(d) The requirement is to identify the capital budgeting technique that does not use cash flows. Answer (d) is correct because the accounting rate of return uses accrual basis net income. Answers (a), (b), and (c) are incorrect because all of the other techniques use cash flows as the primary basis for the calculation.
(b) The requirement is to identify the advantage of the accounting rate of return method. Answer (b) is correct because accounting return is often used as a performance evaluation measure. Therefore, if it is also used as an evaluation technique, the consistency may lead to better decisions. Answer (a) is incorrect because the fact that results are affected by the depreciation method used is a disadvantage. Answer (c) is incorrect because the accounting rate of return method does not consider the time value of money. Answer (d) is incorrect because the accounting rate of return method does not consider the risk of the investment
(d) The accounting rate of return (ARR) computes an approximate rate of return which ignores the time value of money. It is calculated as Expected increase in annual net income ??Initial (or Average) investment in a project. Tam’s expected increase in annual income is as follows: Annual savings in after-tax cash costs $20,000 Annual depreciation on equipment ($100,000 ??10 years) (10,000) Increase in annual net income $10,000 A $100,000 initial investment is required to purchase the equipment. Thus, the ARR of the equipment under consideration by Tam is $10,000 ??$100,000 = 10%
(c) The accounting rate of return method (ARR) computes an approximate rate of return which ignores the time value of money. It is computed as follows: ARR = Expected increase in annual net income Average investment Therefore, $40,000 (as stated in problem) is the numerator, the expected increase in annual income.
(d) The accounting rate of return (ARR) is based on financial statements prepared on the accrual basis. The formula to compute the ARR is ARR = Expected increase in annual net income Initial (or average) investment Both the revenue over life of project and depreciation expense are used in the calculation of ARR. Depreciation expense over the project’s life and other expenses directly associated with the project under consideration including income tax effects are subtracted from revenue over life of the project to determine net income over life of project. Net income over the project’s life is then divided by the economic life to determine annual net income, the numerator of the ARR formula. This is a weakness of the ARR method because it does not consider actual cash flows or the time value of money.
(d) The requirement is to identify the implications of a profitability index of 1.15. Answer (d) is correct because the profitability index is the net present value of future cash flows divided by the amount of the initial investment. If the index is greater than 1.00, the net present value of the investment is positive.
(c) The requirement is to select the rate at which the NPV method assumes that the project’s cash flows are reinvested. The correct answer is (c) because the NPV method assumes that cash flows can be reinvested at the discount rate used in the calculation. This is usually the cost of capital. Answer (a) is incorrect because the internal rate of return method assumes that cash flows are reinvested at that rate. Answer (b) is incorrect because the risk-free rate is never used to evaluate a project. Answer (d) is incorrect because the accounting rate of return is not relevant to the NPV method.
(a) A project’s net present value is determined by considering the project’s cash inflows and cash outflows discounted to their present values using the required rate of return. The initial outlay for the replacement asset is considered to be the cash outflow reduced by any proceeds from the sale of the asset to be replaced.
(c) The requirement is to determine when the discount rate (hurdle rate) must be determined before a capital budgeting method can be used. The payback method measures the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project. The payback method does not consider the time value of money. The time-adjusted rate of return method is also called the internal rate of return method. This method computes the rate of interest at which the present value of expected cash inflows from a project equals the present value of expected cash outflows of the project. Here, the discount rate is not determined in advance but is the end result of the calculation. The net present value method is the correct answer because it calculates the expected net monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present using some predetermined minimum desired rate of return (hurdle rate).
(a) The requirement is to identify a description of the application of the internal rate of return. Answer (a) is correct because the IRR is the interest rate that equates the present value of the future cash inflows with the present value of the future cash outflows.
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