Chapter 26: Q13RQ (page 1464)
How is ARR calculated?
Answer
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What is the payback method of analyzing capital investments?
John Johnson is the majority stockholder in Johnson’s Landscape Company, owning 52% of the company’s stock. John asked his accountant to prepare a capital investment analysis to purchase new mowers. John used the analysis to persuade a loan officer at the local bank to loan the company $100,000. Once the loan was secured, John used the cash to remodel his home, updating the kitchen and bathrooms, installing new flooring, and adding a pool.
Requirements
1. Are John’s actions fraudulent? Why or why not? Does John’s percentage of ownership affect your answer?
2. What steps could the bank take to prevent this type of activity?
Henry Hardware is adding a new product line that will require an investment of \(1,512,000. Managers estimate that this investment will have a 10-year life and generate net cash inflows of \)310,000 the first year, \(270,000 the second year, and \)240,000 each year thereafter for eight years. Compute the payback period. Round to one decimal place.
Hayes Company is considering two capital investments. Both investments have an initial cost of \(10,000,000 and total net cash inflows of \)17,000,000 over 10 years. Hayes requires a 12% rate of return on this type of investment. Expected net cash inflows are as follows:
Year | Plan Alpha | Plan Beta |
1 | \( 1,700,000 | \) 1,700,000 |
2 | 1,700,000 | 2,300,000 |
3 | 1,700,000 | 2,900,000 |
4 | 1,700,000 | 2,300,000 |
5 | 1,700,000 | 1,700,000 |
6 | 1,700,000 | 1,600,000 |
7 | 1,700,000 | 1,200,000 |
8 | 1,700,000 | 800,000 |
9 | 1,700,000 | 400,000 |
10 | 1,700,000 | 2,100,000 |
Total | \( 17,000,000 | \) 17,000,000 |
Requirements
Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue?
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?
After further negotiating, the company can now invest with an initial cost of $9,500,000 for both plans. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?
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?
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