CHAPTER 11

MANAGING LONG-LIVED RESOURCES: CAPITAL BUDGETING

TRUE/FALSE
1. Money is not a productive asset because it is not a long-lived resource.
LO1 False Money is a productive asset.
2. The opportunity of cash is the time value of money.
LO1 True
3. It is not difficult to match the supply and demand for capacity resources over a
period of months or even years.
LO1 False It is difficult to match the supply and demand for capacity resources
over a period of months or even years.
4. Cost allocations ignore the lumpy nature of capacity resources, and estimate
costs as if we can match supply and demand continuously and smoothly.
LO1 True
5. Strategic plans specify how the company intends to achieve its long-term
objectives, and dictate what resources the firm needs to execute its plans.
LO1 True
6. As it relates to capital expenditure decisions, cost of capital is the opportunity
cost of capital required for the proposed investment.
LO2 True
7. The initial outlay for an asset does not include the cost of installation and
training charges.
LO2 False The initial outlay includes all costs incurred to ready the asset for its
intended use.
8. The salvage of an asset is the residual value from disposing of the asset at the
end of its useful life.
LO2 True
9. Setting an estimated life expectancy of an asset too low understates the
profitability of the investment and could result in the firm rejecting profitable
opportunities.
LO2 True
10.The cost of capital is measured as the total of all costs incurred to ready an asset
for its intended use, including purchase price, shipping and delivery, taxes, and
any installation and training costs.
LO2 False The cost of capital is measured as the rate of return that providers of
capital expect from their investment.
11.The two main discounted cash flow techniques used in capital budgeting are net
present value (NPR) and cost-volume-profit (CVP).

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Balakrishnan Managerial Accounting

LO3 False The two main discounted cash flow techniques used in capital
budgeting are net present value (NPV) and internal rate of return (IRR).

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Managing Long-lived Resources: Capital Budgeting

12.When analyzing capital investments using the NPV method, the first step is to
discount the initial investment.
LO3 False The initial investment account is already at its present value. It
requires no discount.
13.The present value factor is also known as the discount factor.
LO3 True.
14.Unlike the Cost-Volume-Profit method, the NPV method does not allow users to
perform what-if sensitivity analysis with respect to various estimates and
assumptions, and to examine alternative scenarios.
LO3 False Like the CVP method, the NPV method allows the user to perform
what-if sensitivity analysis with respect to various estimates and
assumptions, and to examine alternative scenarios.
15.Like the Net Present Value method, the Internal Rate of Return method assumes
that the initial cash outflow takes place at the beginning of the period.
LO3 True
16.Under the payback method to evaluate investments, we compute how long it
takes to recoup the initial investment using discounted cash flows.
LO4 False Under the payback method to evaluate investments, we compute how
long it takes to recoup the initial investment using undiscounted cash
flows.
17.The greatest advantage of the payback method is that the payback period is
easy to compute and to understand.
LO4 True
18.The modified payback method accumulates the present value of future cash
flows over time and compares the cumulative value with the initial cash outlay.
LO4 True
19.The greatest advantage of the modified payback method is that it considers all
future cash flows from a project as does the NPV method.
LO4 False The modified payback method does not consider all future cash flows
from a project as the NPV method does.
20.The accounting rate of return is relatively straightforward to compute, but
ignores the time value of money.
LO4 True
21.Regardless of the method used to evaluate long-lived resources, firms need to
consider one very important factor: present value.
LO5 False Regardless of the method they use to evaluate projects, firms need to
consider one very important factor: taxes.
22.Net cash flows typically equal accounting income.
LO5 False Net cash flows do not typically equal accounting income.

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Balakrishnan/Managerial Accounting, 2e
23.Taxes affect both the amount and timing of cash flows.
LO5 True
24.Depreciation offers a tax shield that reduces the cash outflow associated with
tax payments.
LO5 True
25.U.S. tax laws only allow depreciation deductions using the Modified Accelerated
Cost Recovery System (MACRS).
LO5 False In addition to straight-line depreciation method, U.S. tax laws also
allow depreciation deductions as stipulated by the Modified
Accelerated Cost Recovery System (MACRS).
26.The hurdle rate reflects the minimum expected rate of return of the
management from any project.
LO6 True
27.Estimating future cash inflows and outflows, and identifying the appropriate
discount rate for present value calculations is generally all companies need to
evaluate a given capital expenditure.
LO6 False Estimating future cash inflows and outflows, and identifying the
appropriate discount rate for present value calculations is not enough.
Companies also need to determine the future non-financial costs and
benefits from a capital expenditure.
28.Ignoring future benefits because they are hard to quantify can lead to lost
opportunities.
LO6 True
29.Some firms accept low rates of return to compensate for the risk from taking on
long-lived capital investments.
LO6 False Some firms demand high rates of return to compensate for the risk
from taking on capital investments with longevity.
30.Real option analysis is a collection of mathematical techniques for valuing the
flexibility associated with a project.
LO6 True
31.Assume you inherit cash from a relative and invest the money in a stock fund
that promises an expected annual return. If you want to know how much the
money will grow if you reinvest any interim proceeds in the same fund, use the
Present Value Table for Future Value of an Annuity in Arrears to determine the
amount.
Appendix A False Use the Present Value Table for Future Value of an Investment
to determine the amount.
32.Suppose you want to have $100,000 15 years from now. To determine the
amount you need to invest now at an expected rate of return, use the Present
Value of a Future Financial Need.
Appendix A True

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Managing Long-lived Resources: Capital Budgeting

33.When you were a high school senior, your parents estimated that your college
tuition would $6,000 per year, and the amount would be due at the start of each
year for the next four years. To determine how much your parents needed to
invest when you were a high school senior, they used the table for Present Value
of a Future financial Need.
Appendix A False They used the table for Present Value of an Annuity in Arrears.
34.An annuity is a stream of cash flow with the property that the cash flows are
equal per period.
Appendix A True
35.The only way to compute future values is using the built-in formula in
spreadsheet programs.
Appendix A False We can compute future values by using the built-in formula in
spreadsheet programs or looking up the value factor from a
table.
36.

The formula for the Present Value

of $1 is:

1
(1 +
r)n

Appendix B True
38.The formula for the Future Value of $1 is (1 r) n
Appendix B False The formula for the Future Value of $1 is (1 + r) n.
39.

The formula for the Present Value of an Annuity of $1

in Arrears is:

1
(1+r)n-1
r

Appendix B True
41.

The formula for the Future Value of an Annuity of $1

in Arrears is:

Appendix B True

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1 (1+r)-n 1
r

Balakrishnan/Managerial Accounting, 2e
MULTIPLE CHOICE
43.Despite the widespread use of allocations for decision-making, they suffer from
which of the following drawbacks?
A. They do not account for the time value of money.
B. They do not account for the lumpy nature of capacity resources.
C. They do not account for opportunity costs.
D. A and B only.
E. A, B, and C.
LO1 D
44.Money is a productive asset. Its opportunity cost is:
A. The time value of money.
B. Depreciation.
C. Inflation.
D. Replacement cost.
E. Valuation.
LO1 A
45.Capital budgeting is used to evaluate:
A. Whether the purchase of short-term assets such as securities will provide the
company with an acceptable return
B. The best timing for the sale of an existing long-term assets such as buildings
so it will be the most profitable
C. Whether the purchase of a long-term asset will provide the company a
satisfactory return on their investment
D. The profitability of the addition or deletion of a product lines
LO1-Self test-C
46.Which of the following is a factor that gives capital budgeting an advantage over
cost allocations in making long-term capacity resource decisions?
A. Capital budgeting links costs to certain activities
B. Capital budgeting improves profitability by monitoring performance
C. Capital budgeting considers the magnitude and timing of all cash inflows and
outflows associated with the resource
D. Capital budgeting improves decision making by lumping capacity resources
together
LO1-Pretest-C

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Managing Long-lived Resources: Capital Budgeting

47.Which of the following is true concerning capital budgeting?
A. It treats capacity levels as fixed and capacity costs as noncontrollable.
B. It improves profitability in the short-run by monitoring performance
C. It determines how operations will be financed in the short-run.
D. It links strategic and operating budgets
LO1-Post test-D
48.To judge whether an investment is worthwhile:
A. We need to estimate the benefits over its life.
B. We need to estimate the costs over its life.
C. We must decide whether the investment is the best use of available funds.
D. A and B only.
E. A, B. and C.
LO1 E
49.Capital budgeting:
A. Links strategic and operating budgets.
B. Help determine how much of each capacity resource an organization should
acquire.
C. Help determine how a firm should invest its capital in specific assets.
D. A and B only.
E. A, B and C.
LO1 E
50.Which of the following are the steps which a typical firm performs in capital
budgeting?
A. Identifies and evaluates individual investment proposals.
B. Prioritizes the proposals and decides which ones to execute.
C. Allocates the firms productive capacity among resources.
D. A and B.
E. A, B and C.
LO1 D
51.Capital budgets allocate:
A. Cash flows to functioning activities.
B. Supply to demand.
C. Scarce capital among available investment opportunities.
D. Productive capacity among products.
E. None of the above.
LO2 C

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Balakrishnan/Managerial Accounting, 2e
52.The Fargas Company invested $90,000 in a two-year project in which net cash
inflows for the first year totaled $57,000. Assume that the cash flows for the
year all occur on the last day of the year. If the internal rate of return was exactly
10%, the cash flow for the second year must have been (without considering the
effect of taxes):
A.
$36,300
B.
$30,562
C.
$33,000
D.
$46,231
LO2-Self test-D
53.The controller of Simpson Enterprises estimates that the installation and training
for a new computer system will cost around $125,000. In which element of the
project cash flow elements will this cost be included?
A. Initial outlay
B. Estimated proceeds to be received from the sale at the end of a resources
estimated useful life
C. Part of the routine operating cash flows associated with periodic repairs and
maintenance
D. The opportunity cost of money based on the expected return
LO2-Pretest-A
54.Simpson Enterprises is considering expanding operations and building a new
plant. The current discount rate is 15%. In which element of Simpsons capital
expenditure decision would this be included?
A. Initial outlay
B. Estimated life and salvage value
C. Timing and amounts of operating cash flows
D. Cost of capital
LO2-Post test-D
55.Which of the following is not one of the four elements of a capital expenditure
decision about a single project?
A. Estimated life and salvage value.
B. Depreciation method.
C. Initial outlay.
D. Timing and amounts of operating cash flows.
E. Cost of capital.
LO2 B
56.Which of the following is not a part of the initial outlay for a capital expenditure?
A. Salvage value.
B. Shipping costs.
C. Taxes.
D. Installation costs.
E. Training charges.
LO2 A

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Managing Long-lived Resources: Capital Budgeting

57.Using a reasonable and realistic estimate of life expectancy of a capital
expenditure is important because:
a. Too low of an estimate understates the profitability of the investment.
b. Too high of an estimate could lead to a wasteful use of scarce capital.
c. A profitable opportunity could be rejected if the life expectancy is not
reasonable or realistic.
d. Both A and B.
e. A, B and C.
LO2 E
58.Which of the following is not a typical operating cash outflow from a capital
investment in equipment?
a. Hiring additional personnel.
b. Depreciation
c. Maintenance costs.
d. Repairs.
e. All of the above are typical operating cash outflows.
LO2 B
59.Which of the following is not a factor in increasing cash inflows from external
sales resulting from a capital investment in new equipment?
a. Interest income.
b. Increased sales as a result of increased production.
c. Increased production as a result of fewer reworks.
d. Income from renting out the equipments spare capacity.
e. All of the above are factors in increasing cash inflows.
LO2 A
60.Which of the following methods for evaluating project profitability uses the time
value of money?
a. Payback period.
b. Modified payback period.
c. Internal rate of return.
d. Accounting rate of return.
e. All of the above methods use the time value of money.
LO3 C
61.Which of the following is not a tool for calculating net present value?
a. Present value tables.
b. Spreadsheet programs.
c. Real option analysis.
d. Financial calculators.
e. All of the above are tools for calculating net present value.
LO3 C

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Balakrishnan/Managerial Accounting, 2e
62.Which of the following is not an assumption in performing NPV calculations
found in Chapter 11?
a. The initial cash outflow takes place at the beginning of the period.
b. The internal rate of return is zero.
c. Subsequent cash inflows and outflows occur at the end of the relevant period.
d. The mathematics of new present value calculations assume that firms
reinvest future cash inflows in projects that yield a return that equals the cost
of capital.
e. All of the above are assumptions discussed in Chapter 11.
LO3 B
63.Consider the following facts do not consider the impact of income taxes:
Initial cost of equipment
$45,000
Estimated life
5 years
Salvage value
$5,000
Annual cash inflows
$15,000
Estimated cost of capital
8%
The net present value of the equipment is:
A.
$14,895
B.
$18,300
C.
$63,300
D.
$59,895
LO3-Self test-B
64.Consider the following facts do not consider the impact of income taxes:
Initial cost of equipment
$45,000
Estimated life
5 years
Salvage value
$5,000
Annual cash inflows
$15,000
Estimated cost of capital
8%
The number of years it will take to re-coup the initial investment using the
payback method will be:
A.
2
B.
5
C.
4
D.
3
LO3-Self test-D
65.If the discount rate increases:
A.
There will be no impact on the net present value
B.
The annual cash inflows will need to increase in order to retain the
same net present value
C.
The present value of future cash flows will increase
D.
The internal rate of return requirement will increase
LO3-Self test-B

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Managing Long-lived Resources: Capital Budgeting

66.Consider the following information:
Initial cost of equipment
$108,000
Sales tax and delivery costs
$7,000
Estimated life
7 years
Salvage value
$11,000
Annual cash inflows
$31,000
Estimated cost of capital
13%
Without considering the effect of income taxes, the net present value of the
equipment is:
A.
$26,788
B.
$22,082
C.
$33,757
D.
$29,082
LO3-Self test-A
67.Company X invested in a piece of equipment with an initial cost of $80,000. The
equipment is expected to provide net cash flows of $18,000 per year with an
estimated life of 10 years and no salvage value. The companys cost of capital is
14%. The payback period using the modified payback method and without
considering the impact of taxes is:
A.
4.4 years
B.
7.4 years
C.
8 years
D.
9 years
LO3-Self test-B
68.Using the following data: (and ignoring the impact of income taxes)
Initial cost of equipment
$1,000,000
Annual cash inflows
$191,720
Salvage value
$0
Estimated life
10 years
The internal rate of return on this investment is closest to:
A. 12%
B. 14%
C. 16%
D. 18%
LO3-Self test-B
69.A company has an opportunity cost of capital of 9.5%. Which of the following is
the most acceptable investment for this company?
A. An investment with an IRR of 9.0%
B. An investment with an NPV of $5
C. An investment with an NPV of 0
D. An investment with an NPV of ($5)
LO3-Pretest-B

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Balakrishnan/Managerial Accounting, 2e
70.On January 1, 2013, Nickerman, Inc. plans to purchase a machine for $58,000
that has an estimated salvage value of $12,000, and an estimated life of 4
years. The machine is expected to generate the following cash flows and income
over the next 4 years:
2013
2014
2015
2016
Net income
Operating cash
flows

$10,000

$12,500

$11,000

$8,000

21,500

24,000

22,500

19,500

The opportunity cost of capital is 12%. How much is the NPV?

A. $8,303
B. $15,935
C. ($26,188)
D. ($18,556)
LO3-Pretest-B
71.A machine with a cost of $104,000 and a residual value of $12,000 has an
estimated useful life of 4 years. Operating cash flows are expected to be
$28,000 during year 1 and $33,000 in each of years 2, 3, and 4. The opportunity
cost of capital is 8%. How much is ARR?
A. 54.7%
B. 8.4%
C. 15.1%
D. 38.0%
LO3-Pretest-C
72.On January 1, 2013, Nickerman, Inc. plans to purchase a machine for $46,000
with an estimated life of 4 years. The machine is expected to generate $14,500
of annual net operating cash flows and $3,000 of income over each of the next 4
years. The opportunity cost of capital is 12%. How much is the IRR?
A. 3.17%
B. 10.0%
C. 15.3%
D. 7.0%
LO3-Post test-B
73.What is the payback period for a project that has an initial investment of
$100,000 and $10,000 net cash inflow in the first year, with a $1,000 increase
each year thereafter for a total of 12 years?
A. 10.00 years
B. 18.18years
C. 6.45 years
D. 7.53 years
LO3-Post test-D

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Managing Long-lived Resources: Capital Budgeting

74.A machine with a cost of $212,000 and a residual value of $16,000 has an
estimated useful life of 4 years. Operating cash flows are expected to be
$62,000 during years 1 and 2 and increasing to $75,000 in each of years 3 and
4. The opportunity cost of capital is 10%. How much is ARR?
A. 17.1%
B. 9.2%
C. 60.1%
D. 39.8%
LO3-Post test-A
75.A project is profitable if its internal rate of return:
a. Exceeds its discount rate.
b. Is zero.
c. Exceeds cash outflows of the project.
d. Exceeds its opportunity cost of capital.
e. None of the above.
LO3 D
76.What is the effect on NPV of an asset if the salvage value is ignored?
A. No effect
B. It depends on the cost of the asset being considered for investment.
C. NPV would be overstated.
D. NPV would be understated.
LO3-Post test-D
77.Tosi Enterprises is planning a new investment project. From its inception, Tosi is
using mathematical models to insure the flexibility in its ability to defer,
abandon, expand or contract its investment after the initial evaluation. Which of
the following terms is most associated with this idea?
A. Modified IRR
B. Modified payback period
C. Real options analysis
D. Modified NPV
LO4-Post test-C
78.Which of the following is a common deficiency with the accounting rate of return
method?
A. It is meaningless to compare against other projects.
B. It discounts cash flows using the hurdle rate rather than the opportunity cost
of capital.
C. It ignores the time value of money.
D. It ignores the salvage value of the investment
LO4-Post test-C
79.Why do many people prefer the net present value method to the internal rate of
return method?
a. The net present value method is simpler to compute.
b. The internal rate of return method provides a unique value for each project.
c. The net present value method may produce multiple values of returns for the
same projects.

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Balakrishnan/Managerial Accounting, 2e
d. Both A and B.
e. Both A and C.
LO4 A
80.Gator Manufacturing is considering the purchase of equipment at a cost of
$7,000. Gator expects the equipment to generate cash inflows of $2,000 each
year for the next ten years. The payback period for the equipment is:
a. 35%.
b. 285%.
c. 3.5 years.
d. 2.85 years.
e. 10 years.
LO4 C
81.The only method not used to evaluate capital projects is:
A.
Payback/modified payback
B.
Net present value
C.
Internal rate of return
D.
Regression analysis
LO4-Self test-D
82.The internal rate of return measures:
A.
How quickly the initial investment can be recouped
B.
The discount rate at which the net present value of the project is zero
C.
The profitability of an investment
D.
The rate at which future cash flows must be invested in order to obtain
profitability
LO4-Self test-B
83.Which of the following capital budgeting analysis tools does not account for the
time value of money?
A.
Net present value
B.
Internal rate of return
C.
Payback
D.
Modified payback
LO4-Self test-C
84.A project is considered acceptable if:
A.
The net present value of the project is positive
B.
The internal rate of return is greater than the hurdle rate
C.
The modified payback period is less than the estimated useful life
D.
All of these are true, however a company will still need to determine
how to allocate capital resources and thus they may not choose a project
based on a single criteria as listed above
LO4-Self test-D
85.Which of the following is a disadvantage of the payback method?
A. Potential investments with large operating cash flows are ranked higher than
those with smaller cash flows.

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Managing Long-lived Resources: Capital Budgeting

B. It is difficult to determine the opportunity cost of capital for the payback
method.
C. It uses a large discount rate which tends to undervalue the future cash flows.
D. It does not distinguish between two projects with identical payback periods.
LO4-Pretest-D
86.Cordets Caf has a potential investment of $920,000 which generated a
depreciation tax shield of $50,000 and a tax rate of 25% for 2013. How much
depreciation expense did Cordets Caf record during 2013?
A. $200,000
B. $230,000
C. $217,500
D. $12,500
LO4-Pretest-A
87.Which of the following terms best describes the minimum rate of return
expected by management for any project?
A. Discount rate
B. Internal rate of return
C. Hurdle rate
D. Accounting rate of return
LO4-Pretest-C
88.Which one of the following correctly describes the relationship between the NPV
and discount rate?
A. The higher the discount rate, the higher the NPV of a cash flow
B. The higher the discount rate, the lower the NPV of a cash flow
C. Firms use a lower discount rate to evaluate riskier projects.
D. The higher the discount rate, the more likely a company will accept a
potential capital budgeting project.
LO4-Post test-B
89.Which of the following is not an advantage of the payback method?
a. It focuses on a projects downside risk.
b. It takes into account the time value of money.
c. It is easy to compute.
d. It is easy to understand.
e. All of the above are advantages of the payback method.
LO4 B
90.Which of the following is a disadvantage of the payback method?
a. It overvalues the initial outlay.
b. It undervalues the initial outlay.
c. It overvalues future cash inflows.
d. It undervalues future cash inflows.
e. It is easy to compute but difficult to understand.
LO4 C

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Balakrishnan/Managerial Accounting, 2e
91.Which of the following statements describes the modified payback method?
a. We compute how long it takes to recoup the initial investment using
undiscounted cash flows.
b. The method accumulates the present value of future cash flows over time
and compares the cumulative value with the salvage value of the capital
expenditure.
c. The method accumulates the absolute value of future cash flows over time
and compares the cumulative value with the present value of the capital
expenditure.
d. The year in which the accumulated present value of future cash flows
exceeds the initial cash outflow determines the modified payback period.
e. None of the above describes the modified payback method.
LO4 D
92.The accounting rate of return is computed as:
a. Average annual income from the project divided by average annual
investment.
b. Average annual income from the project divided by the length of time it takes
to recoup the initial investment.
c. Average annual investment divided by the average annual income from the
project.
d. Average annual investment divided by the length of time it takes to recoup
the initial investment.
e. The initial cash outlay divided by the average annual income from the
project.
LO4 A
93.Which statement is true concerning the ending book value of an asset and its
market salvage value?
A. They will always be the same.
B. Salvage value is the estimated gain to be made when selling a capital asset
at the end of its useful life. The actual amount for which a capital asset can
be sold is its market value.
C. Salvage value is the estimated value for which a capital asset can be sold at
the end of its useful life. The actual amount for which a capital asset can be
sold is the gain that will be recognized on the sale.
D. Salvage value is the estimated value for which a capital asset can be sold at
the end of its useful life. The actual amount for which a capital asset can be
sold is its market value.
LO5-Pretest-D
94.A firm pays taxes on:
a. Cash flows.
b. Accounting income.
c. Both A and B.
d. Neither A nor B.
LO5 B
95.How are the following items considered in a net present value calculation?
Depreciation Expense
Sales Taxes

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Managing Long-lived Resources: Capital Budgeting

A.
Included
B.
Excluded
C.
Excluded
D.
Included
LO5-Self test-C

Included
Excluded
Included
Excluded

96.The following information is available concerning a new piece of equipment:

Annual cash inflows
$14,000
Estimated life
6 years
Cost of capital
8%
Internal rate of return
10%
Based on the information, and without considering the impact of taxes, the initial
cost of the equipment was:
A. $60,956
B. $64,722
C. $84,000
D. $75,600
LO5-Self test-A
97.Consider the following information regarding the purchase of a piece of
equipment:
Initial cost
$68,000
Estimated life
5 years
Annual net cash inflows
$21,000
Income tax rate
40%
Cost of Capital
12%
Assuming the company uses straight-line depreciation, the depreciation tax
shield in year 1 would amount to:
A. $5,440
B. $1,632
C. $18,800
D. $13,600
LO5-Self test-A
98.Which of the following is the proper calculation to find the depreciation tax
shield?
A. IRR times the depreciation deduction in a year
B. Tax rate times depreciation deduction in a year
C. IRR divided by the depreciation deduction in a year
D. Tax rate times the total depreciation deductions over the life of an asset
LO5-Post test-B
99.The major reason net cash flows do not typically equal accounting income is:
a. Present value.
b. Depreciation.
c. Taxes.
d. Discounted cash flows.
e. None of the above.
LO5 B

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Balakrishnan/Managerial Accounting, 2e
100. The reduction of cash outflows associated with tax payments because of
depreciation is referred to as:
a. Accrued taxes.
b. Deferred taxes.
c. Depreciation shield.
d. Tax shield.
e. None of the above.
LO5 D
101.
a.
b.
c.
d.
e.
LO5

The depreciation tax shield is computed as:

Accumulated depreciation x tax rate.
Cash outflows from project x tax rate.
Depreciation deduction for the year x tax rate.
Discounted cash outflows from project x tax rate.
None of the above.
C

102.

Redbird Corporation provides the following data:

Cash inflows
$50,000
Cash outflows
$43,000
Net income
$35,000
Depreciation deduction
$ 5,000
Accumulated depreciation
$10,000
Tax rate
30%
What is Redbirds tax shield?
A. $15,000.
B. $12,900.
C. $10,500.
D. $1,500.
E. $3,000.
LO5 D
103. The minimum expected rate of return of the management from any project is
referred to as the:
a. The internal rate of return.
b. The hurdle rate.
c. A number greater than 1.
d. A number less than zero.
e. None of the above.
LO6 B
104. Firms may not always allocate capital to their highest-ranking projects
because:
a. The value of a portfolio may exceed the sum of the NPVs of the individual
projects.
b. Lower-ranking projects may align better with the firms overall strategy.
c. Of synergies across projects.
d. Both A and B.
e. A, B and C.
LO6 E

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Managing Long-lived Resources: Capital Budgeting

105.
a.
b.
c.
d.
e.
LO6

Using high hurdle rates to discount future cash flows lead to:
High risk decisions.
Conservative investments.
Gain advantages over international firms.
Both A and C.
None of the above.
B

106.
a.
b.
c.
d.
e.
LO6

Real options analysis was developed by:

Practitioners.
Academics.
A small business owner.
Both A and B.
A, B and C.
D

107. Which of the following is a key element of value, particularly for projects with
considerable uncertainty in their estimated cash flows?
a. Flexibility.
b. Non-financial considerations.
c. Salvage value.
d. Both A and B.
e. A, B and C.
LO6 A
108. Suppose you inherit $10,000 from your uncle. You invest the money at an
expected annual return of 8% for one year. Which of the following is the formula
to calculate how much will you will have at the end of 10 years?
a. $10,000 x (1 + .08)
b. $10,000 x (1 + 0.08) 10
c. $10,000 x (1 0.08) 10
d. $10,000 x (1.08)
e. $10,000 x (11.08) 10
Appendix A B
109. The formula for the present value of an annuity of $1 in arrears is:
A.
(1 r) n 1
r
B.
(1 r) n
r
C.
1 - (1 + r)
-n

D.

r
1 + (1 + r)
-n

r
1 - (1 - r)
r
Appendix B C
E.

-n

11-19

Balakrishnan/Managerial Accounting, 2e
Problems
1. It is important to understand the reasons for capital budgeting.
Required:
Enter the identifying letters in the blanks below to indicate the term that best
matches each description.
A
B
C
D
E

Capital budgeting
Cost of capital
Discounting
Discount rate
Initial outlay

F
G
H
I
J

Lumpy resource
Present value
Real option analysis
Salvage value
Time value of money

a.____
_

The rate of return employed to compute the present value of future

cash flows.

b.____
_

A collection of mathematical techniques for valuing the flexibility

associated with a project.

c.____
_

The collective term for the mechanisms and tools used to evaluate
expenditures on long-lived resources.

d.____
_

All costs connected with purchasing an asset and getting it ready for
its intended use.

e.____
_

The final one-time costs or benefits associated with disposing a

resource.

f._____

The opportunity cost of money in the form of returns from alternate

investments.

g.____
_

Resources for which it is difficult to match the demand for capacity

with the supply.

h.____
_

Phrase used to denote that a dollar today is worth more than a dollar
tomorrow.

i._____

The practice of expressing a future cash flow in terms of its present

value.

J_____

The value today of a future cash flow.

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Managing Long-lived Resources: Capital Budgeting

2. A capital-expenditure decision about a single project contains four important
elements.
Required:
a. List the four elements and give a brief description of each.
b. Give an example of a capital expenditure decision, identifying the four
elements in your discussion.

3. The initial cash outlay and cash flow projections are presented below for new
equipment that Outdoor Sports, Inc. is evaluating. Outdoor Sports is considering
manufacturing a new line of laser rangefinders:
Initial Cash Outlay
Annual Net cash inflows
Years 1 -5
Salvage value

$1,500,
000
$450,00
0
$100,00
0

Outdoor Sports uses a cost of capital of 12 percent for discounting purposes. It

depreciates its equipment on a straight-line basis over a period of five years.
Present value factors at 12 percent are as follows:
Year 1
.893
Year 2
.797
Year 3
.712
Year 4
.636
Year 5
.567
Required:
a. What is the net present value of the initial outlay?
b. Using the net present value method, evaluate the decision to purchase the
new equipment.

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Balakrishnan/Managerial Accounting, 2e
4. Belks Pizza has purchased a small auto in order to offer delivery to customers.
The auto cost $18,000 and is expected to be used for six years. Having pizza
delivery is expected to increase revenues by approximately $4,000 each year.
The auto will be depreciated straight-line over three years.
Required:
a.

Compute the payback period on the new auto.

b. List three non-financial considerations that Belk may have addressed in

making the decision to purchase the new auto.

5. Murray Motors, Inc. is considering a proposal to purchase a new molding

machine for $720,000. In addition, shipping charges of $4,000, sales tax of
$21,000, and installation charges of $5,000 will be incurred. The machine will
have a useful life of five years, with no salvage value. Murray will use the
straight-line depreciation method for the machine. The applicable tax rate is
30%. The machine is expected to generate annual cash inflows of $420,000
from internal use and $180,000 from outside use. In addition to depreciation
expense, Murray expects cash outflows of $160,000 from variable costs and
$150,000 from fixed costs.
Required:
a. What is Murrays annual net cash flow?
b. What is Murrays taxable income?
c.

How much is the annual depreciation tax shield?

6. St Marys hospital is considering the purchase of a new $900,000 bone scanning

machine that will detect small lesions and early signs of osteoporosis. With the
current patient load, the machine would last approximately seven years. The
hospital administrator has conducted financial analysis and has determined that
the expected financial costs and benefits are approximately equal. The
administrator has asked you for input.
Required:
a. List three non-financial costs associated with purchasing the new machine.
b. List three non-financial benefits associated with purchasing the new machine.
c. List three possible strategies a hospital may have that the purchase of the
new machine might help it accomplish.

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Managing Long-lived Resources: Capital Budgeting

Solutions to Problems
1. Terms (LO1)
a.__D__
_

The rate of return employed to compute the present value of future

cash flows.

b.__H__
_

A collection of mathematical techniques for valuing the flexibility

associated with a project.

c.__A__
_

The collective term for the mechanisms and tools used to evaluate
expenditures on long-lived resources.

d.__E__
_

All costs connected with purchasing an asset and getting it ready

for its intended use.

e.__I___

The final one-time costs or benefits associated with disposing a

resource.

f.__B___

The opportunity cost of money in the form of returns from alternate

investments.

g.__F__
_

Resources for which it is difficult to match the demand for capacity

with the supply.

h.__J___

Phrase used to denote that a dollar today is worth more than a

dollar tomorrow.

i.__C___

The practice of expressing a future cash flow in terms of its present

value.

J__G___

The value today of a future cash flow.

2. Elements of Capital Budget (LO2)

a. The four elements are:
1. Initial Outlay What are the costs associated with acquiring the
resource and getting it ready for use?
2. Estimated Life and Salvage Value How long do we expect to keep the
resource? At the end of this period, are there any additional costs
associated with disposing of the resource? Can we sell the resource to
someone else when we are done with it?
3. Timing and Amounts of Operating Cash Flows What are the expected
operating expenses each year? What are the expected revenues?
4. Cost of Capital What is the opportunity cost of capital required for the
proposed investment?
b. Answers will vary.

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Balakrishnan/Managerial Accounting, 2e
3. Discounted Cash Flow Techniques (LO3)
a. Net present value of the initial outlay - $1,500,000.
b. Net present value method:
Year
Initial Investment
Year 1
Year 2
Year 3
Year 4
Year 5
Net Present
Value

Net Cash
PV Factor
Flow
$1,500,000
1.000
450,000
450,000
450,000
450,000
450,000

.893
.797
.712
.636
.567

Present
Value
($1,500,00
0)
401,850
358,650
320,400
286,200
255,150
$122,250

4. Payback period (LO4)

a. Payback period = $18,000/$4,000 per year = 4.5 years
b. Non-financial considerations:
Competition - If competition has moved into the area, Belk may
have chosen to purchase the vehicle in anticipation of lost
customers if it does not meet the competition.
Customer service - Belk may have purchased the vehicle in order to
deliver pizza because of a desire to satisfy customers who have
requested delivered pizza.
Location Belk may be in a location with little parking and
purchasing an auto to deliver will better serve customers.
Advertising Belk will be able to put advertisements on the auto
making its name better known.

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Managing Long-lived Resources: Capital Budgeting

5. Taxes and Capital Budgeting (LO5)
a. Annual net cash flow:
$420,000 + $180,000 - $160,000 - $150,000 = $290,000
b. Taxable Income:
$290,000 $150,000 depreciation = $140,000
c. Depreciation tax shield:
$150,000 x 30% = $45,000
6. Allocating Capital among Projects (LO6)
a. Answers will vary. Some non-financial costs are:
The hospital may miss an opportunity to invest in a more beneficial
project.
Competition may purchase an even better machine, taking
anticipated customers.
A drug may become available which would replace the need for
bone scans.
The machine may encounter maintenance issues.
The machine may produce negative environmental waste products.
b. Answers will vary. Some non-financial benefits are:
The machine may provide more timely results.
The machine may produce more accurate diagnoses.
The machine may generate better patient service.
The machine may eliminate wasted time and effort on the part of
the operators.
The machine may be safer for the operators.
c. Answers will vary. Some possible strategies are:
If the machine is installed in a mobile unit, it could produce
community goodwill if the scans are offered at low or no cost to
certain residents (elderly or low-income).
The machine may give the hospital a competitive edge over the
other hospitals in the area.
The machine may provide positive exposure for the hospital. For
example, local newspapers or TV stations may interview the
administrator about the need for such a machine.
If the hospital did not have a bone scanning machine, the purchase
of the new machine would provide a new market and source of
revenue.

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Balakrishnan/Managerial Accounting, 2e
End of Chapter Content
Short Answer
1. What is capital budgeting?
2. What does the notion time value of money mean? Why is it important for
project evaluation?
3. Capacity resources are lumpy in nature. What does the term lumpy mean in
this statement? Why is it relevant in the context of capital budgeting?
4. What is the difference between a capital budget and an operating budget?
5. What are the four important elements of a capital expenditure decision?
6. Define the term net present value. Describe how you would calculate the NPV for
a project proposal.
7. Define the term internal rate of return or IRR. Describe how you would calculate
the IRR for a project proposal.
8. List three assumptions underlying the NPV method.
9. List two key advantages of the payback method.
10.What is the difference between the payback and modified payback methods?
11.Define the accounting rate of return.
12.Why are taxes important in capital budgeting?
13.What is a depreciation tax shield? Is this tax shield a cash inflow or a cash
outflow?
14.What is a hurdle rate?
15.Why do many firms begin projects on a small scale before making considerable
investments?

11-26

Managing Long-lived Resources: Capital Budgeting

Solutions to Short Answer
1. (LO1)
Capital budgeting refers to the set of tools companies use to evaluate
large expenditures on long-lived resources.
2. (LO1)
The time value of money arises because a dollar today is worth more
than a dollar tomorrow. Time value of money is important for project evaluation
as cash inflows and outflows occur at different points in time thus, we need to
put these different cash flows on equal footing to compare them.
3. (LO1)
A lumpy resource is one where it is difficult to match the demand for
capacity with the supply. As the text discusses, we cannot buy three-fourths of
an MRI machine capital budgeting techniques recognize this and account for
the timing and magnitude of all cash inflows and outflows associated with
resource acquisition, use, and disposal.
4. (LO1)
Capital budgets link strategic and operating budgets. Operating
budgets allocate the firms productive capacity among products, whereas capital
budgets allocate scarce capital among available investment opportunities.
5. (1) Initial outlay, (2) estimated life and salvage value, (3) timing and amounts of
operating cash flows, and (4) cost of capital.
6. Net present value is the total present value of all cash inflows and outflows. We
compute net present value by discounting future cash inflows and outflows
(using present value tables for our selected discount rate) back into todays
dollars.
7. The internal rate of return (IRR) is the discount rate at which a project has zero
net present value. We can compute the IRR using the appropriate formula in
Excel or a financial calculator
8. (1) The initial cash outflow takes place at the beginning of the period; (2)
Subsequent cash inflows and outflows occur at the end of the relevant period;
(3) the firm reinvests future cash inflows in projects that yield a return that
equals the cost of capital.
9. The payback method is easy to use and understand (e.g., we do not need to
determine the opportunity cost of capital). The payback method also focuses on
a projects downside risk.
10.The modified payback method computes the payback period using discounted
cash flows, meaning that the method accounts for the time value of money.

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Balakrishnan/Managerial Accounting, 2e
11.The accounting rate of return equals the average annual income from a project
divided by the average annual investment in the project.
12.Taxes are important because they affect both the amount and timing of cash
flows.
13.A depreciation tax shield for any given year equals the depreciation deduction
for the year multiplied by the tax rate. We can view the tax shield as a cash
inflow or as a reduction in cash outflows.
14.The hurdle rate is the minimum expected rate of return from any project.
15.To minimize the risks associated with taking on large-scale projects. Small scale
projects allow firms to gain feedback and information regarding whether the
large-scale project will be successful.

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Managing Long-lived Resources: Capital Budgeting

Short Essay
1. What are the tax implications of selling an asset when it still has some economic
value? Consider, in particular, the issue when we use an accelerated
depreciation schedule for calculating taxable income.
2. List and discuss two advantages of the net present value method relative to the
internal rate of return method.
3. The net present value method assumes that future cash inflows are reinvested at
the cost of capital. The internal rate of return method assumes that the
reinvestment takes place at the internal rate of return. Which is a better
assumption and why?
4. What are some of the considerations that go into the choice of discount rate
under the net present value method?
5. Even though the payback method ignores time value of money, many firms
continue to use it when evaluating projects. Why might this practice be in the
managers best interest?
6. List and discuss two advantages and two disadvantages of the accounting rate
of return method.
7. Under the internal rate of return method, how would you decide which projects
to accept and which projects to reject? Explain.
8. Is it always advisable to accept projects with the highest (positive) NPVs? IRRs?
Why or why not?

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Balakrishnan/Managerial Accounting, 2e
Solutions to Short Essay
1. (LO2, LO5)
If there is a difference between the price at which the asset is
being sold and its carrying value, then there will be a cash outflow or inflow in
the form of tax payment or tax savings. In particular, if the asset is being
depreciated in an accelerated manner for tax purposes, the carrying or net book
value is likely to be low. If it is sold for a price that is higher than the carrying
value, then there is a taxable gain, and the company will incur a cash outflow in
the form of tax payment.
2. (LO3)
First, the net present value is simpler to compute. The internal rate of
return is difficult to determine because it involves solving a complex
mathematical expression. Moreover, there can often be multiple solutions, in
which case one has to use good economic intuition to determine the right
solution. Second, the internal rate of return assumes that future net cash inflows
can be invested at the same rate as internal rate of return, whereas the net
present value method assumes that the future net cash inflows can be invested
at the cost at which capital is available to the firm. The latter assumption is more
reasonable.
3. (LO3)

Refer to the answer to 11.19.

4. (LO3)
Under the net present value method, we use the cost of capital as the
discount rate. In doing so, we are essentially assuming that firms reinvest future
cash inflows in projects that yield a return that equals the cost of capital. This
assumption is reasonable because capital providers make available the capital at
a cost based on the return they might secure if they invest the same money
elsewhere.
5. (LO4)
The payback method is a good way to evaluate a projects downside
risk. A risk-averse manager might prefer a project with a small payback period
because the risk of actually losing money is lower. The manager can always
claim that we did not lose a dime on the deal, ignoring the lost opportunity for
making more money in another project. Such behavior to avoid losses (even at
the cost of foregoing gains) is commonly observed in organizations.
6. (LO4)
First, the accounting rate of return is simple to compute. Second, it
meshes well with annual performance measures used to evaluate managers (we
consider this in greater detail in Chapter 13). However, it does not take time
value of money into account and could be misleading performance measure.
7. (LO3)
A project is acceptable if its IRR exceeds its opportunity cost of capital.
Many companies use a subjectively determined internal hurdle rate instead of
the cost of capital for project acceptance decisions. The hurdle rate is the
minimum expected rate of return of the management from any project. Thus,
any project that has an IRR greater than the hurdle rate (which means that the
project will have a positive NPV when discounted at the hurdle rate) would be
acceptable.

11-30

Managing Long-lived Resources: Capital Budgeting

8. (LO3, LO6)Let us discuss the NPV method first. All else equal, it makes sense to
choose the project with the highest NPV for a given level of capital. However,
sometimes projects with lower NPV may be preferable if they offer synergies
with existing operations synergies that were not explicitly considered in
computing NPV because of the difficulty in quantifying them. With respect to IRR,
a similar argument applies. In addition, we know from the chapter that the IRR
method can rank alternatives differently compared to NPV. Thus, it is not clear
that choosing the project with the highest IRR is the best thing to do.

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Balakrishnan/Managerial Accounting, 2e
Exercises
1. Refer to the data in the following table:
Setting

1
2
3
4
Required:

Initial Outlay

Life (years)

Discount Rate
(compounded
annually)

Future Value
(at the end
of life)

$225,000
?
$157,950
$150,000

5
10
8
?

10%
12%
?
12%

?
$400,000
$450,000
$371,400

Treating each row of the table independently, compute the missing information.
Use the present value/future value tables at the end of the book.
2. Kim Barth decides to start a small restaurant near a busy shopping mall. She
applies for a loan of $150,000, to be repaid in five annual installments, with each
installment due at the end of each of the next five years. The bank charges an
interest rate of 10%, compounded annually.
Required:
Compute the annual installment amount. Use the annuity tables at the end of
the book.
3. Quality Metal Works, Inc. is considering a proposal to buy a new furnace for
$2,500,000 (all costs included). The furnace will have a useful life of 10 years,
with no expected salvage value at the end of its life. The firm requires a rate of
return of 8% on all its investments. For convenience, assume that cash flows
occur at the end of each year. Assume straight-line depreciation for tax
purposes. The applicable tax rate is 30%.
Required:
a. Ignore the depreciation tax shield. What are the minimum annual cash inflows
that this furnace must generate for the company to justify the investment?
b. How much is the annual depreciation tax shield? What is the present value of
the depreciation tax shield?
c. If you take into account the depreciation tax shield, will the minimum annual
cash inflows from operations (pretax) needed to justify this investment
increase or decrease? By how much?
4. Pringle Plastics recently sold a forklift for $12,500. The firm, which pays taxes on
income at the rate of 45%, had purchased the forklift for $50,000. The firms
books show accumulated depreciation of $38,700.
Required:
What is the after-tax cash flow due to the sale of the forklift?

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Managing Long-lived Resources: Capital Budgeting

Solutions to Exercises
1. (LO3)
Treating each row of the table independently compute missing
information.
For each setting, we use the appropriate present value factors from the tables in
Appendix B. The relevant table and the factor are given in parentheses for each
setting.
Discount
Life
Settin
Future value
rate
Initial outlay
(year
(at the end of life)
g
(compounded
s)
annually)

$225,000
$128,800

$362,475

10%

(Table 2: Factor
1.611)

(Table 1: Factor
0.322)

10

12%

$400,000

$157,950

14%

450,000

$150,000

12%

$371,400

2. (LO3)
We can find the annuity factor in Appendix B, Table 3, corresponding to
5 years and 10 percent. This factor is 3.791. Thus,
Annual installment amount 3.791 = $150,000, which yields an annual
installment amount as $39,567.40.

3. (LO2, LO5)
a. The present value of minimum annual cash inflows over the furnaces life of
10 years, discounted at 8% should at least equal initial investment of
$2,500,000. That is, its net present value (NPV) should be positive. Referring
to Table 3 in Appendix B, the appropriate annuity factor (10 years, 8%) is
6.710. Therefore,
Annual cash inflows 6.710 $2,500,000, or Annual cash inflows
$372,578 (rounded). Quality Metal Works Inc. must generate minimum
annual (net) cash inflows of $372,578 to justify investment.
b. We are assuming straight-line depreciation for tax purposes. The annual
depreciation is $2,500,000/10 = $250,000. Because depreciation is tax
deductible, the annual tax savings offered by depreciation is $250,000
30% = $75,000.
The present value of this depreciation tax shield over the furnaces life of 10
years, at a discount rate of 8% is $75,000 6.710 = $503,250.

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Balakrishnan/Managerial Accounting, 2e
c. The minimum annual operating cash inflows will decrease by $75,000 to
$297,578 ($372,578-$75,000) because of the tax savings offered by
depreciation.

4. (LO5)
The book value of the fork-lift is $11,300 (= $50,000 - $38,700).
Therefore, the gain on sale is $1,200 (= $12,500 - $11,300). At a tax rate of
45%, this gain gives rise to a tax bill of $540 (1,200 0.45). Therefore, the aftertax cash inflow from the sale of the forklift is $11,960=$12,500- $540.

11-34