Chapter 26 Capital Investment Analysis Student: _ The process by which management plans, evaluates, and controls long-term investment decisions involving fixed assets is called capital investment analysis True False The process by which management plans, evaluates, and controls long-term investment decisions involving fixed assets is called cost-volume-profit analysis True False Care must be taken involving capital investment decisions, since normally a long-term commitment of funds is involved and operations could be affected for many years True False Only managers are encouraged to submit capital investment proposals because they know the processes and are able to match investments with long-term goals True False The methods of evaluating capital investment proposals can be grouped into two general categories that can be referred to as (1) methods that ignore present value and (2) present values methods True False The methods of evaluating capital investment proposals can be grouped into two general categories that can be referred to as (1) average rate of return and (2) cash payback methods True False Average rate of return equals average investment divided by estimated average annual income True False Average rate of return equals estimated average annual income divided by average investment True False The method of analyzing capital investment proposals in which the estimated average annual income is divided by the average investment is the average rate of return method True False 10 The excess of the cash flowing in from revenues over the cash flowing out for expenses is termed net cash flow True False 11 The excess of the cash flowing in from revenues over the cash flowing out for expenses is termed net discounted cash flow True False 12 The computations involved in the net present value method of analyzing capital investment proposals are less involved than those for the average rate of return method True False 13 The computations involved in the net present value method of analyzing capital investment proposals are more involved than those for the average rate of return method True False 14 Methods that ignore present value in capital investment analysis include the cash payback method True False 15 Methods that ignore present value in capital investment analysis include the average rate of return method True False 16 Methods that ignore present value in capital investment analysis include the internal rate of return method True False 17 Methods that ignore present value in capital investment analysis include the net present value method True False 18 The average rate of return method of capital investment analysis gives consideration to the present value of future cash flows True False 19 The cash payback method of capital investment analysis is one of the methods referred to as a present value method True False 20 The anticipated purchase of a fixed asset for $400,000, with a useful life of years and no residual value, is expected to yield total net income of $300,000 for the years The expected average rate of return is 30% True False 21 The anticipated purchase of a fixed asset for $400,000, with a useful life of years and no residual value, is expected to yield total net income of $300,000 for the years The expected average rate of return is 37.5% True False 22 The anticipated purchase of a fixed asset for $400,000, with a useful life of years and no residual value, is expected to yield total net income of $200,000 for the years The expected average rate of return on investment is 50% True False 23 The anticipated purchase of a fixed asset for $400,000, with a useful life of years and no residual value, is expected to yield total net income of $200,000 for the years The expected average rate of return on investment is 25.0% True False 24 In net present value analysis for a proposed capital investment, the expected future net cash flows are averaged and then reduced to their present values True False 25 The expected period of time that will elapse between the date of a capital investment and the complete recovery in cash of the amount invested is called the discount period True False 26 The expected period of time that will elapse between the date of a capital investment and the complete recovery in cash of the amount invested is called the cash payback period True False 27 If a proposed expenditure of $70,000 for a fixed asset with a 4-year life has an annual expected net cash flow and net income of $32,000 and $12,000, respectively, the cash payback period is 2.5 years True False 28 If a proposed expenditure of $80,000 for a fixed asset with a 4-year life has an annual expected net cash flow and net income of $32,000 and $12,000, respectively, the cash payback period is years True False 29 For years one through five, a proposed expenditure of $250,000 for a fixed asset with a 5-year life has expected net income of $40,000, $35,000, $25,000, $25,000, and $25,000, respectively, and net cash flows of $90,000, $85,000, $75,000, $75,000, and $75,000, respectively The cash payback period is years True False 30 For years one through five, a proposed expenditure of $500,000 for a fixed asset with a 5-year life has expected net income of $40,000, $35,000, $25,000, $25,000, and $25,000, respectively, and net cash flows of $90,000, $85,000, $75,000, $75,000, and $75,000, respectively The cash payback period is years True False 31 In net present value analysis for a proposed capital investment, the expected future net cash flows are reduced to their present values True False 32 If in evaluating a proposal by use of the net present value method there is a deficiency of the present value of future cash inflows over the amount to be invested, the proposal should be rejected True False 33 If in evaluating a proposal by use of the net present value method there is a deficiency of the present value of future cash inflows over the amount to be invested, the proposal should be accepted True False 34 If in evaluating a proposal by use of the net present value method there is an excess of the present value of future cash inflows over the amount to be invested, the rate of return on the proposal exceeds the rate used in the analysis True False 35 If in evaluating a proposal by use of the net present value method there is an excess of the present value of future cash inflows over the amount to be invested, the rate of return on the proposal is less than the rate used in the analysis True False 36 A present value index can be used to rank competing capital investment proposals when the net present value method is used True False 37 The internal rate of return method of analyzing capital investment proposals uses the present value concept to compute an internal rate of return expected from the proposals True False 38 A series of equal cash flows at fixed intervals is termed an annuity True False 39 A qualitative characteristic that may impact upon capital investment analysis is the impact of investment proposals on product quality True False 40 A qualitative characteristic that may impact upon capital investment analysis is manufacturing flexibility True False 41 A qualitative characteristic that may impact upon capital investment analysis is employee morale True False 42 A qualitative characteristic that may impact upon capital investment analysis is manufacturing productivity True False 43 A qualitative characteristic that may impact upon capital investment analysis is manufacturing control True False 44 The process by which management allocates available investment funds among competing capital investment proposals is termed present value analysis True False 45 The process by which management allocates available investment funds among competing capital investment proposals is termed capital rationing True False 46 The payback method can be used only when net cash inflows are the same for each period True False 47 The accounting rate of return method of analyzing capital budgeting decisions measures the average rate of return from using the asset over its entire life True False 48 The accounting rate of return is a measure of profitability computed by dividing the average annual cash flows from an asset by the average amount invested in the asset True False 49 Net present value and the payback period are examples of discounted cash flow methods used in capital budgeting decisions True False 50 In calculating the net present value of an investment in equipment, the required investment and its terminal residual value should be subtracted from the present value of all future cash inflows True False 51 In calculating the present value of an investment in equipment, the present value of the terminal residual value should be added to the cash inflows True False 52 The time expected to pass before the net cash flows from an investment would return its initial cost is called the amortization period True False 53 A company is considering purchasing a machine for $21,000 The machine will generate income from operations of $2,000; annual cash flows from the machine will be $3,500 The payback period for the new machine is 10.5 years True False 54 A company is considering purchasing a machine for $21,000 The machine will generate income from operations of $2,000; annual cash flows from the machine will be $3,500 The payback period for the new machine is years True False 55 A company is considering the purchase of a new piece of equipment for $90,000 Predicted annual cash inflows from the investment are $36,000 (year 1), $30,000 (year 2), $18,000 (year 3), $12,000 (year 4), and $6,000 (year 5) The average income from operations over the 5-year life is $20,400 The payback period is 3.5 years True False 56 A company is considering the purchase of a new machine for $48,000 Management expects that the machine can produce sales of $16,000 each year for the next 10 years Expenses are expected to include direct materials, direct labor, and factory overhead totaling $8,000 per year plus depreciation of $4,000 per year All revenues and expenses except depreciation are on a cash basis The payback period for the machine is years True False 57 A company is considering the purchase of a new machine for $48,000 Management expects that the machine can produce sales of $16,000 each year for the next 10 years Expenses are expected to include direct materials, direct labor, and factory overhead totaling $8,000 per year plus depreciation of $4,000 per year All revenues and expenses except depreciation are on a cash basis The payback period for the machine is 12 years True False 58 A company is planning to purchase a machine that will cost $24,000, have a six-year life, and have no salvage value The company expects to sell the machine’s output of 3,000 units evenly throughout each year Total income over the life of the machine is estimated to be $12,000 The machine will generate cash flows per year of $6,000 The payback period for the machine is years True False 59 A company is planning to purchase a machine that will cost $24,000, have a six-year life, and have no salvage value The company expects to sell the machine’s output of 3,000 units evenly throughout each year Total income over the life of the machine is estimated to be $12,000 The machine will generate cash flows per year of $6,000 The payback period for the machine is 12 years True False 60 A company is planning to purchase a machine that will cost $24,000, have a six-year life, and have no salvage value The company expects to sell the machine’s output of 3,000 units evenly throughout each year Total income over the life of the machine is estimated to be $12,000 The machine will generate cash flows per year of $6,000 The accounting rate of return for the machine is 16.7% True False 61 A company is planning to purchase a machine that will cost $24,000, have a six-year life, and have no salvage value The company expects to sell the machine’s output of 3,000 units evenly throughout each year Total income over the life of the machine is estimated to be $12,000 The machine will generate cash flows per year of $6,000 The accounting rate of return for the machine is 50% True False 62 The process by which management plans, evaluates, and controls long-term investment decisions involving fixed assets is called: A absorption cost analysis B variable cost analysis C capital investment analysis D cost-volume-profit analysis 63 Decisions to install new equipment, replace old equipment, and purchase or construct a new building are examples of A sales mix analysis B variable cost analysis C capital investment analysis D variable cost analysis 64 Which of the following is important when evaluating long-term investments? A Investments must earn a reasonable rate of return B The useful life of the asset C Proposals should match long term goals D All of the above 65 Which of the following are present value methods of analyzing capital investment proposals? A Internal rate of return and average rate of return B Average rate of return and net present value C Net present value and internal rate of return D Net present value and payback 66 Which of the following is a present value method of analyzing capital investment proposals? A Average rate of return B Cash payback method C Accounting rate of return D Net present value 67 By converting dollars to be received in the future into current dollars, the present value methods take into consideration that money: A has an international rate of exchange B is the language of business C is the measure of assets, liabilities, and stockholders' equity on financial statements D has a time value 68 Which of the following are two methods of analyzing capital investment proposals that both ignore present value? A Internal rate of return and average rate of return B Net present value and average rate of return C Internal rate of return and net present value D Average rate of return and cash payback method 69 The method of analyzing capital investment proposals that divides the estimated average annual income by the average investment is: A cash payback method B net present value method C internal rate of return method D average rate of return method 70 The primary advantages of the average rate of return method are its ease of computation and the fact that: A it is especially useful to managers whose primary concern is liquidity B there is less possibility of loss from changes in economic conditions and obsolescence when the commitment is short-term C it emphasizes the amount of income earned over the life of the proposal D rankings of proposals are necessary 71 The expected average rate of return for a proposed investment of $600,000 in a fixed asset, with a useful life of four years, straight-line depreciation, no residual value, and an expected total net income of $240,000 for the years, is: A 40% B 20% C 60% D 24% 72 The amount of the average investment for a proposed investment of $90,000 in a fixed asset, with a useful life of four years, straight-line depreciation, no residual value, and an expected total net income of $21,600 for the years, is: A $10,800 B $21,600 C $ 5,400 D $45,000 73 The amount of the estimated average income for a proposed investment of $90,000 in a fixed asset, giving effect to depreciation (straight-line method), with a useful life of four years, no residual value, and an expected total income yield of $21,600, is: A $10,800 B $21,600 C $ 5,400 D $45,000 151 A project has estimated annual net cash flows of $50,000 It is estimated to cost $180,000 Determine the cash payback period 3.6 years ($180,000 / $50,000) 152 A project has estimated annual net cash flows of $90,000 It is estimated to cost $324,000 Determine the cash payback period 3.6 years ($324,000 / $90,000) 153 A project has estimated annual cash flows of $95,000 for four years and is estimated to cost $260,000 Assume a minimum acceptable rate of return of 10% Using the following tables determine the (a) net present value of the project and (b) the present value index, rounded to two decimal places Below is a table for the present value of $1 at compound interest Year 6% 943 890 840 792 747 10% 909 826 751 683 621 12% 893 797 712 636 567 Below is a table for the present value of an annuity of $1 at compound interest Year 6% 943 1.833 2.673 3.465 4.212 10% 909 1.736 2.487 3.170 3.791 (a) $41,150 [$95,000 ´ 3.170) - $260,000] (b) 1.16 ($301,150 / $260,000) 12% 893 1.690 2.402 3.037 3.605 154 A project has estimated annual cash flows of $90,000 for three years and is estimated to cost $250,000 Assume a minimum acceptable rate of return of 10% Using the following tables determine the (a) net present value of the project and (b) the present value index, rounded to two decimal places Below is a table for the present value of $1 at compound interest Year 6% 943 890 840 792 747 10% 909 826 751 683 621 12% 893 797 712 636 567 Below is a table for the present value of an annuity of $1 at compound interest Year 6% 943 1.833 2.673 3.465 4.212 10% 909 1.736 2.487 3.170 3.791 12% 893 1.690 2.402 3.037 3.605 (a) -$26,170 [$90,000 ´ 2.487) - $250,000] (b) 90 ($223,830 / $250,000) 155 A project is estimated to cost $273,840 and provide annual cash flows of $60,000 for seven years Determine the internal rate of return for this project, using the following table Year 10 6% 943 1.833 2.673 3.465 4.212 4.917 5.582 6.210 6.802 7.360 10% 909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 12% 893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 12% [($273,840 / $60,000) = 4.564, the present value of an annuity factor for seven periods at 12% 156 A project is estimated to cost $248,400 and provide annual cash flows of $50,000 for eight years Determine the internal rate of return for this project, using the following table Year 10 6% 943 1.833 2.673 3.465 4.212 4.917 5.582 6.210 6.802 7.360 10% 909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 12% 893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 12% [($248,400 / $50,000) = 4.968, the present value of an annuity factor for eight periods at 12%.] 157 Project A requires an original investment of $65,000 The project will yield cash flows of $15,000 per year for seven years Project B has a calculated net present value of $5,500 over a five year life Project A could be sold at the end of five years for a price of $30,000 (a) Using the proper table below determine the net present value of Project A over a five-year life with salvage value assuming a minimum rate of return of 12% (b) Which project provides the greatest net present value? Below is a table for the present value of $1 at compound interest Year 6% 943 890 840 792 747 10% 909 826 751 683 621 12% 893 797 712 636 567 Below is a table for the present value of an annuity of $1 at compound interest Year 6% 943 1.833 2.673 3.465 4.212 10% 909 1.736 2.487 3.170 3.791 12% 893 1.690 2.402 3.037 3.605 (a) Present value of a $15,000 five year annuity at 12%: Present value of a $30,000 amount, five years at 12% Total present value of Project A: Total cost of Project A: Net present value of Project A $54,075 * 17,010** $71,085 65,000 $6,085 *[$15,000 ´ 3.605 (Present value of an annuity of $1)] **[$30,000 ´ 567 (Present value of $1)] (b) Project A’s net present value of $6,085 is greater than the net present value of Project B, $5,500 158 Project A requires an original investment of $50,000 The project will yield cash flows of $15,000 per year for seven years Project B has a calculated net present value of $13,500 over a four year life Project A could be sold at the end of four years for a price of $25,000 (a) Using the proper table below determine the net present value of Project A over a four-year life with salvage value assuming a minimum rate of return of 12% (b) Which project provides the greatest net present value? Below is a table for the present value of $1 at compound interest Year 6% 943 890 840 792 747 10% 909 826 751 683 621 12% 893 797 712 636 567 Below is a table for the present value of an annuity of $1 at compound interest Year 6% 943 1.833 2.673 3.465 4.212 10% 909 1.736 2.487 3.170 3.791 12% 893 1.690 2.402 3.037 3.605 (a) Present value of a $15,000 four year annuity at 12%: Present value of a $25,000 amount, four years at 12% Total present value of Project A: Total cost of Project A: Net present value of Project A $45,555 * 15,900** $61,455 50,000 $11,455 *[$15,000 ´ 3.037 (Present value of an annuity of $1)] **[$25,000 ´ 636 (Present value of $1)] (b) Project B’s present value of $13,500 is greater than the net present value of Project A of $11,455 159 What is the present value of $8,000 to be received at the end of six years, if the required rate of return is 15%? Below is a table for the present value of $1 at compound interest Year 15% 0.87 0.756 0.658 0.572 0.497 Year 10 15% 0.432 0.376 0.327 0.284 0.247 Below is a table for the present value of an annuity of $1 at compound interest Year 15% 0.87 1.626 2.283 2.855 3.353 Year 10 15% 3.785 4.16 4.487 4.772 5.019 $8,000 * 0.432 = $3,456.00 160 Norton Company is considering a project that will require an initial investment of $750,000 and will return $200,000 each year for five years Required: If taxes are ignored and the required rate of return is 9%, what is the project’s net present value? Based on this analysis, should Norton Company proceed with the project? Below is a table for the present value of $1 at compound interest Year 9% 0.917 0.842 0.772 0.708 0.650 Year 10 9% 0.596 0.547 0.502 0.460 0.422 Below is a table for the present value of an annuity of $1 at compound interest Year 9% Year 9% 0.917 4.486 1.759 5.033 2.531 5.535 3.240 5.995 3.890 10 6.418 ($200,000 * 3.89) - $750,000 = $28,000 Yes, since the net present value is greater than zero, Norton Company should proceed with the project 161 An investment of $185,575 is expected to generate returns of $65,000 per year for each of the next four years What is the investment’s internal rate of return? Below is a table for the present value of $1 at compound interest Year 6% 0.943 0.89 0.84 0.792 0.747 10% 0.909 0.826 0.751 0.683 0.621 12% 0.893 0.797 0.712 0.636 0.567 15% 0.87 0.756 0.658 0.572 0.497 Below is a table for the present value of an annuity of $1 at compound interest Year 6% 10% 12% 15% 0.943 0.909 0.893 0.87 1.833 1.736 1.69 1.626 2.673 2.487 2.402 2.283 3.465 3.17 3.037 2.855 4.212 3.791 3.605 3.353 $185,575 / $65,000 = 2.855 at years = 15% 162 Dickerson Co is evaluating a project requiring a capital expenditure of $810,000 The project has an estimated life of four years and no salvage value The estimated net income and net cash flow from the project are as follows: Year Net Income $ 75,000 100,000 109,000 36,000 $320,000 Net Cash Flow $285,000 290,000 190,000 125,000 $890,000 The company's minimum desired rate of return is 12% The present value of $1 at compound interest of 12% for 1, 2, 3, and years is 893, 797, 712, and 636, respectively Required: Determine the average rate of return on investment, including the effect of depreciation on the investment $320,000 / ($810,000 + $0)/2 = $80,000 = 19.8% $405,000 163 Dickerson Co is evaluating a project requiring a capital expenditure of $810,000 The project has an estimated life of four years and no salvage value The estimated net income and net cash flow from the project are as follows: Year Net Income $ 75,000 100,000 109,000 36,000 $320,000 Net Cash Flow $280,000 300,000 200,000 120,000 $900,000 The company's minimum desired rate of return is 12% The present value of $1 at compound interest of 12% for 1, 2, 3, and years is 893, 797, 712, and 636, respectively Required: Determine the net present value Year Total Amount to be invested Net present value Present Value of $1 at 12% 893 797 712 636 Net Cash Flow $280,000 300,000 200,000 120,000 $900,000 Present Value of Net Cash Flow $250,040 239,100 142,400 76,320 $707,860 810,000 $(102,140) 164 Match each of the following terms with the best definition given below Average income as a percentage of average investment Initial cost divided by Annual net cash inflow of an investment Recognizes that a dollar today is worth more than a dollar tomorrow Capital budgeting The investment analysis method that is most often used by large U.S companies Time value of money concept Net present value method Capital investment analysis Average rate of return Cash payback period 165 Match the term with the correct definition The length of time it will take to recover through cash inflows the dollars of a capital outlay A formal means of analyzing long-range investment decisions The rate of return that makes the net present value of a project equal to zero A stream of equal cash flow amounts The decision model that computes the expected net monetary gain or loss from a project by discounting all expected future cash inflows and outflows to their present value, using a minimum desired rate of return A measure of profitability computed by dividing the average operating income that an asset generates by the average amount of the investment in the asset accounting rate of return net present value annuity capital investment analysis internal rate of return payback period 166 Jimmy Co is considering a 12-year project that is estimated to cost $1,050,000 and has no residual value Jimmy Co seeks to earn an average rate of return of 18% on all capital projects Determine the necessary average annual income (using straight-line depreciation) that must be achieved on this project for this project to be acceptable to Jimmy Co Estimated Average Annual Income Average Investment = Average Rate of Return x ($1,050,000 + $0)/2 = 18 x $525,000 x = 18 = $94,500 167 Proposals L and K each cost $500,000, have 6-year lives, and have expected total cash flows of $720,000 Proposal L is expected to provide equal annual net cash flows of $140,000, while the net cash flows for Proposal K are as follows: Year Year Year Year Year Year $250,000 200,000 100,000 90,000 60,000 20,000 $720,000 Determine the cash payback period for each proposal Round your answers to two decimal places Proposal L: $500,000/$140,000 = 3.57 years Proposal K: $250,000 + $200,000 + ($100,000) = $500,000 = 2.5 years 168 Proposals M and N each cost $600,000, have 6-year lives, and have expected total cash flows of $750,000 Proposal M is expected to provide equal annual net cash flows of $125,000, while the net cash flows for Proposal N are as follows: Year Year Year Year Year Year $250,000 $200,000 $150,000 $ 75,000 $ 50,000 $ 25,000 Determine the cash payback period for each proposal Proposal M: $600,000/$125,000 = 4.8 years Proposal N: $250,000 + $200,000 + $150,000 = $600,000 = years 169 A $550,000 capital investment proposal has an estimated life of four years and no residual value The estimated net cash flows are as follows: Year Net Cash Flow $300,000 280,000 208,000 180,000 The minimum desired rate of return for net present value analysis is 12% The present value of $1 at compound interest of 12% for 1, 2, 3, and years is 893, 797, 712, and 636, respectively Determine the net present value Year Total Amount to be invested Net present value Present Value of $1 at 12% 893 797 712 636 550,000 $203,636 Net Cash Flow $300,000 280,000 208,000 180,000 $968,000 Present Value of Net Cash Flow $267,900 223,160 148,096 114,480 $753,636 170 Sunrise Inc is considering a capital investment proposal that costs $227,500 and has an estimated life of four years and no residual value The estimated net cash flows are as follows: Year Net Cash Flow $97,500 $80,000 $60,000 $40,000 The minimum desired rate of return for net present value analysis is 10% The present value of $1 at compound interest rates of 10% for 1, 2, 3, and years is 909, 826, 751, and 683, respectively Determine the net present value Year Total Amount to be invested Net present value Present Value of $1 at 10% 909 826 751 683 $ Net Cash Flow $ 97,500 80,000 60,000 40,000 $277,500 Present Value of Net Cash Flows $ 88,628 66,080 45,060 27,320 $227,088 227,500 ( 412) 171 The net present value has been computed for Proposals P and Q Relevant data are as follows: Proposal P $245,000 296,500 Amount to be invested Total present value of net cash flow Proposal Q $460,000 425,000 Determine the present value index for each proposal Round your answers to two decimal places Proposal P: $296,500 = 1.21 $245,000 Proposal Q: $425,000 = 0.92 $460,000 172 Vanessa Company is evaluating a project requiring a capital expenditure of $480,000 The project has an estimated life of years and no salvage value The estimated net income and net cash flow from the project are as follows: Year Net Income $ 90,000 80,000 40,000 30,000 $240,000 Net Cash Flow $210,000 200,000 160,000 150,000 $720,000 The company's minimum desired rate of return for net present value analysis is 15% The present value of $1 at compound interest of 15% for 1, 2, 3, and years is 870, 756, 658, and 572, respectively Determine (a) the average rate of return on investment, using straight line depreciation, and (b) the net present value (a) $240,000/4 = $60,000 = 25% ($480,000 + $0)/2 $240,000 (b) Year Total Amount to be invested Net present value Present Value of $1 at 15% 870 756 658 572 Net Cash Flow $ 210,000 200,000 160,000 150,000 $ 720,000 Present Value of Net Cash Flow $ 182,700 151,200 105,280 85,800 $ 524,980 480,000 $ 44,980 173 BAM Co is evaluating a project requiring a capital expenditure of $806,250 The project has an estimated life of four years and no salvage value The estimated net income and net cash flow from the project are as follows: Year Net Income $ 75,000 102,000 109,500 36,000 $322,500 Net Cash Flow $285,000 290,000 190,000 125,000 $890,000 The company's minimum desired rate of return is 12% The present value of $1 at compound interest of 12% for 1, 2, 3, and years is 893, 797, 712, and 636, respectively Determine: (a) the average rate of return on investment, including the effect of depreciation on the investment, and (b) the net present value (a) $322,500/4 = $80,625 = 20% ($806,250 + $0)/2 $403,125 (b) Year Total Amount to be invested Net present value Present Value of $1 at 12% 893 797 712 636 806,250 $(105,835) Net Cash Flow $285,000 290,000 190,000 125,000 $890,000 Present Value of Net Cash Flow $254,505 231,130 135,280 79,500 $700,415 174 The internal rate of return method is used to analyze a $946,250 capital investment proposal with annual net cash flows of $250,000 for each of the six years of its useful life (a) Determine a present value factor for an annuity of $1 which can be used in determining the internal rate of return (b) Based on the factor determined in (a) and the portion of the present value of an annuity of $1 table presented below, determine the internal rate of return for the proposal Year 10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 15% 0.870 1.626 2.283 2.855 3.353 3.785 4.160 20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 (a) $946,250 = 3.785 $250,000 (b) 15% 175 Tipper Co is considering a 10-year project that is estimated to cost $700,000 and has no residual value Tipper seeks to earn an average rate of return of 15% on all capital projects Determine the necessary average annual income (using straight-line depreciation) that must be achieved on this project for this project to be acceptable to Tipper Co Estimated Average Annual Income Average Investment = Average Rate of Return ´ ($700,000 + $0)/2 = 15 ´ $350,000 ´ = 15 = $52,500 176 Proposals A and B each cost $500,000 and have 5-year lives Proposal A is expected to provide equal annual net cash flows of $109,000, while the net cash flows for Proposal B are as follows: Year Year Year Year Year $150,000 140,000 110,000 50,000 50,000 $500,000 Determine the cash payback period for each proposal Round answers to two decimal places Proposal A: $500,000/$109,000 = 4.59 years Proposal B: ($150,000 + $140,000 + $110,000 + $50,000 + $50,000) = $500,000 = years 177 A $400,000 capital investment proposal has an estimated life of four years and no residual value The estimated net cash flows are as follows: Year Net Cash Flow $200,000 150,000 90,000 80,000 The minimum desired rate of return for net present value analysis is 12% The present value of $1 at compound interest of 12% for 1, 2, 3, and years is 893, 797, 712, and 636, respectively Determine the net present value Year Total Amount to be invested Net present value Present Value of $1 at 12% 893 797 712 636 400,000 $13,110 Net Cash Flow $200,000 150,000 90,000 80,000 $520,000 Present Value of Net Cash Flow $178,600 119,550 64,080 50,880 $413,110 178 Mundall Company is considering a project that will require an initial investment of $600,000 and is expected to generate the following cash flows: Year $100,000 Year $250,000 Year $250,000 Year $200,000 Year $100,000 A What is the project’s payback period? B If the required rate of return is 20% and taxes are ignored, what is the project’s net present value? The present value of $1 at compound interest of 20% for 1, 2, 3, and years is 8333, 6944, 5787, 4823 and 4019, respectively A B $100,000 + $250,000 + $250,000 = $600,000, so the payback period is three years ($600,000) * 1.000 = ($600,000) $100,000 * 0.8333 = 83,330 $250,000 * 0.6944 = 173,600 $250,000 * 0.5787 = 144,675 $200,000 * 0.4823 = 96,460 $100,000 * 0.4019 = 40,190 Net present value $(61,745) 179 Identify four capital investment analysis models discussed in the chapter and discuss the strengths and weaknesses of each model The four capital investment models discussed in the chapter are the payback method, the accounting rate of return model, the net present value model, and the internal rate of return model Following are strengths and weaknesses of each: The payback model is easy to understand and is based on cash flows, which are of primary concern to many businesses However, it ignores profitability and the time value of money The accounting rate of return model measures profitability, but it ignores the time value of money The net present value model and the internal rate of return model are both based on cash flows, profitability and the time value of money These models don’t have any of the weaknesses identified with the payback model and the accounting rate of return model 180 What is capital investment analysis? Why are capital investment analysis decisions often difficult and risky? Capital investment analysis is the process of analyzing alternative long-term investments and deciding which assets to acquire and/or sell Capital investment analysis decisions are difficult because they are usually based on predictions about an uncertain future These decisions involve large sums of money committed for long periods of time and may be irreversible 181 Briefly describe the time value of money Why is the time value of money important in capital investment analysis? The time value of money means that a dollar today is worth more than a dollar in the future Since capital investment analysis decisions are often based on cash flows which will be received in the future, managers often use a process called discounting in order to measure future cash flows in the value of today’s dollar ... decisions involving fixed assets is called: A absorption cost analysis B variable cost analysis C capital investment analysis D cost-volume-profit analysis 63 Decisions to install new equipment, replace... or construct a new building are examples of A sales mix analysis B variable cost analysis C capital investment analysis D variable cost analysis 64 Which of the following is important when evaluating... of return method of capital investment analysis gives consideration to the present value of future cash flows True False 19 The cash payback method of capital investment analysis is one of the