Test Bank For Accounting for Decision Making and Control Jerald Zimmerman 10 Edition

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Test Bank For Accounting for Decision Making and Control Jerald Zimmerman 10 Edition

Chapter 03 Test Bank – Static Key

Multiple Choice Questions

1. A lump sum of $5,000 is invested at 10% per year for five years. The company’s cost of capital is 8%. Which is true?

A. The investment has a future value of $7,347

B. The investment has a future value of $8,053

C. The investment has a present value of $5,000

D. The investment has a net present value of $5,000

E. None of the above

$5,000 (1 + 0.1)5 = $8,053

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

Accessibility: Screen Reader Compatible

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Future Values

Topic: Present Values

2. Cash of $12,000 will be received in year 6. Assuming an opportunity cost of capital of 7.2%, which of the following is true?

A. The future value is $18,212

B. The present value is $7,996

C. The present value is $7,907

D. Provide data for tax purposes

E. None of the above

$12,000 × (1 + 0.072)−6 = $7,907

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

Accessibility: Screen Reader Compatible

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Future Values

Topic: Present Values

3. Gorgeous George is evaluating a five-year investment in an oil-change franchise, which costs $120,000 paid up front. Projected net operating cash flows are $60,000 per year. If Gorgeous George buys shares instead of the franchise, he expects an annual return of 12%. Which is true? 

A. The future value of the franchise is $216,287

B. The net present value of the franchise is $216,287

C. The future value of the franchise is $138,900

D. The net present value of the franchise is $96,287

E. None of the above

NPV

=

Sum PV(Op Cash Flows) − Investment

$96,287

=

$216,287 − $120,000

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Decision to Open a Day Spa

Topic: Future Values

Topic: Present Values

4. Furious Fred expects cash flows from an investment as follows:

Yr 1 $3,000, Yr 2 $5,000, Yr 3 $8,000

Using an opportunity cost of capital of 5.6%, the present value is:

A. $14,118

B. $14,523

C. $14,361

D. $14,909

E. none of the above

PVi

=

FVi × PVFi

$14,118

=

$3,000 × (1 + 0.056)−1 + $5,000 × (1.056)−2 + $8,000 × (1.056)−3

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Present Value of a Cash Flow Stream

5. Which is true?

A. The present value of a 20-year annuity of $1,900 at 8% is $16,854

B. A $100,000 bond with a 5% coupon will sell at a premium when the market rate of interest is 6%

C. The issue price of a $150,000 zero coupon bond that matures in 6 years when the market rate of interest is 6% is $105,744

D. The present value of a perpetual income stream of $4,000 when the market rate of interest is 8% is $50,000

E. None of the above

PV of perpetuity

=

Annual income/interest rate

$50,000

=

$4,000/0.08

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Present Values

6. Harriet Harvester (HH) plans to buy a haymaker. It costs $180,000 and is expected to last for five years. She presently hires 10 workers at $3,000 per month for each of the six harvesting months each year. The equipment would eliminate the need for six workers. HH uses straight-line depreciation and projects a salvage value of $23,000. Her tax rate is 21% and opportunity cost of funds is 8.0%. Which is true?

A. The present value of cash flows in year 5 is $24,466

B. NPV is −$24,466

C. NPV is $155,534

D. NPV is −$155,534

E. None of the above

Yr 0

1

2

3

4

5

INV

−$

180,000

Labor savings*

$

36,000

$

36,000

$

36,000

$

36,000

$

36,000

Tax @ 21%

7,560

7,560

7,560

7,560

7,560

Tax shield of depreciation**

6,594

6,594

6,594

6,594

6,594

Salvage value

 23,000

Net cash flows

−$

180,000

$

35,034

$

35,034

$

35,034

$

35,034

$

58,034

NPV @ 8%

−$

24,466

*$3,000 × 6 × 6

**S-L depreciation = (HC − Salvage)/Life = ($180,000 − $23,000)/5 = $31,400

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Essential Points about Capital Budgeting

Topic: Multiple Cash Flows per Year

Topic: Present Values

7. Samuel Survivor is planning to save for retirement 35 years from now. He expects to live 25 years beyond that, and would like an annual retirement income of $38,500 after tax of 30%. What is the lump sum needed to fund retirement, at an expected annual return of 11.2%?

A. $357,888

B. $319,561

C. $456,515

D. $479,118

E. None of the above

Annual pre-tax income

=

Target income/(1 − tax rate)

$55,000

=

$38,500/(1 − 0.3)

PV Annuity

=

Annuity × PVFAn

$456,515

=

$55,000 × 8.30028

PVFAn

=

(1 − (1 + 0.112)−25)/0.112

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

8. Samuel Survivor is planning to save for retirement 35 years from now. He expects to live 25 years beyond that, and would like an annual retirement income of $38,500 after tax of 30%. How much must Samuel Survivor save each year to accumulate the lump sum needed to fund retirement, at an expected annual return of 11.2%?

A. $893

B. $4,062

C. $1,339

D. $937

E. None of the above

Annual pre-tax income = Target income/(1 − tax rate)

$55,000 = $38,500/(1 − 0.3)

PV Annuity = Annuity × PVFAn

$456,515 = $55,000 × 8.30028

PVFAn = (1 − (1 + 0.112)−25)/0.112

Annuity = FV/FVFAn

$1,275 = $456,515/357.888

FVFAn = ((1 + 0.112)35 − 1)/0.112

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Taxes and Depreciation Tax Shields

9. Mirtha Mudflat has sufficient funds to choose one of two investments. The same amount will be invested in either case. Choice one: ten year $100,000 5% Treasury bonds issued to yield 4% per annum, the market rate. Choice two: a risky bond of the same amount that has expected cash flows of $9,000 per year for the same period.

What is the issue price of the Treasury bond?

A. $100,000

B. $108,110

C. $92,278

D. $125,000

E. None of the above

Issue price of the bond:

Par value × PVF

=

$100,000 × (1.04)-10

=

$

67,556

Annuity × PVFAn

=

$5,000 × (1 − (1.04)-10)/0.04

=

$

40,554

$

108,110

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Present Values

10. Mirtha Mudflat has sufficient funds to choose one of two investments. The same amount will be invested in either case. Choice one: ten year $100,000 5% Treasury bonds issued to yield 4% per annum, the market rate. Choice two: a risky bond of the same amount that has expected cash flows of $9,000 per year for the same period.

What is the risk premium that makes Mirtha indifferent between the two investments?

A. 7.80%

B. 5.66%

C. 3.80%

D. 5.00%

E. None of the above

First, solve for the issue price of the bond:

Par value × PVF

=

$100,000 × (1.04)-10

=

$

67,556

Annuity × PVFAn

=

$5,000 × (1 − (1.04)-10)/0.04

=

$

40,554

$

108,110

Then, solve for the IRR, then subtract riskless rate:

INV

=

Annuity × PVFAn + Bond maturity × PVF

PVFAn

=

(INV – PV bond)/Annuity

=

($108,110 − $47,171)/$9,000 = 6.77104(IRR = x%, t = 10)

IRR – riskless

=

7.8% − 4% = 3.8%

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Internal Rate of Return (IRR)

Topic: Present Values

11. Mirtha Mudflat has sufficient funds to choose one of two investments. The same amount will be invested in either case. Choice one: ten year $100,000 5% Treasury bonds issued to yield 4% per annum, the market rate. Choice two: a risky bond of the same amount that has expected cash flows of $9,000 per year for the same period. Assume Mirtha purchased the risky bond for $105,000 and the market rate is 6%. Which is false?

A. Net present value is $17,080

B. Payback occurs at the end of year 10

C. IRR is 8.25%

D. Present value of the cash flows is $122,080

E. None of the above

All are true.

Yr 0

1

2 − 9

10

INV

$

105,000

OPCF

$

9,000

$

9,000

$

9,000

Par

100,000

Net cash flows

$

105,000

$

9,000

$

9,000

$

109,000

NPV $17,080; PV $122,080; IRR 8.25%

Payback is not accomplished by the annual cash flows ($9,000; 10 years). The payback shortfall is covered by the redemption of the bond.

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Decision to Open a Day Spa

Topic: Internal Rate of Return (IRR)

Topic: Payback

Topic: Present Values

12. Peter Pontificator is proposing to purchase a paddle machine, which will cost $5 million, last ten years and have a salvage value of $80,000. Given a tax rate of 21%, and a cost of capital of 8%:

What is the present value of the tax shield if straight-line depreciation is used?

A. $600,000

B. $643,234

C. $745,671

D. $693,286

E. None of the above

SL depreciation = (HC − Salvage)/Life

= ($5,000,000 − $80,000)/10 = $492,000

Annual tax shield = 21% × $492,000 = $103,320 per year

PV of Annuity of $103,320 per year at 8% for 10 years = $693,286

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

Accessibility: Screen Reader Compatible

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Taxes and Depreciation Tax Shields

13. Peter Pontificator is proposing to purchase a paddle machine, which will cost $1 million, last eight years and have a salvage value of 20%. Given a tax rate of 35%, and a cost of capital of 6%:

If double-declining balance depreciation is used, and PP switches to straight-line depreciation in year 6, the present value of the depreciation tax shield is:

A. $287,506

B. $230,005

C. $286,513

D. $229,211

E. none of the above

Double declining rate = 2 × (1/life) = 2 × (1/8) = 25%

The depreciable amount = purchase price. Salvage value is ignored in this method. 

Yr 1

Yr 2

Yr 3

Yr 4

Double declining dep

$

250,000

$

187,500

$

140,625

$

105,469

Depreciation tax shield

35

%

$

87,500

$

65,625

$

49,219

$

36,914

Yr 5

Yr 6

Yr 7

Yr 8

Double declining dep

$

79,102

$

79,102

$

79,102

$

79,102

Depreciation tax shield

$

27,686

$

27,686

$

27,686

$

27,686

NPV

$

287,506

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Present Values

Topic: Taxes and Depreciation Tax Shields

Essay Questions

14. Annuity

Suppose the opportunity cost of capital is 10 percent and you have just won a $1 million lottery that entitles you to $100,000 at the end of each of the next ten years.

Required:

a. What is the minimum lump sum cash payment you would be willing to take now in lieu of the ten-year annuity?

b. What is the minimum lump sum you would be willing to accept at the end of the ten years in lieu of the annuity?

c. Suppose three years have passed and you have just received the third payment and you have seven left when the lottery promoters approach you with an offer to “settle-up for cash.” What is the minimum you would accept (the end of year three)?

d. How would your answer to part (a) change if the first payment came immediately (at t = 0) and the remaining payments were at the beginning instead of at the end of each year?

Feedback:

A. The minimum lump sum you should take is the present value of the cash payments.

PV

=

$100,000 × Annuity Factor (i = 0.10, t = 10)

=

$100,000 × 6.145

=

$614,500

b. This question is essentially (a) in reverse. You are looking for the future value of the cash payments. Looking in the future value in arrears table, the annuity factor is 15.937.

PV

=

$100,000 × 15.937

=

$1,593,700

c. This is similar to (a). This time, t = 7.

PV

=

$100,000 × Annuity Factor (i = 0.10, t = 7)

=

$100,000 × 4.868

=

$486,800

d. To convert an end-of-year payment schedule to a beginning-of-year schedule, we need only multiply by 1 + r. The minimum payment is $614,500 × 1.10 = $675,950.

AACSB: Analytical Thinking

AACSB: Knowledge Application

Accessibility: Keyboard Navigation

AICPA: BB Industry

AICPA: FN Decision Making

AICPA: FN Measurement

Blooms: Apply

Difficulty: 3 Hard

Topic: Annuities

Topic: Future Values

Topic: Opportunity Cost of Capital

Topic: Present Values

15. Identifying the Opportunity Cost of Capital

Don Phelps recently started a dry cleaning business. He would like to expand the business and have a coin-operated laundry also. The expansion of the building and the washing and drying machines will cost $100,000. The bank will lend the business $100,000 at 12 percent interest rate. Don could get a 10 percent interest rate loan if he uses his personal house as collateral. The lower interest rate reflects the increased security of the loan to the bank, because the bank could take Don’s home if he doesn’t pay back the loan. Don currently can put money in the bank and receive 6 percent interest.

Required:

Provide arguments for using 12 percent, 10 percent, and 6 percent as the opportunity cost of capital for evaluating the investment.

Feedback:

The 12 percent rate that the bank wants to charge without the security of the home mortgage probably best reflects the risk of the project. Therefore, the 12 percent interest rate is probably the most appropriate discount rate to use.

The 10 percent rate reflects the interest rate that Don Phelps would have to pay if he uses his personal house as collateral. This rate reflects the interest rate for Don’s total portfolio of assets including his house.

The 6 percent rate reflects the interest rate that Don receives in interest for his bank deposits. If Don decided to use his own cash and not borrow money for the investment, Don’s forgone opportunity of using the cash would be the 6 percent interest if no other investment were available.

AACSB: Analytical Thinking

AACSB: Communication

Accessibility: Keyboard Navigation

Accessibility: Screen Reader Compatible

AICPA: BB Industry

AICPA: FN Risk Analysis

Blooms: Understand

Difficulty: 2 Medium

Topic: Opportunity Cost of Capital

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