Professional Documents
Culture Documents
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Brief Exercises
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. Matching
Short Answer Essay
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Study Objective 1
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MC = Multiple Choice
C = Completion
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BE = Brief Exercise
The chapter also contains one set of eight Matching questions and three Short-Answer Essay
questions.
13-3
Discuss the capital budgeting evaluation process and explain the inputs used in
capital budgeting. Project proposals are gathered from each department and submitted
to a capital budget committee, which screens the proposals and recommends worthy
projects. Company officers decide which projects to fund, and the board of directors
approves the capital budget. In capital budgeting, estimated cash inflows and outflows,
rather than accrual accounting numbers, are the preferred inputs.
2.
Describe the cash payback technique. The cash payback technique identifies the time
period it will take to recoverthe cost of the investment. The formula when net annual cash
flows are the same is as follows: Cost of capital expenditure estimated net annual cash
inflow = cash payback period. The shorter the payback period, the more attractive is the
investment.
3.
Explain the net present value method. Under the net present value method, the present
value of future cash inflows is compared with the capital investment to determine the net
present value. The decision rule is as follows: Accept the project if the net present value is
zero or positive. Reject the project if the net present value is negative.
4.
5.
Describe the profitability index. The profitability index is a tool for comparing the relative
merits of two alternative capital investment opportunities. It is calculated by dividing the
present value of net cash flows by the initial investment. The higher the index, the more
desirable is the project.
6.
7.
Explain the internal rate of return method. The objective of the internal rate of return
method is to find the interest yield of the potential investment, which is expressed as a
percentage rate. The decision rule is this: Accept the project when the internal rate of
return is equal to or greater than the required rate of return. Reject the project when the
internal rate of return is less than the required rate of return.
13-4
8.
Describe the annual rate of return method. The annual rate of return uses accounting
data to indicate the profitability of a capital investment. It is calculated by dividing the
expected annual net income by the amount of the average investment. The higher the rate
of return, the more attractive is the investment.
13-5
TRUE-FALSE STATEMENTS
1.
Capital budgeting decisions usually involve large investments and often have a significant
impact on a company's future profitability.
2.
The capital budgeting committee ultimately approves the capital expenditure budget for
the year.
3.
For purposes of capital budgeting, estimated cash inflows and outflows are preferred for
inputs into the capital budgeting decision tools.
4.
The cash payback technique is a quick way to calculate a project's net present value.
5.
The cash payback period is calculated by dividing the cost of the capital investment by the
annual cash inflow.
6.
The cash payback method is frequently used as a screening tool but it does not take into
consideration the profitability of a project.
7.
The cost of capital is a weighted average of the rates paid on borrowed funds, as well as
on funds provided by investors in the company's shares.
8.
Using the net present value method, a net present value of zero indicates that the project
would not be acceptable.
9.
The net present value method can only be used in capital budgeting if the expected cash
flows from a project are an equal amount each year.
10.
11.
To avoid accepting projects that actually should be rejected, a company should ignore
intangible benefits in calculating net present value.
12.
One way of incorporating intangible benefits into the capital budgeting decision is to
project conservative estimates of the value of the intangible benefits and include them in
the NPV calculation.
13-6
13.
The profitability index is calculated by dividing the total cash flows by the initial
investment.
14.
The profitability index allows comparison of the relative desirability of projects that require
differing initial investments.
15.
Sensitivity analysis uses a number of outcome estimates to get a sense of the variability
among potential returns.
16.
17.
18.
19.
The internal rate of return method is, like the NPV method, a discounted cash flow
technique.
20.
The interest yield of a project is a rate that will cause the present value of the proposed
capital expenditure to equal the present value of the expected annual cash inflows.
21.
Using the internal rate of return method, a project is rejected when the rate of return is
greater than or equal to the required rate of return.
22.
Using the annual rate of return method, a project is acceptable if its rate of return is
greater than management's minimum rate of return.
23.
The annual rate of return method requires dividing a project's annual cash inflows by the
economic life of the project.
24.
A major advantage of the annual rate of return method is that it considers the time value of
money.
25.
An advantage of the annual rate of return method is that it relies on accrual accounting
numbers rather than actual cash flows.
13-7
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13-8
27.
28.
29.
30.
31.
13-9
32.
If an asset costs $60,000 and is expected to have a $5,000 salvage value at the end of its
nine-year life, and generates annual net cash inflows of $10,000 each year, the cash
payback period is
a. 6.5 years.
b. 6 years.
c. 5.5 years.
d. 9 years.
33.
If a payback period for a project is greater than its expected useful life, the
a. project will always be profitable.
b. entire initial investment will not be recovered.
c. project would only be acceptable if the company's cost of capital was low.
d. project's return will always exceed the company's cost of capital.
34.
35.
The cash payback period is calculated by dividing the cost of the capital investment by the
a. annual net income.
b. net annual cash inflow.
c. present value of the cash inflow.
d. present value of the net income.
36.
When using the cash payback technique, the payback period is expressed in terms of
a. a percent.
b. dollars.
c. years.
d. months.
37.
38.
Bark Company is considering buying a machine for $120,000 with an estimated life of ten
years and no salvage value. The straight-line method of depreciation will be used. The
machine is expected to generate net income of $8,000 each year. The cash payback
period on this investment is
a. 15 years.
b. 10 years.
c. 6 years.
13-10
d.
3 years.
39.
The discount rate is referred to by all of the following alternative names except the
a. cost of capital.
b. cutoff rate.
c. hurdle rate.
d. required rate of return.
40.
The rate that a company must pay to obtain funds from creditors and shareholders s
known as the
a. hurdle rate.
b. cost of capital.
c. cutoff rate.
d. all of these.
41.
42.
If a company's required rate of return is 10% and, in using the net present value method,
a project's net present value is zero, this indicates that the
a. project's rate of return exceeds 10%.
b. project's rate of return is less than the minimum rate required.
c. project earns a rate of return of 10%.
d. project earns a rate of return of 0%.
43.
Using the profitability index method, the present value of cash inflows for Project Flower is
$88,000 and the present value of cash inflows of Project Plant is $48,000. If Project
Flower and Project Plant require initial investments of $90,000 and $40,000, respectively,
and have the same useful life, the project that should be accepted is
a. Project Flower.
b. Project Plant.
c. Either project may be accepted.
d. Neither project should be accepted.
44.
Which of the following assumptions is made in order to simplify the net present value
method?
a. All cash flows come at the end of the year.
b. All cash flows are immediately reinvested at the best rate available at the time.
c. All cash flows come at the beginning of the year.
d. All cash flows are not reinvested.
13-11
45.
When the annual cash flows from an investment are unequal, the appropriate table to use
is the
a. future value of 1 table.
b. future value of annuity table.
c. present value of 1 table.
d. present value of annuity table.
46.
If a company uses a 12% discount rate with the net present value method, and then does
the same analysis, but with a 15% discount rate, which of the following is likely to occur?
a. The 12% rate will show the project is more profitable than the 15% rate.
b. The 15% rate will show the project is more profitable than the 12% rate.
c. Both rates will produce the same net present value.
d. The relative profitability of the two studies depends only on the timing of the cash
flows, not on the discount rate.
47.
Intangible benefits in capital budgeting would include all of the following except increased
a. product quality.
b. employee loyalty.
c. salvage value.
d. product safety.
48.
49.
50.
All of the following statements about intangible benefits in capital budgeting are correct
except that they
a. include increased quality and employee loyalty.
b. are difficult to quantify.
c. are often ignored in capital budgeting decisions.
d. cannot be incorporated into the NPV calculation.
13-12
51.
52.
Using a number of outcome estimates to get a sense of the variability among potential
returns is
a. financial analysis.
b. post-audit analysis.
c. sensitivity analysis.
d. outcome analysis.
53.
If a company's required rate of return is 9%, and in using the profitability index method, a
project's index is greater than 1, this indicates that the project's rate of return is
a. equal to 9%.
b. greater than 9%.
c. less than 9%.
d. unacceptable for investment purposes.
54.
55.
The capital budgeting method that takes into account both the size of the original
investment and the discounted cash flows is the
a. cash payback method.
b. internal rate of return method.
c. net present value method.
d. profitability index.
56.
57.
The capital budgeting method that allows comparison of the relative desirability of projects
that require differing initial investments is the
a. cash payback method.
b. internal rate of return method.
c. net present value method.
d. profitability index.
58.
13-13
The following information is available for a potential investment for Panda Company:
Initial investment
Net annual cash inflow
Net present value
Salvage value
Useful life
$40,000
10,000
18,112
5,000
10 yrs.
An approach that uses a number of outcome estimates to get a sense of the variability
among potential returns is
a. the discounted cash flow technique.
b. the net present value method.
c. risk analysis.
d. sensitivity analysis.
60.
61.
62.
A thorough evaluation of how well a project's actual performance matches the projections
made when the project was proposed is called a
a. pre-audit.
b. post-audit.
c. risk analysis.
d. sensitivity analysis.
63.
13-14
b.
c.
d.
64.
A capital budgeting method that takes into consideration the time value of money is the
a. annual rate of return method.
b. return on shareholders' equity method.
c. cash payback technique.
d. internal rate of return method.
65.
66.
In using the internal rate of return method, the internal rate of return factor was 4.0 and
the equal annual cash inflows were $16,000. The initial investment in the project must
have been
a. $8,000.
b. $16,000.
c. $64,000.
d. $32,000.
67.
The capital budgeting technique that finds the interest yield of the potential investment is
the
a. annual rate of return method.
b. internal rate of return method.
c. net present value method.
d. profitability index method.
68.
All of the following statements about the internal rate of return method are correct except
that it
a. recognizes the time value of money.
b. is widely used in practice.
c. is easy to interpret.
d. can be used only when the cash inflows are equal.
2
3
1.783
2.577
1.759
2.531
13-15
1.736
2.487
69.
70.
71.
72.
A company has a minimum required rate of return of 10% and is considering investing in a
project that requires an investment of $68,000 and is expected to generate cash inflows of
$30,000 at the end of each year for 3 years. The present value of future cash inflows for
this project is
a. $68,000.
b. $74,610.
c. $7,930.
d. $6,610
13-16
12%
3.605
4.111
73.
74.
75.
76.
If the equipment is purchased, the annual rate of return expected on this equipment is
a. 37.5%.
b. 31.25%.
c. 11.25%.
d. 6.25%.
78.
a.
b.
c.
d.
13-17
8.89 years.
5.0 years.
3.2 years.
2.67 years.
79.
80.
81.
83.
84.
13-18
b.
c.
d.
85.
14.5%
18%
26.7%
All of the following statements about the annual rate of return method are correct except
that it
a. indicates the profitability of a capital expenditure.
b. ignores the salvage value of an investment.
c. does not consider the time value of money.
d. compares the annual rate of return to managements minimum rate of return.
86.
Peanut Co. is planning on investing in a new 2-year project, Project Jelly. Project
Jelly is expected to produce cash flows of $100,000 and $120,000 in each of the 2 years,
respectively. Peanut requires an internal rate of return of 15%. What is the maximum
amount that Peanut should invest immediately in Project Jelly?
Present Value of 1
Period
15%
1
.870
2
.756
Future Value of 1
Period
1
2
15%
1.150
1.323
a. $191.400
b. $177,720
c. $220,000
d. $273,760
87.
Vault Company wants to purchase an asset with a 3-year useful life, which is expected to
produce cash inflows of $10,000 each year for two years, and $15,000 in year 3. Vault
has a 14% cost of capital, and uses the following factors. What is the present value of
these future cash flows?
Present Value of 1
Period
14%
1
.88
.77
.67
2
3
a.
b.
c.
d.
88.
$30,800
$30,400
$26,550
$34,750
Doris Co. is considering purchasing a new machine which will cost $200,000, but which
will decrease costs each year by $50,000. The useful life of the machine is 10 years. The
machine would be depreciated straight-line with no residual value over its useful life at the
rate of $20,000/year. The payback period is
a. 5.0 years
b. 4.5 years
13-19
c. 4.0 years
d. 10.0 years
89.
Tammy Co. is considering purchasing a machine that will produce annual savings of
$22,000 at the end of the year. Tammy requires a 12% rate of return and the asset has a
5-year useful life. What is the maximum Tammy would be willing to pay for this machine?
Present Value of Annuity of 1
Period
12%
5
3.605
a.
b.
c.
d.
Period
5
Present Value of 1
12%
.567
$43,386
$79,310
$110,000
$62,370
90.
Mystery Co. is considering purchasing a new piece of equipment that will cost $600,000.
The equipment has an estimated useful life of 8 years and no salvage value. The
equipment will produce cash inflows of $215,000 per year and net income of $90,000 per
year. Mystery requires a 10% rate of return. What is the payback period for this
equipment?
a. 8.0 years
b. 3.75 years
c. 2.79 years
d. 6.67 years
91.
Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful
life. The equipment will provide cost savings of $7,300 and will be depreciated straightline over its useful life with no salvage value. Cleaners, Inc. requires a 10% rate of return.
What is the approximate internal rate of return for this investment?
Period
6
a.
b.
c.
d.
92.
8%
4.623
15%
3.784
9%
10%
11%
12%
Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful
life. The equipment will provide cost savings of $7,300 and will be depreciated straightline over its useful life with no salvage value. Cleaners, Inc. requires a 10% rate of return.
What is the approximate net present value of this investment?
Present Value of an Annuity of 1
13-20
Period
6
a.
b.
c.
d.
93.
8%
4.623
9%
4.486
10%
4.355
11%
4.231
12%
4.111
15%
3.784
$13,800
$1,792
$886
$2,748
Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful
life. The equipment will provide cost savings of $7,300 and will be amortized using the
straight-line method over its useful life with no salvage value. Cleaners, Inc. requires a
10% rate of return. What is the approximate profitability index associated with this
equipment?
Period
6
a.
b.
c.
d.
8%
4.623
15%
3.784
1.23
1.03
1.06
.73
94.
Capital budgeting relies on cash inflows and outflows as preferred inputs for calculations
because
a. managers prefer to use cash figures rather than accounting figures.
b. GAAP does not apply to capital budgeting decisions.
c. projects require cash paid out and firms want to know when cash will be returned.
d. cash figures are easier to calculate than accounting figures.
95.
Which of the following would not be considered as an input into a capital budgeting
decision?
a. Scrap value of equipment sold at the end of a project
b. Labour savings as a result of mechanization of a process
c. Cost outlays many years after the project has started
d. Amortization on a straight line basis
96.
97.
c.
d.
13-21
98.
99.
100.
101.
102.
103.
The major difference between the Net Present Value method and the Annual Rate of
Return method in evaluating a capital project is
a. the ARR method is easier for accountants to justify than the NPV method.
b. the NPV method is easier for managers to justify than the ARR method.
13-22
c.
d.
13-23
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
Ans
.
a
d
b
a
d
c
b
b
c
b
c
Item
37.
38.
39.
40.
41.
42.
43.
44.
45.
46.
47.
Ans
.
d
c
a
b
d
c
b
a
c
a
c
Item
48.
49.
50.
51.
52.
53.
54.
55.
56.
57.
58.
Ans
.
b
d
d
c
c
b
b
d
c
d
d
Item
59.
60.
61.
62.
63.
64.
65.
66.
67.
68.
69.
Ans
.
d
c
b
b
d
d
c
c
b
d
d
Item
70.
71.
72.
73.
74.
75.
76.
77.
78.
79.
80.
Ans
.
c
b
b
d
d
b
b
c
c
d
a
Item
81.
82.
83.
84.
85.
86.
87.
88.
89.
90.
91.
Ans
.
Item
Ans.
d
c
c
b
b
b
c
c
b
c
d
92.
93.
94.
95.
96.
97.
98.
99.
100.
101.
102.
103.
b
c
c
d
a
d
d
c
d
b
b
c
13-24
BRIEF EXERCISES
Brief Exercise104
Diamond Co. is considering investing in new equipment that will cost $800,000 with a 8-year
useful life. The new equipment is expected to produce annual net income of $25,000 over its
useful life. Depreciation expense, using the straight-line rate, is $100,000 per year.
Instructions
Calculate the payback period.
Solution 104 (5 min.)
$800,000 ($25,000 + $100,000) = 6.4 years
Brief Exercise105
Madeline Company is proposing to spend $170,000 to purchase a machine that will provide
annual cash flows of $37,000. The appropriate present value factor for 8 periods is 6.73.
Instructions
Calculate the proposed investments net present value, and indicate whether the investment
should be made by Madeline Company.
Solution 105 (5 min.)
Present Value
Cash inflows $37,000 X 6.73
Cash outflow investment $170,000 X 1.00
Net present value
$ 249,010
(170,000)
$79,010
The investment should be made because the net present value is positive.
Brief Exercise106
LeMo Co. is considering investing in a cottage that will cost $310,000. The company expects to
rent the cottage for 7 years, after which it will be sold for $400,000 at that time. LeMo anticipates
cash flows of $60,000 resulting from the cottage and the companys borrowing rate is 9%, while
its cost of capital is 12%.
Instructions
Calculate the net present value of the cottage and indicate whether LeMo should make the
investment.
Solution 106 (5 min.)
Cash
Flows
$60,000
12% Discount
Factor
Present
Value
4.56376
$273,826
400,000 X
0.45235
Capital investment
Net present value
13-25
180,940
454,766
(310,000)
$144,766
Since the net present value is positive, LeMo should accept the project.
Brief Exercise 107
EKPN Co. has hired a consultant to propose a way to increase the companys revenues. The
consultant has evaluated two mutually exclusive projects with the following information provided
for each project:
Capital investment
Annual cash flows
Estimated useful life
Estimated salvage value
Project Chicken
$810,000
210,000
5 years
$130,000
Project Rooster
$200,000
60,000
5 years
$50,000
$210,000 X
130,000 X
8% Discount
Factor
3.99271
0.68058
=
=
Capital investment
Net present value
Present
Value
$838,469
88,475
926,944
(810,000)
$116,944
Cash
Flows
$60,000
50,000
9% Discount
Factor
X
X
3.992711
0.68058
=
=
Present
Value
$239,563
34,029
273,592
(200,000)
13-26
$73,592
Project Rooster has a lower net present value than Project Chicken, but because of its lower capital
investment, it has a higher profitability index. Based on its profitability index, Project Rooster
should be accepted.
Brief Exercise108
An investment costing $72,000 is being contemplated by Mint Co. The investment will have a life
of 5 years with no salvage value and will produce annual cash flows of $19,481.
Instructions
What is the approximate internal rate of return associated with this investment?
Solution 108 (5 min.)
When net annual cash inflows are expected to be equal, the internal rate of return can be
approximated by dividing the capital investment by the net annual cash inflows to determine the
discount factor, and then locating this discount factor on the present value of an annuity table.
$72,000/$19,481 = 3.69591
By tracing across on the 5-year row we see that the discount factor for 11% is 3.69590. Thus, the
internal rate of return on this project is approximately 11%.
Brief Exercise109
Salt Co. is considering investing in a new facility to extract and produce salt. The facility will
increase revenues by $170,000, but will also increase annual expenses by $50,000 including
depreciation. The facility will cost $720,000 to build, but will have a $30,000 salvage value at the
end of its 15-year useful life.
Instructions
Calculate the annual rate of return on this facility.
Solution 109 (5 min.)
The annual rate of return is calculated by dividing expected annual income by the average
investment. The companys expected annual income is:
$170,000 $50,000 = $120,000
Its average investment is:
$720,000 + $30,000
2
= $375,000
13-27
Investment
$150,000
140,000
130,000
60,000
$25,000
25,000
35,000
15,000
4
7560 = 1.25
2
165140 = 1.18
1
175150 = 1.17
13-28
EXERCISES
Exercise 112
Myrnas Gardening is considering the purchase of new lawn equipment. A supplier has offered a
package that will replace Myrnas current equipment. The package price is $30,000. Myrna
believes the equipment will make her more efficient, and therefore it will increase her annual net
cashflow by $5,000. The equipment will have a 9-year useful life and have no salvage value.
Myrnas cost of capital is 8%.
Instructions
(a) Calculate the cash payback period.
(b) Calculate the machines internal rate of return.
(c) Calculate the machines net present value using a discount rate of 8%.
(d) Is the investment acceptable? Why or why not?
Solution 112 (1318 min.)
(a) Cash payback period:
(b) Internal rate of return: Scanning the 9-year line, a factor of 6 represents an internal rate of
return of approximately 9%. The factor at 9% is actually 5.99525.
(c) Net present value using a discount rate of 8%:
Time Period
Cash Flow
PV Factor
Present Value
-0($30,000)
1.0000
($30,000.00)
1-9
5,000
6.24689
31,234.45
Net Present Value
$ 1,234.45
(d) Yes, the investment is acceptable. Indications are that the investment will earn a return
greater than 8%. The internal rate of return is estimated to be 9%, and the net present value
is positive.
Exercise 113
M&H Inc. delivers groceries for seniors. The company is considering purchasing a new van for
$27,000. The van is expected to last 7 years and have a salvage value of $2,000. M&H will use
the straight-line depreciation method. M&H estimates the van will generate revenue of $15,000
per year, and incur expenses of $7,000 plus depreciation. M&Hs cost of capital is 6%.
Instructions
For the new van, calculate the:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.
Solution 113 (1622 min.)
(a)
Total annual cash flow: $15,000 - $7,000 = $8,000
$27,000
Cash payback: = 3.375 years
$8,000
13-29
$27,000 + $2,000
Average Investment: = $14,500
2
$27,000 - $2,000
Annual Depreciation: = $3,571
7 years
Annual Net Income: $8,000 $3,571 = $4,429
$4,429
Average Annual Rate of Return: = 30.5%
$14,500
Exercise 114
Mimi Company is considering a capital investment of $570,000 in new equipment. The equipment
is expected to have a 15-year useful life with no salvage value. Depreciation is calculated by the
straight-line method. During the life of the investment, annual net income and cash inflows are
expected to be $63,000 and $101,000, respectively. Mimi's minimum required rate of return is
11%. The present value of 1 for 15 periods at 11% is .209 and the present value of an annuity of 1
for 15 periods at 11% is 7.191.
Instructions
Calculate each of the following:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.
Solution 114 (1015 min.)
(a) Cash payback period = $570,000 $101,000 = 5.64 years
(b) Present value of cash inflows ($101,000 7.191)= $726,291
Capital investment
570,000
Net present value
$ 156,291
(c) Annual rate of return = $63,000 [($570,000 + $0) 2] = 22.1%
Exercise 115
Dog River Company is considering two capital investment proposals. Relevant data on each
project are as follows:
Project Red
Project Blue
Capital investment
$210,000
$980,000
13-30
15,000
7 years
90,000
7 years
Depreciation is calculated by the straight-line method with no salvage value. Dog River requires
a10% rate of return on all new investments. The present value of 1 for 7 periods at 10% is .513
and the present value of an annuity of 1 for 7 periods is 4.868.
Instructions
(a) Calculate the cash payback period for each project.
(b) Calculate the net present value for each project.
(c) Calculate the annual rate of return for each project.
(d) Which project should DogRiver select?
Solution 115 (1418 min.)
(a)
Annual net income
Annual depreciation
Annual cash inflow
*($210,000 7)
Cash payback period:
(b)
Project Red
$15,000
30,000*
$45,000
**($980,000 7)
$210,000
= 4.67 years
$45,000
Project Red
Present value of cash inflows:
$219,060*
Capital investment
210,000
Net present value
$ 9,060
*($45,000x4.868)
**(230,000 x 4.868)
Project Red
$15,000
= 14.3%
($210,000 + $0) 2
Project Blue
$90,000
140,000**
$230,000
$980,000
= 4.26 years
$230,000
Project Blue
$1,119,640**
980,000
$ 139,640
Project Blue
$90,000
= 18.4%
($980,000 + $0) 2
(d) DogRiver should select Project Blue because it has a larger positive net present value and a
higher annual rate of return. In addition, Project Blue has a slightly shorter cash payback
period.
Exercise 116
Tom Bat became a baseball enthusiast at a very early age. All of his baseball experience has
provided him valuable knowledge of the sport, and he is thinking about going into the batting cage
business. He estimates the construction of a state-of-the-art facility and the purchase of
necessary equipment will cost $539,000. Both the facility and the equipment will be depreciated
over 14 years using the straight-line method and are expected to have zero salvage values. His
required rate of return is 12% (present value factor of 6.6282). Estimated annual net income and
cash flows are as follows:
Revenue
$270,000
Less:
Utility cost
Supplies
Labour
Depreciation
Other
Net income
28,000
7,500
110,000
38,500
23,000
13-31
207,000
$63,000
Instructions
For this investment, calculate:
(a) The net present value.
(b) The internal rate of return.
(c) The cash payback period.
Solution116 (1216 min.)
(a) Net present value of the investment:
Item
Present Value Cash Flow Factor
Initial Investment
($539,000)
1.0000
Revenue
$270,000
Expense
(168,500)*
101,500
6.6282
Net Present Value
*$28,000 + $7,500 + $110,000 + $23,000
Present Value
($539,000)
$
672,762
133,762
Cool
$37,000
40,000
45,000
$122,000
Hot
$40,000
40,000
40,000
$120,000
The equipment will have no salvage value at the end of its three-year life. Vista Company
depreciates equipment using the straight-line method, and requires a minimum rate of return of
9%.
Present value data are as follows:
Present Value of 1
Period
9%
1
.917
2
.842
3
.772
13-32
Instructions
(a) Calculate the net present value of each project.
(b) Calculate the profitability index of each project.
(c) Which project should be selected? Why?
Solution 117 (1216 min.)
(a)
Project Cool
Year
Annual Cash Inflows
Present Value of 1
1
$37,000
.917
2
40,000
.842
3
45,000
.772
$122,000
Present Value
$33,929
33,680
34,740
$102,349
$102,349
87,000
$ 15,349
Project Hot
Present value of cash inflows ($40,000 2.531)
Capital investment
Net present value
$101,240
87,000
$ 14,240
(b)
Profitability index:
Cool
Hot
$102,349 $87,000 = 1.176 ($101,240 $87,000) = 1.164
(c) Both projects are acceptable because both show a positive net present value. Project Cool
is the preferred project because its net present value is greater than project Hot's net present
value and it has a slightly higher profitability index.
Exercise 118
Santana Company is considering investing in a project that will cost $67,000 and have no salvage
value at the end of its 7-year life. It is estimated that the project will generate annual cash inflows
of $16,000 each year. The company requires a 10% rate of return and uses the following
compound interest table:
Period
7
6%
5.582
12%
4.564
Instructions
(a) Calculate (1) the net present value and (2) the profitability index of the project.
(b) Calculate the internal rate of return on this project.
(c) Should Santana invest in this project?
Solution 118 (1018 min.)
(a) (1) Present value of cash inflows ($16,000 4.868)
Capital investment
Net present value
$77,888
67,000
$ 10,888
15%
4.160
(2)
(b)
13-33
$67,000
= 4.188
$16,000
Since the calculated internal rate of return factor of 4.188 is very near the factor 4.160 for
seven periods and 15% interest, this project has an approximate interest yield of 15%.
(c) Santana should invest in this project because it has a positive net present value, a
profitability index above 1, and its internal rate of return of 15% is greater than the company's
10% required rate of return.
Exercise 119
Johnson Company is considering purchasing one of two new machines. The following estimates
are available for each machine:
Machine 1
Machine 2
Initial cost
$152,000
$170,000
Annual cash inflows
50,000
60,000
Annual cash outflows
15,000
20,000
Estimated useful life
6 years
6 years
The company's minimum required rate of return is 9%.
Period
6
8%
4.623
15%
3.784
Instructions
(a) Calculate the (1) net present value, (2) profitability index, and (3) internal rate of return for
each machine.
(b) Which machine should be purchased?
Solution119 (1216 min.)
(a)
(1) Present value of net cash flows
Capital investment
Net present value
*($35,000 4.486)
**($40,000 4.486)
Machine 1
$157,010*
152,000
$ 5,010
Machine 1
$157,010
= 1.03
$152,000
Machine 2
$179,440**
170,000
$ 9,440
Machine 2
$179,440
= 1.06
$170,000
13-34
(3)
Internal rate of return factor
Machine 1
$152,000
= 4.34
$35,000
Machine 2
$170,000
= 4.25
$40,000
(b) Both machines are acceptable because both show a positive net present value, have a
profitability index above 1, and have an internal rate of return greater than the company's
minimum required rate of return. Machine 2 is preferred because its net present value,
profitability index, and internal rate of return are all greater than Machine 1's amounts.
Exercise 120
Yappy Company is considering a capital investment of $320,000 in additional equipment. The
new equipment is expected to have a useful life of 8 years with no salvage value. Depreciation is
calculated by the straight-line method. During the life of the investment, annual net income and
cash inflows are expected to be $22,000 and $62,000, respectively. Yappy requires a 9% return
on all new investments.
Present Value of an Annuity of 1
Period
8%
9%
10%
11%
12%
15%
8
5.747
5.535
5.335
5.146
4.968
4.487
Instructions
(a) Calculate each of the following:
1. Cash payback period.
2. Net present value.
3. Profitability index.
4 Internal rate of return.
5. Annual rate of return.
(b) Indicate whether the investment should be accepted or rejected.
Solution 120 (1520 min.)
(a) 1. Cash payback period: $320,000 $62,000 = 5.16 years
(b)
2.
$343,170
320,000
$ 23,170
3.
4.
5.
Yappy should accept the investment, since its net present value is positive and its internal
rate of return of 11% is greater than the company's required rate of return of 9%. In addition,
13-35
its cash payback period of 5.16 years is significantly shorter than the equipment's useful life
of 8 years.
Exercise 121
Platoon Company is performing a post-audit of a project that was estimated to cost $300,000,
have a useful life of 6 years with a zero salvage value, and result in net cash inflows of $70,000
per year. After the investment has been in operation for a year, revised figures indicate that it
actually cost $340,000, will have a 9-year useful life, and will produce net cash inflows of
$58,000. The present value of an annuity of 1 for 6 years at 10% is 4.355 and for 9 years is
5.759.
Instructions
Determine whether the project should have been accepted based on (a) the original estimates
and then on (b) the actual amounts.
Solution 121 (812 min.)
(a) Present value of the estimated net cash inflows ($70,000 4.355)
Estimated capital investment
Net present value
$304,850
300,000
$ 4,850
Yes, Platoon Company should have invested in the project based on the original estimates,
since the net present value is positive.
(b) Present value of the actual net cash inflows ($58,000 x 5.759)
Actual capital investment
Net present value
$334,022
340,000
($ 5,978)
Platoon should not have invested in the project based on the actual amounts, since the net
present value is negative. The decrease of $10,828 in net present value was caused due to
a decrease of $12,000 per year in net cash inflows and a $40,000 increase in the cost of the
capital investment. This more than offsets the 3-year increase in useful life.
Exercise 122
Sophies Pet Shop is considering the purchase of a new delivery van. Sophie Smith, owner of the
shop, has compiled the following estimates in trying to determine whether the delivery van should
be purchased:
Cost of the van
Annual net cash flows
Salvage value
Estimated useful life
Cost of capital
Present value of an annuity of 1
Present value of 1
$25,000
4,300
3,000
8 years
10%
5.335
.467
Sophie's assistant manager is trying to convince Sophie that the van has other benefits that she
hasn't considered in the initial estimates. These additional benefits, including the free advertising
the store's name painted on the van's doors will provide, are expected to increase net cash flows
by $500 each year.
13-36
Instructions
(a) Calculate the net present value of the van, based on the initial estimates. Should the van be
purchased?
(b) Calculate the net present value, incorporating the additional benefits suggested by the
assistant manager. Should the van be purchased?
(c) Determine how much the additional benefits would have to be worth in order for the van to be
purchased.
Solution 122 (1519 min.)
(a) Present value of annualnetcash flows ($4,300 5.335)
Present value of salvage value ($3,000 .467)
$22,941
1,401
$24,342
Capital investment
25,000
Net present value
($ 658)
Based on the negative net present value of $658, the van should not be purchased.
$25,608
1,401
$27,009
Capital investment
25,000
Net present value
$ 2,009
Incorporating the additional benefits of $500/year into the calculation produces a positive net
present value of $2,009. Therefore, the van should be purchased.
(c) The additional benefits would need to have a total present value of at least $658 in order for
the van to be purchased.
Exercise 123
Blue Jay Corp. is thinking about opening a baseball camp in Oakville. In order to start the camp,
the company would need to purchase land, build five baseball fields, and a dormitory-type
sleeping and dining facility to house 100 players. Each year the camp would be run for 10
sessions of 1 week each. The company would hire college baseball players as coaches. The
camp attendees would be baseball players age 12-18. Property values in Oakville have enjoyed
a steady increase in value. It is expected that after using the facility for 20 years, Blue Jay can
sell the property for more than it was originally purchased for. The following amounts have been
estimated:
Cost of land
$ 600,000
Cost to build dorm and dining facility
2,100,000
Annual cash inflows assuming 100 players and 10 weeks
2,520,000
Annual cash outflows
2,250,000
Estimated useful life
20 years
Salvage value
3,900,000
Discount rate
10%
Present value of an annuity of 1
8.514
Present value of 1
.149
Instructions
(a) Calculate the net present value of the project.
13-37
(b) To gauge the sensitivity of the project to these estimates, assume that if only 80 campers
attend each week, revenues will be $2,085,000 and expenses will be $1,875,000. What is the
net present value using these alternative estimates? Discuss your findings.
(c) Assuming the original facts, what is the net present value if the project is actually riskier than
first assumed, and a 12% discount rate is more appropriate? The present value of 1 at 12%
is .104 and the present value of an annuity of 1 is 7.469.
Solution 123 (1520 min.)
(a) Present value of net cash flows ($270,000 8.514)
Present value of salvage value ($3,900,000 .149)
Capital investment ($600,000 + $2,100,000)
Net present value
(b) Present value of net cash flows ($210,000 8.514)
Present value of salvage value
Capital investment
Net present value
$2,298,780
581,100
$2,879,880
2,700,000
$ 179,880
$1,787,940
581,100
$2,369,040
2,700,000
($330,960)
If the number of campers attending each week is only 80 instead of 100, the net present
value decreases by $510,840 (from a positive $179,880 to a negative $330,960). This
indicates that the camp should not be invested in unless the number attending is closer to
100.
(c) Present value of net cash flows ($270,000 7.469)
Present value of salvage value ($3,900,000 .104)
Capital investment
Net present value
$2,016,630
405,600
$2,422,230
2,700,000
($ 277,770)
Exercise 124
Explain what a capital investment decision is. In your answer, distinguish between independent
and mutually exclusive capital investment decisions.
Solution 124
Such decisions are the outcome of planning, setting goals and priorities, arranging financing and
using various selection criteria to choose amongst a variety of competing projects. Such projects
would be taken on with the view of furthering the company, with the purchase of some type of
asset which would generate an acceptable rate of return.
Independent projects are those that, once accepted or rejected, do not affect the cash flows of
other projects within the company.
Mutually exclusive projects are those that, once accepted or rejected, preclude the acceptance of
all other competing projects.
Exercise125
A certain investment proposal requires an initial outlay of $450,000, and has an expected useful
life of 6 years, with an annual cash inflow of $90,000 received at the end of each year. The
13-38
company uses the straight-line method of depreciation. Ignore income taxes. The company has a
12% incremental cost of borrowing.
Instructions
(a) Compute the payback for the proposal.
(b) Compute the net present value of the proposal.
(c) Would you recommend this proposal be accepted? Explain.
Solution 125
(a) 5 years = $450,000/$90,000
(b) NPV using 12%:
Initial outlay
PV of cash flows ($90,000 x 4.111)
NPV
($450,000)
$369,990
$(80,010)
(c) The company should not accept the proposal. The payback period of 5 years is less than the
expected life of the project, which is positive. However, the NPV is negative which suggests
that the proposal does not meet the companys desired rate of return.
Exercise126
Huttons Feed Supply wishes to purchase a new computerized weigh scales system which will
weigh and price the crops brought in by local farmers. Data on this new system are as follows:
Cost
Salvage value at end of 5 years
Useful life
Annual operating cost
$12,000
$1,000
5 years
$4,000
If the existing computerized weigh scales is kept and used, it would require the purchase and
installation of additional hardware, one year from now, costing $2,000. Management believes the
system will last another 5 years from today, at which time the salvage value is expected to be
$300. Additional information on the existing system is as follows:
Annual operating costs
Remaining book value
Current salvage value
Cost of capital
$9,000
$12,000
$3,000
12%.
Cash Flow
($12,000)
PV Factor
1.0
Total
($12,000)
Notes
Initial purchase cost of weigh scales
0
1
$ 3,000
$ 2,000
1.0
0.893
1-5
5
$ 5,000
3.605
700
0.567
397
13-39
3,000
1,786
The positive NPV indicates that the new weigh scales savings are greater than the companys
cost of capital, so the new equipment should be purchased.
Note: the incremental analysis approach has been used here, rather than showing 2 separate
NPV calculations for the new and old systems. Had 2 separate NPV calculations been done, the
NPV for the new weigh scales would have been higher by $11,208.
Exercise 127
Jillian Grapes is thinking of purchasing a new grape-crushing machine for its factory. The cost of
the new equipment is $50,000. The current machine must be scrapped and will have no value.
The costs associated with operating the two machines are:
Current machine
New Machine
Labour
$7,000
$2,000
Maintenance
3,000
1,000
Utilities
2,000
1,500
Amortization
9,000
11,000
Calculate the payback period if the new machine is purchased
Solution 127
The new machine will have an outlay of $25,000 but will save the company the following money:
Labour
$7,000 $2,000 = $5,000
Maint.
3,000 1,000 = 2,000
Utilities
2,000 1,500 =
500
Amort.
0
Total
$7,500
Payback period $50,000 / $7,500 = 6.67 years
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COMPLETION STATEMENTS
128.
For purposes of capital budgeting, estimated ____________ and outflows are preferred
for inputs into the capital budgeting decision tools.
129.
The technique which identifies the time period required to recover the cost of the
investment is called the ________________ method.
130.
The two discounted cash flow techniques used in capital budgeting are (1) the
_______________________ method and (2) the ______________________ method.
131.
Under the net present value method, the interest rate to be used in discounting the future
cash inflows is the ________________.
132.
In using the net present value approach, a project is acceptable if the project's net present
value is ____________ or_______________.
133.
134.
135.
136.
The internal rate of return method differs from the net present value method in that it
results in finding the ___________________ of the potential investment.
137.
A major limitation of the annual rate of return approach is that it does not consider the
_______________ of money.
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13-42
MATCHING
138.
Match the items below by entering the appropriate code letter in the space provided.
A.
B.
C.
D.
Profitability index
Internal rate of return method
Discounted cash flow techniques
Capital budgeting
E.
F.
G.
H.
____
1. A capital budgeting technique that identifies the time period required to recover the
cost of a capital investment from the annual cash inflow produced by the investment.
____
2. Capital budgeting techniques that consider both the estimated total cash inflows from
the investment and the time value of money.
____
3. A method used in capital budgeting in which cash inflows are discounted to their
present value and then compared to the capital outlay required by the capital
investment.
____
4. A method of comparing alternative projects that take into account both the size of the
investment and its discounted cash flows.
____
5. A method used in capital budgeting that results in finding the interest yield of the
potential investment.
____
6. The average rate of return that the firm must pay to obtain borrowed and equity funds.
____
____
ANSWERS TO MATCHING
1.
5.
2.
6.
3.
7.
4.
8.
13-43
13-44
3.
13-45
It is probably not ethical to modify a proposal at all; certainly not in the way described. The
person submitting the proposal should have the right to know about any changes that were
made, and should have the right to review those changes.
Option #2
($2,700,000)
900,000
900,000
900,000
0
Required:
Prepare a brief report for management in which you make a recommendation for one system or
the other, using the information given.
Solution 141
I recommend that the hospital accept Option #1, to purchase upgrades to our present system and
to buy more efficient scanners. In the first place, the changes will be easier to implement
because the equipment is similar to that which we already use. Secondly, the hospital will have
less money invested in the project, which decreases our risk of loss should the project fail.
Option #2 appears to be too risky.