Mr. Smith inherited an investment. The attorney informed Mr. Smith that at a 6% discount rate, he could choose to withdraw $80,000 of funds from the investment at the end of each of the next five years.

Mr. Smith inherited an investment. The attorney informed Mr. Smith that at a 6% discount rate, he could choose to withdraw $80,000 of funds from the investment at the end of each of the next five years.

What is the present value of the investment (i.e. the present value of $80,000 per year for five years)? (Hint: Use Table B, Present Value of Annuity Table of $1 to compute your answer).

ANSWER

INCORRECT

·         

THE CORRECT ANSWER

$336,960

·         

$306,960

·         

YOU WERE SURE AND INCORRECT

$363,690

·         

$366,069

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I DON'T KNOW YET

The present value of $80,000 at the end of each of the next five years is $336,960. The other answers are not correct.

Present value of annuity = $80,000 at 6% for 5 years using Table B Present Value of Annuity of $1

= 4.212 × $80,000 = $336,960

Which of the following is NOT an example of a cash outflow?

ANSWER

INCORRECT

·         

THE CORRECT ANSWER

The future residual value of an asset

·         

YOU WERE SURE AND INCORRECT

Ongoing cash operating costs and refurbishment of an investment

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An investment’s constant cash repairs

·         

An investment’s continuing cash maintenance costs

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I DON'T KNOW YET

The future residual value of an asset is NOT a component of cash outflows. The other answers are not correct because they are examples of cash outflows. Any future residual value of an asset is a cash inflow. The examples of cash outflows are an investment’s ongoing cash operating costs and refurbishment, repairs, and maintenance costs.

The internal rate of return (IRR) is ________.

ANSWER

INCORRECT

·         

THE CORRECT ANSWER

the rate of return, based on discounted cash flows, that a company can expect to earn by investing in a capital asset

·         

YOU WERE SURE AND INCORRECT

the difference between the present value of the investment’s net cash inflows and the cost of an investment

·         

the result of choosing among alterative capital investments due to limited funds

·         

a measure of profitability computed by dividing the average annual operating income from an asset by the initial investment in the asset

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I DON'T KNOW YET

The internal rate of return (IRR) is the rate of return, based on discounted cash flows, that a company can expect to earn by investing in a capital asset.

The net present value (NPV) is the difference between the present value of the investment’s net cash inflows and the cost of an investment.

The accounting rate of return (ARR) is a measure of profitability computed by dividing the average annual operating income from an asset by the initial investment in the asset.

Capital rationing is the process of choosing among alterative capital investments due to limited funds.

Shoe Shop manufactures and sells shoes. The managerial accountant reported the following profitability index report:

Shoe Shop Profitability Index Report November
	Present value of net cash inflows	Initial Investment	Profitability Index
Blue shoes	$2,600,000	$1,400,000	?
Green shoes	$2,595,000	$1,380,000	?

What are the profitability indices for the blue shoes and the green shoes?

ANSWER

INCORRECT

·         

THE CORRECT ANSWER

1.857%; 1.880%

·         

YOU WERE SURE AND INCORRECT

1.057%; 1.088%

·         

1.875%; 1.880%

·         

1.875%; 1.088%

·         

I DON'T KNOW YET

The profitability indices are 1.857%; 1.880%. The other answers are not correct.

Profitability Index = Present Value of Net Cash Inflows / Initial Investment

Blue shoes profitability index = $2,600,000 / $1,400,000 = 1.857%

Green shoes profitability index = $2,595,000 / $1,380,000 = 1.880%