Chapter 24: Q4DQ (page 1083)
Identify two disadvantages of using the payback period for comparing investments.
The disadvantages are it does not reflect the difference in the net cash flow, it ignores all cash flows after the point, and it ignores the time value of money.
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Grossman Corporation is considering a new project requiring a \(30,000 investment in an asset having no salvage value. The project would produce \)12,000 of pretax income before depreciation at the end of each of the next six years. The company’s income tax rate is 40%. In compiling its tax return and computing its income tax payments, the company can choose between two alternative depreciation schedules as shown in the table.
Straight-Line MACRS
Depreciation Depreciation*
Year 1 . . . . . . . . . . \( 3,000 \)6,000
Year 2 . . . . . . . . . . 6,000 9,600
Year 3 . . . . . . . . . . 6,000 5,760
Year 4 . . . . . . . . . . 6,000 3,456
Year 5 . . . . . . . . . . 6,000 3,456
Year 6 . . . . . . . . . . 2,000 1,728
Totals . . . . . . . . . . . \(30,000 \)30,000
Required
1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following items for each of the six years: (a) pretax income before depreciation, (b) straight-line depreciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)
2. Prepare a five-column table that reports amounts (assuming use of MACRS depreciation) for each of the following items for each of the six years: (a) pretax income before depreciation, (b) MACRS depreciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)
3. Compute the net present value of the investment if straight-line depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)
4. Compute the net present value of the investment if MACRS depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)
Analysis Component
5. Explain why the MACRS depreciation method increases the net present value of this project.
B2B Co. is considering the purchase of equipment that would allow the company to add a new product to its line. The equipment is expected to cost \(360,000 with a 12-year life and no salvage value. It will be depreciated on a straight-line basis. The company expects to sell 144,000 units of the equipment’s product each year. The expected annual income related to this equipment follows.
Compute the (1) payback period and (2) accounting rate of return for this equipment.
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \)225,000
Costs
Materials, labor, and overhead (except depreciation on new equipment) . . . . . . . . . . . . . . . 120,000
Depreciation on new equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,500
Total costs and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172,500
Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,500
Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,750
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 36,750
Project A requires a \(280,000 initial investment for new machinery with a five-year life and a salvage value of \)30,000. The company uses straight-line depreciation. Project A is expected to yield annual net income of $20,000 per year for the next five years. Compute Project A’s payback period.
Why is the present value of \(100 that you expect to receive one year from today worth less than \)100 received today? What is the present value of $100 that you expect to receive one year from today, discounted at 12%?
Retsa Company is considering an investment in technology to improve its operations. The investment will require an initial outlay of \(800,000 and will yield the following expected cash flows. Management requires investments to have a payback period of two years, and it requires a 10% return on its investments.
Period Cash Flow
1 . . . . . . . . . . . . \)450,000
2 . . . . . . . . . . . . 400,000
3 . . . . . . . . . . . . 350,000
4 . . . . . . . . . . . . 300,000
Required
1. Determine the payback period for this investment. (Round the answer to one decimal.)
2. Determine the break-even time for this investment. (Round the answer to one decimal.)
3. Determine the net present value for this investment.
Analysis Component
4. Should management invest in this project? Explain.
5. Compare your answers for parts 1 through 4 with those for Problem 24-5B. What are the causes of the differences in results and your conclusions?
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