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11.E: Capital Budgeting Decisions (Exercises)

  • Page ID
    12145
  • Multiple Choice

    1. Capital investment decisions often involve all of the following except ________.
      1. qualitative factors or considerations
      2. short periods of time
      3. large amounts of money
      4. risk
    Answer:

    b

    1. Preference decisions compare potential projects that meet screening decision criteria and will be ranked in their preference order to differentiate between alternatives with respect to all of the following characteristics except ________.
      1. political prominence
      2. feasibility
      3. desirability
      4. importance
    2. The third step for making a capital investment decision is to establish baseline criteria for alternatives. Which of the following would not be an acceptable baseline criterion?
      1. payback method
      2. accounting rate of return
      3. internal rate of return
      4. inventory turnover
    Answer:

    d

    1. You are explaining time value of money factors to your friend. Which factor would you explain as being larger?
      1. The future value of \(\$1\) for \(12\) periods at \(6\%\) is larger.
      2. The present value of \(\$1\) for \(12\) periods at \(6\%\) is larger.
      3. Neither one is larger because they are equal.
      4. There is not enough information given to answer this question.
    2. If you are saving the same amount each month in order to buy a new sports car when the new models are released, which of the following will help you determine the savings needed?
      1. future value of one dollar (\(\$1\))
      2. present value of one dollar (\(\$1\))
      3. future value of an ordinary annuity
      4. present value of an ordinary annuity
    Answer:

    c

    1. You want to invest \(\$8,000\) at an annual interest rate of \(8\%\) that compounds annually for \(12\) years. Which table will help you determine the value of your account at the end of \(12\) years?
      1. future value of one dollar (\(\$1\))
      2. present value of one dollar (\(\$1\))
      3. future value of an ordinary annuity
      4. present value of an ordinary annuity
    2. Using the information provided, what transaction represents the best application of the present value of an annuity due of \(\$1\)?
      1. Falcon Products leases an office building for \(8\) years with annual lease payments of \(\$100,000\) to be made at the beginning of each year.
      2. Compass, Inc., signs a note of \(\$32,000\), which requires the company to pay back the principal plus interest in four years.
      3. Bahwat Company plans to deposit a lump sum of \(\$100,000\) for the construction of a solar farm in \(4\) years.
      4. NYC Industries leases a car for \(4\) yearly annual lease payments of \(\$12,000\), where payments are made at the end of each year.
    Answer:

    a

    1. Grummet Company is acquiring a new wood lathe with a cash purchase price of \(\$80,000\). The Wood Master Industries (the manufacturer) has agreed to accept \(\$23,500\) at the end of each of the next \(4\) years. Based on this deal, how much interest will Grummet pay over the life of the loan?
      1. \(\$94,000\)
      2. \(\$80,000\)
      3. \(\$23,500\)
      4. \(\$14,000\)
    2. The process that determines the present value of a single payment or stream of payments to be received is ________.
      1. compounding
      2. discounting
      3. annuity
      4. lump-sum
    Answer:

    b

    1. The process of reinvesting interest earned to generate additional earnings over time is ________.
      1. compounding
      2. discounting
      3. annuity
      4. lump-sum
    2. The NPV method assumes that cash inflows associated with a particular investment occur when?
      1. only at the time of the initial investment
      2. only at the end of the year
      3. only at the beginning of the year
      4. at any of these times
    Answer:

    d

    1. Which of the following does not assign a value to a business opportunity using time-value measurement tools?
      1. internal rate of return (IRR) method
      2. net present value (NPV)
      3. discounted cash flow model
      4. payback period method
    2. Which of the following discounts future cash flows to their present value at the expected rate of return, and compares that to the initial investment?
      1. internal rate of return (IRR) method
      2. net present value (NPV)
      3. discounted cash flow model
      4. future value method
    Answer:

    b

    1. This calculation determines profitability or growth potential of an investment, expressed as a percentage, at the point where NPV equals zero
      1. internal rate of return (IRR) method
      2. net present value (NPV)
      3. discounted cash flow model
      4. future value method
    2. The IRR method assumes that cash flows are reinvested at ________.
      1. the internal rate of return
      2. the company’s discount rate
      3. the lower of the company’s discount rate or internal rate of return
      4. an average of the internal rate of return and the discount rate
    Answer:

    a

    1. When using the NPV method for a particular investment decision, if the present value of all cash inflows is greater than the present value of all cash outflows, then ________.
      1. the discount rate used was too high
      2. the investment provides an actual rate of return greater than the discount rate
      3. the investment provides an actual rate of return equal to the discount rate
      4. the discount rate is too low

    Questions

    1. What are the steps involved in the process for capital decision-making?
    Answer:

    The process for capital decision-making involves five steps:

    1. Determine capital needs.
    2. Explore resource limitations.
    3. Establish baseline criteria for alternatives.
    4. Evaluate alternatives using screening and preference decisions.
    5. Make the decision.
    1. Why does a company evaluate both the money allocated to a project and the time allocated to the project?
    2. What is the next thing a company needs to do after it establishes investment criteria?
    Answer:

    The company then needs to establish alternatives, which are options available for investment, and evaluate the options using common measurement methods, including the payback method, accounting rate of return, net present value, and internal rate of return.

    1. What is the screening decision?
    2. Your supervisor is on the company’s capital investment decision team that is to decide on alternatives for the acquisition of a new computer system for the company. The supervisor says, “The book value of the existing computer system for the firm that we are considering replacing is nothing but an accounting amount and as such is irrelevant in the capital expenditure analysis.” Does this reasoning make sense? Why or why not?
    Answer:

    From the standpoint of the decision to replace the asset, the book value of an existing asset is irrelevant. Book value is just the historical cost (or value) of the asset less the total depreciation calculated to date. A gain or loss situation often happens when the asset is sold for more or less than its book value, respectively. It is only at that point that the company truly realizes whether they have extra value or not enough value in the assets. This difference can provide either a gain or a loss to the company that will impact the taxes at year-end. Therefore, gains or losses affecting tax payments, plus cash flows, are important, since cash-flow effects are relevant in capital investment decisions

    1. Ekon owns a small tow-truck business that responds to state patrol requests to tow cars involved in wrecks, as well as to private business requests from customers at various auto repair shops and individuals with stalled autos. Ekon’s business is open \(24/7\) for \(365\) days a year. He is starting to see too many repairs on his three trucks, which either means that he loses business or must divert a truck from another area. He is now trying to consider whether it is best to continue use of the current trucks or whether he needs to invest some money in new trucks. Using the steps for the process of capital decision-making, create an outline with sub-steps that include questions Ekon can use to guide his investigation or considerations of buying new trucks.
    2. What is the payback method used to determine?
    Answer:

    It is used to determine the length of time needed for a long-term project to recapture or pay back the initial investment in the project.

    1. What are one advantage and one disadvantage of the payback method?
    2. What are one advantage and one disadvantage of the accounting rate of return method?
    Answer:

    Advantage: The ARR compares income to the initial investment rather than to cash flows; thus, incremental revenues, cost savings, and incremental expenses associated with the investment are reviewed and provide a more complete picture than payback, which uses cash flows. Disadvantage: ARR is limited in that it does not consider the value of a dollar over time.

    1. What is the equation to calculate the payback period?
    2. What is the equation to calculate the accounting rate of return?
    Answer:

    \(\text {Accounting Rate of Return} = (\text {Incremental revenues} - \text {Incremental expenses}) \div \text {Initial Investment}\)

    1. What is future value and what is one example where it might be used?
    2. Why do businesses consider time value of money before making an investment decision?
    Answer:

    They need to know what the future value is of their investment compared to today’s present value, and what potential earnings they could see because of delayed payment.

    1. What determines the anticipated interest rate payout for an investment?
    2. To calculate present value of a lump sum, which table would be used?
    Answer:

    The Present Value of \(\$1\) table

    1. What is the definition of present value?
    2. What is the difference between the discount rate used for net present value and the internal rate of return methods?
    Answer:

    For NPV computations, a minimum required rate of return or discount rate is used as a screening tool to determine whether or not a capital investment decision meets a predetermined set of criteria. If the net present value of an investment is positive, then the capital investment generates an actual return greater than the discount rate and the project will be deemed acceptable. The discount rate, however, is not the actual rate of return earned by the project. 

    The internal rate of return determines the actual rate of return that a project earns.

    1. Briefly explain how NPV is computed and interpreted.
    2. What is the basic benefit of using IRR?
    Answer:

    The internal rate of return (IRR) shows the profitability or growth potential of an investment. All external factors are removed from calculation, such as inflation concerns, and the project with the highest return rate percentage is considered for investment. A company may have several viable alternatives that need a differentiating factor. IRR gives a solid differentiation, presented as a percentage rather than a dollar figure, as seen in NPV. This removes bias from projects with dissimilar NPVs and is a way to compare more than one option

    1. How is the IRR determined if there are uneven cash flows?
    2. A fellow student studying managerial accounting says, “The net present value (NPV) weighs early receipts of cash much more heavily than more distant receipts of cash.” Do you agree or disagree? Why?
    Answer:

    Answers will vary but should include something like the following: the NPV weighs the early receipt of cash more heavily because when the receipts come in earlier, the discount is closer to 100%; however, the interest rate also impact the NPV.

    1. What are the strengths and weaknesses of NPV?
    2. What are the strengths and weaknesses of IRR?
    Answer:

    Strengths: It considers the time value of money, removes the dollar bias, and allows for a company to make a decision, unlike non-time value methods. Weaknesses: It has a bias toward return rates instead of higher risk investment consideration, uses a more difficult calculation, and does not consider the time it will take to recoup an investment.

    1. How does the size of the initial investment affect the internal rate of return on the net present value models?

    Exercise Set A

    1. Bob’s Auto Repair has determined that it needs new lift equipment to acquire more business opportunities. However, one or more alternatives meet or exceed the minimum expectations Bob has for the new lift equipment. As a result, what type of decision should Bob make for his company?
    2. In practice, external factors can impact a capital investment. Give a current external factor that may currently impact or cause instability of capital spending either here or abroad.
    3. If a copy center is considering the purchase of a new copy machine with an initial investment cost of \(\$150,000\) and the center expects an annual net cash flow of \(\$20,000\) per year, what is the payback period?
    4. Assume a company is going to make an investment of \(\$450,000\) in a machine and the following are the cash flows that two different products would bring in years one through four. Which of the two options would you choose based on the payback method?
    Option A, Product A; Option B, Product B (respectively): $190,000, $150,000; 190,000, 180,000; 60,000, 60,000; 20,000, 70,000.
    1. If a garden center is considering the purchase of a new tractor with an initial investment cost of \(\$120,000\), and the center expects a return of \(\$30,000\) in year one, \(\$20,000\) in years two and three, \(\$15,000\) in years four and five, and \(\$10,000\) in year six and beyond, what is the payback period?
    2. The management of Kawneer North America is considering investing in a new facility and the following cash flows are expected to result from the investment:
    Year, Investment (cash outflow), Cash Inflow (respectively): 1, $1,900,000, 100,000; 2, $550,000, 200,000; 3, - , 360,000; 4, - , 480,000; 5, - , 510,000; 6, - , 600,000; 7, - , 590,000; 8, - , 300,000; 9, - , 250,000; 10, - , 250,000.
    1. What is the payback period of this uneven cash flow?
    2. Does your answer change if year \(10\)’s cash inflow changes to \(\$500,000\)?
    1. A mini-mart needs a new freezer and the initial investment will cost \(\$300,000\). Incremental revenues, including cost savings, are \(\$200,000\), and incremental expenses, including depreciation, are \(\$125,000\). There is no salvage value. What is the accounting rate of return (ARR)?
    2. You put \(\$250\) in the bank for \(5\) years at \(12\%\).
      1. If interest is added at the end of the year, how much will you have in the bank after one year? Calculate the amount you will have in the bank at the end of year two and continue to calculate all the way to the end of the fifth year.
      2. Use the future value of \(\$1\) table in Appendix 14.2 and verify that your answer is correct.
    3. If you invest \(\$12,000\) today, how much will you have in (for further instructions on future value in Excel, see Appendix 14.3):
      1. \(10\) years at \(9\%\)
      2. \(8\) years at \(12\%\)
      3. \(14\) years at \(15\%\)
      4. \(19\) years at \(18\%\)
    4. You have been depositing money into an account yearly based on the following amounts, rates, and times. What is the value of that investment account at the end of that period?
    Amount of Investment, Rate, Time, Value at the End of the Period (respectively): $8,000, 20%, 15 years, ?; 12,000, 15, 10 years, ?; 15,500, 12, 5 years, ?; 35,500, 10, 2 years, ?
    1. How much would you invest today in order to receive \(\$30,000\) in each of the following (for further instructions on present value in Excel, see Appendix 14.3):
      1. \(10\) years at \(9\%\)
      2. \(8\) years at \(12\%\)
      3. \(14\) years at \(15\%\)
      4. \(19\) years at \(18\%\)
    2. Your friend has a trust fund that will pay her the following amounts at the given interest rate for the given number of years. Calculate the current (present) value of your friend’s trust fund payments. For further instructions on future value in Excel, see Appendix 14.3.
    Amount of Yearly Receipt, Rate, Time, Current Value (respectively): $6,200, 10%, 5 years, ?; 12,200, 12, 10 years, ?; 18,000, 15, 15 years, ?; 22,500, 20, 20 years, ?
    1. Julio Company is considering the purchase of a new bubble packaging machine. If the machine will provide \(\$20,000\) annual savings for \(10\) years and can be sold for \(\$50,000\) at the end of the period, what is the present value of the machine investment at a \(9\%\) interest rate with savings realized at year end?
    2. How much must be invested now to receive \(\$30,000\) for \(10\) years if the first \(\$30,000\) is received one year from now and the rate is \(8\%\)?
    3. Project A costs \(\$5,000\) and will generate annual after-tax net cash inflows of \(\$1,800\) for five years. What is the NPV using \(8\%\) as the discount rate?
    4. Project B cost \(\$5,000\) and will generate after-tax net cash inflows of \(\$500\) in year one, \(\$1,200\) in year two, \(\$2,000\) in year three, \(\$2,500\) in year four, and \(\$2,000\) in year five. What is the NPV using \(8\%\) as the discount rate? For further instructions on net present value in Excel, see Appendix 14.3.
    5. Gardner Denver Company is considering the purchase of a new piece of factory equipment that will cost \(\$420,000\) and will generate \(\$95,000\) per year for \(5\) years. Calculate the IRR for this piece of equipment. For further instructions on internal rate of return in Excel, see Appendix 14.3.
    6. Consolidated Aluminum is considering the purchase of a new machine that will cost \(\$308,000\) and provide the following cash flows over the next five years: \(\$88,000\), \(\$92,000\), \(\$91,000\), \(\$72,000\), and \(\$71,000\). Calculate the IRR for this piece of equipment. For further instructions on internal rate of return in Excel, see Appendix 14.3.
    7. Redbird Company is considering a project with an initial investment of \(\$265,000\) in new equipment that will yield annual net cash flows of \(\$45,800\) each year over its seven-year life. The company’s minimum required rate of return is \(8\%\). What is the internal rate of return? Should Redbird accept the project based on IRR?
    8. Towson Industries is considering an investment of \(\$256,950\) that is expected to generate returns of \(\$90,000\) per year for each of the next four years. What is the investment’s internal rate of return?
    9. Cinemar Productions bought a piece of equipment for \(\$55,898\) that will last for \(5\) years. The equipment will generate net operating cash flows of \(\$14,000\) per year and will have no salvage value at the end of its life. What is the internal rate of return?

    Exercise Set B

    1. Margo’s Memories, a company that specializes in photography and creating family and group photo portfolios, has \(50\) stores in major malls around the U.S. The company is considering an online business, which will require a substantial investment in web design, security, payment processing, and technology in order to launch successfully. What potential advantages or disadvantages will be difficult to quantify from a capital investment standpoint?
    2. Boxer Production, Inc., is in the process of considering a flexible manufacturing system that will help the company react more swiftly to customer needs. The controller, Mick Morrell, estimated that the system will have a \(10\)-year life and a required return of \(10\%\) with a net present value of negative \(\$500,000\). Nevertheless, he acknowledges that he did not quantify the potential sales increases that might result from this improvement on the issue of on-time delivery, because it was too difficult to quantify. If there is a general agreement that qualitative factors may offer an additional net cash flow of \(\$150,000\) per year, how should Boxer proceed with this investment?
    3. A restaurant is considering the purchase of new tables and chairs for their dining room with an initial investment cost of \(\$515,000\), and the restaurant expects an annual net cash flow of \(\$103,000\) per year. What is the payback period?
    4. Assume a company is going to make an investment in a machine of \(\$825,000\) and the following are the cash flows that two different products would bring. Which of the two options would you choose based on the payback method?
    Option A, Product A; Option B, Product B (respectively): $245,000, $225,000; 195,000, 345,000, 295,000, 250,000; 200,000, 50,000.
    1. A grocery store is considering the purchase of a new refrigeration unit with an initial investment of \(\$412,000\), and the store expects a return of \(\$100,000\) in year one, \(\$72,000\) in years two and three, \(\$65,000\) in years four and five, and \(\$38,000\) in year six and beyond, what is the payback period?
    2. The management of Ryland International is considering investing in a new facility and the following cash flows are expected to result from the investment:
    Year, Investment (cash outflow), Cash Inflow (respectively): 1, $700,000, 200,000; 2, $2,100,000, 400,000; 3, - , 260,000; 4, - , 360,000; 5, - , 260,000; 6, - , 800,000; 7, - , 480,000; 8, - , 400,000; 9, - , 420,000; 10, - , 420,000.
    1. What is the payback period of this uneven cash flow?
    2. Does your answer change if year \(6\)’s cash inflow changes to \(\$920,000\)?
    1. An auto repair company needs a new machine that will check for defective sensors. The machine has an initial investment of \(\$224,000\). Incremental revenues, including cost savings, are \(\$120,000\), and incremental expenses, including depreciation, are \(\$50,000\). There is no salvage value. What is the accounting rate of return (ARR)?
    2. You put \(\$600\) in the bank for \(3\) years at \(15\%\).
      1. If interest is added at the end of the year, how much will you have in the bank after one year? Calculate the amount you will have in the bank at the end of year two and continue to calculate all the way to the end of the third year.
      2. Use the future value of \(\$1\) table in Appendix 14.2 and verify that your answer is correct.
    3. If you invest \(\$15,000\) today, how much will you have in (for further instructions on future value in Excel, see Appendix 14.3):
      1. \(20\) years at \(22\%\)
      2. \(12\) years at \(10\%\)
      3. \(5\) years at \(14\%\)
      4. \(2\) years at \(7\%\)
    4. You have been depositing money into an account yearly based on the following investment amounts, rates and times. What is the value of that investment account at the end of that period?
    Amount of Investment, Rate, Time, Value at the End of the Period (respectively): $4,000, 12%, 14 years, ?; 6,000, 15, 10 years, ?; 13,500, 10, 8 years, ?; 22,250, 20, 6 years, ?
    1. How much would you invest today in order to receive \(\$30,000\) in each of the following (for further instructions on present value in Excel, see Appendix 14.3):
      1. \(20\) years at \(22\%\)
      2. \(12\) years at \(10\%\)
      3. \(5\) years at \(14\%\)
      4. \(2\) years at \(7\%\)
    2. Your friend has a trust fund that will pay her the following amounts at the given interest rate for the given number of years. Calculate the current (present) value of your friend’s trust fund payments. For further instructions on present value in Excel, see Appendix 14.3.
    Amount of Yearly Receipt, Rate, Time, Current Value (respectively): $5,000, 10%, 5 years, ?; 7,500, 12, 10 years, ?; 14,000, 15, 15 years, ?; 25,000, 20, 20 years, ?
    1. Conestoga Plumbing plans to invest in a new pump that is anticipated to provide annual savings for \(10\) years of \(\$50,000\). The pump can be sold at the end of the period for \(\$100,000\). What is the present value of the investment in the pump at a \(9\%\) interest rate given that savings are realized at year end?
    2. How much must be invested now to receive \(\$50,000\) for \(8\) years if the first \(\$50,000\) is received in one year and the rate is \(10\%\)?
    3. Project X costs \(\$10,000\) and will generate annual net cash inflows of \(\$4,800\) for five years. What is the NPV using \(8\%\) as the discount rate?
    4. Project Y cost \(\$8,000\) and will generate net cash inflows of \(\$1,500\) in year one, \(\$2,000\) in year two, \(\$2,500\) in year three, \(\$3,000\) in year four and \(\$2,000\) in year five. What is the NPV using \(8\%\) as the discount rate?
    5. Caduceus Company is considering the purchase of a new piece of factory equipment that will cost \(\$565,000\) and will generate \(\$135,000\) per year for \(5\) years. Calculate the IRR for this piece of equipment. For further instructions on internal rate of return in Excel, see Appendix 14.3.
    6. Garnette Corp is considering the purchase of a new machine that will cost \(\$342,000\) and provide the following cash flows over the next five years: \(\$99,000\), \(\$88,000\), \(\$92,000\), \(\$87,000\), and \(\$72,000\). Calculate the IRR for this piece of equipment. For further instructions on internal rate of return in Excel, see Appendix 14.3.
    7. Wallace Company is considering two projects. Their required rate of return is \(10\%\).
      Project A Project B
    Initial investment $170,000 $48,000
    Annual cash flows $41,352 $12,022
    Life of the project 6 years 5 years

    Which of the two projects, A or B, is better in terms of internal rate of return?

    1. Taos Productions bought a piece of equipment for \(\$79,860\) that will last for \(5\) years. The equipment will generate net operating cash flows of \(\$20,000\) per year and will have no salvage value at the end of its life. What is the internal rate of return?

    Problem Set A

    1. Your company is planning to purchase a new log splitter for its lawn and garden business. The new splitter has an initial investment of \(\$180,000\). It is expected to generate \(\$25,000\) of annual cash flows, provide incremental cash revenues of \(\$150,000\), and incur incremental cash expenses of \(\$100,000\) annually. What is the payback period and accounting rate of return (ARR)?
    2. Jasmine Manufacturing is considering a project that will require an initial investment of \(\$52,000\) and is expected to generate future cash flows of \(\$10,000\) for years \(1\) through \(3\), \(\$8,000\) for years \(4\) and \(5\), and \(\$2,000\) for years \(6\) through \(10\). What is the payback period for this project?
    3. Use the tables in Appendix 14.2 to answer the following questions.
      1. If you would like to accumulate \(\$2,500\) over the next \(4\) years when the interest rate is \(15\%\), how much do you need to deposit in the account?
      2. If you place \(\$6,200\) in a savings account, how much will you have at the end of \(7\) years with a \(12\%\) interest rate?
      3. You invest \(\$8,000\) per year for \(10\) years at \(12\%\) interest, how much will you have at the end of \(10\) years?
      4. You win the lottery and can either receive \(\$750,000\) as a lump sum or \(\$50,000\) per year for \(20\) years. Assuming you can earn \(8\%\) interest, which do you recommend and why?
    4. Ralston Consulting, Inc., has a \(\$25,000\) overdue debt with Supplier No. 1. The company is low on cash, with only \(\$7,000\) in the checking account and does not want to borrow any more cash. Supplier No. 1 agrees to settle the account in one of two ways:
      • Option 1: Pay \(\$7,000\) now and \(\$23,750\) when some large projects are finished, two years from today.
      • Option 2: Pay \(\$35,000\) three years from today, when even larger projects are finished.

        Assuming that the only factor in the decision is the cost of money (\(8\%\)), which option should Ralston choose?

    1. Falkland, Inc., is considering the purchase of a patent that has a cost of \(\$50,000\) and an estimated revenue producing life of \(4\) years. Falkland has a cost of capital of \(8\%\). The patent is expected to generate the following amounts of annual income and cash flows:
    Year 1, 2, 3, and 4 respectively: Net Income: $5,100, 6,500, 6,300, 3,000; Operating cash flows: $17,050, 18,450, 18,250, 14,850.
    1. What is the NPV of the investment?
    2. What happens if the required rate of return increases?
    1. There are two projects under consideration by the Rainbow factory. Each of the projects will require an initial investment of \(\$35,000\) and is expected to generate the following cash flows:
    First year, Second Year, Third Year, Total (respectively): Alpha Project: 32,000, 22,500, 5,000, 59,500. Beta Project: 7,500, 23,500, 28,000, 59,000.

        If the discount rate is \(12\%\), compute the NPV of each project.

    1. There are two projects under consideration by the Rainbow factory. Each of the projects will require an initial investment of \(\$35,000\) and is expected to generate the following cash flows:
    First year, Second Year, Third Year, Total (respectively): Alpha Project: 32,000, 22,500, 5,000, 59,500. Beta Project: 7,500, 23,500, 28,000, 59,000.

    Use the information from the previous exercise to calculate the internal rate of return on both projects and make a recommendation on which one to accept. For further instructions on internal rate of return in Excel, see Appendix 14.3.

    1. Pompeii’s Pizza has a delivery car that it uses for pizza deliveries. The transmission needs to be replaced and there are several other repairs that need to be done. The car is nearing the end of its life, so the options are to either overhaul the car or replace it with a new car. Pompeii’s has put together the following budgetary items:
    Present Car: Transmission replacement and other work needed $8,500, annual Cash Operating Cost $12,500, Fair Market Value Now $5,000, FMV in five more years $500. New Car: Purchase cost new $31,000, Annual Cash Operating Cost 10,000, FMV in five more years $5,000.

    If Pompeii’s replaces the transmission of the pizza delivery vehicle, they expect to be able to use the vehicle for another \(5\) years. If they sell the old vehicle and purchase a new vehicle, they will use that vehicle for 5 years and then trade it in for another new pizza delivery vehicle. If they trade for the new delivery vehicle, their operating expenses will decrease because the new vehicle is more gas efficient and the maintenance on a new car is less. This project is analyzed using a discount rate of \(12\%\). What should Pompeii’s do?

    1. Pitt Company is considering two alternative investments. The company requires a \(12\%\) return from its investments. Neither option has a salvage value.
    Project X, Project Y, Respectively. Initial Investment $180,000, 118,000. Net cash flows anticipated in year: 1, 82,000, 35,000; 2, 59,000, 55,000; 3, 92,000, 72,000; 4, 81,000, 68,000; 5, 76,000, 27,000.

    Compute the IRR for both projects and recommend one of them. For further instructions on internal rate of return in Excel, see Appendix 14.3.

    1. The Ham and Egg Restaurant is considering an investment in a new oven that has a cost of \(\$60,000\), with annual net cash flows of \(\$9,950\) for \(8\) years. The required rate of return is \(6\%\). Compute the net present value of this investment to determine whether or not you would recommend that Ham and Egg invest in this oven.
    2. Gallant Sports is considering the purchase of a new rock-climbing facility. The company estimates that the construction will require an initial outlay of \(\$350,000\). Other cash flows are estimated as follows:
    Year 1 ($60,000). Year 2 $140,000. Year 3 $210,000. Year 4 $130,000.

    Assuming the company limits its analysis to four years due to economic uncertainties, determine the net present value of the rock-climbing facility. Should the company develop the facility if the required rate of return is \(6\%\)?

    Problem Set B

    1. A bookstore is planning to purchase an automated inventory/remote marketing system, which includes an upgrade to a more sophisticated cash register system. The package has an initial investment cost of \(\$360,000\). It is expected to generate \(\$144,000\) of annual cash flows, reduce costs and provide incremental cash revenues of \(\$326,000\), and incur incremental cash expenses of \(\$200,000\) annually. What is the payback period and accounting rate of return (ARR)?
    2. Markoff Products is considering two competing projects, but only one will be selected. Project A requires an initial investment of \(\$42,000\) and is expected to generate future cash flows of \(\$6,000\) for each of the next \(50\) years. Project B requires an initial investment of \(\$210,000\) and will generate \(\$30,000\) for each of the next \(10\) years. If Markoff requires a payback of \(8\) years or less, which project should it select based on payback periods?
    3. Use the tables in Appendix 14.2 to answer the following questions.
      1. If you would like to accumulate \(\$4,200\) over the next \(6\) years when the interest rate is \(8\%\), how much do you need to deposit in the account?
      2. If you place \(\$8,700\) in a savings account, how much will you have at the end of \(12\) years with an interest rate of \(8\%\)?
      3. You invest \(\$2,000\) per year, at the end of the year, for \(20\) years at \(10\%\) interest. How much will you have at the end of \(20\) years?
      4. You win the lottery and can either receive \(\$500,000\) as a lump sum or \(\$60,000\) per year for \(20\) years. Assuming you can earn \(3\%\) interest, which do you recommend and why?
    4. Chang Consulting, Inc., has a \(\$15,000\) overdue debt with Supplier No. 1. The company is low on cash, with only \(\$4,000\) in the checking account and does not want to borrow any more cash. Supplier No. 1 agrees to settle the account in one of two ways:
      • Option 1: Pay \(\$4,000\) now and \(\$18,750\) when some large projects are finished, two years from today.
      • Option 2: Pay \(\$25,000\) three years from today, when even larger projects are finished.

        Assuming that the only factor in the decision is the cost of money (\(8\%\)), which option should Clary choose?

    1. Mason, Inc., is considering the purchase of a patent that has a cost of \(\$85,000\) and an estimated revenue producing life of \(4\) years. Mason has a required rate of return that is \(12\%\) and a cost of capital of \(11\%\). The patent is expected to generate the following amounts of annual income and cash flows:
    Year 1, 2, 3, and 4 respectively: Net Income: $6,900, 9,600, 3,000, 6,300. Operating cash flows: 19,500, 18,700, 20,250, 15,9000
    1. What is the NPV of the investment?
    2. What happens if the required rate of return increases?
    1. There are two projects under consideration by the Rainbow factory. Each of the projects will require an initial investment or \(\$28,000\) and is expected to generate the following cash flows:
    First Year, Second Year, Third Year, Total (respectively): Alpha Project: 22,000, 23,500, 5,000, 50,500. Beta Project: 12,700, 22,000, 15,800, 50,500.

        If the discount rate is \(5\%\) compute the NPV of each project and make a recommendation of the project to be chosen.

    1. Use the information from the previous exercise to calculate the Internal Rate of Return on both projects and make a recommendation regarding which one to accept.
    2. D&M Pizza has a delivery car that is uses for pizza deliveries. The transmission needs to be replaced, and there are several other repairs that need to be done. The car is nearing the end of its life, so the options are to either overhaul the car or replace it with a new car. D&M’s has put together the following budgetary items:
    Present Car: Transmission replacement and other work needed $6,500, annual Cash Operating Cost $8,500, Fair Market Value Now $6,000, FMV in five more years $100. New Car: Purchase cost new $30,000, Annual Cash Operating Cost 7,500, FMV in five more years $6,000.

    If D&M replaces the transmission of the pizza delivery vehicle, they expect to be able to use the vehicle for another \(5\) years. If they purchase a new vehicle, they will sell the existing one and use the new vehicle for 5 years and then trade it in for another new pizza delivery vehicle. If they trade for the new delivery vehicle, their operating expenses will decrease because the new vehicle is more gas efficient. This project is analyzed using a discount rate of \(15\%\). What should D&M do?

    1. Joliet Company is considering two alternative investments. The company requires an \(18\%\) return from its investments.
    Project X, Project Y, Respectively: Initial Investment $108,000, 98,000. Net cash flows anticipated in year: 1, 36,000, 25,000; 2, 39,000, 45,000; 3, 32,000, 42,000; 4, 34,000, 28,000; 5, 25,000, 17,000.

        Compute the IRR for both Projects and recommend one of them. For further instructions on internal rate of return in Excel, see Appendix 14.3.

    1. Bouvier Restaurant is considering an investment in a grill that costs \(\$140,000\), and will produce annual net cash flows of \(\$21,950\) for \(8\) years. The required rate of return is \(6\%\). Compute the net present value of this investment to determine whether Bouvier should invest in the grill.

    Thought Provokers

    1. What is the benefit(s) of the accountant’s involvement in the capital investment decision?
    2. Austin’s cell phone manufacturer wants to upgrade their product mix to encompass an exciting new feature on their cell phone. This would require a new high-tech machine. You are excited about his new project and are recommending the purchase to your board of directors. Here is the information you have compiled in order to complete this recommendation:
    Unit selling price $45, Unit variable cost $25, Fixed Costs $200,000, Depreciation costs $35,000, Expected sales 10,000 units per year.

    According to the information, the project will last \(10\) years and require an initial investment of \(\$800,000\), depreciated with straight-line over the life of the project until the final value is zero. The firm’s tax rate is \(30\%\) and the required rate of return is \(12\%\). You believe that the variable cost and sales volume may be as much as \(10\%\) higher or lower than the initial estimate. Your boss understands the risks but asks you to explain the alternatives in a brief memo to the board. Write a memo to the Board of Directors objectively weighing out the pros and cons of this project and make your recommendation(s).

    1. Would you rather have \(\$7,500\) today or at the end of \(20\) years after it has been invested at \(15\%\)? Explain your answer. The following are independent situations. For each capital budgeting project, indicate whether management should accept or reject the project and list a brief reason why.
    2. Midas Corp. evaluated a potential investment and determined the NPV to be zero. Midas Corp.’s required rate of return is \(9.1\%\) and its cost of capital is \(6.4\%\).
    3. Giorgio Co. is looking at an investment project with an internal rate of return of \(10.8\%\). The initial outlay for the investment is \(\$90,000\). The hurdle rate or minimum acceptable rate of return is \(10.2\%\).
    4. Dinaro Inc. is looking at an investment project that has an NPV of (\(\$5,000\)). The hurdle rate is \(8\%\).
    5. You begin a new job at Cabrera Medical Supplies. The company is considering a new accounting system, with an initial investment of about half a million dollars for new software and hardware. You are excited for the opportunity to apply your managerial accounting skills regarding screening and preference methods to decide on the best system for the company. Your boss is a little old-school, and when you mention some of the things you learned in managerial accounting, he says, “Discounted cash flow methods are not the only way to approach this. I have more of a gut reaction approach that blows most managers out of the water when they become absorbed by discounted cash flow methods (DCF).” How would you react and what would you discuss with your boss?
    6. Fenton, Inc., has established a new strategic plan that calls for new capital investment. The company has a \(9.8\%\) required rate of return and an \(8.3\%\) cost of capital. Fenton currently has a return of \(10\%\) on its other investments. The proposed new investments have equal annual cash inflows expected. Management used a screening procedure of calculating a payback period for potential investments and annual cash flows, and the IRR for the \(7\) possible investments are shown. Each investment has a \(6\)-year expected useful life and no salvage value.
    Payback Period, IRR, Investment Cost (respectively): Project A1, 4.2, 10.5%, $130,000; Project B2, 5.9, 5.1%, $67,000; Project C3, 5.0, 13.4%, $83,000; Project D4, 4.8, 7.4%, $61,000; Project E5, 3.2, 12.1%, $115,000; Project F6, 4.0, 9.9%, $65,000; Project G7, 6.3, 9.8%, $76,000.
    1. Identify which project(s) is/are unacceptable and briefly state the conceptual justification as to why each of your choices is unacceptable.
    2. Assume Fenton has \(\$330,000\) available to spend. Which remaining projects should Fenton invest in and in what order?
    3. If Fenton was not limited to a spending amount, should they invest in all of the projects given the company is evaluated using return on investment?