481
CHAPTER 15
CAPITAL INVESTMENT ANALYSIS
CLASS DISCUSSION QUESTIONS
1. The principal objections to the use of the
average rate of return method are its failure
to consider the expected cash flows from the
proposals and the timing of these flows.
4. The cash payback period ignores the cash
flows that occur after the cash payback peri-
od; the net present value method includes
all cash flows in the analysis. The cash pay-
back period also ignores the time value of
money, which is included by the net present
value method.
5. A one-year payback will not equal a 100%
average rate of return because the payback
period is based on cash flows; the average
rate of return is based on income. The de-
preciation on the project will prevent the two
methods from being equal.
8. The $115,000 net present value indicates
the proposal is desirable because the pro-
posal is expected to recover the investment
and provide more than the minimum rate of
return.
9. The net present values indicate both projects
are desirable but not necessarily equal in
desirability. The present value index can be
used to compare the two projects. For
the method assumes the cash received from
the proposal during its useful life will be re-
invested at the rate of return used to com-
pute the present value of the proposal. This
assumption may not always be reasonable.
11. The computations for the internal rate of
return method are more complex than those
for the methods that ignore present value.
Also, the method assumes the cash received
from the proposal during its useful life will be
reinvested at the internal rate of return. This
assumption may not always be reasonable.
12. Allowable deductions for depreciation.
should be considered.
482
16. Monsanto indicated that it recognized the
market was demanding higher product quality
that could be achieved only with a large
investment in process control technology
Monsanto indicated the following six consid-
erations in making its investment:
a. After-tax cash flows
b. Labor savings
483
E15–1
Testing Diagnostic
Equipment Software
Estimated average annual income:
$122,400 ÷ 8 years…………………………………………………. $15,300
$42,625 ÷ 5 years ………………………………………………….. $ 8,525
E15–2
Return of
Rate
Average
=
*The effect of the savings in wages expense is an increase in income.
484
E15–3
Return
on
Investment
= Investment Average
Income AnnualAverageEstimated
*The depreciation of the equipment is included in the factory overhead cost per
unit.
E15–4
a. Year 1 Years 2–9 Last Year
Operating cash flows:
Annual revenues (120,000 units × $9) …… $1,080,000 $1,080,000 $1,080,000
Selling expenses (15% × $1,080,000) …….. (162,000) (162,000) (162,000)
Cost to manufacture
(120,000 units × $4.75)*……………………. (570,000) (570,000) (570,000)
Net operating cash flows ………………… $ 348,000 $ 348,000 $ 348,000
b. The cash payback will occur on December 2 of Year 1. Net operating cash
flows for Year 1 are $348,000, which is $29,000 per month ($348,000 ÷ 12
485
E15–5
Location 1: $500,000 ÷ $125,000 = 4-year cash payback period.
Location 2: Three-year cash payback period, as indicated next.
Net Cash Cumulative
Flow Net Cash Flows
Year 1 ……………………………………………………… $200,000 $200,000
E15–6
a. The Shampoo/Conditioner product line is recommended, based on its shorter
cash payback period. The cash payback period for both products can be
determined using the following schedule:
Initial investment: $2,800,000
Shampoo/Conditioner Body Wash
Net Cash Cumulative Net Net Cash Cumulative Net
Flow Cash Flows Flow Cash Flows
Year 1 $700,000 $ 700,000 $400,000 $ 400,000
Year 2 650,000 1,350,000 400,000 800,000
Year 3 550,000 1,900,000 400,000 1,200,000
b. The cash payback periods are different between the two product lines
because Shampoo/Conditioner earns cash faster than does Body Wash. The
cash payback method emphasizes the initial years’ net cash flows in deter-
less net cash flows in the initial years.
486
E15–6, Concluded
c. The cash payback would be 4 years, 8 months, determined as follows:
At the end of Year 4 the cumulative net cash flows for Shampoo/Conditioner
E15–7
a.
Present Value Net Cash Present Value of
Year of $1 at 10% Flow Net Cash Flow
1 0.909 $ 50,000 $ 45,450
2 0.826 45,000 37,170
487
E15–8
a.
20Y4 20Y5 20Y6 20Y7 20Y8
Revenues …………. $ 35,000 $ 35,000 $ 35,000 $ 35,000 $ 35,000
Driver salary …….. (25,000) (26,000) (27,000) (28,000) (29,000)
Operating costs … (4,500) (4,500) (4,500) (4,500) (4,500)
b.
Net Cash Flow Present Value of Present Value of
Year [from part (a)] $1 at 12% Net Cash Flow
20Y4 $5,500 0.893 $ 4,911.50
20Y5 4,500 0.797 3,586.50
488
E15–9
a.
(in millions)
Annual revenues ………………………………………………………………………. $7.5
Total expenses …………………………………………………………………………. $3.0
b.
(in millions,
except present
value factor)
Annual net cash flow ………………………………………………………………… $ 6.5
Present value of an annuity of $1 at 10% for 20 periods ……………… × 8.5136
489
E15–10
a. Annual cash inflows:
Hours of operation ……………………………….. 1,850
Revenue per hour …………………………………. × $140
Revenue per year …………………………………. $ 259,000
Annual cash outflows:
Hours of operation ……………………………….. 1,850
Fuel cost per hour …………………………….. $48
b. Annual net cash flow (at the end of each of five years) ………………. $ 92,000
Present value of annuity of $1 at 10% for five periods (Exhibit 5) .. × 3.791
490
E15–11
a. Revenues (3,600 × 300 days × $450) …………………………………….. $ 486,000,000
Less: Variable expenses (3,600 × 300 days × $90) ……………….. (97,200,000)
Fixed expenses (other than depreciation) ………………….. (100,000,000)
Annual net cash flows …………………………………………………………. $ 288,800,000
b. Present value of annual net cash flows ($288,800,000 × 5.650) $ 1,631,720,000
E15–12
a. Present Value Index = Total Present Value of Net Cash Flow
Amount to Be Invested
Present value index of Somerset = $441,000
$450,000 = 0.98
491
E15–13
a. Annual net cash flows by machine:
Stitching: $135,000 = 7,500 hours × 60 incremental baseballs × $0.30
Golf Ball: $240,000 = 6,000 hrs. × $40 labor cost saved per hour
Stitching Machine
Annual net cash flows (at the end of each of 8 years) ………………… $135,000
Golf Ball Machine
Annual net cash flows (at the end of each of 8 years) ………………… $ 240,000
Present value of an annuity of $1 at 15% for 8 years (Exhibit 5) ….. × 4.487
b. Present Value Index = Invested Be to Amount
Flows Cash Net of ValuePresent Total
Present value index of the stitching machine: 600,484$
745,605$ = 1.25
492
E15–14
a. Average rate of return on investment: 1,700,000*
($10,000,000 + $2,000,000) ÷ 2 = 28.3%
*The annual income of $1,700,000 is equal to the annual cash flow of $2,500,000
less the annual depreciation expense of $800,000 [($10,000,000 – $2,000,000) ÷
10 years]
E15–15
a. Payback period: $500,000
$2,375,000 = 4.75 years
Note: Assuming the cash flows evenly throughout the year, the cash payback
would be 4 years, 9 months or 4.75 years.
493
E15–15, Concluded
The cost of the automated assembly equipment does not stop with the
initial purchase price and installation costs. The equipment will require the
company to hire engineers and support personnel to keep the machines
running, to program the software, and to debug new programs. The
E15–16
a. Present Value Factor for an
Annuity of $1 for 8 Periods = Amount to Be Invested
Annual Net Cash Flow
E15–17
Periods 10 for $1 of Annuity
an for Factor luePresent Va = Flows Cash Net Annual
Invested Be to Amount
494
E15–18
a. Delivery Truck
Cash received from additional deliveries (90,000 bags × $0.35) ….. $31,500
Cash used for operating expenses (24,000 miles × $0.55) ………….. (13,200)
Net cash flows for delivery truck ………………………………………………. $ 18,300
Bagging Machine
Direct labor savings (2.5 hrs. per day × $20 per hr. × 240 days per yr.) = $12,000
=
Amount to Be Invested
Annual Net Cash Flows
b. To: Management
Re: Investment Recommendation
An internal rate of return analysis was performed for the delivery truck and
bagging machine investments. The internal rate of return for the bagging
Present Value Factor for an
Annuity of $1 for 5 Periods
495
E15–19
a. Present value of annual net cash flows ($620,000 × 5.650*) ………… $ 3,503,000
Amount to be invested ……………………………………………………………… (3,810,000)
Net present value …………………………………………………………………….. $ (307,000)
*Present value of an annuity of $1 at 12% for 10 periods from text Exhibit 5.
E15–20
With an expected useful life of eight years, the cash payback period could not be
greater than eight years. This would indicate the cost of the initial investment
would not be recovered during the useful life of the asset. However, there would
496
E15–21
Office Building
Present Value Net Cash Present Value of
Year of $1 at 15% Flow Net Cash Flow
1 0.870 $ 475,000 $ 413,250
2 0.756 300,000 226,800
Condominium Complex
Present Value Net Cash Present Value of
Year of $1 at 15% Flow Net Cash Flow
1 0.870 $ 600,000 $ 522,000
2 0.756 450,000 340,200
Net present value ……………………… $ 206,900
The net present value of both projects is positive; thus, both proposals are ac-
ceptable. However, the net present value of the condominium complex exceeds
that of the office building. Thus, the condominium complex should be preferred if
there is enough investment money for only one of the projects.
497
E15–22
a.
Blending Equipment
Equal annual cash flows for Years 1–4 …………………………. $ 18,000
Present value of a $1 annuity at 12% for four periods ……. × 3.037
Computer System
Equal annual cash flows for Years 1–4 …………………………. $ 10,000
Present value of a $1 annuity at 12% for four periods ……. × 3.037
b.
Present value index of blending equipment: 000,45$
846,57$ = 1.29 (Rounded)
498
PROBLEMS
P15–1
1. a. Average rate of return for both projects:
()
2÷ 0$+000,800$
5÷ 000,330$ = 000,400$
000,66$ = 16.5%
b. Net present value analysis:
Present Value of
Net Cash Flows Net Cash Flows
Distribution Internet Distribution Internet
Present Value of Center Tracking Center Tracking
Year $1 at 15% Expansion Technology Expansion Technology
1 0.870 $ 226,000 $ 360,000 $ 196,620 $ 313,200
2. The report to the capital investment committee can take many forms. The
report should, as a minimum, present the following points:
a. Both projects offer the same average annual rate of return.
499
P15–2
1. a. Cash payback period for both products: 2 years (the year in which accu-
mulated net cash flows equal $200,000), shown as follows:
Primitive Camping Lakeside Fishing
Net Cash Cumulative Net Cash Cumulative
Year Flows Net Cash Flow Year Flows Net Cash Flow
b. Net present value analysis:
Present Value of Present Value of
Net Cash Flow Net Cash Flow
Primitive Lakeside Primitive Lakeside
Year $1 at 10% Camping Fishing Camping Fishing
1 0.909 $110,000 $ 94,000 $ 99,990.00 $ 85,446.00
2. The report can take many forms and should include the following four points:
a. Both products offer the same total net cash flows.
b. Both products offer the same cash payback period.