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ch09 - Chapter 9 Capital Budgeting and Other Long-Run...

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Chapter 9 Capital Budgeting and Other Long-Run Decisions QUESTIONS 1. A capital expenditure decision is a decision involving the acquisition of a long-lived asset. 2. Time value of money must be considered because the value of money received in the future from an investment is not equivalent to the value of money expended to acquire the investment in the current period. 3. Two approaches that consider the time value of money are the net present value (NPV) approach and the internal rate of return (IRR) approach. 4. With the net present value approach, investments are accepted if the net present value is equal to or greater than zero. With the internal rate of return approach, investments are accepted if the internal rate of return is equal to or greater than the required rate of return. 5. The cost of equity is the return demanded by shareholders for the risk they bear in supplying capital to the firm. 6. Because depreciation reduces taxable income, it results in a tax savings equal to the tax rate times the amount of depreciation. 7. The net present value and internal rate of return methods consider the total stream of cash flows as well as the time value of money. Meanwhile, the payback method does not consider the total stream of cash flows and it does not consider the time value of money. Also, the accounting rate of return method does not consider the time value of money. 8. Managers may concentrate on short-run profitability rather than net present value if their performance is evaluated and compensated based on current period profit. 9. With uneven cash flows, the internal rate of return is calculated using a trial and error approach. Managers “guess” at the IRR and calculate the present value. If the present value is greater than zero, the guess is increased. If the present value is negative, the guess is decreased. 10. In many cases, the benefits of an investment are difficult to quantify (i.e., they are soft benefits). However, ignoring them is equivalent to ignoring cash inflows and tends to discourage investment.
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Jiambalvo Managerial Accounting EXERCISES E1. LO 2 Interest expense is not treated as a cash outflow because the “charge” for interest is included in the cost of capital (i.e., the hurdle or discount rate). E2. LO 2 The NPV is positive and Sally should make the investment. Time Cash Flow PV Factors PV Amounts 0 (32,000,000) 1.0000 $(32,000,000) 1 6,500,000 0.9091 5,909,150 2 6,500,000 0.8264 5,371,600 3 6,500,000 0.7513 4,883,450 4 6,500,000 0.6830 4,439,500 5 6,500,000 0.6209 4,035,850 6 6,500,000 0.5645 3,669,250 7 6,500,000 0.5132 3,335,800 8 6,500,000 0.4665 3,032,250 NPV $ 2,676,850 Effect on End of Year Year Income Investment ROI 1 2,500,000 28,000,000 0.089 2 2,500,000 24,000,000 0.104 3 2,500,000 20,000,000 0.125 4 2,500,000 16,000,000 0.156 5 2,500,000 12,000,000 0.208 6 2,500,000 8,000,000 0.313 7 2,500,000 4,000,000 0.625 8 2,500,000 0 division by zero not defined Although the project has a positive NPV, if Pauline is overly focused on short-term performance, she may hesitate to make the investment, which has a relatively low ROI in the first year. Note that ROI increases 9-2
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Chapter 9 Capital Budgeting Decisions dramatically as the book value of the investment decreases due to depreciation.
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