Solution to Capital Investment’s Exercises

EXERCISE 27.1

(a) The cash payback period is:

£56,000 ÷ £8,000 = 7 years

The net present value is:

8%
Cash Discount Present
Flows X Factor = Value
Present value of net annual cash flows £ 8,000 X 5.74664 = £45,973
Present value of residual value  27,000 X  .54027 =  14,587
 60,560
Less: Capital investment  56,000
Net present value £ 4,560

(b) In order to meet the cash payback criteria, the project would have
to have a cash payback period of less than 4 years (8 ÷ 2). It does
not meet this criteria. The net present value is positive, however,
suggesting the project should be accepted. The reason for the
difference is that the project’s high estimated residual value
increases the present value of the project. The net present value
is a better indicator of the project’s worth.

EXERCISE 27.2

(a)
AA
Year Net Annual Cash Flow Cumulative Net Cash Flow
1 € 7,000 € 7,000
2 9,000 16,000
3 12,000 28,000

Cash payback period 2.50 years

€22,000 – €16,000 = €6,000
€6,000 ÷ €12,000 = .50
BB
 €22,000 ÷ €10,000 = 2.2 years

CC
Year Net Annual Cash Flow Cumulative Net Cash Flow
1 €13,000 €13,000
2 12,000 25,000
3 11,000 36,000

Cash payback period 1.75 years

€22,000 – €13,000 = €9,000
€9,000 ÷ €12,000 = .75

The most desirable project is CC because it has the shortest

payback period. The least desirable project is AA because it has
the longest payback period. As indicated, only CC is acceptable
because its cash payback is 1.75 years.

(b) AA BB CC
Discount Cash Present Cash Present Cash Present
Year Factor Flow Value Flow Value Flow Value
1 .89286 € 7,000 € 6,250 €10,000 € 8,929 €13,000 €11,607
2 .79719   9,000   7,175 10,000   7,972  12,000   9,566
3 .71178  12,000   8,541 10,000   7,118  11,000   7,830
Total present value  21,966  24,019(1)  29,003
Less: Investment (22,000) (22,000) (22,000)
Net present value €  (34) € 2,019 € 7,003

(1) This total may also be obtained from Table 4: €10,000 X 2.40183 =
€24,018. (The difference of €1 is due to rounding)

Project CC is still the most desirable project. Also, on the basis of

net present values, project BB is also acceptable. Project AA is
not desirable.
Investment in new equipment.............. €2,450,000
Disposal of old equipment.............. (250,000)
Additional training required................. 85,000
Net initial investment required............. €2,285,000

Calculation of net present value:

 Discount Present
Year Factor, 9% Amount Value
Cash flows 1 0.91743 € 390,000 €
357,798
2 0.84168 400,000 336,672
3 0.77218 411,000 317,366
4 0.70843 426,000 301,791
5 0.64993 434,000 282,070
6 0.59627 435,000 259,377
7 0.54703 436,000 238,505

Maintenance 5 0.64993 (100,000)

(64,993)
Net cash flows from
    operations: 2,028,586
Terminal residual value 7 0.54703 400,000
     218,812
Present value of
   cash inflows 2,247,398
Less: Initial investment 2,285,000
Net present value €
(37,602)

Based on the net present calculation alone, the sewing machine

should not be purchased. However, the internal rate of return would
be only slightly lower than the 9% minimum required, so the company
may want to look at some of the non-quantitative factors involved.
Machine A
Cash 9% Discount Present
Flows X Factor = Value

Present value of net annual cash flows ₩15,000,000 X 5.53482 = ₩83,022,300

Present value of residual value       0 X  .50187 =        0
  83,022,300
Less: Capital investment   75,500,000
Net present value ₩ 7,522,300

Profitability index = ₩83,022,300/₩75,500,000 = 1.10

Machine B
Cash 9% Discount Present
Flows X Factor = Value

Present value of net annual cash flows ₩30,000,000 X 5.53482 = (₩166,044,600

Present value of residual value       0 X  .50187 = (        0)
( 166,044,600)
Less: Capital investment ( 180,000,000)
Net present value ₩ (13,955,400)

Profitability index = ₩166,044,600/₩180,000,000 = .92

Machine B has a negative net present value, and also a lower

profitability
index. Machine B should be rejected and Machine A should be
purchased.

EXERCISE 27.5

When net annual cash flows are expected to be equal, the internal rate
of return can be approximated by dividing the capital investment by
the net annual cash flows to determine the discount factor, and then
locating this discount factor on the present value of an annuity table.

Rs4,300,000/Rs1,010,000 = 4.25743

By tracing across on the 6-year row, we see that the discount factor
for 11% is 4.23054. Thus, the internal rate of return on this project is
approximately 11%. Since this is above the company’s required rate
of return, the project should be accepted.
EXERCISE 27.6

(a) Total net investment = £29,300 + £1,500 – £2,000 = £28,800

Annual net cash flow = £7,000

Payback period = £28,800 ÷ £7,000 = 4.1 years

(b) Net present value approximates zero when discount rate is 12%.
Present
Item Amount Years PV Factor Value
 Net annual cash flows £7,000 1–6 4.11141 £28,780
Less: Capital investment  28,800
Net present value £ (20)

(c) Because the approximate internal rate of return of 12% exceeds the required rate of

return of 10%, the investment should be accepted.

EXERCISE 27.7

(a)
Internal
Rate of Closest Internal
Capital Net Annual Cash Return Discount Rate of
Project Investment ÷ Flows* = Factor Factor Return

22A HK$2,400,000 ÷ (HK$155,000 + HK$400,000) = 4.324 4.35526 10%

23A HK$2,700,000 ÷ (HK$206,000 + HK$300,000) = 5.336 5.32825 12%
24A HK$2,800,000 ÷ (HK$157,000 + HK$400,000) = 5.027 5.03295 9%

*(Annual income + Depreciation expense)

(b) The acceptable projects are 22A and 23A because their rates of
return are equal to or greater than the 10% required rate of return.
EXERCISE 27.8

The annual rate of return is calculated by dividing expected annual

income by the average investment. The company’s expected annual
income is:

€70,000 – €41,500 = €28,500

Its average investment is:

€300,000 + €80,000 = €190,000

2

Therefore, its annual rate of return is:

€28,500 ÷ €190,000 = 15%

EXERCISE 27.9

(a) Cost of hoist:  €32,400 + €3,300 + €700 = €36,400.

Net annual cash flows:
Number of extra mufflers 5 X 52 weeks (a)   
260
Contribution margin per muffler (€72 – €36 – €16) (b) X
€20
Total net annual cash flows (a) X (b) €5,200
Cash payback period = €36,400 ÷ €5,200 = 7 years.

(b) Average investment: (€36,400 + €3,000) ÷ 2 = €19,700.

Annual depreciation: (€36,400 – €3,000) ÷ 8 = €4,175.
Annual net income:  €5,200 – €4,175 = €1,025.
Annual rate of return = €1,025 ÷ €19,700 = 5.2% (rounded).
EXERCISE 27.10

(a) 1. Cash payback period: $190,000 ÷ $50,000 = 3.8 years.

2. Annual rate of return: $12,000 ÷ [($190,000 + $0) ÷ 2] =

12.63%.

(b) Item Amount Years PV Factor Present Value

Net annual cash flows $ 50,000 1–5 3.60478 $180,239))
Less: Capital 190,000
investment $  (9,761)))
Net present value

EXERCISE 27.11

(a)
Year Net Annual Cash Flow Cumulative Net Cash Flow
1 ¥45,000,000 ¥ 45,000,000
2 40,000,000 85,000,000
3 35,000,000   120,000,000
 Cash payback period 2.57 years (2 + [(¥105,000,000 – ¥85,000,000)
÷ ¥35,000, 000])

(b) Average annual net income = (¥10,000,000 + ¥12,000,000 +

¥14,000, 000+ ¥16,000,000 + ¥18,000,000) ÷ 5 = ¥14,000,000
Average investment = (¥105,000,000 + ¥0) ÷ 2 = ¥52,500,000
Annual rate of return = ¥14,000,000 ÷ ¥52,500,000 = 26.67%

(c) Discount
Present
Year Factor, 11% Amount     
Value     
Net cash flows 1 0.90090 ¥45,000,000
¥  40,540,500
2 0.81162 40,000,000 32,464,800
3 0.73119 35,000,000 25,591,650
4 0.65873 30,000,000 19,761,900
5 0.59345 25,000,000
14,836,250
Present value of cash
   in flows 133,195,100
Less: Initial investment
  105,000,000

Net present value

¥   28,195,100