. ee Solutions to Salt Study Problems 331 10.3 Accounting rate of return Internal rate of return 10.5 Modified internal rate of return Self-Study Problems 10.4 Premium Manufacturing Company is evaluating two forklift systems to us i its plant that pro duces the towers for a windmill power farm The costs and the cash flows from these systems ate shown below. Ifthe company uses « 12 percent discount rate forall projects, determine which forkit system should be purchased using the net present value (NPV) approach Yearo Year Year2 Year 3 : =$31123.450 $979,225 $1,358,886 $2,111,497 Forklifts —$4137.410 $875,236, $1,765,225 $2,865,110 10.2 Ruiledge, Inc., has invested $100,000 ina project that will produce cash flows of $45,000, $37,500, ‘and $42,950 over the next three years. Find the payback period forthe project. 10.3 Perryman Crafts Corp. is evaluating two independent capital projects that will each cost the ‘company $250,000. The two projects will provide the following cash flows Year Project A Project B 1 $80,750 $32,450 2 93,450 76,125 3 40,235. 153,250 gai 145,655 96,110 ‘Which project will be chosen ifthe company's payback criterion is three years? What if the com. [pany accepts all projects as long as the payback period is less than five years? 10.4 Terrell Corp. is looking into purchasing a machine for its business that will cost $117,250 and will be depreciated on a straight-line basis over a five-year period. The sales and expenses (excluding depre- ation) for the next five years are shown in the following table. The company’s tax rate is 4 percent. Year3 Year Years $242,455 $255440 $267,125 $1499 $143,112 $133,556 ‘The company will accept all projects that provide an accounting rate of return (ARR) of at least 45, percent. Should the company accept this project? 10.5. Refer to Problem 10.1. Compute the IRR for each ofthe two systems. Is the investment decision 4ifferent from the one indicated by NPV? Solutions to Self-Study Problems 10.1. NPVs for two forklift systems: [NPV for Otis Forklifts: ¢,_NCE, NPVou = Bare a $979,225 | $1,358,886 , $2.111497 = =$3,123,450 + $979225 , $1,358,886 , S2111007 ete uy * uP = =$3,123,450 + $874,308 + $1,083,296 + $1,502,922(1.127 [3710 + $781,461 + $1,407,227 + $2,039,329 the Otis forklift since it has a larger NPV. ct Frey + Cea age $17,500 $42,950 per yearSons 37440 572.679 23,450 pied) peat) $70,350 § 46,900 TG ne = (~$24,691 + $17,778 + = $35,143.60 $51,293 + $58,659 + $72,679)/5 s2u1497 sh (us) 27,513 + $1,388,344 5 + $1,318,357of Copital Budgeting ions “40.1. Explain why the cost of apa is referred to asthe “hurdle” rate in capital Budgeting, “40.2 @. Acompany is building « new plant onthe outskirts of Smallesile. The town has offered to donate the land, and as part of the agreement, the company will have to build an access road {from the main highway to the plant. How will the project of building of the road be classified in capital budgeting analysis? bb. Sykes, Inc. is considering two projects: a plant expansion and a new computer system for the firms production department. Classify these projects as independent, mutually exclusive, ‘or contingent projects and explain your reasoning. ‘¢. Your firm is currently considering the upgrading of the operating systems of all the firm's ‘One alternative is to choose the Linux operating system that a local computer ‘services firm has offered to install and maintain. Microsoft has also put in a bid to install the ‘new Windows Vista operating system for businesses. What types of projects are these? In the context of capital budgeting, what is “capital rationing”? Provide two conditions under which a set of projects might be characterized as mutually exclusive. ‘a A firm invests in a project that is expected to ear a return of 12 percent. Ifthe appropriate ‘ost of capital i also 12 percent, 1b. What isthe impact on the frm ifit accepts a project with a negative NPV? ‘dentfy the weaknesses of the payback period method, at are the strengths and weaknesses ofthe accounting rate of return approach? -what circumstances might the IRR and NPV approaches have conflicting results? ‘modified IRR (MIRR) alleviates two concerns with using the IRR method for evaluating investments. What are | ‘Construction Company has an overall (composite) cost of capital of 12 percent. This ost of capital reflects the cost of capital for an Elkridge Construction project with average risk. the frm takes on projects of various risk levels. The company experience suggests that tisk projects have a cost of capital of 10 percent and high-risk projects have a cost of capital Percent. Which ofthe following projects should the company select to maximize share sent is planning t0 spend $650,000 on a new this action will result in additional cash flows of discount rate is 17.5 percent, what is the NPV on, 1s considering purchasing «new machine at FD «cashflows of $814,322, $863,275,Questions and Problems 335 Mints, confectioner, is considering purchasing a new jelly bean- ‘of $312,500. The company’s management projects thatthe cash flows '$121,450 for the next seven years. Ifthe appropriate discount rate is for the project? Incorporated management is considering investing in two alterna- systems are mutually exclusive, and the cost of the new equipment are shown in the accompanying table. Ifthe firm uses a 9 percent tion systems, in which system should the firm invest? hat are the payback periods for production systems 1 and. and the firm always chooses projects with the lowest the firm invest? ‘machinery at a cost of $3,768,966. The company’s man- ‘ash flows of $979,225, $1,158,886, and $1,881,497 inventory-management computer software at a investment over the next six years will produce the $387,479, $516345, $645,766, and $618,325. ntin banking software at cost of 1,875,000. [cost savings over the next several years. If asa result additional cash flows of $586,212, $713,277, is the investments payback period? ‘Capitol Corp. management is expecting a proj- ies yore tere ink ¢ $212,500. Ifthe firms acceptance deci-Cranje Industries is expanding product ine andits production capacity. eots and expected cash flows of the two independent projects are given in the folowing “the firm uses a discount rat of 164 percent for such projects. ‘are the NPVs ofthe two projects? both projects be accepted? o either? or neither? Explain your reasoning, Seto ie: Emporia Mils management i evaluating two alternative heating systems. gsare given in the following table. The firm uses 11.5 percent to aeee Corp. is investing $9,365,000 in new technolo- Po nefits in the first three years after installation (as can following cash flows), and smaller constant benefits in each of the next four years. Payback period for the project assuming a discount rate of 10 percent? 3 $3,378.91 rate of return (MIRR): Morningside Bakeries has recently purchased ‘of $650,000. The firm expects to generate cashflows of $275,000 in each of “The cost of capital is 14 percent, What is the MIRR for this project? rate of return (MIRR): Sycamore Home Furnishings is considering ac- that can create customized window treatments ‘he equipment will cost ‘cash flows of $85,000 over each of the next six years Ifthe cost of {s the MIRR on this project? Great Flights, Inc., an aviation firm, is considering purchasing three ‘$161 million. The company would lease the aircraft o an airline, Cash the IRR of this project? Problem 10.5, Compute the IRR for both production system has the higher IRR? Which production system has the higher ‘rankings of systems 1 and 2 are diferent. on is considering investments in two new golf apparel ‘Due toa funding constraint, these lines are mutually exchu~ ed cashflows over is three-year lif, as well asthe IRR and.1,375,112 1,176,558 1,212,645, "1,582,156 1,365,882 to Problem 10.28, are the IRRS forthe projects? the IRR criterion indicate diferent decision than the NPV criterion? how you would expec the management of Draconian Measures to decide. Inc is currently evaluating three projects that are independent. The cost of funds canbe 136 percent or 14.8 percent depending on ther financing plan. Al three project cont the at $500,000. Expected cash flow streams ar shown in the following table. Which projects be accepted ata discount rate of 14.8 percent? What if the discount rate was 13.6 percent? following table: The appropriate cost of capital is 145 percent. Compute identify the projects that should be accepted. mutualy exclusive projects The cost of capita is 15 percent. wing table, Which projec shouldbe accepted?depreciation, will be $898,620 annually. The machinery will be to's salvage value of $0 over 6 years using the straight-line method. The compa. ‘is 30 percent, and the cost of capital is 16 percent. the payback period? caterer is purchasing refrigerated trucks at a total cost of $3.25 million. ‘this investment is expected tobe $750,000 for the next five years. An will be $650,000, The cos of capital is 17 percent d payback period? investment? two independent projects. The costs and expected cash flows are ‘The cost of capital is 10 percent.