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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

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

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.

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

$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

=

$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

=

($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

$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)

Total sales...................................................................

Net cash margin.........................................................

Net cash flow...................................................................

$ 90

30%

$ 27

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

20

5

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

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

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

Present value of lease purchase option..........................

67,500

175,000

242,500

600,000

0.386

231,600

28,7631

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.

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

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.

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

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 =

Amount to be invested

$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

Amount to be invested

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 *

* 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

$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.

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

$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

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

$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.

Amount to be invested..........................................................................

Net present value..................................................................................

(7,474)

$76,960

84,434

$

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 =

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.

$220,000 5

$44,000

=

= 16%

$275,000

2

$550,000 + $0

Year

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%

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)

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

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

Amount to be invested

$510,520

= 0.98*

$520,000

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 =

Amount to be invested

Present value index of the TV station:

$546,660

= 1.17*

$466,020

$1,457,760

= 1.06*

$1,370,400

*Rounded.

2.

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

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

Year

Present Value of

$1 at 15%

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.

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

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

$300,000 5

$60,000

=

= 16.7% (rounded)

$360,000

$0) 2

( $720,000 +

$18,000

$90,000 5

=

= 29.0% (rounded)

$62,000

$0) 2

( $124,000 +

$70,000 5

$14,000

=

= 9.3% (rounded)

$150,000

+ $0) 2

( $300,000

$130,000 5

$26,000

=

= 23.1% (rounded)

$112,500

$0) 2

( $225,000 +

Prob. 256A

Continued

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

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

Amount to be invested

$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.

$45,000 5

$9,000

$80,000 $0 2 = $40,000 = 22.5%

Present Value of

Year

$1 at 10%

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%

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)

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

Amount to be invested

$882,980

Present value index of railcars:

$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 =

Amount to be invested

$1,902,000

Present value index of the distribution network expansion:

$507,200

= 1.11*

$456,800

*Rounded.

2.

Amount to be invested

Annual net cash flow

$1,822,200

Distribution network expansion:

$456,800

= 2.855

$160,000

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

Year

Present Value of

$1 at 15%

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.

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

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

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

$80,000 5

( $500,000 + $0)

$16,000

= 6.4%

$250,000

$27,000

$135,000 5

=

= 24%

$112,500

$0) 2

( $225,000 +

$330,000 5

$66,000

=

= 22%

$300,000

2

( $600,000 + $0)

$20,000

$100,000 5

=

= 13.3%

$150,000

($300,000 + $0) 2

Prob. 256B

Continued

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*

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

Amount to be invested

$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

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

$ 249,747

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

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

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 =

Average investment

$180,000 4

Project A: (

= 25%

$360,000 + $0) 2

Project B:

$187,200 4

= 26%

($360,000 + $0) 2

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%

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.

$420

$2,132

1,500

$ 632

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