(2) If the interest rate is 18%:

Exercise 1 (Computation of simple and compound

interest)
A company is considering to start a new product line. The new product line requires the
installation of new machines and equipment. For this purpose, company wants to
borrow money by issuing bonds of $10,000 for 12-year period. The interest on these = $2,000 × [(1 + 18%)10 – 1/18%(1 + i)10]
bonds is to be paid at a rate of 8% per year. = $2,000 × 4.494*
= $8,988
Required: *Value of [(1 + 18%)10 – 1/18%(1 + i)10] from present value of an annuity of $1 in arrears
Compute the amount of interest to be paid to bondholders over 12-year period: table.
 if the simple interest is charged.
 if the interest is compounded annually. Exercise-4 (Net present value method – uneven cash
Solution:
(1) If interest is simple: flows)
I = Pin Proposal X and proposal Y require an initial investment of $10,000 and are
= $10,000 × 8% × 12 expected to generate an equal cash inflow of $20,000 over their life of four years.
= $10,000 × 0.08 × 12 The net cash inflow for each year of life of both the proposals is given below:
= $9,600

(2) If interest is compounded annually:

To compute compound interest for 12-year period, we would compute compound
amount first using compound amount formula and then compute compound interest by
deducting the principal amount from compound amount.
S = P(1 + i)n
= $10,000 × (1 + 8%)12 Required:
=$10,000 × 2.518* Compute the present value of cash inflows generated by both the proposals
= $25,180 assuming a discount rate of 18%.
Which of the two proposals is better if compared using net present value
Interest to be earned over 8-year period: $25,180 – $10,000 = $15,180 method?
*Value of (1 + 8%)12 from future value of $1 table: 12 periods; 8% interest rate.
Solution:
Exercise 2 (Computation of present value of a single (1). Present values of proposal X and proposal Y:
Both the proposals generate uneven cash inflows. The present value of cash
sum ) inflow of both the proposals would, therefore, be computed by multiplying the net
An employee plans to retire in 15 years. After retirement, he will need an amount of cash inflow generated in each individual year by the present value of $1 at given
$20,000 to start a interest rate of 18%. These calculations are given below:
small business.
*Value from present value of $1 table.
Notice that both the investment proposals
Required: Compute the amount that employee needs to invest today to have an
generate equal cash inflow of $20,000 in 4-
amount of $20,000 upon his retirement assuming an interest rate of: year period but present value of proposal
- 10% compounded annually. Y’s cash inflow is greater than the present
- 14% compounded annually. value of proposal X’s cash inflow by
Solution: $2,204 . The reason is that proposal Y
(1) Investment required at 10% interest rate: generates most of its cash inflow in earlier years whereas proposal X generates
PV = FV × 1/(1 + r)n most of its cash inflow in later years. It reminds us that the money has a time
= $20,000 × 1/(1 + 10%)15 value.
= $20,000 × 0.239*
= $4780 (2). Comparison of two proposals using net present value (NPV) method:
*Value of 1/(1 + 10%)15 from present value of $1 table: 15 periods; 10%. NPV = Initial cost – Present value of cash inflows
NPV of proposal X: $10,000 – $12,348 = $2,348
(1) Investment required at 14% interest rate: NPV of proposal Y: $10,000 – $14,552 = $4,552
PV = FV × 1/(1 + r)n The net present value of both the proposals are positive and therefore both the
= $20,000 × 1/(1 + 14%)15 proposals are acceptable if evaluated using net present value method.
The proposal Y, however, promises a higher net present value than proposal X
= $20,000 × 0.140*
and is therefore a better investment to choose.
=$2,800

Exercise-5 (Present value index – ranking investment

*Value of 1/(1 + 14%)15 from present value of $1 table: 15 periods; 14% interest rate.
Exercise 3 (Computation of present value of an annuity)
A woman will need an amount of $2,000 to go on vacations with her husband at the end
of each year for 10 years. For this purpose she wants to invest some money in a saving
bank but does not know the exact amount of money to invest.
projects)
The management of National company is considering three competing investments –
investment P, investment Q and investment R. The information about the requirement of initial
amount of investment, present value of net cash inflow and net present value of all three
investments is given below:

Required: What amount does she require to invest now to receive an income of $2,000
at the end of each year for 10 years if:
the interest rate is 15%
the interest rate is 18%
Required:
Solution: Choose the most desirable proposal using present value index (profitability index).
Because woman needs equal amounts at the end of each year, it is an annuity and she
Solution:
needs to invest an amount that is equal to the present value of this annuity at given
As each investment requires a different initial investment, the proposals would be ranked using
interest rate. present value index (also called profitability index).
(1) If the interest rate is 15%: Present value index = Present value of cash inflows/Initial investment

Proposal P: $36,000/$35,000 = 1.03

Proposal Q: $21,000/$20,000 = 1.05
Proposal R: $12,000/$11,000 = 1.09
= $2,000 × [(1 + 15%)10 – 1/15%(1 + i)10]
= $2,000 × 5.019* Proposal R is the most desirable proposal because it has the highest present value index.
= $10,038
*Value of [(1 + 15%)10 – 1/15%(1 + i)10] from present value of an annuity of $1 in arrears
table.
Exercise-6 (Capital budgeting with unequal proposal
lives)
The National Food Company is comparing two proposals – proposal L and proposal M.
Proposal L has a useful life of 7 years whereas proposal M has a useful life of 4 years.
Both the proposals require an equal initial investment of $180,000. The information
about cash inflow expected from proposal L and proposal M is given below:
Payback period = years before full recovery + (Unrecovered investment at start of the
The management of National Food Company wants a 10% year/Cash flow during the year)
rate of return on capital investments. = 5 + (3,000/6,000)
Required: Compare two proposals using net present = 5 + 0.5
value method. = 5.5 years or 5 years and *6 months
Solution: *0.5 × 12
(1) Computation of net present value: The entire investment is expected to recover by the middle of sixth year. The payback
The two proposals have unequal useful lives and therefore their net present value period of this project is, therefore, 5.5 years or 5 years and six months.
cannot be directly compared. To make the proposals comparable, we assume that Conclusion:
proposal L is terminated at the end of 4th year which is the end of the life of proposal The project is acceptable because payback period promised by the project is shorter
M. For this purpose we have to estimate the residual value of proposal L and assume than the maximum desired payback period of the management.
that the proposal is sold at its estimated residual value at the end of 4th year.
The net present value of proposal L and proposal M is computed below: Exercise-9 (Computation of accounting rate of return –
Net present value of proposal L:
cost reduction project)
Rahat Manufacturing company uses accounting rate of return to analyze investment in
plant assets. The company wants to reduce its total annual cost by purchasing a new
equipment to be installed in the factory. The relevant information about investment in
new equipment is presented to you:
- Amount required to purchase the equipment: $90,000
- Expected annual cost savings: $18,750
- Useful life of the equipment: 16 years
- Straight line depreciation per year: $5,625
*Value from present value of $1 table. - Residual value of the equipment at the end of 16-year period: $0
**Residual value of the proposal L assumed at the end of 4th year. - Required rate of return: 16%
Net present value of proposal M: Required:
Compute accounting rate of return (or simple rate of return) of the equipment.
Is this investment desirable?
Solution:
(1) Computation of accounting rate of return (simple rate of return):
Accounting/simple rate of return = Net cost savings/Initial investment
= $13,125/$90,000
*Value from present value of an annuity of $1 in arrears table. = 14.58%
(2) Decision: *Annual cost savings – Depreciation:
Proposal L looks more desirable because its net present value is more than that of = $18,750 – $5,625
proposal M. = $13,125
(2) Conclusion:
Exercise-7 (Payback period method- even cash flows) The accounting rate of return of the equipment is 14.58% which is less than the desired
LASANI Stone Crushing company is considering to purchase a new machine. The cost of rate of return of the management. If only accounting rate of return is considered, the
the machine is $360,000 and the life of the machine is 10 years. The machine will reduce investment is not desirable.
annual costs by $75,000.
The management uses payback period method to evaluate capital investments because Exercise-10 (Payback period method with salvage value)
the quick recovery of any capital investment is very important for the company. The Black Stone company sells crushed stone to government contractors as well as to
small business owners involved in construction business. The company needs to replace
Required: Compute the payback period for this proposal. Would the company purchase an old equipment with a new one. The new equipment can increase production as well
new machine if maximum desired payback period of the management is 4 years? as improve the quality of crushed stone. The
information about annual incremental
Solution: revenues and costs associated with the new
Computation of payback period: equipment is given below:
The cost saving of the machine is even (i.e., same amount of cost savings each year). The
payback period can therefore be easily computed using payback period formula: The only non-cash expense in the
Payback period = Investment required to purchase the machine/Net annual cost above income statement is the depreciation.
savings The new equipment would cost $240,000
= $360,000/$75,000 and the old equipment can be sold to a small company for its salvage value of $15,000.
= 4.8 years
Conclusion: Required: Would the company invest in new equipment if the desired payback period is
The payback period of the machine is 4.8 years which is longer than the desired payback 2.5 years or less?
period of the company. The machine would therefore not be purchased.
Solution:
Exercise-8 (Computation of payback period – uneven Step 1 Computation of net annual cash inflow:
The net operating income is not equal to net cash flow because it has been obtained
cash flows) after taking into account the depreciation – a non-cash expense. We would add the
The investment and expected cash inflows of a project depreciation back to net operating income to get the incremental net cash inflow figure.
over 8-year period is given below: It is shown below:
$60,000 + $30,000 = $90,000
Required: Compute the payback period of the project. Step 2: Computation of investment:
Would the project be acceptable if the maximum The price of new equipment is $240,000 and the salvage value of the old equipment is
desired payback period is 7 years? $15,000. The required investment is, therefore, $225,000 ($240,000 – $15,000).
Step 3: Computation of payback period:
Solution: Payback period = Investment required for the project/Net annual cash inflow
As the expected cash flows is uneven (different cash = $225,000/$90,000
flows in different periods), the payback formula cannot be used to compute payback = 2.5 years
period of this project. The payback period for this project would be computed by The equipment promises a payback period of 2.5 years that is equal to the maximum
tracking the unrecovered investment year by year. desired payback period of the company. The equipment would, therefore, be
purchased.
 Step 2: Computation of average incremental annual income:
Exercise-11 (Internal rate of return method – cash
inflow)
Fast Carriage Company is considering to purchase a large truck. The expected useful life
of the truck is 14 years. The cost and net cash inflow associated with the new truck is as
follows:
Cost of new truck: $273,400
Expected annual net cash inflow: $50,000

Required: Compute internal rate of return of the truck. Is the investment in truck
desirable if management wants a 15% return on all such investments? Average income = (45,000 + 115,000 + 195,000 + 145,000 + 75,000 + 7,000)/6
= $97,000
Solution: Step 3: Computation of accounting rate of return:
Step 1; Computation of internal rate of return factor: If initial investment is used as denominator:
The first step is to compute internal rate of return factor by dividing investment Accounting rate of return = Incremental accounting income/Initial investment
required to purchase truck by net annual cash inflows. = $97,000 / $650,000
Internal rate of return factor = Investment required/Net annual cash inflow = 14.92%
= $273,400/$50,000 If average investment is used as denominator:
= 5.468 Accounting rate of return = Incremental accounting income/Average investment
Step 2; Finding the internal rate of return promised by truck: = $97,000 / $335,000*
We would search for the factor (5.468) computed in step 1 in “present value of an = 28.96%
annuity of $1 in arrears table“. In 14-period line, we can see that 5.468 factor represents *Average investment in project:
a 16% rate of return. The internal rate of return of the truck is, therefore, 16%. ($650,000 + $20,000)/2
Step 3; Comparing truck’s rate of return and management’s desired rate of return: = $335,000
As the internal rate of return of the truck (16%) found in step 2 is greater than the
management’s desired rate of return (15%), the investment in new truck is desirable.
Exercise-14 (Accounting rate of return using average
Exercise-12 (Accounting/simple rate of return method investment)
A stone crushing company is planning to purchase a Wheel Loader to be used for
with salvage value) conveying raw stone to a large Stone Crushing Machine and loading crushed stone in
A proposal to purchase a new machine is being considered by the management trucks. A new Wheel loader can be purchased directly from Caterpillar company for
of HiTech manufacturing company. The new machine would increase production and $150,000. The new Wheel Loader will reduce the annual cost by $25,500 and increase
revenues. HiTech uses accounting rate of return method to evaluate capital investments annual operating expenses by $4,500. The useful life of the Wheel Loader is 20 years.
like this. The relevant data is given below: After 20 years it will have a salvage value of $30,000. Company uses straight line
- Cost of new machine: $1,200,000 method of depreciation for all assets.
- Useful life of the machine: 10 years
- Expected annual cash inflows associated with the new machine: $450,000 Required:
- Operating expenses associated with the new machine: $26,000 Compute accounting rate of return of wheel loader using average investment approach.
- Salvage value of the machine at the end of 10-year period: $80,000
The expected annual cash inflows given above is the only revenue that the new machine Solution:
will generate. The operating expenses of $26,000 given above do not include the annual Step 1; Computation of depreciation:
depreciation of the machine. HiTech company uses straight-line method of Annual depreciation = (Cost of the asset – Salvage value)/Useful life
depreciation to depreciate all of its plant assets. = ($150,000 – $30,000)/20
= $6,000
Required: Step 2; Computation of annual net cost saving:
Compute accounting/simple rate of return of the machine. Annual net cost saving = $25,500 – ($4,500 + $6,000)
Would HiTec company purchase the machine if its desired accounting/simple rate of = $15,000
return is 20%? Step 3; Computation of average investment in asset:
Because the company uses straight line method of depreciation, the average investment
Solution: can be computed by adding cost of the asset to the residual value and thn dividing by 2.
(1) Accounting/simple rate of return: It is shown below:
Incremental operating income per year = $450,000 – ($26,000 exp. + $112,000 dep.*) Average investment = (Cost of the asset + Residual value)/2
= $312,000 = ($150,000 + $30,000)/2
*($1,200,000 Cost – $80,000 Salvage value)/10 years = $90,000
= $1,120,000/10 years Step 4; Computation of accounting rate of return:
= $112,000 Accounting rate of return = Annual net cost saving / average investment
Accounting/simple rate of return = Incremental accounting income/Initial investment = $15,000 / $90,000
= $312,000/$1,200,000 = 16.67%
= 26% Note: In this exercise, we have used average investment as the denominator of the
(2) Decision of the management: formula. But sometime analysts use original cost of the asset as the denominator. See
Management should purchase new machine because it promises a 26% exercise 9, 12and 13.
accounting/simple rate of return that is higher than the management’s desired
accounting/simple rate of return.
Exercise-15 (Comparison of two projects using net
Exercise-13 (Accounting rate of return – uneven cash present value method)
Wellness company is trying to choose the best investment project from two alternative
flows) projects. The company has $30,000 to invest. The information about two alternatives is
A project of $650,000 is expected to generate the following cash flows over its useful given below:
life:
The discount rate of Wellness
The project does not require any cash company is 15%.
expenses. Depreciation is to be provided using
straight line method. According to accounting Required:
policies of the company, the salvage value is Give your recommendation to the
treated as the reduction in depreciable basis. company in selecting the best project to invest $30,000. Use net present value (NPV)
Required: Compute accounting rate of return method for your answer.
from the above information.
Solution:
Solution: Net present value (NPV) of project X:
Step 1: Computation of annual depreciation expenses:
(Cost – salvage value)/life of the asset
($650,000 – $20,000)/6
$10,5000
 *Value from “present value
of an annuity of $1 in arrears
table“.
**Tax savings from
depreciation tax shield –
depreciation is a tax
deductible expense.
*Value from present value of annuity of $1 in arrears table. The printing machine has a
Net present value (NPV) of project Y: positive net present value of
$40,402 that makes the machine an acceptable investment.

Exercise-18 (Tax savings from depreciation tax shield)

The Marshal company has just purchased an asset costing $420,000. The straight line
method of depreciation will be used and the entire cost of the asset will be depreciated
over 6 years. The tax rate of Marshal company is 30%.
**Value from present value of $1 table
Required: Calculate annual tax savings from depreciation tax shield.
Recommendation:
Project Y’s net present value is $9,240 which is more than project X’s net present value.
Solution:
Project Y is therefore, more desirable.
The annual depreciation would be computed first and then multiplied by 30% or 0.30 to
find the annual tax savings from depreciation tax shield.
Exercise-16 (Net present value analysis of two Annual depreciation = $420,000 / 6 years
= $70,000
alternatives) Annual tax savings from depreciation tax shield = $70,000 × 0.30
The Sunshine company is considering two projects, project A and project B. Project A = $21,000
requires the purchase of an equipment but no working capital investment whereas The Marshal company will save $21,000 tax per year.
project B requires a working capital
investment but no equipment. The
relevant information for net present Exercise-19 (After-tax cost computation)
value analysis is given below: The projected income statement of
Eastern company is given below:
The working capital required for
project B will be released at the end of Eastern company wants to start a training
project life. Sunshine company uses an 18% discount rate. program that would cost $20,000. The
training program is a tax deductible
Required: Are the two projects comparable using net present value (NPV)? If yes, Select expense. The tax rate of Eastern
the best investment using net present value (NPV) method. (Ignore income tax). company is 30%.
Solution:
Yes, the two projects are comparable because both the projects require equal amount Required:
of initial investment. Prepare a new projected income
NPV of project A: statement of Eastern company to show
the effect of training program on net operating income and income tax. What would be
the after-tax cost of training program.

Solution:
(1) Projected income statement
with training program:
*Value from “present value of an annuity of $1 in arrears table“. (2) Computation of after-tax cost
**Value from “present value of $1 table”. of training program:
NPV of project B: Because the training program is a
tax deductible expense, it would
reduce the taxable income of the
company by $20,000 and reduce
the income tax by $6,000 ($39,000
– 33,000). The after-tax cost of
training program would, therefore,
*Value from “present value of an annuity of $1 in arrears table“. be $14,000 ($20,000 – $6,000).
**Value from “present value of $1 table“. Alternatively, we can compute the
Conclusion: after-tax cost easily by using after-
According to NPV method, project A looks more desirable because its net present value tax cost formula:
is more than project B. After-tax cost = (1 – tax rate) × Tax deductible expense
= (1 – 0.3) × $20,000
= 0.7 × $20,000
Exercise-17 (After-tax cash flows in net present value = $14,000
analysis)
The Falcon company is considering to purchase a printing machine. The relevant Exercise-20 (Payback and accounting rate of return
information is given below:
- Cost of the printing machine: $150,000
method)
- Annual cash inflows: $45,000 The Euro Transport company wants to purchase a new truck. The truck would cost
- Useful life of printing machine: 15 years $225,000 and its salvage value would be 10% at the end of its 20-year useful life. The
- Salvage value (Residual value) after 15-year period: $10,000 annual estimated revenues and costs associated with the new truck are given below:
- Annual cash expenses: $5,000
Falcon company uses straight line method of depreciation. Salvage value is not taken Required:
into account for calculating depreciation for tax purposes. Tax rate of Falcon company is Compute payback period of the
30% . Company requires a 14% after-tax return on all investments. truck. Is the investment in new
truck desirable if maximum
Required: Compute net present value of the printing machine. desired payback period of the
Solution: Euro Transport company is 5
Net annual cash inflow = Annual cash inflow – Annual cash expenses years?
= $45,000 – $5,000 Compute the accounting rate of
= $40,000 return promised by the truck.
Would the Euro Transport company be interested in new truck if minimum required
accounting rate of return is 12%?
Solution:
(1). Payback Analysis:
Payback period = Cost of the truck / Net annual cash inflows
= $225,000/$45,000*
= 5 years
*Depreciation is a non-cash expense and has, therefore, been added back to the net
operating income to obtain net annual cash inflows.
Because the payback period of the truck is equal to the maximum desired payback
period of the Euro Transport company, the investment is desirable.

(2). Accounting rate of return Analysis:

Accounting rate of return = Incremental net operating income/Initial investment
= $34,875/$225,000
= 15.5%
The accounting rate of return promised by the truck is more than the accounting rate of
return of the Euro Transport company. The investment in new truck is, therefore,
desirable according to accounting rate of return analysis.