Exam 14: Capital Investment Decisions

In practice,managers often choose a discount rate that is less than the cost of capital.

Postaudits supply feedback to managers that should help improve future decision making.

Present value of an annuity of $1 in arrears Periods 4\% 6\% 8\% 10\% 12\% 14\% 1 0.962 0.943 0.926 0.909 0.893 0.877 2 1.886 1.833 1.783 1.736 1.690 1.647 3 2.775 2.673 2.577 2.487 2.402 2.322 4 3.630 3.465 3.312 3.170 3.037 2.914 5 4.452 4.212 3.993 3.791 3.605 4.433 6 5.242 4.917 4.623 4.355 4.111 3.889 7 6.002 5.582 5.206 4.868 4.564 4.288 8 6.733 6.210 5.747 5.335 4.968 4.639 9 7.435 6.802 6.247 5.759 5.328 4.946 10 8.111 7.360 6.710 6.145 5.650 5.216 -Refer to the Figure.Galway Company is considering a project with an initial investment of $124,450 that will yield annual net cash flows of $32,000 and will be depreciated at $20,742 per year over its six-year life.What is the internal rate of return?

Projects that affect the cash flows of other projects are called independent projects.

A company is considering two projects. Froject I Froject II Initial investment \ 60,000 \ 60,000 Cash inflow Year 1 \ 30,000 \ 15,000 Cash inflow Year 2 \ 30,000 \ 15,000 Cash inflow Year 3 \ 30,000 \ 30,000 Cash inflow Year 4 \ 30,000 \ 70,000 Cash inflow Year 5 \ 30,000 \ 70,000 -Refer to the Figure.What is the payback period for Project II?

The internal rate of return model does NOT consistently result in choices that maximize firm wealth.

If the net present value of an investment is zero,the investment earns less than the minimum required rate of return.

A company is considering two projects. Project A Project B Initial investment \ 150,000 \ 150,000 Cash inflow Year 1 \ 50,000 \ 40,000 Cash inflow Year 2 \ 50,000 \ 40,000 Cash inflow Year 3 \ 50,000 \ 40,000 Cash inflow Year 4 \ 50,000 \ 60,000 Cash inflow Year 5 \ 50,000 \ 80,000 -Refer to the Figure.What is the payback period for Project B?

Figure 14-10 Present value of $1 Present value of an annuity of $1 Periods 4\% 6\% 8\% 10\% 12\% 14\% 1 0.962 0.943 0.926 0.909 0.893 0.877 2 0.925 0.890 0.857 0.826 0.797 0.769 3 0.889 0.840 0.794 0.751 0.712 0.675 4 0.855 0.792 0.735 0.683 0.636 0.592 5 0.822 0.747 0.681 0.621 0.567 0.519 6 0.790 0.705 0.630 0.564 0.507 0.456 7 0.760 0.665 0.583 0.513 0.452 0.400 8 0.731 0.627 0.540 0.467 0.404 0.351 9 0.703 0.592 0.500 0.424 0.361 0.308 10 0.676 0.558 0.463 0.386 0.322 0.270 Periods 4\% 6\% 8\% 10\% 12\% 14\% 1 0.962 0.943 0.926 0.909 0.893 0.877 2 1.886 1.833 1.783 1.736 1.690 1.647 3 2.775 2.673 2.577 2.487 2.402 2.322 4 3.630 3.465 3.312 3.170 3.037 2.914 5 4.452 4.212 3.993 3.791 3.605 3.433 6 5.242 4.917 4.623 4.355 4.111 3.889 7 6.002 5.582 5.206 4.868 4.564 4.288 8 6.733 6.210 5.747 5.335 4.968 4.639 9 7.435 6.802 6.247 5.759 5.328 4.946 10 8.111 7.360 6.710 6.145 5.650 5.216 -Refer to Figure 14-10.Marousis Company is considering an investment that will have an initial cost of $1,000,000 yield annual net cash inflows of $260,000.Yearly depreciation will be $200,000.The equipment is expected to be useful for five years,at which point it will be scrapped with no salvage value.Marousis requires a minimum rate of return of 10%. A. What is the accounting rate of return? B. What is the net present value? Is the investment acceptable? C. Now suppose that Marousis believes it can sell the equipment at the end of five years for $100,000. What is the net present value? Is the investment acceptable? D. What can you say about the IRR in the first case (no salvage value) versus the IRR in the second case ($100,000 salvage value)?

Runder Company is evaluating a proposal to purchase a new machine that would cost $100,000 and have a salvage value of $10,000 in four years.It would provide annual operating cash savings of $10,000,as follows: If the new machine is purchased,the old machine will be sold for its current salvage value of $20,000.If the new machine is not purchased,the old machine will be disposed of in four years at a predicted salvage value of $2,000.The old machine's present book value is $40,000.If kept,in one year the old machine will require repairs predicted to cost $35,000. Dale Davis's cost of capital is 14%. Required: Should the new machine be purchased? Why or why not? Old Machine New Machine Salaries \ 40,000 \ 36,000 Supplies 7,000 5,000 Maintenance 9,000 5,000 Total \ 56,000 \ 46,000

Cary Swenson is considering investing $30,000 in a project with the following cash revenues and expenses: Cash Expenses \& Revenues Depreciation Year 1 \ 10,000 \ 12,000 Year 2 \ 12,000 \ 11,000 Year 3 \ 15,000 \ 12,000 Year 4 \ 20,000 \ 12,000 Year 5 \ 22,000 \ 12,000 Year 6 \ 25,000 \ 15,000 Year 7 \ 25,000 \ 15,000 Year 8 \ 25,000 \ 15,000 -Refer to the Figure.What is the average income for the project?

Present value of an annuity of $1 in arrears Periods 4\% 6\% 8\% 10\% 12\% 14\% 1 0.962 0.943 0.926 0.909 0.893 0.877 2 1.886 1.833 1.783 1.736 1.690 1.647 3 2.775 2.673 2.577 2.487 2.402 2.322 4 3.630 3.465 3.312 3.170 3.037 2.914 5 4.452 4.212 3.993 3.791 3.605 4.433 6 5.242 4.917 4.623 4.355 4.111 3.889 7 6.002 5.582 5.206 4.868 4.564 4.288 8 6.733 6.210 5.747 5.335 4.968 4.639 9 7.435 6.802 6.247 5.759 5.328 4.946 10 8.111 7.360 6.710 6.145 5.650 5.216 -Refer to the Figure.Coriander Company is considering a project with an initial investment of $426,800 in new equipment that will yield annual net cash flows of $80,000 and will be depreciated at $53,350 per year over its eight-year life.What is the internal rate of return?

Cantar,Inc.has the opportunity to invest in new equipment that will cost $113,000.The net cash inflows for 10 years equal $20,000 per year.What is the internal rate of return for the investment? A partial table of the present value of an annuity of $1 in arrears is as follows: Year 2\% 4\% 6\% 8\% 10\% 12\% 14\% 16\% 10 7.983 8.111 7.360 6.710 6.145 5.650 5.216 4.833

A key element in the capital investment process is called a preaudit.

Payroll Inc.Office Services is considering the purchase of a new computer system to replace the one in operation.Data on the new computer system are as follows: If the existing computer system is kept and used,it would require the purchase of additional hardware a year from now costing $2,000.After the use of the system for five years,the salvage value would be $300.Additional information on the existing system is as follows: Cost \ 12,000 Salvage value at the end of five years \ 1,000 Useful life, in years \ 4,000 The company uses the straight-line method of depreciation. Required: Should the new system be purchased? Why or why not? Additional years of use 5 Annual operating costs \ 9,000 Remaining book value \ 12,000 Current sal vage value \ 3,000 Cost of capital 12\%

Marco Marousis invested in a project that required an initial amount of $52,160 and returned cash inflows of $10,000 per year for 10 years.A partial table of the present value of an annuity of $1 in arrears is as follows: What is the internal rate of return for this investment? Year 2\% 4\% 6\% 8\% 10\% 12\% 14\% 16\% 10 7.983 8.111 7.360 6.710 6.145 5.650 5.216 4.833

Which of the following compares the actual benefits from an investment with the estimated benefits,and the actual operating costs of the investment with estimated operating costs?

In general terms,how much will a sound capital investment earn?

Martin Brother is considering investing $20,000 in a project with the following cash revenues and expenses: Cash Expenses \& Revenues Depreciation Year 1 \ 8,000 \ 8,000 Year 2 \ 12,000 \ 8,000 Year 3 \ 15,000 \ 9,000 Year 4 \ 20,000 \ 10,000 Year 5 \ 20,000 \ 10,000 -Refer to the Figure.Assume straight-line depreciation over five years.What would be the payback period for this investment?

The accounting rate of return is used more often than the internal rate of return.