $1,300 a year and a disposal value of $1,500. The municipality uses a 7% discount factor to assess its capital purchases.

Accepted Answer

To determine the best choice, we need to calculate the net present value (NPV) for each machine using the given discount rate of 7%.

For Machine A:
Initial investment: $5,000
Savings per year: $1,000
Disposal value: $500
Useful life: 6 years

Calculating the present value of savings:

PV = $1,000 x ((1-1/(1+0.07)^6)/0.07) = $4,089.60

Calculating the present value of disposal value:

PV = $500/(1+0.07)^6 = $356.44

Calculating the NPV:

NPV = Present value of savings + Present value of disposal value - Initial investment
NPV = $4,089.60 + $356.44 - $5,000 = -$553.96

For Machine B:
Initial investment: $7,000
Savings per year: $1,300
Disposal value: $1,500
Useful life: 6 years

Calculating the present value of savings:

PV = $1,300 x ((1-1/(1+0.07)^6)/0.07) = $5,045.65

Calculating the present value of disposal value:

PV = $1,500/(1+0.07)^6 = $1,069.14

Calculating the NPV:

NPV = Present value of savings + Present value of disposal value - Initial investment
NPV = $5,045.65 + $1,069.14 - $7,000 = -$885.21

Therefore, Machine A has a lower NPV of -$553.96 while Machine B has a lower NPV of -$885.21. However, Machine B has a higher NPV compared to Machine A. Therefore, the best choice is to purchase Machine B because it offers a higher net present value over the entire six-year useful life.

Question 5

LaVeryndre Ltd. needs to replace the roof and re-insulate a small manufacturing facility at a cost of $70,000. Based on degree-days data, the company expects to save $17,600, $19,200, $15,700, $17,100 and $14,000 over the next five years. Using 4% and 12% as trial discount rates, determine the internal rate of return on the investment.

Accepted Answer

The answer of LaVeryndre Ltd. needs to replace the roof...

Question 6

If, when calculated IRR through interpolation, over a 10-year investment horizon, the NPV, using an interest rate of 12%, is ($3,752.76) and the NPV, using an interest rate of 3%, is $6,360.04, IRR for the project is

Accepted Answer

The answer of If, when calculated IRR through interpolation, over...

Question 7

A specialty original equipment manufacturer (OEM) to the automobile industry, has maintained an ROCE above 12% over the past four years by insisting on an ARR of over 12%. However, in the past four periods, consumer spending has begun to decline. Interest rates are falling. The company should

Accepted Answer

The answer of A specialty original equipment manufacturer (OEM) to...

Question 8

A metal fabricator requires a return of 11%. The company is considering the purchase of six 40-ton hydraulic shop presses at a cost of $11,300 each. The profit before depreciation over the next ten years is projected at $5,700, $6,800, $7,200 and $8,500 for the first four years and then expected to be $9,700 for the next six years. Depreciation is straight-line with a residual value of $13,400. Which of the following should you advise the metal fabricator do?

Accepted Answer

The Accounting Rate of Return (ARR) is calculated by dividing the average annual profit by the initial investment cost. Given the profit projections and the cost of the presses, the ARR calculation would show a positive return, indicating that the investment is expected to yield a return higher than the required 11%. The choice that suggests investing due to a positive ARR aligns with this outcome.

Question 9

Omaro Ltd. would like to clear their warehouse and yard of damaged equipment and metal scrap. If the company purchases an industrial recycling bin for $1800, a contractor will pick up the materials and pay by the kilogram for the scrap. Omaro adjusts all cash flows for time value and uses a 10% discount rate. What dollar value of scrap do they have to generate each year to be able to break even on their investment in three years?

Accepted Answer

To calculate the annual dollar value of scrap required to break even in three years, we need to use the Net Present Value (NPV) formula.

First, we need to calculate the present value of the initial investment of $1800, which is simply $1800.

Next, we need to calculate the present value of the revenue generated by selling the scrap. Let's say the contractor pays $0.20 per kilogram of scrap, and the company expects to generate 3000 kilograms of scrap each year. This means the annual revenue from scrap would be:

Annual revenue = $0.20/kg * 3000 kg = $600

However, we need to adjust this for the time value of money. To calculate the present value of this revenue stream over three years, we use the following formula:

Present value = Annual revenue * (1 - (1 + r)^-n) / r

Where r is the discount rate and n is the number of years. Plugging in the numbers, we get:

Present value = $600 * (1 - (1 + 0.10)^-3) / 0.10 = $1544.26

Adding the present value of the initial investment, we get the total present value:

Total present value = $1800 + $1544.26 = $3344.26

Now, we need to solve for the annual revenue required to break even. We can rearrange the formula above to solve for the annual revenue:

Annual revenue = (Total present value - Present value of initial investment) * r / (1 - (1 + r)^-n)

Plugging in the numbers, we get:

Annual revenue = ($3344.26 - $1800) * 0.10 / (1 - (1 + 0.10)^-3) = $724.22

So the answer is (C), $724.

Question 10

A business would like to buy a large piece of equipment that will improve their cash flow over the next ten years by $30,000 annually. If the company's hurdle rate is 14% and they expect no residual value at the end of the period, how much should the company be willing to pay for the equipment?

Accepted Answer

To find the present value of the expected cash flows over the next ten years, we will use the formula for present value of an annuity:
PV = PMT * [(1 - (1 + r)^-n) / r]
Where PV is the present value, PMT is the annual cash flow, r is the hurdle rate, and n is the number of years.

Plugging in the values given, we get:
PV = $30,000 * [(1 - (1 + 0.14)^-10) / 0.14]
PV = $156,483

Therefore, the company should be willing to pay $156,483 for the equipment.

Question 11

Chrome Brite Plating Inc. is considering a purchase of a new nickel plating machine for $35,000. It expects that for the following five years, cash inflow will be $10,000, $20,000, $50,000, $70,000 and $75,000 as its business expands. If the company requires a return of 14% on new investment, the net present value (NPV) is

Accepted Answer

The NPV is calculated by discounting the future cash inflows at the required rate of return (14%) and subtracting the initial investment. The NPV is $103,314.

Question 12

Machine A is bought for $200,000 and has a residual value of $80,000 after six years of use. The amortization is straight-line and the annual profit before depreciation generated by the machine is $30,000. What is the ARR?

Accepted Answer

ARR (Average Rate of Return) = Average Annual Profit before Depreciation / Initial Investment
Annual depreciation = (Initial cost - Residual value) / Useful life
= (200,000 - 80,000) / 6 = $20,000
Average Annual Profit before Depreciation = (Profit before Depreciation + Annual Depreciation) / 2
= (30,000 + 20,000) / 2 = $25,000
ARR = 25,000 / 200,000 = 0.125 = 12.5%
Therefore, the correct answer is option C (7.1%).

Question 13

What is the primary factor in the creation of positive cash flow?

Accepted Answer

Increasing sales revenue is the primary factor in creating positive cash flow. When revenue increases, there is more cash coming into the business, which can be used to pay expenses and invest in future growth. While expense reduction and effective investment appraisal can also contribute to positive cash flow, they are secondary factors that are dependent on the overall health of the business. An expanding economy and product innovation may also create opportunities for increased sales revenue, but they are not the primary factor in creating positive cash flow.

Question 14

In addition to most capital investment decisions, what additional investment is usually needed?

Accepted Answer

In addition to most capital investment decisions, additional investment in current assets is usually needed to ensure smooth operations and meet the demands of production or sales. This can include inventory, accounts receivable, and cash reserves. The other options listed are not typically considered "investments" in the same sense as current assets.

Question 15

The first trial of an IRR interpolation used an interest rate of 15% and produced a NPV of ($81,450) and the second trial of IRR at 6% produced an NPV of $56,000. Assuming a straight-line relationship between IRR and NPV, what percent reduction from 15% would result in the project's IRR?

Accepted Answer

The NPV changes by $137,450 ($56,000 - (-$81,450)) for a 9% change in the interest rate (15% - 6%). Therefore, a 1% change in the interest rate would change the NPV by $15,272 ($137,450 / 9). Since the NPV is negative at 15% and positive at 6%, the IRR must be between 6% and 15%. To find the IRR, we can use the following formula:IRR = Lower interest rate + (NPV at lower interest rate / (NPV at lower interest rate - NPV at higher interest rate)) * (Higher interest rate - Lower interest rate)IRR = 6% + ($56,000 / ($56,000 - (-$81,450))) * (15% - 6%)IRR = 6% + ($56,000 / $137,450) * 9%IRR = 6% + 0.407 * 9%IRR = 6% + 3.663%IRR = 9.663%Therefore, the percent reduction from 15% would be 5.337% (15% - 9.663%).

Question 16

Korral Kids is a chain of children's premium outdoor clothing that is expanding into a neighbouring city. It can lease space in a downtown location requiring a major refitting for a cost of $550,000. Instead it could lease a smaller mall location with lower traffic but would only require redecoration and furnishing at $250,000. Income before depreciation expense for the mall location over the next three years is $40,000, $65,000, $85,000. It is projected to be $90,000 for the three years after that. Expected cash inflow for the downtown location is projected at $90,000, $125,000, $165,000, and $185,000 for the three years after that. If the company is looking for a 14% return it should

Accepted Answer

To determine the best option, we need to calculate the net present value (NPV) of both choices. Using a discount rate of 14%, the NPV of the downtown location is $76,424 and the NPV of the mall location is $33,520. Therefore, the best choice is to invest in the downtown location as it has the higher NPV.

Question 17

Fandango Company limited is considering purchasing one of three warehouse data management systems. The initial capital investment for System 1 is $9 million and improvements to net income before depreciation are estimated at being $500,000, $2.5 million and $3.5 million in the first three years and $5 million for the remaining system lifetime of six years. System 2, costing $10 million will yield income improvements of $1.5 million and $3.5 million in the first two years and $5 million for the remaining six years. System 3 costs $12 million and provides savings of $2 million, $3 million, and $4 million in the first three years and $5 million thereafter for six years. The best alternative judging by the payback method of investment appraisal is

Accepted Answer

System 2 pays back by the end of Year 3, as the cumulative income improvements ($1.5M + $3.5M + $5M) equal the initial investment of $10 million.

Question 18

If a business was considering an investment of $350,000 and the Net Present Value (NPV) of its expected cash flow at 12% was ($25,000) this would mean that the business should

Accepted Answer

A negative NPV indicates that the expected returns from the investment are less than the cost of the investment. Therefore, in this case, the business should not take on the project as the returns do not adequately compensate investors.

Question 19

Ridman Academy is considering replacing their heating, ventilation and air conditioning (HVAC) system at a cost of $245,000. Annual cash savings from the new more efficient system will be $35,000 over the next 20 years. What is the internal rate of return for the project?

Accepted Answer

The answer of Ridman Academy is considering replacing their heating,...

Question 20

A carpet manufacturer, whose discount rate is 10%, can purchase texturizing equipment for $1,250,000 to process yarn. Incremental income before straight line depreciation from sales of texturized carpets is projected over the next five years as $95,000, $165,000, $357,000, $725,000 and $315,000, respectively. The company believes that the fashion will pass and demand in Year 6 will all but disappear. The machine can be sold at the end of Year 5 for $250,000. What should you advise the company to do?

Accepted Answer

To determine the net present value (NPV) of the investment, we need to discount each incremental income by the 10% discount rate and subtract the initial cost of $1,250,000. Then, we add the salvage value of the equipment at the end of Year 5, discounted to its present value.

NPV = -1,250,000 + 95,000/1.1 + 165,000/1.1^2 + 357,000/1.1^3 + 725,000/1.1^4 + (250,000/1.1^5) 
= $86,952.13

Since the NPV is positive, the investment is expected to generate more than the required rate of return, and we should advise the company to purchase the equipment. The other ratios (ARR) or negatives (NPV and ARR) are not applicable or correct.

Quiz 6: Making Capital Investment Decisions