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Free CMA Exam Braindumps (page: 68)

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The technique that measures the number of years required for the after-tax cash flows to recover the initial investment in a project is called the

  1. Net present value method.
  2. Payback method.
  3. Profitability index method.
  4. Accounting rate of return method.

Answer(s): B

Explanation:

The usual payback formula divides the initial investment by the constant net annual cash The payback method is unsophisticated in that it ignores the time value of money, but it is widely used because of its simplicity and emphasis on recovery of the initial investment.



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Capital budgeting methods are often divided into two classifications: project screening and project ranking. Which one of the following is considered a ranking method rather than a screening method?

  1. Net present value.
  2. Time-adjusted rate of return.
  3. Profitability index.
  4. Accounting rate of return.

Answer(s): C

Explanation:

The profitability index is the ratio of the present value of future net cash inflows to the initial cash investment. This variation of the net present value method facilitates comparison of different-sized investments. Were it not for this comparison feature. the profitability index would be no better than the net present value method. Thus. It is the comparison, or ranking, advantage that makes the profitability index different from the other capital budgeting tools



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Woods, Inc. is considering four independent investment proposals. Woods has $3 million available for investment during the present period. The investment outlay for each project and its projected net present value (NPV) is presented below.


Which of the following project options should be recommended to Woods' management?

  1. Projects I, II, and Ill only.
  2. Projects I, II, and IV only.
  3. Projects II, Ill, and IV only.
  4. Projects Ill and IV only.

Answer(s): A

Explanation:

Capital rationing exists when a firm sets a limit on the amount of funds to be invested during a given period. In such situations, a firm cannot afford to undertake all profitable projects. The profitability index (or excess present value index) is a method for ranking projects to ensure that limited resources are placed with the investments that will return the highest net present value (NPV).



Ranked in order of desirability, they are III, II, IV, and I). Since only $3 million is available for funding, only Ill, II, and I will be selected.



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MS Trucking is considering the purchase of a new piece of equipment that has a net initial investment with a present value of $300,000. The equipment has an estimated useful life of3years. For tax purposes1 the equipment will be fully depreciated a rates of 30%, 40%, and 30% in years one, two, and three, respectively. The new machine is expected to have a $20,000 salvage value. The machine is expected to save the company $170,000 per year in operating expenses. MS Trucking has a 40% marginal income tax rate and a 16% cost of capital. Discount rates for a 16% rate are:


What is the net present value of this project?

  1. $31684
  2. $26,556
  3. $94,640
  4. $18,864

Answer(s): B

Explanation:

The NPV method discounts the expected cash flows from a project using the required rate of return. A project is acceptable if its NPV is positive. The future cash inflows consist of $170,000 of saved expenses per year minus income taxes after deducting depreciation. In the first year, the after-tax cash inflow is $170000 minus taxes of $32000 {[$170,000 -- ($300,000 x 30%) depreciation] x 40%}, or $138,000. In the second year, the after4ax cash inflow is $170,000 minus taxes of $20000 {[$170,000--($300000 x40%) depreciation] x40%}, or $150,000. In the third year, the after-tax cash inflow (excluding salvage value) is again $138,000. Also in the third year, the after-tax cash inflow from the salvage value is $12,000 [$20,000 x (1.0-- .40)]. Accordingly, the total for the third year is $150,000 ($138,000 + $12,000). The sum of these cash flows discounted using the factors for the present value of $1 at a rate of 16% is $326,556.


Thus, the NPV is $26,556 ($326556 -- $300,000 initial outflow).






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