NAME: LAARNI D.

LIBO-ON
SECTION: K5-2

EXERCISE 13–1 Payback Method

Required:
1. Determine the payback period of the investment.
Year Investment Cash Inflow Unrecovered
Investment
1 $15,000 $14,000
2 $8,000 $2,000 $20,000
3 $2,500 $17,500
4 $4,000 $13,500
5 $5,000 $8,500
6 $6,000 $2,500
7 $5,000 $0
8 $4,000 $0
9 $3,000 $0
10 $2,000 $0

PAYBACK PERIOD OF THE INVESTMENT

Payback Period = 6 + ($2,500/$5,000)
= 6.5 years

Therefore, the derivations above shows that the investment project is fully recovered in
approximately, 6.5 years or an average of 7 years.

2. Would the payback period be affected if the cash inflow in the last year were several
times as large? No, the payback period will not be affected if the cash flow in the last
year were several times as large.

EXERCISE 13–2 Net Present Value Method

Required:
1. Determine the net present value of the investment in the machine.
Now 1 2 3 4 5
Purchase of machine $(27,000)
Reduced operating costs $7,000 $7,000 $7,000 $7,000 $7,000
Total cash flows (a) $(27,000) $7,000 $7,000 $7,000 $7,000 $7,000
Discount factor (12%) (b) 1,000 0.893 0.797 0.712 0.636 0.567
Present value (a)x(b) $(27,000) $6,251 $5,579 $4,984 $4,452 $3,969
Net Present Value $(1,765)

2. What is the difference between the total, undiscounted cash inflows and cash outflows over
the entire life of the machine?
Item Cash Flow Years Total Cash
Flows
Annual cost savings $7,000 5 $35,000
Initial investment $(27,000) 1 (27,000)
Net Cash flow $8,000
NAME: LAARNI D. LIBO-ON
SECTION: K5-2

EXERCISE 13–3 Internal Rate of Return

Required:
1. What would be the total annual cash inflows associated with the new machine for capital
budgeting purposes?
ANNUAL CASH INFLOWS
Annual savings in part-time help $3,800
Added Contribution Margin 1,200
Annual Cash Inflows $5,000

2. Find the internal rate of return promised by the new machine to the nearest whole
percent.
INTERNAL RATE OF RETURN
Internal Rate of Return = Investment required/Annual Cash Inflow
= $18,600/$5,000
= 3.720 represent 16% internal rate or return

3. In addition to the data given previously, assume that the machine will have a $9,125
salvage value at the end of six years. Under these conditions, compute the internal rate
of return to the nearest whole percent. (Hint: You may find it helpful to use the net
present value approach; find the discount rate that will cause the net present value to be
closest to zero.)
Amount of 22% Present Value of
Item Year(s) Cash Flows Factor Cash Flows
(a) (b) (a) x (b)
Initial Investment Now $(18,600) 1,000 $(18,600)
Annual cash Inflows 1-6 $5,000 3.167 15,835
Salvage value 6 $9,125 0.303 2,765
Net present Value $0

INTERNAL RATE OF RETURN

Internal Rate of Return = Investment required/Annual Cash Inflow
= $18,600/$15,835
= 1.175

EXERCISE 13–5 Preference Ranking

Required:
1. Compute the project profitability index for each investment proposal.
Proposal Net Present Value (a) Investment Profitability
Number Required (b) Index (a)/(b)
A $36,000 $90,000 0.40
B $38,000 $100,000 0.38
C $35,000 $70,000 0.50
D $40,000 $120,000 0.33

2. Rank the proposals in terms of preference.

Proposal Profitability
Number Index
C 0.50
A 0.40
B 0.38
D 0.33
NAME: LAARNI D. LIBO-ON
SECTION: K5-2

EXERCISE 13–6 Simple Rate of Return Method

Required:
Compute the simple rate of return on the new automated bottling machine.
Annual incremental net operating income
Operating cost of old machine $30,000
LESS: Operating Cost of New Machine 12,000
LESS: Annual depreciation on the new machine ($120,000/10 years) 12,000
Annual incremental net operating income $6,000

Initial Investment
Cost of the new machine $120,000
LESS: Salvage Value of old machine 40,000
Initial Investment $80,000

SIMPLE RATE OF RETURN

Simple Rate of Return = Annual incremental net of operating income/Initial Investment
= $6,000/$80,000
= 7.5%

EXERCISE 13–7 Net Present Value Analysis of Two Alternatives

Required:
Which investment alternative (if either) would you recommend that the company accept? Show
all computations using the net present value format. Prepare separate computations for each
project.
NET PRESENT VALUE FOR Now Years 1-6 Year 6
PROJECT A
Purchase of equipment $(100,000)
Annual cash inflows $21,000
Salvage Value $8,000
Total Cash Flows (a) $(100,000) $21,000 $8,000
Discount Factor (14%) (b) 1,000 3.889 0.456
Present Value (a) x (b) $(100,000) $81,669 $3,648
Net Present Value $(14,683)

NET PRESENT VALUE FOR Now Years 1-6 Year 6

PROJECT B
Working capital invested $(100,000)
Annual cash inflows $16,000
Working capital released $100,000
Total Cash Flows (a) $(100,000) $16,000 $100,000
Discount Factor (14%) (b) 1,000 3,889 0.456
Present Value (a) x (b) $(100,000) $62,224 $45,600
Net Present Value $7,824

Based on the calculations above, I would recommend that the company needs to accept
Project B rather than Project A. Specifically, Project A has a negative net present value while
Project B has a positive net present value.

EXERCISE 13–8 Payback Period and Simple Rate of Return

Required:
1. Assume that Nick’s Novelties, Inc., will not purchase new games unless they provide a
payback period of five years or less. Would the company purchase the new games?
NAME: LAARNI D. LIBO-ON
SECTION: K5-2

ANNUAL NET CASH INFLOW

Net operating Income $40,000
ADD: Noncash Deduction for 35,000
depreciation
Annual Net Cash Inflow $75,000

PAYBACK PERIOD
Payback Period = Investment required/Annual Cash Inflow
= $300,000/$75,000 per year
= 4.0 years

Yes, the company would purchase new games, specifically, the pinball machines. It is
because the payback period less than the maximum 5 years required by the company.

2. Compute the simple rate of return promised by the games. If the company requires a
simple rate of return of at least 12%, will the games be purchased?
SIMPLE RATE OF RETURN
Simple Rate of Return = Annual incremental net of operating income/Initial Investment
= $40,000/$300,000
= 13.3%

Yes, the pinball machine would be purchased even if there is simple rate of return of at
least 12%. In this problem, it is clear the 13.3% exceeds 12%.

EXERCISE 13–11 Preference Ranking of Investment Projects [LO13–5]

Required:
1. Compute the project profitability index for each project.
Project Net Present Value (a) Investment Profitability
Required (b) Index (a)/(b)
A $44,323 160,000 0.28
B $42,000 135,000 0.31
C $35,035 100,000 0.35
D $38,136 175,000 0.22

2. In order of preference, rank the four projects in terms of:

a. Net present value.
b. Project profitability index.
c. Internal rate of return.
Project Net Present
Value
A 1
B 2
C 4
D 3
Project Internal Rate of
Profitability Index Return
3 3
2 4
1 2
4 1

3. Which ranking do you prefer? Why?

Objectively, I prefer Project C because it has the lowest capital investment requirements,
highest profitability index, and the second-best internal rate of return out of the four
projects.