Exercises: Set B 1

EXERCISES: SET B
E12-1B Burns Corporation is considering purchasing a new delivery truck. The truck has Compute cash payback and net
many advantages over the company’s current truck (not the least of which is that it runs). The present value.
new truck would cost $48,000. Because of the increased capacity, reduced maintenance costs, (SO 2, 3)
and increased fuel economy, the new truck is expected to generate cost savings of $8,000. At
the end of 8 years the company will sell the truck for an estimated $24,000. Traditionally the
company has used a rule of thumb that a proposal should not be accepted unless it has a pay-
back period that is less than 70% of the asset’s estimated useful life. Sam Leyland, a new manager,
has suggested that the company should not rely solely on the payback approach, but should
also employ the net present value method when evaluating new projects. The company’s cost
of capital is 8%.
Instructions
(a) Compute the cash payback period and net present value of the proposed investment.
(b) Does the project meet the company’s cash payback criteria? Does it meet the net present
value criteria for acceptance? Discuss your results.

E12-2B Santos Manufacturing Company is considering three new projects, each requiring an Compute cash payback period
equipment investment of $24,000. Each project will last for 3 years and produce the following and net present value.
cash inflows. (SO 2, 3)

Year AA BB CC
1 $ 7,000 $ 9,500 $13,000
2 9,000 9,500 9,000
3 12,000 9,500 10,000
Total $28,000 $28,500 $32,000

The equipment’s salvage value is zero. Santos uses straight-line depreciation. Santos will not ac-
cept any project with a payback period over 2.5 years. Santos’s minimum required rate of return
is 12%.

Instructions
(a) Compute each project’s payback period, indicating the most desirable project and the least
desirable project using this method. (Round to two decimals.)
(b) Compute the net present value of each project. Does your evaluation change? (Round to
nearest dollar.)

E12-3B ASU Corp. is considering purchasing one of two new diagnostic machines. Either ma- Compute net present value and
chine would make it possible for the company to bid on jobs that it currently isn’t equipped to do. profitability index.
Estimates regarding each machine are provided below. (SO 3, 5)

Machine A Machine B
Original cost $98,000 $170,000
Estimated life 8 years 8 years
Salvage value –0– –0–
Estimated annual cash inflows $25,000 $40,000
Estimated annual cash outflows $5,000 $12,000

Instructions
Calculate the net present value and profitability index of each machine. Assume a 9% discount
rate. Which machine should be purchased?

E12-4B Duncan Corporation is involved in the business of injection molding of plastics. It is Determine internal rate of
considering the purchase of a new computer-aided design and manufacturing machine for return.
$425,000. The company believes that with this new machine it will improve productivity and in- (SO 7)
crease quality, resulting in an increase in net annual cash flows of $115,000 for the next 5 years.
Management requires a 12% rate of return on all new investments.

Instructions
Calculate the internal rate of return on this new machine. Should the investment be accepted?
2 Chapter 12 Planning for Capital Investments
Determine internal rate of
return.
(SO 7)
Calculate annual rate of return.
(SO 8)
Compute cash payback period
and annual rate of return.
(SO 2, 8)
Computer annual rate of
return, cash payback period,
and net present value.
(SO 2, 3, 8)
E12-5B Sigma Company is considering three capital expenditure projects. Relevant data for
the projects are as follows.
Annual Life of
Project Investment Income Project
22A $225,000 $11,400 6 years
23A 270,000 17,000 9 years
24A 288,000 16,400 8 years
Annual income is constant over the life of the project. Each project is expected to have zero
salvage value at the end of the project. Sigma Company uses the straight-line method of
depreciation.
Instructions
(a) Determine the internal rate of return for each project. Round the internal rate of return
factor to three decimals.
(b) If Sigma Company’s minimum required rate of return is 9%, which projects are
acceptable?
E12-6B Wright Company is considering opening a new hair salon in Mesa, Arizona. The cost
of building a new salon is $400,000. A new salon will normally generate annual revenues of
$85,000, with annual expenses (including depreciation) of $40,000. At the end of 20 years the
salon will have a salvage value of $100,000.
Instructions
Calculate the annual rate of return on the project.
E12-7B Taschner Service Center just purchased an automobile hoist for $18,000. The hoist has
a 5-year life and an estimated salvage value of $1,050. Installation costs were $3,900, and freight
charges were $850. Taschner uses straight-line depreciation.
The new hoist will be used to replace mufflers and tires on automobiles. Taschner estimates
that the new hoist will enable his mechanics to replace five extra mufflers per week. Each muf-
fler sells for $75 installed.The cost of a muffler is $35, and the labor cost to install a muffler is $15.
Instructions
(a) Compute the payback period for the new hoist.
(b) Compute the annual rate of return for the new hoist. (Round to one decimal.)
E12-8B Ortmeier Company is considering a capital investment of $200,000 in additional
productive facilities. The new machinery is expected to have a useful life of 5 years with no sal-
vage value. Depreciation is by the straight-line method. During the life of the investment, an-
nual net income and cash inflows are expected to be $20,000 and $60,000, respectively.
Ortmeier has a 12% cost of capital rate, which is the minimum acceptable rate of return on the
investment.
Instructions
(Round to two decimals.)
(a) Compute (1) the cash payback period and (2) the annual rate of return on the proposed
capital expenditure.
(b) Using the discounted cash flow technique, compute the net present value.
 Problems: Set C 3

PROBLEMS: SET C
P12-1C The Bynes and Moody partnership is considering three long-term capital investment Compute rate of return, cash
proposals. Each investment has a useful life of 5 years. Relevant data on each project are as payback, and net present value.
follows. (SO 2, 3, 8)

Project Amanda Project Debbie Project Penelope

Capital investment $140,000 $170,000 $190,000
Annual net income:
Year 1 $ 9,000 $12,500 $19,000
2 9,000 12,000 15,000
3 9,000 11,000 14,000
4 9,000 8,000 9,000
5 9,000 6,000 8,000
Total $45,000 $49,500 $65,000

Depreciation is computed by the straight-line method with no salvage value. The company’s cost
of capital is 12%. (Assume cash flows occur evenly throughout the year.)
Instructions
(a) Compute the cash payback period for each project. (Round to two decimals.)
(b) Compute the net present value for each project. (Round to nearest dollar.) (b) A $(6,623); P $(3,872)
(c) Compute the annual rate of return for each project. (Round to two decimals.) (Hint: Use
average annual net income in your computation.)
(d) Rank the projects on each of the foregoing bases. Which project do you recommend?

P12-2C Ben Paul is an accounting major at a western university located approximately Compute annual rate of return,
60 miles from a major city. Many of the students attending the university are from the metro- cash payback, and net present
politan area and visit their homes regularly on the weekends. Ben, an entrepreneur at heart, value.
realizes that few good commuting alternatives are available for students doing weekend travel. (SO 2, 3, 8)
He believes that a weekend commuting service could be organized and run profitably from
several suburban and downtown shopping mall locations. Ben has gathered the following invest-
ment information.
1. Five used vans would cost a total of $90,000 to purchase and would have a 3-year useful life
with negligible salvage value. Ben plans to use straight-line depreciation.
2. Ten drivers would have to be employed at a total payroll expense of $43,200.
3. Other annual out-of-pocket expenses associated with running the commuter service would
include Gasoline $26,000, Maintenance $4,000, Repairs $6,000, Insurance $4,500, Advertising
$2,200.
4. Ben desires to earn a return of 15% on his investment.
5. Ben expects each van to make ten round trips weekly and carry an average of six students
each trip. The service is expected to operate 32 weeks each year, and each student will be
charged $15 for a round-trip ticket.
Instructions
(a) Determine the annual (1) net income and (2) net annual cash flows for the commuter (a) (1) $28,100
service.
(b) Compute (1) the cash payback period and (2) the annual rate of return. (Round to two (b) (1) 1.55 years
decimals.)
(c) Compute the net present value of the commuter service. (Round to the nearest dollar.)
(d) What should Ben conclude from these computations?

P12-3C Platteville Eye Clinic is considering investing in new optical scanning equipment. It has Compute net present value,
two options: Option A would have an initial lower cost but would require a significant expendi- profitability index, and internal
ture for rebuilding after 3 years. Option B would require no rebuilding expenditure, but its main- rate of return.
tenance costs would be higher. Since the option B machine is of initial higher quality, it is expected (SO 3, 5, 7)
to have a salvage value at the end of its useful life. The following estimates were made of the cash
flows. The company’s cost of capital is 11%.
4 Chapter 12 Planning for Capital Investments
(a) (1) NPV A $(5,988)
(3) IRR B 12%
Compute net present value
considering intangible benefits.
(SO 3, 4)
(a) NPV $(9,486)
(b) NPV $21,990
Compute net present value and
internal rate of return with
sensitivity analysis.
(SO 3, 7)
Option A Option B
Initial cost $100,000 $160,000
Annual cash inflows $56,000 $60,000
Annual cash outflows $26,000 $23,000
Cost to rebuild (end of year 3) $45,000 $0
Salvage value $0 $15,000
Estimated useful life 6 years 6 years
Instructions
(a) Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for
each option. (Hint: To solve for internal rate of return, experiment with alternative discount
rates to arrive at a net present value of zero.)
(b) Which option should be accepted?
P12-4C Beka’s Auto Repair is considering the purchase of a new tow truck. The garage doesn’t
currently have a tow truck, and the $65,000 price tag for a new truck would represent a major
expenditure for the garage. Beka Grace, owner of the garage, has compiled the following estimates
in trying to determine whether to purchase the truck.
Initial cost $65,000
Estimated useful life 8 years
Net annual cash inflows from towing $9,600
Overhaul costs (end of year 4) $6,000
Salvage value $18,000
Beka’s good friend, Josh Michaels, stopped by. He is trying to convince Beka that the tow truck
will have other benefits that Beka hasn’t even considered. First, he says, cars that need towing
need to be fixed. Thus, when Beka tows them to her facility her repair revenues will increase.
Second, he notes that the tow truck could have a plow mounted on it, thus saving Beka the cost
of plowing her parking lot. (Josh will give her a used plow blade for free if Beka will plow Josh’s
driveway.) Third, he notes that the truck will generate goodwill; that is, people who are rescued
by Beka and her tow truck will feel grateful and might be more inclined to used her service sta-
tion in the future, or buy gas there. Fourth, the tow truck will have “Beka’s Auto Repair” on its
doors, hood, and back tailgate—a form of free advertising wherever the tow truck goes.
Josh estimates that, at a minimum, these benefits would be worth the following.
Additional annual net cash flows from repair work $3,600
Annual savings from plowing 600
Additional annual net cash flows from customer “goodwill” 1,200
Additional annual net cash flows resulting from free advertising 500
The company’s cost of capital is 10%.
Instructions
(a) Calculate the net present value, ignoring the additional benefits described by Josh. Should
the tow truck be purchased?
(b) Calculate the net present value, incorporating the additional benefits suggested by Josh.
Should the tow truck be purchased?
(c) Suppose Josh has been overly optimistic in his assessment of the value of the additional
benefits. At a minimum, how much would the additional benefits have to be worth in order
for the project to be accepted?
P12-5C Brandon Corp. is thinking about opening a basketball camp in Texas. In order to start
the camp, the company would need to purchase land and build eight basketball courts and a
dormitory-type sleeping and dining facility to house 110 basketball players. Each year the camp
would be run for 8 sessions of 1 week each. The company would hire college basketball players as
coaches. The camp attendees would be male and female basketball players ages 12 to 18. Property
values in Texas have enjoyed a steady increase in value. It is expected that after using the facility for
20 years, Brandon can sell the property for more than it was originally purchased for.The following
amounts have been estimated.
 Problems: Set C 5
Cost of land $ 200,000
Cost to build dorm and dining facility $ 350,000
Annual cash inflows assuming 110 players and 8 weeks $ 700,000
Annual cash outflows $ 560,000
Estimated useful life 20 years
Salvage value $ 700,000
Discount rate 12%

Instructions
(a) Calculate the net present value of the project. (a) NPV $568,291
(b) To gauge the sensitivity of the project to these estimates, assume that if only 90 campers
attend each week, annual cash inflows will be $570,000 and annual cash outflows will be
$510,000. What is the net present value using these alternative estimates? Discuss your
findings.
(c) Assuming the original facts, what is the net present value if the project is actually riskier than
first assumed, and a 15% discount rate is more appropriate?
(d) Assume that during the first 5 years the annual net cash inflows each year were only $70,000. (d) IRR 15%
At the end of the fifth year, the company is running low on cash, so management decides to
sell the property for $635,000. What was the actual internal rate of return on the project?
Explain how this return was possible given that the camp did not appear to be successful.