IMANET IMANET Certifications IMANET-CMA Questions & Answers

• Question 241:

  Whatney Co. is considering the acquisition of a new, more efficient press. The cost of the press is $360,000, and the press has an estimated 6-year life with zero salvage value. Whatney uses straight-line depreciation for both financial reporting and income tax reporting purposes and has a 40% corporate income tax rate. In evaluating equipment acquisitions of this type, Whatney uses a goal of a 4-year payback period. To meet Whatney's desired payback period, the press must produce a minimum annual before4ax operating cash savings of

  A. $90,000

  B. $110,000

  C. $114,000

  D. $150,000

  Correct Answer: B

  Payback is the number of years required to complete the return of the original investment. Given a periodic constant cash flow, the payback period equals net investment divided by the constant expected periodic after-tax cash flow. The desired payback period is 4 years1 so the constant after-tax annual cash flow must be $90,000 ($360,000 ?4). Assuming that the company has sufficient other income to permit realization of the full tax savings, depreciation of the machine will shield $60,000 ($360000 ?6) of income from taxation each year, an after-tax cash savings of $24000 ($60,000 x 40%). Thus, the machine must generate an additional $66,000 ($90,000 -- $24,000) of after-tax cash savings from operations. This amount is equivalent to $1 10,000 [$66,000 ?(1 .0 -- .4)] of before-tax operating cash savings.

• Question 242:

  The bailout payback method

  A. Incorporates the time value of money.

  B. Equals the recovery period from normal operations.

  C. Eliminates the disposal value from the payback calculation.

  D. Measures the risk if a project is terminated.

  Correct Answer: D

  The payback period equals the net investment divided by the average expected cash flow, resulting in the number of years required to recover the original investment. The bailout payback incorporates the salvage value of the asset into the calculation. It determines the length of the payback period when the periodic cash inflows are combined with the salvage value. Hence, the method measures risk. The longer the payback period, the more risky the investment.

• Question 243:

  The payback reciprocal can be used to approximate a project's

  A. Profitability' index.

  B. Net present value.

  C. Accounting rate of return if the cash flow pattern is relatively stable.

  D. Internal rate of return if the cash flow pattern is relatively stable.

  Correct Answer: D

• Question 244:

  Which one of the following statements about the payback method of investment analysis is correct? The payback method

  A. Does not consider the time value of money.

  B. Considers cash flows after the payback has been reached.

  C. Uses discounted cash flow techniques.

  D. Generally leads to the same decision as other methods for long4erm projects.

  Correct Answer: A

  The payback method calculates the amount of time required to complete the return of the original investment, i.e.1 the time it takes for a new asset to pay for itself. Although the payback method is easy to calculate, it has inherent problems. The time value of money and returns after the payback period are not considered.

• Question 245:

  The length of time required to recover the initial cash outlay of a capital project is determined by using the

  A. Discounted cash flow method.

  B. Payback method.

  C. Weighted net present value method.

  D. Net present value method.

  Correct Answer: B

  The payback method measures the number of years required to complete the return of the original investment. This measure is computed by dividing the net investment by the average expected cash inflows to be generated, resulting in the number of years required to recover the original investment. The payback method gives no consideration to the time value of money, and there is no consideration of returns after the payback period.

• Question 246:

  Jasper Company has a payback goal of 3 years on new equipment acquisitions. A new sorter is being evaluated that costs $450000 and has a 5-year life. Straight-line depreciation will be used; no salvage is anticipated. Jasper is subject to a 40% income tax rate. To meet the company's payback goal, the sorter must generate reductions in annual cash operating costs of

  A. $60,000

  B. $100,000

  C. $150,000

  D. $190,000

  Correct Answer: D

  Given a periodic constant cash flow, the payback period is calculated by dividing cost by the annual cash inflows, or cash savings. To achieve a payback period of 3 years, the annual increment in net cash inflow generated by the investment must be $150,000 ($450000 + 3-year targeted payback period). This amount equals the total reduction in cash operating costs minus related taxes. Depreciation is $90000 ($450,000 + 5 years). Because depreciation is a non cash deductible expense, it shields $90,000 of the cash savings from taxation. Accordingly, $60000 ($150000 --$90,000) of the additional net cash inflow must come from after-tax net income. At a 40% tax rate, $60,000 of after-tax income equals $100000 ($60,000 + 60%) of pre-tax income from cost savings, and the outflow for taxes is $40,000. Thus, the annual reduction in cash operating costs required is $190,000 ($150,000 additional net cash inflow required + $40,000 tax outflow).

• Question 247:

  A characteristic of the payback method (before taxes) is that it

  A. Incorporates the time value of money.

  B. Neglects total project profitability.

  C. Uses accrual accounting inflows in the numerator of the calculation.

  D. Uses the estimated expected life of the asset in the denominator of the calculation.

  Correct Answer: B

  The payback method calculates the number of years required to complete the return of the original investment. This measure is computed by dividing the net investment required by the average expected cash flow to be generated, resulting in the number of years required to recover the original investment. Payback is easy to calculate but has two principal problems: it ignores the time value of money, and it gives no consideration to returns after the payback period. Thus, it ignores total project profitability.

• Question 248:

  The internal rate of return is

  A. The breakeven borrowing rate for the project in question.

  B. The yield rate/effective rate of interest quoted on long-term debt and other instruments.

  C. Favorable when it exceeds the hurdle rate.

  D. All of the answers are correct.

  Correct Answer: D

  The internal rate of return (IRR) is the discount rate at which the present value of the cash flows equals the original investment. Thus, the NPV of the project is zero at the IRR. The IRR is also the maximum borrowing cost the firm could afford to pay for a specific project. The IRR is similar to the yield rate/ effective rate quoted in the business media.

• Question 249:

  The internal rate of return on an investment

  A. Usually coincides with the company's hurdle rate.

  B. Disregards discounted cash flows.

  C. May produce different rankings from the net present value method on mutually exclusive projects.

  D. Would tend to be reduced if a company used an accelerated method of depreciation for tax purposes rather than the straight-line method.

  Correct Answer: C

  Investment projects may be mutually exclusive under conditions of capital rationing (limited capital). In other words, scarcity of resources will prevent an entity from undertaking all available profitable activities. Under the PR method, an interest rate is computed such that the present value of the expected future cash flows equals the cost of the investment (NPV = 0). The IRR method assumes that the cash flows will be reinvested at the IRR. The NPV is the excess of the present value of the estimated net cash inflows over the net cost of the investment. The cost of capital must be specified in the NPV method. An assumption of the NPV method is that cash flows from the investment will be reinvested at the particular project's cost of capital. Because of the difference in the assumptions regarding the reinvestment of cash flows, the two methods will occasionally give different answers regarding the ranking of mutually exclusive projects. Moreover, the IRR method may rank several small, short-lived projects ahead of a large project with a lower rate of return but with a longer life span. However, the large project might return more dollars to the company because of the larger amount invested and the longer time span over which earnings will accrue. When faced with capital rationing, an investor will want to invest in projects that generate the most dollars in relation to the limited resources available and the size and returns from the possible investments. Thus, the NPV method should be used because it determines the aggregate present value for each feasible combination of projects.

• Question 250:

  High-Tech Industries is considering the acquisition of a new state-of-the-art manufacturing machine to replace a less efficient machine. Hi-Tech has completed a net present value analysis and found it to be favorable. Which one of the following factors should not be of concern to Hi-Tech in its acquisition considerations?

  A. The availability of any necessary financing.

  B. The probability of near-term technological changes to the manufacturing process.

  C. The investment tax credit.

  D. Maintenance requirements, warranties, and availability of service arrangements.

  Correct Answer: C

  The investment tax credit is of no concern because it no longer exists. The 1986 Tax Reform Act eliminated the investment tax credit.