A projects net present value, ignoring income tax considerations, is normally affected by the

What is the Net Present Value Rule?

The net present value rule is the idea that company managers and investors should only invest in projects or engage in transactions that have a positive net present value (NPV). They should avoid investing in projects that have a negative net present value. It is a logical outgrowth of net present value theory.

Understanding Net Present Value

Understanding the Net Present Value Rule

According to the net present value theory, investing in something that has a net present value greater than zero should logically increase a company's earnings. In the case of an investor, the investment should increase the shareholder's wealth. Companies may also participate in projects with neutral NPV when they are associated with future intangible and currently immeasurable benefits or where they enable ongoing investments to happen.

Although most companies follow the net present value rule, there are circumstances where it is not a factor. For example, a company with significant debt issues may abandon or postpone undertaking a project with a positive NPV. The company may take the opposite direction as it redirects capital to resolve an immediately pressing debt issue. Poor corporate governance can also cause a company to ignore or miscalculate NPV.

How the Net Present Value Rule is Used

Net present value, commonly seen in capital budgeting projects, accounts for the time value of money (TVM). Time value of money is the idea that future money has less value than presently available capital, due to the earnings potential of the present money. A business will use a discounted cash flow (DCF) calculation, which will reflect the potential change in wealth from a particular project. The computation will factor in the time value of money by discounting the projected cash flows back to the present, using a company's weighted average cost of capital (WACC). A project or investment's NPV equals the present value of net cash inflows the project is expected to generate, minus the initial capital required for the project.

During the company's decision-making process, it will use the net present value rule to decide whether to pursue a project, such as an acquisition. If the calculated NPV of a project is negative (< 0), the project is expected to result in a net loss for the company. As a result, and according to the rule, the company should not pursue the project. If a project's NPV is positive (> 0), the company can expect a profit and should consider moving forward with the investment. If a project's NPV is neutral (= 0), the project is not expected to result in any significant gain or loss for the company. With a neutral NPV, management uses non-monetary factors, such as intangible benefits created, to decide on the investment.

Hardy Company must maintain a compensating balance of $50,000 in its checking account as one of the conditions of its short-term 6% bank loan of $500,000. Hardy's checking account earns 2% interest. Ordinarily, Hardy would maintain a $20,000 balance in the account for transaction purposes. What is the loan's approximate effective interest rate?

a. 5.88%

b. 6.00%

c. 6.17%

d. 6.25%

d. 6.25%

The compensating balance condition requires a minimum balance that is $30,000 greater than usually maintained, so Hardy effectively has  $470,000 loan. Annually, Hardy will pay $30,000 ($500,000 x 6%) in interest for the loan and will earn only $600 ($30,000 x 2%) in interest on the excessive compensating balance. Effectively, Hardy pays $29,400 for a $470,000 loan, resulting in a 6.25% ($29,400 / $470,000) effective interest rate.

Nor Corporation borrowed money using a discounted note with a stated 6% interest rate and a face amount of $400,000. What is the effective rate of interest on the debt?

a. 5.62%

b. 6.00%

c. 6.38%

d. 6.76%

c. 6.38%

With a discounted note, Nor effectively has borrowed $376K [$400K - (6% x $400K)]. The interest for the loan is $24K (6% x $400K). $24K / $376K = 6.38%.

Commercial paper

a. Generally has interest rates lower than treasury bills

b. Has maturities of greater than 1 year

c. Is a secured promissory note

d. Typically does not have an active secondary market

d. Typically does not have an active secondary market

What is the largest source of short-term credit for small businesses?

a. Commercial paper

b. Debentures

c. Mortgages

d. Trade credit

Mason has a $400,000 loan with a stated 6% interest rate. Mason must maintain a 20% compensating balance in its checking account. Without the loan provisions, Mason otherwise would keep a zero balance in its checking account. What is the effective rate of interest on the loan?

a. 4.5%

b. 6.0%

c. 7.5%

d. 26%

c. 7.5%

With the 20% compensating balance provision, Mason effectively has borrowed $320K (80% x $400K). The interest for the loan is $24K (6% x $400K). $24K / $320K = 7.5%.

Why would a firm generally choose to finance temporary assets with short-term debt?

a. Matching the maturities of assets and liabilities reduces risk

b. short-term interest rates have traditionally been more stable than long-term interest rates

c. A firm that borrows heavily long term is more apt to be unable to repay the debt than a firm that borrows heavily short term

d. Financing requirements remain constant

a. Matching the maturities of assets and liabilities reduces risk

A company has an outstanding one-year bank loan of $500,000 at a stated interest rate of 8%.  The company is required to maintain a 20% compensating balance in its checking account.  The company would maintain a zero balance in this account if the requirement did not exist.  What is the effective interest rate of the loan?

a. 8%    b. 10%    c. 20%    d. 28%

Which of the following ratios would most likely be used by management to evaluate short-term liquidity?

a. Return on total assets

b. Sales to cash

c. Accounts receivable turnover

d. Acid test ratio

Farrow Co. is applying for a loan in which the bank requires a quick ratio of at least 1.  Farrow's quick ratio is 0.8.  Which of the following actions would increase Farrow's quick ratio?

a. Purchasing inventory through the issuance of a long-term note

b. Implementing stronger procedures to collect accounts receivable at a faster rate

c. Paying an existing account payable

d. Selling obsolete inventory at a loss

d. Selling obsolete inventory at a loss

A company has cash of $100 million, accounts receivable of $600 million, current assets of $1.2 billion, accounts payable of $400 million, and current liabilities of $900 million.  What is its acid-test (quick) ratio?

a. 0.11

b. 0.78

c. 1.75

d. 2.11

At the end of its fiscal year, Krist, Inc. had the following account balances:

Cash                    $  5,000 AR                          10,000 Inventory              20,000 AP                          15,000 ST note payable      5,000 LT note payable    35,000

What is Krist’s quick (acid-test) ratio?

a. 0.273                  b. 0.636 c. 0.750                  d. 1.750

c. 0.750

The quick (acid-test) ratio is cash plus marketable securities plus net receivables divided by current liabilities. There are no reported marketable securities. Cash = $5,000. Net receivables = $10,000. Current liabilities = $15,000 + $5,000 = $20,000. Quick ratio = ($5,000 + $10,000) $15,000 ÷ $20,000 = 0.75.

K Company finances each asset with financial instruments with maturities with lengths similar to asset life. What is this policy called?

a. Financial leverage b. Hedging approach c. Operating leverage d. Return maximization

Which of the following statement is true with regard to financial derivatives?

a. A forward contract is a forward-based derivative that obligates two parties to trade a series of cash flows at specified future settlement dates. b. Due to their extreme risk, extensive purchase of derivatives are more likely to occur when markets are stable. c. Use of derivatives should eliminate risk. d. Using derivatives divides financial risk into separate elements that can be exchanged between entities.

d. Using derivatives divides financial risk into separate elements that can be exchanged between entities.

How do exchange clearinghouses promote liquidity in futures markets?

I. The daily mark to market decreases the risk that the other party to a futures contract will be unable to meet its obligations on the maturity date.

II. Exchanges develop appropriate incentives so that traders do not assume unwarranted risks.

III. Exchanges use standardized contracts.

A company has several long-term floating-rate bonds outstanding. The company’s cash flows have stabilized, and the company is considering hedging interest rate risk. Which of the following derivative instruments is recommended for this purpose?

a. Structured short-term note b. Forward contract on a commodity c. Futures contract on a stock d. Swap agreement

The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?

a. The decline in the value of the investment should be reflected in the determination of net present value. b. Depreciation adjusts the book value of the investment. c. Depreciation represents cash outflow that must be added back to net income. d. Depreciation increases cash flow by reducing income taxes

d. Depreciation increases cash flow by reducing income taxes

When estimating cash flow for use in capital budgeting, depreciation is

a. Included as a cash or other cost b. Excluded for all purposes in the computation c. Utilized to estimate the salvage value of an investment d. Utilized in determining the tax costs or benefit

d. Utilized in determining the tax costs or benefit

Helm (tax exempt) invested $400,000 in a 5 yr project at beg of Yr 1. Helm estimates that annual cash savings from this project will be $130k. The $400,000 of assets is depreciated over their 5 yr life on straight-line basis. Helm's desired ROR is 12%. PV factors                           At 12%   At 14%   At 16%

PV of 1 for 5 periods             0.57       0.52     0.48

PV of annuity of 1 for 5 per   3.60       3.40     3.30

What is the net present value of the project?

a. $36k     b. 57k     c. 68k     d. 250k

The net present value of the project is the amount of the excess of the present value of the cash flows over the cost of the project. As the entity is a tax-exempt organization, the effect of income taxes is irrelevant.

Annual cash flow                     $ 130,000 Present value annuity factor

Present value of cash flows     $ 468,000 Less: Cost of project

Net present value of project     $   68,000

Helm (tax-exempt) invested $400,000 in a 5 yr project at beg of Yr 1. Helm estimates annual cash savings from this project will be $130,000. The $400,000 of assets will be depreciated over 5yr life on straight-line. Helm's desired ROR is 12%.

  PV Info At                           12%       14%     16%

PV of 1 for 5 periods             0.57       0.52     0.48

PV of annuity of 1 for 5 per 3.60       3.40     3.30

What is the internal rate of return on this project?

a. less than 12%       b. Less than 12% More than 14% b. >16%, <14%           d. More than 16%

To determine internal rate of return (IRR) on this project, the NPV of the project is computed at 12%, 14%, and 16%. Since the machine has a positive NPV at a discount rate of 14%, and 16% the IRR exceeds 16%.

                                            14%                 16%

Annual cash flow         $ 130,000       $ 130,000  PV annuity factor

PV of cash flows           $ 442,000       $ 429,000  Less: Cost of project

Net present value         $   42,000       $   29,500

Helm (tax-exempt) invested $400,000 in a 5 yr project at beg of Yr 1. Helm estimates annual cash savings from this project will be $130,000. The $400,000 of assets will be depreciated over 5yr life on straight-line. Helm's desired ROR is 12%.

  PV Info At                           12%       14%     16%

PV of 1 for 5 periods             0.57       0.52     0.48

PV of annuity of 1 for 5 per 3.60       3.40     3.30

For the 1st year, what is Helm's accounting ROR (ARR), based on the project's average BV for Year 1?

a. 12.5%                        b. 13.9% c. 15.6%                        d. 36.1%

b. 13.9% To determine ARR, based on the project's average BV for Yr 1, annual depreciation expense and average BV for Yr 1 must be computed. Depreciation expense on the straight-line basis is $80,000 [($400,000 - $0) / 5 years] BV the end of Year 1 is $320,000 ($400,000 - $80,000). The ARR based on the project's average BV for Yr 1 is average annual accounting income divided by average BV. ($130,000 - $80,000) / $360,000 = 13.9%

Mudd is planning to buy a coin-op machine costing $20,000. that will be depreciated over a 5-yr period using straight-line w/no salvage. Mudd estimates the machine will yield annual cash inflow, net of depreciation & income taxes, of $6,000. At these discount rates, the NPV of the investment are:

Discount rate           NPV

12%                     + $1,629   Their discounted ROR

14%                         + 599     on this machine is

16%                         - 354       a. 3.3%   b. 10%

18%                         - 1,237     c. 12%   d. 15.3%

d. 15.3% The IRR of an investment is the discount rate that would yield a NPV of $0. The table of net present values included in this problem indicates that a 14% discount rate yields a positive NPV, whereas a 16% rate yields a negative NPV. Therefore, IRR is between 14% and 16%; only 15.3%, satisfies this requirement.

The discount rate (hurdle rate of return) must be determined in advance for the

a. Payback period method b. Time adjusted rate of return method c. Net present value method d. Internal rate of return method

c. Net present value method

Which of the following capital budgeting techniques implicitly assumes that the cash flows are reinvested at the company's minimum required rate of return?

The capital budgeting technique known as accounting rate of return uses

I. Revenue over life of project II. Depreciation expense III. Time value of money

Polo Co. requires higher rates of return for projects with a life span greater than five years. Projects extending beyond five years must earn a higher specified rate of return. Which of the following capital budgeting techniques can readily accommodate this requirement?

The capital budgeting technique known as payback period uses

I. Depreciation expense II. Time value of money III. Cash flow over entire life of project

only III. Cash flow over entire life of project

Payback period =   Initial cash outlay / Annual net cash inflows

A project has an expected economic life of eight years. In the calculation of the net present value of the proposed project, salvage value would be

a. Excluded from the calculation of the net present value b. Included as a cash inflow at the future amount of the estimated salvage value c. Included as a cash inflow at the estimated salvage value d. Included as a cash inflow at the present value of the estimated salvage value

d. Included as a cash inflow at the present value of the estimated salvage value

If income tax considerations are ignored, how is depreciation expense used in the following capital budgeting techniques (included/excluded)?

How are the following used in the calculation of the internal rate of return of a proposed project (included or excluded)? Ignore income tax considerations.

Residual sales value of project Depreciation expense

Include Residual sales value, exclude depreciation expense

Tam is purchasing of equipment that would cost $100,000, that would save $20,000 /yr in after-tax cash costs. its useful life is 10 yrs, w/ no residual value, straight-line depreciation. Tam's predetermined minimum desired rate of return is 12%. PV of an annuity of 1 at 12% for 10 periods is 5.65. PV of 1 due in 10 periods at 12% is 0.322. What is NPV?

a. $5760     b. $6440       c. $12,200     d. $13,000

Under the NPV method, the PV of all cash inflows associated with an investment are compared with the PV of all cash outflows. The difference between the PV of these cash flows is the NPV of the project and determines whether or not it is acceptable .

Annual cash inflows     $   20,000 Times: PV factor

PV of cash inflows           $ 113,000  Less: Initial investment

) NPV of project                 $   13,000

Tam is purchasing of equipment that would cost $100,000, that would save $20,000 /yr in after-tax cash costs. its useful life is 10 yrs, w/ no residual value, straight-line depreciation. Tam's predetermined minimum desired rate of return is 12%. PV of an annuity of 1 at 12% for 10 periods is 5.65. PV of 1 due in 10 periods at 12% is 0.322. What is the payback period? a. 4 years                         b. 4.4 years c. 4.5 years                     d. 5 years

d. 5 years

The payback period is the period of time it takes for the cumulative sum of annual net cash inflows from a project to equal the initial cost outlay. When the annual net cash inflows from the project are a constant amount, the payback period for the project is the inital cash outlay divided by the annual net cash inflows = $100,000 / $20,000 = 5.0 years.

Tam is purchasing of equipment that would cost $100,000, that would save $20,000 /yr in after-tax cash costs. its useful life is 10 yrs, w/ no residual value, straight-line depreciation. Tam's predetermined minimum desired rate of return is 12%. PV of an annuity of 1 at 12% for 10 periods is 5.65. PV of 1 due in 10 periods at 12% is 0.322. What is the accrual accounting rate of return based (ARR) on initial investment? a. 30%         b.. 20%         c. 12%       d. 10%

d. 10% The ARR on initial investment (ARR) is computed by dividing the average accounting income the machine generates by the cost of the initial investment. The average annual accounting income generated by the machine is the expected annual after-tax cash savings in operating expenses less annual depreciation expense [i.e., $20,000 - ($100,000 / 10) = $10,000]. ARR = $10,000 / $100,000 = 10%

Tam is purchasing of equipment that would cost $100,000, that would save $20,000 /yr in after-tax cash costs. its useful life is 10 yrs, w/ no residual value, straight-line depreciation. Tam's predetermined minimum desired rate of return is 12%. PV of an annuity of 1 at 12% for 10 periods is 5.65. PV of 1 due in 10 periods at 12% is 0.322. In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns closest to what amount? a. 0.65     b. 1.30         c. 5.00         d. 5.65

c. 5.00

The IRR is the interest rate which would make the PV of the future expected cash flows equal to the initial investment. Since the annual net cash inflows from the project are a constant amount, the IRR of the investment is calculated as follows.:

Annual cash flows x PV factor = Cost of initial investment

$20,000 x Present value factor = $100,000 so

Present value factor = $100,000 / $20,000

Neu Co. is considering the purchase of an investment that has a positive net present value based on Neu's 12% hurdle rate. The internal rate of return would be

a. 0 b. 12% c. > 12% d. < 12%

c. > 12%
"hurdle" rate is the minimum acceptable rate for a project

Major Corp. is purchasing a machine for $5,000 that will have an estimated useful life of 5 yrs w/ no salvage value, that will increase Major's after-tax cash flow by $2,000 annually for 5 yrs. They use straight-line depreciation and have incremental borrowing rate of 10%. The PV factors for 10% are as follows: Ordinary annuity with five payments 3.79 Annuity due for five payments 4.17

Using the payback method, how many years will it take to pay back Major's initial investment in the machine?

a. 2.50     b. 5.00     c. 7.58     d. 8.34

a. 2.50 years

$5,000 / $2,000 = 2.5.

Payback period = Initial cash flow outlay / Annual net cash inflows

Lin Co. is buying machinery it expects will increase average annual operating income by $40,000. The initial increase in the required investment is $60,000, and the average increase in required investment is $30,000. To compute the accrual accounting rate of return, what amount should be used as the numerator in the ratio?

a. $20,000                       b. $30,000 c. $40,000                       d. $60,000

c. $40,000

The accrual accounting rate of return for a project is computed by dividing the average annual income the project generates by the initial (or average) increase in required investment.

Which of the following characteristics represent an advantage of the internal rate of return technique over the accounting rate of return technique in evaluating a project?

I. Recognition of the project's salvage value

II. Emphasis on cash flows

III. Recognition of the time value of money

A project's net present value, ignoring income tax considerations, is normally affected by the

a. Proceeds from the sale of the asset to be replaced b. Carrying amount of the asset to be replaced by the project c. Amount of annual depreciation on the asset to be replaced d. Amount of annual depreciation on fixed assets used directly on the project

a. Proceeds from the sale of the asset to be replaced

Para Co. is reviewing the following data relating to an energy saving investment:

Cost $50,000 Residual value at the end of 5 years 10,000 PV of an annuity of 1 at 12% for 5 years 3.60 PV of 1 due in 5 years at 12% 0.57
What would be the annual savings needed to make the investment realize a 12% yield?

a. $3189                       b. $11.111 c. $12,889                     d. $13,889

The annual savings needed to realize a 12% yield can be obtained by dividing the $44,300 by the 3.60 present value of an annuity at 12% for 5 years. Thus, the annual savings needed are $12,306

($44,300 / 3.60), rounded to the nearest dollar.

Cost $50,000 Less: Present Value of Residual Value ($10,000 x 0.57)

) Present Value of Annual Savings Needed $44,300

Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are:

Period: 1 0.88 2 1.65 3 2.32
Using a 14% cost of capital, what is the present value of these future savings?

a. $59,600                               b. $60,800 c. $62,900                               d. $69,500

The PV for a single sum in 3 yrs is the difference between the PV of an annuity for 3 yrs and the PV of an annuity for 2 yrs. (2.32 - 1.65 = 0.67)

Reduction costs, 1st 2 yrs ($30,000 x 1.65)   $49,500 Reduction costs Yr 3 ($20,000 x 0.67) 13,400 PV of future cost savings $62,900   Reduction costs all 3 yrs ($20,000 x 2.32) $46,400 Add'l reduction in costs for 2 years ($10,000 x 1.65) 16,500 PV of future cost savings (alt method) $62,900

For the next 2 years, a lease is estimated to have an operating net cash inflow of $7,500 per annum, before adjusting for $5,000 per annum tax basis lease amortization, and a 40% tax rate. The present value of an ordinary annuity of $1 per year at 10% for 2 years is $1.74. What is the lease's after-tax present value using a 10% discount factor? a. $2610 b. $4350 c. $9570 d. $11.310

d. $11.310 first determine the tax. Next, the tax liability is subtracted from the cash flow before taxes to determine the after-tax cash flow. This amount is then multiplied by the present value of an annuity factor to determine the after-tax present value of the lease.

Oak Company bought a machine they will depreciate on straight-line basis over 7 yrs w/ no salvage value. They expect it to generate after-tax net cash inflows of $110,000 each. Oak's minimum rate of return is 12%. Information on PV factors:
- PV of $1 at 12% at the end of seven periods 0.0452

- PV of an ordinary annuity of $1 at 12% for 7 periods 4.564

Assuming a positive NPV of $12,000, what was the cost of the machine?

a. $480k   b. $490.,040   c. $502,040     d. 514,040

b. $490.,040

The net present value (NPV) of $12,000 is the present value of the ordinary annuity of $110,000 less the unknown cash outflow (X).
$110,000 x 4.564 - X = $12,000
X = $502,040 - $12,000
X = $490,040

Which of the following is a strength of the payback method?

a. It considers cash flows for all years of the project. b. It distinguishes the sources of cash inflows. c. It considers the time value of money. d. It is easy to understand.

d. It is easy to understand.

A project should be accepted if the present value of cash flows from the project is?

a. Equal to the initial investment b. Less than the initial investment c. Greater than the initial investment d. Equal to zero

c. Greater than the initial investment

Capital projects may be classified by type of project. Which classification generally would be assigned to a project to retrofit equipment to meet new safety regulations?

a. Cost-reduction replacements b. Expansion of existing products or markets c. Expansion into new product lines or markets d. Mandated investments

The profitability index is a variation on which of the following capital budgeting models?

a. Internal rate of return b. Economic value-added c. Net present value d. Discounted payback

A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?

a. Less than the company's weighted average cost of capital b. Less than the project's internal rate of return c. Greater than the company's weighted average cost of capital d. Greater than the project's internal rate of return

b. Less than the project's internal rate of return

Which of the following statements is true regarding the payback method?

a. It does not consider the time value of money. b. It is the time required to recover the investment and earn a profit. c. It is a measure of how profitable one investment project is compared to another. d. The salvage value of old equipment is ignored in the event of equipment replacement.

a. It does not consider the time value of money.

Net present value as used in investment decision-making is stated in terms of which of the following options?

a. Net income b. Earnings before interest, taxes, and depreciation c. Earnings before interest and taxes d. Cash flow

Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?

a. Accounting rate of return b. Payback period c. Internal rate of return d. Cost-benefit ratio

c. Internal rate of return

A company purchases an item for $43,000. The salvage value of the item is $3,000. The cost of capital is 8%. Pertinent information related to this purchase is as follows:

Net cash flows     PV factor at 8% Year 1     $10,000                     0.926 Year 2     $15,000                     0.857 Year 3     $20,000                     0.794 Year 4     $27,000                     0.735

What is the discounted payback period in years?

a. 3.10    b. 3.25      c. 2.90      d. 3.14

b. 3.25
Discounting year 1 ($10,000 × 0.926 = $9,260) + year 2 ($15,000 × 0.857 = $12,855) + year 3 ($20,000 × 0.794 = $15,880) = cash flows yields $37,995. Year 4 discounted cash flows are $27,000 × 0.735 = $19,845. $43,000 - $37,995 = $5,005. $5,005 / $19,845 = 0.25 (rounded). 3 years plus 0.25 years equals 3.25 years. salvage value is received beyond the payback period and is irrelevant.

What is an internal rate of return?

a. A net present value b. An accounting rate of return c. A payback period expected from an investment d. A time-adjusted rate of return from an investment

d. A time-adjusted rate of return from an investment

Which of the following events would decrease the internal rate of return of a proposed asset purchase?

a. Decrease tax credits on the asset b. Decrease related working capital requirements c. Shorten the payback period d. Use accelerated, instead of straight-line depreciation

a. Decrease tax credits on the asset

Which of the following changes would result in the highest present value?

a. A $100 decrease in taxes each year for four years b. A $100 decrease in the cash outflow each year for three years c. A $100 increase in disposal value at the end of four years d. A $100 increase in cash inflow each year for three years

a. A $100 decrease in taxes each year for four years

Which of the following is an advantage of net present value modeling?

a. It is measured in time, not dollars. b. It uses accrual basis, not cash basis accounting for a project. c. It uses the accounting rate of return. d. It accounts for compounding of returns.

d. It accounts for compounding of returns.

A client wants to know how many years it will take before the accumulated cash flows from an investment exceed the initial investment, without taking the time value of money into account. Which of the following financial models should be used?

a. Payback period b. Discounted payback period c. Internal rate of return d. Net present value

How does tax rate affect net present value?

What decreases NPV of a project?

What is the NPV decision rule for independent projects?

Why is net present value important to a project?