Professional Documents
Culture Documents
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EXERCISES
Ex. 251
Testing
Equipment Centrifuge
Estimated average annual income:
$10,500 4.......................................................................
$12,250 5.......................................................................
$2,625
Average investment:
($42,000 + 0) 2...............................................................
($56,000 + 0) 2...............................................................
$21,000
12.5%
$2,450
$28,000
Ex. 252
Average
Average annual income
= Average investment
rate
of return
=
$6,750
$50,000
= 13.5%
* The effect of the savings in wages expense is an increase in income.
8.75%
Ex. 253
Average
Average annual income
= Average investment
rate
of return
=
$135,000
$450,000
= 30%
* The depreciation of the equipment is included in the factory overhead cost per
unit.
Ex. 254
Year 1
Initial investment..............................................
Operating cash flows:
Annual revenues (8,000 units $36).........
Selling expenses (5% $288,000).............
Cost to manufacture
(8,000 units $19.55)*...........................
Net operating cash flows......................
Total for year 1..................................................
Total for years 214 (operating cash flow)....
Residual value.............................................
Total for last year..............................................
Years 214
Last Year
$ 288,000
(14,400)
$ 288,000
(14,400)
$ 288,000
(14,400)
(156,400)
$ 117,200
$ (120,800)
(156,400)
$ 117,200
(156,400)
$ 117,200
$ (238,000)
$ 117,200
10,000
$ 127,200
Ex. 255
Proposal 1: $250,000 $50,000 = 5-year cash payback period.
Proposal 2: 4-year cash payback period, as indicated below.
Net Cash
Flow
Year 1....................................................$80,000
Year 2......................................................70,000
Year 3......................................................50,000
Year 4......................................................50,000
$
150,000
200,000
250,000
Cumulative
Net Cash Flows
80,000
Ex. 256
a. The Liquid Soap product line is recommended, based on its shorter cash
payback period. The cash payback period for both products can be
determined using the following schedule:
Initial investment: $550,000
Liquid Soap
Net Cash
Cumulative Net
Flow
Cash Flows
Year 1
Year 2
Year 3
Year 4
Year 5
$150,000
140,000
130,000
130,000
$150,000
290,000
420,000
550,000
Net Cash
Flow
Cosmetics
Cumulative Net
Cash Flows
$110,000
110,000
110,000
110,000
110,000
$110,000
220,000
330,000
440,000
550,000
Liquid Soap has a 4-year cash payback, and Cosmetics has a 5-year cash
payback period.
b. The cash payback periods are different between the two product lines
because Liquid Soap earns cash faster than does Cosmetics. Even though
both products earn the same total net cash flow over the 8-year planning
horizon, Liquid Soap returns cash faster in the earlier years. The cash
payback method emphasizes the initial years net cash flows in determining
the cash payback period. Thus, the project with the greatest net cash flows in
the early years of the project life will be favored over the one with less net
cash flows in the initial years.
Ex. 257
a.
Year
Present Value
of $1 at 12%
1
0.893
2
0.797
3
0.712
4
0.636
Total..................................................
Amount to be invested...................
Net present value............................
Net Cash
Flow
Present Value of
Net Cash Flow
$150,000
120,000
75,000
75,000
$420,000
$ 133,950
95,640
53,400
47,700
$ 330,690
340,000
$ (9,310)
b. No. The ($9,310) net present value indicates that the return on the proposal is
less than the minimum desired rate of return of 12%.
Ex. 258
a. (All amounts are in $millions.)
2006 cash flow:
Gross ticket sales......................................................
Production cost..........................................................
Marketing cost............................................................
Net cash flow from theatrical release...........................
$125
$100
40
$ (15)
$ 90
30%
$ 27
20
5
Present Value
of $1 at 20%
2006
1.000
2007
0.833
2008
0.694
2009
0.579
Net present value............................
Net Cash
Flow
$(15)
27
20
5
Present Value of
Net Cash Flow
$(15)
22
14
3
$ 24
b. Even though the film lost money at the box office, the project was financially
successful as a whole due to additional cash flows from home video sales,
pay TV, and network TV syndication.
Ex. 259
a. Cash inflows:
Hours of operation.......................................
Revenue per hour.........................................
Revenue per year..........................................
Cash outflows:
Hours of operation.......................................
Fuel cost per hour........................................
Labor cost per hour.....................................
Total fuel and labor costs per hour............
Fuel and labor costs per year.....................
1,500
$98.00
$ 147,000
1,500
$28.00
22.00
$50.00
(75,000)
(12,000)
$ 60,000
$ 60,000
3.791
$ 227,460
235,000
$ (7,540
c. No. Crowe should not accept the investment because the bulldozer cost
exceeds the present value of the cash flows at the minimum desired rate of
return of 10%. The bulldozer might be an attractive investment if Crowe could
get a price reduction, increase the hourly revenue rate, increase the annual
hours of use, or extend the useful life of the bulldozer.
Ex. 2510
Apartment Complex
Year
Present Value
of $1 at 15%
1
0.870
2
0.756
3
0.658
4
0.572
4
0.572
Total..................................................
Amount to be invested...................
Net present value............................
Net Cash
Flow
$
220,000
200,000
200,000
180,000
420,000
$ 1,220,000
Present Value of
Net Cash Flow
$ 191,400
151,200
131,600
102,960
240,240
$ 817,400
(775,000)
$ 42,400
Office Building
Year
Present Value
of $1 at 15%
1
0.870
2
0.756
3
0.658
4
0.572
Total..................................................
Amount to be invested...................
Net present value............................
Net Cash
Flow
$
300,000
300,000
275,000
275,000
$ 1,150,000
Present Value of
Net Cash Flow
$ 261,000
226,800
180,950
157,300
$ 826,050
(775,000)
$ 51,050
The net present value of both projects are positive; thus, both proposals are
acceptable. However, the net present value of the office building exceeds that of
the apartment complex. Thus, the office building should be preferred if there is
enough investment money for only one of the projects.
Note to Instructors: Since the investment amount is the same, the net present
value can be compared to determine preference. That is, the present value index
will show the same preference ordering.
Ex. 2511
Initial investment to develop a restaurant unit...............
Less: Initial franchise fee..................................................
Net investment....................................................................
Years 110
Royalty:
Average unit revenue..................................................
Royalty rate..................................................................
Royalty cash flow...............................................................
Annual lease and other cash flows..................................
Total annual cash flows.....................................................
Present value of a $1 annuity for 10 years at 10%
(Exhibit 2).....................................................................
Present value of annual cash flows.................................
$ 1,993,000
300,000
$ 1,693,000
$1,500,000
4.5%
$
$
6.145
$ 1,490,163
67,500
175,000
242,500
600,000
0.386
231,600
28,7631
Note to Instructors: This problem is developed from the perspective of IHOP, the
franchiser. The franchisees present value calculation would be determined from
the present value of the net annual cash inflows from operating the restaurant
(including the cost of royalties and lease payments) as compared to the cash
outflows for the initial franchise fee and lease purchase option.
Ex. 2512
a.
$ 223,200,000
54,000,000
78,000,000
$ 91,200,000
$ 515,280,000
27,370,000
$ 542,650,000
510,000,000
$ 32,650,000
c.
$ 230,400,000
54,000,000
78,000,000
$ 98,400,000
$ 493,869,600
20,995,000
$ 514,864,600
510,000,000
$ 4,864,600
The net present value is positive. Thus, the increase in price is sufficient to
earn a 15% rate of return.
Ex. 2513
Present value index =
$308,256
= 0.96
$321,100
$158,895
= 1.07
$148,500
Ex. 2514
a. Annual net cash flow
Sewing Machine:
$75,000 = 2,000 hours 50 baseballs $0.75
Annual net cash flow
Packing Machine:
$32,000 = 1,600 $20 labor cost saved per hour
Sewing Machine:
Annual net cash flow (at the end of each of eight years).................
Present value of an annuity of $1 at 15% for 8 years (Exhibit 2).....
Present value of annual net cash flows..............................................
Less amount to be invested.................................................................
Net present value..................................................................................
$ 75,000
4.487
$336,525
311,600
$ 24,925
Packing Machine:
Annual net cash flow (at the end of each of eight years).................
Present value of an annuity of $1 at 15% for 8 years (Exhibit 2).....
Present value of annual net cash flows..............................................
Less amount to be invested.................................................................
Net present value..................................................................................
$ 32,000
4.487
$143,584
126,690
$ 16,894
$336,525
= 1.08
$311,600
$143,584
= 1.13
$126,690
c. The present value index indicates that the packing machine would be the
preferred investment, assuming that all other qualitative considerations are
equal. Note that the net present value of the sewing machine is greater than
the packing machines. However, the sewing machine requires a greater
investment than the packing machine, for very little extra net present value.
Thus, the present value index indicates the packing machine is favored.
Ex. 2515
$46,880 *
$468,800
= 5 years
$93,760
Ex. 2516
a.
Amount to be invested
Annual net cash flow
$74,520
$15,000
4.968
b. 12%
Ex. 2517
Equal annual savings per year:
$250,000,000
= $83,333,333
3
$190,250,0 00
= 2.283
$83,333,33 3
Go to row three in Exhibit 2. In row three, the column associated with the factor
2.283 is 15%. Thus, the internal rate of return under these assumptions is 15%.
Ex. 2518
a. Delivery Truck
Cash received from additional delivery (40,000 bags $0.35)........
Cash used for operating expenses (16,000 miles $0.32)...............
Net cash flow for delivery truck...........................................................
Present value factor for an
annuity of $1 for 6 periods
Amount to be invested
Annual net cash flow
$36,506
$8,880
4.111
$14,000
5,120
$ 8,880
Amount to be invested
Annual net cash flow
=
=
$27,555
$7,280
3.785
$7,280
Ex. 2518
Concluded
b. To: Management
Re: Investment Recommendation
An internal rate of return analysis was performed for the delivery truck and
bagging machine investments. The internal rate of return for the bagging
machine is 15%, while the delivery truck is 12% (detailed analysis available).
In addition, there do not appear to be any qualitative considerations that
would favor the delivery truck. Therefore, the recommendation is to invest in
the bagging machine. If additional funds become available, however, the
delivery truck would be an acceptable investment because the internal rate of
return of 12% exceeds the companys minimum rate of return of 11%.
Ex. 2519
a.
$76,960
84,434
$
Amount to be invested
Annual net cash flow
$84,434
$18,500
4.564
Ex. 2520
With an expected useful life of 4 years, the cash payback period could not be
greater than 4 years. This would indicate that the cost of the initial investment
would not be recovered during the useful life of the asset. However, there would
be no average rate of return in such a case because a net loss would result. If the
25% average rate of return and useful life are correct, the cash payback period
must be less than 4 years. Alternatively, if both the 25% average rate of return and
4.5 years for the cash payback period are correct, the machinery must have a
useful life of more than 4 years.
Ex. 2521
a. Since all the cash flows are incurred in the local economy under this
assumption, it is likely that the internal rate of return of the new plant will
decline. This is because the cash profits earned on the plant will be less in
U.S. dollars as a result of the devaluation. For example, if the product sold for
a profit of 10 units of local currency, it would need to double to 20 units of
local currency in order to generate the same U.S. dollars of profit. This could
be done with a large price increase. However, such a price increase would
probably significantly reduce demand. If the price stayed the same, then the
number of U.S. dollars earned in profit would be halved.
b. If the plant produced for export only, then the expenses would be incurred in
local currency, while the revenues would be earned in U.S. dollars. This could
work in favor of the project because the expenses in U.S. dollar terms would
decline. For example, if the local wages were 16 units of local currency per
hour, then after the devaluation, these 16 units would cost half as much in
U.S. dollar terms (from $4 to $2). Since the product is sold in the United
States, the currency exchange rate would have no impact on revenues. The
net result is that the cash flows in U.S. dollar terms would potentially
increase, increasing the internal rate of return.
PROBLEMS
Prob. 251A
1.
$550,000 + $0
Year
1
0.893
$154,000
$135,000
2
0.797
154,000
145,000
3
0.712
154,000
155,000
4
0.636
154,000
165,000
5
0.567
154,000
170,000
Total................................. $770,000
$770,000
Amount to be invested..............................................
Net present value.......................................................
Present Value of
Net Cash Flow
Tracking
Warehouse
Technology
$137,522
122,738
109,648
97,944
87,318
$555,170
550,000
$ 5,170
$120,555
115,565
110,360
104,940
96,390
$547,810
550,000
$ (2,190)
2. The report to the capital investment committee can take many forms. The
report should, as a minimum, present the following points:
a. Both projects offer the same average annual rate of return.
b. The warehouse net present value exceeds the selected rate established
for discounted cash flows (12%), while the tracking technology does not.
Thus, considering only quantitative factors, the warehouse investment
should be selected.
Prob. 252A
1.
a. Cash payback period for both products: 2 years (the year in which
accumulated net cash flows equal $420,000).
b. Net present value analysis:
Year
Present
Value of
$1 at 15%
1
0.870
$220,000
$150,000
2
0.756
200,000
270,000
3
0.658
180,000
190,000
4
0.572
40,000
30,000
5
0.497
30,000
30,000
Total............................. $670,000
$670,000
Amount to be invested..............................................
Net present value.......................................................
Present Value of
Net Cash Flow
Home &
Todays
Garden
Teen
$191,400
151,200
118,440
22,880
14,910
$498,830
420,000
$ 78,830
$130,500
204,120
125,020
17,160
14,910
$491,710
420,000
$ 71,710
2. The report can take many forms and should include, as a minimum, the
following points:
a. Both products offer the same total net cash flow.
b. Both products offer the same cash payback period.
c. Because of the timing of the receipt of the net cash flows, the Home &
Garden magazine offers a higher net present value.
d. Both products provide a positive net present value. This means both
products would be acceptable, since they exceed the minimum rate of
return.
Prob. 253A
1.
Branch Office Expansion
Year
Present Value
of $1 at 20%
Net Cash
Flow
Present Value of
Net Cash Flow
1
0.833
$260,000
2
0.694
240,000
3
0.579
220,000
Total.............................................................
$720,000
Amount to be invested....................................................................
Net present value.............................................................................
$216,580
166,560
127,380
$510,520
520,000
$ (9,480)
Present Value
of $1 at 20%
Net Cash
Flow
Present Value of
Net Cash Flow
1
0.833
$200,000
2
0.694
195,000
3
0.579
185,000
Total.............................................................
$580,000
Amount to be invested....................................................................
Net present value.............................................................................
$166,600
135,330
107,115
$409,045
380,000
$ 29,045
Present Value
of $1 at 20%
Net Cash
Flow
Present Value of
Net Cash Flow
1
0.833
$325,000
2
0.694
310,000
3
0.579
305,000
Total.............................................................
$940,000
Amount to be invested....................................................................
Net present value.............................................................................
$270,725
215,140
176,595
$662,460
625,000
$ 37,460
Prob. 253A
Concluded
$510,520
= 0.98*
$520,000
$409,045
= 1.08*
$380,000
$662,460
= 1.06*
$625,000
*Rounded.
3. The computer system upgrade has the largest present value index. Although
the Internet bill-pay has the largest net present value, it returns less present
value per dollar invested than does the computer system upgrade, as
revealed by the present value indexes (1.08 to 1.06). (The present value index
for the branch office expansion is less than 1, indicating that it does not meet
the minimum rate of return standard.)
Prob. 254A
1.
a. Radio Station:
Annual net cash flow (at the end of each of four years).............
Present value of an annuity of $1 at 12% for 4 years (Exhibit 2)
Present value of annual net cash flows........................................
Less amount to be invested...........................................................
Net present value.............................................................................
TV Station:
Annual net cash flow (at the end of each of four years).............
Present value of an annuity of $1 at 12% for 4 years (Exhibit 2)
Present value of annual net cash flows........................................
Less amount to be invested...........................................................
Net present value.............................................................................
b. Present value index =
$546,660
= 1.17*
$466,020
$1,457,760
= 1.06*
$1,370,400
*Rounded.
2.
Amount to be invested
Annual net cash flow
$466,020
= 2.589
$180,000
$1,370,400
= 2.855
$480,000
$
$
180,000
3.037
546,660
466,020
80,640
$ 480,000
3.037
$ 1,457,760
1,370,400
$
87,360
Prob. 254A
Concluded
3. By using the internal rate of return method, all proposals are automatically
placed on a common basis. For example, the net present value analyses in
(1a) indicated that the net present value was greater for the TV station.
However, it was necessary to use the present value index to determine that
the radio station had a greater present value per dollar of investment (greater
rate of return). By using the internal rate of return method, it can be easily
seen that the radio stations rate of 20% is greater than the TV stations rate
of 15%.
Prob. 255A
1. Net present value analysis:
Site A:
Annual net cash flow (at the end of each of six years).....................
Present value of an annuity of $1 at 15% for 6 years (Exhibit 2).....
Present value of annual net cash flows..............................................
Less amount to be invested.................................................................
Net present value..................................................................................
$140,000
3.785
$529,900
465,000
$ 64,900
Site B:
Annual net cash flow (at the end of each of four years)...................
Present value of an annuity of $1 at 15% for 4 years (Exhibit 2).....
Present value of annual net cash flows..............................................
Less amount to be invested.................................................................
Net present value..................................................................................
$210,000
2.855
$599,550
465,000
$134,550
Year
Present Value of
$1 at 15%
1
0.870
$140,000 $210,000
2
0.756
140,000
210,000
3
0.658
140,000
210,000
4
0.572
140,000
210,000
Residual value........ 0.572
300,000
0
Total............................................... $860,000 $840,000
Amount to be invested.........................................................
Net present value..................................................................
Present Value of
Net Cash Flow
Site A
Site B
$121,800 $182,700
105,840
158,760
92,120
138,180
80,080
120,120
171,600
0
$571,440 $599,760
465,000
465,000
$106,440 $134,760*
*This amount differs from the net present value calculation in (1) due to
rounding error.
3. To: Investment Committee
Both Sites A and B have a positive net present value. This means that both
projects meet our minimum expected return of 15% and would be acceptable
investments. However, if funds are limited and only one of the two projects
can be funded, then the two projects must be compared over equal lives.
Thus, the residual value of Site A at the end of period 4 is used to equalize the
two lives. The net present value of the two projects over equal lives indicates
that Site B has a higher net present value and would be a superior
investment.
Prob. 256A
1.
Net Cash
Flow
Cumulative
Net Cash Flows
$220,000
220,000
220,000
60,000
$220,000
440,000
660,000
720,000
* The net cash flow for year 4 is $180,000. Hence, the net cash flow per month
is $15,000 ($180,000 12). Thus, 4 months are needed to accumulate an
additional $60,000 (4 $15,000).
Proposal B: 2-year cash payback period, as follows:
Year
1
2
Net Cash
Flow
$40,000
84,000
Cumulative
Net Cash Flows
$ 40,000
124,000
Net Cash
Flow
$80,000
80,000
80,000
60,000
Cumulative
Net Cash Flows
$ 80,000
160,000
240,000
300,000
*The net cash flow required is $60,000 out of $80,000 in year 4, or 75%. Thus,
75% of 12 mos. is 9 mos.
Proposal D: 3-year cash payback period, as follows:
Year
1
2
3
Net Cash
Flow
$80,000
80,000
65,000
Cumulative
Net Cash Flows
$ 80,000
160,000
225,000
Prob. 256A
2.
Continued
( $720,000 +
( $124,000 +
( $300,000
( $225,000 +
Prob. 256A
Continued
Cash Payback
Period
A
B
C
D
3 yrs., 4 mos.
2 yrs.
3 yrs., 9 mos.
3 yrs.
Average Rate
of Return
Accept for
Further Analysis
16.7%
29.0
9.3
23.1
Reject
X*
X
X
X
Present Value
of $1 at 10%
Net Cash
Flow
Present Value of
Net Cash Flow
1
0.909
$ 40,000
2
0.826
84,000
3
0.751
40,000
4
0.683
30,000
5
0.621
20,000
Total.................................................................. $214,000
Amount to be invested....................................................................
Net present value.............................................................................
$ 36,360
69,384
30,040
20,490
12,420
$168,694
124,000
$ 44,694
Proposal D:
Year
Present Value
of $1 at 10%
Net Cash
Flow
Present Value of
Net Cash Flow
1
0.909
$ 80,000
2
0.826
80,000
3
0.751
65,000
4
0.683
65,000
5
0.621
65,000
Total.................................................................. $355,000
Amount to be invested....................................................................
Net present value.............................................................................
$ 72,720
66,080
48,815
44,395
40,365
$272,375
225,000
$ 47,375
Prob. 256A
Concluded
$168,694
= 1.36*
$124,000
$272,375
= 1.21*
$225,000
*Rounded.
6. Based upon the net present value, the proposals should be ranked as
follows:
Proposal D:
$47,375
Proposal B:
$44,694
7. Based upon the present value index (the amount of present value per dollar
invested), the proposals should be ranked as follows:
Proposal B:
1.36
Proposal D:
1.21
8. The present value indexes indicate that although Proposal D has the larger
net present value, it is not as attractive as Proposal B in terms of the amount
of present value per dollar invested. Proposal D requires the larger
investment. Thus, management should use investment resources for
Proposal B before investing in Proposal D.
Prob. 251B
1.
1
0.909
$ 25,000
$ 35,000
2
0.826
25,000
30,000
3
0.751
25,000
25,000
4
0.683
25,000
20,000
5
0.621
25,000
15,000
Total............................... $125,000 $125,000
Amount to be invested..............................................
Net present value.......................................................
Present Value of
Net Cash Flow
Greenhouse Skid Loader
$ 22,725
20,650
18,775
17,075
15,525
$ 94,750
80,000
$ 14,750
$ 31,815
24,780
18,775
13,660
9,315
$ 98,345
80,000
$ 18,345
2. The report to the capital investment committee can take many forms. The
report should, as a minimum, present the following points:
a. Both projects offer the same average annual rate of return.
b. Although both projects exceed the selected rate established for
discounted cash flows, the skid loader offers a larger net present value.
The skid loader has a larger net present value because larger cash flows
occur earlier in time for the skid loader compared to the greenhouse.
Thus, if only one of the two projects can be accepted, the skid loader
would be the more attractive.
Prob. 252B
1.
a. Cash payback period for both projects: 3 years (the year in which
accumulated net cash flows equal $740,000).
b. Net present value analysis:
Year
Present Value of
$1 at 20%
1
0.833
$ 270,000 $ 250,000
2
0.694
250,000
250,000
3
0.579
220,000
240,000
4
0.482
250,000
240,000
5
0.402
260,000
270,000
Total............................... $1,250,000 $1,250,000
Amount to be invested..............................................
Net present value.......................................................
Present Value of
Net Cash Flow
Plant
Retail Store
Expansion
Expansion
$224,910
173,500
127,380
120,500
104,520
$750,810
740,000
$ 10,810
$208,250
173,500
138,960
115,680
108,540
$744,930
740,000
$ 4,930
2. The report can take many forms and should include, as a minimum, the
following points:
a. Both projects offer the same total net cash flow.
b. Both projects offer the same cash payback period.
c. Because of the timing of the receipt of the net cash flows, the plant
expansion offers a higher net present value.
d. Both projects provide a positive net present value. This means both
projects would be acceptable, since they exceed the minimum rate of
return.
Prob. 253B
1.
Route Expansion
Year
Present Value
of $1 at 15%
Net Cash
Flow
1
0.870
$ 420,000
2
0.756
380,000
3
0.658
350,000
Total................................................. $1,150,000
Amount to be invested.........................................................
Net present value..................................................................
Present Value of
Net Cash Flow
$365,400
287,280
230,300
$882,980
840,000
$ 42,980
Acquire Railcars
Year
Present Value
of $1 at 15%
Net Cash
Flow
1
0.870
$225,000
2
0.756
200,000
3
0.658
180,000
Total.................................................
$605,000
Amount to be invested.........................................................
Net present value..................................................................
Present Value of
Net Cash Flow
$195,750
151,200
118,440
$465,390
490,000
$ (24,610)
Present Value
of $1 at 15%
Net Cash
Flow
1
0.870
$210,000
2
0.756
200,000
3
0.658
180,000
Total.................................................
$590,000
Amount to be invested.........................................................
Net present value..................................................................
Present Value of
Net Cash Flow
$182,700
151,200
118,440
$452,340
420,000
$ 32,340
Prob. 253B
Concluded
$465,390
= 0.95*
$490,000
$452,340
= 1.08*
$420,000
*Rounded.
3. The maintenance yard has the largest present value index. Although route
expansion has the largest net present value, it returns less present value per
dollar invested than does the maintenance yard, as revealed by the present
value indexes (1.08 to 1.05). (The present value index for the railcars is less
than 1, indicating that it does not meet the minimum rate of return standard.)
Prob. 254B
1.
a. Generating Unit:
Annual net cash flow (at the end of each of four years)...................
Present value of an annuity of $1 at 10% for 4 years (Exhibit 2).....
Present value of annual net cash flows..............................................
1,902,000
Less amount to be invested.................................................................
Net present value..................................................................................
Distribution Network Expansion:
Annual net cash flow (at the end of each of four years)...................
Present value of an annuity of $1 at 10% for 4 years (Exhibit 2).....
Present value of annual net cash flows..............................................
Less amount to be invested.................................................................
Net present value..................................................................................
b. Present value index =
*Rounded.
2.
Amount to be invested
Annual net cash flow
$1,822,200
$456,800
= 2.855
$160,000
$ 600,000
3.17
$
$
1,822,200
79,800
$160,000
3.17
$507,200
456,800
$ 50,400
Prob. 254B
Concluded
3. By using the internal rate of return method, all projects are automatically
placed on a common basis. For example, it was necessary to use the present
value index to determine that the distribution network expansion had a
greater present value per dollar of investment (greater rate of return). By
using the internal rate of return method, it can be easily seen that the
distribution network expansions rate of return of 15% is greater than the
generating units rate of 12%.
Prob. 255B
1. Net present value analysis:
Project I:
Annual net cash flow (at the end of each of six years)..................
Present value of an annuity of $1 at 15% for 6 years (Exhibit 2)...
Present value of annual net cash flows...........................................
Less amount to be invested..............................................................
Net present value................................................................................
$ 65,000
3.785
$246,025
200,000
$ 46,025
Project II:
Annual net cash flow (at the end of each of four years)................
Present value of an annuity of $1 at 15% for 4 years (Exhibit 2)...
Present value of annual net cash flows...........................................
Less amount to be invested..............................................................
Net present value................................................................................
$
97,500
2.855
$278,362.50
200,000.00
$ 78,362.50
Year
Present Value of
$1 at 15%
1
0.870
$ 65,000 $ 97,500
2
0.756
65,000
97,500
3
0.658
65,000
97,500
4
0.572
65,000
97,500
Residual value..... 0.572
140,000
0
Total............................................ $400,000 $390,000
Amount to be invested....................................................
Net present value.............................................................
Present Value of
Net Cash Flow
Project I Project II
$ 56,550
49,140
42,770
37,180
80,080
$265,720
200,000
$ 65,720
$ 84,825
73,710
64,155
55,770
0
$278,460
200,000
$ 78,460*
* This amount differs from the net present value calculation in (1) due to
rounding error.
3. To: Investment Committee
Both Projects I and II have a positive net present value. This means that both
projects meet our minimum expected return of 15% and would be acceptable
investments. However, if funds are limited and only one of the two projects
can be funded, then the two projects must be compared over equal lives.
Thus, the residual value of Project I at the end of period 4 is used to equalize
the two lives. The net present value of the two projects over equal lives
indicates that Project II has a higher net present value and would be a
superior investment.
Prob. 256B
1.
Net Cash
Flow
Cumulative
Net Cash Flows
1
2
3
4
$140,000
140,000
140,000
80,000
$140,000
280,000
420,000
500,000
Net Cash
Flow
Cumulative
Net Cash Flows
$100,000
80,000
45,000
$100,000
180,000
225,000
*The cash flow required for investment payback in Year 3 is $45,000, which is
three-fourths ($45,000 $60,000) of Year 3s cash flow. Thus, 9 months
(three-fourths of 12 months) are needed to accumulate an additional
$45,000.
Proposal C: 3-year cash payback period, as follows:
Year
Net Cash
Flow
Cumulative
Net Cash Flows
1
2
3
$220,000
200,000
180,000
$220,000
420,000
600,000
Net Cash
Flow
Cumulative
Net Cash Flows
$125,000
95,000
60,000
20,000
$125,000
220,000
280,000
300,000
*The cash flow required for investment payback in Year 4 is $20,000, which is
one-third ($20,000 $60,000) of Year 4s cash flow. Thus, 4 months (one-third
of 12 months) are needed to accumulate an additional $20,000.
Prob. 256B
2.
Continued
( $500,000 + $0)
$16,000
= 6.4%
$250,000
( $225,000 +
( $600,000 + $0)
Prob. 256B
Continued
Cash Payback
Period
Average Rate
of Return
4 yrs.
2 yrs., 9 mos.
3 yrs.
3 yrs., 4 mos.
Accept for
Further Analysis
6.4%
24.0
22.0
13.3
Reject
X
X
X
X*
Present Value
of $1 at 10%
Net Cash
Flow
Present Value of
Net Cash Flow
1
0.909
$100,000
2
0.826
80,000
3
0.751
60,000
4
0.683
60,000
5
0.621
60,000
Total.................................................................. $360,000
Amount to be invested....................................................................
Net present value.............................................................................
$ 90,900
66,080
45,060
40,980
37,260
$280,280
225,000
$ 55,280
Proposal C:
Year
Present Value
of $1 at 10%
Net Cash
Flow
Present Value of
Net Cash Flow
1
0.909
$220,000
2
0.826
200,000
3
0.751
180,000
4
0.683
180,000
5
0.621
150,000
Total.................................................................. $930,000
Amount to be invested....................................................................
Net present value.............................................................................
$199,980
165,200
135,180
122,940
93,150
$716,450
600,000
$116,450
Prob. 256B
Concluded
$280,280
= 1.25*
$225,000
$716,450
= 1.19*
$600,000
*Rounded.
6. Based upon the net present value, the proposals should be ranked as
follows:
Proposal C:
$116,450
Proposal B:
$55,280
7. Based upon the present value index (the amount of present value per dollar
invested), the proposals should be ranked as follows:
Proposal B:
1.25
Proposal C:
1.19
8. The present value indexes indicate that although Proposal C has the larger
net present value, it is not as attractive as Proposal B in terms of the amount
of present value per dollar invested. Proposal C requires the larger
investment. Thus, management should use investment resources for
Proposal B before investing in Proposal C.
SPECIAL ACTIVITIES
Activity 251
The plant manager wants a project to become accepted and places pressure on
the analyst to come up with the right numbers. I. M. is right when he states that
the net present value analysis has many assumptions and room for
interpretation. Many use this room for interpretation to work the numbers until
they satisfy the minimum return (hurdle) rate. In fact, some analysts state that
they start with the hurdle rate and work back into the numbers. Clearly, this is not
what should be expected of Kelly.
Kelly made an honest effort to discuss the assumptions. Kellys last statement
was an open attempt to begin a conversation around assumptions. This is
legitimate. Notice that I. M. jumped on that opening and dictated a course of
action. Instead of discussing assumptions, I. M. stated what the assumptions are
to be and how they are to be reflected in the analysis. This is no more than
cooking the analysis. Kelly needs to respond strongly to this attempt by I. M. to
circumvent the process by countering his argument. For example, Kelly might
point out that it is by no means clear that more storage space translates into
more sales. In fact, it is probably just the opposite. More storage space means
that more product waits a long time before being shipped to the customer. This
means that the customer is guaranteed to receive dated product that may be
inferior to product that has been recently produced. More warehouse space is
counter to a just-in-time orientation. Kelly is really trying to prevent the plant
manager from going down the wrong path. I. M. needs to work on his systems so
that he doesnt need the warehouse space.
This very difficult issue revolves around the nature of ethical dilemmas. Kelly has
brief tenure with the organization. She has very little organizational clout and
could easily find her career short-circuited by crossing I. M. It might be tempting
for Kelly to slide on this oneafter all, who would know? If the project is
eventually a failure, its unlikely that the decision would come back to haunt Kelly.
Much time will have passed, and Kelly will likely be in another job in the company.
The decision to confront I. M. has immediate repercussions. This is the heart of
real world ethical dilemmas. The dilemma occurs when the ethical decision has
grave short-term consequences (I. M. short-circuits the career) and few seemingly
long-term rewards (no one sees the ethical decision), while the unethical decision
looks appealing in the short term (I. M. is my friend) and potentially safe in the
long term (whos going to find out?). The ethical management accountant will
recognize these pressures and make the short-term decisions in order to build a
strong reputation that can be a very powerful asset later in ones career. The key
is to recognize that trading off short-term gain for ones long-term reputation can
be very harmful. Thus, enlightened self-interest indicates that the ethical course
of action to rebuff I. M. is rational and correct.
Activity 252
1. Annual salary................................................................................
Present value of $1 annuity for 10 years at 10%......................
Present value of undergraduate option as of the end
of undergraduate degree (beginning of graduate
degree)....................................................................................
$ 40,000
6.145
$ (12,000)
$ 245,800
Annual salary................................................................................
Present value of $1 annuity for 9 years at 10%........................
Present value salary to end of graduate year...........................
Present value of $1 for 1 year at 10%........................................
Present value of salary at the beginning of graduate year.....
$ 50,000
5.759
$ 287,950
0.909
$ 261,747
$ 249,747
10
50K
50K
50K
50K
50K
50K
50K
50K
50K
$ 249,747
245,800
$ 3,947
Note to Instructors: This solution accounts for the opportunity cost of graduate
school in terms of lost earnings during the graduate year. To maintain simplicity,
the solution does not account for likely growth in earnings over time.
Activity 253
$1,250,000
Activity 254
In all three companies, the executives indicate that financial investment analysis
plays a minor role in the selection of projects. The reason is that all three
companies deal with products that have highly uncertain future cash flows. Thus,
any attempt at a financial investment analysis could be highly suspect. Instead,
these managers rely on strategic considerations. These considerations include
responding to competitors, developing new markets and products for customers,
and improving quality. The executives indicate that business judgment is more
important for these strategic, longer-term decisions than is financial investment
analysis. This suggests that financial investment analysis is better suited for
investments that have more predictable cash flows with possible short duration.
Activity 255
1. Average rate of return =
$180,000 4
Project A: (
= 25%
$360,000 + $0) 2
Project B:
$187,200 4
= 26%
($360,000 + $0) 2
Year
Present Value of
$1 at 12%
Present Value of
Net Cash Flow
Project A
Project B
1
0.893
$ 155,000
$ 115,000
$ 138,415
2
0.797
140,000
130,000
111,580
3
0.712
130,000
148,000
92,560
4
0.636
115,000
154,200
73,140
Total....................................... $ 540,000
$ 547,200
$ 415,695
Amount to be invested......................................................
360,000
Net present value............................................................... $ 55,695
$ 102,695
103,610
105,376
98,071
$ 409,752
360,000
$ 49,752
As the analysis indicates, the internal rate of return for Projects A and B
exceeds 12%. Thus, although the average rate of return is higher for Project B,
the timing of the receipt of the net cash flows for Project A results in a higher
net present value than for Project B.
Activity 256
This activity could be assigned individually or in groups. This activity has the
student(s) perform a capital investment analysis for a desktop computer, using
information available to them on the Internet and from a local business. The
actual answer depends on the actual numbers determined by the student(s). Have
a number of students (or groups) provide their answers to the class and note the
variation (or lack thereof) between the various analyses. Use this to show that
there are often many answers to even simple problems, depending on the
assumptions (e.g., what is considered a mid-range computer) and underlying
data (e.g., rental rate). Below is a sample answer based on our own data and
assumptions:
Assumed hourly rental rate..............................................................
Semester cost (35 hours $12).......................................................
Present value of $420 for six semiannual periods at 5%
($420 5.07569)......................................................................
Less assumed price of a mid-range computer..............................
Net present value..............................................................................
The computer should be purchased.