Problem.1.

“If we can get that new robot to combine with our other automated equipment, we wil have
a complete flexible manufacturing system in place in our Northridge plant,” said Hal Swain, production
manager for Diller Products.
“Let’s just hope that reduced labor and inventory costs can justify its acquisition,” replied Linda Wycoff,
the controller. Otherwise, we will never get it. You Know how the president feels about equipment
paying for itself out of reduced costs.”
Selected data relating to the robot are provided below:
Particulars Taka
Cost of the robot Tk.1,600,000
Software and installation 700,000
Annual savings in labor costs ?
Annual savings in inventory costs 190,000
Monthly increase in power and maintenance costs 2,500
Salvage value in 12 years 90,000
Useful life 12 years

Engineering studies suggest that use of the robot will result in a savings of 20,000 direct labor hours
each year. The labor rate is Tk.16 per hour. Also, the smoother work flow made possible by the FMS will
allow the company to reduce the amount of inventory on hand by Tk.300,000. The released funds will
be available for use elsewhere in the company. This inventory reduction will take place in the first year
of operation. The company requires a 20% return on all investments in automated equipment.
Required:
I. Determine the net annual cost savings if the robot is purchased. (Do not include the Tk.300,000
inventory reduction or the salvage value in this computation.)
II. Compute the net present value of the proposed investment in the robot. Based on these data
would you recommend that the robot be purchased? Explain.
III. Assume that the robot is purchased. At the end of the first year, Linda Wycoff has found that
some items didn’t work out as planned. Due to unforeseen problems, software and installation
costs were Tk.125,000 more than estimated, and direct labor has been reduced by only 17,500
hours per year, rather than by 20,000 hours. Assuming that all other cost data were accurate,
does it appear that the company made a wise investment? Show computations, using the net
present value format as in (2) above.
IV. Upon seeing your analysis in (3) above, the president stated, “That robot is the worst
investment we have ever made. And here we will be stuck with it for years.”
i. Explain to the president what benefits other than cost savings might accrue from use of
the new robot and FMS.
ii. Compute for he president the dollar amount of cash inflow that would be needed each
year from the benefits in (a) above in order for the equipment to yield a 20% rate of
return.
Solution: Computation of the net annual cost savings:

Savings in labor costs (Tk.16 per hour X 20,000 hours) …………. Tk.320,000
Savings in inventory carrying costs……………………………………….. 190,000
Total………………………………………………………………………………………. 510,000
Less increased power and maintenance cost
(Tk.2,500 per month X 12 months)……………………………. 30,000
Net annual cost savings…………………………………………………………… Tk.480,000

II.
Particulars Year (s) Amount of 20% Present value of
Cash Flows Factor Cash Flows
Cost of the robot Now Tk.(1,600,000) 1 Tk.(1,600,000)
Software and installation Now (700,000) 1 (700,000)
Cash released from inventory 1 300,000 0.8333 249,900
Net annual cost savings 1-12 480,000 4.439 2,130,720
Salvage value 12 90,000 0.112 10,080
Net present value Tk.90,700

Yes, the robot should be purchased. It has a positive net present value at a 20% discount rate.

III. Recomputation of the annual cost savings:

Savings in labor costs (Tk.16 per hour X 17,500 hours)…………………. TK.280,000
Savings in inventory carrying costs ………………………………………………… 190,000
Total……………………………………………………………………………………………….. 470,000
Less increased power and maintenance cost
(Tk.2,500 per month X 12 months)……………………………………. 30,000
Net annual cost savings…………………………………………………………………… Tk.440,000
Recomputation of the net present value of the project:
Particulars Year (s) Amount of 20% Present value of
Cash Flows Factor Cash Flows
Cost of the robot Now Tk.(1,600,000) 1 Tk.(1,600,000)
Software and installation Now (825,000) 1 (825,000)
Cash released from inventory 1 300,000 0.8333 249,900
Net annual cost savings 1-12 440,000 4.439 1,953,160
Salvage value 12 90,000 0.112 10,080
Net present value Tk.(211,860)

IV.i. Several intangible benefits are usually associated with investments in automated equipment. These
intangible benefits include such items as:
 Greater throughput.
 Greater variety of products.
  Higher quality.
 Reduction in investors.
The president should understand that the value of these benefits can equal or exceed any savings that
may come from reduced labor cost. However, these benefits are hard to quantify.
ii. Additional present value required/Factor for 12 years= Tk.211,860/4.439=Tk.47,727
Thus, the intangible benefits in part (a) will have to be worth at least Tk.47,727 per year in order for the
robot to yield to yield a 20% rate of return.

Problem:2: ABC Company has an opportunity to produce and sell a revolutionary new smoke detector
for homes. To determine whether this would be a profitable venture, the company has gathered the
following data on probable costs and market potential:
a) New equipment would have to be acquired to produce the smoke detector. The equipment
would cost $100,000 and be usable for 12 years. After 12 years, it would have a salvage value
equal to 10% of the original cost.
b) Production and sales of the smoke detector would require a working capital investment of
$40,000 to finance accounts receivable, inventories, and day-to-day cash needs. This working
capital would be released for use elsewhere after 12 years.
c) An extensive marketing study projects sales in units over the next 12 years as follows:
Year Sales in Units
1 4,000
2 7,000
3 10,000
4-12 12,000
d) The smoke detectors would sell for $45 each; variable costs for production, administration, and
sales would be $25 per unit.
e) To gain entry into t he market, the company would have to advertise heavily in the early years of
sales. The advertising program follows:
Year Amount of Advertising
1-2 $70,000
3 50,000
4-12 40,000

f) Other fixed costs for salaries, insurance, maintenance, and straight-line depreciation on
equipment would total $127,500 per year. (Depreciation is based on cost less salvage value.)
g) Atwood Company views the smoke detector as a somewhat risky venture: therefore, the
company would require a minimum 20% rate of return in order to accept it as a new product.

Required:
1. Company the net cash inflow (Cash receipts less yearly cash operating expenses) anticipated
from sale of the smoke detectors for each year over the next 12 years.
 2. Using the data computed in (1) above and other data provided in the problem, determine the
net present value of the proposed investment. Would you recommend that Atwood Company
accept the smoke detector as a new product?
Solution:

Year-1 Year-2 Year-3 Year-4-12

Sales in units 4,000 7,000 10,000 12,000
Sales in dollars (@ $45 each) $180,000 $315,000 $450,000 $540,000
Less: Variable expenses (@ $25 each) 100,000 175,000 250,000 300,000
Contribution Margin 80,000 140,000 200,000 240,000
Less: fixed expenses: Advertising 70,000 70,000 50,000 40,000
Other fixed expenses* 120,000 120,000 120,000 120,000
Total fixed expenses 190,000 190,000 170,000 160,000
Net cash inflow (outflow) $(110,000) $(50,000) $30,000 $80,000

*Depreciation is not a cash outflow and therefore must be eliminated when determining the net cash
flow. The analysis is:

Cost of equipment $100,000

Less salvage value (10%) 10,000
Net depreciable cost $90,000
$90,000/12 years= $7,500 per year depreciation
$127,500- $7,500 depreciation= $120,000 cash fixed expenses.
2. The net present value of the proposed investment would be:
Items Year Amount of CFs 20% factor PV of CFs
Investment in equipment Now $(100,000) 1.00 $(100,000)
Working capital Investment Now (40,000) 1.00 (40,000)
Yearly cash flows 1 (110,000) 0.833 (91,630)
Yearly cash flows 2 (50,000) 0.694) (34,700)
Yearly cash flows 3 30,000 0.579 17,370
Yearly cash flows 4-12 80,000 2.333* 186,640
Salvage value of equipment 12 10,000 0.112 1,120
Release of working capital 12 40,000 0.112 4,480
Net present value $(56,720)
*Present value factor for 12 periods……………………………. 4.439
Present value factor for 3 periods……………………………… 2.106
Present value factor for 9 periods, starting 4
Periods in the future…………………………………………………… 2.333
Since the net present value is negative, the company should not accept the smoke detector as a new
product.

Question.3. The management of Revco Products is exploring five different investment opportunities.
Information on the five projects under study follows:
 Project Number
1 2 3 4 5
Investment required $(270,000) $(450,000) $(400,000) $(360,000) $(480,000)
Present values of Cash
flows at 10% discount rate 336,140 522,970 379,760 433,400 567,270
Net present value $66,140 $72,970 $(20,240) $73,400 $87,270
List of the project 6 years 3 years 5 years 12 years 6 years
Internal rate of return 18% 19% 8% 14% 16%

The company’s required rate of return is 10%; thus, a 10% discount rate has been used in the present
value computations above. Limited funds are available for investment, so the company can’t accept all
of the available projects.
Required:
1. Compute the project profitability index for each investment project.
2. Rank the five projects according to preference, in terms of :
a. Net present value.
b. Project profitability index.
c. Internal rate of return.
3. Which rank do you prefer? Why?

Solution.3.

1. The formula for the profitability index is :

Profitability index= Present value of cash inflows/Investment required.
The index for the projects under consideration would be:
Project 1: $567,270/$480,000= 1.18
Project 2: $433,400/$360,000= 1.20
Project 3: $336,140/$270,000= 1.24
Project 4: $522,970/$450,000= 1.16
Project 5: $379,760/$400,000= 0.95
2. a, b, and c.
Net Present Value Profitability Index Internal Rate of Return
1st Preference 1 3 4
nd
2 Preference 2 2 3
3rd Preference 4 1 1
th
4 Preference 3 4 2
5th Preference 5 5 5

3. Which ranking is best will depend on Austin Company’s opportunities for reinvesting funds as
they are released from a project. The internal rate of return method assumes that any released
funds are reinvested at the rate of return shown for a project. This means that funds released
from project # 4 would have to be reinvested in another project yielding an internal rate of
return of 19%. Another project yielding such a high rate of return might be difficult to find.
The profitability index approach also assumes that funds released from a project are reinvested
in other projects. But the assumption is that the return earned by these other projects is equal
to the discount rate, which in this case only 10%. On balance, the profitability index is generally
regarded as being the most dependable method of ranking competing projects.
The net present value is inferior to the profitability index as a ranking device, since it looks only
at the total amount of net present value from a project and does not consider the amount of
investment required. For example, it ranks project# 3 as fourth in terms of preference because
of its low net present value; yet this project is the best available in terms of the amount of cash
inflow generated for each dollar of investment (as shown by the profitability index.)