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CHAPTER 25

CAPITAL INVESTMENT ANALYSIS


CLASS DISCUSSION QUESTIONS
1. The principal objections to the use of the
average rate of return method are its failing
to consider the expected cash flows from
the proposals and the timing of these flows.
2. The principal limitations of the cash payback
method are its failure to consider cash flows
occurring after the payback period and its
failure to use present value concepts.
3. The average rate of return is not based on
cash flows, but on operating income. Thus,
for example, the average rate of return will
include the impact of depreciation, but the
internal rate of return will not. In addition,
the internal rate of return approach will use
time value of money concepts, while the
average rate of return does not.
4. The cash payback period ignores the cash
flows that occur after the cash payback
period, while the net present value method
includes all cash flows in the analysis. The
cash payback period also ignores the time
value of money, which is also included in
the net present value method.
5. A one-year payback will not equal a 100%
average rate of return because the payback
period is based on cash flows, while the
average rate of return is based on income.
The depreciation on the project will prevent
the two methods from reconciling.
6. The cash payback period ignores cash flows
occurring after the payback period, which
will often include large salvage values.
7. The majority of the cash flows of a new
motion picture are earned within two years
of release. Thus, the time value of money
aspect of the cash flows is less significant
for motion pictures than for projects with
time extended cash flows. This would favor
the use of a cash payback period for
evaluating the cash flows of the project.
8. The $9,750 net present value indicates that
the proposal is desirable because the
proposal is expected to recover the
investment and provide more than the
minimum rate of return.
9. The net present values indicate that both
projects are desirable, but not necessarily

10.

11.

12.
13.

14.

15.

16.

95

equal in desirability. The present value index


can be used to compare the two projects.
For example, assume one project required
an investment of $10,000 and the other an
investment of $100,000. The present value
indexes would be calculated as 0.5 and
0.05, respectively, for the two projects. That
is, a $5,000 net present value on a $10,000
investment would be more desirable than
the same net present value on a $100,000
investment.
The computations for the net present value
method are more complex than those for
the methods that ignore present value. Also,
the method assumes that the cash received
from the proposal during its useful life will
be reinvested at the rate of return used to
compute the present value of the proposal.
This assumption may not always be
reasonable.
The computations for the internal rate of
return method are more complex than those
for the methods that ignore present value.
Also, the method assumes that the cash
received from the proposal during its useful
life will be reinvested at the internal rate of
return.
Allowable deductions for depreciation.
The life of the proposal with the longer life
can be adjusted to a time period that is
equal to the life of the proposal with the
shorter life.
The major advantages of leasing are that it
avoids the need to use funds to purchase
assets and reduces some of the risk of loss
if the asset becomes obsolete. There may
also be some income tax advantages to
leasing.
The speed-up of delivery of products, higher
production
quality,
and
greater
manufacturing flexibility are examples of
qualitative
factors
that
should
be
considered.
Monsanto indicated that it recognized that
the market was demanding higher product
quality that could be achieved only with a
large investment in process control
technology and automated laboratory

equipment. The process control technology


could reduce the variation in the size of
fibers. More uniform fibers, in turn, improve
the efficiency of the processes used by
carpet manufacturers. The local area
network (LAN) was not a stand-alone
investment, but it linked the process control
information to operators and management
via computer linkages. Thus, the LAN was
an integral part of the investment portfolio.
Monsanto
indicated
the
following
considerations in making its investment:
a. After-tax cash flows.
b. Labor savings.

c. Accepting projects that do not have a


quantifiable payback, such as enablers
that allow projects with more visible
benefits to be put into place (such as
LAN enabling the process control
technology
to
communicate
information).
d. Allowing estimates of increased sales
due to higher quality.
e. Considering inventory reductions in the
cost of savings.
f. Avoiding reactive investment but
considering the organizational vision
and long-term strategic direction in the
investment decision.

96

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

Average rate of return:


$2,625 $21,000..............................................................
$2,450 $28,000..............................................................

12.5%

$2,450

$28,000

Ex. 252
Average
Average annual income
= Average investment
rate
of return
=

Average savings* Annual depreciation Additional operating costs

Beginning cost + Residual value 2


$26,000
$88,000 8 $8,250
=
$94,000 + $6,000 2
=

$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
=

Annual revenues Annual product costs *

Beginning cost + Residual value

($325 4,500 units)


($295 4,500 units)
($870,000 + $30,000) 2

$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

*The fixed overhead relates to the depreciation on the equipment [($184,000


$10,000) 15 years 8,000 units = $1.45]. Depreciation is not a cash flow and
should not be considered in the analysis.

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)

2007 home video sales:


Total sales...................................................................
Net cash margin.........................................................
Net cash flow...................................................................

$ 90
30%
$ 27

2008 pay TV......................................................................


2009 syndication.............................................................

20
5

Net present value:


Year

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

Maintenance costs per year........................


Annual net cash flow...................................
b. Annual net cash flow (at the end of each of five years)....................
Present value of annuity of $1 at 10% for five periods.....................
Present value of annual net cash flows..............................................
Less: Amount to be invested...............................................................
Net present value..................................................................................

(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

Lease purchase option......................................................


Present value of $1 for 10 years at 10% (Exhibit 1)........
Present value of lease purchase option..........................

Net present value per restaurant unit..............................

67,500
175,000
242,500

600,000
0.386
231,600
28,7631

$1,693,000 + $1,490,163 + $231,600. Thus, the restaurant exceeds IHOPs


minimum rate of return objective.

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.

Revenues (3,000 80% 300 days $310)..................................


Less: Variable expenses (3,000 80% 300 days $75)..........
Fixed expenses (other than depreciation)........................
Annual net cash flow.......................................................................

$ 223,200,000
54,000,000
78,000,000
$ 91,200,000

b. Present value of annual net cash flows ($91,200,000 5.65).....


Present value of salvage value ($85,000,000 0.322).................
Total present value..........................................................................
Initial investment..............................................................................
Net present value.............................................................................

$ 515,280,000
27,370,000
$ 542,650,000
510,000,000
$ 32,650,000

c.

Annual cash flow assuming $320 revenue per cruise day:


Revenues (3,000 80% 300 days $320)..................................
Less: Variable expenses (3,000 80% 300 days $75)..........
Fixed expenses (other than depreciation)........................
Annual net cash flow.......................................................................

$ 230,400,000
54,000,000
78,000,000
$ 98,400,000

Net present value calculation at 15% minimum rate of return:


Present value of annual net cash flows ($98,400,000 5.019)...
Present value of salvage value ($85,000,000 0.247).................
Total present value..........................................................................
Initial investment..............................................................................
Net present value.............................................................................

$ 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 =

Total present value of net cash flow


Amount to be invested

Present value index of Proposal A:

$308,256
= 0.96
$321,100

Present value index of Proposal B:

$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

b. Present value index =

Total present value of net cash flow


Amount to be invested

Present value index of the sewing machine:


Present value index of the packing machine:

$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 *

a. Average rate of return on investment: $468,800 2 = 20%


* The annual earnings are equal to the cash flow less the annual depreciation
expense, shown as follows:
$93,760 ($468,800 10 years) = $46,880
b. Cash payback period:
c.

$468,800
= 5 years
$93,760

Present value of annual net cash flows ($93,760 5.65*)................


$529,744
Amount to be invested..........................................................................
468,800
Net present value..................................................................................
$ 60,944
*Present value of an annuity of $1 at 12% for 10 periods from chapter table.

Ex. 2516
a.

Present value factor for an


annuity of $1 for 8 periods

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

Present value of an annuity factor:

$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

Internal Rate of Return = 12% (from text Exhibit 2)


Bagging Machine
Direct labor savings (2.0 hrs./day $14/hr. 260 days/yr.)..............
Present value factor for an
annuity of $1 for 6 periods

Amount to be invested
Annual net cash flow

=
=

$27,555
$7,280

3.785

Internal Rate of Return = 15% (from text Exhibit 2)

$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.

Present value of annual net cash flows ($18,500 4.16*)................


Amount to be invested..........................................................................
Net present value..................................................................................
(7,474)

$76,960
84,434
$

*Present value of an annuity of $1 at 15% for 7 periods from text Exhibit 2.


b. The rate of return is less than 15% because there is a negative net present
value.
c. Present value factor for an annuity of $1 =

Internal rate of return

Amount to be invested
Annual net cash flow

$84,434
$18,500

4.564

12% (from text Exhibit 2)

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.

a. Average annual rate of return for both projects:


$220,000 5
$44,000
=
= 16%
$275,000
2

$550,000 + $0

b. Net present value analysis:

Year

Net Cash Flow


Present Value of
Tracking
$1 at 12%
Warehouse Technology

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%

Net Cash Flow


Home &
Todays
Garden
Teen

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)

Computer System Upgrade


Year

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

Install Internet Bill-Pay


Year

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

2. Present value index =

Total present value of net cash flow


Amount to be invested

Present value index of branch office:

$510,520
= 0.98*
$520,000

Present value index of computer system:


Present value index of Internet bill-pay:

$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 =

Total present value of net cash flow


Amount to be invested

Present value index of the radio station:


Present value index of the TV station:

$546,660
= 1.17*
$466,020

$1,457,760
= 1.06*
$1,370,400

*Rounded.
2.

a. Present value factor for an annuity of $1 =


Radio Station:
TV Station:

Amount to be invested
Annual net cash flow

$466,020
= 2.589
$180,000

$1,370,400
= 2.855
$480,000

b. Internal rate of return: (determined from Exhibit 2 in text)


Radio Station: 20%
TV Station: 15%

$
$

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

2. Net present value analysis:

Year

Present Value of
$1 at 15%

Net Cash Flow


Site A
Site B

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.

Proposal A: 3-year and 4 months cash payback period, as follows:


Year
1
2
3
4 months*

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

Proposal C: 3-year and 9 months cash payback period, as follows:


Year
1
2
3
9 months*

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

Proposal A: 16.7% average rate of return, determined as follows:


$300,000 5
$60,000
=
= 16.7% (rounded)
$360,000
$0) 2

( $720,000 +

Proposal B: 29% average rate of return, determined as follows:


$18,000
$90,000 5
=
= 29.0% (rounded)
$62,000
$0) 2

( $124,000 +

Proposal C: 9.3% average rate of return, determined as follows:


$70,000 5
$14,000
=
= 9.3% (rounded)
$150,000
+ $0) 2

( $300,000

Proposal D: 23.1% average rate of return, determined as follows:


$130,000 5
$26,000
=
= 23.1% (rounded)
$112,500
$0) 2

( $225,000 +

Prob. 256A

Continued

3. Of the four proposed investments, only Proposals B and D meet the


companys requirements, as the following table indicates:
Proposal

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

* Proposal A is rejected because it fails to meet the maximum payback period


requirement, even though it meets the minimum accounting rate of return
requirement.
4.
Proposal B:
Year

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

5. Present value index =

Total present value of net cash flow


Amount to be invested

Present value index of Proposal B:

$168,694
= 1.36*
$124,000

Present value index of Proposal D:

$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.

a. Average annual rate of return for both projects:


$45,000 5
$9,000
$80,000 $0 2 = $40,000 = 22.5%

b. Net present value analysis:


Present Value of
Year
$1 at 10%

Net Cash Flow


Greenhouse Skid Loader

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%

Net Cash Flow


Plant
Retail Store
Expansion Expansion

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)

New Maintenance Yard


Year

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

2. Present value index =

Total present value of net cash flow


Amount to be invested
$882,980

Present value index of route expansion: $840,000 = 1.05*


Present value index of railcars:

$465,390
= 0.95*
$490,000

Present value index of maintenance yard:

$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 =

Total present value of net cash flow


Amount to be invested
$1,902,000

Present value index of the generating unit: $1,822,200 = 1.04*


Present value index of the distribution network expansion:
$507,200
= 1.11*
$456,800

*Rounded.
2.

a. Present value factor for an annuity of $1 =

Amount to be invested
Annual net cash flow

$1,822,200

Generating unit: $600,000 = 3.037


Distribution network expansion:

$456,800
= 2.855
$160,000

b. Internal rate of return: (determined from Exhibit 2 in text)


Generating unit: 12%
Distribution network expansion: 15%

$ 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

2. Net present value analysis:

Year

Present Value of
$1 at 15%

Net Cash Flow


Project I Project II

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.

Proposal A: 4-year cash payback period, as follows:


Year

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

Proposal B: 2-year, 9-month cash payback period, as follows:


Year
1
2
9 months*

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

Proposal D: 3-year, 4-month cash payback period, as follows:


Year
1
2
3
4 months*

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

Proposal A: 6.4% average rate of return, determined as follows:


$80,000 5

( $500,000 + $0)

$16,000
= 6.4%
$250,000

Proposal B: 24% average rate of return, determined as follows:


$27,000
$135,000 5
=
= 24%
$112,500
$0) 2

( $225,000 +

Proposal C: 22% average rate of return, determined as follows:


$330,000 5
$66,000
=
= 22%
$300,000
2

( $600,000 + $0)

Proposal D: 13.3% average rate of return, determined as follows:


$20,000
$100,000 5
=
= 13.3%
$150,000
($300,000 + $0) 2

Prob. 256B

Continued

3. Of the four proposed investments, only Proposals B and C meet the


companys requirements, as the following table indicates:
Proposal
A
B
C
D

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*

*Proposal D is rejected because it fails to meet the maximum payback period


requirement, even though it meets the minimum accounting rate of return
requirement.
4.
Proposal B:
Year

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

5. Present value index =

Total present value of net cash flow


Amount to be invested

Present value index of Proposal B:

$280,280
= 1.25*
$225,000

Present value index of Proposal C:

$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

2. Annual tuition at the beginning of the graduate year..............

$ (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

Present value of graduate option at beginning of graduate


year (salary less tuition)........................................................

$ 249,747

Note: The present values of 1. and 2. must both be determined as of the


beginning of the graduate year in order to be compared. Thus, the present
value of the salary at the end of graduate school must be brought back one
period to the beginning of the graduate year, since this salary stream is
delayed by one year of schooling. The timeline below shows the calculation:
1
($12,000)
$261,747
$249,747

10

50K

50K

50K

50K

50K

50K

50K

50K

50K

($50,000 5.759) 0.909

3. Present value of graduate option..............................................


Present value of undergraduate option....................................
Net benefit of graduate option...................................................

$ 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

1. Payback period: $250,000 = 5 years


2. Net present value:
Present value factor for an annuity of $1, 10 periods at 10%: 6.145
Net present value = (6.145 $250,000) $1,250,000 = $286,250
3. Some critical elements that are missing from this analysis are:
a. The manager is viewing the acquisition of robots as a labor-saving device.
This is probably a limited way to view the investment. Instead, the robots
should allow the company to produce the product with higher quality and
higher flexibility. This should translate into greater sales volume, better
pricing, and lower inventories. All of these could be brought into the
analysis.
b. The cost of the robots does not stop with the initial purchase price and
installation costs. The robots will require the company to hire engineers
and support personnel to keep the machines running, to program the
software, and to debug new programs. The operators will require new
training. Thus, extensive training costs will likely be incurred. It would not
be surprising to see a large portion of the direct labor savings lost by
hiring expensive indirect labor support for the technology.
c. There will likely be a start-up or learning curve with this new technology
that will cause the benefits to be delayed.
d. The analysis fails to account for taxes.

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 =

Estimated average annual income


Average investment

$180,000 4

Project A: (
= 25%
$360,000 + $0) 2
Project B:

$187,200 4
= 26%
($360,000 + $0) 2

2. The timing of net cash flows to be received from a capital investment


proposal is important because cash on hand can be invested to earn more
cash. Therefore, the sooner the cash is received from a project, the better.
One means of evaluating the effect of the timing of net cash flows on projects
is to establish a minimum rate of return and then use the net present value
method to determine whether or not the present value from the project
exceeds the amount to be invested. If the present value equals or exceeds the
amount of the investment, the project is desirable. For Projects A and B, the
net present value method of analysis, based on a rate of return of 12%, is
illustrated below.

Year

Present Value of
$1 at 12%

Net Cash Flow


Project A
Project B

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.

$12 per hour


$420
$2,132
1,500
$ 632