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Chapter 12

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Cash Payback
Period

Action Plan

Watertown Paper Corporation is considering adding another machine for the manufacture
of corrugated cardboard. The machine would cost $900,000. It would have an estimated
life of six years and no salvage value. The company estimates that annual cash inflows
would increase by $400,000 and that annual cash outflows would increase by $190,000.
Compute the cash payback period.

Solution

Annual cash inflows 2


Annual cash outflows 5
Net annual cash flow.
Cash payback
period 5 Cost of
capital investment/Net
annual cash flow.

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Estimated annual cash inflows


Estimated annual cash outflows

$400,000
190,000

Net annual cash flow

$210,000

Cash payback period 5 $900,000/$210,000 5 4.3 years.


Related exercise material: BE12-1 and

DO IT!

12-1.

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Net Present Value

Watertown Paper Corporation is considering adding another machine for the manufacture
of corrugated cardboard. The machine would cost $900,000. It would have an estimated
life of six years and no salvage value. The company estimates that annual cash inflows
would increase by $400,000 and that annual cash outflows would increase by $190,000.
Management has a required rate of return of 9%. Calculate the net present value on this
project and discuss whether it should be accepted.

Solution
Action Plan

Estimated annual cash


inflows 2 Estimated
annual cash outflows 5
Net annual cash flow.
Use the NPV technique
to calculate the difference
between net cash
flows and the initial
investment.
Accept the project if
the net present value is
positive.

Estimated annual cash inflows


Estimated annual cash outflows

$400,000
190,000

Net annual cash flow

$210,000

Present value of net annual cash flows


Capital investment

Cash Flow

9% Discount
Factor

Present
Value

$210,000

4.48592a

$942,043
900,000

Net present value

$ 42,043

Table 4, Appendix A, 9%, six years

Since the net present value is greater than zero, Watertown should accept the project.
Related exercise material: BE12-2, BE12-3, E12-1, E12-2, E12-3, and

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12-2.

D-1

D-2

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Internal Rate
of Return
Action Plan

Estimated annual cash


inflows 2 Estimated
annual cash outflows 5
Net annual cash flow.
Capital investment/Net
annual cash flows 5
Internal rate of return
factor.
Look up the factor in
the present value of an
annuity table to find
the internal rate of
return.
Accept the project if
the internal rate of
return is equal to or
greater than the
required rate of return.

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Watertown Paper Corporation is considering adding another machine for the manufacture
of corrugated cardboard. The machine would cost $900,000. It would have an estimated
life of six years and no salvage value. The company estimates that annual cash inflows
would increase by $400,000 and that annual cash outflows would increase by $190,000.
Management has a required rate of return of 9%. Calculate the internal rate of return on
this project and discuss whether it should be accepted.

Solution
Estimated annual cash inflows
Estimated annual cash outflows

$400,000
190,000

Net annual cash flow

$210,000

$900,000/210,000 5 4.285714. Using Table 4 of Appendix A and the factors that correspond with the six-payment row, 4.285714 is between the factors for 10% and 11%.
Since the project has an internal rate that is greater than 10% and the required rate of
return is only 9%, the project should be accepted.
Related exercise material: BE12-7, BE12-8, E12-5, E12-6, E12-7, and

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12-3.

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Annual Rate of
Return

Watertown Paper Corporation is considering adding another machine for the manufacture
of corrugated cardboard. The machine would cost $900,000. It would have an estimated
life of six years and no salvage value. The company estimates that annual revenues would
increase by $400,000 and that annual expenses excluding depreciation would increase by
$190,000. It uses the straight-line method to compute depreciation expense. Management
has a required rate of return of 9%. Compute the annual rate of return.

Solution
Action Plan

Expected annual net


income 5 Annual
revenues 2 Annual
expenses (including
depreciation expense).
Annual rate of
return 5 Expected
annual net income/
Average investment.
Average investment 5
(Original investment 1
Value at end of useful
life)/2.

Revenues
Less:
Expenses (excluding depreciation)
Depreciation ($900,000/6 years)

$400,000
$190,000
150,000

Annual net income

340,000
$ 60,000

Average investment 5 ($900,000 1 0)/2 5 $450,000.


Annual rate of return 5 $60,000/$450,000 5 13.3%.
Since the annual rate of return (13.33%) is greater than Watertowns required rate of
return (9%), the proposed project is acceptable.
Related exercise material: BE12-9, E12-8, E12-9, E12-10, E12-11, and

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12-4.

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Comprehensive

DO IT!

Cornfield Company is considering a long-term capital investment project in laser equipment.


This will require an investment of $280,000, and it will have a useful life of five years. Annual
net income is expected to be $16,000 a year. Depreciation is computed by the straight-line
method with no salvage value. The companys cost of capital is 10%. (Hint: Assume cash
flows can be computed by adding back depreciation expense.)

Instructions
(Round all computations to two decimal places.)
(a) Compute the cash payback period for the project. (Round to two decimals.)
(b) Compute the net present value for the project. (Round to nearest dollar.)
(c) Compute the annual rate of return for the project.

Action Plan

(d) Should the project be accepted? Why?

Calculate the time it

Solution to Comprehensive DO IT!

will take to pay back the


investment: cost of the
investment divided by
net annual cash flows.
When calculating NPV,
remember that net
annual cash flow equals
annual net income plus
annual depreciation
expense.
Be careful to use the
correct discount factor
in using the net present
value method.
Calculate the annual
rate of return: expected
annual net income
divided by average
investment.

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(a) $280,000 4 $72,000 ($16,000 1 $56,000) 5 3.89 years


(b)
Present Value
at 10%
Discount factor for five payments
Present value of net cash flows:
$72,000 3 3.79079
Capital investment
Negative net present value

3.79079
$272,937
280,000
$ (7,063)

(c) $16,000 4 $140,000 ($280,000 4 2) 5 11.4%


(d) The annual rate of return of 11.4% is good. However, the cash payback period is
78% of the projects useful life, and net present value is negative. The recommendation is to reject the project.

REVIEW

DO IT! 12-1 Wallowa Company is considering a long-term investment project called ZIP. Compute the cash payback
ZIP will require an investment of $120,000. It will have a useful life of four years and no period for an investment.
salvage value. Annual cash inflows would increase by $80,000, and annual cash outflows (LO 2), AP
would increase by $40,000. Compute the cash payback period.
DO IT! 12-2 Wallowa Company is considering a long-term investment project called ZIP. Calculate net present value
ZIP will require an investment of $120,000. It will have a useful life of four years and no of an investment.
salvage value. Annual cash inflows would increase by $80,000, and annual cash outflows (LO 3), AN
would increase by $40,000. The companys required rate of return is 12%. Calculate the net
present value on this project and discuss whether it should be accepted.
DO IT! 12-3 Wallowa Company is considering a long-term investment project called ZIP.

Calculate internal rate of

ZIP will require an investment of $120,000. It will have a useful life of four years and no return.
salvage value. Annual cash inflows would increase by $80,000, and annual cash outflows (LO 7), AN
would increase by $40,000. The companys required rate of return is 12%. Calculate the
internal rate of return on this project and discuss whether it should be accepted.
DO IT! 12-4 Wallowa Company is considering a long-term investment project called ZIP. Calculate annual rate of
ZIP will require an investment of $120,000. It will have a useful life of four years and no return.
salvage value. Annual revenues would increase by $80,000, and annual expenses (exclud- (LO 8), AP
ing depreciation) would increase by $40,000. Wallowa uses the straight-line method to
compute depreciation expense. The companys required rate of return is 12%. Compute
the annual rate of return.

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