1. Which of the following statements regarding relevant costs and sunk costs is incorrect?

a. A serious drawback associated with the incremental approach of relevant cost study is that the incremental approach is cumbersome if more than two alternatives are considered.

b. The type of cost presented to management for an equipment replacement decision should be limited to relevant costs.

c. A sunk cost is a cost which cannot be avoided because it already has been incurred.

d. Relevant costs can be studied using an incremental approach but should not be considered with a full project approach.

Answerd. Relevant costs can be studied by using either a full project or incremental approach. The other statements are correct.

 

2. Deep Channel Ferry Company is evaluating whether to purchase a more fuel-efficient boat or continue to use the boat they currently own. Both boats are identical except for the engine. The fuel-efficient boat costs $620,000, has an estimated service life of five years, has no salvage value, and will have variable operating costs of $100,000 per year. The boat currently owned had an original cost of $320,000, has an existing book value of $160,000, has an estimated remaining service life of five years, has no salvage value at the end of its service life, has a current disposal value (now) of $120,000, and has variable operating costs of $200,000 per year. Ignoring present value and tax considerations, what should Deep Channel do?

a. Buy the fuel-efficient boat.

b. Keep the existing boat.

c. Be indifferent between the fuel-efficient boat and the existing boat.

d. Cannot be determined.

Answerc. Deep channel would be indifferent between the fuel-efficient boat and the existing boat. The relevant costs associated with the purchase decision would include a $620,000 cash outflow for the purchase price, plus $500,000 of operating expenses ($100,000 times 5 years), minus $120,000 which would be netted from the sale of the old boat. The total relevant costs are $1,000,000. The operating costs associated with retaining the old boat also amount to $1,000,000 ($200,000 times 5 years). In summary, there is no difference between the relevant costs of the two alternatives.

 

3. The effect on a company's operating income of discontinuing a department with a contribution margin of $8,000 and allocated overhead of $16,000 (of which $7,000 cannot be eliminated) would be to:

a. Decrease operating income by $1,000.

b. Decrease operating income by $9,000.

c. Increase operating income by $1,000.

d. Increase operating income by $8,000.

Answerc. While the company would forego $8,000 of contribution margin, they would also eliminate $9,000 of overhead ($16,000 minus $7,000). The net effect would cause an increase in income of $1,000.

 

4. For a retail outlet chain with multiple stores, which of the following statements would be correct?

a. Stores which have a net loss should be discontinued.

b. Stores with a negative contribution margin should be discontinued.

c. Stores with a negative contribution margin should be discontinued provided such discontinuation will not cause an increase in sales at other stores.

d. Stores with a negative contribution margin should not be discontinued if such discontinuation will cause profitable stores to bear a portion of the unprofitable store's overhead.

Answerb. Any store with a negative contribution margin should be discontinued, as it cannot even cover variable costs with the sales revenue it is generating. That is to say, increasing sales increase losses.

 

5. Lansing Department Store provided information regarding three departments:

Assuming the trends in costs and revenues continue, which department should be discontinued?

a. A only

b. B only

c. C only

d. More than one department should be discontinued.

Answer d. All three departments should be discontinued. Department C is clearly subject to discontinuation since variable costs exceed sales. Department B should be discontinued because the contribution margin for the department does not cover the department's avoidable fixed costs. Department A would be discontinued because, in discontinuing Department B and C, the unavoidable fixed costs would then have to be absorbed by Department A. In so doing, A's contribution margin is no longer capable of covering the full costs which exist.

 

6. Which of the following statements regarding capital budgeting decisions is incorrect?

a. Capital budgeting analysis techniques are applicable to equipment replacement decisions.

b. The amount and timing of cash flows is critical to the calculation of the net present value of an investment.

c. The cost of capital is equal to a company's maximum desired rate of return.

d. In a capital budgeting decision, the amount of the initial investment required is critical to the analysis; it is not treated as a sunk cost.

Answerc. The cost of capital is the collective cost of funds, is subject to a fair amount of judgment in determination, and is not synonymous with the maximum desired rate of return. The other statements are all correct.

 

7. Analyze the following statements regarding capital budgeting decisions and determine which is correct.

a. The net present value of decision making and capital budgeting is superior to the payback method in that it considers the time value of money.

b. Assuming a 6% interest rate, the factor 0.94340 would be taken from a compound interest (future value) table of factors.

c. The internal rate of return capital budgeting technique does not consider the time value of money.

d. All capital budgeting techniques will produce the same decision in selecting among alternatives.

Answera. The net present value method does consider the time value, whereas the payback method does not. "b" is incorrect. The factor would reflect a present value amount; a future amount would be greater than 1. "c" is incorrect because the internal rate of return does consider the time value of money. "d" is incorrect. Depending on the specific circumstances, different methods may produce different results.

 

8. How much will $1.00 invested at 10% (compounded annually) grow to by the end of 3 years?

a. $.70

b. $1.21

c. $1.30

d. $1.331

Answerd. $1.331. Because of compounding, $1.00 invested at 10% will grow to $1.331 ($1.00 X 1.1 = $1.10; $1.10 X 1.1 = $1.21; $1.21 X 1.1 = $1.331).

 

9. Which of the following methods of evaluating capital budgeting proposals rests on the assumption that income is uniform over the life of an investment?

a. Internal rate of return

b. Payback method

c. Net present value

d. Accounting rate of return

Answerd. The accounting rate of return method is based on an average annual amount of net income. An inherent presumption is that this income occurs each year over the life of an investment. The internal rate of return method and net present value method both directly incorporate the timing and amounts of cash flows. The payback method simply evaluates the amount of time it takes to recover the initial amount of the investment (considering fluctuations in annual cash flow amounts).

 

10. Michaels, Inc., purchased a machine for $100,000. The machine has a useful life of five years and no salvage value. Straight-line depreciation is to be used. The machine is expected to generate cash flow from operations, net of income taxes, of $30,000 in each of the five years. Michaels' expected rate of return is 10%. Information on present value factors is as follows:

What would be the net present value?

a. $6,862.

b. $13,724.

c. $50,000.

d. $62,092.

Answer

 

11. Birmingham Manufacturing purchased a new machine for $100,000. The machine will last ten years and is to be depreciated by the straight-line method. The estimated salvage value of the machine is zero. The machine should generate a yearly cash inflow of $25,000. What is the accounting rate of return on this investment ignoring income taxes?

a. 5%

b. 15%

c. 25%

d. 35%

Answerb. 15%. The average annual accounting income is $15,000 ($25,000 cash flow minus $10,000 annual depreciation). $15,000 divided by $100,000 equals a 15% accounting rate of return.

 

12. Depreciation is incorporated into the discounted cash flow analysis of an investment proposal because it:

a. Is a cost of operations which cannot be avoided.

b. Results in an annual cash outflow.

c. Is a cash inflow.

d. Reduces the cash outlay for income taxes.

Answerd. The amount of depreciation reduces taxable income, thereby generating tax savings. This should be incorporated into the discounted cash flow analysis.

 

13. In general, the presence of taxes:

a. Will cause the net present value of an investment to increase.

b. Will cause the internal rate of return to decrease.

c. Does not change the accounting rate of return.

d. All of these.

Answerb. Taxes are likely to cause the internal rate of return to decrease. Because most cash inflows are taxable, the net after-tax cash available to consider as return on investment is reduced. Likewise, the net present value of an investment is typically reduced for the same reasons. Furthermore, the accounting rate of return is based on income which should probably be computed on a net-of-tax basis.

 

14. What is the internal rate of return associated with a $20,000 investment which returns $11,000 at the end of year 1 and $12,100 at the end of year 2?

a. 10%

b. 11%

c. 12%

d. 13%

Answera. 10%. The present value of $11,000 at the end of one year plus the present value of $12,100 at the end of year two equals the $20,000 amount. Because present value factors were not provided, one solution approach is to experiment with the alternative rates. For example, the $20,000 investment would return $2,000 at a 10% rate of return at the end of the first year. The return of $11,000 consists of $2,000 return on investment and $9,000 return of investment (reducing the remaining amount of investment to $11,000). The $11,000 investment would grow to $12,100 at the end of the second year ($11,000 X 1.1). This is equal to the amount which is then returned at the end of year two.

 

15. Fleming Company is considering the purchase of a new machine. The machine cost $200,000 and will generate yearly cash inflow of $30,000. What is the payback period?

a. 4 years and 8 months.

b. 6 years and 8 months.

c. 6 years and 9 months.

d. 15 years.

Answerb. 6 years and 8 months. The $200,000 investment divided by $30,000 equals six and two-thirds years, or six years and eight months.