Deck 14: Capital Investment Decisions

Question 1

Describe at least one qualitative factor that NoFat should consider, in addition to the financial factors, in making its final decision regarding the acceptance or rejection of the special sales offer.

Answer 1

One important qualitative factor is product reputation , the perception of the public about olestra's safety. In particular, a large percentage of NoFat's customers might be concerned that olestra is not a safe ingredient for human ingestion given its apparent effectiveness in cleaning up toxic waste sites.
As a result, the acceptance of PU's special sales offer might significantly decrease NoFat's regular sales of olestra.

Question 2

What is the role that the required rate of return plays in the NPV model In the IRR model

Answer 2

In an NPV model, the required rate of return serves as the discount rate, which helps in the calculation of the present value of the cash inflows and the present value of the cash outflows. In IRR model, the required rate of return serves as the bench mark or the cut off rate against which the IRR is compared to find out the whether an investment is acceptable or not.

Question 3

Assume that there are two competing projects, A and B. Project A has a NPV of $1,000 and an IRR of 15%. Project B has an NPV of $800 and an IRR of 20%. Which of the following is true

A) Project A should be chosen because it has a higher NPV.
B) Project B should be chosen because it has a higher IRR.
C) It is not possible to use NPV or IRR to choose between the two projects.
D) Neither project should be chosen.
E) None of these.

Answer 3

A. Project A should be chosen because it has a higher NPV.
Given that:
Project NPV IRR
A $1,000 15%
B $800 20%
Since, NPV measures the impact that competing projects have on the value of the firm, choosing the project with the largest NPV is consistent with maximizing the wealth of the shareholders.

Question 4

Basic Net Present Value Analysis
James Chesser, process engineer, knows that the acceptance of a new process design will depend on its economic feasibility. The new process is designed to improve environmental performance. On the negative side, the process design requires new equipment and an infusion of working capital. The equipment will cost $400,000, and its cash operating expenses will total $90,000 per year. The equipment will last for seven years but will need a major overhaul costing $40,000 at the end of the fifth year. At the end of seven years, the equipment will be sold for $32,000. An increase in working capital totaling $40,000 will also be needed at the beginning. This will be recovered at the end of the seven years.
On the positive side, James estimates that the new process will save $180,000 per year in environmental costs (fines and cleanup costs avoided). The cost of capital is 10 percent.
Required:
1. Prepare a schedule of cash flows for the proposed project. (Note: Assume that there are no income taxes.)
2. Compute the NPV of the project. Should the new process design be accepted

Question 5

Mutually exclusive capital budgeting projects are those that

A) if accepted or rejected do not affect the cash flows of other projects.
B) if accepted will produce a negative NPV.
C) if rejected preclude the acceptance of all other competing projects.
D) if accepted preclude the acceptance of all other competing projects.
E) if rejected imply that all other competing projects have a positive NPV.

Question 6

NPV measures

A) the profitability of an investment.
B) the change in wealth.
C) the change in firm value.
D) the difference in present value of cash inflows and outflows.
E) all of these.

Question 7

Payback Period
Ventura Manufacturing is considering an investment in a new automated manufacturing system. The new system requires an investment of $3,000,000 and either has (a) even cash flows of $750,000 per year or (b) the following expected annual cash flows: $375,000, $375,000, $1,000,000, $1,000,000, and $250,000.
Required:
Calculate the payback period for each case.

Question 8

Net Present Value Analysis
Vernal Communications Company is considering the production and marketing of a communications system that will increase the efficiency of messaging for small businesses or branch offices of large companies. Each unit hooked into the system is assigned a mailbox number, which can be matched to a telephone extension number, providing access to messages 24 hours a day. Up to 20 units can be hooked into the system, allowing the delivery of the same message to as many as 20 people. Personal codes can be used to make messages confidential. Furthermore, messages can be reviewed, recorded, cancelled, replied to, or deleted all during the same message playback. Indicators wired to the telephone blink whenever new messages are present.
To produce this product, a $1.5 million investment in new equipment is required. The equipment will last 10 years but will need major maintenance costing $125,000 at the end of its sixth year. The salvage value of the equipment at the end of 10 years is estimated to be $80,000. If this new system is produced, working capital must also be increased by $75,000. This capital will be restored at the end of the product's 10 year life cycle. Revenues from the sale of the product are estimated at $1.6 million per year. Cash operating expenses are estimated at $1.3 million per year.
Required:
1. Prepare a schedule of cash flows for the proposed project.( Note : Assume that there are no income taxes.)
2. Assuming that Vernal's cost of capital is 12 percent, compute the project's NPV. Should the product be produced

Question 9

What is the payback period Compute the payback period for an investment requiring an initial outlay of $80,000 with expected annual cash inflows of $30,000.

Question 10

Explain how the NPV is used to determine whether a project should be accepted or rejected.

Question 11

Accounting Rate of Return
Monson Company invested $15,000,000 in a new product line. The life cycle of the product is projected to be seven years with the following net income stream: $300,000, $900,000, $1,000,000, $1,800,000, $2,400,000, $3,800,000, and $2,400,000.
Required:
Calculate the ARR.

Question 12

Basic Internal Rate of Return Analysis
Megan Murray, owner of Golding Company, was approached by a local dealer of air-conditioning units. The dealer proposed replacing Golding's old cooling system with a modern, more efficient system. The cost of the new system was quoted at $226,000, but it would save $40,000 per year in energy costs. The estimated life of the new system is 10 years, with no salvage value expected. Excited over the possibility of saving $40,000 per year and having a more reliable unit, Megan requested an analysis of the project's economic viability. All capital projects are required to earn at least the firm's cost of capital, which is 8 percent. There are no income taxes.
Required:
1. Calculate the project's IRR. Should the company acquire the new cooling system
2. Suppose that energy savings are less than claimed. Calculate the minimum annual cash savings that must be realized for the project to earn a rate equal to the firm's cost of capital.
3. Suppose that the life of the new system is overestimated by two years. Repeat Requirements 1 and 2 under this assumption.
4. Conceptual Connection: Explain the implications of the answers from Requirements 1, 2, and 3.

Question 13

If Allyson decides to use NoFat's 10% mark-up pricing method to set the price for PU's special sales offer,
a. Calculate the price that NoFat would charge PU for each pound of olestra.
b. Calculate the relevant profit that NoFat would earn if it set the special sales price by using its mark-up pricing method. (Hint: Use the estimate of relevant costs that you calculated in response to Requirement 1b.)
c. Explain why NoFat should accept or reject the special sales offer if it uses its mark-up pricing method to set the special sales price.

Question 14

NPV is calculated by using

A) the required rate of return.
B) accounting income.
C) the IRR.
D) the future value of cash flows.
E) none of these.

Question 15

Net Present Value
Holland Inc. has just completed development of a new cell phone. The new product is expected to produce annual revenues of $1,350,000. Producing the cell phone requires an investment in new equipment, costing $1,440,000. The cell phone has a projected life cycle of 5 years. After 5 years, the equipment can be sold for $180,000. Working capital is also expected to increase by $180,000, which Holland will recover by the end of the new product's life cycle. Annual cash operating expenses are estimated at $810,000. The required rate of return is 8%.
Required:
1. Prepare a schedule of the projected annual cash flows.
2. Calculate the NPV using only discount factors from Exhibit 14B.1 (p. 647).
3. Calculate the NPV using discount factors from both Exhibit 14B.1 and 14B.2 (p. 648).

Question 16

Net Present Value, Uncertainty
Ondi Airlines is interested in acquiring a new aircraft to service a new route. The route will be from Tulsa to Denver. The aircraft will fly one round-trip daily except for scheduled maintenance days. There are 15 maintenance days scheduled each year. The seating capacity of the aircraft is 150. Flights are expected to be fully booked. The average revenue per passenger per flight (one-way) is $235. Annual operating costs of the aircraft follow:
The aircraft will cost $120,000,000 and has an expected life of 20 years. The company requires a 12% return. Assume there are no income taxes.
Required:
1. Calculate the NPV for the aircraft. Should the company buy it
2. In discussing the proposal, the marketing manager for the airline believes that the assumption of 100% booking is unrealistic. He believes that the booking rate will be somewhere between 70 and 90%, with the most likely rate being 80%. Recalculate the NPV by using an 80% seating capacity. Should the aircraft be purchased
3. Calculate the average seating rate that would be needed so that NPV will equal zero. Round the seating rate to the nearest percent.
4. CONCEPTUAL CONNECTION Suppose that the price per passenger could be increased by 10% without any effect on demand. What is the average seating rate now needed to achieve a NPV equal to zero What would you now recommend Round the seating rate to the nearest percent.

Question 17

An investment of $1,000 produces a net annual cash inflow of $2,000 for each of five years. What is the payback period

A) Two years
B) One-half year
C) Unacceptable
D) Three years
E) Cannot be determined

Question 18

The IRR is the true or actual rate of return being earned by the project. Do you agree or disagree Discuss.

Question 19

Internal Rate of Return
Jardin Company produces a variety of gardening tools and aids. The company is examining the possibility of investing in a new production system that will reduce the costs of the current system. The new system will require a cash investment of $2,303,600 and will produce net cash savings of $400,000 per year. The system has a projected life of nine years.
Required:
Calculate the IRR for the new production system.

Question 20

Review of Basic Capital Budgeting Procedures
Dr. Whitley Avard, a plastic surgeon, had just returned from a conference in which she learned of a new surgical procedure for removing wrinkles around eyes, reducing the time to perform the normal procedure by 50%. Given her patient-load pressures, Dr. Avard is excited to try out the new technique. By decreasing the time spent on eye treatments or procedures, she can increase her total revenues by performing more services within a work period. In order to implement the new procedure, special equipment costing $74,000 is needed. The equipment has an expected life of 4 years, with a salvage value of $6,000. Dr. Avard estimates that her cash revenues will increase by the following amounts:
She also expects additional cash expenses amounting to $3,000 per year. The cost of capital is 12%. Assume that there are no income taxes.
Required:
1. Compute the payback period for the new equipment.
2. Compute the ARR. Round the percentage to two decimal places.
3. CONCEPTUAL CONNECTION Compute the NPV and IRR for the project. Use 14% as your first guess for IRR. Should Dr. Avard purchase the new equipment Should she be concerned about payback or the ARR in making this decision
4. CONCEPTUAL CONNECTION Before finalizing her decision, Dr. Avard decided to call two plastic surgeons who have been using the new procedure for the past six months. The conversations revealed a somewhat less glowing report than she received at the conference. The new procedure reduced the time required by about 25% rather than the advertised 50%. Dr. Avard estimated that the net operating cash flows of the procedure would be cut by one-third because of the extra time and cost involved (salvage value would be unaffected). Using this information, recompute the NPV of the project. What would you now recommend

Question 21

Name and discuss three possible reasons that the payback period is used to help make capital investment decisions.

Question 22

Using NPV, a project is rejected if it is

A) equal to zero.
B) negative.
C) positive.
D) equal to the required rate of return.
E) greater than the cost of capital.

Question 23

NPV and IRR, Mutually Exclusive Projects
Hardy Inc. intends to invest in one of two competing types of computer-aided manufacturing equipment: CAM X and CAM Y. Both CAM X and CAM Y models have a project life of 10 years. The purchase price of the CAM X model is $3,000,000, and it has a net annual after-tax cash inflow of $750,000. The CAM Y model is more expensive, selling for $3,500,000, but it will produce a net annual after-tax cash inflow of $875,000. The cost of capital for the company is 10 percent.
Required:
1. Calculate the NPV for each project. Which model would you recommend
2. Calculate the IRR for each project. Which model would you recommend

Question 24

Net Present Value and Competing Alternatives
Stillwater Designs has been rebuilding Model 100, Model 120, and Model 150 Kicker subwoofers that were returned for warranty action. Customers returning the subwoofers receive a new replacement. The warranty returns are then rebuilt and resold (as seconds). Tent sales are often used to sell the rebuilt speakers. As part of the rebuilding process, the speakers are demagnetized so that metal pieces and shavings can be removed. A demagnetizing (demag) machine is used to achieve this objective. A product design change has made the most recent Model 150 speakers too tall for the demag machine. They no longer fit in the demag machine.
Stillwater Designs has two alternatives that it is currently considering. First, a new demag machine can be bought that has a different design, eliminating the fit problem. The cost of this machine is $600,000, and it will last 5 years. Second, Stillwater can keep the current machine and sell the 150 speakers for scrap, using the old demag machine for the Model 100 and 120 speakers only. A rebuilt speaker sells for $295 and costs $274.65 to rebuild (for materials, labor, and overhead cash outlays). The $274.65 outlay includes the annual operating cash effects of the new demag machine. If not rebuilt, the Model 150 speakers can be sold for $4 each as scrap. There are 10,000 Model 150 warranty returns per year. Assume that the required rate of return is 10%.
Required:
1. Determine which alternative is the best for Stillwater Designs by using NPV analysis.
2. CONCEPTUAL CONNECTION Determine which alternative is best for Stillwater Designs by using an IRR analysis. Explain why NPV analysis is a better approach.

Question 25

Assume that NoFat pays for all costs with cash. Also, assume a 10% discount rate, a 5-year time horizon, and all cash flows occur at the end of the year. Using an NPV approach to discount future cash flows to present value,
a. Calculate the NPV of accepting the special sale with the assumed positive relevant profit of $10,000 per year (i.e., the special sales alternative).
b. Calculate the NPV of downsizing capacity as previously described (i.e., the down sizing alternative).
c. Based on the NPV of Calculations a and b, identify and explain which of these two alternatives is best for NoFat to pursue in the long term.

Question 26

Explain what a postaudit is and how it can provide useful input for future capital investment decisions, especially those involving advanced technology.

Question 27

Payback Period
Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.
a. Colby Hepworth has just invested $400,000 in a book and video store. She expects to receive a cash income of $120,000 per year from the investment.
b. Kylie Sorensen has just invested $1,400,000 in a new biomedical technology. She expects to receive the following cash flows over the next 5 years: $350,000, $490,000, $700,000, $420,000, and $280,000.
c. Carsen Nabors invested in a project that has a payback period of 4 years. The project brings in $960,000 per year.
d. Rahn Booth invested $1,300,000 in a project that pays him an even amount per year for 5 years. The payback period is 2.5 years.
Required:
1. What is the payback period for Colby
2. What is the payback period for Kylie
3. How much did Carsen invest in the project
4. How much cash does Rahn receive each year

Question 28

Basic Net Present Value Analysis, Competing Projects
Kildare Medical Center, a for-profit hospital, has three investment opportunities: (1) adding a wing for in-patient treatment of substance abuse, (2) adding a pathology laboratory, and (3) expanding the outpatient surgery wing. The initial investments and the net present value for the three alternatives are as follows:
Although the hospital would like to invest in all three alternatives, only $1.5 million is available.
Required:
1. Rank the projects on the basis of NPV, and allocate the funds in order of this ranking. What project or projects were selected What is the total NPV realized by the medical center using this approach
2. CONCEPTUAL CONNECTION Assume that the size of the lot on which the hospital is located makes the substance abuse wing and the outpatient surgery wing mutually exclusive. With unlimited capital, which of those two projects would be chosen With limited capital and the three projects being considered, which projects would be chosen
3. CONCEPTUAL CONNECTION Form a group with two to four other students, and discuss qualitative considerations that should be considered in capital budgeting evaluations. Identify three such considerations.

Question 29

An investment of $1,000 produces a net cash inflow of $500 in the first year and $750 in the second year. What is the payback period

A) 1.67 years
B) 0.50 year
C) 2.00 years
D) 1.20 years
E) Cannot be determined.

Question 30

If the present value of future cash flows is $4,200 for an investment that requires an outlay of $3,000, the NPV

A) is $200.
B) is $1,000.
C) is $1,200.
D) is $2,200.
E) cannot be determined.

Question 31

Accounting Rate of Return
Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.
a. Cobre Company is considering the purchase of new equipment that will speed up the process for extracting copper. The equipment will cost $3,600,000 and have a life of 5 years with no expected salvage value. The expected cash flows associated with the project are as follows:
b. Emily Hansen is considering investing in one of the following two projects. Either project will require an investment of $75,000. The expected cash revenues minus cash expenses for the two projects follow. Assume each project is depreciable.
c. Suppose that a project has an ARR of 30% (based on initial investment) and that the average net income of the project is $120,000.
d. Suppose that a project has an ARR of 50% and that the investment is $150,000.
Required:
1. Compute the ARR on the new equipment that Cobre Company is considering.
2. CONCEPTUAL CONNECTION Which project should Emily Hansen choose based on the ARR Notice that the payback period is the same for both investments (thus equally preferred). Unlike the payback period, explain why ARR correctly signals that one project should be preferred over the other.
3. How much did the company in Scenario c invest in the project
4. What is the average net income earned by the project in Scenario d

Question 32

Payback, Net Present Value, Internal Rate of Return, Intangible Benefits, Inflation Adjustment
Foster Company wants to buy a numerically controlled (NC) machine to be used in producing specially machined parts for manufacturers of trenching machines (to replace an existing manual system). The outlay required is $3,500,000. The NC equipment will last 5 years with no expected salvage value. The expected incremental after-tax cash flows (cash flows of the NC equipment minus cash flows of the old equipment) associated with the project follow:
Foster has a cost of capital equal to 10%. The above cash flows are expressed without any consideration of inflation.
Required:
1. Compute the payback period.
2. Calculate the NPV and IRR of the proposed project.
3. CONCEPTUAL CONNECTION Inflation is expected to be 5% per year for the next 5 years. The discount rate of 10% is composed of two elements: the real rate and the inflationary element. Since the discount rate has an inflationary component, the projected cash flows should also be adjusted to account for inflation. Make this adjustment, and recalculate the NPV. Comment on the importance of adjusting cash flows for inflationary effects.

Question 33

What is the accounting rate of return Compute the ARR for an investment that requires an initial outlay of $300,000 and promises an average net income of $100,000.

Question 34

Explain why NPV is generally preferred over IRR when choosing among competing or mutually exclusive projects. Why would managers continue to use IRR to choose among mutually exclusive projects

Question 35

Net Present Value
Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.
a. Southward Manufacturing is considering the purchase of a new welding system. The cash benefits will be $400,000 per year. The system costs $2,250,000 and will last 10 years.
b. Kaylin Day is interested in investing in a women's specialty shop. The cost of the investment is $180,000. She estimates that the return from owning her own shop will be $35,000 per year. She estimates that the shop will have a useful life of 6 years.
c. Goates Company calculated the NPV of a project and found it to be $21,300. The project's life was estimated to be 8 years. The required rate of return used for the NPV calculation was 10%. The project was expected to produce annual after-tax cash flows of $45,000.
Required:
1. Compute the NPV for Southward Manufacturing, assuming a discount rate of 12%. Should the company buy the new welding system
2. CONCEPTUAL CONNECTION Assuming a required rate of return of 8%, calculate the NPV for Kaylin Day's investment. Should she invest What if the estimated return was $45,000 per year Would this affect the decision What does this tell you about your analysis
3. What was the required investment for Goates Company's project

Question 36

Cost of Capital, Net Present Value
Leakam Company's product engineering department has developed a new product that has a 3-year life cycle. Production of the product requires development of a new process that requires a current $100,000 capital outlay. The $100,000 will be raised by issuing $60,000 of bonds and by selling new stock for $40,000. The $60,000 in bonds will have net (after-tax) interest payments of $3,000 at the end of each of the 3 years, with the principal being repaid at the end of Year 3. The stock issue carries with it an expectation of a 17.5% return, expressed in the form of dividends at the end of each year ($7,000 in dividends is expected for each of the next 3 years). The sources of capital for this investment represent the same proportion and costs that the company typically has. Finally, the project will produce after-tax cash inflows of $50,000 per year for the next 3 years.
Required:
1. Compute the cost of capital for the project. ( Hint : The cost of capital is a weighted average of the two sources of capital where the weights are the proportion of capital from each source.)
2. CONCEPTUAL CONNECTION Compute the NPV for the project. Explain why it is not necessary to subtract the interest payments and the dividend payments and appreciation from the inflow of $50,000 in carrying out this computation.

Question 37

Explain the difference between independent projects and mutually exclusive projects.

Question 38

The payback period suffers from which of the following deficiencies

A) It is a rough measure of the uncertainty of future cash flows.
B) It helps control the risk of obsolescence.
C) It ignores the uncertainty of future cash flows.
D) It ignores the financial performance of a project beyond the payback period.
E) Both c and d.

Question 39

Assume that an investment of $1,000 produces a future cash flow of $1,000. The discount factor for this future cash flow is 0.80. The NPV is

A) $0.
B) $110.
C) ($200).
D) $911.
E) none of these.

Question 40

Internal Rate of Return
Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.
a. Cuenca Company is considering the purchase of new equipment that will speed up the process for producing flash drives. The equipment will cost $7,200,000 and have a life of 5 years with no expected salvage value. The expected cash flows associated with the project follow:
b. Kathy Shorts is evaluating an investment in an information system that will save $240,000 per year. She estimates that the system will last 10 years. The system will cost $1,248,000. Her company's cost of capital is 10%.
c. Elmo Enterprises just announced that a new plant would be built in Helper, Utah. Elmo told its stockholders that the plant has an expected life of 15 years and an expected IRR equal to 25%. The cost of building the plant is expected to be $2,880,000.
Required:
1. Calculate the IRR for Cuenca Company. The company's cost of capital is 16%. Should the new equipment be purchased
2. Calculate Kathy Short's IRR. Should she acquire the new system
3. What should be Elmo Enterprises' expected annual cash flow from the plant

Question 41

Capital Investment, Advanced Manufacturing Environment
''I know that it's the thing to do,'' insisted Pamela Kincaid, vice president of finance for Colgate Manufacturing. ''If we are going to be competitive, we need to build this completely automated plant.''
''I'm not so sure,'' replied Bill Thomas, CEO of Colgate. ''The savings from labor reductions and increased productivity are only $4 million per year. The price tag for this factory-and it's a small one-is $45 million. That gives a payback period of more than 11 years. That's a long time to put the company's money at risk.''
''Yeah, but you're overlooking the savings that we'll get from the increase in quality,'' interjected John Simpson, production manager. ''With this system, we can decrease our waste and our rework time significantly. Those savings are worth another million dollars per year.''
''Another million will only cut the payback to about 9 years,'' retorted Bill. ''Ron, you're the marketing manager-do you have any insights ''
''Well, there are other factors to consider, such as service quality and market share. I think that increasing our product quality and improving our delivery service will make us a lot more competitive. I know for a fact that two of our competitors have decided against automation. That'll give us a shot at their customers, provided our product is of higher quality and we can deliver it faster. I estimate that it'll increase our net cash benefits by another $2.4 million.''
''Wow! Now that's impressive,'' Bill exclaimed, nearly convinced. ''The payback is now getting down to a reasonable level.''
''I agree,'' said Pamela, ''but we do need to be sure that it's a sound investment. I know that estimates for construction of the facility have gone as high as $48 million. I also know that the expected residual value, after the 20 years of service we expect to get, is $5 million. I think I had better see if this project can cover our 14% cost of capital.''
''Now wait a minute, Pamela,'' Bill demanded. ''You know that I usually insist on a 20% rate of return, especially for a project of this magnitude.''
Required:
1. Compute the NPV of the project by using the original savings and investment figures. Calculate by using discount rates of 14% and 20%. Include salvage value in the computation.
2. Compute the NPV of the project using the additional benefits noted by the production and marketing managers. Also, use the original cost estimate of $45 million. Again, calculate for both possible discount rates.
3. Compute the NPV of the project using all estimates of cash flows, including the possible initial outlay of $48 million. Calculate by using discount rates of 14% and 20%.
4. CONCEPTUAL CONNECTION If you were making the decision, what would you do Explain.

Question 42

Conduct a relevant analysis of the special sales offer by calculating the following:
a. The relevant revenues associated with the special sales offer
b. The relevant costs associated with the special sales offer
c. The relevant profit associated with the special sales offer

Question 43

The NPV is the same as the profit of a project expressed in present dollars. Do you agree Explain.

Question 44

Suppose that a firm must choose between two mutually exclusive projects, both of which have negative NPVs. Explain how a firm can legitimately choose between two such projects.

Question 45

Net Present Value and Competing Projects
Wilburton Hospital is investigating the possibility of investing in new dialysis equipment. Two local manufacturers of this equipment are being considered as sources of the equipment. After-tax cash inflows for the two competing projects are as follows:
Both projects require an initial investment of $700,000. In both cases, assume that the equipment has a life of five years with no salvage value.
Required:
1. Assuming a discount rate of 12 percent, compute the net present value of each piece of equipment.
2. A third option has surfaced for equipment purchased from an out-of-state supplier. The cost is also $700,000, but this equipment will produce even cash flows over its five-year life. What must the annual cash flow be for this equipment to be selected over the other two Assume a 12 percent discount rate.

Question 46

Postaudit, Sensitivity Analysis
Newmarge Products Inc. is evaluating a new design for one of its manufacturing processes. The new design will eliminate the production of a toxic solid residue. The initial cost of the system is estimated at $860,000 and includes computerized equipment, software, and installation. There is no expected salvage value. The new system has a useful life of 8 years and is projected to produce cash operating savings of $225,000 per year over the old system (reducing labor costs and costs of processing and disposing of toxic waste). The cost of capital is 16%.
Required:
1. Compute the NPV of the new system.
2. One year after implementation, the internal audit staff noted the following about the new system: (1) the cost of acquiring the system was $60,000 more than expected due to higher installation costs, and (2) the annual cost savings were $20,000 less than expected because more labor cost was needed than anticipated. Using the changes in expected costs and benefits, compute the NPV as if this information had been available 1 year ago. Did the company make the right decision
3. CONCEPTUAL CONNECTION Upon reporting the results mentioned in the postaudit, the marketing manager responded in a memo to the internal auditing department indicating that revenues had increased by $60,000 per year because of increased purchases by environmentally sensitive customers. Describe the effect that this has on the analysis in Requirement 2.
4. CONCEPTUAL CONNECTION Why is a postaudit beneficial to a firm

Question 47

Capital investments should

A) always produce an increase in market share.
B) only be analyzed using the ARR.
C) earn back their original capital outlay plus a reasonable return.
D) always be done using a payback criterion.
E) do none of these.

Question 48

The ARR has one specific advantage not possessed by the payback period in that it

A) considers the time value of money.
B) measures the value added by a project.
C) is always an accurate measure of profitability.
D) is more widely accepted by financial managers.
E) considers the profitability of a project beyond the payback period.

Question 49

Which of the following is not true regarding the IRR

A) The IRR is the interest rate that sets the present value of a project's cash inflows equal to the present value of the project's cost.
B) The IRR is the interest rate that sets the NPV equal to zero.
C) The popularity of IRR may be attributable to the fact that it is a rate of return, a concept that is comfortably used by managers.
D) If the IRR is greater than the required rate of return, then the project is acceptable.
E) The IRR is the most reliable of the capital budgeting methods.

Question 50

Payback, Accounting Rate of Return, Net Present Value, Internal Rate of Return
Craig Company wants to buy a numerically controlled (NC) machine to be used in producing specially machined parts for manufacturers of tractors. The outlay required is $640,000. The NC equipment will last five years with no expected salvage value. The expected after-tax cash flows associated with the project follow:
Required:
1. Compute the payback period for the NC equipment.
2. Compute the NC equipment's ARR.
3. Compute the investment's NPV, assuming a required rate of return of 10 percent.
4. Compute the investment's IRR.

Question 51

Discount Rates, Automated Manufacturing, Competing Investments
Patterson Company is considering two competing investments. The first is for a standard piece of production equipment. The second is for computer-aided manufacturing (CAM) equipment. The investment and after-tax operating cash flows follow:
Patterson uses a discount rate of 18% for all of its investments. Patterson's cost of capital is 10%.
Required:
1. Calculate the NPV for each investment by using a discount rate of 18%.
2. Calculate the NPV for each investment by using a discount rate of 10%.
3. CONCEPTUAL CONNECTION Which rate should Patterson use to compute the NPV Explain.

Question 52

Explain why the timing and quantity of cash flows are important in capital investment decisions.

Question 53

Explain the relationship between NPV and a firm's value.

Question 54

Using IRR, a project is rejected if the IRR

A) is equal to the required rate of return.
B) is less than the required rate of return.
C) is greater than the cost of capital.
D) is greater than the required rate of return.
E) produces an NPV equal to zero.

Question 55

Payback, Accounting Rate of Return, Present Value, Net Present Value, Internal Rate of Return
All scenarios are independent of all other scenarios. Assume that all cash flows are after-tax cash flows.
a. Kambry Day is considering investing in one of the following two projects. Either project will require an investment of $20,000. The expected cash flows for the two projects follow. Assume that each project is depreciable.
b. Wilma Golding is retiring and has the option to take her retirement as a lump sum of $450,000 or to receive $30,000 per year for 20 years. Wilma's required rate of return is 6%.
c. David Booth is interested in investing in some tools and equipment so that he can do independent drywalling. The cost of the tools and equipment is $30,000. He estimates that the return from owning his own equipment will be $9,000 per year. The tools and equipment will last 6 years.
d. Patsy Folson is evaluating what appears to be an attractive opportunity. She is currently the owner of a small manufacturing company and has the opportunity to acquire another small company's equipment that would provide production of a part currently purchased externally. She estimates that the savings from internal production will be $75,000 per year. She estimates that the equipment will last 10 years. The owner is asking $400,000 for the equipment. Her company's cost of capital is 8%.
Required:
1. CONCEPTUAL CONNECTION What is the payback period for each of Kambry Day's projects If rapid payback is important, which project should be chosen Which would you choose
2. CONCEPTUAL CONNECTION Which of Kambry's projects should be chosen based on the ARR Explain why the ARR performs better than the payback period in this setting.
3. Assuming that Wilma Golding will live for another 20 years, should she take the lump sum or the annuity
4. Assuming a required rate of return of 8% for David Booth, calculate the NPV of the investment. Should David invest
5. Calculate the IRR for Patsy Folson's project. Should Patsy acquire the equipment

Question 56

Quality, Market Share, Automated Manufacturing Environment
Fabre Company, Patterson Company's competitor, is considering the same investments as Patterson. Refer to the data in Problem 14-47 above. Assume that Fabre's cost of capital is 14%.
Required:
1. Calculate the NPV of each alternative by using the 14% rate.
2. CONCEPTUAL CONNECTION Now assume that if the standard equipment is purchased, the competitive position of the firm will deteriorate because of lower quality (relative to competitors who did automate). Marketing estimates that the loss in market share will decrease the projected net cash inflows by 50% for Years 3 through 10. Recalculate the NPV of the standard equipment given this outcome. What is the decision now Discuss the importance of assessing the effect of intangible benefits.

Question 57

Based solely on financial factors, explain why NoFat should accept or reject PU's special sales offer.

Question 58

An investment of $2,000 provides an average net income of $400. Depreciation is $40 per year with zero salvage value. The ARR using the original investment is

A) 44%.
B) 22%.
C) 20%.
D) 40%.
E) none of these.

Question 59

A postaudit

A) is a follow-up analysis of a capital project, once implemented.
B) compares the actual benefits with the estimated benefits.
C) evaluates the overall outcome of the investment.
D) proposes corrective action, if needed.
E) does all of these.

Question 60

Net Present Value, Basic Concepts
Tree Company is considering an investment that requires an outlay of $240,000 and promises an after-tax cash inflow one year from now of $277,200. The company's cost of capital is 10 percent.
Required:
1. Break the $277,200 future cash inflow into three components: (a) the return of the original investment, (b) the cost of capital, and (c) the profit earned on the investment. Now compute the present value of the profit earned on the investment.
2. Conceptual Connection: Compute the NPV of the investment. Compare this with the present value of the profit computed in Requirement 1. What does this tell you about the meaning of NPV

Question 61

Capital Investment and Ethical Behavior
Manny Carson, certified management accountant and controller of Wakeman Enterprises, has been given permission to acquire a new computer and software for the company's accounting system. The capital investment analysis showed an NPV of $100,000. However, the initial estimates of acquisition and installation costs were made on the basis of tentative costs without any formal bids. Manny now has two formal bids, one that would allow the firm to meet or beat the original projected NPV and one that would reduce the projected NPV by $50,000. The second bid involves a system that would increase both the initial cost and the operating cost.
Normally, Manny would take the first bid without hesitation. However, Todd Downing, the owner of the firm presenting the second bid, is a close friend. Manny called Todd and explained the situation, offering Todd an opportunity to alter his bid and win the job. Todd thanked Manny and then made a counteroffer.
Todd: Listen, Manny, this job at the original price is the key to a successful year for me. The revenues will help me gain approval for the loan I need for renovation and expansion. If I don't get that loan, I see hard times ahead. The financial stats for loan approval are so marginal that reducing the bid price may blow my chances.
Manny: Losing the bid altogether would be even worse, don't you think
Todd: True. However, if you award me the job, I'll be able to add personnel. I know that your son is looking for a job, and I can offer him a good salary and a promising future. Additionally, I'll be able to take you and your wife on that vacation to Hawaii that we've been talking about.
Manny: Well, you have a point. My son is having an awful time finding a job, and he has a wife and three kids to support. My wife is tired of having them live with us. She and I could use a vacation. I doubt that the other bidder would make any fuss if we turned it down. Its offices are out of state, after all.
Todd: Out of state All the more reason to turn it down. Given the state's economy, it seems almost criminal to take business outside. Those are the kind of business decisions that cause problems for people like your son.
Required:
Evaluate the ethical behavior of Manny. Should Manny have called Todd in the first place What if Todd had agreed to meet the lower bid price-would there have been any problems Identify the parts of the Statement of Ethical Professional Practice (Chapter 1) that Manny may be violating, if any.

Question 62

To make a capital investment decision, a manager must

A) estimate the quantity and timing of cash flows.
B) assess the risk of the investment.
C) consider the impact of the investment on the firm's profits.
D) choose a decision criterion to assess viability of the investment (such as payback period or NPV).
E) do all of these.

Question 63

What is the cost of capital What role does it play in capital investment decisions

Question 64

Postaudits of capital projects are useful because

A) they are not very costly.
B) they have no significant limitations.
C) the assumptions underlying the original analyses are often invalidated by changes in the actual working environment.
D) they help to ensure that resources are used wisely.
E) of all of these.

Question 65

Solving for Unknowns
Each of the following scenarios are independent. Assume that all cash flows are after-tax cash flows.
a. Thomas Company is investing $120,000 in a project that will yield a uniform series of cash inflows over the next 4 years.
b. Video Repair has decided to invest in some new electronic equipment. The equipment will have a 3-year life and will produce a uniform series of cash savings. The NPV of the equipment is $1,750, using a discount rate of 8%. The IRR is 12%.
c. A new lathe costing $60,096 will produce savings of $12,000 per year.
d. The NPV of a project is $3,927. The project has a life of 4 years and produces the following cash flows:
The cost of the project is two times the cash flow produced in Year 4. The discount rate is 10%.
Required:
1. If the internal rate of return is 14% for Thomas Company, how much cash inflow per year can be expected
2. Determine the investment and the amount of cash savings realized each year for Video Repair.
3. For Scenario c, how many years must the lathe last if an IRR of 18% is realized
4. For Scenario d, find the cost of the project and the cash flow for Year 4.

Question 66

Payback, Net Present Value, Internal Rate of Return, Effects of Differences in Sales on Project Viability
Shaftel Ready Mix is a processor and supplier of concrete, aggregate, and rock products. The company operates in the intermountain western United States. Currently, Shaftel has 14 cementprocessing plants and a labor force of more than 375 employees. With the exception of cement powder, all materials (e.g., aggregates and sand) are produced internally by the company. The demand for concrete and aggregates has been growing steadily nationally. In the West, the growth rate has been above the national average. Because of this growth, Shaftel has more than tripled its gross revenues over the past 10 years.
Of the intermountain states, Arizona has been experiencing the most growth. Processing plants have been added over the past several years, and the company is considering the addition of yet another plant to be located in Scottsdale. A major advantage of another plant in Arizona is the ability to operate year round, a feature not found in states such as Utah and Wyoming.
In setting up the new plant, land would have to be purchased and a small building constructed. Equipment and furniture would not need to be purchased; these items would be transferred from a plant that opened in Wyoming during the oil boom period and closed a few years after the end of that boom. However, the equipment needs some repair and modifications before it can be used. The equipment has a book value of $200,000, and the furniture has a book value of $30,000. Neither has any outside market value. Other costs, such as the installation of a silo, well, electrical hookups, and so on, will be incurred. No salvage value is expected. The summary of the initial investment costs by category is as follows:
Estimates concerning the operation of the Scottsdale plant follow:
After reviewing these data, Karl Flemming, vice president of operations, argued against the proposed plant. Karl was concerned because the plant would earn significantly less than the normal 8.3% return on sales. All other plants in the company were earning between 7.5 and 8.5% on sales. Karl also noted that it would take more than 5 years to recover the total initial outlay of $582,000. In the past, the company had always insisted that payback be no more than 4 years. The company's cost of capital is 10%. Assume that there are no income taxes.
Required:
1. Prepare a variable-costing income statement for the proposed plant. Compute the ratio of net income to sales. Is Karl correct that the return on sales is significantly lower than the company average
2. Compute the payback period for the proposed plant. Is Karl right that the payback period is greater than 4 years Explain. Suppose you were told that the equipment being transferred from Wyoming could be sold for its book value. Would this affect your answer
3. Compute the NPV and the IRR for the proposed plant. Would your answer be affected if you were told that the furniture and equipment could be sold for their book values If so, repeat the analysis with this effect considered.
4. Compute the cubic yards of cement that must be sold for the new plant to break even. Using this break-even volume, compute the NPV and the IRR. Would the investment be acceptable If so, explain why an investment that promises to do nothing more than break even can be viewed as acceptable.
5. Compute the volume of cement that must be sold for the IRR to equal the firm's cost of capital. Using this volume, compute the firm's expected annual income. Explain this result.

Question 67

The time value of money is ignored by the payback period and the ARR. Explain why this is a major deficiency in these two models.

Question 68

If the NPV is positive, it signals

A) that the initial investment has been recovered.
B) that the required rate of return has been earned.
C) that the value of the firm has increased.
D) all of these.
E) both a and b.

Question 69

For competing projects, NPV is preferred to IRR because

A) maximizing IRR maximizes the wealth of the owners.
B) in the final analysis, relative profitability is what counts.
C) choosing the project with the largest NPV maximizes the wealth of the shareholders.
D) assuming that cash flows are reinvested at the computed IRR is more realistic than assuming that cash flows are reinvested at the required rate of return.
E) of all of the above.

Question 70

Net Present Value versus Internal Rate of Return
Skiba Company is thinking about two different modifications to its current manufacturing process. The after-tax cash flows associated with the two investments follow:
Skiba's cost of capital is 10%.
Required:
1. Compute the NPV and the IRR for each investment.
2. CONCEPTUAL CONNECTION Explain why the project with the larger NPV is the correct choice for Skiba.