ngineering Economics, 5e (Fraser)
Chapter 6 Depreciation and Financial Accounting
6.1 Multiple Choice Questions
1) What is depreciation?
- A) The decline in value of a future good due to the time we have to wait to receive that good.
- B) The decline in value of expected future income, due to inflation.
- C) The tendency of money in a bank account to lose value over time.
- D) The loss in an asset’s value over time.
- E) The accumulation of money in an interest-bearing account over time.
Answer: D
Diff: 1 Type: MC Page Ref: 165
Topic: 6.2. Depreciation and depreciation accounting
Skill: Recall
User1: Qualitative
2) What is functional loss?
- A) Functional loss occurs when the asset can still perform its function despite a loss in its market value.
- B) Functional loss occurs when the asset becomes unusable to to misuse.
- C) Functional loss occurs when the asset wears out due to being used for its intended function.
- D) Functional loss occurs when the asset wears out due to the passage of time, whether or not it is used.
- E) Functional loss occurs when the asset can still perform its original function, but that function is no longer valued.
Answer: E
Diff: 1 Type: MC Page Ref: 165
Topic: 6.2. Depreciation and depreciation accounting
Skill: Recall
User1: Qualitative
3) What is the difference between market value and book value?
- A) The market value represents the price for which an asset could be sold at the end of its physical life whereas the book value represents the depreciated value of the asset for accounting purposes.
- B) The market value represents the price for which an asset could be sold at any point in its life, whereas the book value represents the depreciated value of the asset for accounting purposes.
- C) The market value represents the price for which an asset could be sold at any point in its life whereas the book value represents the actual value of an asset at the end of its useful life.
- D) The market value represents the price for which an asset could be sold at the end of its physical life whereas the book value represents the price for which an asset could be sold at the end of its useful life
- E) The market value represents the price for which an asset could be sold at the end of its useful life whereas the book value represents the depreciated value of an asset for accounting purposes.
Answer: B
Diff: 2 Type: MC Page Ref: 165
Topic: 6.2. Depreciation and depreciation accounting
Skill: Recall
User1: Qualitative
4) The only depreciation models needed for corporate tax calculations in Canada are:
- A) straight-line and declining balance.
- B) declining balance and double-declining balance.
- C) straight-line and Sum-of-year’s digits.
- D) straight-line and units-of-production.
- E) declining-balance and 150%-declining-balance.
Answer: A
Diff: 2 Type: MC Page Ref: 166
Topic: 6.2. Depreciation and depreciation accounting
Skill: Recall
User1: Qualitative
5) Your accounting records show that an asset in use has book value of $7 119.14. The asset cost $30 000 when it was purchased and has been depreciated under the declining balance depreciation method with a 25% depreciation rate. How many years has the asset been in service?
- A) 1 year
- B) 2 years
- C) 3 years
- D) 4 years
- E) 5 years
Answer: E
Diff: 2 Type: MC Page Ref: 168-171
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
6) Calculate the salvage value of equipment with a service life of 15 years if it was purchased 5 years ago for $120 000 and depreciates at the rate of 10% per year.
- A) $5 400
- B) $12 000
- C) $24 707
- D) $60 000
- E) $70 859
Answer: C
Diff: 2 Type: MC Page Ref: 168-171
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
7) What are the two basic summary financial statements that provide information about a firm’s revenues, expenses, assets and liabilities?
- A) the cash flow statement and the statement of retained earning
- B) the income statement and the cash flow statement
- C) the statement of retained earning and the balance sheet
- D) the balance sheet and the cash flow statement
- E) the income statement and the balance sheet
Answer: E
Diff: 2 Type: MC Page Ref: 172
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
8) For a given firm, the balance sheet
- A) summarizes firm’s revenues and expenses over a period of time.
- B) gives the firm’s assets, liabilities and owners’ equity at a moment in time.
- C) provides the firm’s net income.
- D) lists the individuals and institutions that own the company assets.
- E) gives the firm’s assets, liabilities and owners’ equity over a period of time.
Answer: B
Diff: 2 Type: MC Page Ref: 172-177
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
9) Owner’s equity
- A) is the difference between a firm’s assets and liabilities.
- B) is cash and other assets that could be converted to cash within a relatively short period of time, usually a year or less.
- C) is the cumulative sum of earnings from all transactions that can be reinvested in the business.
- D) is the price per share set at the time the shares are originally issued.
- E) is the sum of the firm’s long-term assets and current assets.
Answer: A
Diff: 3 Type: MC Page Ref: 175
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
10) What is the distinguishing feature of a limited partnership?
- A) Some partners are involved as investors while other partners manage everyday operations.
- B) The partners have liabilities limited to their personal assets only.
- C) The partners can elect the board of directors that selects the managers to run the business in the interest of the partners
- D) The partners run the business together and share all profits and losses according to the partnership agreement.
- E) The partners have their investments protected from the creditors; however, they are liable for up to the amount of their assets.
Answer: A
Diff: 3 Type: MC Page Ref: 175
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
11) You are one of five partners in a general partnership. You have invested $10 000 of your own money in the business. The business is unsuccessful and is left with no assets and liabilities of $100 000. Your partners all leave the country leaving no forwarding addresses. How much of the debt are you legally responsible for?
- A) $2 000
- B) $10 000
- C) $20 000
- D) $30 000
- E) $100 000
Answer: E
Diff: 3 Type: MC Page Ref: 176
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
12) You are one of five shareholders in a corporation. You have invested $10 000 of your own money in the corporation. The business is unsuccessful and is left with no assets and liabilities of $100 000. Your partners all leave the country leaving no forwarding addresses. How much of the debt are you legally responsible for?
- A) $0
- B) $2 000
- C) $10 000
- D) $20 000
- E) $100 000
Answer: E
Diff: 3 Type: MC Page Ref: 176
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
13) Your supervisor, Ms. Applebee, is asking you to provide her with the cost of equipment the firm owns. Where will you look for it?
- A) in a balance sheet under the Current Assets
- B) in a balance sheet under the Long-Term Assets
- C) in an income statement under the Operating Expenses
- D) in an income statement under the Revenues
- E) in an income statement under the Expenses
Answer: B
Diff: 2 Type: MC Page Ref: 172-176
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
14) In a balance sheet Current Assets are $4 000; Long-term Assets are $6 000; Total Owners’ Equity is $6 000; Current Liabilities are $3 000. What are Long-term Liabilities?
- A) $1 000
- B) $5 000
- C) $9 000
- D) $13 000
- E) $15 000
Answer: A
Diff: 2 Type: MC Page Ref: 172-176
Topic: 6.3. Elements of financial accounting
Skill: Applied
User1: Quantitative
15) Which of the following are not quick assets?
- A) Notes receivable
- B) Temporary investments
- C) Cash and deposits
- D) Capital assets
- E) Accounts receivable
Answer: D
Diff: 2 Type: MC Page Ref: 172-176
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
16) In a balance sheet Current Assets are $9 000; Long-term Assets are $11 000; Current Liabilities are $7 000; Long-term Liabilities are $8 000; and Total Owners’ Equity is $5 000. What is the equity ratio?
- A) 0.25
- B) 0.33
- C) 0.50
- D) 0.75
- E) 1.0
Answer: A
Diff: 2 Type: MC Page Ref: 183
Topic: 6.3. Elements of financial accounting
Skill: Applied
User1: Quantitative
17) Calculate the depreciation rate of a vehicle if it was bought 5 years ago for $25 000 and can be sold now for $8 200.
- A) 20%
- B) 32%
- C) 48%
- D) 68%
- E) 80%
Answer: A
Diff: 2 Type: MC Page Ref: 168-169
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
18) The net-profit ratio is defined as:
- A) net income divided by total equity.
- B) revenue divided by net income.
- C) net income divided by total assets.
- D) net income divided by revenue.
- E) revenue divided by total assets.
Answer: C
Diff: 1 Type: MC Page Ref: 186
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
19) Charles has just purchased a car for $9 520. He expects that the value of this car will decline by 5% each year. Eventually Charles wants to sell this car for at least $6 000 and buy a new one. How many years should Charles use this car before he can sell it?
- A) 12
- B) 10
- C) 8
- D) 6
- E) 4
Answer: C
Diff: 2 Type: MC Page Ref: 168-169
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
20) The Balance Sheet of YYY Ltd. is as follows:
ASSETS
Current Assets
Cash $30 000
Accounts receivable $20 000
Raw materials inventory $50 000
Finished goods inventory $600 000
Total current Assets $700 000
Long-Term Assets
Equipment $2 000 000
Buildings $1 100 000
Land $400 000
Total Long-Term Assets $3 500 000
TOTAL ASSETS $4 200 000
LIABILITIES & OWNER’S EQUITY
Current Liabilities
Accounts payable $10 000
Current loans $60 000
Total current liabilities $70 000
Long-Term Liabilities
Long-term loans $900 000
TOTAL LIABILITIES $970 000
Owners’ equity
Common stock $2 130 000
Retained Earnings $1 100 000
TOTAL OWNERS’ EQUITY $3 230 000
TOTAL LIABILITIES
AND OWNERS’ EQUITY $4 200 000
What is the current ratio of this company?
- A) 0.43
- B) 0.50
- C) 2.00
- D) 6.00
- E) 10.00
Answer: E
Diff: 1 Type: MC Page Ref: 181
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Quantitative
21) The Balance Sheet of YYY Ltd. is as follows:
ASSETS
Current Assets
Cash $30 000
Accounts receivable $20 000
Raw materials inventory $50 000
Finished goods inventory $600 000
Total current Assets $700 000
Long-Term Assets
Equipment $2 000 000
Buildings $1 100 000
Land $400 000
Total Long-Term Assets $3 500 000
TOTAL ASSETS $4 200 000
LIABILITIES & OWNER’S EQUITY
Current Liabilities
Accounts payable $10 000
Current loans $60 000
Total current liabilities $70 000
Long-Term Liabilities
Long-term loans $900 000
TOTAL LIABILITIES $970 000
Owners’ equity
Common stock $2 130 000
Retained Earnings $1 100 000
TOTAL OWNERS’ EQUITY $3 230 000
TOTAL LIABILITIES
AND OWNERS’ EQUITY $4 200 000
If the sales of this company are $5 400 000, what is the company’s inventory-turnover ratio?
- A) 8.4
- B) 9.0
- C) 8.3
- D) 12.0
- E) 18.00
Answer: C
Diff: 1 Type: MC Page Ref: 185
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Quantitative
22) What items should be treated as extraordinary items for a Canadian company that sells its goods to the US market?
- A) loss of revenues caused by the Bank of Canada as it raises the bank rate
- B) loss of revenues caused by the US government as it imposes extra duties on the company’s goods
- C) loss of revenues caused by the increased delays on the Canada-US border that occur due to new security measures
- D) loss of revenues caused by the changes in demand for the company’s goods in the US
- E) loss of revenues caused by the longer haul of goods that occurs as a result of heavy snow on the roads
Answer: E
Diff: 2 Type: MC Page Ref: 186
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
23) Working capital ratio is
- A) the ratio of total assets to total liabilities.
- B) the ratio of total current assets to total current liabilities.
- C) the ratio of total owners’ equity to total assets.
- D) the ratio of current assets to long-term assets.
- E) the ratio of long-term assets to long-term liabilities.
Answer: B
Diff: 1 Type: MC Page Ref: 187
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
24) The extent to which a business relies on debt in its operations is reflected in
- A) the equity ratio.
- B) the return-on-equity ratio.
- C) the quick ratio.
- D) the net-profit ratio.
- E) the return-on-asset ratio.
Answer: A
Diff: 1 Type: MC Page Ref: 187
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
25) The return-on-assets ratio is a reflection of a business’s
- A) marginal costs.
- B) profitability.
- C) marginal revenue.
- D) marginal benefits.
- E) net annual savings.
Answer: B
Diff: 1 Type: MC Page Ref: 187
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
26) A company buys a corrugated-metal building to store fertiliser. Because of a change in plans, no fertiliser is ever stored in the building, but it rusts away due to exposure to the rain. What kind of depreciation is this?
- A) a functional loss
- B) a time-related physical loss
- C) a use-related physical loss
- D) a technological loss
- E) a social loss
Answer: B
Diff: 1 Type: MC Page Ref: 165
Topic: 6.2. Depreciation and depreciation accounting
Skill: Recall
User1: Qualitative
27) From the standpoint of financial accounting, annual revenue is
- A) a component of the Balance Sheet.
- B) a through variable.
- C) an across variable.
- D) an asset.
- E) a liability.
Answer: B
Diff: 2 Type: MC Page Ref: 172
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
28) What is the depreciation rate of a physical asset with the purchase price of $150 000 and salvage value of $16 100 after 10 years of service?
- A) 16.40%
- B) 16.66%
- C) 20.00%
- D) 25.00%
- E) 59.20%
Answer: C
Diff: 2 Type: MC Page Ref: 169
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
29) A computer was bought for $2 000. After three years of service it can be sold for $500. If straight line depreciation is assumed, what was the computer’s book value at the end of year 2?
- A) $2 000
- B) $1 500
- C) $1 000
- D) $500
- E) $0
Answer: C
Diff: 2 Type: MC Page Ref: 166-167
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
30) The most popular depreciation method for physical assets in Canada is
- A) 150%-declining-balance depreciation.
- B) declining-balance depreciation.
- C) sum-of-the-years’-digits depreciation.
- D) double-declining-balance depreciation.
- E) units-of-production depreciation.
Answer: B
Diff: 1 Type: MC Page Ref: 169-170
Topic: 6.2. Depreciation and depreciation accounting
Skill: Recall
User1: Qualitative
31) One of the major drawbacks of the inventory-turnover ratio is that:
- A) Inventories are an across variable while sales are a through variable.
- B) Inventories are a through variable while sales are an across variable.
- C) Sales are measured at costs while inventories are measured in terms of market prices.
- D) It includes only quick assets.
- E) It includes only current liabilities.
Answer: A
Diff: 2 Type: MC Page Ref: 186
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
32) Two assets, A and B, are purchased for the same price. Each loses 10% of its value in the first year. Subsequently, the value of A continues to decline in the same way by declining-balance depreciation, while the value of B continues to decline in the same way by straight-line depreciation. Which will have the greater book value in five years time?
- A) A
- B) B
- C) Their book values will always be equal.
- D) Their book values will generally be different, but they are exactly equal at the end of the fifth year.
- E) It is impossible to say without knowing the MARR.
Answer: A
Diff: 3 Type: MC Page Ref: 166-171
Topic: 6.2. Depreciation and depreciation accounting
Skill: Recall
User1: Quantitative
33) A factory produces two million hand-held computers a year. The annual fixed costs of the factory are $25 000 000, and the marginal cost of each computer is $7. What is the average cost per unit?
- A) $12.25
- B) $16.25
- C) $17.30
- D) $18.75
- E) $19.50
Answer: E
Diff: 2 Type: MC Page Ref: 208
Topic: 6.A. Cost Estimation
Skill: Applied
User1: Quantitative
34) You are trying to estimate the annual cost of setting up a branch of an engineering consulting business in Vancouver, based on your experience of running the original business in Halifax. The original business employs 80 engineers, whereas the Vancouver branch will initially employ 15. On the other hand, Vancouver salaries are typically 50% higher than those paid in Halifax. If the annual salary bill for the Halifax office is $9 000 000, give an order of magnitude estimate for the salary bill of the Vancouver office.
- A) $844 000
- B) $1 687 000
- C) $2 400 000
- D) $2 530 000
- E) $2 953 000
Answer: D
Diff: 2 Type: MC Page Ref: 209-210
Topic: 6.A. Cost Estimation
Skill: Applied
User1: Quantitative
35) You are trying to estimate the annual cost of setting up a branch of a manufacturing business in Vancouver, based on your experience of running a similar business in Halifax. The original business produces 800 units per year, whereas the Vancouver branch will produce 1 700. If the cost of setting up the Halifax operation was $9 000 000 and the capacity factor is 0.6, give an order of magnitude estimate for the cost of setting up the Vancouver operation.
- A) $5 400 000
- B) $11 475 000$
- C) $14 147 000
- D) $19 125 000
- E) $20 250 000
Answer: C
Diff: 2 Type: MC Page Ref: 210
Topic: 6.A. Cost Estimation
Skill: Applied
User1: Quantitative
36) You run a software development business in Toronto. You are offered a chance to bid on a government contract that you estimate will require 600 000 lines of code, deliverable in one year.
You have developed a model: Effort = 3.0(KLOC)1.2 to predict the effort, in programmer-months, required to complete a job, where `KLOC’ stands for `thousands of lines of code’. On the basis of this model, how many programmers should you assign to work on the project?
- A) 150
- B) 450
- C) 540
- D) 1 800
- E) 6 500
Answer: C
Diff: 2 Type: MC Page Ref: 210
Topic: 6.A. Cost Estimation
Skill: Applied
User1: Quantitative
37) Your company recently constructed a steel mill producing 600 000 tons of steel per year, for a construction cost of $12 000 000. You know that a rival company has constructed a similar mill, producing twice as much steel, at a cost of $20 900 000. Based on these figures, what is your estimate of the capacity factor for the steel industry?
- A) 0.5
- B) 0.6
- C) 0.7
- D) 0.8
- E) 0.9
Answer: D
Diff: 2 Type: MC Page Ref: 210
Topic: 6.A. Cost Estimation
Skill: Applied
User1: Quantitative
6.2 Short Answer Questions
1) A hydraulic press has just been purchased. It will have a book value of $6 465 in year 5. The present worth of its salvage value at the end of year 10 is $700, assuming a MARR of 7%. What is the purchase price of the press?
Answer: We can set the following equations:
P * (1 – d)5 = 6 465
P * (1 – d)10/1.0710 = 700
The second equation can be re-written as
P * (1 – d)5 * (1 – d)5/1.0710 = 700
Substituting the first one into the last expression:
6 465 * (1 – d)5/1.0710 = 700
and solving for d, we find that d = 0.266 or 26.6%
P can be found from the first equation as follows:
P * (1 – 0.266)5 = 6 465
So P = $30 353
Diff: 3 Type: SA Page Ref: 168-171
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
2) If a new technology comes into existence which partially replaces some old technology, how the loss in the value of the old technology can be classified?
Answer: This is an example of functional loss. The value of the old technology decreases because there is a better and cheaper way of producing services via the new technology.
Diff: 1 Type: SA Page Ref: 165
Topic: 6.2. Depreciation and depreciation accounting
Skill: Recall
User1: Qualitative
3) Explain the difference between scrap value and salvage value
Answer: Scrap value is the value of an asset at the end of its physical life while salvage value is the value of an asset at the end of its useful life. Useful life can be shorter than or equal to, but never longer than an asset’s physical life.
Diff: 1 Type: SA Page Ref: 165
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Qualitative
4) It is known that the book value of an asset depreciated through declining balance depreciation is
$3 000 in year 3. Purchase price of the asset was $3 800. What is the asset’s salvage value at the end of its useful life, which is 10 years?
Answer: First we can find the depreciation rate from
d = 1 – = 0.0758 or 7.58%
Salvage value at the end of the asset’s life is its book value in year 10 or
BV(10) = P * (1 – d)10 = $3 800 * (1 – 0.0758)10 = $1 727.60
Diff: 2 Type: SA Page Ref: 169
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
5) Consider the following balance sheet:
| ASSETS | LIABILITIES |
| Cash = $200 000 | Accounts payable = $100 000 |
| Accounts receivable = $200 000 | Taxes = $400 000 |
| Inventories = $100 000 | Long-term loans = $1 500 000 |
| Building and equipment = $2 000 000 | |
| Land = $3 000 000 | |
| TOTAL ASSETS = $5 500 000 | TOTAL LIABILITIES = $2 000 000 |
Define and calculate the acid-test ratio.
Answer:
Acid-test ratio or quick ratio is defined as:
Quick assets are the most liquid assets. In this case they are cash of $200 000 and accounts receivable of $200 000. Current liabilities include accounts payable of $100 000 and taxes of $400 000. Therefore, the acid-test ratio is:
= 0.8
Diff: 2 Type: SA Page Ref: 182
Topic: 6.3. Elements of financial accounting
Skill: Applied
User1: Quantitative
6) According to a firm’s balance sheet total assets account for $10 million while total liabilities account for $8 million. Calculate the equity ratio.
Answer: The equity ratio is defined as:
We know that Total Assets are $10 million. By definition, Total Owners’ Equity is the difference between Total Assets and Total Liabilities which is $10 million – $8 million = $2 million. Therefore, the equity ratio is:
= 0.2
Diff: 2 Type: SA Page Ref: 183
Topic: 6.3. Elements of financial accounting
Skill: Applied
User1: Quantitative
7) What is the major advantage and the major drawback of the straight line depreciation method?
Answer: The straight-line depreciation method has the great advantage of being easy to calculate. It also is easy to understand and is in common use. The main problem with the method is that its assumption of a constant rate of loss in asset value is often not valid.
Diff: 1 Type: SA Page Ref: 168
Topic: 6.2. Depreciation and depreciation accounting
Skill: Recall
User1: Qualitative
8) Suppose that the purchase price of a piece of equipment is $1 million. Its salvage value at the end of its 5-year service life is $500 000. Depreciate this asset using straight line depreciation and declining balance depreciation
Answer: For Straight Line depreciation (SLD), we need to find the depreciation amount per year:
= $100 000
Under SLD, the asset’s value loses this amount per year.
For Declining Balance Depreciation (DBD), we need to calculate the depreciation rate:
d = 1 – = 0.129
For DBD, the asset loses 12.9% of its value per year. Now we can calculate the book value in each year under both methods. The results are summarized in the following table:
| SLD | DBD |
| BV(0) | 1 000 000 | 1 000 000 |
| BV(1) | 900 000 | 871 000 |
| BV(2) | 800 000 | 758 641 |
| BV(3) | 700 000 | 660 776 |
| BV(4) | 600 000 | 575 536 |
| BV(5) | 500 000 | 500 000 |
Diff: 2 Type: SA Page Ref: 166-171
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
9) A piece of equipment has just been purchased. It is expected to have a 5-year service life and to depreciate via the declining balance method. The present worth of its salvage value is $1 000. If the depreciation rate is 10%,and the MARR is also 10%, what was the purchase price of this equipment?
Answer: The following equation captures this
P*(1 – 0.1 )5/1.15 = 1 000
where P is the purchase price of the equipment. Solving for P:
P = 1 000 * = $2 727.41
Diff: 3 Type: SA Page Ref: 169
Topic: 6.2. Depreciation and depreciation accounting
Skill: Applied
User1: Quantitative
10) What is the difference between financial accounting and managerial accounting?
Answer: Financial accounting is concerned with recording and organizing the financial data of a business, which include revenues and expenses, and an enterprise’s resources and the claims on those resources. Management accounting is concerned with the costs and benefits of
the various activities of an enterprise. The goal of management accounting is to provide
managers with information to help in decision making.
Diff: 1 Type: SA Page Ref: 171
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
11) How are assets defined in a Balance Sheet? What types of assets are usually included in this financial document?
Answer: Assets are everything a business owns. Usually two types of assets are included in a Balance Sheet: (i) current assets and (ii) long-term assets. Current assets are cash and other assets that could be converted to cash within a relatively short period of time, usually a year or less.
Inventory and accounts receivable are examples of non-cash current assets. Long-term
assets (also called fixed assets or non-current assets) are assets that are not expected to
be converted to cash in the short term, usually taken to be one year
Diff: 2 Type: SA Page Ref: 173
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
12) Explain how owners’ equity is defined
Answer: Owners’ equity is the interest of the owner or owners of a firm in its assets. Owners’ equity usually appears as two components on a balance sheet of a corporation. The first is the par value of the owners’ shares. When an enterprise is first organized, it is authorized to issue a certain number of shares. Par value is the price per share set by the corporation at the time the shares are originally issued. At any time after the first sale, the shares may be traded at prices that are greater than or less than the par value, depending on investors’ expectations of the return that will be earned by the business in the future.
The second part of owners’ equity usually shown on the balance sheet is retained earnings. Retained earnings includes the cumulative sum of earnings from normal operations in addition to gains (or losses) from transactions like the sale of plant assets or investments -the proceeds of which have been reinvested in the business
Diff: 3 Type: SA Page Ref: 175-176
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
13) What is the fundamental difference between a Balance Sheet and an Income Statement?
Answer: A balance sheet is a snapshot of an enterprise’s financial position at a particular point in time, normally the last day of an accounting period. A firm’s financial position is summarized in a balance sheet by listing its assets, liabilities, and owners’ (or shareholders’) equity. An income statement summarizes an enterprise’s revenues and expenses over a specified accounting period. In accounting sense, a balance sheet includes across variables while an income statement includes through variables.
Diff: 2 Type: SA Page Ref: 172, 177
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
14) What is the cost principle of accounting?
Answer: The cost principle of accounting states that assets are to be valued on the basis of their cost as opposed to market or other values. For example, the value of plant and equipment is based on cost. The value reported in the balance sheet is given by the initial cost minus accumulated depreciation
Diff: 1 Type: SA Page Ref: 180
Topic: 6.3. Elements of financial accounting
Skill: Recall
User1: Qualitative
15) Suppose that a business has $100 million in long-term assets and $50 million in current assets. The business’s liabilities are: current liabilities = $30 million and long-term liabilities = $80 million. Calculate the equity ratio and comment on the business’s performance on the basis of this ratio.
Answer: The equity ratio is defined as:
Total Assets = Current Assets + Long-Term Assets = $50 + $100 = $150 million
Total Owners’ Equity = Total Assets – Total Liabilities
Total Liabilities = Current Liabilities + Long-Term Liabilities
Therefore,
Total Liabilities = $30 + $80 = $110 million
Total Owners’ Equity = $150 – $110 = $40 million
Equity Ratio = = 0.27. The ratio is worryingly low. It suggests that the business carries an excessive amount of debt.
Diff: 3 Type: SA Page Ref: 183-184
Topic: 6.3. Elements of financial accounting
Skill: Applied
User1: Quantitative
Engineering Economics, 5e (Fraser)
Chapter 7 Replacement Decisions
7.1 Multiple Choice Questions
1) What is the economic life of an asset ?
- A) the service life that accounts for the costs of an asset replacement
- B) the service life that minimizes the marginal cost of an asset
- C) the service life that maximizes revenues generated by an asset
- D) the service life that minimizes the average cost of an asset over time
- E) the service life that minimizes the cost of replacing the asset
Answer: D
Diff: 1 Type: MC Page Ref: 223
Topic: 7.5. Defender and challenger are identical
Skill: Recall
User1: Qualitative
2) What is the equivalent annual cost (EAC)?
- A) annual cost of the initial investment in an asset spread over its economic life
- B) average annual cost of owning and operating an asset over its economic life
- C) the market cost of replacing the service provided by an asset
- D) the sum of the asset’s depreciation and its operating costs in any given year
- E) the difference between the profits generated by an asset and the cost of operating it
Answer: B
Diff: 1 Type: MC Page Ref: 218
Topic: 7.2. A replacement example
Skill: Recall
User1: Qualitative
3) TRINITY Ltd. produces different pieces of furniture. A set of electric drills used in the production of furniture wears out rapidly, after which the firm scraps them. Calculate the equivalent annual cost (capital costs) of a set of electric drills if the firm buys the set for $4 500 and uses it for 5 years. Assume an annual interest rate of 8%.
- A) $900
- B) $1 082
- C) $1 127
- D) $1 206
- E) $1 284
Answer: C
Diff: 2 Type: MC Page Ref: 218
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
4) In order to make a replacement decision, a firm calculated the equivalent annual cost of owning an asset as follows:
| Replacement Period | Salvage Value | EAC Capital Costs | Annual Repair Costs | EAC Repair Costs |
| 1 | $1420 | $1,287 | – | – |
| 2 | $1,102 | $1,082 | $400 | $189 |
| 3 | $910 | $976 | $600 | $298 |
| 4 | $795 | $812 | $800 | $437 |
| 5 | $580 | $673 | $1,200 | $592 |
When should the firm replace its equipment?
- A) in 1 year
- B) in 2 years
- C) in 3 years
- D) in 4 years
- E) in 5 years
Answer: D
Diff: 2 Type: MC Page Ref: 222-224
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
5) Currently a firm replaces its equipment every year. It has calculated the equivalent annual cost of replacement as follows:
| Replacement Period | Salvage Value | EAC Capital Costs | Annual Repair Costs | EAC Repair Costs |
| 1 | $1420 | $1,287 | – | – |
| 2 | $1,102 | $1,082 | $400 | $189 |
| 3 | $910 | $976 | $600 | $298 |
| 4 | $795 | $812 | $800 | $437 |
| 5 | $580 | $673 | $1,200 | $592 |
How much can the firm save by making a replacement decision based on the economic life criterion?
- A) 16
- B) 22
- C) 25
- D) 38
- E) 44
Answer: D
Diff: 2 Type: MC Page Ref: 222-224
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
6) Which of the following can be called the defender?
- A) a building that a company owns
- B) a bank account that a company owns
- C) a loan that a company has just taken from a bank
- D) a fleet of trucks that a company is currently planning to purchase
- E) a share held by a company
Answer: A
Diff: 1 Type: MC Page Ref: 219
Topic: 7.2. A replacement example
Skill: Recall
User1: Qualitative
7) Which of the following can be called the challenger?
- A) a revenue generated by a company
- B) machinery that a company wants to acquire
- C) an assembly line that a company wants to replace
- D) a piece of land that a company owns
- E) payments that a company receives from its clients
Answer: B
Diff: 1 Type: MC Page Ref: 219
Topic: 7.2. A replacement example
Skill: Recall
User1: Qualitative
8) What are the two reasons that a large portion of capacity cost is usually incurred early in the life of the capacity?
- A) (i) maintenance costs are usually higher in the early part of the capacity’s life, and (ii) assets lose their value most quickly early in their lives
- B) (i) installation costs are often large, and are incurred up-front, and (ii) maintenance costs are usually higher in the early part of the capacity’s life
- C) (i) assets lose their value most quickly early in their lives and (ii) installation costs are often large, and are incurred up-front
- D) (i) installation costs are often large, and are incurred up-front and (ii) there is a substantial cost associated with getting an asset ready for sale as salvage
- E) (i) there is a substantial cost associated with getting an asset ready for sale as salvage (ii) operating costs tend to fall as staff get more expert in using the asset
Answer: C
Diff: 2 Type: MC Page Ref: 221
Topic: 7.3. Reasons for replacement or retirement
Skill: Recall
User1: Qualitative
9) Which of the following can be treated as a part of installation costs?
- A) the costs of purchasing new equipment
- B) the costs of personnel retraining
- C) the costs of the loss in capacity value
- D) the difference between the purchase price and the salvage value
- E) the initial investment
Answer: B
Diff: 1 Type: MC Page Ref: 221
Topic: 7.2. A replacement example
Skill: Recall
User1: Qualitative
10) If it is said that the economic life of a challenger is four years it means that
- A) the payback period is four years.
- B) four years are required for the challenger to recover its initial investment.
- C) four years are required for the challenger to recover its operating and maintenance costs.
- D) the equivalent annual cost in year four is at its minimum.
- E) the equivalent annual cost is decreasing over four years.
Answer: D
Diff: 2 Type: MC Page Ref: 223
Topic: 7.5. Defender and challenger are identical
Skill: Recall
User1: Qualitative
11) In order to make a replacement decision when the defender and the challenger are identical, one should assume that
- A) the economic lives of the assets are very long relative to the planning time horizon.
- B) the technology can be changed during the economic life of an asset.
- C) the relative price and interest rate vary over time.
- D) the replacement decision is repeated an indefinitely large number of times.
- E) the defender and the challenger are made using different technologies.
Answer: D
Diff: 2 Type: MC Page Ref: 222-223
Topic: 7.5. Defender and challenger are identical
Skill: Recall
User1: Qualitative
12) A replacement study showed that the components of the total costs of an asset are as follows:
What is the economic life of an asset?
- A) 7 years
- B) 7.5 years
- C) 8 years
- D) 9 years
- E) 12 years
Answer: C
Diff: 1 Type: MC Page Ref: 223
Topic: 7.5. Defender and challenger are identical
Skill: Recall
User1: Quantitative
13) A company bought and installed an assembly line for $5 million and $0.5 million respectively. The company plans to use this assembly line for 8 years and then sell it for $100 000. Calculate the equivalent annual capital costs of the assembly line if the capital recovery factor is 0.1874, and a MARR is 10% for the capital investment.
- A) $0.997 mln.
- B) $1.012 mln.
- C) $1.022 mln.
- D) $1.027 mln.
- E) $1.046 mln.
Answer: C
Diff: 3 Type: MC Page Ref: 218
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
14) Capital cost per period
- A) mostly falls with an increase in the service life of an asset.
- B) always rises with an increase in the service life of an asset.
- C) can decline at some point in the service life of an asset if it requires a major overhaul.
- D) usually increases over time.
- E) remains constant over time.
Answer: A
Diff: 2 Type: MC Page Ref: 223
Topic: 7.4. Capital costs and other costs
Skill: Recall
User1: Qualitative
15) When making a replacement decision
- A) capital costs of the challenger are irrelevant.
- B) capital costs of the defender are irrelevant.
- C) operating costs of the defender are irrelevant.
- D) capital costs of the defender incurred in the past are irrelevant.
- E) operating costs of the challenger are irrelevant.
Answer: D
Diff: 2 Type: MC Page Ref: 230-231
Topic: 7.4. Capital costs and other costs
Skill: Recall
User1: Qualitative
16) What are the two conditions behind the One Year Principle?
- A) Capital costs for a defender are small compared to the operating costs, and the annual operating costs are gradually increasing.
- B) Capital costs for a defender are higher than the operating costs, and the annual operating costs are gradually increasing.
- C) Capital costs for a defender are less than the operating costs, and the increase in annual operating costs is not monotonic.
- D) Capital costs for a defender are higher than the operating costs, and the increase in annual operating costs is not monotonic.
- E) Capital costs for a defender are less than the operating costs, and the annual operating costs are monotonically declining.
Answer: A
Diff: 2 Type: MC Page Ref: 227-228
Topic: 7.6. Challenger is different from defender; challenger repeats indefinitely
Skill: Recall
User1: Qualitative
17) Shultz Ltd. produces portable electric band saws. Currently Shultz Ltd. pays its subcontractor $6.14 per power unit excluding material costs. It is expected that sales of the electric band saws will be as high as 7 500 per year. Should Shultz Ltd. produce power units itself if the equivalent annual cost for the company to install and run the production equipment would be $49 568?
- A) Yes, because own production would be cheaper by $0.22 per unit.
- B) Yes, because own production would be cheaper by $0.47 per unit.
- C) No, because own production would be $0.57 per unit more expensive.
- D) No, because own production would be $0.22 per unit more expensive.
- E) No, because own production would be $0.47 per unit more expensive.
Answer: E
Diff: 2 Type: MC Page Ref: 218-219
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
18) What asset will most likely contain sunk cost?
- A) refrigerator
- B) airplane
- C) administrative building
- D) rail tracks
- E) auto repair equipment
Answer: D
Diff: 2 Type: MC Page Ref: 230
Topic: 7.6. Challenger is different from defender; challenger repeats indefinitely
Skill: Recall
User1: Qualitative
19) Suppose that operating costs associated with the 5-year service life of an asset start with $1 000 in the first year increasing by $500 thereafter. Calculate the EAC(Operating) if annual rate is 10%.
- A) $1 505
- B) $1 905
- C) $2 005
- D) $2 105
- E) $2 205
Answer: B
Diff: 3 Type: MC Page Ref: 219
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
20) This table gives the data relevant to a replacement decision:
| Year | Salvage Value | Maintenance Costs | EAC (Capital Costs) | EAC (Maintenance Costs) | Total |
| 1 | $32 000 | $4 000 | $38 416 | $4 000 | $42 416 |
| 2 | 24 500 | 8 000 | 24 783 | 5 923 | 30 706 |
| 3 | 16 350 | 16 000 | 20 263 | 9 027 | 29 291 |
| 4 | 11 280 | 32 000 | 17 182 | 14 125 | 31 307 |
| 5 | 8 420 | 64 000 | 14 895 | 22 627 | 37 521 |
If the MARR is 8.0%, what is the purchase price of this equipment?
- A) $65 200
- B) $66 700
- C) $67 400
- D) $68 500
- E) $69 300
Answer: A
Diff: 3 Type: MC Page Ref: 218-219
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
21) This table gives the data relevant to a replacement decision:
| Year | Salvage Value | Maintenance Costs | EAC (Capital Costs) | EAC (Maintenance Costs) | Total |
| 1 | $28 900 | $3 000 | $33 558 | $3 000 | $36 558 |
| 2 | 22 670 | 6 000 | 21 921 | 4 429 | 26 349 |
| 3 | 15 300 | 12 000 | | 6 716 | |
| 4 | 11 280 | 24 000 | 15 482 | 10 440 | 25 922 |
| 5 | 7 800 | 48 000 | 13 701 | 16 592 | 30 293 |
What is the EAC (Capital Costs) for year 3 at the MARR of 10%?
- A) $16 840
- B) $17 622
- C) $18 181
- D) $18 210
- E) $19 460
Answer: D
Diff: 3 Type: MC Page Ref: 218
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
22) This table gives the data relevant to a replacement decision:
| Year | Salvage Value | Maintenance Costs | EAC (Capital Costs) | EAC (Maintenance Costs) | Total |
| 1 | $35 260 | $4 500 | $30 597 | $4 500 | $35 097 |
| 2 | 18 256 | 7 000 | 25 803 | | |
| 3 | 14 520 | 14 000 | 19 688 | 8 201 | 27 889 |
| 4 | 12 569 | 27 500 | 16 179 | 12 359 | 28 538 |
| 5 | 8 598 | 44 900 | 14 385 | 17 689 | 32 075 |
What is the EAC (Maintenance Costs )for year 2 at the MARR of 10%?
- A) $5 220
- B) $5 690
- C) $5 980
- D) $6 210
- E) $6 740
Answer: B
Diff: 3 Type: MC Page Ref: 218-219
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
23) This table gives the data relevant to a replacement decision:
| Year | Salvage Value | Maintenance Costs | EAC (Capital Costs) | EAC (Maintenance Costs) | Total |
| 1 | $38 450 | $4 200 | $38 022 | $4 200 | $42 222 |
| 2 | 19 580 | 8 100 | 30 733 | 6 057 | 36 790 |
| 3 | 16 520 | 15 260 | 22 964 | 8 837 | 31 802 |
| 4 | | 27 560 | 19 456 | 12 872 | 32 327 |
| 5 | 9 210 | 49 500 | 16 831 | 18 871 | 35 702 |
What is the Salvage Value in year 4 at the MARR of 10%?
- A) $10 640
- B) $10 850
- C) $11 030
- D) $11 210
- E) $11 490
Answer: E
Diff: 3 Type: MC Page Ref: 218-219
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
24) A printing and duplicating company owns ten photocopying machines. Which of the following associated expenses is a variable cost?
- A) the rental of the office space where the photocopiers are kept
- B) supplies of paper and toner
- C) the salary of the operator who runs and maintains the machines
- D) the interest on the loan the company took out to buy the copiers
- E) the lighting and heating of the office in which the photocopiers are kept
Answer: B
Diff: 2 Type: MC Page Ref: 221-222
Topic: 7.1. Introduction
Skill: Recall
User1: Qualitative
25) If the challenger is different from the defender, and the challenger does not repeat, what should one do to make an educated decision about replacement?
- A) Compute the economic life and the associated EAC of all the challengers.
- B) Compute the EAC of the remaining economic life of the defender.
- C) Keep the defender.
- D) Replace the defender by the challenger immediately.
- E) Structure the problem as a set of mutually exclusive alternatives.
Answer: E
Diff: 2 Type: MC Page Ref: 234-235
Topic: 7.7. Challenger is different from defender; challenger does not repeat
Skill: Recall
User1: Qualitative
26) Maintenance costs are mostly a part of
- A) fixed costs and as such should be included in the evaluation of EAC (Capital).
- B) fixed costs and as such should be included in the evaluation of EAC (Operating).
- C) variable costs and as such should be included in the evaluation of EAC (Capital).
- D) variable costs and as such should be included in the evaluation of EAC (Operating).
- E) Maintenance costs are neither fixed or variable costs and therefore, should be excluded from EAC calculations.
Answer: D
Diff: 2 Type: MC Page Ref: 223
Topic: 7.4. Capital costs and other costs
Skill: Recall
User1: Qualitative
27) If a challenger is different from the defender, and the challenger does not repeat, replacement decision should be based on
- A) economic life of the first challenger only.
- B) comparison of the defender with the last challenger.
- C) marginal costs of the sequence of all challengers.
- D) all possible combinations of the defender and all challengers over some study period.
- E) installation costs of all challengers.
Answer: D
Diff: 2 Type: MC Page Ref: 234-235
Topic: 7.7. Challenger is different from defender; challenger does not repeat
Skill: Recall
User1: Qualitative
28) Capital costs are usually:
- A) variable costs that directly depend on the level of production.
- B) fixed costs that do not directly depend on the level of production.
- C) negligible compared with operating costs.
- D) the most important factor in determining the economic life of an asset.
- E) costs of administrative overhead.
Answer: B
Diff: 1 Type: MC Page Ref: 221
Topic: 7.4. Capital costs and other costs
Skill: Recall
User1: Qualitative
29) What is the economic life of the following asset, given that its purchase price is $60 000 and the MARR = 10% ?
| YEAR | SALVAGE VALUE | OPERATING COST |
| 1 | $40 000 | $20 000 |
| 2 | $20 000 | $20 000 |
| 3 | $10 000 | $40 000 |
| 4 | $5 000 | $50 000 |
- A) more than 4 years since EAC is increasing over 4 years
- B) 1 year and EAC = $46 000
- C) 2 years and EAC = $45 048
- D) 3 years and EAC = $47 147
- E) 4 years and EAC = $45 000
Answer: C
Diff: 3 Type: MC Page Ref: 222-223
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
30) If the interest rate is 10%, the depreciation rate of an asset is 10%, its service life is 10 years and its first cost is $10 million then EAC(Capital) for a ten-year life is
- A) $1.000 million.
- B) $1.060 million.
- C) $1.349 million.
- D) $1.409 million.
- E) $1.977 million.
Answer: D
Diff: 3 Type: MC Page Ref: 224
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
31) You are considering purchase of a new furnace. Its initial cost, including installation, is $3 000, and it will cost $200 a year in fuel over its 10-year life. You expect that it can then be sold for $300. If your MARR is 10%, what is the equivalent annual cost of owning the furnace?
- A) $469
- B) $569
- C) $669
- D) $769
- E) $869
Answer: C
Diff: 2 Type: MC Page Ref: 218
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
32) An asset has an initial cost of $10 000. Its maintenance costs are $300 in the first year, and go up by 20% per year thereafter. Its salvage value declines by straight-line depreciation over ten years. If your MARR is 10%, what is its economic life?
- A) 2 years
- B) 3 years
- C) 4 years
- D) 5 years
- E) 6 years
Answer: E
Diff: 2 Type: MC Page Ref: 222-227
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
33) You buy a new car for $20 000. Its salvage value declines by declining-balance depreciation of 10% per year, while its maintenance costs are $500 in the first year and go up by $400 a year. If your MARR is 5%, what is the EAC to you of keeping it until it reaches the end of its economic life?
- A) $4 358
- B) $4 335
- C) $4 327
- D) $4 333
- E) $4 352
Answer: C
Diff: 2 Type: MC Page Ref: 222-227
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
34) A BMW costs $35 000, its salvage value declines by declining-balance depreciation of 10% per year, and its maintenance costs are $100 in the first year and go up by $500 a year. Mary and Tom both like to drive BMWs. Mary trades her car in for a new model every year, whereas Tom keeps his until it reaches its economic life, then trades it in. Mary and Tom both have MARRs of 5%. How much more does Mary pay for her car per year, on average, than Tom?
- A) They each pay the same.
- B) $569
- C) $615
- D) $769
- E) $869
Answer: C
Diff: 2 Type: MC Page Ref: 222-227
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
35) A stamping machine currently has a salvage value of $10 000, and this will drop by 20% per year from now on. Its expected maintenance costs are $1 000 for this year, but in the following year it is expected to need a major overhaul, costing $3 500. In the year following the overhaul, its maintenance costs will be $500, and these will then go up by 30% per year. Your MARR is 10%. There is a challenger available that will do the same job for an EAC of $3 400. When should you replace the old machine?
- A) right now
- B) in two years time
- C) in four years time
- D) in six years time
- E) in eight years time
Answer: E
Diff: 2 Type: MC Page Ref: 231-233
Topic: 7.6. Challenger is different from defender; challenger repeats indefinitely
Skill: Applied
User1: Quantitative
36) A new laptop has just come onto the market that you estimate will have an equivalent annual cost of $500. You could sell your current laptop right away for $1 000, or you could spend $500 on an upgrade. At the end of this year, after the upgrade, it will have a resale value of $800, going down by $200 a year. Once its salvage value reaches zero, its physical life is over. If both laptops provide equivalent functionality, when should you replace your current laptop? Your MARR is 5%.
- A) Replace it now.
- B) Replace it in 2 years.
- C) Replace it in 3 years.
- D) Replace it in 4 years.
- E) Replace it in 5 years.
Answer: E
Diff: 2 Type: MC Page Ref: 231-233
Topic: 7.6. Challenger is different from defender; challenger repeats indefinitely
Skill: Applied
User1: Quantitative
37) A Tata costs $10 000, its salvage value declines by straight-line depreciation of $1 250 per year, and its maintenance costs are $100 in the first year and go up by 50% a year. Raj and Rashid both like to drive Tata’s. Raj trades her car in for a new model when it reaches its economic life, whereas Rashid keeps his until it reaches the end of its physical life. Raj and Rashid both have MARRs of 5%. How much more does Rashid pay for his Tata per year, on average, than Raj?
- A) They both pay the same.
- B) $53
- C) $64
- D) $77
- E) $112
Answer: B
Diff: 2 Type: MC Page Ref: 218
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
7.2 Short Answer Questions
1) What is the difference between replacement of an existing physical asset and its retirement?
Answer: Retirement is removal of an existing physical asset from use without being replaced. It happens if the service that the asset provides is no longer needed. However, if there is an ongoing need for the service the asset provides, then it should be replaced whenever a cheaper way to provide the service appears.
Diff: 1 Type: SA Page Ref: 220
Topic: 7.3. Reasons for replacement or retirement
Skill: Recall
User1: Qualitative
2) Define the concept of the economic life of an asset and describe the circumstances under which the concept is applied to replacement decisions.
Answer: The economic life of a physical asset is the service life that minimizes the average cost of owning and using the asset. We base replacement decisions on a comparison of the annual costs of defender and challenger, assuming both are calculated over the economic life of the assets.
Diff: 2 Type: SA Page Ref: 223
Topic: 7.5. Defender and challenger are identical
Skill: Recall
User1: Qualitative
3) A trucking company evaluates its fleet of vehicles. According to its balance sheet, a three-year-old van has the book value of $21 870. Currently its maintenance costs are $1 000 per year. They have increased by 20% annually and are expected to increase by the same percentage in the future. Calculate the equivalent annual costs for the first six years knowing that the van’s purchase price was $30 000 and the minimum acceptable rate of return is 15%.
Answer: First it is necessary to calculate the depreciation rate d as follows:
d = 1 – = 0.1 or 10%. The economic life is associated with the minimum Equivalent Annual Cost (EAC). EAC is calculated in the following table:
| Year | Salvage Value | EAC (Maintenance) | EAC (Capital) | EAC |
| 0 | 30 000 | – | – | – |
| 1 | 27 000 | 694 | 7 500 | 8 194 |
| 2 | 24 300 | 759 | 7 151 | 7 910 |
| 3 | 21 870 | 828 | 6 842 | 7 670 |
| 4 | 19 683 | 902 | 6 567 | 7 469 |
| 5 | 17 715 | 982 | 6 321 | 7 303 |
Salvage value in year N = BV(N) = P(1 – d)N
Annual maintenance cost AMC in year N = AMC(N) = AMC(1) x (1 + 0.2)N. And we know that the maintenance cost in year 1 was 1000/1.22 = $694
Equivalent Annual Cost (Operating) for a lifetime of N years is
EAC(operating, N) = ( * (P/F, i, t)) x (A/P, i, N)
Equivalent Annual Cost (Capital) in any given year N is
EAC(capital, N) = (P – S) x (A/P, i, N) + Si
The Equivalent Annual Cost is
EAC (N) = EAC(operating, N) + EAC(capital, N)
where BV is the book value, P is the purchase price, S is the salvage value and i is the MARR.
From the table, the economic life of the van is at least 5 years.
Diff: 3 Type: SA Page Ref: 218-219
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
4) A transportation company has bought a truck 5 years ago for $60 000. Currently its market value is $35 000. Maintenance costs of the truck are $2 000 per year, increasing by $500 with each year. A new truck of the same capacity costs $65 000 with constant maintenance costs of $500 for the duration of its service life of 10 years. Assuming 10% depreciation rate for both trucks and 5% annual interest rate, should the company buy the new truck now?
Answer: Let’s calculate the EAC of keeping the old truck one more year:
Salvage value at the end of that year is $35 000 * (1 – 0.1) = $31 500
EAC(Capital) = (35 000 – 31 500)*(A/P, 5%, 1) + 0.05 * 31 500 = $5 250
EAC = EAC(Capital) + EAC(operating) = 5 250 + 2 000 = $7 250
We expect that the EAC of keeping the old truck for longer than this will be higher, because of the rapid increase in maintenance costs.
Now let’s calculate the EAC of the new truck over its 10-year service life:
Salvage value = 65 000 * (1 – 0.1)10 = $22 664.10
EAC(Capital) = (65 000 – 22 664.10) * (A/P, 5%, 10) + 0.05 * 22 664.10 = $6 615.74
EAC = EAC(Capital) + EAC(Operating) = 6 615.74 + 500 = $7 115.74
Since the EAC of the new truck is lower, the company is better off buying it right now.
Diff: 3 Type: SA Page Ref: 218-219
Topic: 7.6. Challenger is different from defender; challenger repeats indefinitely
Skill: Applied
User1: Quantitative
5) What is sunk cost ? Explain how it affects replacement decisions.
Answer: Sunk cost is the unrecoverable portion of an investment. Once an asset has been installed and has been in operation for some time, all costs incurred up to that time are no longer relevant to replacement decisions. Only costs that will be incurred in keeping and operating the asset from this time on are relevant.
Diff: 2 Type: SA Page Ref: 230-231
Topic: 7.6. Challenger is different from defender; challenger repeats indefinitely
Skill: Recall
User1: Qualitative
6) Stan bought a car three years ago for $20 000. Recently he got a promotion and is deciding whether to keep his old car or to buy a new one. His dealer told him that the current market price of his old car is $15 000. The car maintenance costs are $1 000 now, and they are going to increase each year by at least $500. Stan compares his old car with a new one that, he calculates, would have an equivalent annual cost of $4 100. What is Stan’s optimal decision if his current interest rate is 7%?
Answer: First it is necessary to derive the implicit depreciation rate given the dealer’s information
d = 1 – = 0.1 or 10%
Equivalent Annual Cost (Capital, N) in any year N can be calculated as follows:
EAC(capital, N) = (P – S) x (A/P, i, N) + Si
where P is the current market price, S is the salvage value and i is the interest rate.
Equivalent Annual Cost (Operating, N) in any given year N is:
EAC(operating, N) = ( * (P/F, i, t)) * (A/P, i, N)
where AMCt is the annual maintenance cost in period t.
If Stan keeps his old car for one more year, then:
– EAC(capital, 1) = [15 000 – 15 000 x (1 – 0.1)] x 1.07 + 15 000 x (1 – 0.1) x 0.07 = $2 550
– EAC(operating, 1) = 1 500 = $1 500
– EAC = 2 550 + 1 500 = $4 050
Since the EAC is less than the EAC of the new car, Stan should keep his old car for at least one more year.
If Stan keeps his old car for two more years:
– EAC(capital, 2) = [15 000 – 15 000 * (1 – 0.1)2] * (0.5531) + 15 000 * (1 – 0.1)2 * 0.07 = $2 427
– EAC(operating, 2) = (1 500 * 0.934 + 2 000 * 0.873) * 0.5531 = $1 741
– EAC = 2 427 + 1 741 = $4 168
Since now the EAC of the old car exceeds the EAC of the new car, Stan should keep his old car for one more year and then consider buying a new one (taking into account any changes that may have occurred during the year, such as a new model coming out.)
Diff: 3 Type: SA Page Ref: 227
Topic: 7.6. Challenger is different from defender; challenger repeats indefinitely
Skill: Applied
User1: Quantitative
7) A new computer costs $4 000. It depreciates at 15% annually. The computer maintenance costs are $200 in the first year increasing by 50% per year thereafter. Calculate the EAC over the first five years of the computer’s life, assuming a 20% interest rate. What is the economic life of the computer?
Answer: The following table summarizes all calculations:
| Year | Salvage Value | EAC (Capital) | EAC (Maintenance) | EAC Total |
| 0 | 4 000.00 | – | – | – |
| 1 | 3 400.00 | 1 400.00 | 200.00 | 1 600.00 |
| 2 | 2 890.00 | 1 304.42 | 245.43 | 1 549.85 |
| 3 | 2 456.50 | 1 223.93 | 301.62 | 1 525.55 |
| 4 | 2 088.03 | 1 156.25 | 371.22 | 1 527.47 |
| 5 | 1 774.82 | 1 099.19 | 457.45 | 1 556.64 |
Salvage value in any given year N is
S(N) = P x (1 – d)N
Equivalent Annual Cost (Capital, N) in any given year N is
EAC(capital, N) = (P – S) x (A/P, i, N) + Si
Annual operation cost in any given year N is
AOC(N) = 200 x (1 + 0.5)N-1
Equivalent Annual Cost (Operating, N) in any given year N is
EAC(operating, N) = ( x (P/F, i, t)) x (A/P, i, N)
Since the EAC of $1 525.55 in year 3 is the least, the economic life of the computer is 3 years.
Diff: 2 Type: SA Page Ref: 222-227
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
8) OMON Consulting is evaluating different scenarios to replace its existing technological line to produce compact computer discs. A four-year time horizon is used in this evaluation. One challenger is available at present, and it is expected that a new technology will be available in two years. List all potential scenarios associated with this evaluation.
Answer: The following table summarizes all potential scenarios:
| Scenario | Defender Life | Challenger I Life | Challenger II Life |
| 1 | 4 | 0 | 0 |
| 2 | 3 | 1 | 0 |
| 3 | 3 | 0 | 1 |
| 4 | 2 | 2 | 0 |
| 5 | 2 | 1 | 1 |
| 6 | 2 | 0 | 2 |
| 7 | 1 | 3 | 0 |
| 8 | 1 | 2 | 1 |
| 9 | 1 | 1 | 2 |
| 10 | 0 | 4 | 0 |
| 11 | 0 | 3 | 1 |
| 12 | 0 | 2 | 2 |
Diff: 2 Type: SA Page Ref: 234-235
Topic: 7.7. Challenger is different from defender; challenger does not repeat
Skill: Applied
User1: Qualitative
9) NB Power is considering replacing its existing electricity generator. The current market value of the generator is $15 000. It depreciates at 25% per year. The generator produces 153 megawatt-hours of electricity annually and requires $3 000 in maintenance costs per year. Moreover, the maintenance costs are expected to increase by $1 200 per year in the future. On the other hand, there is another generator in the market that provides electricity at $0.059 per kilowatt-hour. What should NB Power do if the MARR is 8%?
Answer: If the old generator is kept for one more year then:
EAC(capital, 1) = (P-S) * (A/P, 8%, 1) + Si
= [15 000 – 15 000(1 – 0.25)] * (1 + 0.08) + 15 000(1 – 0.25) * 0.08
= $4 950
EAC(maintenance, 1) = 3 000 + 1 200 = $4 200
EAC(Total) = 4 950 + 4 200 = $9 150
Unit cost of electricity = $9 150/153 000 kilowatt-hours = $0.0598/kilowatt-hour
It is time to replace the old generator, since the new one provides a cheaper way to produce electricity.
Diff: 2 Type: SA Page Ref: 217-219
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
10) What are the three basic replacement schemes discussed in Chapter 7?
Answer: The three are:
- Identical defender and challenger.
- Different defender and challenger but all succeeding challengers are identical to the first.
- Different defender and challengers, and challengers do not repeat.
Diff: 1 Type: SA Page Ref: 222-235
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Qualitative
11) The salvage value of an electric generator is $10 000, while its purchase price five years ago was $20 000. It produces 45.5 megawatt-hours of electricity per year and requires $800 in annual maintenance costs. A new generator can produce electricity at $0.05 per kilowatt-hour. Should the new generator be purchased if the annual interest rate is 7%?
Answer: Since information on the new generator is given in terms of per unit cost, it is necessary to calculate the unit cost of electricity produced by the old generator. Unit costs can be defined as
Therefore, we have to calculate the EAC of the defender—old generator—if we keep it for one more year. Given information about the defender, we can calculate the depreciation rate as follows:
d = 1 – = 0.12945
Therefore, the salvage value of the defender at the end of year 6 will be
$10 000*(1 – 0.12945) = $8 705
EAC(Capital) = (10 000 – 8 705) * (A/P, 7%, 1) + 0.07 * 8 705 = $1 994
EAC(Total) = EAC(Capital) + EAC(Maintenance) = 1 994 + 800 = $2 794
Now we can calculate unit cost of electricity produced by the defender:
= $0.06/kilowatt-hour
Since the new generator produces cheaper electricity, it should be purchased
Diff: 2 Type: SA Page Ref: 217-219
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
12) A three-year-old small crane is being considered for early replacement. Its current market value is $13 000. Estimated future market values and annual operating costs for the next five years are given in the following table:
| Year | Market Value, P | Annual Operating Cost, AOC |
| 0 | 13 000 | – |
| 1 | 9 000 | 2 500 |
| 2 | 8 000 | 2 700 |
| 3 | 6 000 | 3 000 |
| 4 | 2 000 | 3 500 |
| 5 | 0 | 4 500 |
What is the economic life for this crane if the interest rate is 10% per year?
Answer: In order to find the economic life, it is necessary to calculate the Equivalent Annual Costs (EAC) as the sum of the EAC (capital) and EAC (operating).
In any given year N:
EAC(operating, N) = ( * (P/F, i, t)) * (A/P, i, N)
where AOCt is the annual operating cost in period t.
In any given year N:
EAC(capital, N) = (P – S) * (A/P, i, N) + Si
where P is the market value, S is the salvage value, and i is the annual interest rate.
In this case, the salvage value is the market value of the crane next year. All the required calculations are presented in the following table:
| Year | Salvage Value | EAC (Maintenance) | EAC (Capital) | EAC Total |
| 0 | 13 000 | – | | |
| 1 | 9 000 | 2 500 | 5 300 | 7 800 |
| 2 | 8 000 | 2 595 | 3 681 | 6 276 |
| 3 | 6 000 | 2 717 | 3 415 | 6 132 |
| 4 | 2 000 | 2 887 | 3 671 | 6 558 |
| 5 | 0 | 3 150 | 3 429 | 6 579 |
The economic life of the crane is three years, since this is when the EAC is minimized.
Diff: 2 Type: SA Page Ref: 222-223
Topic: 7.5. Defender and challenger are identical
Skill: Applied
User1: Quantitative
13) A communication system cost $65 000 to buy and $4 000 to install ten years ago. Currently the ten-year-old system can be sold for $7 000, but it will cost $1 000 to remove it. If it’s sold in a year’s time, the net income, after paying removal costs, will be $1 000. A new communication system costs $50 000 plus $500 to install it. Assuming 5% depreciation rate for the new system, 7% annual interest rate, by how much would the operating costs of the old system have to exceed operating costs of the new one for the old system to be replaced immediately?
Answer: First of all, the purchase price and the installation costs of the old system are sunk costs. They are irrelevant for the replacement decision.
Immediate replacement is needed only if annual equivalent cost of keeping the old system one more year exceeds the equivalent annual cost of the new system.
Current value of the old system is $7 000 – $1 000 (removal cost) = $6 000 and its salvage value at the end of the year is equal to $1 000. Therefore, equivalent annual cost (capital) to keep the system one more year is:
EAC(Capital, 1) = (6 000 – 1 000) * (A/P, 7%, 1) + 1 000 * 0.07
= $5 420
In turn, given the information on the new system, its equivalent annual cost (capital) is:
EAC(Capital, 1) = [50 000 + 500 – 50 000 * (1 – 0.05)] *(A/P, 7%, 1) + 50 000 * (1 – 0.05) * 0.07
= $6 535
So if the money saved on operating costs is to offset the difference in capital costs, operating the new system must be cheaper than operating the old system by $6 535 – $5 420 = $1 150.
Diff: 3 Type: SA Page Ref: 227-228
Topic: 7.6. Challenger is different from defender; challenger repeats indefinitely
Skill: Applied
User1: Quantitative
14) An old asset—a piece of equipment—has a current market value of $10 000. Its purchase price 5 years ago was $15 000. Installation costs were $2 000 in year 1 with some adjustment costs in year 2. If you are to calculate the EAC (Capital) to keep this asset in operation, what value should be assigned to P in the formula EAC(Capital) = (P – S)*(A/P, i, N) + iS?
Answer: This asset is a defender in terms of replacement decisions. Therefore, P should be assigned the value of $10 000, which is the current market value of the asset. All other costs are sunk costs, and are irrelevant for replacement decision
Diff: 1 Type: SA Page Ref: 230-231
Topic: 7.6. Challenger is different from defender; challenger repeats indefinitely
Skill: Applied
User1: Quantitative
15) The University has just invested $9 000 in a new desktop publishing system. From past experience, annual cash returns are estimated asA(t) = $8000 – $4000(1 + 0.15)t-1S(t) = $6000(1 – 0.3)twhere A(t) stands for the net cash flow in period t and S(t) stands for the salvage value at the end of year t, and t ≥ 1.If the MARR is 12%, compute the annual equivalent cost in year 2
Answer: We calculate salvage value in year 2 as
S(2) = 6 000 * (1 – 0.3)2 = $2 940
Now we can calculate EAC(Capital) as follows:
EAC(Capital) = (P – S) * (A/P, 12%, 2) +i S
= (9 000 – 2 940) * 0.5917 + 0.12 * 2 040
= $3 938.50
In terms of annual cash flows, in year 1 and year 2:
A(1) = 8 000 – 4 000*(1 + 0.15)0
= $4 000
A(2) = 8 000 – 4 000*(1 + 0.15)
= $3 400
Both are cash inflows or benefits (not costs!) Therefore, EAC (Operating) in this case is
EAC(Operating) = [- – ] * (A/P, 12%, 2)
= [-3 571.43 – 2 710.46] * 0.5917
= -$3 716.99
EAC = EAC(Capital) + EAC(Operating) = 3 938.50 – 3 716.99 = $221.51
Diff: 3 Type: SA Page Ref: 217-219
Topic: 7.2. A replacement example
Skill: Applied
User1: Quantitative
