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Business LibreTexts

11.7: Summary

  • Page ID
    10419
  • Section Summaries

     

    11.1 Describe Capital Investment Decisions and How They Are Applied

    • Capital investment decisions select a project for future business development. These projects typically require a large outlay of cash, provide an uncertain return, and tie up resources for an extended period of time.
    • Having a large number of alternatives requires a careful budgeting and analysis process. This process includes determining capital needs, exploring resource limitations, establishing baseline criteria for alternatives, evaluating alternatives using screening and preference decisions, and making the decision.
    • Screening decisions help eliminate undesirable alternatives that may waste time and money. Preference decisions rank alternatives emerging from the screening process to help make the final decision. Both decision avenues use capital budgeting methods to select between alternatives.

    11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions

    • The payback method determines how long it will take a company to recoup their investment. Annual cash flows are compared to the initial investment but the time value of money is not considered and cashflows beyond the payback period are ignored.
    • The accounting rate of return considers incremental net income as it compares to the initial investment. Time value of money is not considered with this method.
    • Incremental net income determines the net income expected if the company accepts the investment opportunity, as opposed to not investing. Incremental net income is the difference between incremental revenues and incremental expenses.

    11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities

    • A dollar is worth more today than it will be in the future. This is due to many reasons including the power of investment in today’s economy, market inflation, and the ability to use the money in the present to make more money in the future, with interest.
    • Present value expresses the future value of a dollar in today’s (present) value. Present value tables, showing the present value factor intersection of periods and interest rate, are used to multiply by the final payout amount to compute today’s value.
    • The future value shows what the value of an investment will be after a certain period of time. Future value tables, showing the future value factor intersection of periods and interest rate, are used to multiply by the initial investment amount to compute future value.
    • A lump sum is a one-time payment after a certain period of time, whereas an ordinary annuity involves equal installments in a series of payments over time. A business can use lump sum or ordinary annuity calculations for present value and future value calculations.

    11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions

    • The discounted cash flow model assigns values to a project’s alternatives using time value of money and discounts future rates back to present value. Two measurement tools are used in discounted cash flows: net present value and internal rate of return.
    • Net present value considers an expected rate of return, converts future cash flows into present value, and compares that to the initial investment cost. If the outcome is positive, the company would look to invest in the project.
    • Internal rate of return shows the profitability of an investment, where NPV equals zero. If the corresponding interest rate exceeds the expected rate of return, the company would invest in the project.

    11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions

    • The payback method uses a simple calculation, removes unviable alternatives quickly, and considers investment risk. However, it disregards the time value of money, ignores profitability, and does not consider cash flows after recouping the investment.
    • The accounting rate of return uses a simple calculation, considers profitability, and removes unviable options quickly. However, it disregards the time value of money, values return rates more than risk, and ignores external influential factors.
    • Net present value considers the time value of money, ranks higher risk investments, and compares future earnings in today’s value. However, it cannot easily compare dissimilar investment opportunities, it uses a more difficult calculation, and it has limitations with the estimation of an expected rate of return.
    • Internal rate of return considers the time value of money, removes the dollar bias, and leads a company to a decision, unlike non-time value methods. However, it has a bias toward return rates instead of higher risk investment consideration, it is a more difficult calculation, and it does not consider the time it will take to recoup an investment.

     

    Key Terms

     

    accounting rate of return (ARR)
    return on investment considering changes to net income
    alternatives
    options available for investment
    annuities due
    equal installments paid at the beginning of each payment period within the series
    annuity
    series of equal payments made over time
    capital investment
    company’s contribution of funds toward long-term assets for further growth; also called capital budgeting
    cash flow
    cash receipts and cash disbursements as a result of business activity
    cash inflow
    money received or cost savings from a capital investment
    cash outflow
    money paid or increased cost expenditures from capital investment
    compounding
    earning interest on previous interest earned, along with the interest earned on the original investment
    discounted cash flow model
    assigns a value to a business opportunity using time-value measurement tools
    discounting
    process that determines the present value of a single payment or stream of payments to be received
    future value (FV)
    value of an investment after a certain period of time
    hurdle rate
    minimum required rate of return on an investment to consider an alternative for further evaluation
    internal rate of return method (IRR)
    calculation to determine profitability or growth potential of an investment, expressed as a percentage, at the point where NPV equals zero
    lump sum
    one-time payment or repayment of funds at a particular point in time
    net present value method (NPV)
    discounts future cash flows to their present value at the expected rate of return, and compares that to the initial investment
    non-time value methods
    analysis that does not consider the comparison value of a dollar today to a dollar in the future
    operating expenses
    daily operational costs not associated with the direct selling of products or services
    ordinary annuities
    equal installments paid at the end of each payment period within the series
    payback method (PM)
    calculation of the length of time it takes a company to recoup their initial investment
    preference decision
    process of comparing potential projects that meet screening decision criteria, and will rank order of importance, feasibility, and desirability to differentiate among alternatives
    present value (PV)
    future value of an investment expressed in today’s value
    screening decision
    process of removing alternatives from the decision-making process that would be less desirable to pursue given their inability to meet basic standards
    time value of money
    assertion that the value of a dollar today is worth more than the value of a dollar in the future

     

    Multiple Choice

     

    1

    LO 11.1Capital 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
    2

    LO 11.1Preference 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
    3

    LO 11.1The 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
    4

    LO 11.3You 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.
    5

    LO 11.3If 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
    6

    LO 11.3You 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
    7

    LO 11.3Using 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.
    8

    LO 11.3Grummet 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
    9

    LO 11.3The 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
    10

    LO 11.3The process of reinvesting interest earned to generate additional earnings over time is ________.

    1. compounding
    2. discounting
    3. annuity
    4. lump-sum
    11

    LO 11.4The 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
    12

    LO 11.4Which 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
    13

    LO 11.4Which 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
    14

    LO 11.4This 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
    15

    LO 11.5The 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
    16

    LO 11.5When 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

    LO 11.1What are the steps involved in the process for capital decision-making?

    2

    LO 11.1Why does a company evaluate both the money allocated to a project and the time allocated to the project?

    3

    LO 11.1What is the next thing a company needs to do after it establishes investment criteria?

    4

    LO 11.1What is the screening decision?

    5

    LO 11.1Your 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?

    6

    LO 11.1Ekon 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.

    7

    LO 11.2What is the payback method used to determine?

    8

    LO 11.2What are one advantage and one disadvantage of the payback method?

    9

    LO 11.2What are one advantage and one disadvantage of the accounting rate of return method?

    10

    LO 11.2What is the equation to calculate the payback period?

    11

    LO 11.2What is the equation to calculate the accounting rate of return?

    12

    LO 11.3What is future value and what is one example where it might be used?

    13

    LO 11.3Why do businesses consider time value of money before making an investment decision?

    14

    LO 11.3What determines the anticipated interest rate payout for an investment?

    15

    LO 11.3To calculate present value of a lump sum, which table would be used?

    16

    LO 11.3What is the definition of present value?

    17

    LO 11.4What is the difference between the discount rate used for net present value and the internal rate of return methods?

    18

    LO 11.4Briefly explain how NPV is computed and interpreted.

    19

    LO 11.4What is the basic benefit of using IRR?

    20

    LO 11.4How is the IRR determined if there are uneven cash flows?

    21

    LO 11.5A 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?

    22

    LO 11.5What are the strengths and weaknesses of NPV?

    23

    LO 11.5What are the strengths and weaknesses of IRR?

    24

    LO 11.5How does the size of the initial investment affect the internal rate of return on the net present value models?

     

    Exercise Set A

     

    EA1

    LO 11.1Bob’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?

    EA2

    LO 11.1In 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.

    EA3

    LO 11.2If 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?

    EA4

    LO 11.2Assume 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.
    EA5

    LO 11.2If 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?

    EA6

    LO 11.2The 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?
    EA7

    LO 11.2A 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)?

    EA8

    LO 11.3You 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 B and verify that your answer is correct.
    EA9

    LO 11.3If you invest $12,000 today, how much will you have in (for further instructions on future value in Excel, seeAppendix C):

    1. 10 years at 9%
    2. 8 years at 12%
    3. 14 years at 15%
    4. 19 years at 18%
    EA10

    LO 11.3You 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, ?
    EA11

    LO 11.3How 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 C):

    1. 10 years at 9%
    2. 8 years at 12%
    3. 14 years at 15%
    4. 19 years at 18%
    EA12

    LO 11.3Your 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 C.

    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, ?
    EA13

    LO 11.3Julio 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?

    EA14

    LO 11.3How 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%?

    EA15

    LO 11.4Project 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?

    EA16

    LO 11.4Project 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 C.

    EA17

    LO 11.4Gardner 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 C.

    EA18

    LO 11.4Consolidated 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 C.

    EA19

    LO 11.4Redbird 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?

    EA20

    LO 11.5Towson 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?

    EA21

    LO 11.5Cinemar 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

     

    EB1

    LO 11.1Margo’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?

    EB2

    LO 11.1Boxer 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?

    EB3

    LO 11.2A 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?

    EB4

    LO 11.2Assume 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.
    EB5

    LO 11.2A 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?

    EB6

    LO 11.2The 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?
    EB7

    LO 11.2An 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)?

    EB8

    LO 11.3You 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 B and verify that your answer is correct.
    EB9

    LO 11.3If you invest $15,000 today, how much will you have in (for further instructions on future value in Excel, seeAppendix C):

    1. 20 years at 22%
    2. 12 years at 10%
    3. 5 years at 14%
    4. 2 years at 7%
    EB10

    LO 11.3You 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, ?
    EB11

    LO 11.3How 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 C):

    1. 20 years at 22%
    2. 12 years at 10%
    3. 5 years at 14%
    4. 2 years at 7%
    EB12

    LO 11.3Your 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 C.

    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, ?
    EB13

    LO 11.3Conestoga 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?

    EB14

    LO 11.3How 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%?

    EB15

    LO 11.4Project 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?

    EB16

    LO 11.4Project 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?

    EB17

    LO 11.4Caduceus 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 C.

    EB18

    LO 11.4Garnette 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 C.

    EB19

    LO 11.4Wallace 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?

    EB20

    LO 11.5Taos 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

     

    PA1

    LO 11.2Your 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)?

    PA2

    LO 11.2Jasmine 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?

    PA3

    LO 11.3Use the tables in Appendix B 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?
    PA4

    LO 11.3Ralston 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?

    PA5

    LO 11.4Falkland, 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?
    PA6

    LO 11.4There 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.

    PA7

    LO 11.4There 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 C.

    PA8

    LO 11.4Pompeii’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?

    PA9

    LO 11.4Pitt 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, seeAppendix C.

    PA10

    LO 11.5The 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.

    PA11

    LO 11.5Gallant 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

     

    PB1

    LO 11.2A 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)?

    PB2

    LO 11.2Markoff 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?

    PB3

    LO 11.3Use the tables in Appendix B 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?
    PB4

    LO 11.3Chang 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?

    PB5

    LO 11.4Mason, 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?
    PB6

    LO 11.4There 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.

    PB7

    LO 11.4Use 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.

    PB8

    LO 11.4D&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?

    PB9

    LO 11.4Joliet 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, seeAppendix C.

    PB10

    LO 11.5Bouvier 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

     

    TP1

    LO 11.1What is the benefit(s) of the accountant’s involvement in the capital investment decision?

    TP2

    LO 11.1Austin’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).

    TP3

    LO 11.3Would 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.

    TP4

    LO 11.4Midas 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%.

    TP5

    LO 11.4Giorgio 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%.

    TP6

    LO 11.4Dinaro Inc. is looking at an investment project that has an NPV of ($5,000). The hurdle rate is 8%.

    TP7

    LO 11.4You 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?

    TP8

    LO 11.5Fenton, 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?