Problem 1:
Lamar Company is considering a project that would have an eight-year life and require a $2,400,000 investment in equipment. At the end of eight years, the project would terminate and the equipment would have no salvage value. The project would provide net operating income each year as follows:
The company’s discount rate is 12%. Required: 1. Compute the annual net cash inflow from the project. 2. Compute the project’s net present value. Is the project acceptable? (Answer : Yes) 3. Find the project’s internal project’s internal rate of return to the nearest whole percent. (Answer: 13%) 4. Compute the project’s payback period. (Answer period. (Answer 4.8 years) 5. Compute the project’s simple rate of return. (Answer 8.3%)
Solution:
Problem 2:
The management of Kunkel Company is considering the purchase of a $40,000 machine that would reduce operating costs by $7,000 per year. At the end of the machine’s eight -year useful life, it will have zero scrap value. The company’s required rate of return is 12%. Required: (Ignore income taxes.) 1. Determine the net present value of the investment in the machine. (Answer: USD. -5,224) 2. What is the difference between the total, undiscounted cash inflows and cash outflows over the entire life of the machine? (Answer: USD 16,000) Solution:
Problem 3:
Wendell’s Donut Shoppe is investigating the purchase of a new $18,600 donut -making machine. The new machine would permit the company to reduce the amount of part-time help needed, at a cost savings of $3,800 per year. In addition, the new machine would allow the company to produce one new style of donut, resulting in the sale of 1,000 dozen more donuts each year. The company realizes a contribution margin of $1.20 per dozen donuts sold. The new machine would have a six year useful life. Required: (Ignore income taxes.) 1. What would be the total annual cash inflows associated with the new machine for capital budgeting purposes? (Answer USD 5,000) 2. Find the internal rate of return promised by the new machine to the nearest whole percent. (Answer around 16%) 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. (Answer 22%) Solution:
Problem 4:
A piece of laborsaving equipment has just come onto the market that Mitsui Electronics, Ltd., could use to reduce costs in one of its plants in Japan. Relevant data relating to the equipment follow (currency is in thousands of yen, denoted by ¥):
Required: (Ignore income taxes.) 1. Compute the payback period for the equipment. If the company requires a payback period of four years or less, would the equipment be purchased? (Answer: 4.8 years, NO)
2. Compute the simple rate of return on the equipment. Use straight-line depreciation based on the equipment’s useful life. Would the equipment be purchased if the company’s required rate of return is 14%? (Answer: 12.5%, NO)
Solution:
Problem 5:
Labeau Products, Ltd., of Perth, Australia, has $35,000 to invest. The company is trying to decide between two alternative uses for the funds as follows:
The company’s discount rate is 18%. Required: (Ignore income taxes.)
Which alternative would you recommend that the company accept? Show all computations using the net present value approach. Prepare separate computations for each project. (Answer: Project X) Solution:
Problem 6:
Kathy Myers frequently purchases stocks and bonds, but she is uncertain how to determine the rate of return that she is earning. For example, three years ago she paid $13,000 for 200 shares of Malti Company’s common stock. She received a $420 cash dividend on the stock at the end of each year for three years. At the end of three years, she sold the stock for $16,000. Kathy would like to earn a return of at least 14% on all of her investments. She is not sure whether the Malti Company stock provided a 14% return and would like some help with the necessary computations. Required: (Ignore income taxes.) Using the net present value method, determine whether or not the Malti Company stock provided a 14% return. (Answer: NPV USD -1,225, NO) Solution:
Problem 7:
Nick’s Novelties, Inc., is considering the purchase of electronic pinball machines to place in amusement houses. The machines would cost a total of $300,000, have an eight-year useful life, and have a total salvage value of $20,000. The company estimates that annual revenues and expenses associated with the machines would be as follows:
Required: (Ignore income taxes.) 1. Assume that Nick’s Novelties, Inc., will not purchase new equipment unless it provides a payback period of five years or less. Would the company purchase the pinball machines? (Answer: Payback 4 years, YES) 2. Compute the simple rate of return promised by the pinball machines. If the company requires a simple rate of return of at least 12%, will the pinball machines be purchased? (Answer: 13.3%, YES) Solutions:
Problem 8:
“I’m not sure we should lay out $500,000 for that automated welding machine,” said Jim Alder, president of the Superior Equipment Company. “That’s a lot of money, and it would cost us $80,000 for software and installation, and another $3,000 every month just to maintain the thing. In addition, the manufacturer admits that it would cost $45,000 more at the end of seven years to replace worn-out parts.” “I admit it’s a lot of money,” said Franci Rogers, the controller. “But you know the turnover problem we’ve had with the welding crew. This machine would re place six welders at a cost savings of $108,000 per year. And we would save another $6,500 per year in reduced material waste. When you figure that the automated welder would last for 12 years, I’m sure the return would be greater than our 16% required rate of return.” “I’m still not convinced,” countered Mr. Alder. “We can only get $12,000 scrap value out of our old welding equipment if we sell it now, and in 12 years the new machine will only be worth $20,000 for parts. But have your people workup the figures and we’ll talk about them at the executive committee meeting tomorrow.” Required: (Ignore income taxes.)
1. Compute the annual net cost savings promised by the automated welding machine. (Answer: USD 78,500) 2. Using the data from (1) above and other data from the problem, compute the automated welding machine’s net present value. (Use the incremental -cost approach.) Would you recommend purchasing the automated welding machine? Explain. (Answer: NPV $ -172,605, No) Solutions:
Problem 9:
Raul Martinas, professor of languages at BRAC University, owns a small office building adjacent to the university campus. He acquired the property 10 years ago at a total cost of $530,000- $50,000 for the land and $480,000 for the building. He has just received an offer from a realty company that wants to purchase the property; however, the property has been a good source of income over the years, so Professor Martinas is unsure whether he should keep it or sell it. His alternatives are: Alternative 1: Keep the property. Professor Martinas’ accountant has kept careful records of the income
realized from the property over the past 10 years. These records indicate the following annual revenues and expenses:
Professor Martinas makes a $12,000 mortgage payment each year on the property. The mortgage will be paid off in eight more years. He has been depreciating the building by the straight-line method, assuming a salvage value of $80,000 for the building which he still thinks is an appropriate figure. He feels sure that the building can be rented for another 15 years. He also feels sure that 15 years from now the land will be worth three times what he paid for it. Alternative 2: Sell the property. A realty company has offered to purchase the property by paying
$175,000 immediately and $26,500 per year for the next 15 years. Control of the property would go to the realty company immediately. To sell the property, Professor Martinas would need to pay the mortgage off, which could be done by making a lump-sum payment of $90,000. Required: Assume that Professor Martinas requires a 12% rate of return. Would you recommend he keep or sell the property? Show computations using the total-cost approach to net present value. (Answer: Keep, NPV for keep is $ 309,402 and for sell is 265,492) Solutions:
Problem 10:
The Midtown Cafeteria employs fi ve people to operate antiquated dishwashing equipment. The cost of wages for these people and for maintenance of the equipment is $85,000 per year. Management is considering the purchase of a single, highly automated dishwashing machine that would cost $140,000 and have a useful life of 12 years. This machine would require the services of only three people to operate at a cost of $48,000 per year. A maintenance contract on the machine would cost an additional $2,000 per year. New water jets would be needed on the machine in six years at a total cost of $15,000. The old equipment is fully depreciated and has no resale value. The new machine will have a salvage value of $9,000 at the end of its 12-year useful life. For tax purposes, the company computes depreciation deductions assuming zero salvage value and uses straight-line depreciation. The new dishwashing machine would be depreciated over seven years. Management requires a 14% after-tax return on all equipment purchases. The company’s tax rate is 30%. Required:
1. Determine the before-tax annual net cost savings that the new dishwashing machine will provide. (Answer: $ 35,000) 2. Using the data from (1) above and other data from the exercise, compute the new dishwashing machine’s net present value. Would you recommend that it be purchased? (Answer: NPV $ 20,920, YES) Solutions:
Probable Short Questions and Answers 1. What is the difference between capital budgeting screening decisions and capital budgeting preference decisions? Capital budgeting screening decisions concern whether a proposed investment project passes a preset hurdle, such as a 15% rate of return. Capital budgeting preference decisions are concerned with choosing from among two or more alternative investment projects, each of which has passed the hurdle. 2. What is meant by the term time value of money? The time value of money refers to the fact that a dollar received today is more valuable than a dollar received in the future simply because a dollar received today can be invested to yield more than a dollar in the future. 3. What is meant by the term discounting? Discounting is the process of computing the present value of a future cash flow. Discounting gives recognition to the time value of money and makes it possible to meaningfully add together cash flows that occur at different times. 4. Why isn’t accounting net income used in the net present value and internal rate of return methods of making capital budgeting decisions? Accounting net income is based on accruals rather than on cash flows. Both the net present value and internal rate of return methods focus on cash flows.
5. Why are discounted cash flow methods of making capital budgeting decisions superior to other methods? Discounted cash flow methods are superior to other methods of making capital budgeting decisions because they recognize the time value of money and take into account all future cash flows. 6. What is net present value? Can it ever be negative? Explain. Net present value is the present value of cash inflows less the present value of the cash outflows. The net present value can be negative if the present value of the outflows is greater than the present value of the inflows. 7. Identify two simplifying assumptions associated with discounted cash flow methods of making capital budgeting decisions. One simplifying assumption is that all cash flows occur at the end of a period. Another is that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.
8. If a company has to pay interest of 14% on long-term debt, then its cost of capital is 14%. Do you agree? Explain. No. The cost of capital is not simply the interest paid on long-term debt. The cost of capital is a weighted average of the individual costs of all sources of financing, both debt and equity. 9. What is meant by an investment project’s internal rate of return? How is the internal rate of return computed? The internal rate of return is the rate of return on an investment project over its life. It is computed by finding the discount rate that results in a zero net present value for the project. 10. Explain how the cost of capital serves as a screening tool when using (a) the net present value method and (b) the internal rate of return method. The cost of capital is a hurdle that must be cleared before an investment project will be accepted. In the case of the net present value method, the cost of capital is used as the discount rate. If the net present value of the project is positive, then the project is acceptable because its rate of return is greater than the cost of capital. In the case of the internal rate of return method, the cost of capital is compared to a project’s internal rate of return. If the project’s internal rate
of return is greater than the cost of capital, then the project is acceptable. 11. As the discount rate increases, the present value of a given future cash flow also increases. Do you agree? Explain. No. As the discount rate increases, the present value of a given future cash flow decreases. For example, the present value factor for a discount rate of 12% for cash to be received ten years from now is 0.322, whereas the present value factor for a discount rate of 14% over the same period is 0.270. If the cash to be received in ten years is $10,000, the present value in the first case is $3,220, but only $2,700 in the second case. Thus, as the discount rate increases, the present value of a given future cash flow decreases. 12. Refer to 4. Is the return on this investment proposal exactly 14%, more than 14%, or less than 14%? Explain. The internal rate of return is more than 14% since the net present value is positive. The internal rate of return would be 14% only if the net present value (evaluated using a 14% discount rate) is zero. The internal rate of return would be less than 14% if the net present value (evaluated using a 14% discount rate) is negative. 13. How is the project profitability index computed, and what does it measure? The project profitability index is computed by dividing the net present value of the cash flows from an investment project by the investment required. The index measures the profit (in terms of net present value) provided by each dollar of investment in a project. The higher the project profitability index, the more desirable is the investment project. 14. What is meant by the term payback period? How is the payback period determined? How can the payback method be useful?
The payback period is the length of time for an investment to fully recover its initial cost out of the cash receipts that it generates. The payback method is used as a screening tool for investment proposals. The payback method is useful when a company has cash flow problems. The payback method is also used in industries where obsolescence is very rapid. 15. What is the major criticism of the payback and simple rate of return methods of making capital budgeting decisions? Neither the payback method nor the simple rate of return method considers the time value of money. Under both methods, a dollar received in the future is weighed the same as a dollar received today. Furthermore, the payback method ignores all cash flows that occur after the initial investment has been recovered.
