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Problems 7

Proposal A has the highest net present value of $18,225 and accrual accounting rate of return of 16.7%, making it the best option. Proposal B has the second highest net present value of $14,445 and same accrual rate of return as Proposal A. Proposal C has the shortest payback period of 1 year but the lowest net present value and accrual rate of return, ranking it as the worst choice.

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77 views

Problems 7

Proposal A has the highest net present value of $18,225 and accrual accounting rate of return of 16.7%, making it the best option. Proposal B has the second highest net present value of $14,445 and same accrual rate of return as Proposal A. Proposal C has the shortest payback period of 1 year but the lowest net present value and accrual rate of return, ranking it as the worst choice.

Uploaded by

joj
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Stop & Look Bookstore desires to buy a new coding machine to help control book inventories.

The machine sells for $36,586 and requires working capital of $4,000. Its estimated useful
life is five years and will have a salvage value of $4,000. Recovery of working capital will
be $4,000 at the end of its useful life. Annual cash savings from the purchase of the
machine will be $10,000.

Required:

a. Compute the net present value at a 14% required rate of return.


b. Compute the internal rate of return.
c. Determine the payback period of the investment.

Answer:

a.
Predicted PV PV of
Cash Flows Year(s) Factor Cash Flows
Investment $(36,586) 0 1.000 $(36,586)
Working capital needed (4,000) 0 1.000 (4,000)
Annual operations 10,000 1-5 3.433 34,330
Working capital returned 4,000 5 0.519 2,076
Salvage value 4,000 5 0.519 2,076
Net present value $(2,104)

b. Trial and error is required. Because net present value is negative in part a, the
internal rate of return is less than 14%. Start by trying 12%.

Predicted PV PV of
Cash Flows Year(s) Factor Cash Flows
Investment $(36,586) 0 1.000 $(36,586)
Working capital needed (4,000) 0 1.000 (4,000)
Annual operations 10,000 1-5 3.605 36,050
Working capital returned 4,000 5 0.567 2,268
Salvage value 4,000 5 0.567 2,268
Net present value $-0-

With a zero net present value, the internal rate of return is 12%.

c. Payback period = ($36,586 + $4,000)/$10,000 = 4.06 years.


Hansel Manufacturing is considering buying an automated machine that costs $250,000. It
requires working capital of $25,000. Annual cash savings are anticipated to be $103,000
for five years. The company uses straight-line depreciation. The salvage value at the end of
five years is expected to be $10,000. The working capital will be recovered at the end of
the machine's life.

Required:

Compute the accrual accounting rate of return based on the initial investment.

Answer:

Accrual accounting income = $103,000 - (($250,000 - $10,000)/5)


= $103,000 - $48,000
= $ 55,000

AARR with initial investment = $55,000/($250,000 + $25,000)


= $55,000/$275,000
= 0.20

Difficulty: 2 Objective: 6

Alex and Alexa, baseball consultants, are in need of a microcomputer network for their
staff. They have received three proposals, with related facts as follows:

Proposal A Proposal B Proposal C


Initial investment in equipment $90,000 $90,000 $90,000
Annual cash increase in
operations:
Year 1 80,000 45,000 90,000
Year 2 10,000 45,000 0
Year 3 45,000 45,000 0
Salvage value 0 0 0
Estimated life 3 yrs 3 yrs 1 yr

The company uses straight-line depreciation for all capital assets.

Required:

a. Compute the payback period, net present value, and accrual accounting rate of
return with initial investment, for each proposal. Use a required rate of return of 14%.

b. Rank each proposal 1, 2, and 3 using each method separately. Which proposal is
best? Why?
Answer:

a. Payback Method

Payback for Proposal A: Year 1 $80,000


Year 2 10,000
Payback is 2 years $90,000

Payback for Proposal B: Year 1 $45,000


Year 2 45,000
Payback is 2 years $90,000

Payback for proposal C: Year 1 $90,000


Payback is 1 year

Net Present Value:

Proposal A: Predicted PV of
Cash Flows Year(s) PV Factor Cash Flows

Investment $(90,000) 0 1.000 $(90,000)


Annual operations:
Year 1 80,000 1 0.877 70,160
Year 2 10,000 2 0.769 7,690
Year 3 45,000 3 0.675 30,375
Net present value $ 18,225

Proposal B: Predicted PV of
Cash Flows Year(s) PV Factor Cash Flows

Investment $(90,000) 0 1.000 $(90,000)


Annual operations:
Year 1 45,000 1 0.877 39,465
Year 2 45,000 2 0.769 34,605
Year 3 45,000 3 0.675 30,375
Net present value $ 14,445

Proposal C: Predicted PV Of
Cash Flows Year(s) PV Factor Cash Flows

Investment $(90,000) 0 1.000 $(90,000)


Annual operations:
Year 1 90,000 1 0.877 78,930
Net present value $ 11,070
(continued)

Accrual Accounting Rate of Return:

Proposal A: (80,000 + 10,000 + 45,000)/3 - (90,000/3) = 0.167


90,000

Proposal B: (45,000-30,000)/90,000 = 0.167

Proposal C: (90,000- 90,000)/90,000 = 0.0

b. Summary:

Method Proposal A Proposal B Proposal C


Payback method ranks 2.5 2.5 1.0
Net present value 1.0 2.0 3.0
AARR 1.5 1.5 3.0

Even though Proposal C is Number 1 for payback, it comes in last with the other two
methods. Because the net present value method takes into account the time value of money
and the other proposals are less comprehensive, Proposal A would be the best alternative.

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