PROBLEM 12-10B Ranking of Investment Projects (LO2)

CHECK FIGURE
(1) Project B profitability index !"#$
Walters Corporation has limited funds available for investment and must ration the funds among five competing
projects. Selected information on the five projects follows:
Project
Investment
Required
Net Present
Value
Life of the
Project (years)
A.......................................................................................................................................... $16!"## $"$!1%& 6
'.......................................................................................................................................... $1&&!%## $()!&## 1"
C.......................................................................................................................................... $6!### $&)!&"# )
*.......................................................................................................................................... $1##!### $($!### &
+.......................................................................................................................................... $1("!### $,)!(#- $
.he net present values above have been computed using a 1#/ discount rate. .he compan0 wants 0our assistance in
determining which project to accept first! second! and so forth.
Required:
1. Compute the profitabilit0 inde1 for each project.
&. 2n order of preference! ran3 the five projects in terms of:
a. 4et present value.
b. 5roject profitabilit0 inde1.
(. Which ran3ing do 0ou prefer6 Wh06
PROBLEM 12-11B Preference Ranking of Investment Projects (LO2)
CHECK FIGURE
(1) Project # profitability index !"$!
.he management of 7upert Compan0 is e1ploring four different investment opportunities. 2nformation
on the four projects under stud0 follows:
5roject 4umber
1 & ( "
2nvestment re8uired . . . . . . ,$%"#!###- ,$)##!###- ,$$&#!###- ,$)6#!###-
5resent value of cash inflows
at a 1#/ discount rate. . . . . . .
. . . . 6$&!&# 1!#"%!)"# 66!## 1!1("!%"#
4et present value. . . . . . . $1(&!&# $1"%!)"# $1"6!## $1$"!%"#
9ife of the project . . . . . . . . ) 0ears 6 0ears 1 0ears 1& 0ears
2nternal rate of return . . . . . 1/ 1)/ 1"/ 16/
.he compan0:s re8uired rate of return is 1#/; thus! a 1#/ discount rate has been used in the present value
computations above. 9imited funds are available for investment! so the compan0 can:t accept all of the available
projects.
Required:
1. Compute the project profitabilit0 inde1 for each investment project.
&. 7an3 the four projects according to preference! in terms of:
a. 4et present value
b. 5roject profitabilit0 inde1
c. 2nternal rate of return
(. Which ran3ing do 0ou prefer6 Wh06
PROBLEM 12-12B Basic Net Present a!"e #na!$sis (LO1)
CHECK FIGURE
%et pre&ent 'al(e (R)*)+))
Windsor <ines! 9td.! of 4amibia! is contemplating the purchase of e8uipment to e1ploit a mineral deposit on land to
which the compan0 has mineral rights. An engineering and cost anal0sis has been made! and it is e1pected that the
following cash flows would be associated with opening and operating a mine in the area:
Cost of new e8uipment and timbers . . . . . . . . . . . . . . . . . . . .
. . . 71)&!%##
Wor3ing capital re8uired . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . 7$#!###
Annual net cash
receipts . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . 7"!###=
Cost to construct new roads in three 0ears . . . . . . . . . . . . . . .
. . . 7&!###
Salvage value of e8uipment in four
0ears . . . . . . . . . . . . . . . . . . . 7"%!%##
=7eceipts from sales of ore! less out>of>poc3et costs for salaries! utilities!
insurance! and so forth.
.he currenc0 in 4amibia is the rand! denoted here b0 7. .he mineral deposit would be e1hausted after four 0ears of
mining. At that point! the wor3ing capital would be released for reinvestment elsewhere. .he compan0:s re8uired
rate of return is &#/.
Required:
,2gnore income ta1es.- *etermine the net present value of the proposed mining project. Should the
project be accepted6 +1plain.
PROBLEM 12-1%B Basic Net Present a!"e #na!$sis (LO1)
CHECK FIGURE
(1) ,-$*)!! ann(al ca&. flo/&
.he Sweettooth <anufacturing Compan0 would li3e to bu0 a new 2talian>made machine that would automaticall0
?dip@ chocolates. .he dipping operation is currentl0 done largel0 b0 hand. .he machine the compan0 is considering
costs $16#!###. .he manufacturer estimates that the machine would be usable for 1& 0ears but would re8uire the
replacement of several 3e0 parts at the end of the 6th 0ear. .hese parts would cost $!###! including installation.
After 1& 0ears! the machine could be sold for $$!###.
.he compan0 estimates that the cost to operate the machine will be onl0 $6!%## per 0ear. .he present method of
dipping chocolates costs $"#!### per 0ear. 2n addition to reducing costs! the new machine will increase production
b0 %!### bo1es of chocolates per 0ear. .he compan0 realiAes a contribution margin of $1.# per bo1. An 1/ rate of
return is re8uired on all investments.
Required:
1. What are the net annual cash inflows that will be provided b0 the new dipping machine6
&. Compute the new machine:s net present value. Bse the incremental cost approach and round all dollar amounts
to the nearest whole dollar.
PROBLEM 12-1&B 'im(!e Rate of Ret"rn) Pa$*ack (LO+, LO-)
CHECK FIGURE
(1) %et operatin0 inco1e ,1!2*!!!
5ete Samuels has an opportunit0 to ac8uire a franchise from Creen .ea! 2nc.! to dispense froAen 0ogurt products
under the Creen .ea name. <r. Samuels has assembled the following information relating to the franchise:
a. A suitable location in a large shopping mall can be rented for $!$%# per month.
b. 7emodeling and necessar0 e8uipment would cost $6$%!###. .he e8uipment would have a 1%>0ear life and an
$"%!### salvage value. Straight>line depreciation would be used! and the salvage value would be considered in
computing depreciation.
c. 'ased on similar outlets elsewhere! <r. Swanson estimates that sales would total $$%#!### per 0ear. 2ngredients
would cost &#/ of sales.
d. Dperating costs would include $1$%!### per 0ear for salaries! $!$%# per 0ear for insurance! and $6$!%## per 0ear
for utilities. 2n addition! <r. Swanson would have to pa0 a commission to Creen .ea! 2nc.! of 1&.%/ of sales.
Required:
,2gnore income ta1es.-
1. 5repare a contribution format income statement that shows the e1pected net operating income each 0ear from the
franchise outlet.
&. Compute the simple rate of return promised b0 the outlet. 2f <r. Samuels re8uires a simple rate of return of at
least 1&/! should he ac8uire the franchise6
(. Compute the pa0bac3 period on the outlet. 2f <r. Samuels wants a pa0bac3 of four 0ears or less! will he ac8uire
the franchise6
PROBLEM 12-1+B .ee( or 'e!! Pro(ert$ (LO1)
CHECK FIGURE
Keep t.e property alternati'e ,-)#*-33 P4 of ca&. flo/&
7ud0 <artin! professor of languages at +astern Bniversit0! owns a small office building adjacent to the universit0
campus. Ee ac8uired the propert0 1# 0ears ago at a total cost of $6&#!###F$6#!### for the land and $%6#!### for
the building. Ee has just received an offer from a realt0 compan0 that wants to purchase the propert0; however! the
propert0 has been a good source of income over the 0ears! so 5rofessor <artin is unsure whether he should 3eep it
or sell it. Eis alternatives are:
Keep the property. 5rofessor <artin:s accountant has 3ept careful records of the income realiAed from the
propert0 over the past 1# 0ears. .hese records indicate the following annual revenues and e1penses:
7ental receipts $1#!###
9ess building e1penses:
Btilities $("!###
*epreciation of building 1!###
5ropert0 ta1es and insurance
&1!###
7epairs and maintenance
11!###
Custodial help and supplies
"%!### 1&)!###
4et operating income $ %1!###
5rofessor <artin ma3es a $1"!### mortgage pa0ment each 0ear on the propert0. .he mortgage will be paid off in
eight more 0ears. Ee has been depreciating the building b0 the straight>line method! assuming a salvage value of
$11#!### for the building which he still thin3s is an appropriate figure. Ee feels sure that the building can be
rented for another 1% 0ears. Ee also feels sure that 1% 0ears from now the land will be worth ( times what he paid
for it.
Sell the property. A realt0 compan0 has offered to purchase the propert0 b0 pa0ing $&&#!### immediatel0 and
$(%!%## per 0ear for the ne1t 1% 0ears. Control of the propert0 would go to the realt0 compan0 immediatel0. .o
sell the propert0! 5rofessor <artinas would need to pa0 the mortgage off! which could be done b0 ma3ing a lump>
sum pa0ment of $$%!###.
Required:
Assume that 5rofessor <artin re8uires a 1&/ rate of return. Would 0ou recommend he 3eep or sell the propert06
Show computations using the total>cost approach to net present value.
PROBLEM 12-1-B 'im(!e Rate of Ret"rn an/ Pa$*ack Met0o/s (LO%, LO&)
CHECK FIGURE
($) 1)"!5 ret(rn
.eton +ntertainment contains a number of electronic games as well as a miniature golf course and various rides
located outside the building. *ave .eton! the owner! would li3e to construct a water slide on one portion of his
propert0. <r. .eton has gathered the following information about the slide:
a. Water slide e8uipment could be purchased and installed at a cost of $""#!###. According to the manufacturer!
the slide would be usable for % 0ears after which it would have no salvage value.
b. <r. .eton would use straight>line depreciation on the slide e8uipment.
c. .o ma3e room for the water slide! several rides would be dismantled and sold. .hese rides are full0 depreciated!
but the0 could be sold for $&#!### to an amusement par3 in a nearb0 cit0.
d. <r. .eton has concluded that water slides would increase tic3et sales b0 $(1)!### per 0ear.
e. 'ased on e1perience at other water slides! <r. .eton estimates that annual incremental operating e1penses for
the slide would be: salaries! $)!###; insurance! $&%!###; utilities! $1$!###; and maintenance! $&!###.
Required:
1. 5repare an income statement showing the e1pected net operating income each 0ear from the water slide.
&. Compute the simple rate of return e1pected from the water slide. 'ased on this computation! would the water
slide be constructed if <r. .eton re8uires a simple rate of return of at least 1"/ on all investments6
(. Compute the pa0bac3 period for the water slide. 2f <r. .eton accepts an0 project with a pa0bac3 period of %
0ears or less! would the water slide be constructed6
PROBLEM 12-11B Net Present a!"e #na!$sis (LO1)
CHECK FIGURE
(1) ,#)*$2! net ann(al ca&. flo/
2n eight 0ears! Gir3 7ambler will retire. Ee is e1ploring the possibilit0 of opening a self>service car wash. .he car
wash could be managed in the free time he has available from his regular occupation! and it could be closed easil0
when he retires. After careful stud0! Gir3 has determined the following:
a. A building in which a car wash could be installed is available under an >0ear lease at a cost of $&!1## per
month.
b. 5urchase and installation costs of e8uipment would total $16#!###. 2n 0ears the e8uipment could be sold for
about 1#/ of its original cost.
c. An investment of an additional $1!### would be re8uired to cover wor3ing capital needs for cleaning supplies!
change funds! and so forth. After eight 0ears! this wor3ing capital would be released for investment elsewhere.
d. 'oth a wash and a vacuum service would be offered with a wash costing $1.6# and the vacuum costing $#.&#
per use.
e. .he onl0 variable costs associated with the operation would be &( cents per wash for water and 1% cents per use
of the vacuum for electricit0.
f. 2n addition to rent! monthl0 costs of operation would be: cleaning! $"#; insurance! $$#; and maintenance!
$%&#.
g. Cross receipts from the auto wash would be about $1!6## per wee3. According to the e1perience of other car
washes! #/ of the customers using the wash would also use the vacuum.
<r. 7ambler will not open the car wash unless it provides at least an / return.
Required:
1. Assuming that the car wash will be open %& wee3s a 0ear! compute the e1pected net annual cash receipts ,gross
cash receipts less cash disbursements- from its operation. ,*o not include the cost of the e8uipment! the
wor3ing capital! or the salvage value in these computations.-
&. Would 0ou advise <r. 7ambler to open the car wash6 Show computations using the net present value method of
investment anal0sis. 7ound all dollar figures to the nearest whole dollar.
PROBLEM 12-12B Net Present a!"e #na!$sis of a Lease or B"$ 3ecision (LO1)
CHECK FIGURE
(1) %et pre&ent 'al(e of p(rc.a&e alternati'e ,(1-)*2!2)
.he *aniels Compan0 provides cars for its sales staff. 2n the past! the compan0 has alwa0s purchased its cars from a
dealer and then sold the cars after three 0ears of use. .he compan0:s present fleet of cars is three 0ears old and will
be sold ver0 shortl0. .o provide a replacement fleet! the compan0 is considering two alternatives:
Purchase alternative: .he compan0 can purchase the cars! as in the past! and sell the cars after three 0ears of use.
.en cars will be needed! which can be purchased at a discounted price of $1!$## each. 2f this alternative is
accepted! the following costs will be incurred on the fleet as a whole:
Annual cost of servicing! ta1es!
and licensing . . . . . . . . . . . . . . . . . $(!(##
7epairs! first 0ear. . . . . . . . . . . . . . . . $1!6%#
7epairs! second 0ear . . . . . . . . . . . . . $"!"##
7epairs! third 0ear . . . . . . . . . . . . . . . . $6!6##
At the end of three 0ears! the fleet could be sold for one>half of the original purchase price.
Lease alternative: .he compan0 can lease the cars under a three>0ear lease contract. .he lease cost would be
$6#!%## per 0ear ,the first pa0ment due at the end of Hear 1-. As part of this lease cost! the owner would provide all
servicing and repairs! license the cars! and pa0 all the ta1es. 7itewa0 would be re8uired to ma3e a $11!### securit0
deposit at the beginning of the lease period! which would be refunded when the cars were returned to the owner at
the end of the lease contract.
7itewa0 Ad Agenc0:s re8uired rate of return is 1/.
Required:
,2gnore income ta1es.-
1. Bse the total>cost approach to determine the present value of the cash flows associated with each alternative.
7ound all dollar amounts to the nearest whole dollar.
&. Which alternative should the compan0 accept6
PROBLEM 12-14B Net Present a!"e #na!$sis of 'ec"rities (LO1)
CHECK FIGURE
(1) ,2*#$2 %P4 of co11on &toc6
9isa Springfield received $&##!### from her mother:s estate. She placed the funds into the hands of a bro3er! who
purchased the following securities on 9inda:s behalf:
a. Common stoc3 was purchased at a cost of $1&%!###. .he stoc3 paid no dividends! but it was sold for $&#!###
at the end of three 0ears.
b. 5referred stoc3 was purchased at its par value of $"%!###. .he stoc3 paid a 6/ dividend ,based on par value-
each 0ear for three 0ears. At the end of three 0ears! the stoc3 was sold for $"(!###.
c. 'onds were purchased at a cost of $(#!###. .he bonds paid $1!## in interest ever0 si1 months. After three
0ears! the bonds were sold for $&)!###. ,4ote: 2n discounting a cash flow that occurs semiannuall0! the
procedure is to halve the discount rate and double the number of periods. Bse the same procedure in discounting
the proceeds from the sale.-
.he securities were all sold at the end of three 0ears so that 9isa would have funds available to open a new business
venture. .he bro3er stated that the investments had earned more than a 16/ return! and he gave 9inda the following
computation to support his statement:
Common stoc3:
Cain on sale ,$&#!### I $1&%!###- $(!###
5referred stoc3:
*ividends paid ,6/ J $"%!### J ( 0ears- !1##
9oss on sale ,$"(!### I $"%!###- ,&!###-
'onds:
2nterest paid ,$1!## J 6 periods- 1#!##
9oss on sale ,$&)!### I $(#!###- ,1!###-
4et gain on all investments $)!)##
$)!)## K (
0ears L 16.%/
$&##!###
Required:
1. Bsing a 16/ discount rate! compute the net present value of each of the three investments. Dn which
investment,s- did 9isa earn a 16/ rate of return6 ,7ound computations to the nearest whole dollar.-
&. Considering all three investments together! did 9isa earn a 16/ rate of return6 +1plain.
(. 9isa wants to use the $&#!### proceeds ,$&#!### M $"(!### M $&)!### L $&#!###- from sale of the securities
to open a fast>food franchise under 1#>0ear contract. What net annual cash inflow must the store generate for
9isa to earn a 1"/ return over the 1#>0ear period6 ,7ound computations to the nearest whole dollar.-
PROBLEM 12-20B Net Present a!"e) 5ota! an/ Incrementa! #((roac0es (LO1)
CHECK FIGURE
(1) ,1*)+$ %P4 in fa'or of 6eepin0 old tr(c6
'eecher .ruc3ing! S.A.! of 5anama! has a small truc3 that it uses for intracit0 deliveries. .he truc3 is worn out and
must be either overhauled or replaced with a new truc3. .he compan0 has assembled the following information.
,5anama uses the B.S. dollar as its currenc0-:
Present
Truc
Ne!
Truc
5urchase cost new $&%!### $(6!###
7emaining boo3 value $11!###
Dverhaul needed now $!##
Annual cash operating costs $1#!%## $$!###
Salvage valueFnow $)!###
Salvage valueFeight 0ears from now $## $%!%##
2f the compan0 3eeps and overhauls its present deliver0 truc3! then the truc3 will be usable for eight more 0ears. 2f a
new truc3 is purchased! it will be used for eight 0ears! after which it will be traded in on another truc3. .he new
truc3 would be diesel>operated! resulting in a substantial reduction in annual operating costs! as shown above.
.he compan0 computes depreciation on a straight>line basis. All investment projects are evaluated using a 16/
discount rate.
Required:
1. Should 'eecher .ruc3ing 3eep the old truc3 or purchase the new one6 Bse the total>cost approach to net present
value in ma3ing 0our decision. 7ound to the nearest whole dollar.
&. 7edo ,1- above! this time using the incremental>cost approach.
PROBLEM 12-21B 'im(!e Rate of Ret"rn an/ Pa$*ack #na!$sis of 56o Mac0ines (LO%, LO&)
CHECK FIGURE
(1b) 1$")5 ret(rn
Eardwood <anufacturing Compan0 is considering the purchase of two different items of e8uipment! as described
below:
Machine A. A compacting machine has just come onto the mar3et that would permit Eardwood <anufacturing
Compan0 to compress sawdust into various shelving products. At present the sawdust is disposed of as a waste
product. .he following information is available on the machine:
a. .he machine would cost $(6#!### and would have a 1#/ salvage value at the end of its 1&>0ear useful life.
.he compan0 uses straight>line depreciation and considers salvage value in computing depreciation
deductions.
b. .he shelving products manufactured from use of the machine would generate revenues of $&6!&%# per 0ear.
Nariable manufacturing costs would be &#/ of sales.
c. Oi1ed e1penses associated with the new shelving products would be ,per 0ear-: advertising! $"%!###; salaries!
$1#%!###; utilities! $6!1##; and insurance! $)##.
Machine B. A second machine has come onto the mar3et that would allow Eardwood <anufacturing Compan0 to
automate a sanding process that is now done largel0 b0 hand. .he following information is available:
a. .he new sanding machine would cost $&%#!### and would have no salvage value at the end of its 1#>0ear
useful life. .he compan0 would use straight>line depreciation on the new machine.
b. Several old pieces of sanding e8uipment that are full0 depreciated would be disposed of at a scrap value of
$1&!%##.
c. .he new sanding machine would provide substantial annual savings in cash operating costs. 2t would re8uire
an operator at an annual salar0 of $&%!### and $%!### in annual maintenance costs. .he current! hand>
operated sanding procedure costs the compan0 $)&!%## per 0ear in total.
Eardwood <anufacturing Compan0 re8uires a simple rate of return of 1%/ on all e8uipment purchases. Also! the
compan0 will not purchase e8uipment unless the e8uipment has a pa0bac3 period of ".# 0ears or less.
Required:
1. Oor machine A:
a. 5repare an income statement showing the e1pected net operating income each 0ear from the new shelving
products. Bse the contribution format.
b. Compute the simple rate of return.
c. Compute the pa0bac3 period.
&. Oor machine ':
a. Compute the simple rate of return.
b. Compute the pa0bac3 period
(. According to the compan0:s criteria! which machine! if either! should the compan0 purchase6
PROBLEM 12-22B Net Present a!"e #na!$sis of a Ne6 Pro/"ct (LO1)
CHECK FIGURE
(1) %et ca&. inflo/ for year # ,1$!*!!!
Pohnston +lectronics has just developed a new electronic device which! when mounted on an automobile! will tell
the driver how man0 miles the automobile is traveling per gallon of gasoline.
.he compan0 is an1ious to begin production of the new device. .o this end! mar3eting and cost studies have
been made to determine probable costs and mar3et potential. .hese studies have provided the following information:
a. 4ew e8uipment would have to be ac8uired to produce the device. .he e8uipment would cost $($!### and
have a 1&>0ear useful life. After 1& 0ears! it would have a salvage value of about $1!###.
b. Sales in units over the ne1t 1& 0ears are projected to be as follows:
Hear
Sales in
Bnits
1 . . . . . . . . . . . . . $!&##
& . . . . . . . . . . . . . 1"!"##
( . . . . . . . . . . . . . 1!###
"I1&. . . . . . . . . . &1!6##
c. 5roduction and sales of the device would re8uire wor3ing capital of $$&!### to finance accounts receivable!
inventories! and da0>to>da0 cash needs. .his wor3ing capital would be released at the end of the project:s
life.
d. .he devices would sell for $"& each; variable costs for production! administration! and sales would be $1
per unit.
e. Oi1ed costs for salaries! maintenance! propert0 ta1es! insurance! and straight>line depreciation on the
e8uipment would total $16&!### per 0ear. ,*epreciation is based on cost less salvage value.-
f. .o gain rapid entr0 into the mar3et! the compan0 would have to advertise heavil0. .he advertising program
would be:
Hear
Amount of
Hearl0
Advertising
1I
& . . . . . . . . . $&16!###
( . . . . . . . . . .
. $1#!###
"I1&. . . . . . . . $1""!###
g. .he compan0:s re8uired rate of return is 1"/.
Required:
,2gnore income ta1es.-
1. Compute the net cash inflow ,cash receipts less 0earl0 cash operating e1penses- anticipated from sale of the
device for each 0ear over the ne1t 1& 0ears.
&. Bsing the data computed in ,1- above and other data provided in the problem! determine the net present
value of the proposed investment. Would 0ou recommend that Pohnston accept the device as a new
product6