Accounting Chapter 26 Homework Instead Of discussing Assumptions Jerrod Stated What The Assumptions Are And How They are

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CHAPTER 26 Capital Investment Analysis

Prob. 26-3B (Concluded)

$400,240

$420,000

*Rounded

3. The computer system upgrade has the largest present value index. Although the

ATM kiosk expansion has the largest net present value, it returns less present

value per dollar invested than does the computer system, as revealed by the

Present value index

of branch office: = 0.95*

Present Value Index = Total Present Value of Net Cash Flow

Amount to Be Invested

CHAPTER 26 Capital Investment Analysis

Prob. 26-4B

1. a. After Hours:

Annual net cash flow (at the end of each of 4 years)……………………

…

$ 320,000

× Present value of an annuity of $1 at 10% for 4 years (Exhibit 5)……

…

3.170

Sun Fun:

Annual net cash flow (at the end of each of 4 years)……………………

…

$290,000

× Present value of an annuity of $1 at 10% for 4 years (Exhibit 5)……

…

3.170

Present value of annual net cash flows……………………………………

…

$919,300

Less amount to be invested…………………………………………………

…

880,730

Net present value………………………………………………………………

…

$ 38,570

Present Value Index =

Total Present Value of Net Cash Flow

Amount to Be Invested

2. Present Value Factor for an Annuity of $1 Amount to Be Invested

Annual Net Cash Flow

a. =

After Hours: $913,600 = 2.855

$320,000

…

CHAPTER 26 Capital Investment Analysis

Prob. 26-4B (Concluded)

3. The net present value, present value index, and internal rate of return all indicate

that After Hours is a better financial opportunity compared with Sun Fun , although

both investments meet the minimum return criterion of 10%. The present value index

indicates that After Hours had a greater present value per dollar of investment. The

internal rate of return method places all proposals on a common basis. As a result,

CHAPTER 26 Capital Investment Analysis

Prob. 26-5B

1. Net present value analysis:

Wichita:

Annual net cash flow (at the end of each of 6 years)………………………… $ 310,000

× Present value of an annuity of $1 at 20% for 6 years (Exhibit 5)………… 3.326

Present value of annual net cash flows………………………………………… $1,031,060

Less amount to be invested………………………………………………………

…

900,000

Net present value…………………………………………………………………… $ 131,060

Topeka:

Net present value…………………………………………………………………… $ 135,600

2. Net present value analysis:

Wichita Topeka Witchita

1 $ 310,000 $ 400,000 $ 258,230 $ 333,200

2 310,000 400,000 215,140 277,600

3 310,000 400,000 179,490 231,600

3. To: Investment Committee

Both Wichita and Topeka have a positive net present value. This means that both

projects meet our minimum expected return of 20% and would be acceptable

investments. However, if funds are limited and only one of the two projects can be

funded, then the two projects must be compared over equal lives. Thus, the residual

Year

0.833

0.694

0.579

Net Cash FlowNet Cash Flow

Present Value of

$1 at 20%

Value of

Present

Topeka

…

CHAPTER 26 Capital Investment Analysis

Prob. 26-6B

1. Proposal A: 3-year, 6-month cash payback period, as follows:

Net Cash Cumulative

Year Flow Net Cash Flows

1 $200,000 $200,000

2 200,000 400,000

*The cash flow required is $80,000 out of $160,000 in Year 4. Thus, 1/2 of 12 months

is 6 months.

Proposal B: 4-year cash payback period, as follows:

Net Cash Cumulative

Year Flow Net Cash Flows

1 $90,000 $ 90,000

2 90,000 180,000

Proposal C: 2-year cash payback period, as follows:

Net Cash Cumulative

Year Flow Net Cash Flows

1 $55,000 $ 55,000

2 53,000 108,000

Proposal D: 2-year, 3-month cash payback period, as follows:

Net Cash Cumulative

Year Flow Net Cash Flows

CHAPTER 26 Capital Investment Analysis

Prob. 26-6B (Continued)

2. Proposal A: 14.1% average rate of return, determined as follows:

$48,000

$340,000

Proposal B: 2.5% average rate of return, determined as follows:

$4,000

$160,000

2.5%

14.1% (rounded)

($680,000 + $0) ÷ 2

$240,000 ÷ 5

($320,000 + $0) ÷ 2

$20,000 ÷ 5

CHAPTER 26 Capital Investment Analysis

Prob. 26-6B (Continued)

3. Of the four proposed investments, only Proposals C and D meet the company’s

requirements, as the following table indicates:

Cash Paybac

Average Rate Accept fo

Proposal Period of Return Further Analysis Reject

A 3 yrs., 6 mos. 14.1% X*

Present Value Net Cash Present Value of

Year of $1 at 15% Flow Net Cash Flow

1 0.870 $ 55,000 $ 47,850

2 0.756 53,000 40,068

3 0.658 50,000 32,900

Present Value Net Cash Present Value of

Year of $1 at 15% Flow Net Cash Flow

1 0.870 $180,000 $156,600

2 0.756 180,000 136,080

3 0.658 160,000 105,280

Proposal C

Proposal D

CHAPTER 26 Capital Investment Analysis

Prob. 26-6B (Concluded)

6. Based on the net present value, the proposals should be ranked as follows:

Proposal D: $94,920

Proposal C: $62,067

7. Based on the present value index (the amount of present value per dollar invested),

8. The present value indexes indicate that although Proposal D has the larger net

present value, it is not as attractive as Proposal C in terms of the amount of

present value per dollar invested. Proposal D requires the larger investment.

Present Value Index =

Total Present Value of Net Cash Flow

Amount to Be Invested

CHAPTER 26 Capital Investment Analysis

CP 26-1

The plant manager wants a project to be accepted and places pressure on the analyst

to come up with the “right numbers.” Jerrod is right when he states that the net present

value analysis has many assumptions and room for interpretation. Many analysts use

this room for interpretation to work the numbers until they satisfy the minimum return

(hurdle) rate. In fact, some analysts state that they start with the hurdle rate and work

back into the numbers. Clearly, this is not what should be expected of Danielle.

by countering his argument. For example, Danielle might point out that it is by no means

clear that more storage space translates into more sales. In fact, it is probably just the

opposite. More storage space means that more product waits a long time before being

shipped to the customer. This means that the customer is guaranteed to receive dated

product that may be inferior to product that was recently produced. More warehouse

space is counter to a just-in-time orientation. Danielle is really trying to prevent the plant

manager from going down the wrong path. Jerrod needs to work on his systems so

that he doesn’t need the warehouse space.

This very difficult issue revolves around the nature of ethical dilemmas. Danielle has

brief tenure with the organization. She has very little organizational clout and could

easily find her career short-circuited by crossing Jerrod. It might be tempting for

Danielle to slide on this one—after all, who would know? If the project is eventually a

failure, it’s unlikely that the decision would come back to haunt Danielle. Much time will

have passed, and Danielle will likely be in another job in the company. The decision to

confront Jerrod has immediate repercussions. This is the heart of real-world ethical

dilemmas. The dilemma occurs when the ethical decision has grave short-term

consequences (Jerrod short-circuits Danielle’s career) and few seemingly long-term

CASES & PROJECTS

CHAPTER 26 Capital Investment Analysis

CP 26-2

This activity could be assigned individually or in groups. This activity has the student(s)

perform a capital investment analysis for a desktop computer, using information

available to them on the Internet and from a local business. The actual answer depends

on the numbers determined by the student(s). Have a number of students (or groups

provide their answers to the class and note the variation (or lack thereof) between the

various analyses. Use this to show that there are often many answers to even simple

problems, depending on the assumptions (e.g., what is considered a “mid-range”

computer) and underlying data (e.g., rental rate). Below is a sample answer based on

our own data and assumptions:

Assumed hourly rental rate………………………………………………

…

$8 per hour

Semester cost (40 hours × $8)…………………………………………… $320

CP 26-3

Memo

To: Tom Greene

From: Ima Student

Re: Effect of Exchange Rate Changes on Internal Rate of Return

I have reviewed the impact of possible exchange rate changes on the company’s internal

rate of return and determined that the impact will be significantly different depending on

where the product is ultimately sold. If the product is sold locally, it is likely that the

internal rate of return on the new plant will decline because all net cash flows are

incurred in the local economy. This is because the cash profits earned on the plant will

be less in U.S. dollars as a result of the devaluation. For example, if the product sold for

If, however, the plant produced for export only, then the expenses would be incurred in

local currency, while the revenues would be earned in U.S. dollars. This could work in

favor of the project because the expenses in U.S. dollar terms would decline. For

CHAPTER 26 Capital Investment Analysis

CP 26-4

2. Annual tuition at the beginning of graduate year………………………………

…

$ (12,000)

Annual salary…………………………………………………………………………

…

$ 66,000

× Present value of $1 annuity for 9 years at 10%………………………………

…

5.759

Present value salary to end of graduate year……………………………………

…

$380,094

× Present value of $1 for 1 year at 10%……………………………………………

…

0.909

Present value of salary at the beginning of graduate year……………………

…

$345,505

Present value of graduate option at the beginning of

graduate year (salary less tuition)………………………………………………

…

$333,505

Note: The present values of parts (1) and (2) must both be determined as of the

beginning of the graduate year in order to be compared. Thus, the present value

of the salary at the end of graduate school must be brought back 1 period to

the beginning of the graduate year, since this salary stream is delayed by 1 year

of schooling. The timeline below shows the computation.

…

Note to Instructors: This solution accounts for the opportunity cost of graduate

school in terms of lost earnings during the graduate year. To maintain simplicity,

the solution does not account for likely growth in earnings over time or income tax

effects. In addition, the undergraduate tuition and opportunity cost to obtain the

undergraduate degree are treated as sunk costs relative to the decision to attend

graduate school and, thus, are not relevant to the analysis.

…

CHAPTER 26 Capital Investment Analysis

CP 26-5

In all three companies, the executives indicate that financial investment analysis

plays a minor role in the selection of projects. The reason is that all three companies

deal with products that have highly uncertain future cash flows. Thus, any attempt

at a financial investment analysis could be highly suspect. Instead, these managers

CP 26-6

a. All cash flows assumed to occur at the end of the year. All amounts are

2018 cash flow: in millions

Gross ticket sales……………………………………………………………

…

$ 420

Production cost………………………………………………………………

…

(340)

…

(90)

Net

resent value:

Present Value Net Cash Present Value of

Year of $1 at 20% Flow Net Cash Flow

2018 0.833 $(10) $ (8)

2019 0.694 60 42

2020 0.579 20 12

2021 0.482 10 5

Net present value……………………………………………………………

…

$51