60. Which of the following capital investment models would be preferred when choosing among mutually
exclusive alternatives?
a.
payback period
b.
accounting rate of return
c.
IRR
d.
NPV
61. Five mutually exclusive projects had the following information:
A
B
C
D
E
NPV
£200
£400
£2,000
£1,000
£(400)
IRR
11%
13%
10%
12%
8%
Which project is preferred?
a.
Project A
b.
Project B
c.
Project C
d.
Project D
62. A company invests in a project that realizes an internal rate of return equal to its cost of capital. This
project should:
a.
increase the value of the company.
b.
have little or no effect on the value of the company.
c.
decrease the value of the company.
d.
cause the company to realize an infinite net present value.
63. In computing the net present value of a project, a manager uses a cost of capital number that is too
low. This error causes the manager to compute a net present value that:
a.
is lower that what it in fact should be.
b.
is higher that what it in fact should be.
c.
has no effect on the net present value computation.
d.
is undefined in mathematical terms.
64. The internal rate of return model assumes that all net cash inflows are reinvested at the:
a.
project’s internal rate of return.
b.
discount rate.
c.
prime rate.
d.
none of the above.
65. The problem with the accounting rate of return is that it fails to consider the:
a.
profitability of the project.
b.
life of the project.
c.
timing of cash flows.
d.
effect on net income.
66. Which of the following is a capital investment criterion, but NOT captured in any of the basic capital
budgeting models examined in the text?
a.
the period of time required to recoup an initial investment
b.
various non-quantitative factors
c.
the time value of money
d.
the company’s discount rate
SHORT ANSWER
1. Compare the various quantitative models used to evaluate capital budgeting proposals. Which models
are preferred if used as the only criterion?
PROBLEM
1. (Memorandum required)
Simon Enterprises is considering the purchase of a flexible manufacturing system. The savings
associated with the system are estimated to be as follows:
Increased quality
£75,000
Decrease in operating costs
20,000
Increase in on-time deliveries
5,000
The system will cost £400,000 and will last ten years. The system would have a salvage value of
£30,000 at the end of ten years. The company’s cost of capital is 8 per cent.
Required:
Prepare a memorandum to management with your recommendation regarding whether Simon
Enterprises should purchase the flexible manufacturing system. Include a discussion of qualitative
factors that might influence management’s decision. Include your supporting calculations (including
NPV analysis.)
2. A capital investment project requires an investment of £1,000,000. It has an expected life of five years
with annual cash flows of £240,000 received at the end of each year.
Required:
a.
Compute payback for the project.
b.
Compute the internal rate of return for the project.
c.
Compute the net present value of the project using a 12 per cent discount rate. Ignore income
taxes.
d.
Would you recommend this project be accepted? Why or why not?
3. A capital investment project requires an investment of £75,000 and has an expected life of four years.
Annual cash flows at the end of each year are expected to be as follows:
Year
Amount
1
£40,000
2
£30,000
3
£10,000
4
£35,000
Required:
a.
Compute payback assuming that the cash flows occur evenly throughout the year.
b.
Compute the net present value of the project using a 12 per cent discount rate.
2.5 years
Projected Net Cash Inflows
1
£40,000
_5,000 (1/2 10,000)
b.
Net present value: £14,010
Cash flows
Net present value
Annuity discount factor, 5 years, 7% = 4.100
Present value of cash inflows (£240,000 3.605)
Net present value
4. Mitchell, Inc., is considering two mutually exclusive projects. Project 1 requires an investment of
£80,000, while Project 2 requires an investment of £90,000.
Cash revenues and cash costs for each project are shown below:
____________________PROJECT 1_____________________
YEAR
___1___
___2___
___3___
___4___
Revenues
£30,000
£50,000
£70,000
£90,000
Variable costs
8,000
12,000
20,000
25,000
Fixed costs
12,000
10,000
10,000
10,000
____________________PROJECT 2_____________________
YEAR
___1___
___2___
___3___
___4___
Revenues
£65,000
£80,000
£60,000
£40,000
Variable costs
15,000
30,000
14,000
12,000
Fixed costs
5,000
20,000
10,000
8,000
The company estimates that at the end of the fourth year Project 1 would have a salvage value of
£10,000 and Project 2 would have a salvage value of £5,000.
Required:
a.
Determine the net present value of EACH project using an 8 per cent discount rate.
b.
Prepare a memorandum for management stating your recommendation. Include
supporting calculations in good form.
Project 1:
Investment
Revenues
Variable costs
Fixed costs
Salvage value
Net cash flows
PV factors, 8%
Present values
Net present value
Project 2:
Investment
Revenues
Variable costs
Fixed costs
Salvage value
Net cash flows
PV factors, 8%
Present values
Net present value
5. KT Enterprises is considering the purchase of a flexible manufacturing system. The savings associated
with the system are estimated to be as follows:
Increased quality
£40,000
Decrease in operating costs
20,000
Increase in on-time deliveries
9,000
The system will cost £250,000 and will last seven years. The system would have a salvage value of
£30,000 at the end of seven years. The company’s cost of capital is 8 per cent.
Required:
Prepare a memorandum to management with your recommendation regarding whether KT Enterprises
should purchase the flexible manufacturing system. Include a discussion of qualitative factors that
might influence management’s decision. Include your supporting calculations (including NPV
analysis).
The memorandum can also be graded upon the following factors:
6. A capital investment project requires an investment of £350,000. It has an expected life of ten years
with annual cash flows of £50,000 received at the end of each year.
Required:
a.
Compute payback for the project.
b.
Determine the accounting rate of return for the project, based on the initial capital investment.
c.
Compute the internal rate of return for the project.
d.
Compute the net present value of the project using a 14 per cent discount rate.
e.
Would you recommend this project be accepted? Why or why not?
7. A capital investment project requires an investment of £145,000 and has an expected life of four years.
Annual cash flows at the end of each year are expected to be as follows:
Year
Amount
1
£35,000
2
£45,000
3
£55,000
4
£50,000
Required:
a.
Compute payback assuming that the cash flows occur evenly throughout the year.
b.
Compute the net present value of the project using an 8 per cent discount rate.
8. Maxim, Inc., is considering two mutually exclusive projects. Project 1 requires an investment of
£40,000, while Project 2 requires an investment of £30,000. Cash revenues and cash costs for each
project are shown below.
_____________________PROJECT 1___________________
YEAR
___1___
___2___
___3___
___4___
Revenues
£13,000
£18,000
£35,000
£25,000
Variable costs
7,000
9,000
12,000
12,000
Fixed costs
1,000
2,000
3,000
1,000
_________________PROJECT 2__________________
YEAR
___1___
___2___
___3___
__4___
Revenues
£22,000
£38,000
£16,000
£9,000
Variable costs
12,000
21,000
8,000
5,000
Fixed costs
4,000
3,000
2,000
1,000
Year
1
2
3
(.20 50,000)
b.
Net present value: £6,395
____0____
Investment
£(145,000)
Cash flows
£45,000
Present values
£38,565
Net present value
£ 6,395
The company estimates that at the end of the fourth year Project 1 would have a salvage value of
£3,000 and Project 2 would have a salvage value of £1,000.
Required:
a.
Determine the net present value of EACH project using a 16 per cent discount rate.
b.
Prepare a memorandum for management stating your recommendation. Include
supporting calculations in good form.
9. Explain what a capital investment decision is. In your answer, distinguish between independent and
mutually exclusive capital investment decisions.
10. A capital investment project requires an investment of £450,000. It has an expected life of six years
with an annual cash flow of £90,000 received at the end of each year. The company uses the
straight-line method of depreciation. Ignore income taxes.
Required:
a.
Compute payback for the project.
b.
Compute the net present value of the project using a 12 per cent discount rate.
c.
Would you recommend this project be accepted? Why or why not?
5 years £450,000/£90,000
b.
NPV using a 12 per cent discount rate:
Investment
Present value of cash flow (£90,000 4.111)
Net present value
11. Fill in the lettered blanks in the following table:
Investment A
Investment B
Investment C
Amount of investment
£40,000
(a)
£20,000
Economic life in years
10
5
8
Annual cash flow
£ 5,000
(b)
£ 2,500
Payback period in years
(c)
4
(d)
Present value of cash flows
(e)
£33,000
(f)
Net present value
£ 5,500
£ 3,000
(£1,000)
a.
£33,000 – £3,000 = £30,000
b.
£30,000/4 = £7,500
c.
£40,000/£5,000 = 8
d.
£20,000/£2,500 = 8
e.
£40,000 + £5,500 = £45,500
£20,000 – £1,000 = £19,000
12. Van Dyke Company is evaluating a capital expenditure proposal that has the following predicted cash
flows:
Original investment
£45,000
Cash flow:
Year 1
£17,500
Year 2
25,000
Year 3
15,000
Salvage value
-0-
Discount rate
14%
Required:
Determine the following values:
a.
Net present value of the investment
b.
Proposal’s internal rate of return
c.
Payback period
13. Barker Production Company is considering the purchase of a flexible manufacturing system. The
after-tax cash benefits/savings associated with the system are as follows:
Decreased waste
£ 75,000
Increased quality
100,000
Decrease in operating costs
62,500
Increase in on-time deliveries
12,500
The system will cost £750,000 and will last ten years. The company’s cost of capital is 10 per cent.
Required:
a.
What is the payback period for the flexible manufacturing system?
b.
What is the NPV for the flexible manufacturing system?
c.
What is the IRR for the flexible manufacturing system?
Period
Cash Flow
Present Value Factor
Present Value
1
2
3
Total present value
Less original investment
Net present value
b.
Approximately 14%
c.
2 + £2,500/£15,000 = 2.167 years
14. Dale Davis 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:
Old Machine
New Machine
Salaries
£40,000
£36,000
Supplies
7,000
5,000
Maintenance
__9,000
__5,000
Total
£56,000
£46,000
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 per cent.
Required:
Should the new machine be purchased? Why or why not?
Comment
£(100,000)
Outlay cost
Salvage of old
Repairs avoided
Lower operating
costs
____4,736
Difference in
salvage value
Net present value of
new machine
PTS: 1 REF: 13.4
ESSAY
1. Describe capital investment in the advanced manufacturing environment.