Class cases Ch 13: Capital Budgeting Decisions

Ex.1, 2, 6, 7 and 13

EXERCISE 13–1 Payback Method

The management of Unter Corporation, an architectural design firm, is considering an
investment with the following cash flows:

Required:

1. Determine the payback period of the investment.

2. Would the payback period be affected if the cash inflow in the last year were several
times as large?

Answer for Exercise 13-1

1.The payback period is determined as follows:
Unrecovered
Year Investment Cash Inflow Investment
1 $15,000 $1,000 $14,000
2 $8,000 $2,000 $20,000
3 $2,500 $17,500
4 $4,000 $13,500
5 $5,000 $8,500
6 $6,000 $2,500
7 $5,000 $0
8 $4,000 $0
9 $3,000 $0
10 $2,000 $0
The investment in the project is fully recovered in the 7th year. To be more exact, the
payback period is approximately 6.5 years.

2. Because the investment is recovered prior to the last year, the amount of the cash inflow
in the last year has no effect on the payback period.
1
EXERCISE 13–2 Net Present Value Method

The management of Kunkel Company is considering the purchase of a $27,000 machine that
would reduce operating costs by $7,000 per year. At the end of the machine’s five-year useful
life, it will have zero scrap value. The company’s required rate of return is 12%.

Required:

1. Determine the net present value of the investment in the machine.

2. What is the difference between the total, undiscounted cash inflows and cash outflows
over the entire life of the machine?

Answer for Exercise 13-2 (10 minutes)

1.
Now 1 2 3 4 5

Purchase of machine ...............................................

$(27,000)

Reduced operating costs.........................................

________ $7,000 $7,000 $7,000 $7,000 $7,000

Total cash flows (a) .................................................

$(27,000) $7,000 $7,000 $7,000 $7,000 $7,000

Discount factor (12%) (b) ........................................

1.000 0.893 0.797 0.712 0.636 0.567

Present value (a)×(b) ...............................................

$(27,000) $6,251 $5,579 $4,984 $4,452 $3,969

Net present value....................................................

$(1,765)

Note: The annual reduction in operating costs can also be converted to

its present value using the discount factor of 3.605 as shown in Exhibit
13B-2 in Appendix 13B.

2.
Total
Cash Cash
Item Flow Years Flows
Annual cost savings .. $7,000 5 $ 35,000
Initial investment ..... $(27,000) 1 (27,000)
Net cash flow ........... $ 8,000

2
EXERCISE 13–6 Simple Rate of Return Method

The management of Ballard MicroBrew is considering the purchase of an automated bottling

machine for $120,000. The machine would replace an old piece of equipment that costs $30,000
per year to operate. The new machine would cost $12,000 per year to operate. The old machine
currently in use could be sold now for a scrap value of $40,000. The new machine would have a
useful life of 10 years with no salvage value.

Required:

Required: Compute the simple rate of return on the new automated bottling machine.

Answer for Exercise 13-6

This is a cost reduction project, so the simple rate of return would be
computed as follows:

Operating cost of old machine .................... $ 30,000

Less operating cost of new machine ........... 12,000
Less annual depreciation on the new
machine ($120,000 ÷ 10 years) ............... 12,000
Annual incremental net operating income ... $ 6,000
Cost of the new machine ........................... $120,000
Scrap value of old machine ........................ 40,000
Initial investment....................................... $ 80,000

Simple rate = Annual incremental net operating income

of return Initial investment
$6,000
= = 7.5%
$80,000

3
EXERCISE 13–7 Net Present Value Analysis of Two Alternatives

Perit Industries has $100,000 to invest. The company is trying to decide between two alternative
uses of the funds. The alternatives are:

The working capital needed for project B will be released at the end of six years for investment
elsewhere. Perit Industries’ discount rate is 14%.

Required:

Which investment alternative (if either) would you recommend that the company accept? Show
all computations using the net present value format. Prepare separate computations for each
project.

4
Exercise 13-7 (15 minutes)
Project A:
Now 1 2 3 4 5 6

Purchase of equipment ............................................ $(100,000)

Annual cash inflows ................................................ $21,000 $21,000 $21,000 $21,000 $21,000 $21,000
Salvage value .......................................................... _______ ______ ______ ______ ______ ______ 8,000
Total cash flows (a) .................................................
$(100,000) $21,000 $21,000 $21,000 $21,000 $21,000 $29,000
Discount factor (14%) (b)........................................ 1.000 0.877 0.769 0.675 0.592 0.519 0.456
Present value (a)×(b) ...............................................$(100,000) $18,417 $16,149 $14,175 $12,432 $10,899 $13,224
Net present value ..................................................... $(14,704)

Project B:
Now 1 2 3 4 5 6
Working capital invested ......................... $(100,000)
Annual cash inflows ................................ $16,000 $16,000 $16,000 $16,000 $16,000 $ 16,000
Working capital released ......................... _______ ______ ______ ______ ______ ______ 100,000
Total cash flows (a) ................................. $(100,000) $16,000 $16,000 $16,000 $16,000 $16,000 $116,000
Discount factor (14%) (b) ........................ 1.000 0.877 0.769 0.675 0.592 0.519 0.456
Present value (a)×(b) ............................... $(100,000) $14,032 $12,304 $10,800 $9,472 $8,304 $52,896
Net present value ..................................... $7,808

The $100,000 should be invested in Project B rather than in Project A. Project B has a positive net
present value whereas Project A has a negative net present value.

5
EXERCISE 13–13 Basic Payback Period and Simple Rate of Return Computations

A piece of laborsaving equipment has just come onto the market that Mitsui Electronics, Ltd.,
could use to reduce costs in one of its plants in Japan. Relevant data relating to the equipment
follow:

Required:

1. Compute the payback period for the equipment. If the company requires a payback period
of four years or less, would the equipment be purchased?
2. Compute the simple rate of return on the equipment. Use straight-line depreciation based
on the equipment’s useful life. Would the equipment be purchased if the company’s
required rate of return is 14%?

Answer for Eexercise 13-13

1. The payback period is:

Investment required
Payback period =
Annual net cash inflow
$432,000
= = 4.8 years
$90,000
No, the equipment would not be purchased because the payback period
(4.8 years) exceeds the company’s maximum payback time (4.0 years).

2. The simple rate of return would be computed as follows:

Annual cost savings ............................................... $90,000
Less annual depreciation ($432,000 ÷ 12 years) ...... 36,000
Annual incremental net operating income ............... $54,000

6
 Annual incremental net operating income
Simple rate of return =
Initial investment
$54, 000
= = 12.5%
$432, 000

No, the equipment would not be purchased because its 12.5% rate of
return is less than the company’s 14% required rate of return.