Problems: Set B 1

PROBLEMS: SET B

P12-1B The Borders and Noble partnership is considering three long-term capital invest- Compute annual rate of
ment proposals. Each investment has a useful life of 5 years. Relevant data on each project return, cash payback, and net
are as follows. present value.
(LO 1, 2, 5), AN
Project Mary Project Winnie Project Sarah
Capital investment $140,000 $175,000 $190,000
Annual net income:
Year 1 $10,000 $12,500 $19,000
2 10,000 12,000 16,000
3 10,000 11,000 14,000
4 10,000 8,000 9,000
5 10,000 6,000 8,000
Total $50,000 $49,500 $66,000

Depreciation is computed by the straight-line method with no salvage value. The compa-
ny’s cost of capital is 12%. (Assume cash flows occur evenly throughout the year.)

Instructions
(a) Compute the cash payback period for each project. (Round to two decimals.)
(b) Compute the net present value for each project. (Round to nearest dollar.) (b) M $(3,018); S $(3,075)
(c) Compute the annual rate of return for each project. (Round to two decimals.)
(Hint: Use average annual net income in your computation.)
(d) Rank the projects on each of the foregoing bases. Which project do you recommend?

P12-2B Ben Paul is an accounting major at a western university located approximately 60 Compute annual rate of
miles from a major city. Many of the students attending the university are from the metro- return, cash payback, and net
politan area and visit their homes regularly on the weekends. Ben, an entrepreneur at present value.
heart, realizes that few good commuting alternatives are available for students doing (LO 1, 2, 5), AN
weekend travel. He believes that a weekend commuting service could be organized and
run profitably from several suburban and downtown shopping mall locations. Ben has
gathered the following investment information.
1. Five used vans would cost a total of $90,000 to purchase and would have a 3-year use-
ful life with negligible salvage value. Ben plans to use straight-line depreciation.
2. Ten drivers would have to be employed at a total payroll expense of $43,000.
3. Other annual out-of-pocket expenses associated with running the commuter service
would include Gasoline $26,000, Maintenance $4,000, Repairs $5,300, Insurance
$4,500, Advertising $2,200.
4. Ben desires to earn a return of 15% on his investment.
5. Ben expects each van to make ten round trips weekly and carry an average of six
students each trip. The service is expected to operate 32 weeks each year, and each
student will be charged $15 for a round-trip ticket.
Instructions
(a) Determine the annual (1) net income and (2) net annual cash flows for the commuter (a) (1) $29,000
service.
(b) Compute (1) the cash payback period and (2) the annual rate of return. (Round to two (b) (1) 1.53 years
decimals.)
(c) Compute the net present value of the commuter service. (Round to the nearest dollar.)
(d) What should Ben conclude from these computations?

P12-3B Platteville Eye Clinic is considering investing in new optical-scanning equip- Compute net present value,
ment. It has two options: Option A would have an initial lower cost but would require a profitability index, and
significant expenditure for rebuilding after 3 years. Option B would require no rebuilding internal rate of return.
expenditure, but its maintenance costs would be higher. Since the Option B machine is of (LO 2, 3, 4), AN
initial higher quality, it is expected to have a salvage value at the end of its useful life. The
following estimates were made of the cash flows. The company’s cost of capital is 11%.
2 12 Planning for Capital Investments
(a) (1) NPV A $(3,376)
(3) IRR B 12%
Compute net present value
considering intangible benefits.
(LO 2, 3), E
(a) NPV $(11,102)
(b) NPV $15,039
Compute net present value
and internal rate of return
with sensitivity analysis.
(LO 2, 4), E
Option A Option B
Initial cost $100,000 $160,000
Annual cash inflows $56,000 $60,000
Annual cash outflows $24,000 $24,000
Cost to rebuild (end of year 3) $53,000 $0
Salvage value $0 $24,000
Estimated useful life 6 years 6 years
Instructions
(a) Compute the (1) net present value, (2) profitability index, and (3) internal rate of
return for each option. (Hint: To solve for internal rate of return, experiment with
alternative discount rates to arrive at a net present value of zero.)
(b) Which option should be accepted?
P12-4B Isaac’s Auto Repair is considering the purchase of a new tow truck. The garage
doesn’t currently have a tow truck, and the $65,000 price tag for a new truck would rep-
resent a major expenditure for the garage. Isaac Mayer, owner of the garage, has compiled
the following estimates in trying to determine whether to purchase the truck.
Initial cost $65,000
Estimated useful life 8 years
Net annual cash inflows from towing $9,600
Overhaul costs (end of year 4) $7,000
Salvage value $16,000
Isaac’s good friend, Brad Jolie, stopped by. He is trying to convince Isaac that the tow truck
will have other benefits that Isaac hasn’t even considered. First, he says, cars that need
towing need to be fixed. Thus, when Isaac tows them to his facility his repair revenues will
increase. Second, he notes that the tow truck could have a plow mounted on it, thus saving
Isaac the cost of plowing his parking lot. (Brad will give him a used plow blade for free if
Isaac will plow Brad’s driveway.) Third, he notes that the truck will generate goodwill; that
is, people who are rescued by Isaac and his tow truck will feel grateful and might be more
inclined to use his service station in the future or buy gas there. Fourth, the tow truck will
have “Isaac’s Auto Repair” on its doors, hood, and back tailgate—a form of free advertising
wherever the tow truck goes.
Brad estimates that, at a minimum, these benefits would be worth the following.
Additional annual net cash flows from repair work $2,600
Annual savings from plowing 600
Additional annual net cash flows from customer “goodwill” 1,200
Additional annual net cash flows resulting from free advertising 500
The company’s cost of capital is 10%.
Instructions
(a) Calculate the net present value, ignoring the additional benefits described by Brad.
Should the tow truck be purchased?
(b) Calculate the net present value, incorporating the additional benefits suggested by
Brad. Should the tow truck be purchased?
(c) Suppose Brad has been overly optimistic in his assessment of the value of the addi-
tional benefits. At a minimum, how much would the additional benefits have to be
worth in order for the project to be accepted?
P12-5B Lewis Corp. is thinking about opening a basketball camp in Texas. In order to
start the camp, the company would need to purchase land and build eight basketball
courts and a dormitory-type sleeping and dining facility to house 110 basketball players.
Each year, the camp would be run for 8 sessions of 1 week each. The company would hire
college basketball players as coaches. The camp attendees would be male and female
basketball players ages 12 to 18. Property values in Texas have enjoyed a steady increase
in value. It is expected that after using the facility for 20 years, Lewis can sell the property
for more than it was originally purchased for. The amounts shown on the next page have
been estimated.
Cost of land $200,000
Cost to build dorm and dining facility $350,000
Annual cash inflows assuming 110 players and 8 weeks $700,000
Annual cash outflows $570,000
 Problems: Set B 3

Estimated useful life 20 years

Salvage value $700,000
Discount rate 12%

Instructions
(a) Calculate the net present value of the project. (a) NPV $493,596
(b) To gauge the sensitivity of the project to these estimates, assume that if only 90 campers
attend each week, annual cash inflows will be $570,000 and annual cash outflows will
be $508,000. What is the net present value using these alternative estimates? Discuss
your findings.
(c) Assuming the original facts, what is the net present value if the project is actually risk-
ier than first assumed, and a 15% discount rate is more appropriate?
(d) Assume that during the first 5 years the annual net cash inflows each year were only (d) IRR 15%
$65,000. At the end of the fifth year, the company is running low on cash, so manage-
ment decides to sell the property for $668,000. What was the actual internal rate of
return on the project? Explain how this return was possible given that the camp did
not appear to be successful.