Chapter 13 B Exercises

Question 1

Brief Exercise104
Diamond Co. is considering investing in new equipment that will cost $800,000 with a 8-year useful life. The new equipment is expected to produce annual net income of $25,000 over its useful life. Depreciation expense, using the straight-line rate, is $100,000 per year.

Instructions
Calculate the payback period.

Answer 1

Solution 104 (5 min.)

$800,000 ÷ ($25,000 + $100,000) = 6.4 years

Question 2

Brief Exercise105
Madeline Company is proposing to spend $170,000 to purchase a machine that will provide annual cash flows of $37,000. The appropriate present value factor for 8 periods is 6.73.

Instructions
Calculate the proposed investment’s net present value, and indicate whether the investment should be made by Madeline Company.

Answer 2

Solution 105 (5 min.)

Present Value

Cash inflows – $37,000 X 6.73
Cash outflow – investment $170,000 X 1.00
Net present value	$ 249,010
 (170,000)
$  79,010

The investment should be made because the net present value is positive.

Question 3

Brief Exercise106
LeMo Co. is considering investing in a cottage that will cost $310,000. The company expects to rent the cottage for 7 years, after which it will be sold for $400,000 at that time. LeMo anticipates cash flows of $60,000 resulting from the cottage and the company’s borrowing rate is 9%, while its cost of capital is 12%.

Instructions
Calculate the net present value of the cottage and indicate whether LeMo should make the investment.

Answer 3

Solution 106 (5 min.)

	Cash
Flows	
X	12% Discount
Factor	
=	Present
Value

Present value of annual cash flows
Present value of salvage value

Capital investment
Net present value	$60,000
 400,000	X
X	4.56376
0.45235	=
=	$273,826
 180,940
 454,766
 (310,000)
$ 144,766

Since the net present value is positive, LeMo should accept the project.

Question 4

Brief Exercise 107
EKPN Co. has hired a consultant to propose a way to increase the company’s revenues. The consultant has evaluated two mutually exclusive projects with the following information provided for each project:
Chicken Rooster
Capital investment $810,000 $200,000
Annual cash flows 210,000 60,000
Estimated useful life 5 years 5 years Estimated salvage value $130,000 $50,000

EXPN Co. uses a discount rate of 8% to evaluate both projects.

Instructions

(a) Calculate the net present value of both projects.
(b) Calculate the profitability index for each project.
(c) Which project should EKPN accept?

Answer 4

Project Chicken
		Cash
Flows	
X	8% Discount
Factor	
=	Present
Value

Present value of annual cash flows
Present value of salvage value

Capital investment
Net present value		$210,000
130,000	X
X	3.99271
0.68058	=
=	$838,469
  88,475
 926,944
 (810,000)
$116,944

Profitability index = $926,944/$810,000 = 1.144

Project Rooster
		Cash
Flows	
X	9% Discount
Factor	
=	Present
Value

Present value of annual cash flows
Present value of salvage value

Capital investment
Net present value		$60,000
 50,000	X
X	3.992711
0.68058	=
=	$239,563
  34,029
 273,592
 (200,000)
$ 73,592

Profitability index = $273,592/$200,000 = 1.368

Project Rooster has a lower net present value than Project Chicken, but because of its lower capital investment, it has a higher profitability index. Based on its profitability index, Project Rooster should be accepted.

Question 5

Brief Exercise108
An investment costing $72,000 is being contemplated by Mint Co. The investment will have a life of 5 years with no salvage value and will produce annual cash flows of $19,481.

Instructions
What is the approximate internal rate of return associated with this investment?

Answer 5

Solution 108 (5 min.)
When net annual cash inflows are expected to be equal, the internal rate of return can be approximated by dividing the capital investment by the net annual cash inflows to determine the discount factor, and then locating this discount factor on the present value of an annuity table.

$72,000/$19,481 = 3.69591

By tracing across on the 5-year row we see that the discount factor for 11% is 3.69590. Thus, the internal rate of return on this project is approximately 11%.

Question 6

Brief Exercise109
Salt Co. is considering investing in a new facility to extract and produce salt. The facility will increase revenues by $170,000, but will also increase annual expenses by $50,000 including depreciation. The facility will cost $720,000 to build, but will have a $30,000 salvage value at the end of its 15-year useful life.

Instructions
Calculate the annual rate of return on this facility.

Answer 6

The company’s expected annual income is:

$170,000 – $50,000 = $120,000

Its average investment is:

($720,000 + $30,000	)   / 2=	$375,000

Therefore, its annual rate of return is:

$120,000/$375,000 = 32%

Question 7

Brief Exercise 110
The manager of Induction Ltd. wants to evaluate the profitability of four potential new projects and has provided you with the following information

		Project	Investment	Net Present Value
		1	$150,000	$25,000
		2	140,000	25,000
		3	130,000	35,000
		4	60,000	15,000

Using the profitability index approach, rank the four projects

Answer 7

3
165÷130 = 1.27

4
75÷60 = 1.25

2
165÷140 = 1.18

1
175÷150 = 1.17

Question 8

Brief Exercise 111
Johnstown Ltd. wants to buy a new machine for its main product line. It costs $60,000 and will save the company $9,000 per year for the next ten years.
Calculate the payback for the company on this machine.

Answer 8

$60,000 ÷ $9,000 = 6.67 years