Chapter 26: Q11RQ (page 1463)
What are some criticisms of the payback method?
Answer
The payback method ignores the time value of money.
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Suppose Hunter Valley is deciding whether to purchase new accounting software. The payback for the $30,050 software package is two years, and the software’s expected life is three years. Hunter Valley’s required rate of return for this type of project is 10.0%. Assuming equal yearly cash flows, what are the expected annual net cash savings from the new software?
Spencer Wilkes is the marketing manager at Darby Company. Last year, Spencer recommended the company approve a capital investment project for the addition of a new product line. Spencer’s recommendation included predicted cash inflows for five years from the sales of the new product line. Darby Company has been selling the new products for almost one year. The company has a policy of conducting annual post audits on capital investments, and Spencer is concerned about the one-year post-audit because sales in the first year have been lower than he estimated. However, sales have been increasing for the last couple of months, and Spencer expects that by the end of the second year, actual sales will exceed his estimates for the first two years combined.
Spencer wants to shift some sales from the second year of the project into the first year. Doing so will make it appear that his cash flow predictions were accurate. With accurate estimates, he will be able to avoid a poor performance evaluation. Spencer has discussed his plan with a couple of key sales representatives, urging them to report sales in the current month that will not be shipped until a later month. Spencer has justified this course of action by explaining that there will be no effect on the annual financial statements because the project year does not coincide with the fiscal year––by the time the accounting year ends, the sales will have actually occurred.
Requirements
1. What is the fundamental ethical issue? Who are the affected parties?
2. If you were a sales representative at Darby Company, how would you respond to Spencer’s request? Why?
3. If you were Spencer’s manager and you discovered his plan, how would you respond?
4. Are there other courses of action Spencer could take?
Refer to Short Exercise S26-4. Continue to assume that the expansion has no residual value. What is the project’s IRR? Is the investment attractive? Why or why not?
What is capital rationing?
What is the profitability index? When is it used?
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