PTC5 Flashcards
TabC Present Value of an Ordinary Annuity
Techneeco, Inc. is considering producing and selling a new product. Techneeco will evaluate the economic feasibility of pursuing the new product using the net present value approach.
The production line for the new product will cost $600,000 and installation and related costs will be $200,000. The new equipment is expected to have 4-year life and at the end of its useful life to Techneeco the equipment will have a residual value of $60,000.
If it undertakes the project, Techneeco will finance it with a 4-year loan for the full $800,000. Techneeco’s weighted average cost of capital is 8%. The prime rate of interest is 6%.
Techneeco’s tax rate is 30%.
Techneeco has developed estimates of revenues and expenses for each of the four years of the production line life. Those estimates are provided at the Proposed New Product Estimates tab. All estimated revenues will be on a cash basis and all estimated expenses are expect to be paid during the period incurred.
Management has asked that you provide the following information concerning the proposed new product:
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1 1. In carrying out the net present value analysis of its project, what amount should Techneeco use as the present value of project cash inflows?
1,176,000
2 2. In carrying out the net present value analysis of its project, what amount should Techneeco use as the present value of project cash outflows?
650,475
3 3. Based on a net present value evaluation, is Techneeco’s proposed project economically feasible?
Yes
4 4. Independent of your answers above, ASSUME the net present value of the proposed project is $90,000. If Techneeco is to compare the proposed new product project with other projects, using net present value of the project, what is the profitability index for the proposed new product project? PI = (Show as X.XXX, for example 0.123)
pv1 8% .926
2 .857
3 .794
4 .735
Cash inflows are computed for each year as the present value of estimated revenue less the estimated cash-based expenses plus the tax shield resulting from the tax deductible depreciation expense. Because depreciation is a non-cash expense, it must be added back (to reduce expenses) in getting cash-based expenses. Since the net cash inflow for each year is different, to get present values the specific present value of $1 factor for each period has to be applied to the cash inflow for the period. The correct factor will be at the intersection of the correct number of periods (n) and 8%, the firm’s weighted average cost of capital (8%), not the prime rate of interest (6%). Projects should be evaluated using the firm’s weighted average cost of capital. Further, there is nothing to suggest that Techneeco would qualify for the prime rate, which is available only to very highly qualified firms.
In addition to the operating cash inflows, there also is a cash inflow associated with the residual value of the equipment. Because that equipment has an expected sales value of $60,000 at the end of the project, that amount has to be discounted to its present value using the present value of $1 factor for 4 periods at 8%.
Present value of an annuity factors are not appropriate because there are no cash inflows of equal amounts for the four periods (i.e., no annuity).
The sum of the present value of operating cash inflows ($791,495) plus the present value of the residual value ($44,100) gives the present value of total cash inflows ($835,595) (See the separate Answer Worksheet for detailed calculations.)
The only cash outflows for the project are the initial investment in equipment ($600,000) and installation and related costs ($200,000), for a total $800,000. Since that investment is incurred at the start of the project, it is at present value; no discounting is required.
When the net present value method is used, a project is economically feasible if the net present value of cash flows is zero or greater. The net present value of Techneeco’s project is:
PV of cash inflows $835,595
PVof cash outflows 800,000
PV of net cash flows (NPV) $ 35,595 (positive)
Therefore, the project is economically feasible.
The profitability index (PI) provides a measure for comparing projects by determining the benefit to cost ratio for each project and using those resulting ratios to rank competing projects. The benefit is the net present value of the project; the cost is the initial investment. When the net present value is used in the PI calculation, the computation is:
PI = Net Present Value/Cost
For Techneeco’s proposed project the given NPV is $90,000; the project cost is $800,000
Therefore, the PI = $90,000/$800,000 = 0.1125, rounded to 0.113.
ANSWER WORKSHEET
Year Estimated Depreciation Estimated Total Expenses (Including Depreciation) Add Non-Cash In-Flow Total Cash $1 Factor Present Value of Amount Present Value
1 $2,50,000 – $1,50,000 + $40,000 = $1,40,000 × 0.926 = $1,29,640
2 5,00,000 2,75,000 75,000 3,00,000 0.857 2,57,100
3 5,00,000 2,50,000 70,000 3,20,000 0.794 2,54,080
4 3,50,000 2,10,000 65,000 2,05,000 0.735 1,50,675
Total $16,00,000 $8,85,000 $2,50,000 $9,65,000 $7,91,495
Residual Value Calculation
Residual Value Present Value of $1 Factor Present Value Amount
$60,000 × 0.735 = $44,100
Net Present Value Calculation
PV of Cash Inflows: Revenue-based $7,91,495 Residual-based 44,100 Total PV of Cash Inflows $8,35,595 PV of Cash Outflows: Production line $(6,00,000) Installation (2,00,000) Total PV of Cash Outflow $(8,00,000) Net Present Value $35,595 PROFITABILITY INDEX (PI) CALCULATION
PI = NPV/Initial Cost NPV = $90,000 (Given) Initial Cost = $800,000 (Given) PI = $90,000/$800,000 PI = 0.1125 report a content error © 2018, John Wiley & Sons, Inc.Con
The management of Taylor Corporation is attempting to adopt new performance measures. Henry Warren, the chief executive officer, has asked you to prepare a memorandum describing how management should choose between alternative measures.
This memorandum is designed to assist you in deciding how to select among different performance measures for Taylor Corporation.
Selecting among different performance measures requires an understanding how the measures will be used. Possible uses include for compensation, resource allocation, and business unit performance. Different measures are more appropriate for different purposes.
It is important that all performance measures reflect the strategy of the company. Measures that are strategic communicate the goals of the organization and motivate management to pursue those goals. Performance measures must also represent economic reality. They should provide a clear and accurate measure of relative performance. Finally, if the measures are used to evaluate and compensate managers, they should be sensitive to factors that are in the manager’s control and not sensitive to factors beyond the manager’s control. The measures should be clearly controllable by the manager being evaluated.
As you can see, selection of appropriate performance measures is a complex process. If you would like to discuss your selection of measures in more detail, please contact me.
Thank you.
Future CPA
The firm has already defined its strategic goals and objectives for the next five years. As part of the planning process as a finance manager, it is your job to create the master budget for the firm. A master budget encompasses many components, gathered from all departments within a company. Prepare a memo to be distributed to various department managers explaining what the major parts of the master budget include in order to educate employees on the importance of realistic figures. Be sure to identify the various supporting budgets you will need to compile the master budget.
lease discuss this communication with your direct reports as appropriate. The budgeting process is a collaborative effort, and compliance on all fronts is appreciated. As we begin to prepare the master budget for the firm, we would like your help in submitting realistic forecasts and estimates for your department as requested.
The master budget consists of the financial budget and the operating budget. The operating budgets are prepared first and show revenues and expenses, and the resulting budgeted income statement. First, the sales budget is prepared, based on our sales forecasts. Then the production schedule is prepared to meet these sales expectations. Next, we will schedule out the direct materials purchases budget, direct labor budget, overhead budget, and ending finished goods inventory budget. We will have beginning finished goods in inventory and will therefore also prepare a cost of goods sold budget right away. Finally, we will create a nonmanufacturing budget including selling, general, and administrative expenses. At this point, we will be able to create the budgeted income statement with all of the data gathered in the previously mentioned budgets.
The financial budget encompasses the cash budget, the budgeted balance sheet, and the budget for capital expenditures. As a whole, the operating budgets and the financial budgets result in the master budgets based on all of the assumptions of the business.
If anyone has questions or would like more detail, feel free to contact me or set up a time to discuss.
Sincerely,
[Your Name]
Future CPA
In a meeting with Alan Warren, the new Chief Operating Officer of your employer, he tells you, “One of my concerns is how effectively our accounts receivable are being collected.” He then asks you to prepare a memorandum identifying and briefly describing measures that could be used to monitor accounts receivable collections, both at the individual account level and in total for all accounts receivable.
This is to respond to your request for information about alternative measures that could be used to help manage the collection of accounts receivable, both for individual accounts and for accounts receivable in total.
The collection status of individual accounts receivable can be monitored using an aging of accounts receivable. In an aging of accounts receivable, the amount due for each account is shown in terms of its due date. Typically, the total amount due for each individual account is separated into discrete time periods such as the amount not yet due, and the amounts 1 to 30 days overdue, 31 to 60 days overdue, 61 to 90 days overdue, and over 90 days overdue, but any time periods could be used. Since this information is provided for each customer with an account receivable, those that are overdue are identified and the seriousness of each delinquent account is known so that appropriate action can be taken.
An aging of accounts receivable also shows for each time period used the total amount due, which is useful in monitoring the collection status of all accounts receivable. For example, the amount of receivables in each of the aging categories expressed as a percentage of the total accounts receivable reflects the relative delinquency amount for each of the aging categories.
A number of other measures are useful in monitoring accounts receivable in the aggregate. The approaches commonly focus on a measure of the time that accounts receivable remain collectable, and include, among others:
- Average collection period, which measure the number of days on average it takes to collect accounts receivable. This measure shows the average number of days it takes the firm to convert accounts receivable to cash. It is computed as: (Days in Year x Average Accounts Receivable)/Credit Sales for Period.
- Accounts receivable turnover, which measures the number of times that total accounts receivable are incurred and collected (turnover) during a period. This measure indicates both the quality of credit policies and the efficiency of collection procedures. It is computed as: Net Credit Sales/Average Net Accounts Receivable.
- Number of days’ sales in average accounts receivable, which measures the average number of days required to collect receivables and is a variation of the average collection period (described above), but uses accounts receivable turnover in the computation. It is computed as: Number of business days in a fiscal year (e.g., 360 or 365)/Accounts Receivable Turnover.
These measures should be compared over time within the firm and with averages for all firms in our industry.
The average number of days required to collect receivables is a measure that is especially useful when compared with the period for which we extend credit. If the average number of days required to collect receivables is materially longer than the credit terms extended, it is an indication that accounts receivable are not being collected as effectively as expected.
Other aggregate measures for accounts receivable management can be developed, depending on the specific areas of concern.
Please let me know if I can provide additional information about measures used to manage accounts receivable.
Sincerely,
I.M. Candidate
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