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- Net Present Value
- ch12
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>

DO IT!

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 outflows 5

Net annual cash flow.

Cash payback

period 5 Cost of

capital investment/Net

annual cash flow.

>

Estimated annual cash outflows

$400,000

190,000

$210,000

Related exercise material: BE12-1 and

DO IT!

12-1.

DO IT!

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

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 outflows

$400,000

190,000

$210,000

Capital investment

Cash Flow

9% Discount

Factor

Present

Value

$210,000

4.48592a

$942,043

900,000

$ 42,043

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

DO IT!

12-2.

D-1

D-2

>

DO IT!

DO IT!

Internal Rate

of Return

Action Plan

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.

>

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

$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

DO IT!

12-3.

DO IT!

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

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

340,000

$ 60,000

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

DO IT!

12-4.

>

Comprehensive

DO IT!

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

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.

>

DO IT!

(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)

(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.

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.

D-3

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