Horngren'S Financial And Managerial Accounting

Refer to Short Exercise S26-4. Continue to assume that the expansion has no residual value. What is the project’s IRR? Is the investment attractive? Why or why not?

Hicks Company is considering an investment opportunity with the following expected net cash inflows: Year 1, \(235,000; Year 2, \)195,000; Year 3, \(125,000. The company uses a discount rate of 6%, and the initial investment is \)365,000. Calculate the NPV of the investment. Should the company invest in the project? Why or why not?

Question: Defining capital investments and the capital budgeting process

Match each capital budgeting method with its definition. 

Methods 

1. Accounting rate of return 

2. Internal rate of return 

3. Net present value 

4. Payback 

Definitions 

1. Is only concerned with the time it takes to get cash outflows returned. 
2. Considers operating income but not the time value of money in its analyses. 
3. Compares the present value of cash outflows to the present value of cash inflows to determine investment worthiness. 
4. The true rate of return an investment earns.

Question: Defining capital investment terms 

Fill in each statement with the appropriate capital investment analysis method: 

Payback, ARR, NPV, or IRR. Some statements may have more than one answer. 

1. _____ is (are) more appropriate for long-term investments. 
2. _____ highlights risky investments. 
3. _____ shows the effect of the investment on the company’s accrual-based income. 
4. _____ is the interest rate that makes the NPV of an investment equal to zero. 
5. _____ requires management to identify the discount rate when used. 
6. _____ provides management with information on how fast the cash invested will be recouped. 
7. _____ is the rate of return, using discounted cash flows, a company can expect to earn by investing in the asset. 
8. _____ does not consider the asset’s profitability. 
9. _____ uses accrual accounting rather than net cash inflows in its computation.

Question: Using payback to make capital investment decisions Consider the following three projects. All three have an initial investment of \(800,000.

Requirements 

1. Determine the payback period of each project. Rank the projects from most desirable to least desirable based on payback. 
2. Are there other factors that should be considered in addition to the payback period?

Henry Co. is considering acquiring a manufacturing plant. The purchase price is \(1,200,000. The owners believe the plant will generate net cash inflows of \)325,000 annually. It will have to be replaced in six years. Use the payback method to determine whether Henry should purchase this plant. Round to one decimal place.

Henry Hardware is adding a new product line that will require an investment of \(1,512,000. Managers estimate that this investment will have a 10-year life and generate net cash inflows of \)310,000 the first year, \(270,000 the second year, and \)240,000 each year thereafter for eight years. Compute the payback period. Round to one decimal place.

Using ARR to make capital investment decisions Refer to the Henry Hardware information in Exercise E26-20. Assume the project has no residual value. Compute the ARR for the investment. Round to two places.

Henry Hardware is adding a new product line that will require an investment of \(1,512,000. Managers estimate that this investment will have a 10-year life and generate net cash inflows of \)310,000 the first year, \(270,000 the second year, and \)240,000 each year thereafter for eight years.

Using the time value of money Helen wants to take the next four years off work to travel around the world. She estimates her annual cash needs at $31,000 (if she needs more, she will work odd jobs). Helen believes she can invest her savings at 10% until she depletes her funds. Requirements 

1. How much money does Helen need now to fund her travels? 
2. After speaking with a number of banks, Helen learns she will only be able to invest her funds at 6%. How much does she need now to fund her travels?

Congratulations! You have won a state lottery. The state lottery offers you the following (after-tax) payout options:

Assuming you can earn 6% on your funds, which option would you prefer?

Using NPV to make capital investment decisions Holmes Industries is deciding whether to automate one phase of its production process. The manufacturing equipment has a six-year life and will cost \(910,000. 

Requirements 

Holmes could refurbish the equipment at the end of six years for \(104,000. The refurbished equipment could be used one more year, providing \)77,000 of net cash inflows in year 7. Additionally, the refurbished equipment would have a $55,000 residual value at the end of year 7. Should Holmes invest in the equipment and refurbish it after six years? (Hint: In addition to your answer to Requirement 1, discount the additional cash outflow and inflows back to the present value.)

Use the NPV method to determine whether Hawkins Products should invest in the

following projects:

• Project A: Costs \(285,000 and offers seven annual net cash inflows of \)55,000. Hawkins Products requires an annual return of 14% on investments of this nature.

• Project B: Costs \(395,000 and offers 10 annual net cash inflows of \)77,000. Hawkins Products demands an annual return of 12% on investments of this nature.

Requirements

1. What is the NPV of each project? Assume neither project has a residual value. Round 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 two decimal places.

Using IRR to make capital investment decisions 

Refer to the data regarding Hawkins Products in Exercise E26-25. Compute the IRR of each project, and use this information to identify the better investment.

Hudson Manufacturing is considering three capital investment proposals. At this time, Hudson only has funds available to pursue one of the three investments.

Which investment should Hudson pursue at this time? Why?

Mountain Manufacturing is considering the following capital investment proposals. Mountain’s requirement criteria include a maximum payback period of five years and a required rate of return of 12.5%. Determine if each investment is acceptable or should be rejected (ignore qualitative factors). Rank the acceptable investments in order from most desirable to least desirable

You are planning for a very early retirement. You would like to retire at age 40 and have enough money saved to be able to withdraw \(215,000 per year for the next 40 years (based on family history, you think you will live to age 80). You plan to save by making 10 equal annual installments (from age 30 to age 40) into a fairly risky investment fund that you expect will earn 10% per year. You will leave the money in this fund until it is completely depleted when you are 80 years old.

Requirements

1. How much money must you accumulate by retirement to make your plan work? (Hint: Find the present value of the \)215,000 withdrawals.)

2. How does this amount compare to the total amount you will withdraw from the investment during retirement? How can these numbers be so different?

Splash Nation is considering purchasing a water park in Atlanta, Georgia, for \(1,910,000. The new facility will generate annual net cash inflows of \)483,000 foreight years. Engineers estimate that the facility will remain useful for eight years andhave no residual value. The company uses straight-line depreciation, and its stockholdersdemand an annual return of 10% on investments of this nature.

Requirements

1. Compute the payback, the ARR, the NPV, the IRR, and the profitability index ofthis investment.

2. Recommend whether the company should invest in this project.

Hill Company operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of\(8,700,000. Expected annual net cash inflows are \)1,550,000 for 10 years, with zeroresidual value at the end of 10 years. Under Plan B, Hill Company would open threelarger shops at a cost of \(8,340,000. This plan is expected to generate net cash inflowsof \)990,000 per year for 10 years, the estimated useful life of the properties. Estimatedresidual value for Plan B is $1,200,000. Hill Company uses straight-line depreciationand requires an annual return of 10%.

Requirements

1. Compute the payback, the ARR, the NPV, and the profitability index of thesetwo plans.

2. What are the strengths and weaknesses of these capital budgeting methods?

3. Which expansion plan should Hill Company choose? Why?

4. Estimate Plan A’s IRR. How does the IRR compare with the company’s requiredrate of return?

Henderson Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machineat a cost of \(1,200,000. If refurbished, Henderson expects the machine to last anothereight years and then have no residual value. Option 2 is to replace the machine at acost of \)4,600,000. A new machine would last 10 years and have no residual value.Henderson expects the following net cash inflows from the two options:

YearRefurbish CurrentPurchase New

MachineMachine

1 \( 350,000 \) 3,780,000

2 340,000 510,000

3 270,000 440,000

4 200,000 370,000

5 130,000 300,000

6 130,000 300,000

7 130,000 300,000

8 130,000 300,000

9 300,000

10 300,000

Total \( 1,680,000 \) 6,900,000

Henderson uses straight-line depreciation and requires an annual return of 10%.

Requirements

1. Compute the payback, the ARR, the NPV, and the profitability index of these twooptions.

2. Which option should Henderson choose? Why?

You are planning for early retirement. You would like to retire at age 40 and have enough money saved to be able to withdraw \(220,000 per year for the next 30 years (based on family history, you think you will live to age 70). You plan to save by making 20 equal annual instalments (from age 20 to age 40) into a fairly risky investment fund that you expect will earn 8% per year. You will leave the money in this fund until it is completely depleted when you are 70 years old. 

Requirements 

1. How much money must you accumulate by retirement to make your plan work? (Hint: Find the present value of the \)220,000 withdrawals.) 

2. How does this amount compare to the total amount you will withdraw from the investment during retirement? How can these numbers be so different?

Water City is considering purchasing a water park in Omaha, Nebraska, for \(1,920,000. The new facility will generate annual net cash inflows of \)472,000 for eight years. Engineers estimate that the facility will remain useful for eight years and have no residual value. The company uses straight-line depreciation, and its stockholders demand an annual return of 12% on investments of this nature. 

Requirements 

1. Compute the payback, the ARR, the NPV, the IRR, and the profitability index of this investment. 

2. Recommend whether the company should invest in this project.

Howard Company operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of \(8,500,000. Expected annual net cash inflows are \)1,600,000 for 10 years, with zero residual value at the end of 10 years. Under Plan B, Howard Company would open three larger shops at a cost of \(8,100,000. This plan is expected to generate net cash inflows of \)1,000,000 per year for 10 years, which is the estimated useful life of the properties. Estimated residual value for Plan B is $990,000. Howard Company uses straight-line depreciation and requires an annual return of 6%.

Requirements 

1. Compute the payback, the ARR, the NPV, and the profitability index of these two plans. 

2. What are the strengths and weaknesses of these capital budgeting methods? 

3. Which expansion plan should Howard Company choose? Why? 

4. Estimate Plan A’s IRR. How does the IRR compare with the company’s required rate of return?

Hayes Company is considering two capital investments. Both investments have an initial cost of \(10,000,000 and total net cash inflows of \)17,000,000 over 10 years. Hayes requires a 12% rate of return on this type of investment. Expected net cash inflows are as follows:  

Requirements 

1. Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue? 

2. Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not? 

3. After further negotiating, the company can now invest with an initial cost of $9,500,000 for both plans. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?

Using payback, ARR, and NPV with unequal cash flows

Hughes Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machine at a cost of \(2,600,000. If refurbished, Hughes expects the machine to last another eight years and then have no residual value. Option 2 is to replace the machine at a cost of \)3,800,000. A new machine would last 10 years and have no residual value. Hughes expects the following net cash inflows from the two options:

Hughes uses straight-line depreciation and requires an annual return of 10%. 

Requirements 

1. Compute the payback, the ARR, the NPV, and the profitability index of these two options.

2. Which option should Hughes choose? Why?

Hamilton Company is considering two capital investments. Both investments have an initial cost of \(7,000,000 and total net cash inflows of \)16,000,000 over 10 years. Hamilton requires a 20% rate of return on this type of investment. Expected net cash inflows are as follows:

Requirements 

1. Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue? 

2. Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not? 

3. After further negotiating, the company can now invest with an initial cost of \)6,500,000. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?

P26-40 Using payback, ARR, NPV, and IRR to make capital investment decisions

This problem continues the Piedmont Computer Company situation from Chapter 25. Piedmont Computer Company is considering purchasing two different types of servers. Server A will generate net cash inflows of \(25,000 per year and have a zero residual value. Server A’s estimated useful life is three years, and it costs \)45,000. Server B will generate net cash inflows of \(25,000 in year 1, \)15,000 in year 2, and \(5,000 in year 3. Server B has a \)5,000 residual value and an estimated useful life of three years. Server B also costs $45,000. Piedmont Computer Company’s required rate of return is 14%. 

Requirements 

1. Calculate payback, accounting rate of return, net present value, and internal rate of return for both server investments. Use Microsoft Excel to calculate NPV and IRR. 

2. Assuming capital rationing applies, which server should Piedmont Computer Company invest in?

Spencer Wilkes is the marketing manager at Darby Company. Last year, Spencer recommended the company approve a capital investment project for the addition of a new product line. Spencer’s recommendation included predicted cash inflows for five years from the sales of the new product line. Darby Company has been selling the new products for almost one year. The company has a policy of conducting annual post audits on capital investments, and Spencer is concerned about the one-year post-audit because sales in the first year have been lower than he estimated. However, sales have been increasing for the last couple of months, and Spencer expects that by the end of the second year, actual sales will exceed his estimates for the first two years combined.

Spencer wants to shift some sales from the second year of the project into the first year. Doing so will make it appear that his cash flow predictions were accurate. With accurate estimates, he will be able to avoid a poor performance evaluation. Spencer has discussed his plan with a couple of key sales representatives, urging them to report sales in the current month that will not be shipped until a later month. Spencer has justified this course of action by explaining that there will be no effect on the annual financial statements because the project year does not coincide with the fiscal year––by the time the accounting year ends, the sales will have actually occurred. 

Requirements 

1. What is the fundamental ethical issue? Who are the affected parties? 

2. If you were a sales representative at Darby Company, how would you respond to Spencer’s request? Why? 

3. If you were Spencer’s manager and you discovered his plan, how would you respond? 

4. Are there other courses of action Spencer could take?

John Johnson is the majority stockholder in Johnson’s Landscape Company, owning 52% of the company’s stock. John asked his accountant to prepare a capital investment analysis to purchase new mowers. John used the analysis to persuade a loan officer at the local bank to loan the company $100,000. Once the loan was secured, John used the cash to remodel his home, updating the kitchen and bathrooms, installing new flooring, and adding a pool. 

Requirements 

1. Are John’s actions fraudulent? Why or why not? Does John’s percentage of ownership affect your answer? 

2. What steps could the bank take to prevent this type of activity?