Manager Accountment

Exercises and Answers EXERCISE 14–1 Payback Method [LO14–1] The management of Unter Corporation, an architectural design firm, is considering an investment with the following cash flows: Year Investment Cash Inflow 1 . . . . . . . $15,000 …….$1,000 2 . . . . . . . $ 8,000………$2,000 3 . . . . . . ………………..$2,500 4 . . . . . . . ………………$4,000 5 . . . . . . . ………………$5,000 6 . . . . . . . ………………$6,000 7 . . . . . . . ………………$5,000 8 . . . . . . . ………………$4,000 9 . . . . . . . ………………$3,000 10 . . . . . . . ……………..$2,000 Required: 1. Determine the payback period of the investment. 2. Would the payback period be affected if the cash inflow in the last year were several times as large? Exercise 14-1 (10 minutes) 1. The payback period is determined as follows: Year 1 2 3 4 5 6 7 8 9 10 Investment $15,000 $8,000 Cash Inflow $1,000 $2,000 $2,500 $4,000 $5,000 $6,000 $5,000 $4,000 $3,000 $2,000 Unrecovered Investment $14,000 $20,000 $17,500 $13,500 $8,500 $2,500 $0 $0 $0 $0 The investment in the project is fully recovered in the 7th year. To be more exact, the payback period is approximately 6.5 years [= 6 + ($2,500 ÷ $5,000)]. 2. Because the investment is recovered prior to the last year, the amount of the cash inflow in the last year has no effect on the payback period. EXERCISE 14–2 Net Present Value Method [LO14–2] The management of Kunkel Company is considering the purchase of a $27,000 machine that would reduce operating costs by $7,000 per year. At the end of the machine’s five-year useful life, it will have zero scrap value. The company’s required rate of return is 12%. Required: 1. Determine the net present value of the investment in the machine. 2. What is the difference between the total, undiscounted cash inflows and cash outflows over the entire life of the machine? Exercise 14-2 (10 minutes) 1. Purchase of machine .............................. Reduced operating costs ........................ Total cash flows (a) ............................... Discount factor (12%) (b)...................... Present value (a)×(b) ............................. Net present value ................................... Now $(27,000) $(27,000) 1.000 $(27,000) $(1,765) 2. Item Annual cost savings ..... Initial investment ......... Net cash flow ............... Cash Years Flow $7,000 5 $(27,000) 1 Total Cash Flows $ 35,000 (27,000) $ 8,000 Years 1-5 $7,000 $7,000 3.605 $25,235 EXERCISE 13–5 Preference Ranking [LO14–5] Information on four investment proposals is given below: Investment Proposal A B C D Investment required . . ……. . $(90,000) $(100,000) $(70,000) $(120,000) Present value of cash inflows .. 126,000 138,000 105,000 160,000 Net present value . . . . . . .. . . $ 36,000 $ 38,000 $ 35,000 $ 40,000 Life of the project . . . . . . . . . . 5 years 7 years 6 years 6 years Required: 1. Compute the project profitability index for each investment proposal. 2. Rank the proposals in terms of preference. Exercise 14-5 (10 minutes) 1. The profitability index for each proposal is: Proposal Number Present Value of Cash Inflows (a) Investment Required (b) Profitability Index (a) (b) A B C D $126,000 $138,000 $105,000 $160,000 $90,000 $100,000 $70,000 $120,000 1.40 1.38 1.50 1.33 2. The ranking is: Proposal Number C A B D Profitability Index 1.50 1.40 1.38 1.33 Note that proposal D has the highest net present value, but it ranks lowest in terms of the profitability index. EXERCISE 14–6 Simple Rate of Return Method [LO13–6] The management of Ballard MicroBrew is considering the purchase of an automated bottling machine for $120,000. The machine would replace an old piece of equipment that costs $30,000 per year to operate. The new machine would cost $12,000 per year to operate. The old machine currently in use could be sold now for a scrap value of $40,000. The new machine would have a useful life of 10 years with no salvage value. Required: 1. What is the annual depreciation expense associated with the new bottling machine? 2. What is the annual incremental net operating income provided by the new bottling machine? 3. What is the amount of the initial investment associated with the project that should be used for calculating the simple rate of return? 4. Compute the simple rate of return on the new automated bottling machine. Exercise 14-6 (10 minutes) 1. The annual depreciation expense is computed as follows: Cost of the new machine (a) ...................... Useful life in years (b) ............................... Annual depreciation expense (a) ÷ (b) ....... $120,000 10 $12,000 2. The annual incremental net operating income is computed as follows: Operating cost of old machine.................... Less operating cost of new machine ........... Less annual depreciation on the new machine ($120,000 ÷ 10 years)............... Annual incremental net operating income ... $ 30,000 12,000 12,000 $ 6,000 3. The initial investment is computed as follows: Cost of the new machine ........................... Less salvage value of old machine .............. Initial investment ...................................... $120,000 40,000 $ 80,000 4. The simple rate of return is computed as follows: Simple rate = Annual incremental net operating income of return Initial investment = $6,000 = 7.5% $80,000 EXERCISE 14–7 Net Present Value Analysis of Two Alternatives [LO14– 2] Perit Industries has $100,000 to invest. The company is trying to decide between two alternative uses of the funds. The alternatives are: Project A Project B $0 Cost of equipment required . . . . . . . . . . . . . . . . . $100,000 Working capital investment required . . . . . . . . . . . $0 $100,000 Annual cash inflows . . . . . . . . . . . . . . . . . . . . . . . . $21,000 $16,000 Salvage value of equipment in six years . . . . . . . . $8,000 $0 Life of the project . . . . . . . . . . . . . . . . . . . . . . . . . 6 years 6 years The working capital needed for project B will be released at the end of six years for investment elsewhere. Perit Industries’ discount rate is 14%. Required: 1. Compute the net present value for project A. 2. Compute the net present value for project B. 3. Which investment alternative (if either) would you recommend that the company accept? Exercise 14-7 (15 minutes) 1. Project A: Purchase of equipment .................................. Annual cash inflows ...................................... Salvage value ................................................. Total cash flows (a) ....................................... Discount factor (14%) (b) .............................. Present value (a)×(b) ..................................... Net present value ........................................... Now $(100,000) $(100,000) 1.000 $(100,000) $(14,683) Years 1-6 Year 6 $21,000 $21,000 3.889 $81,669 $8,000 $8,000 0.456 $3,648 2. Project B: Working capital invested .............................. Annual cash inflows ..................................... Working capital released .............................. Total cash flows (a) ...................................... Discount factor (14%) (b) ............................. Present value (a)×(b) .................................... Net present value .......................................... Now $(100,000) Years 1-6 $16,000 $(100,000) 1.000 $(100,000) $7,824 $16,000 3.889 $62,224 Year 6 $100,000 $100,000 0.456 $45,600 3. The $100,000 should be invested in Project B rather than in Project A. Project B has a positive net present value whereas Project A has a negative net present value. PROBLEM 14–18 Net Present Value Analysis [LO14–2] Oakmont Company has an opportunity to manufacture and sell a new product for a four-year period. The company’s discount rate is 15%. After careful study, Oakmont estimated the following costs and revenues for the new product: Cost of equipment needed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $130,000 Working capital needed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000 Overhaul of the equipment in two years . . . . . . . . . . . . . . . . . . . . $8,000 Salvage value of the equipment in four years . . . . . . . . . . . . . . . . $12,000 Annual revenues and costs: Sales revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000 Variable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 Fixed out-of-pocket operating costs . . . . . . . . . . . . . . . . . . . . . . . $70,000 When the project concludes in four years the working capital will be released for investment elsewhere within the company. Required: Calculate the net present value of this investment opportunity. Problem 14-18 (20 minutes) The net present value is computed as follows: Purchase of equipment Working capital investment Sales Variable expenses Fixed out-of-pocket costs Overhaul of equipment Working capital released Salvage value of equipment Total cash flows (a) Discount factor (15%) (b) Present value (a)×(b) Net present value Now $(130,000) (60,000) _________ $(190,000) 1.000 $(190,000) $16,496 1 2 3 4 $250,000 (120,000) (70,000) $250,000 (120,000) (70,000) (8,000) $250,000 (120,000) (70,000) $250,000 (120,000) (70,000) ________ $60,000 0.870 $52,200 _______ $52,000 0.756 $39,312 _______ $60,000 0.658 $39,480 60,000 12,000 $132,000 0.572 $75,504 Note: The sales ($250,000), variable expenses ($120,000), and fixed out-of-pocket costs ($70,000) can also be discounted to their present values using the appropriate discount factor (2.855) from Exhibit 14B-2 in Appendix 14B. Item Years Purchase of Equipment Working Capital Overhaul of Equipment Salvage Value of Equipment Release of Working Capital Annual Net Cash Inflow (Income) NPV Now Now 2 4 4 1- 4 Cash Flow (130,000) (60,000) (8,000) 12,000 60,000 60,000 PV Factor 1 1 0.756 0.572 0.572 2.855 PV (130,000) (60,000) (6,048) 6,864 34,320 171,300 16,436