Chapter 26: Q22RQ (page 1464)
What is net present value?
The term net present value (NPV) shows the current total present value of the future cash flow. If the NPV of an investment is positive, then the investment will attractive.
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Question: Defining capital investments and the capital budgeting process
Match each capital budgeting method with its definition.
Methods
1. Accounting rate of return
2. Internal rate of return
3. Net present value
4. Payback
Definitions
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?
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?
Henderson Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machineat a cost of \(1,200,000. If refurbished, Henderson expects the machine to last anothereight years and then have no residual value. Option 2 is to replace the machine at acost of \)4,600,000. A new machine would last 10 years and have no residual value.Henderson expects the following net cash inflows from the two options:
YearRefurbish CurrentPurchase New
MachineMachine
1 \( 350,000 \) 3,780,000
2 340,000 510,000
3 270,000 440,000
4 200,000 370,000
5 130,000 300,000
6 130,000 300,000
7 130,000 300,000
8 130,000 300,000
9 300,000
10 300,000
Total \( 1,680,000 \) 6,900,000
Henderson uses straight-line depreciation and requires an annual return of 10%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of these twooptions.
2. Which option should Henderson choose? Why?
What is the decision rule for ARR?
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