Chapter 24: Q9DQ (page 1083)
If a potential investment’s internal rate of return is above the company’s hurdle rate, should the investment be made?
The investment should be made when the investment’s internal rate of return is above the hurdle rate.
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Archer Foods has a freezer that is in need of repair and is considering whether to replace the old freezer with a new freezer or have the old freezer extensively repaired. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.
Alternative 1: Keep the old freezer and have it repaired. If the old freezer is repaired, it will be kept for another eight years and then sold for its salvage value.
Cost of old freezer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \(75,000
Cost of repair . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Annual expected revenues generated . . . . . . . . . . . . . . . 63,000
Annual cash operating costs after repair . . . . . . . . . . . . . 55,000
Salvage value of old freezer in 8 years . . . . . . . . . . . . . . 3,000
Alternative 2: Sell the old freezer and buy a new one. The new freezer is larger than the old one and will allow the company to expand its product offerings, thereby generating more revenues. Also, it is more energy efficient and will yield substantial operating cost savings.
Cost of new freezer............................. \)150,000
Salvage value of old freezer now.................. 5,000
Annual expected revenues generated . . . . . . . . . . . . . . 68,000
Annual cash operating costs . . . . . . . . . . . . . . . . . . . . . . 30,000
Salvage value of new freezer in 8 years . . . . . . . . . . . . . 8,000
Required
1. Determine the net present value of alternative 1.
2. Determine the net present value of alternative 2.
3. Which alternative do you recommend that management select? Explain.
What is the average amount invested in a machine during its predicted five-year life if it costs \(200,000 and has a \)20,000 salvage value? Assume that net income is received evenly throughout each year and straight-line depreciation is used.
Manning Corporation is considering a new project requiring a \(90,000 investment in test equipment with no salvage value. The project would produce \)66,000 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 the two alternative depreciation schedules shown in the table.
Straight-Line MACRS
Depreciation Depreciation*
Year 1 . . . . . . . . . . \( 9,000 \)18,000
Year 2 . . . . . . . . . . 18,000 28,800
Year 3 . . . . . . . . . . 18,000 17,280
Year 4 . . . . . . . . . . 18,000 10,368
Year 5 . . . . . . . . . . 18,000 10,368
Year 6 . . . . . . . . . . 9,000 5,184
Totals . . . . . . . . . . . \(90,000 \)90,000
Required
1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following 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 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 income amount 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 this project’s net present value.
After evaluating the risk of the investment described in Exercise 24-8, B2B Co. concludes that it must earn at least an 8% return on this investment. Compute the net present value of this investment. (Round the net present value to the nearest dollar.)
Aikman Company has an opportunity to invest in one of two projects. Project A requires a \(240,000 investment for new machinery with a four-year life and no salvage value. Project B also requires a \)240,000 investment for new machinery with a three-year life and no salvage value. The two projects yield the following predicted annual results. The company uses straight-line depreciation, and cash flows occur evenly throughout each year. Company
Project A Project B
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \(250,000 \)200,000
Expenses Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 25,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 30,000
Overhead including depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 90,000
Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 18,000
Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193,000 163,000
Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,000 37,000
Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,100 11,100
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \( 39,900 \) 25,900
Required
1. Compute each project’s annual expected net cash flows. (Round net cash flows to the nearest dollar.)
2. Determine each project’s payback period. (Round the payback period to two decimals.)
3. Compute each project’s accounting rate of return. (Round the percentage return to one decimal.)
4. Determine each project’s net present value using 8% as the discount rate. For part 4 only, assume that cash flows occur at each year-end. (Round net present values to the nearest dollar.)
Analysis Component
5. Identify the project you would recommend to management and explain your choice.
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