Chapter 26: 1RQ (page 1463)
Explain the difference between capital assets, capital investments, and capital budgeting.
Capital assets, capital investments, and capital budgeting are associated with maintaining and utilizing the funds and other resources for the most profitable outcomes.
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How is the present value of an annuity determined?
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:
Year | Plan Alpha | Plan Beta |
1 | \(1,600,000 | \)1,600,000 |
2 | \(1,600,000 | 2,200,000 |
3 | \)1,600,000 | 2,800,000 |
4 | \(1,600,000 | 2,200,000 |
5 | \)1,600,000 | 1,600,000 |
6 | \(1,600,000 | 1,500,000 |
7 | \)1,600,000 | 1,300,000 |
8 | \(1,600,000 | 1,100,000 |
9 | \)1,600,000 | 900,000 |
10 | \(1,600,000 | 800,000 |
Total | \)16,000,000 | \(16,000,000 |
Requirements
1. Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue?
2. Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not?
3. After further negotiating, the company can now invest with an initial cost of \)6,500,000. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?
What is capital rationing?
Hudson Manufacturing is considering three capital investment proposals. At this time, Hudson only has funds available to pursue one of the three investments.
Equipment A | Equipment B | Equipment C | |
Present value of net cash inflows | \(1,647,351 | \)1,969,888 | \(2,064,830 |
Initial investment | (1,484,100) | (1,641,573) | (1,764,812) |
NPV | \)163,251 | \(328,315 | \)300,018 |
Which investment should Hudson pursue at this time? Why?
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.
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