QUESTION: 96 Topic 2: Part 3 Sec Two (63 to 105)

The internal rate of return on an investment

Usually coincides with the company's hurdle rate.
Disregards discounted cash flows.
May produce different rankings from the net present value method on mutually exclusive projects.
Would tend to be reduced if a company used an accelerated method of depreciation for tax purposes rather than the straight-line method.

Answer(s): C

Explanation:

Investment projects may be mutually exclusive under conditions of capital rationing (limited capital). In other words, scarcity of resources will prevent an entity from undertaking all available profitable activities. Under the PR method, an interest rate is computed such that the present value of the expected future cash flows equals the cost of the investment (NPV = 0). The IRR method assumes that the cash flows will be reinvested at the IRR. The NPV is the excess of the present value of the estimated net cash inflows over the net cost of the investment. The cost of capital must be specified in the NPV method. An assumption of the NPV method is that cash flows from the investment will be reinvested at the particular project's cost of capital. Because of the difference in the assumptions regarding the reinvestment of cash flows, the two methods will occasionally give different answers regarding the ranking of mutually exclusive projects. Moreover, the IRR method may rank several small, short-lived projects ahead of a large project with a lower rate of return but with a longer life span. However, the large project might return more dollars to the company because of the larger amount invested and the longer time span over which earnings will accrue. When faced with capital rationing, an investor will want to invest in projects that generate the most dollars in relation to the limited resources available and the size and returns from the possible investments. Thus, the NPV method should be used because it determines the aggregate present value for each feasible combination of projects.

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QUESTION: 97 Topic 2: Part 3 Sec Two (63 to 105)

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The internal rate of return is

The breakeven borrowing rate for the project in question.
The yield rate/effective rate of interest quoted on long-term debt and other instruments.
Favorable when it exceeds the hurdle rate.
All of the answers are correct.

Answer(s): D

Explanation:

The internal rate of return (IRR) is the discount rate at which the present value of the cash flows equals the original investment. Thus, the NPV of the project is zero at the IRR. The IRR is also the maximum borrowing cost the firm could afford to pay for a specific project. The IRR is similar to the yield rate/effective rate quoted in the business media.

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QUESTION: 98 Topic 2: Part 3 Sec Two (63 to 105)

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A characteristic of the payback method (before taxes) is that it

Incorporates the time value of money.
Neglects total project profitability.
Uses accrual accounting inflows in the numerator of the calculation.
Uses the estimated expected life of the asset in the denominator of the calculation.

Answer(s): B

Explanation:

The payback method calculates the number of years required to complete the return of the original investment. This measure is computed by dividing the net investment required by the average expected cash flow to be generated, resulting in the number of years required to recover the original investment. Payback is easy to calculate but has two principal problems: it ignores the time value of money, and it gives no consideration to returns after the payback period. Thus, it ignores total project profitability.

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QUESTION: 99 Topic 2: Part 3 Sec Two (63 to 105)

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Jasper Company has a payback goal of 3 years on new equipment acquisitions. A new sorter is being evaluated that costs $450000 and has a 5-year life. Straight-line depreciation will be used; no salvage is anticipated. Jasper is subject to a 40% income tax rate. To meet the company's payback goal, the sorter must generate reductions in annual cash operating costs of

$60,000
$100,000
$150,000
$190,000

Answer(s): D

Explanation:

Given a periodic constant cash flow, the payback period is calculated by dividing cost by the annual cash inflows, or cash savings. To achieve a payback period of 3 years, the annual increment in net cash inflow generated by the investment must be $150,000 ($450000 + 3-year targeted payback period). This amount equals the total reduction in cash operating costs minus related taxes. Depreciation is $90000 ($450,000 + 5 years). Because depreciation is a non cash deductible expense, it shields $90,000 of the cash savings from taxation. Accordingly, $60000 ($150000 --$90,000) of the additional net cash inflow must come from after-tax net income. At a 40% tax rate, $60,000 of after-tax income equals $100000 ($60,000 + 60%) of pre-tax income from cost savings, and the outflow for taxes is $40,000. Thus, the annual reduction in cash operating costs required is $190,000 ($150,000 additional net cash inflow required + $40,000 tax outflow).

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QUESTION: 96 Topic 2: Part 3 Sec Two (63 to 105)

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QUESTION: 97 Topic 2: Part 3 Sec Two (63 to 105)

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QUESTION: 98 Topic 2: Part 3 Sec Two (63 to 105)

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QUESTION: 99 Topic 2: Part 3 Sec Two (63 to 105)

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