PFM Chap no 26 all solutions

Practice Problem

BE26-1 The steps in management’s decision-making process are listed in random order below. Indicate
the order in which the steps should be executed. ________ Make a decision. ________ Review results of
the decision. ________ Identify the problem and assign ________ Determine and evaluate possible
responsibility. courses of action.

Answer:
The correct order is:
1.
Identify the problem and assign responsibility.

2.
Determine and evaluate possible courses of action.

3.
Make a decision.

4. 
Review results of the decision.

BE26-2 Bogart Company is considering two alternatives. Alternative A will have revenues of $160,000
and costs of $100,000. Alternative B will have revenues of $180,000 and costs of $125,000. Compare
Alternative A to Alternative B showing incremental revenues, costs, and net income.

Answer:
 
            Net Income
Alternative Alternative Increase
 A B (Decrease)
             
Revenues   $160,000   $180,000   ($ 20,000)
Costs  100,000  125,000   (25,000)
Net income $ 60,000 $ 55,000 ($   5,000)

Alternative A is better than Alternative B.

BE26-3 At Bargain Electronics, it costs $30 per unit ($20 variable and $10 fi xed) to make an MP3 player
that normally sells for $45. A foreign wholesaler offers to buy 3,000 units at $25 each. Bargain
Electronics will incur special shipping costs of $3 per unit. Assuming that Bargain Electronics has excess
operating capacity, indicate the net income (loss) Bargain Electronics would realize by accepting the
special order.

Answer:
 

            Net Income

Reject Accept Increase

Order Order (Decrease)

Revenues   $0   $75,000 * ($ 75,000)

Costs x Variable manufacturing  0  60,000 ** ( (60,000)

                  Shipping  0   9,000 *** (  (9,000)

Net income $0 $ 6,000 ($  6,000)

The special order should be accepted.

*3,000 X $25

**3,000 X $20

***3,000 X $ 3
BE26-4 Manson Industries incurs unit costs of $8 ($5 variable and $3 fi xed) in making an assembly part
for its fi nished product. A supplier offers to make 10,000 of the assembly part at $6 per unit. If the offer
is accepted, Manson will save all variable costs but no fi xed costs. Prepare an analysis showing the total
cost saving, if any, Manson will realize by buying the part. Identify the steps in management’s
decisionmaking process. (LO 1) Determine incremental changes. (LO 1) Determine whether to accept a
special order. (LO 2) Determine whether to make or buy a part. (LO 2)

Answer:

Make Buy
Variable manufacturing costs $50,000 $   –0–   
Fixed manufacturing costs  30,000  30,000
Purchase price   –0–    60,000
          Total annual cost $80,000 $90,000

The decision should be to make the part.

BE26-5 Pine Street Inc. makes unfi nished bookcases that it sells for $62. Production costs are $36
variable and $10 fi xed. Because it has unused capacity, Pine Street is considering fi nishing the
bookcases and selling them for $70. Variable fi nishing costs are expected to be $6 per unit with no
increase in fi xed costs. Prepare an analysis on a per unit basis showing whether Pine Street should sell
unfi nished or fi nished bookcases.

Answer:
 

        Process   Net Income

Sell Further Increase (Decrease)

             

Sales price per unit   $62.00   $70.00   $8.00

Cost per unit      

          Variable  36.00  42.00        (6.00)

          Fixed  10.00  10.00     0

( (6.00)
                Total  46.00  52.00
$2.00
Net income per unit $16.00 $18.00

 
The bookcases should be processed further because the incremental revenues exceed incremental costs by
$2.00 per unit.

BE26-6 Bryant Company has a factory machine with a book value of $90,000 and a remaining useful life
of 5 years. It can be sold for $30,000. A new machine is available at a cost of $400,000. This machine will
have a 5-year useful life with no salvage value. The new machine will lower annual variable
manufacturing costs from $600,000 to $500,000. Prepare an analysis showing whether the old machine
should be retained or replaced.

nswer:
 

            Net 5-Year

    Income

Retain Replace Increase

Equipment Equipment (Decrease)

             

Variable manufacturing costs            

  for 5 years $3,000,000 $2,500,000   ($ 500,000

((400,000)
New machine cost (30,000) 400,000  
30,000
Sell old machine   (30,000)   $ 130,000
$2,870,000
          Total $3,000,000

The old factory machine should be replaced.

BE26-7 Lisah, Inc., manufactures golf clubs in three models. For the year, the Big Bart line has a net loss
of $10,000 from sales $200,000, variable costs $180,000, and fi xed costs $30,000. If the Big Bart line is
eliminated, $20,000 of fi xed costs will remain. Prepare an analysis showing whether the Big Bart line
should be eliminated.

Answer:
 

 
            Net Income

Continue Eliminate Increase (Decrease)

             

Sales   $200,000   $    –0–    $(200,000)

Variable costs  180,000      –0–   (180,000)

Contribution margin   20,000  (   –0–    (20,000)

Fixed costs   30,000   20,000)  ( 10,000)

Net income ($ (10,000) $(20,000) $ (10,000)

The Big Bart product line should be continued because $20,000 of contribution margin will not
be realized if the line is eliminated. This amount is greater than the $10,000 savings of fixed
costs.

BE26-8 Rihanna Company is considering purchasing new equipment for $450,000. It is expected that the
equipment will produce net annual cash fl ows of $60,000 over its 10-year useful life. Annual
depreciation will be $45,000. Compute the cash payback period.

Answer:
The length of time required to recuperate the price of an investment. The payback period of an
assumed investment or plan is a significant determining factor whether to assume the place or
plan, as longer payback periods are characteristically not wanted for investment decisions. The
formulation to compute payback period of a project based on whether the cash flow per period
from the project is smooth or rough. In circumstance they are smooth, the method to compute
payback period is

Calculated as:
Payback Period = Cost of Project / Annual Cash Inflows
$450,000 / $60,000 = 7.5 years

BE26-9 Swift Oil Company is considering investing in a new oil well. It is expected that the oil well will
increase annual revenues by $130,000 and will increase annual expenses by $70,000 including
depreciation. The oil well will cost $490,000 and will have a $10,000 salvage value at the end of its 10-
year useful life. Calculate the annual rate of return.
Answer:
 

The annual rate of return is calculated by dividing expected annual income by the average investment. The
company’s expected annual income is:

          $130,000 – $70,000 = $60,000

Its average investment is:

  $490,000 + $10,000
= $250,000
2

Therefore, its annual rate of return is:

          $60,000/$250,000 = 24%

BE26-10 McKnight Company is considering two different, mutually exclusive capital expenditure
proposals. Project A will cost $400,000, has an expected useful life of 10 years, a salvage value of zero,
and is expected to increase net annual cash fl ows by $70,000. Project B will cost $310,000, has an
expected useful life of 10 years, a salvage value of zero, and is expected to increase net annual cash fl
ows by $55,000. A discount rate of 9% is appropriate for both projects. Compute the net present value
of each project. Which project should be accepted?

Answer:
 

Project A

    Cash   9% Discount   Present

Flows X Factor = Value

Present value of net annual cash flows   $70,000 X 6.41766 = $449,236

Present value of salvage value       0 X  .42241 =        0

   449,236

Less: Capital investment  400,000

Net present value $ 49,236

Project B

    Cash   9% Discount   Present

Flows X Factor = Value

Present value of net annual cash flows   $55,000 X 6.41766 = $352,971

Present value of salvage value       0 X  .42241 =        0

   352,971

Less: Capital investment  310,000

Net present value $ 42,971

Project A has a higher net present value than Project B, and it should be accepted.

BE26-11 Kanye Company is evaluating the purchase of a rebuilt spot-welding machine to be used in the
manufacture of a new product. The machine will cost $176,000, has an estimated useful life of 7 years, a
salvage value of zero, and will increase net annual cash fl ows by $35,000. What is its approximate
internal rate of return?

Question:
Kanye Company is evaluating the purchase of a rebuilt spot-welding machine to be used in the
manufacture of a new product. The machine will cost $176,000, has an estimated useful life of 7
years, a  salvage value  of zero, and will increase net annual cash flows by $35,000. What is its
approximate internal rate of return?

Answer:
 
When net annual cash flows are expected to be equal, the internal rate of return can be approximated by
dividing the capital investment by the net annual cash flows to determine the discount factor, and then locating
this discount factor on the present value of an annuity table.

          $176,000/$35,000 = 5.02857

By tracing across on the 7-year row we see that the discount factor for 9% is 5.03295. Thus, the internal rate of
return on this project is approximately 9%.

BE26-12 Hsung Company accumulates the following data concerning a proposed capital investment:
cash cost $215,000, net annual cash fl ows $40,000, and present value factor of cash infl ows for 10
years 5.65 (rounded). Determine the net present value, and indicate whether the investment should be
made.

Answer:
 
  Present Value

   

Net annual cash flows – $40,000 X 5.65 $226,000

Capital investment  215,000

Net present value $ 11,000

The investment should be made because the net present value is positive.

E26-1 As a study aid, your classmate Pascal Adams has prepared the following list of statements about
decision-making and incremental analysis. 1. The fi rst step in management’s decision-making process is,
“Determine and evaluate possible courses of action.” 2. The fi nal step in management’s decision-
making process is to actually make the decision. 3. Accounting’s contribution to management’s decision-
making process occurs primarily in evaluating possible courses of action and in reviewing the results. 4.
In making business decisions, management ordinarily considers only fi nancial information because it is
objectively determined. 5. Decisions involve a choice among alternative courses of action. 6. The process
used to identify the fi nancial data that change under alternative courses of action is called incremental
analysis. 7. Costs that are the same under all alternative courses of action sometimes affect the decision.
8. When using incremental analysis, some costs will always change under alternative courses of action,
but revenues will not. 9. Variable costs will change under alternative courses of action, but fi xed costs
will not. Instructions Identify each statement as true or false. If false, indicate how to correct the
statement

Answer:
 

1.      False. The first step in management’s decision-making process is “identify the problem and
assign responsibility”.

2.      False. The final step in management’s decision-making process is to review the results of
the decision.

3.      True.

4.      False. In making business decisions, management ordinarily considers both financial and
nonfinancial information.

5.      True.

6.      True.

7.      False. Costs that are the same under all alternative courses of action do not affect the
decision.

8.      False. When using incremental analysis, either costs or revenues or both will change under
alternative courses of action.

9.      False. Sometimes variable costs will not change under alternative courses of action, but fixed
costs will.
E26-2 Gruden Company produces golf discs which it normally sells to retailers for $7 each. The cost of
manufacturing 20,000 golf discs is: Materials $ 10,000 Labor 30,000 Variable overhead 20,000 Fixed
overhead 40,000 Total $100,000 Gruden also incurs 5% sales commission ($0.35) on each disc sold.
McGee Corporation offers Gruden $4.80 per disc for 5,000 discs. McGee would sell the discs under its
own brand name in foreign markets not yet served by Gruden. If Gruden accepts the offer, its fi xed
overhead will increase from $40,000 to $46,000 due to the purchase of a new imprinting machine. No
sales commission will result from the special order. Instructions (a) Prepare an incremental analysis for
the special order. (b) Should Gruden accept the special order? Why or why not? (c) What assumptions
underlie the decision made in part (b)?

Answer:
 

(a)     Reject   Accept   Net Income

Order Order Increase (Decrease)

               

  Revenues ($4.80)   $ –0–   $24,000   $24,000

Materials ($0.50)  –0–   (2,500)
                     (2,500)
Labor ($1.50)  –0–   (7,500)
                     (7,500)
Variable overhead ($1.00)  –0–   (5,000)
                     (5,000)
Fixed overhead  –0–   (6,000)
                     (6,000)
Sales commissions   –0–   –0–    
  –0–     
Net income $ –0– $ 3,000
$ 3,000

(b)      As shown in the incremental analysis, Gruden should accept the special order because
incremental revenue exceeds incremental expenses by $3,000.

(c)      It is assumed that sales of the golf discs in other markets would not be affected by this
special order. If other sales were affected, Gruden would have to consider the lost sales in
making the decision. Second, if Gruden is operating at full capacity, it is likely that the
special order would be rejected.

 
E26-3 Moonbeam Company manufactures toasters. For the fi rst 8 months of 2017, the company
reported the following operating results while operating at 75% of plant capacity: Sales (350,000 units)
$4,375,000 Cost of goods sold 2,600,000 Gross profi t 1,775,000 Operating expenses 840,000 Net
income $ 935,000 Cost of goods sold was 70% variable and 30% fi xed; operating expenses were 80%
variable and 20% fi xed. In September, Moonbeam receives a special order for 15,000 toasters at $7.60
each from Luna Company of Ciudad Juarez. Acceptance of the order would result in an additional $3,000
of shipping costs but no increase in fi xed costs. Instructions (a) Prepare an incremental analysis for the
special order. (b) Should Moonbeam accept the special order? Why or why not?

Answer:
 

(a)             Net Income

Reject Accept Increase

Order Order (Decrease)

  Revenues (15,000 X $7.60)   $0   $114,000   ($114,000)

 0
Cost of goods sold   78,000  (1) (  (78,000)
 0
Operating expenses $0   31,800  (2) (  (31,800)

Net income $  4,200 ($  4,200)

          (1)      Variable cost of goods sold = $2,600,000 X 70% = $1,820,000.

                    Variable cost of goods sold per unit = $1,820,000 ÷ 350,000 = $5.20

                    Variable cost of goods sold for the special order = $5.20 X 15,000

                                                                                                                         = $78,000.

          (2)      Variable operating expenses = $840,000 X 80% = $672,000

                                          $672,000 ÷ 350,000 = $1.92 per unit

                                                    15,000 X $1.92 = $28,800

                                               $28,800 + $3,000 = $31,800

(b)     As shown in the incremental analysis, Moonbeam Company should accept the special order because
incremental revenues exceed incremental expenses by $4,200.
E26-4 Pottery Ranch Inc. has been manufacturing its own fi nials for its curtain rods. The company is
currently operating at 100% of capacity, and variable manufacturing overhead is charged to
production at the rate of 70% of direct labor cost. The direct materials and direct labor cost per
unit to make a pair of fi nials are $4 and $5, respectively. Normal production is 30,000 curtain
rods per year. Analyze statements about decision-making and incremental analysis. (LO 1) Use
incremental analysis for special-order decision. (LO 2) Use incremental analysis for special-order
decision. (LO 2) Use incremental analysis for make-or-buy decision. (LO 2) Find more at
www.downloadslide.com Exercises 1179 A supplier offers to make a pair of fi nials at a price of
$12.95 per unit. If Pottery Ranch accepts the supplier’s offer, all variable manufacturing costs will
be eliminated, but the $45,000 of fi xed manufacturing overhead currently being charged to the fi
nials will have to be absorbed by other products. Instructions (a) Prepare the incremental analysis
for the decision to make or buy the fi nials. (b) Should Pottery Ranch buy the fi nials? (c) Would
your answer be different in (b) if the productive capacity released by not making the fi nials could
be used to produce income of $20,000?

Answer:
 

(a)             Net Income

    Increase

Make Buy (Decrease)

  Direct materials (30,000 X $4.00)   $120,000   $      0  $ 120,000

Direct labor (30,000 X $5.00)  150,000        0 150,000

Variable overhead costs      

  ($150,000 X 70%)  105,000        0 105,000

Fixed manufacturing costs   45,000   45,000        0

Purchase price (30,000 X $12.95)        0  388,500 ( (388,500)

          Total annual cost $420,000 $433,500 ($ (13,500)

(b)     No, Pottery Ranch should not purchase the finials. As indicated by the incremental
analysis, it would cost the company $13,500 more to purchase the finials.

(c)      Yes, by purchasing the finials, a total cost saving of $6,500 will result as shown below.

 
              Net Income

    Increase

Make Buy (Decrease)

  Total annual cost (above)   $420,000   $433,500   $(13,500)

Opportunity cost   20,000 _____0  (20,000)

$433,500
Total cost $440,000 $( 6,500)

 E26-5 Anna Garden recently opened her own basketweaving studio. She sells fi nished baskets in
addition to the raw materials needed by customers to weave baskets of their own. Anna has put
together a variety of raw material kits, each including materials at various stages of completion.
Unfortunately, owing to space limitations, Anna is unable to carry all varieties of kits originally
assembled and must choose between two basic packages. The basic introductory kit includes undyed,
uncut reeds (with dye included) for weaving one basket. This basic package costs Anna $16 and sells for
$30. The second kit, called Stage 2, includes cut reeds that have already been dyed. With this kit the
customer need only soak the reeds and weave the basket. Anna is able to produce the second kit by
using the basic materials included in the fi rst kit and adding one hour of her own time, which she values
at $18 per hour. Because she is more effi cient at cutting and dying reeds than her average customer,
Anna is able to make two kits of the dyed reeds, in one hour, from one kit of undyed reeds. The Stage 2
kit sells for $36. Instructions Determine whether Anna’s basketweaving studio should carry the basic
introductory kit with undyed and uncut reeds or the Stage 2 kit with reeds already dyed and cut. Prepare
an incremental analysis to support your answer.

Question:
Anna Garden recently opened her own basketweaving studio. She sells finished baskets in
addition to the raw materials needed by customers to weave baskets of their own. Anna has
put together a variety of raw material kits, each including materials at various stages of
completion. Unfortunately, owing to space limitations, Anna is unable to carry all varieties of
kits originally assembled and must choose between two basic packages.

The basic introductory kit includes undyed, uncut reeds (with dye included) for weaving one
basket. This basic package costs Anna $16 and sells for $30. The second kit, called Stage 2,
includes cut reeds that have already been dyed. With this kit the customer need only soak the
reeds and weave the basket. Anna is able to produce the second kit by using the basic materials
included in the first kit and adding one hour of her own time, which she values at $18 per hour.
Because she is more efficient at cutting and dying reeds than her average customer, Anna is
able to make two kits of the dyed reeds, in one hour, from one kit of undyed reeds. The Stage 2
kit sells for $36.

Instructions
Determine whether Anna's basket weaving studio should carry the basic introductory kit with
undyed and uncut reeds or the Stage 2 kit with reeds already dyed and cut. Prepare an
incremental analysis to support your answer.

Answer:

(1)        The cost of materials decreases because Anna can make two Stage 2 Kits from the
materials for a basic kit.
 
(2)        The total time to make the two kits is one hour at $18 per hour or $9 per unit.
[Net inc. incr./(decr.) = Incremental rev. + DM cost savings – Incremental DL cost]; ($6 +
$8 - $9)
 
Anna should carry the Stage 2 Kits. The incremental revenue, $6, exceeds the
incremental processing costs, $1. Thus, net income will increase by processing the kits
further.
E26-6 Johnson Enterprises uses a computer to handle its sales invoices. Lately, business has been so
good that it takes an extra 3 hours per night, plus every third Saturday, to keep up with the volume of
sales invoices. Management is considering updating its computer with a faster model that would
eliminate all of the overtime processing. Current Machine New Machine Original purchase cost $15,000
$25,000 Accumulated depreciation $ 6,000 — Estimated annual operating costs $25,000 $20,000
Remaining useful life 5 years 5 years If sold now, the current machine would have a salvage value of
$6,000. If operated for the remainder of its useful life, the current machine would have zero salvage
value. The new machine is expected to have zero salvage value after 5 years. Instructions Should the
current machine be replaced
Answer:
 

            Net Income

Retain Replace Increase

Machine Machine (Decrease)

             

Operating costs   $125,000  (1) ($100,000) (2) ($ 25,000

New machine cost        0 (  25,000) (   (25,000)

Salvage value (old)        0 (   (6,000) (   6,000

          Total $125,000 ($119,000) ($   6,000

(1)      $25,000 X 5.

(2)      $20,000 X 5.

The current machine should be replaced. The incremental analysis shows that net income for
the five-year period will be $6,000 higher by replacing the current machine.

E26-7 Veronica Mars, a recent graduate of Bell’s accounting program, evaluated the operating
performance of Dunn Company’s six divisions. Veronica made the following presentation to Dunn’s
board of directors and suggested the Percy Division be eliminated. “If the Percy Division is eliminated,”
she said, “our total profi ts would increase by $26,000.” The Other Percy Five Divisions Division Total
Sales $1,664,200 $100,000 $1,764,200 Cost of goods sold 978,520 76,000 1,054,520 Gross profi t
685,680 24,000 709,680 Operating expenses 527,940 50,000 577,940 Net income $ 157,740 $ (26,000) $
131,740 In the Percy Division, cost of goods sold is $61,000 variable and $15,000 fi xed, and operating
expenses are $30,000 variable and $20,000 fi xed. None of the Percy Division’s fi xed costs will be
eliminated if the division is discontinued. Instructions Is Veronica right about eliminating the Percy
Division? Prepare a schedule to support your answer.

Answer:
 
             Net Income

    Increase

Continue Eliminate (Decrease)

Sales   $100,000)   $(     0)   $(100,000)

Variable costs      

          Cost of goods sold ( 61,000) (     0) (61,000)

          Operating expenses (30,000) (     0) (30,000)

                    Total variable (91,000) (     0) (91,000)

Contribution margin (9,000) (     0) (9,000)

Fixed costs      

          Cost of goods sold (15,000) (15,000) (     0)

          Operating expenses (20,000) (20,000) (     0)

                    Total fixed (35,000) (35,000) (     0)

Net income (loss) $(26,000) $(35,000) $ (9,000)

Veronica is incorrect. The incremental analysis shows that net income will be $9,000 less if the Percy Division
is eliminated. This amount equals the contribution margin that would be lost through discontinuing the
division.
E26-8 Cawley Company makes three models of tasers. Information on the three products is given below.
Tingler Shocker Stunner Sales $300,000 $500,000 $200,000 Variable expenses 150,000 200,000 145,000
Contribution margin 150,000 300,000 55,000 Fixed expenses 120,000 230,000 95,000 Net income $
30,000 $ 70,000 $ (40,000) Fixed expenses consist of $300,000 of common costs allocated to the three
products based on relative sales, and additional fi xed expenses of $30,000 (Tingler), $80,000 (Shocker),
and $35,000 (Stunner). The common costs will be incurred regardless of how many models are
produced. The other fi xed expenses would be eliminated if a model is phased out. James Watt, an
executive with the company, feels the Stunner line should be discontinued to increase the company’s
net income. Instructions (a) Compute current net income for Cawley Company. (b) Compute net income
by product line and in total for Cawley Company if the company discontinues the Stunner product line.
(Hint: Allocate the $300,000 common costs to the two remaining product lines based on their relative
sales.) (c) Should Cawley eliminate the Stunner product line? Why or why not?

Answer:
 
(a)       $30,000 + $70,000 – $40,000 = $60,000

(b)   Tingler   Shocker   Total

Sales   $300,000   $500,000   $800,000

   150,000    350,000
Variable expenses    200,000
  150,000   450,000
Contribution margin    142,500*   300,000    410,000
$    7,500 $  40,000
Fixed expenses   267,500**

Net income $  32,500

            *$30,000 + [($300,000 ÷ $800,000) X $300,000]

          **$80,000 + [($500,000 ÷ $800,000) X $300,000]

(c)      As shown in the analysis above, Cawley should not eliminate the Stunner product line.
Elimination of the line would cause net income to drop from $60,000 to $40,000. The
reason for this decrease in net income is that elimination of the product line would result
in the loss of $55,000 of contribution margin while saving only $35,000 of fixed expense

E26-9 Doug’s Custom Construction Company is considering three new projects, each requiring an
equipment investment of $22,000. Each project will last for 3 years and produce the following net
annual cash fl ows. Year AA BB CC 1 $ 7,000 $10,000 $13,000 2 9,000 10,000 12,000 3 12,000 10,000
11,000 Total $28,000 $30,000 $36,000 The equipment’s salvage value is zero, and Doug uses straight-
line depreciation. Doug will not accept any project with a cash payback period over 2 years. Doug’s
required rate of return is 12%. Instructions (a) Compute each project’s payback period, indicating the
most desirable project and the least desirable project using this method. (Round to two decimals and
assume in your computations that cash fl ows occur evenly throughout the year.) (b) Compute the net
present value of each project. Does your evaluation change? (Round to nearest dollar.)

Answer:
(a)      
          Cash payback period 2.50 years
          $22,000 – $16,000 = $6,000
          $6,000 ÷ $12,000 = .50
BB
          22,000 ÷ 10,000 = 2.2 years

          Cash payback period 1.75 years

          $22,000 – 13,000 = $9,000
          $9,000 ÷ $12,000 = .75

The most desirable project is CC because it has the shortest payback period. The least
desirable project is AA because it has the longest payback period. As indicated, only CC is
acceptable because its cash payback is 1.75 years.
(b)
 (1)    

This total may also be obtained from Table 4: $10,000 X 2.40183 = $24,018. (The
difference of $1 is due to rounding)

Project CC is still the most desirable project. Also, on the basis of net present values,
project BB is also acceptable. Project AA is not desirable.

E26-10 Vilas Company is considering a capital investment of $190,000 in additional productive facilities.
The new machinery is expected to have a useful life of 5 years with no salvage value. Depreciation is by
the straight-line method. During the life of the investment, annual net income and net annual cash fl
ows are expected to be $12,000 and $50,000, respectively. Vilas has a 12% cost of capital rate, which is
the required rate of return on the investment. Instructions (Round to two decimals.) (a) Compute (1) the
cash payback period and (2) the annual rate of return on the proposed capital expenditure. (b) Using the
discounted cash fl ow technique, compute the net present value.

Answer:
 
(a)      1.       Cash payback period: $190,000 ÷ $50,000 = 3.8 years.

          2.       Annual rate of return: $12,000 ÷ [($190,000 + $0) ÷ 2] = 12.63%.

(b) Item   Amount   Years   PV Factor   Present Value

                   

  Net annual cash flows   $ 50,000   1–5   3.60478    $180,239))

Capital investment        (190,000)

Net present value  $  (9,761)))

 
E26-11 Iggy Company is considering three capital expenditure projects. Relevant data for the projects
are as follows. Annual Life of Project Investment Income Project 22A $240,000 $15,500 6 years 23A
270,000 20,600 9 years 24A 280,000 15,700 7 years Use incremental analysis for elimination of a
product line. (LO 2) Compute cash payback period and net present value. (LO 3) Compute annual rate of
return, cash payback period, and net present value. (LO 3, 4) Determine internal rate of return. (LO 4)
Find more at www.downloadslide.com Problems: Set A 1181 Annual income is constant over the life of
the project. Each project is expected to have zero salvage value at the end of the project. Iggy Company
uses the straight-line method of depreciation. Instructions (a) Determine the internal rate of return for
each project. Round the internal rate of return factor to three decimals. (b) If Iggy Company’s required
rate of return is 10%, which projects are acceptable?

Answer:
 

(a)  

              Internal        

          Rate of Closest Internal

  Capital   Net Annual Cash   Return Discount Rate of

Project Investment ÷ Flows* = Factor Factor Return

  22A   $240,000 ÷ ($15,500 + $40,000) =  4.324   4.35526   10%

23A $270,000 ÷ ($20,600 + $30,000) =  5.336 5.32825 12%

24A $280,000 ÷ ($15,700 + $40,000) =  5.027 5.03295 9%

          *(Annual income + Depreciation expense)

(b)     The acceptable projects are 22A and 23A because their rates of return are equal to or greater than the
10% required rate of return.

Answer:
 

(a)      Project A: ($50,000 X 3.88965) - $200,000 = $(5,518)

          Project B: ($65,000 X 5.03295) - $300,000 = $27,142

(b)     Leung should invest in Project B only. Project B is acceptable because it has a positive net
present value. Project A is unacceptable because it has a negative net present value.
 

(c)      Project A (adjusted): ($60,000 X 3.88965) - $225,000 = $8,379. Leung's decision would

change. Now both projects are acceptable.