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?
Answer(s): C
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
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?
Answer(s): A
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.
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?
Answer(s): B
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).
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 profitability index for the project?
The profitability index is the present value of the future net cash inflows divided by the present value of the net initial investment. The present value of the future net cash inflows is $326,556. Hence, the profitability index is 1.089 ($326,556 $300,000).
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:The payback period for this investment is
The payback period is the time required to recover the original investment. The annual net after-tax cash inflows for Year 1 through Year 3 are $138,000, $150,000, and $150,000, respectively, as determined by the following: In Year I, the after-tax cash inflow is $170,000 minus taxes of $32,000 {[$1 70,000 -- ($300,000 x 30%) depreciation] x40%}, or $138,000. In Year 2, the after-tax cash inflow is $170,000 minus taxes of $20,000 {[$1 70,000 -- ($300,000 x 40%) depreciation] x 40%}, or $150,000. In Year 3, the after-tax cash inflow (excluding salvage value) is again $138,000. After2years, $288,000 ($138,000 + $150,000) will have been recovered. Consequently, the first $12,000 received in Year 3 will recoup the initial investment. Because $12,000 represents .08 ofYear3 net after-tax cash inflows ($12,000 + $150,000), the payback period is 2.09 years.
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