Capital Investment Decisions Chapter 26 Exercises

Net Present Value In-Class Exercise Exercise No. Page S26-14 1631 Net Present Value

Net Present Value Exercise S26-14: Jeffers is considering an investment opportunity with the following expected net cash flows. Year 1 - $225,000 Year 2 - $150,000 Year 3 - $100,000 The company uses a discount rate of 12% and the initial investment is $350,000. Requirements: (1) Calculate the NPV of the investment. (2) Should the company invest in the project?

Net Present Value Since the NPV is positive, the company should invest in the project.

Payback Period In-Class Exercise: Exercise No. Page E26-18 1633 Payback Period (Even)

Payback Period Exercise E26-18: Preston Co. is considering acquiring a manufacturing plant. The purchase price is $1,100,000. The owners believe the plant will generate net cash inflows of $297,000 annually. The plant will have to be replaced in six years. Requirement: Use the payback method to determine whether Preston should purchase this plant. Round answer to one decimal place.

Payback Period

Net Present Value In-Class Exercise Exercise No. Page E26-23 1634 Using NPV in Capital Investment Decisions

Net Present Value Exercise E26-23: Sprocket Industries is deciding whether to automate on phase of its production process. The manufacturing equipments has a six-year life and will cost $905,000. Projected cash flows are as follows: Year 1 ………………$260,000 Year 2 ………………$254,000 Year 3 ………………$225,000 Year 4 ……………….$215,000 Year 5 ……………….$205,000 Year 6 ……………….$173,000 Requirements: (1) Compute this project’s NPV using Sproket’s 16% hurdle rate. Should Sproket invest in the equipment? (2) Sproket could refurbish the equi9pment at the end of six years for $103,000. The refurbished equipment could be used for one more year, providing $75,000 of net cash inflows in Year7. The equipment would have a $54,000 residual value at the end of Year 7. Should Sproket invest in the equipment and refurbish it after six years?

Net Present Value Since the NPV is negative, the company should not invest in the project.

Net Present Value In-Class Exercise: Exercise No. Page E26-24 1635 Net Present Value & Probability Index

Net Present Value Exercise E26-24: Use the NPV method to determine whether Kyler Products should invest in the following projects. (1) Project A: Costs $260,000 and offers seven annual net cash inflows of $57,000. Kyler requires an annual return of 16% on investments of this nature. (2) Project B: Costs $375,000 and offers ten annual net cash inflows of $75,000. Kyler demands an annual return of 14% on investments of this nature. Requirements: (1) What is the NPV of each project? Assume neither project has a residual value. Round your answer to two decimal places. (2) What is the maximum acceptable price to pay for each project? (3) What is the profitability index of each project? Round to 2 places.

Net Present Value Present value of annuity (Table B-2) (Period 7, 16% column)

Net Present Value Present value of annuity (Table B-2) (Period 10, 14% column)

Net Present Value Maximum acceptable price

Profitability Index

Internal Rate of Return In-Class Exercise: Exercise No. Page E26-25 1635 Internal Rate of Return

Internal Rate of Return Project A Computation of the IRR using data from Exercise E26-24.

Internal Rate of Return Investment Amount Annual Cash Flow PV Factor = Calculated PV Factor: PV Factor PV Factor $260,000 $57,000 4.561 = = = PV Table B-2 - (PV of an Annuity): 7 Years (12% column) > 4.564 IRR = Approx. 12%

Internal Rate of Return Investment Amount Annual Cash Flow PV Factor = Calculated PV Factor: PV Factor PV Factor $260,000 $57,000 4.561 = = = PV Table B-2 - (PV of an Annuity): 7 Years (12% column) > 4.564 IRR = Approx. 12%

Internal Rate of Return Investment Amount Annual Cash Flow PV Factor = Calculated PV Factor: PV Factor PV Factor $260,000 $57,000 4.561 = = = PV Table B-2 - (PV of an Annuity): 7 Years (12% column) > 4.564 (Compared to) IRR = Approx. 12%+ Since Smart Touch requires a 16% return, the project would not be acceptable.

Internal Rate of Return Project B Computation of the IRR using data from Exercise E26-24.

Internal Rate of Return Investment Amount Annual Cash Flow PV Factor = Calculated PV Factor: PV Factor PV Factor $375,000 $75,000 5.000 = = = PV Table B-2 - (PV of an Annuity): 10 Years (15% column) > 5.019 IRR = Approx. 15%+

Internal Rate of Return Investment Amount Annual Cash Flow PV Factor = Calculated PV Factor: PV Factor PV Factor $375,000 $75,000 5.000 = = = PV Table B-2 - (PV of an Annuity): 10 Years (15% column) > 5.019 IRR = Approx. 15%+

Internal Rate of Return Investment Amount Annual Cash Flow PV Factor = Calculated PV Factor: PV Factor PV Factor $375,000 $75,000 5.000 = = = PV Table B-2 - (PV of an Annuity): 10 Years (15% column) > 5.019 (Compared to) IRR = Approx. 15%+ Since Smart Touch requires a minimum return of 14%, the project is considered acceptable and is the best investment.

Capital Investment Decisions In-Class Exercise Exercise No. Page E26-26 1635 Capital Investment Decisions

Capital Investment Decisions Exercise E26-26: Brighton Manufacturing is considering three capital investment proposals. At this time, Brighton only has funds available to pursue one of the three investments. Equipment A Equipment B Equipment C PV of net cash inflows…… $1,735,915 …….. $1,969,888 …… $2,207,765 Initial investment…………. (1,563,887)…….. (1,169,397) …… (1,886,979) Net Present Value………… $ 172,028 …….. $ 300,491 …… $ 320,786 Requirement: (1) Which investment should Brighton pursue at this time?

Capital Investment Decisions Best investment based on highest return. Exercise E26-26: Because each of the three alternatives requires a different initial investment, using only the net present value for comparison, is not the best approach. The profitability index of an investment provides a better measurement of the alternatives (provides the number of dollars returned for each dollar invested). Best investment based on highest return.