Chapter 26: Q15RQ (page 1464)
Why is it preferable to receive cash sooner rather than later?
Answer
The basic rule is that cash received now can be invested to generate revenue sooner than cash received later.
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Using ARR to make capital investment decisions Refer to the Henry Hardware information in Exercise E26-20. Assume the project has no residual value. Compute the ARR for the investment. Round to two places.
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.
Question: Using the payback and accounting rate of return methods to make capital investment decisions
Consider how Hunter Valley Snow Park Lodge could use capital budgeting to decide whether the \(11,000,000 Snow Park Lodge expansion would be a good investment. Assume Hunter Valley’s managers developed the following estimates concerning the expansion:
Number of additional skiers per day 121 skiers Average number of days per year that weather conditions allow skiing at Hunter Valley 142 days Useful life of expansion (in years) 7 years Average cash spent by each skier per day \) 241 Average variable cost of serving each skier per day 83 Cost of expansion 11,000,000 Discount rate 10% |
Assume that Hunter Valley uses the straight-line depreciation method and expects the lodge expansion to have a residual value of $600,000 at the end of its seven-year life.
Requirements
P26-40 Using payback, ARR, NPV, and IRR to make capital investment decisions
This problem continues the Piedmont Computer Company situation from Chapter 25. Piedmont Computer Company is considering purchasing two different types of servers. Server A will generate net cash inflows of \(25,000 per year and have a zero residual value. Server A’s estimated useful life is three years, and it costs \)45,000. Server B will generate net cash inflows of \(25,000 in year 1, \)15,000 in year 2, and \(5,000 in year 3. Server B has a \)5,000 residual value and an estimated useful life of three years. Server B also costs $45,000. Piedmont Computer Company’s required rate of return is 14%.
Requirements
1. Calculate payback, accounting rate of return, net present value, and internal rate of return for both server investments. Use Microsoft Excel to calculate NPV and IRR.
2. Assuming capital rationing applies, which server should Piedmont Computer Company invest in?
Cornell Company is considering a project with an initial investment of \(596,500 that is expected to produce cash inflows of \)125,000 for nine years. Cornell’s required rate of return is 12%.
14. What is the NPV of the project?
15. What is the IRR of the project?
16. Is this an acceptable project for Cornell?
Howard Company operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of \(8,500,000. Expected annual net cash inflows are \)1,600,000 for 10 years, with zero residual value at the end of 10 years. Under Plan B, Howard Company would open three larger shops at a cost of \(8,100,000. This plan is expected to generate net cash inflows of \)1,000,000 per year for 10 years, which is the estimated useful life of the properties. Estimated residual value for Plan B is $990,000. Howard Company uses straight-line depreciation and requires an annual return of 6%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of these two plans.
2. What are the strengths and weaknesses of these capital budgeting methods?
3. Which expansion plan should Howard Company choose? Why?
4. Estimate Plan A’s IRR. How does the IRR compare with the company’s required rate of return?
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