ASSIGNMENT MATERIAL Di D iscussi ion Questi ions
ASSIGNMENT MATERIAL
A company invests $100,000 in plant assets with an estimated 20-year service life and no salvage value. These assets contribute $10,000 to annual net income when depreciation is computed on a straight-line basis. Compute the payback period and explain your computation.
Doug’s Conveyor Systems, Inc., is considering two investment proposals (1 and 2). Data for the two proposals are presented here:
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EXERCISE 26.1 Understanding Payback Period B
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EXERCISE 26.2 Using Return on Investment to Evaluate Proposals B
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Landry’s Tool Supply Corporation is considering purchasing a machine that costs $56,000 and will produce annual cash flows of $19,000 for six years. The machine will be repurchased at the end of six years for $2,000. What is the net present value of the proposed investment? Landry’s requires a 12 percent return on all capital investments.
A company is trying to decide whether to go ahead with an investment opportunity that costs
$35,650. The expected incremental cash inflows are $78,000, while the expected incremental cash outflows are $67,500. What is the payback period?
Some types of capital investments have associated cash flows that are very difficult to estimate, while other types of capital investments have associated cash flows that are very easy to estimate. Name two capital investments, one that has associated cash flows that are easy to estimate and one that has associated cash flows that are difficult to estimate. Explain how these two types of investments differ and why the associated cash flows are easier or more difficult to estimate.
Assume that the required rate of return for investment projects at Rippenstock Corporation is 12 percent. One department has proposed investment in new equipment with a 10-year life span and a present value of expected future annual cash flows of $120,000. The equipment’s initial outlay cost is $125,000 and it has a salvage value of $10,000. Will this investment project meet the required rate of return for the company?
Ron Jasper manages a factory for Frombees Inc. A salesperson for new factory equipment has persuaded Ron that the new equipment offered by her company would be less dangerous for the employees and lower the sound level in the factory significantly. Ron believes that employees would be more satisfied with their jobs as a result of reduced danger and lower sound levels. Ron has always said that satisfied employees are more productive. Thus, in making the cash flow esti- mates for the new equipment, Ron has included increased cash flows from increased productivity.
In fact, these estimated increases in productivity are just enough to allow the net present value of the proposal to be positive. Name at least two reasons why the net present value estimates could be optimistic.
The Cook County Authority is considering the purchase of a small plane to transport government officials. It is hoped that the plane will save money on travel costs for government employees.
Assume the county requires a 10 percent rate of return. If the plane’s cost is $250,000 and it can be sold in five years for $75,000, what minimum annual savings in transportation costs is needed in order to make the plane a good investment?
Sam’s Gardening Centers has multiple stores in the northeastern United States. Sam’s is consider- ing investing in an “online” store. In addition to the identifiable cash flows such as increased sales and the initial costs to invest in software and personnel, other nonfinancial considerations may exist. Identify nonfinancial issues that Sam’s should consider.
Exercises
The following are 10 technical accounting terms introduced or emphasized in this chapter:
Net present value Capital budgeting Incremental analysis Discount rate Payback period Present value
Sunk cost Salvage value Return on average investment Capital budget audit
Each of the following statements may (or may not) describe one of these technical terms. For each statement, indicate the accounting term described, or answer “None” if the statement does not cor- rectly describe any of the terms.
a. The examination of differences among revenue, costs, and cash flows under alternative courses of action.
b. A cost incurred in the past that cannot be changed as a result of future actions.
c. The process of planning and evaluating proposals for investments in plant assets.
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EXERCISE 26.4 Net Present Value Computations B
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EXERCISE 26.5 Computations for the Payback Period C
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EXERCISE 26.6 Capital Investment Challenges
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EXERCISE 26.7 Net Present Value and Required Rate of Return
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EXERCISE 26.8 Capital Budgeting Behaviors
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EXERCISE 26.9 Net Present Value Analysis
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EXERCISE 26.10 Nonfinancial
Investment Concerns B
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accounting
EXERCISE 26.1 Accounting Terminology
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Exercises accounting
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d. The average annual net income from an investment expressed as a percentage of the average amount invested.
e. The length of time necessary to recover the entire cost of an investment from resulting annual net cash flows.
f. The present value of an investment’s expected future cash flows.
g. The amount of money today that is considered equivalent to the cash flows expected to take place in the future.
h. The required rate of return used by an investor to discount future cash flows to their present value.
i. Often an investment’s final cash flows to be considered in discounted cash flow analysis.
Heartland Paper Company is considering the purchase of a new high-speed cutting machine. Two cutting machine manufacturers have approached Heartland with proposals: (1) Toledo Tools and (2) Akron Industries. Regardless of which vendor Heartland chooses, the following incremental cash flows are expected to be realized:
EXERCISE 26.2 Payback Period
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Incremental Cash Incremental Cash Year Inflows Outflows
1 . . . $26,000 $20,000 2 . . . 27,000 21,000 3 . . . 32,000 26,000 4 . . . 35,000 29,000 5 . . . 34,000 28,000 6 . . . 33,000 27,000
A B C D Investment cost . . . $44,000 $45,000 $50,000 $ ? Estimated salvage value . . . 8,000 5,000 ? 4,000 Average estimated net income . . . 6,000 ? 5,400 4,500 Return on average investment . . . ? 28% 20% 15%
a. If the machine manufactured by Toledo Tools costs $27,000, what is its expected payback period?
b. If the machine manufactured by Akron Industries has a payback period of 66 months, what is its cost?
c. Which of the machines is most attractive based on its respective payback period? Should Heartland base its decision entirely on this criterion? Explain your answer.
Foz Co. is considering four investment proposals (A, B, C, and D). The following table provides data concerning each of these investments:
EXERCISE 26.3 Understanding Return on Average
Investment Relationships on
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Solve for the missing information pertaining to each investment proposal.
Using the tables in Exhibits 26–3 and 26–4 , determine the present value of the following cash flows, discounted at an annual rate of 15 percent:
a. $10,000 to be received 20 years from today.
b. $15,000 to be received annually for 10 years.
c. $10,000 to be received annually for five years, with an additional $12,000 salvage value expected at the end of the fifth year.
d. $30,000 to be received annually for the first three years, followed by $20,000 received annu- ally for the next two years (total of five years in which cash is received).
EXERCISE 26.4 Discounting Cash Flows
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The following information relates to three independent investment decisions, each with a 10-year life and no salvage value:
EXERCISE 26.5 Understanding Net Present Value Relationships E
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A B C
Investment cost . . . $ ? $141,250 $80,520 Incremental annual cash inflows . . . 14,000 37,000 19,000 Incremental annual cash outflows . . . 6,000 ? 7,000 Discount rate yielding a net present value of zero . . . 10% 12% ?
Revenue from contract sales . . . $325,000 Expenses other than depreciation . . . $225,000
Depreciation (straight-line basis) . . . 75,000 300,000 Increase in net income from contract work . . . $ 25,000
Revenue from sales of new luggage . . . $975,000 Expenses other than depreciation . . . $675,000
Depreciation (straight-line basis) . . . 225,000 (900,000) Increase in net income from the new line . . . $ 75,000 Using the present value tables in Exhibits 26–3 and 26–4 , solve for the missing information per- taining to each investment proposal.
Bowman Corporation is considering an investment in special-purpose equipment to enable the company to obtain a four-year government contract for the manufacture of a special item. The equipment costs $300,000 and would have no salvage value when the contract expires at the end of the four years. Estimated annual operating results of the project are as follows:
EXERCISE 26.6 Analyzing a Capital Investment Proposal E
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All revenue and all expenses other than depreciation will be received or paid in cash in the same period as recognized for accounting purposes. Compute the following for Bowman’s proposal to undertake the contract work:
a. Payback period.
b. Return on average investment.
c. Net present value of the proposal to undertake contract work, discounted at an annual rate of 12 percent. (Refer to annuity table in Exhibit 26–4 .)
Northwest Records is considering the purchase of Seattle Sound, Inc., a small company that pro- motes and manages “grunge” bands. The terms of the agreement require that Northwest pay the current owners of Seattle Sound $530,000 to purchase the company. Northwest executives estimate that the investment will generate annual net cash flows of $200,000. They do not feel, however, that demand for grunge music will extend beyond four years. Therefore, they plan to liquidate the entire investment in Seattle Sound at its projected book value of $50,000 at the end of the fourth year. Due to the high risk associated with this venture, Northwest requires a minimum rate of return of 20 percent.
a. Compute the payback period for Northwest’s proposed investment in Seattle Sound.
b. Compute the net present value of the Seattle Sound proposal, using the tables in Exhibits 26–3 and 26–4 .
c. What nonfinancial factors would you recommend that Northwest executives take into consid- eration regarding this proposal?
Pack & Carry is debating whether to invest in new equipment to manufacture a line of high-quality luggage. The new equipment would cost $900,000, with an estimated four-year life and no salvage value. The estimated annual operating results with the new equipment are as follows:
EXERCISE 26.7 Analyzing a Capital Investment Proposal
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EXERCISE 26.8 Analyzing a Capital Investment Proposal E
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All revenue from the new luggage line and all expenses (except depreciation) will be received or paid in cash in the same period as recognized for accounting purposes. You are to compute the following for the investment in the new equipment to produce the new luggage line:
a. Annual cash flows.
b. Payback period.
c. Return on average investment.
d. Total present value of the expected future annual cash inflows, discounted at an annual rate of 10 percent.
e. Net present value of the proposed investment discounted at 10 percent.
The division managers of Chester Construction Corporation submit capital investment proposals each year for evaluation at the corporate level. Typically, the total dollar amount requested by the divisional managers far exceeds the company’s capital investment budget. Thus, each proposal is first ranked by its estimated net present value as a primary screening criterion.
Jeff Hensel, the manager of Chester’s commercial construction division, often overstates the projected cash flows associated with his proposals, and thereby inflates their net present values. He does so because, in his words, “Everybody else is doing it.”
a. Assume that all the division managers do overstate cash flow projections in their proposals.
What would you do if you were recently promoted to division manager and had to compete for funding under these circumstances?
b. What controls might be implemented to discourage the routine overstatement of capital bud- geting estimates by the division managers?
EnterTech has noticed a significant decrease in the profitability of its line of portable CD players.
The production manager believes that the source of the trouble is old, inefficient equipment used to manufacture the product. The issue raised, therefore, is whether EnterTech should (1) buy new equipment at a cost of $120,000 or (2) continue using its present equipment.
It is unlikely that demand for these portable CD players will extend beyond a five-year time horizon. EnterTech estimates that both the new equipment and the present equipment will have a remaining useful life of five years and no salvage value.
The new equipment is expected to produce annual cash savings in manufacturing costs of
$34,000, before taking into consideration depreciation and taxes. However, management does not believe that the use of new equipment will have any effect on sales volume. Thus, its decision rests entirely on the magnitude of the potential cost savings.
The old equipment has a book value of $100,000. However, it can be sold for only $20,000 if it is replaced. EnterTech has an average tax rate of 40 percent and uses straight-line depreciation for tax purposes. The company requires a minimum return of 12 percent on all investments in plant assets.
a. Compute the net present value of the new machine using the tables in Exhibits 26–3 and 26–4 . b. What nonfinancial factors should EnterTech consider?
c. If the manager of EnterTech is uncertain about the accuracy of the cost savings estimate, what actions could be taken to double-check the estimate?
Suppose Concrete Suppliers Inc. sells one of its $155,000 concrete trucks, with an original five- year economic life, at the end of Year 3 after taking three years of straight-line depreciation.
Concrete Suppliers has a 40 percent tax rate. If the truck is sold for its book value, there is no tax effect. If Concrete Suppliers sells the truck for more or less than its book value, there is a gain or loss that has a tax effect.
a. Show the effects on cash flow in Year 3 if the sales price is $80,000.
b. Show the effects on cash flow in Year 3 if the sales price is $20,000.
Refer to Exercise 26.11. Assume Concrete Suppliers Inc. has assembled the following expected annual income statement data for each of its trucks.
EXERCISE 26.9 Competing Investment Proposals
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EXERCISE 26.10 Replacing Existing Equipment
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EXERCISE 26.11 Gains and Losses on Sale of Equipment E
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EXERCISE 26.12 Depreciation and Cash Flow E
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Problem Set A 1135
Analyze the above income statement data for expected cash flow effects each year.
The Radiology Department at St. Joseph’s Hospital, a not-for-profit, is considering purchasing a mag- netic resonance imaging (MRI) machine. The cost to purchase and install an MRI is approximately
$2,000,000. Assume St. Joseph’s would like a minimum 8 percent return and that the economic life of the MRI is expected to be 10 years, with no salvage value. Assume that if the MRI is installed, the net cash flows are expected to increase by $300,000 per year. Use Exhibit 26–4 for present value factors.
a. Find the NPV of the MRI.
b. Should the hospital acquire the MRI?
c. What nonfinancial considerations might be important to the MRI investment decision?
Over the next four years, the City of Inditiny, Massachusetts, is expecting the following cash flows from a federal grant: Year 1—$150,000; Year 2—$220,000; Year 3—$250,000; Year 4—$175,000.
The city wants to use the grant as collateral for a loan, but it is unsure about its net present value.
What is the net present value of the grant if the rate of return is expected to be 5 percent? What if the rate of return is expected to be 8 percent? Use Exhibit 26–3 for your solution.
The section titled “Impairment of Long-Lived Assets” can be found on page A-11 in the Home Depot 2009 financial information in Appendix A. In this section, Home Depot explains proce- dures used to estimate the carrying value of stores closed. Use this section to answer the following questions:
a. Explain how Home Depot decides to close a store ?
b. What amounts and types or categories of expenses related to the closed stores are recognized?
c. Compute the tax-related cash flow impact of the charges to SG&A resulting from the closed stores (assume a 35 percent tax rate).
d. What nonfinancial factors, related to the store closings, are mentioned by Home Depot? Name other nonfinancial factors you think are important.