Chap11-Rev - reviewer PDF

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REVIEW PROBLEM: COMPARISON OF CAPITAL BUDGETING METHODSLamar Company is considering a project that would have an eight-year life and require a $2,400,000 investment in equipment. At the end of eight years, the project would terminate and the equipment would have no salvage value. The project would p...

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REVIEW PROBLEM: COMPARISON OF CAPITAL BUDGETING METHODS Lamar Company is considering a project that would have an eight-year life and require a $2,400,000 investment in equipment. At the end of eight years, the project would terminate and the equipment would have no salvage value. The project would provide net operating income each year as follows:

The company's discount rate is 12%. Required: 1. Compute the annual net cash inflow from the project. 2. Compute the project's net present value. Is the project acceptable? 3. Compute the project's payback period. 4. Compute the project's simple rate of return. Solution to Review Problem 1. The annual net cash inflow can be computed by deducting the cash expenses from sales:

Or the annual net cash inflow can be computed by adding depreciation back to net operating income:

2. The net present value is computed as follows:

Yes, the project is acceptable because it has a positive net present value. 3. The formula for the payback period is:

Page 514 4. The formula for the simple rate of return is:

THE FOUNDATIONAL 15 Cardinal Company is considering a project that would require a $2,975,000 investment in equipment with a useful life of five years. At the end of five years, the project would terminate and the equipment would be sold for its salvage value of $300,000. The company's discount rate is 14%. The project would provide net operating income each year as follows:

Required: 1. Which item(s) in the income statement shown above will not affect cash flows? Depreciation $535,000 2. What are the project's annual net cash inflows? NOI + depreciation $465000 + 535,000 = $1,000,000 3. What is the present value of the project's annual net cash inflows? $1 M, Annuity 5 years @ 14% $1 M * 3.433 = $3.433 M 4. What is the present value of the equipment's salvage value at the end of five years? $300,000 5 years @ 14 % 300,000 *.519 = $155,700 5. What is the project's net present value? Cost of equip. now ($2,975,000) Annual cash inflows 3,433,000 Salvage value 155,700 Project NPV $ 613,700 6. What is the project profitability index for this project? (Round your answer to the nearest whole percent.) Profitability index: NPV / Investment = 613,700/2,975,000 = 21% 7. What is the project's payback period? Payback = Investment / Annual net cash inflows 2,975,000/1,000,000 = 2.98 years Do not consider salvage because the investment is recovered within 5 years so its irrelevant.

8.

9.

10.

11. 12.

13.

14.

What is the project's simple rate of return for each of the five years? RR each 5 years NOI/Invesment : 465/2975 = 15,6% NOI includes depreciation, RR is calculated on accounting net operating income not cash inflow. Should not deduct salvage value of new equipment only that of the amount realized from the sale of the old equipment. Note: solution sheet for 8., 12. and 15 are incorrect. If the company's discount rate was 16% instead of 14%, would you expect the project's net present value to be higher than, lower than, or the same as your answer to question 4? No computations are necessary. Discount rate 16% NPV would be lower because it 16% compared to 14% reduces the NPV of cash inflows. If the equipment's salvage value was $500,000 instead of $300,000, would you expect the project's payback period to be higher than, lower than, or the same as your answer to question 7? No computations are necessary. Payback period is the same because the salvage value is irrelevant. If the equipment's salvage value was $500,000 instead of $300,000, would you expect the project's net present value to be higher than, lower than, or the same as your answer to question 4? No computations are necessary. Salvage value is higher, so cash inflow will be higher in year 5, increasing NPV. If the equipment's salvage value was $500,000 instead of $300,000, what would be the project's simple rate of return? Depreciation will be lower (2,975,000-500,000)/5= 495,000 vs 535,000, thus increasing NOI by 40,000 per year. 465,000+40,000 = 505,000 505,000/2,975,000 = 17% Assume a postaudit showed that all estimates (including total sales) were exactly correct except for the variable expense ratio, which actually turned out to be 45%. What was the project's actual net present value? When Variable expense ration = 45%, Contribution margin = 55%. Contribution margin 2,735,000 * 55% = 1,504,250 Less Fixed expenses 1,270,000 NOI $ 234,250 Add Depreciation 535,000 Annual cash inflows, 14%, 5 years 769,250 2,640,835 Salvage value in 5 years .0519 155,700 Less initial investment NOW (2,975,000) Net present value (178,465) Assume a postaudit showed that all estimates (including total sales) were exactly correct except for the variable expense ratio, which actually turned out to be 45%. What was the project's actual payback period? $2,975,000/769,250= 3.87 yearsAssume a postaudit showed that all estimates (including total sales) were exactly correct except for the variable expense ratio, which actually turned out to be 45%. What was the project's actual simple rate of return? RR each 5 years NOI/Invesment : 234,250/2,975,000 = 7.9% NOI includes depreciation, RR is calculated on accounting net operating income not cash inflow. Should not deduct salvage value of new equipment only that of the amount realized from the sale of the old equipment.

EXERCISES EXERCISE 11–1 Net Present Value Method [LO1] The management of Opry Company, a wholesale distributor of suntan products, is considering the purchase of a $25,000 machine that would reduce operating costs in its warehouse by $4,000 per year. At the end of the machine's 10-year useful life, it will have no scrap value. The company's required rate of return is 12%. Required: 1. Determine the net present value of the investment in the machine. 2. What is the difference between the total, undiscounted cash inflows and cash outflows over the entire life of the machine?

3. Item Annual cost savings............... Initial investment................... Net present value.................. 2.

Year(s) 1-10 Now

Cash Flow $4,000 $(25,000)

12% Present Value Factor of Cash Flows 5.650 $ 22,600 1.000 (25,000) $ (2,400 )

Item Annual cost savings............... Initial investment................... Net cash flow........................

Cash Flow $4,000 $(25,000)

Years 10 1

Total Cash Flows $ 40,000 (25,000) $ 15,000

Note: Total undiscounted (Cash in – Cash out) EXERCISE 11–2 Preference Ranking [LO2] Information on four investment proposals is given below:

Required: 1. Compute the project profitability index for each investment proposal. 2. Rank the proposals in terms of preference.

1. The project profitability index for each proposal is: Investment Required Net Present Value (b) Proposal (a) A $34,000 $85,000 B $50,000 $200,000 C $45,000 $90,000 D $51,000 $170,000

Project Profitability Index (a) ÷ (b) 0.40 0.25 0.50 0.30

2. The ranking is:

Proposal C A D B

Project Profitability Index 0.50 0.40 0.30 0.25

Note that proposals D and B have the highest net present values of the four proposals, but they rank at the bottom of the list in terms of the project profitability index.

EXERCISE 11–3 Payback Method [LO3] The management of Weimar, Inc., a civil engineering design company, is considering an investment in a high-quality blueprint printer with the following cash flows:

Required: 1. Determine the payback period of the investment. 2. Would the payback period be affected if the cash inflow in the last year were several times larger?

1.The payback period is determined as follows: 3.

4.

Cash Unrecovered Year Investment Inflow Investment 1 $38,000 $2,000 $36,000 2 $6,000 $4,000 $38,000 3 $8,000 $30,000 4 $9,000 $21,000 5 $12,000 $9,000 6 $10,000 $0 7 $8,000 $0 8 $6,000 $0 9 $5,000 $0 10 $5,000 $0 The investment in the project is fully recovered in the 6th year. To be more exact, the payback period is approximately 6.9 years. 2. Because the investment is recovered prior to the last year, the amount of the cash inflow in the last year has no effect on the payback period.

EXERCISE 11–4 Simple Rate of Return Method [LO4] The management of Wallingford MicroBrew is considering the purchase of an automated bottling machine for $80,000. The machine would replace an old piece of equipment that costs $33,000 per year to operate. The new machine would cost $10,000 per year to operate. The old machine currently in use could be sold now for a scrap value of $5,000. The new machine would have a useful life of 10 years with no salvage value. Required: Compute the simple rate of return on the new automated bottling machine.The annual incremental net operating

income is determined by comparing the operating cost of the old machine to the operating cost of the new machine and the depreciation that would be taken on the new machine: Operating cost of old machine..................................................

$33,000

Less operating cost of new machine......................................... Less annual depreciation on the new machine ($80,000 ÷ 10 years)................................................................................. Annual incremental net operating income.................................

10,000 8,000 $15,000

Cost of the new machine......................................................... Less scrap value of old machine............................................... Initial investment....................................................................

$80,000 5,000 $75,000

Simple rate = Annual incremental net operating income of return Initial investment =

$15,000 = 20% $75,000

EXERCISE 11–5 Payback Period and Simple Rate of Return [LO3, LO4] The Heritage Amusement Park would like to construct a new ride called the Sonic Boom, which the park management feels would be very popular. The ride would cost $450,000 to construct, and it would have a 10% salvage value at the end of its 15-year useful life. The company estimates that the following annual costs and revenues would be associated with the ride:

Required: (Ignore income taxes.) 1. Assume that the Heritage Amusement Park will not construct a new ride unless the ride provides a payback period of six years or less. Does the Sonic Boom ride satisfy this requirement? 2. Compute the simple rate of return promised by the new ride. If Heritage Amusement Park requires a simple rate of return of at least 12%, does the Sonic Boom ride meet this criterion?

3.

1. Computation of the annual cash inflow associated with the new ride: Net operating income.......................................................... $63,000 Add: Noncash deduction for depreciation.............................. 27,000 Annual net cash inflow........................................................ $90,000 The payback computation would be:

Payback period = =

Investment required Net annual cash inflow $450,000 = 5 years $90,000 per year

Yes, the new ride meets the requirement. The payback period is less than the maximum 6 years required by the Park.

Annual incremental net operating income Initial investment

Simple rate of return = =

$63,000 = 14% $450,000

2. The simple rate of return would be: Yes, the new ride satisfies the criterion. Its 14% return exceeds the Park’s requirement of a 12% return.

EXERCISE 11–6 Comparison of Projects Using Net Present Value [LO1] Sharp Company has $15,000 to invest. The company is trying to decide between two alternative uses of the funds as follows:

Sharp Company uses a 16% discount rate. Required: (Ignore income taxes.) Which investment would you recommend that the company accept? Show all computations using net present value. Prepare separate computations for each investment.

Item

Year(s)

Amount of Cash Flows

16% Factor

Present Value of Cash Flows

Project A: Investment required.......... Annual cash inflows........... Net present value..............

Now 1-10

$(15,000) $4,000

1.000 4.833

$(15,000) 19,332 $ 4,332

Project B: Investment....................... Cash inflow....................... Net present value..............

Now 10

$(15,000) $60,000

1.000 0.227

$(15,000) 13,620 $ (1,380)

Project A should be selected. Project B does not provide the required 16% return, as shown by its negative net present value.

EXERCISE 11–7 Basic Payback Period and Simple Rate of Return Computations [LO3, L04] Martin Company is considering the purchase of a new piece of equipment. Relevant information concerning the equipment follows:

Required: (Ignore income taxes.) 1. Compute the payback period for the equipment. If the company rejects all proposals with a payback period of more than four years, would the equipment be purchased? 2. Compute the simple rate of return on the equipment. Use straight-line depreciation based on the equipment's useful life. Would the equipment be purchased if the company's required rate of return is 14%?

1. The payback period is:

Payback Period = =

Investment required Net annual cash inflow $180,000 = 4.8 years $37,500 per year

No, the equipment would not be purchased, because the 4.8-year payback period exceeds the company’s maximum 4-year payback period. 2. The simple rate of return would be computed as follows: Annual cost savings.............................................................................. Less annual depreciation ($180,000 ÷ 12 years)..................................... Annual incremental net operating income..............................................

$37,500 15,000 $22,500

3.

Simple rate of return = =

Annual incremental net operating income Initial investment $22,500 = 12.5% $180,000

4.

The equipment would not be purchased because its 12.5% rate of return is less than the company’s 14% required rate of return. 5. EXERCISE 11–8 Net Present Value Analysis of Two Alternatives [LO1] Wriston Company has $300,000 to invest. The company is trying to decide between two alternative uses of the funds. The alternatives are as follows:

The working capital needed for project B will be released for investment elsewhere at the end of seven years. Wriston Company uses a 20% discount rate.

Required: (Ignore income taxes.) Which investment alternative (if either) would you recommend that the company accept? Show all computations using the net present value format. Prepare separate computations for each project.

Item

Year(s)

Amount of Cash Flows

20% Factor

Present Value of Cash Flows

Project A: Cost of the equipment................................... Annual cash inflows....................................... Salvage value of the equipment..................... Net present value..........................................

Now 1-7 7

$(300,000) $80,000 $20,000

1.000 3.605 0.279

$(300,000) 288,400 5,580 $ (6,020 )

Project B: Working capital investment............................ Annual cash inflows....................................... Working capital released................................ Net present value..........................................

Now 1-7 7

$(300,000) $60,000 $300,000

1.000 3.605 0.279

$(300,000) 216,300 83,700 $ 0

The $300,000 should be invested in Project B rather than in Project A. Project B has a zero net present value, which means that it promises exactly a 20% rate of return. Project A is not acceptable at all, since it has a negative net present value.

EXERCISE 11–9 Basic Net Present Value Analysis [LO1] On January 2, Fred Critchfield paid $18,000 for 900 shares of the common stock of Acme Company. Mr. Critchfield received an $0.80 per share dividend on the stock at the end of each year for four years. At the end of four years, he sold the stock for $22,500. Mr. Critchfield has a goal of earning a minimum return of 12% on all of his investments. Required: (Ignore income taxes.) Did Mr. Critchfield earn a 12% return on the stock? Use the net present value method and the general format shown in Exhibit 11–2. Round all computations to the nearest whole dollar.

Ex Exe erc rcis is ise e1 1111-9 9 (10 minutes)

Purchase of the stock................... Annual dividends*........................ Sale of the stock.......................... Net present value........................

Year(s) Now 1-4 4

Amount of Cash Flows $(18,000) $720 $22,500

12% Factor 1.000 3.037 0.636

Present Value of Cash Flows $(18,000) 2,187 14,310 $( 1,503)

*900 shares × $0.80 per share per year = $720 per year. No, Mr. Critchfield did not earn a 12% return on the stock. The negative net present value indicates that the rate of return on the investment is less than the discount rate of 12%. PROBLEMS PROBLEM 11–10A Basic Net Present Value Analysis [LO1] Renfree Mines, Inc., owns the mining rights to a large tract of land in a mountainous area. The tract contains a mineral deposit that the company believes might be commercially attractive to mine and sell. An engineering and cost analysis has been made, and it is expected that the following cash flows would be associated with opening and operating a mine in the area:

The mineral deposit would be exhausted after five years of mining. At that point, the working capital would be released for reinvestment elsewhere. The company's required rate of return is 14%. Required: (Ignore income taxes.) Determine the net present value of the proposed mining project. Should the project be accepted? Explain.

Item Cost of equipment required......................... Working capital required.............................. Annual net cash receipts............................. Cost of road repairs.................................... Salvage value of equipment......................... Working capital released............................. Net present value.......................................

Year(s) Now Now 1-5 3 5 5

Amount of Cash Flows $(850,000) $(100,000) $230,000 $(60,000) $200,000 $100,000

14% Factor 1.000 1.000 3.433 0.675 0.519 0.519

Present Value of Cash Flows $(850,000) (100,000) 789,590 (40,500) 103,800 51,900 $ (45,210)

No, the project should not be accepted; it has a negative net present value. This means that the rate of return on the investment is less than the company’s required rate of return of 14%. PROBLEM 11–11A Preference Ranking of Investment Projects [LO2] Austin Company is investigating four different investment opportunities. Information on the four projects under study is given below:

Because the company's required rate of return is 10%, a 10% discount rate has been used in the above present value computations. Limited funds are available for investment, so the company can't accept all of the available projects. Required: 1. Compute the project profitability index for each investment project. 87270/480000= 18.2% 73400/360000=20.4% 66140/270000=24.5% 72970/450000=16.3%

2.

3.

Rank the four projects according to preference, in terms of: a. Net present value.1,2,4,3, b. Project profitability index. Ranking: 3,2,1,4 c. Internal rate of return. 4,3,1,2 Which ranking do you prefer? Why? B takes into account the invest...