Chapter 26: Q20RQ (page 1464)
How is the present value of an annuity determined?
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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?
Using NPV to make capital investment decisions Holmes Industries is deciding whether to automate one phase of its production process. The manufacturing equipment has a six-year life and will cost \(910,000.
Year 1 \) 262,000 Year 2 254,000 Year 3 222,000 Year 4 215,000 Year 5 200,000 Year 6 175,000 |
Requirements
Holmes could refurbish the equipment at the end of six years for \(104,000. The refurbished equipment could be used one more year, providing \)77,000 of net cash inflows in year 7. Additionally, the refurbished equipment would have a $55,000 residual value at the end of year 7. Should Holmes invest in the equipment and refurbish it after six years? (Hint: In addition to your answer to Requirement 1, discount the additional cash outflow and inflows back to the present value.)
What is capital rationing?
List some common cash outflows from capital investments.
Using accounting rate of return to make capital investment decisions
Carter Company is considering three investment opportunities with the following accounting rates of return:
Project X | Project Y | Project Z | |
ARR | 13.25% | 6.58% | 10.47% |
Use the decision rule for ARR to rank the projects from most desirable to least desirable. Carter Company’s required rate of return is 8%.
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