Accounting for Decision Making and Control Jerald Zimmerman 10th – Test Bank
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Sample Test
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?
1. The
investment has a future value of $7,347
1. The
investment has a future value of $8,053
1. The
investment has a present value of $5,000
1. The
investment has a net present value of $5,000
1. None
of the above
$5,000 (1 + 0.1)5 =
$8,053
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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?
1. The
future value is $18,212
1. The
present value is $7,996
1. The
present value is $7,907
1. Provide
data for tax purposes
1. None
of the above
$12,000 × (1 + 0.072)−6 =
$7,907
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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?
1. The
future value of the franchise is $216,287
1. The
net present value of the franchise is $216,287
1. The
future value of the franchise is $138,900
1. The
net present value of the franchise is $96,287
1. None
of the above
|
NPV |
= |
Sum PV(Op Cash Flows) − Investment |
|
$96,287 |
= |
$216,287 − $120,000 |
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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:
1. $14,118
1. $14,523
1. $14,361
1. $14,909
1. 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 |
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Topic: Present Value of a Cash Flow Stream
5. Which
is true?
1. The
present value of a 20-year annuity of $1,900 at 8% is $16,854
1. A
$100,000 bond with a 5% coupon will sell at a premium when the market rate of
interest is 6%
1. 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
1. The
present value of a perpetual income stream of $4,000 when the market rate of
interest is 8% is $50,000
1. None
of the above
|
PV of perpetuity |
= |
Annual income/interest rate |
|
$50,000 |
= |
$4,000/0.08 |
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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?
1. The
present value of cash flows in year 5 is $24,466
1. NPV
is −$24,466
1. NPV
is $155,534
1. NPV
is −$155,534
1. None
of the above
|
|
Yr 0 |
1 |
2 |
3 |
4 |
5 |
||||||||||||
|
INV |
−$ |
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
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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%?
1. $357,888
1. $319,561
1. $456,515
1. $479,118
1. 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 |
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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%?
1. $893
1. $4,062
1. $1,339
1. $937
1. None
of the above
|
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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?
1. $100,000
2. $108,110
3. $92,278
4. $125,000
5. 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 |
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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?
7. 7.80%
5. 5.66%
3. 3.80%
5. 5.00%
1. 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% |
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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?
1. Net
present value is $17,080
1. Payback
occurs at the end of year 10
8. IRR
is 8.25%
1. Present
value of the cash flows is $122,080
2. 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.
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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?
1. $600,000
1. $643,234
1. $745,671
1. $693,286
1. 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
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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 of20%.
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:
1. $287,506
1. $230,005
1. $286,513
1. $229,211
1. 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 |
|
|
|
|
|
|
|
|
|
|
|
|
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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:
1. What
is the minimum lump sum cash payment you would be willing to take now in lieu
of the ten-year annuity?
1. What
is the minimum lump sum you would be willing to accept at the end of the ten
years in lieu of the annuity?
1. 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)?
2. 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:
1. 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 |
15.
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 |
7. 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 |
1. 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.
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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.
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Topic: Opportunity Cost of Capital
16.
Financing Charges and Net Present Value
The president of the company is not convinced that the interest
expense should be excluded from the calculation of the net present value. He
points out that, “Interest is a cash flow. You are supposed to discount cash
flows. We borrowed money to completely finance this project. Why not discount
interest expenditures?” The president is so convinced that he asks you, the
controller, to calculate the net present value including the interest expense.
How can you adjust the net present value analysis to compensate
for the inclusion of the interest expense?
Feedback:
Many possible ways exist for examining this problem. From a
theoretical perspective, of course, interest expense (like dividends) is
excluded because it is captured in the discount rate.
But here is another way of viewing an investment. An investment that
is entirely debt-financed is a positive NPV project if, at the end of the
project, there is excess cash after paying the interest and the principal of
the debt. This can be seen in the following equation where early cash flows are
re-invested at a rate “r” to pay off the principal of the loan at the end of n
periods, which is also the length of the project.
(CF1)(1 + r)n−1 + (CF2)(1 +
r)n−2 + …. + (CFn)
> or < Investment (= Principal)
where CFi = Cash flows in
period i including interest payments.
If the left hand side of the equation is greater than the right
hand side of the equation, the investment has a positive NPV and is acceptable.
This analysis assumes complete debt financing to capture all of the opportunity
cost of using cash.
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Topic: Decision to Open a Day Spa
Topic: Essential Points about Capital Budgeting
Topic: Opportunity Cost of Capital
17.
Asset Replacement
The Baltic Company is considering the purchase of a new machine
tool to replace an obsolete one. The machine being used for the operation has a
tax book value of $80,000, with an annual depreciation expense of $8,000. It
has a salvage value (resale value) of $40,000, is in good working order, and
will last, physically, for at least 10 more years. The proposed machine will
perform the operation so much more efficiently that Baltic engineers estimate
that labor, material, and other direct costs of the operation will be reduced
$60,000 a year, if it is installed. The proposed machine costs $240,000
delivered and installed, and its economic life is estimated at 10 years, with
zero salvage value. The company expects to earn 14 percent on its investment
after taxes (14 percent is the firm’s cost of capital). The tax rate is 21
percent, and the firm uses straight-line depreciation. Any gain or loss on the
machine is subject to tax at 21 percent.
Should Baltic buy the new machine?
Feedback:
This problem is best solved via the incremental method.
|
Initial investment |
|
(240,000 |
) |
|
Disposal of old machine |
$ |
40,000 |
|
|
Reduction in tax liability from selling
old machine |
|
8,400 |
|
|
NET COST OF NEW MACHINE |
|
(191,600 |
) |
|
Depreciation on new machine |
$ |
24,000 |
|
Depreciation on old machine |
|
8,000 |
|
Increase in depreciation |
$ |
16,000 |
|
Increase in depreciation tax shield |
|
3,360 |
|
Reduction in operating expenses |
|
47,400 |
|
Increase in depreciation tax shield
(from above) |
|
3,360 |
|
Total annual cash flows |
$ |
50,760 |
|
Present value of annual cash flows |
$ |
264,770 |
|
NET COST OF NEW MACHINE |
(191,600 |
) |
|
Present value of annual cash flows |
264,770 |
|
|
Net present value |
73,170 |
|
Baltic should purchase the new machine.
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Topic: Annuities
Topic: Decision to Open a Day Spa
Topic: Present Values
Topic: Taxes and Depreciation Tax Shields
Chapter 03 Test Bank – Static Summary
|
Category |
# of Questions |
|
AACSB: Analytical Thinking |
3 |
|
AACSB: Communication |
2 |
|
AACSB: Knowledge Application |
15 |
|
Accessibility: Keyboard Navigation |
17 |
|
Accessibility: Screen Reader Compatible |
5 |
|
AICPA: BB Industry |
17 |
|
AICPA: FN Decision Making |
2 |
|
AICPA: FN Measurement |
16 |
|
AICPA: FN Risk Analysis |
1 |
|
Blooms: Analyze |
1 |
|
Blooms: Apply |
16 |
|
Blooms: Understand |
2 |
|
Difficulty: 2 Medium |
1 |
|
Difficulty: 3 Hard |
16 |
|
Topic: Annuities |
12 |
|
Topic: Decision to Open a Day Spa |
4 |
|
Topic: Essential Points about Capital Budgeting |
2 |
|
Topic: Future Values |
4 |
|
Topic: Internal Rate of Return (IRR) |
2 |
|
Topic: Multiple Cash Flows per Year |
1 |
|
Topic: Opportunity Cost of Capital |
3 |
|
Topic: Payback |
1 |
|
Topic: Present Value of a Cash Flow Stream |
1 |
|
Topic: Present Values |
11 |
|
Topic: Taxes and Depreciation Tax Shields |
4 |
|
|
Chapter 05 Test Bank – Static Key
Multiple Choice Questions
1. Each
of the following responsibility centers and decision rights are correctly
matched, except:
1. Cost
center—input mix
1. Investment
center—capital invested
1. Profit
center—capital invested
1. Investment
center—product mix
1. Profit
center—input mix
Cost centers have decision rights for the input mix; profit
centers for input mix, product mix, and selling prices; investment centers for
input mix, product mix, selling prices and capital invested.
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Topic: Responsibility Accounting
2. Mesopotamian
Materials Inc. (MMI) has two decentralized divisions (Ur and Babylon) that have
decision making responsibility over the amount of resources invested in their
divisions. Recent financial extracts for both divisions are presented below:
|
|
Ur |
|
Babylon |
|||
|
Fixed assets, gross |
$ |
2,500 |
|
$ |
4,000 |
|
|
Accumulated depreciation |
$ |
1,500 |
|
$ |
1,200 |
|
|
Other assets |
$ |
500 |
|
$ |
750 |
|
|
Liabilities |
$ |
500 |
|
$ |
1,000 |
|
|
Sales |
$ |
6,750 |
|
$ |
7,200 |
|
|
Net income after tax* |
$ |
743 |
|
$ |
1,008 |
|
|
Average age of fixed assets (years) |
|
15 |
|
|
5 |
|
*Net income is after tax but before interest
MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI
measures division performance based on the book value of net assets. The
producer price index 15 years ago was 100, 116 five years ago, and currently is
125.
Using historical costs, which is true?
1. Ur’s
return on sales (net income percentage) is 14%
1. Ur’s
return on net assets (RONA) is 74%
6. Babylon’s
net asset turnover is 6.75
1. Babylon’s
return on assets (ROA) is 40%
1. None
of the choices are correct
|
|
Ur |
|
Babylon |
||||
|
Gross fixed assets |
$ |
2,500 |
|
|
$ |
4,000 |
|
|
Accumulated depreciation |
−$ |
1,500 |
|
|
−$ |
1,200 |
|
|
Net fixed assets |
$ |
1,000 |
|
|
$ |
2,800 |
|
|
Other assets |
$ |
500 |
|
|
$ |
750 |
|
|
Total assets |
$ |
1,500 |
|
|
$ |
3,550 |
|
|
Liabilities |
−$ |
500 |
|
|
−$ |
1,000 |
|
|
Net assets |
$ |
1,000 |
|
|
$ |
2,550 |
|
|
RONA = Net income |
$ |
743 |
|
|
$ |
1,008 |
|
|
Net assets |
$ |
1,000 |
|
|
$ |
2,550 |
|
|
Return on net assets (historical) |
|
74.3 |
% |
|
|
39.5 |
% |
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Topic: Investment Centers
3. Mesopotamian
Materials Inc. (MMI) has two decentralized divisions (Ur and Babylon) that have
decision making responsibility over the amount of resources invested in their
divisions. Recent financial extracts for both divisions are presented below:
|
Ur |
|
Babylon |
||||
|
Fixed assets, gross |
$ |
2,500 |
|
$ |
4,000 |
|
|
Accumulated depreciation |
$ |
1,500 |
|
$ |
1,200 |
|
|
Other assets |
$ |
500 |
|
$ |
750 |
|
|
Liabilities |
$ |
500 |
|
$ |
1,000 |
|
|
Sales |
$ |
6,750 |
|
$ |
7,200 |
|
|
Net income after tax* |
$ |
743 |
|
$ |
1,008 |
|
|
Average age of fixed assets (years) |
|
15 |
|
|
5 |
|
*Net income is after tax but before interest
MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI
measures division performance based on the book value of net assets. The
producer price index 15 years ago was 100, 116 five years ago, and currently is
125.
Ur can increase its ROI by:
1. increasing
product contribution margin
1. increasing
sales volume
1. reducing
discretionary expenses
1. taking
on debt
1. all
of the choices are correct
All of these strategies can be utilized to increase ROI.
However, not all of these are necessarily beneficial to the parent company or
the shareholders. Thus it is customary to supplement ROI performance measures
with constraints and minimum performance or expenditure targets.
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4. Mesopotamian
Materials Inc. (MMI) has two decentralized divisions (Ur and Babylon) that have
decision making responsibility over the amount of resources invested in their
divisions. Recent financial extracts for both divisions are presented below:
|
Ur |
|
Babylon |
||||
|
Fixed assets, gross |
$ |
2,500 |
|
$ |
4,000 |
|
|
Accumulated depreciation |
$ |
1,500 |
|
$ |
1,200 |
|
|
Other assets |
$ |
500 |
|
$ |
750 |
|
|
Liabilities |
$ |
500 |
|
$ |
1,000 |
|
|
Sales |
$ |
6,750 |
|
$ |
7,200 |
|
|
Net income after tax* |
$ |
743 |
|
$ |
1,008 |
|
|
Average age of fixed assets (years) |
|
15 |
|
|
5 |
|
*Net income is after tax but before interest
MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI
measures division performance based on the book value of net assets. The
producer price index 15 years ago was 100, 116 five years ago, and currently is
125.
Using historical costs, which is true?
1. Babylon
is a profit center
1. At a
WACC of 5%, Ur’s residual income is lower than Babylon’s by $123
11.
At the planned WACC (11.5%), Ur’s residual income is higher than
Babylon’s by $87
1. At a
WACC of 25%, Ur’s residual income is higher than Babylon’s by $123
1. None
of the choices are correct
|
Ur |
Babylon |
Diff |
||||||
|
Net income after tax |
$ |
743 |
$ |
1,008 |
|
|
|
|
|
Cost of capital (WACC @ 25% on net
assets) |
−$ |
250 |
−$ |
638 |
|
|
|
|
|
Residual income |
$ |
493 |
$ |
370 |
$ |
123 |
|
|
Note that the magnitude (and, therefore, relative ranking) of
residual income is critically dependent on the WACC. A lower WACC favors
divisions with higher net assets (such as Babylon), whereas a high charge for
the use of corporate funds favors divisions with lower net assets (such as Ur).
Because managers have decision making responsibility over the
amount of resources invested in their divisions, both Ur and Babylon are
investment centers.
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Topic: Profit Centers
5. Honolulu
Enterprises has two decentralized divisions (Coconut and Guava) that have
decision making responsibility over the amount of resources invested in their
divisions. Recent financial extracts for both divisions are presented below:
|
Coconut |
Guava |
|||||
|
Fixed assets, gross |
$ |
4,500 |
|
$ |
7,200 |
|
|
Accumulated depreciation |
$ |
2,700 |
|
$ |
2,160 |
|
|
Other assets |
$ |
900 |
|
$ |
1,350 |
|
|
Liabilities |
$ |
900 |
|
$ |
1,800 |
|
|
Sales |
$ |
12,150 |
|
$ |
12,960 |
|
|
Net income after tax* |
$ |
1,330 |
|
$ |
1,810 |
|
|
Average age of fixed assets (years) |
|
15 |
|
|
5 |
|
*Net income is after tax but before interest
Honolulu’s weighted average cost of capital (WACC) is 15% and
the company uses residual income as a method to evaluate performance. Which of
the following statements is correct?
1. Coconut’s
ROI will be raised by divesting of a project with a 20% ROI but its RI will be
lower.
3. Coconut’s
RI will decrease by taking on a project with a $12 cost and net income before
interest of $3.
1. Guava’s
RI will increase by taking on a project with an $8 cost and net income before
interest of $1.1.
1. Coconut’s
RI is less than Guava’s RI.
1. None
of the choices are correct
Coconut’s current ROI is 49.3% [$1,330 ÷ ($4,500 − $2,700 +
$900)]. If Coconut divests of a project with a 20% ROI its current ROI will
increase. But, since the project’s ROI exceeds the WACC, its RI will decrease.
If Coconut takes on a project with a $12 cost and net income before interest of
$3, its RI will increase by $1.2 ($12 × 0.15 = $1.8; $3 − $1.8 = $1.2). If
Guava takes on a project with an $8 cost and net income before interest of
$1.1, its RI will decrease by $.1 ($8 × 0.15 = $1.2; $1.1 − $1.2 = − $0.1.
Coconut’s RI is $925 [($4,500 − $2,700 + $900) × 0.15] = $405; $1,330 − $405 =
$925. Guava’s RI is $851.5 [($7,200 − $2,160 + $1,350) × 0.15] = $958.5; $1,810
− $958.5 = $851.5
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Topic: Investment Centers
6. Economic
value added (EVA):
1. uses
the same basic formula as return on investment (ROI)
1. ignores
R&D spending
1. decreases
a manager’s incentive to maximize firm value
1. is
easy to administer
1. measures
the total return after deducting the cost of all capital employed by the firm
The formula is based on the residual income, not ROI, approach.
It utilizes a tax-adjusted WACC (for which advocate recommend adding back
R&D spending) and is complex to administer. Where it is adopted in
incentive plans, managers have increased incentives to maximize firm value. EVA
measures the total return after deducting the cost of all capital.
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Topic: Economic Value Added (EVA®)
7. Given
the following division performance indicators, which is true?
|
|
Division |
||||||||
|
|
A |
B |
C |
||||||
|
Sales |
$ |
500 |
|
|
|
|
|
|
|
|
Net profit |
$ |
10 |
|
$ |
20 |
|
|
|
|
|
Net assets |
|
|
|
|
|
|
$ |
80 |
|
|
Return on sales |
|
|
|
|
6.0 |
% |
|
4.0 |
% |
|
Asset turnover |
|
10 |
|
|
5 |
|
|
|
|
|
Return on assets |
|
|
|
|
|
|
|
15.0 |
% |
1. A’s
return on assets is double that of B
1. C is
the best division at managing its assets
66.
A’s sales are 66.7% bigger than C’s
1. B
would benefit least from a 10% increase in sales
1. All
of the choices are correct
Division A’s sales of $500 are 66.7% bigger than C’s sales of
$300.
|
Division |
|||||||||
|
|
A |
B |
C |
||||||
|
Sales |
$ |
500.0 |
|
$ |
333.3 |
|
$ |
300.0 |
|
|
Net profit |
$ |
10.0 |
|
$ |
20.0 |
|
$ |
12.00 |
|
|
Net assets |
$ |
50.0 |
|
$ |
66.7 |
|
$ |
80.0 |
|
|
Return on sales |
|
2.0 |
% |
|
6.0 |
% |
|
4.0 |
% |
|
Asset turnover |
|
10.0 |
|
|
5.0 |
|
|
3.8 |
|
|
Return on assets |
|
20.0 |
% |
|
30.0 |
% |
|
15.0 |
% |
|
Return on sales = Net profit/Sales |
|||||||||
|
Asset turnover = Sales/Net assets |
|||||||||
|
Return on assets = Net
profit/assets |
|||||||||
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Topic: Investment Centers
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