University:
Grand Rapids Community College
Course:
Financial and Managerial Accounting: Information for Decisions - John J. Wild
Academic year:

2024
Views:

466

Pages:

2
Author:

stud_ice13

Key Capital Budgeting Concepts 1. Payback Period: o Measures the time needed to recover the initial investment. o Equal Cash Flows: Divide initial investment by the annual cash flow. o Unequal Cash Flows: Calculate cumulative cash flows year by year to identify when they turn positive. 2. Accounting Rate of Return (ARR): o Shows the average percentage return on an investment based on annual income over the average investment. o Formula: ARR=Annual IncomeAverage Investment 3. Net Present Value (NPV): o Calculates the present value of net cash flows minus the initial investment. o NPV Decision Rule: Invest if NPV > 0. o Profitability Index: Used to compare projects with different investment amounts; choose the project with the highest index (must be > 1.0). 4. Internal Rate of Return (IRR): o The discount rate at which NPV equals zero. o Decision Rule: Invest if IRR > hurdle rate. 5. Break-Even Time (BET): o Measures the time until the discounted cash flows equal the initial investment, incorporating the time value of money. 6. Key Terms: o Hurdle Rate: Minimum required rate of return. o Cost of Capital: The rate of return needed to justify an investment. Multiple Choice Quiz Answers Explained 1. Payback Period Calculation: o Equipment cost: $270,000 o Annual net cash flow: $61,200 o Payback Period = $270,000 / $61,200 = 4.4 years. o Answer: (c) 4.4 years 2. Disadvantage of Payback Period: o The payback period does not consider cash flows beyond the payback point, which is its main limitation. o Answer: (a) Ignores cash flows beyond the payback period. 3. Accounting Rate of Return Calculation: o Machine cost: $180,000, expected life: 9 years, annual income: $8,550, no salvage value. o ARR = $8,550 / (($180,000 + $0) / 2) = $8,550 / $90,000 = 9.5%. o Answer: (d) 9.5% 4. Minimum Acceptable Rate of Return: The required rate of return is called the hurdle rate. o Answer: (a) Hurdle rate 5. Net Present Value Calculation: o Machine cost: $90,000, annual cash flow: $33,600, useful life: 3 years, discount rate: 12%. o Using the present value of an annuity for 12% over three years (factor approximately 2.4018): NPV=(33,600×2.4018)−90,000=80,700−90,000=−9,300 o Answer: (e) $(9,300) o