Horngrens Financial and

Horngren's Financial and Managerial Accounting, The Managerial Chapters Instructor's Solution Manual Tracie and Brenda Horngren's Financial & Managerial Accounting (The Managerial Chapters) 8th Edition, Global Edition Miller-Nobles Tracie, Mattison Brenda,

Managerial Chapters Arranged Reverse: 11-1 1 / 4

11-1

Chapter M:11

Capital Investment Decisions

Review Questions

• Explain the difference between capital assets, capital investments, and capital budgeting.

A capital asset is an operational asset used for a long period of time. A capital investment is the acquisition of a capital asset. Capital budgeting is the process of making capital investment decisions, planning to invest in long-term assets in a way that returns the most profitability to the company.

• Describe the capital budgeting process.

The capital budgeting process consists of the following:

• Step 1: Develop strategies (long-term goals).

• Step 2: Plan.

o Substep 1: Identify potential capital investments.

o Substep 2: Analyze potential capital investments.

o Substep 3: Apply capital rationing.

• Step 3: Direct. (Acquire and use approved capital investments.)

• Step 4: Control. (Perform post-audits, during and at the end of the investment’s life.)

• What is capital rationing?

Capital rationing is the process of ranking and choosing among alternative capital investments based on the availability of funds. Managers must determine if and when to make specific capital investments, so capital rationing occurs when the company has limited cash available to invest in long-term assets.

• What are post-audits? When are they conducted?

A post-audit is the comparison of actual results of capital investments to the projected results. The comparisons help companies determine whether the investments are going as planned and deserve continued support, or whether they should abandon the project and dispose of the assets. Post-audits should be routinely performed during the life of the project, not just at the end of the project life span. The intermediate post-audits allow managers to make adjustments to the projects during their lifetimes. Managers also use feedback from post-audits to better estimate projections for future projects. If managers expect routine post-audits, they will more likely submit realistic estimates with their capital investment proposals.

• List some common cash inflows from capital investments.

Cash inflows from a capital investment include cash revenue generated by the investment, cash savings in operating costs, and any future residual value of the investment (asset).

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11-2

• List some common cash outflows from capital investments.

Cash outflows from a capital investment include the initial investment (acquisition cost), cash operating costs incurred, and cash paid for refurbishment, repairs, and maintenance.

• What is the payback method of analyzing capital investments?

The payback method is a capital investment analysis method that measures the length of time it takes to recover, in net cash inflows, the cost of the initial investment.

• How is payback calculated with equal net cash inflows?

If net cash inflows are equal, the payback period (in years) of an investment is calculated with the

following formula: Amount invested / Expected annual net cash inflow.

• How is payback calculated with unequal net cash inflows?

If net cash inflows are unequal, the payback period (in years) of an investment is calculated as

follows:

• Add the accumulated net cash inflows for full years before complete recovery, then

Payback = Number of Full Years + Amount needed to complete recovery in next year Net cash inflow in next year

• What is the decision rule for payback?

The decision rule for payback is: Investments with shorter payback periods are more desirable, all else being equal.

• What are some criticisms of the payback method?

The major criticisms of the payback method are that it ignores the time value of money, it focuses only on time to recover an investment, not on profitability, and it ignores any cash flows that occur after the payback period.

• What is the accounting rate of return?

The accounting rate of return (ARR) is a capital investment analysis method that measures the profitability of an investment.

• How is ARR calculated?

The accounting rate of return (ARR) on an investment is calculated with the following formula: Average annual operating income / Average amount invested.

• What is the decision rule for ARR?

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11-3 The decision rule for accounting rate of return is: If the expected accounting rate of return meets or exceeds the required rate of return, then invest. If it is less than the required rate of return, then do not invest.

• Why is it preferable to receive cash sooner rather than later?

A dollar received today is worth more than a dollar to be received in the future because today’s dollar can be invested to earn additional interest over time. The fact that invested cash earns interest over time is called the time value of money and explains why it is preferable to receive cash sooner rather than later.

• What is an annuity? How does it differ from a lump sum payment?

An annuity is a stream of equal cash payments made at equal time intervals. In contrast, a lump sum payment is a one-time cash payment.

• How does compound interest differ from simple interest?

Simple interest means that interest is calculated only on the principal amount. In contrast, compound interest means that interest is calculated on the principal and on all previously earned interest. Compound interest assumes that all interest earned will remain invested and earn additional interest at the same interest rate. Over the life of a given investment, the total amount of compound interest is more than the total amount of simple interest.

• Explain the difference between the present value factor tables—Present Value of $1 and Present

Value of Ordinary Annuity of $1.

The Present Value of $1 table (Appendix A, Table A-1) is used to calculate the value today of one future amount (a lump sum). The Present Value of Ordinary Annuity of $1 table (Appendix A, Table A-2) is used to calculate the value today of a series of equal future amounts (an annuity).

• How is the present value of a lump sum determined?

The present value (PV) of a lump sum is determined with the following formula: Future value × PV factor (Appendix A, Table A-1) for the applicable interest rate i and period of time n.

• How is the present value of an annuity determined?

The present value (PV) of an annuity is determined with the following formula: Amount of each net cash inflow × Ordinary Annuity PV factor (Appendix A, Table A-2) for the applicable interest rate i and period of time n.

• Why are net present value and internal rate of return considered discounted cash flow methods?

Net present value (NPV) and internal rate of return (IRR) are considered discounted cash flow methods because they incorporate compound interest (by assuming that future cash flows will be reinvested when they are received) and make comparisons by converting all cash flows to the same point in time—namely the present value. The NPV and IRR methods rely on present value ..

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