Mini Case 9-4 Essay
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Chapter 9: Exercises 9-4, 9-7, 9-8, 9-9, 9-11, 9-12, 9-14, 9-16 (pages 347-348) • Problems 9-7, 9-12, 9-17 (pages 351-355)
EXERCISE 9-4. Using Present Value Tables [LO 1] What is the present value of $600 per year for five years if the required return is 10 percent (answer using Table 2 in Appendix B).
Cash Present Value Flow Factor Total $600 3.7908 $2,274.48
EXERCISE 9-7. Calculate Present Value [LO 2] Juanita Martinez is ready to retire and has a choice of three pension plans. Plan A provides for an immediate cash payment of $200,000. Plan B provides for the payment of $20,000 per year for 10 years and the payment of $200,000 at the end of year 10. …show more content…
Plan C will pay $35,000 per year for 10 years. Juanita Martinez desires a return of 8 percent.Determine the present value of each plan and select the best one.
Plan A Total $200,000
Plan B Cash Present Value Flow Factor Total $ 20,000 6.7101 $134,202 200,000 .4632 92,640 $226,842
Plan C Cash Present Value Flow Factor Total $35,000 6.7101 $234,853.50
Plan C should be selected as it has the highest present value.
EXERCISE 9-8. Calculate Net Present Value [LO 2] An investment that costs $60,000 will return $25,000 per year for five years.Determine the net present value of the investment if the required rate of return is 14 percent. (Ignore taxes.) Should the investment be undertaken? Cash Present Value Flow Factor Total ($60,000) 1.0000 ($60,000.00) 25,000 3.4331 85,827.50 $ 25,827.50
EXERCISE 9-9.
Calculate the Internal Rate of Return [LO 3] An investment that costs $100,000 will reduce operating costs by $20,000 per year for 10 years.Determine the internal rate of return of the investment (ignore taxes).Should the investment be undertaken if the required rate of return is 18 percent?
The investment should not be undertaken because the internal rate of return of 15% is less than the required rate of 18%.
Initial outlay $100,000 Annuity amount 20,000
Outlay ÷ annuity amount = PV of annuity factor 5.00
Internal rate of return 15%
EXERCISE 9-11. Depreciation Tax Shield [LO 4] Strauss Corporation is making a $60,000 investment in equipment with a five-year life.The company uses the straight-line method of depreciation and has a tax rate of 40 percent.The company’s required rate of return is 12 percent. Required What is the present value of the tax savings related to depreciation of the equipment?
Annual depreciation $60,000 ÷ 5 years $12,000.00 Annual tax savings $12,000 .40 $4,800.00
Present value of $4,800 per year for 5 years at 12% $4,800 3.6048
$17,303.04
EXERCISE 9-12. Cash Flow Implications of Tax Losses [LO 4] WesternGear.com is expected to have operating losses of $250,000 in its first year of business and $150,000 in its second year. However, the company expects to have income before taxes of $300,000 in its third year and $450,000 in its fourth year.The company’s required rate of return is 12 percent. Required Assume a tax rate of 40 percent and that current losses can be used to offset taxable income in future years.What is the present value of tax savings related to the operating losses in years 1 and 2?
Year Income (Loss) 1 ($250,000) 2 (150,000) 3 300,000 4 450,000
The $250,000 loss in year 1 will offset income in year 3 resulting in a tax savings of $100,000 (i.e., $250,000 40% tax rate) in year 3.
With respect to the $150,000 loss in year 2, $50,000 of it can be used to offset income in year 3 (resulting in a tax savings of $20,000 in year 3) and $100,000 of it can be used to offset income in year 4 (resulting in a tax savings of $40,000 in year 4).
Cash Present Value Flow Factor Total $100,000 .7118 $71,180 20,000 .7118 14,236 40,000 .6355 25,420 $110,836
EXERCISE 9-14. Calculate the Payback Period [LO 6] The Sunny Valley Wheat Cooperative is considering the construction of a new silo. It will cost $75,000 to construct the silo. Determine the payback period if the expected cash inflows are $15,000 per year.
The payback period is 5 years as follows:
Cost $75,000 Cash inflows 15,000
Cost ÷ Cash inflows = Payback period 5 years
EXERCISE 9-16. IRR and Unequal Cash Flows [LO 3] Newport Department Store is considering development of an e-commerce business. The company estimates that development will require an initial outlay of $1,470,000.Other cash flows will be as follows: Year 1 ($700,000) Year 2 $221,000 Year 3 $750,000 Year 4 $850,000 Year 5 $940,000 Required Assuming the company limits its analysis to five years, estimate the internal rate of return of the e-commerce business. Should the company develop the e-commerce business if the required rate of return is 12 percent?
As indicated, the NPV is close to zero ($289) at a rate of 7%. Thus, the IRR is approximately 7%. Given that the required rate of return is 12%, the e-commerce business should not be developed.
PV at Cash PV 6% Flow Factor Total $(1,470,000) 1.0000 $(1,470,000) (700,000) 0.9434 (660,380) 221,000 0.8900 196,690 750,000 0.8396 629,700 850,000 0.7921 673,285 940,000 0.7473 702,462 $ 71,757
PV at Cash PV 7% Flow Factor Total $(1,470,000) 1.0000 $(1,470,000) (700,000) 0.9346 (654,220) 221,000 0.8734 193,021 750,000 0.8163 612,225 850,000 0.7629 648,465 940,000 0.7130 670,220 $ (289)
PROBLEM 9-7. Net Present Value, Internal Rate of Return, Payback, Accounting Rate of Return, and Taxes [LO 2, 3, 4, 6] Adrian Sonnetson, the owner of Adrian Motors, is considering the addition of a paint and body shop to his automobile dealership.Construction of a building and the purchase of necessary equipment is estimated to cost $800,000, and both the building and equipment will be depreciated over 10 years using the straight-line method.The building and equipment have zero estimated residual value at the end of 10 years.Sonnetson’s required rate of return for this project is 12 percent.Net income related to each year of the investment is as follows: Revenue $500,000 Less: Material cost 70,000 Labor 150,000 Depreciation 80,000 Other 10,000 Income before taxes 190,000 Taxes at 40% 76,000 Net income $114,000 Required a. Determine the net present value of the investment in the paint and body shop. Should Sonnetson invest in the paint and body shop? b. Calculate the internal rate of return of the investment (approximate). c. Calculate the payback period of the investment. d. Calculate the accounting rate of return.
a. The net present value is positive $296,138.80. Thus the company should invest in the paint and body shop.
Net income $ 114,000 Add depreciation 80,000 Annual cash flow $194,000 Cash Present Value Flow Factor Total $194,000 5.6502 $1,096,138.80 (800,000) 1.0000 (800,000.00) $ 296,138.80
b. A present value of an annuity factor of 4.1237 implies an IRR of approximately 20 percent.
Initial outlay $800,000 Annuity amount 194,000
Cost ÷ annuity = PV of annuity factor 4.1237 Note—the annuity factor for 20% is 4.1925.
c. The payback period is approximately 4.1 years:
Initial outlay $800,000 Annual cash flow 194,000
Cost ÷ annuity = number of years to recover initial investment 4.1237
d. The accounting rate of return is approximately 29%:
Average income $114,000
Average investment ($800,000 ÷ 2) 400,000
Average income ÷ average investment = accounting rate of return 28.5%
PROBLEM 9-12. Comprehensive Capital Budgeting Problem [LO 2,6] Van Doren Corporation is considering producing a new product,Autodial.Marketing data indicate that the company will be able to sell 45,000 units per year at $30.The product will be produced in a section of an existing factory that is currently not in use. To produce Autodial,Van Doren must buy a machine that costs $500,000.The machine has an expected life of five years and will have an ending residual value of $15,000. Van Doren will depreciate the machine over five years using the straight-line method for both tax and financial reporting purposes. In addition to the cost of the machine, the company will incur incremental manufacturing costs of $370,000 for component parts, $425,000 for direct labor, and $200,000 of miscellaneous costs. Also, the company plans to spend $150,000 annually to advertise Autodial. Van Doren has a tax rate of 40 percent, and the company’s required rate of return is 12 percent. Required a. Compute the net present value. b. Compute the payback period. c. Compute the accounting rate of return. d. Should Van Doren make the investment required to produce Autodial? PROBLEM 9-17. Conflict between Performance Evaluation and Use of NPV [LO 7] Division managers at Creighton Aerospace are evaluated and rewarded based on ROI (return on investment) targets. In the current year, Delmar Richards, the president of the commercial products division, has an ROI target of 12 percent. If the division has an ROI of 12 percent or greater, Delmar will receive 250,000 options on Creighton stock in addition to a base salary of $400,000. The commercial products division is considering a major investment in product development, which has a net present value of $25,000,000.However, the investment will have a negative effect on reported profit over the next two years, after which the investment will begin to have a significant positive effect on firm profitability for the next eight years. Required a. Discuss the potential conflict between the company’s evaluation/compensation system and Delmar’s focus on the NPV of the investment in product development. b. Suppose Delmar currently holds stock in Creighton Aerospace with a market value of $1,250,000 and has options on 500,000 shares (awarded in previous years). Is this likely to acerbate or mitigate the conflict you discussed in part a?
a. Revenue (45,000 $30) $1,350,000 Less: Component cost 370,000 Direct labor 425,000 Depreciation 97,000 Miscellaneous 200,000 Advertising 150,000 Income before taxes 108,000 Taxes 43,200 Net income 64,800 Depreciation 97,000 Annual cash flow $ 161,800
Cash Present Value Flow Factor Total $161,800 3.6048 $583,256.64 15,000 .5674 8,511.00 (500,000) 1.0000 (500,000.00) $ 91,767.64
b. The payback period is approximately 3.09 years:
Initial outlay $500,000 Annual cash flow ÷ 161,800
Number of years to recover initial investment 3.09 years
c. The accounting rate of return is 26%:
Average income $64,800 Average investment ($500,000 ÷ 2) ÷ $250,000
Accounting rate of return 26%
d. Given the positive NPV, the company should invest in Autodial.
Chapter 9: Exercises 9-4, 9-7, 9-8, 9-9, 9-11, 9-12, 9-14, 9-16 (pages 347-348) • Problems 9-7, 9-12, 9-17 (pages 351-355)
EXERCISE 9-4. Using Present Value Tables [LO 1] What is the present value of $600 per year for five years if the required return is 10 percent (answer using Table 2 in Appendix B).
Cash Present Value Flow Factor Total $600 3.7908 $2,274.48
EXERCISE 9-7. Calculate Present Value [LO 2] Juanita Martinez is ready to retire and has a choice of three pension plans. Plan A provides for an immediate cash payment of $200,000. Plan B provides for the payment of $20,000 per year for 10 years and the payment of $200,000 at the end of year 10. …show more content…
Plan C will pay $35,000 per year for 10 years. Juanita Martinez desires a return of 8 percent.Determine the present value of each plan and select the best one.
Plan A Total $200,000
Plan B Cash Present Value Flow Factor Total $ 20,000 6.7101 $134,202 200,000 .4632 92,640 $226,842
Plan C Cash Present Value Flow Factor Total $35,000 6.7101 $234,853.50
Plan C should be selected as it has the highest present value.
EXERCISE 9-8. Calculate Net Present Value [LO 2] An investment that costs $60,000 will return $25,000 per year for five years.Determine the net present value of the investment if the required rate of return is 14 percent. (Ignore taxes.) Should the investment be undertaken? Cash Present Value Flow Factor Total ($60,000) 1.0000 ($60,000.00) 25,000 3.4331 85,827.50 $ 25,827.50
EXERCISE 9-9.
Calculate the Internal Rate of Return [LO 3] An investment that costs $100,000 will reduce operating costs by $20,000 per year for 10 years.Determine the internal rate of return of the investment (ignore taxes).Should the investment be undertaken if the required rate of return is 18 percent?
The investment should not be undertaken because the internal rate of return of 15% is less than the required rate of 18%.
Initial outlay $100,000 Annuity amount 20,000
Outlay ÷ annuity amount = PV of annuity factor 5.00
Internal rate of return 15%
EXERCISE 9-11. Depreciation Tax Shield [LO 4] Strauss Corporation is making a $60,000 investment in equipment with a five-year life.The company uses the straight-line method of depreciation and has a tax rate of 40 percent.The company’s required rate of return is 12 percent. Required What is the present value of the tax savings related to depreciation of the equipment?
Annual depreciation $60,000 ÷ 5 years $12,000.00 Annual tax savings $12,000 .40 $4,800.00
Present value of $4,800 per year for 5 years at 12% $4,800 3.6048
$17,303.04
EXERCISE 9-12. Cash Flow Implications of Tax Losses [LO 4] WesternGear.com is expected to have operating losses of $250,000 in its first year of business and $150,000 in its second year. However, the company expects to have income before taxes of $300,000 in its third year and $450,000 in its fourth year.The company’s required rate of return is 12 percent. Required Assume a tax rate of 40 percent and that current losses can be used to offset taxable income in future years.What is the present value of tax savings related to the operating losses in years 1 and 2?
Year Income (Loss) 1 ($250,000) 2 (150,000) 3 300,000 4 450,000
The $250,000 loss in year 1 will offset income in year 3 resulting in a tax savings of $100,000 (i.e., $250,000 40% tax rate) in year 3.
With respect to the $150,000 loss in year 2, $50,000 of it can be used to offset income in year 3 (resulting in a tax savings of $20,000 in year 3) and $100,000 of it can be used to offset income in year 4 (resulting in a tax savings of $40,000 in year 4).
Cash Present Value Flow Factor Total $100,000 .7118 $71,180 20,000 .7118 14,236 40,000 .6355 25,420 $110,836
EXERCISE 9-14. Calculate the Payback Period [LO 6] The Sunny Valley Wheat Cooperative is considering the construction of a new silo. It will cost $75,000 to construct the silo. Determine the payback period if the expected cash inflows are $15,000 per year.
The payback period is 5 years as follows:
Cost $75,000 Cash inflows 15,000
Cost ÷ Cash inflows = Payback period 5 years
EXERCISE 9-16. IRR and Unequal Cash Flows [LO 3] Newport Department Store is considering development of an e-commerce business. The company estimates that development will require an initial outlay of $1,470,000.Other cash flows will be as follows: Year 1 ($700,000) Year 2 $221,000 Year 3 $750,000 Year 4 $850,000 Year 5 $940,000 Required Assuming the company limits its analysis to five years, estimate the internal rate of return of the e-commerce business. Should the company develop the e-commerce business if the required rate of return is 12 percent?
As indicated, the NPV is close to zero ($289) at a rate of 7%. Thus, the IRR is approximately 7%. Given that the required rate of return is 12%, the e-commerce business should not be developed.
PV at Cash PV 6% Flow Factor Total $(1,470,000) 1.0000 $(1,470,000) (700,000) 0.9434 (660,380) 221,000 0.8900 196,690 750,000 0.8396 629,700 850,000 0.7921 673,285 940,000 0.7473 702,462 $ 71,757
PV at Cash PV 7% Flow Factor Total $(1,470,000) 1.0000 $(1,470,000) (700,000) 0.9346 (654,220) 221,000 0.8734 193,021 750,000 0.8163 612,225 850,000 0.7629 648,465 940,000 0.7130 670,220 $ (289)
PROBLEM 9-7. Net Present Value, Internal Rate of Return, Payback, Accounting Rate of Return, and Taxes [LO 2, 3, 4, 6] Adrian Sonnetson, the owner of Adrian Motors, is considering the addition of a paint and body shop to his automobile dealership.Construction of a building and the purchase of necessary equipment is estimated to cost $800,000, and both the building and equipment will be depreciated over 10 years using the straight-line method.The building and equipment have zero estimated residual value at the end of 10 years.Sonnetson’s required rate of return for this project is 12 percent.Net income related to each year of the investment is as follows: Revenue $500,000 Less: Material cost 70,000 Labor 150,000 Depreciation 80,000 Other 10,000 Income before taxes 190,000 Taxes at 40% 76,000 Net income $114,000 Required a. Determine the net present value of the investment in the paint and body shop. Should Sonnetson invest in the paint and body shop? b. Calculate the internal rate of return of the investment (approximate). c. Calculate the payback period of the investment. d. Calculate the accounting rate of return.
a. The net present value is positive $296,138.80. Thus the company should invest in the paint and body shop.
Net income $ 114,000 Add depreciation 80,000 Annual cash flow $194,000 Cash Present Value Flow Factor Total $194,000 5.6502 $1,096,138.80 (800,000) 1.0000 (800,000.00) $ 296,138.80
b. A present value of an annuity factor of 4.1237 implies an IRR of approximately 20 percent.
Initial outlay $800,000 Annuity amount 194,000
Cost ÷ annuity = PV of annuity factor 4.1237 Note—the annuity factor for 20% is 4.1925.
c. The payback period is approximately 4.1 years:
Initial outlay $800,000 Annual cash flow 194,000
Cost ÷ annuity = number of years to recover initial investment 4.1237
d. The accounting rate of return is approximately 29%:
Average income $114,000
Average investment ($800,000 ÷ 2) 400,000
Average income ÷ average investment = accounting rate of return 28.5%
PROBLEM 9-12. Comprehensive Capital Budgeting Problem [LO 2,6] Van Doren Corporation is considering producing a new product,Autodial.Marketing data indicate that the company will be able to sell 45,000 units per year at $30.The product will be produced in a section of an existing factory that is currently not in use. To produce Autodial,Van Doren must buy a machine that costs $500,000.The machine has an expected life of five years and will have an ending residual value of $15,000. Van Doren will depreciate the machine over five years using the straight-line method for both tax and financial reporting purposes. In addition to the cost of the machine, the company will incur incremental manufacturing costs of $370,000 for component parts, $425,000 for direct labor, and $200,000 of miscellaneous costs. Also, the company plans to spend $150,000 annually to advertise Autodial. Van Doren has a tax rate of 40 percent, and the company’s required rate of return is 12 percent. Required a. Compute the net present value. b. Compute the payback period. c. Compute the accounting rate of return. d. Should Van Doren make the investment required to produce Autodial? PROBLEM 9-17. Conflict between Performance Evaluation and Use of NPV [LO 7] Division managers at Creighton Aerospace are evaluated and rewarded based on ROI (return on investment) targets. In the current year, Delmar Richards, the president of the commercial products division, has an ROI target of 12 percent. If the division has an ROI of 12 percent or greater, Delmar will receive 250,000 options on Creighton stock in addition to a base salary of $400,000. The commercial products division is considering a major investment in product development, which has a net present value of $25,000,000.However, the investment will have a negative effect on reported profit over the next two years, after which the investment will begin to have a significant positive effect on firm profitability for the next eight years. Required a. Discuss the potential conflict between the company’s evaluation/compensation system and Delmar’s focus on the NPV of the investment in product development. b. Suppose Delmar currently holds stock in Creighton Aerospace with a market value of $1,250,000 and has options on 500,000 shares (awarded in previous years). Is this likely to acerbate or mitigate the conflict you discussed in part a?
a. Revenue (45,000 $30) $1,350,000 Less: Component cost 370,000 Direct labor 425,000 Depreciation 97,000 Miscellaneous 200,000 Advertising 150,000 Income before taxes 108,000 Taxes 43,200 Net income 64,800 Depreciation 97,000 Annual cash flow $ 161,800
Cash Present Value Flow Factor Total $161,800 3.6048 $583,256.64 15,000 .5674 8,511.00 (500,000) 1.0000 (500,000.00) $ 91,767.64
b. The payback period is approximately 3.09 years:
Initial outlay $500,000 Annual cash flow ÷ 161,800
Number of years to recover initial investment 3.09 years
c. The accounting rate of return is 26%:
Average income $64,800 Average investment ($500,000 ÷ 2) ÷ $250,000
Accounting rate of return 26%
d. Given the positive NPV, the company should invest in Autodial.