Chapter 26: Q26RQ (page 1464)
How is IRR calculated with equal net cash inflows?
By subtracting the anticipated future cash flows from the initial beginning value, dividing the result by the actual value, and multiplying the result by 100, one can determine the internal rate of return.
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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?
Hill 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\(8,700,000. Expected annual net cash inflows are \)1,550,000 for 10 years, with zeroresidual value at the end of 10 years. Under Plan B, Hill Company would open threelarger shops at a cost of \(8,340,000. This plan is expected to generate net cash inflowsof \)990,000 per year for 10 years, the estimated useful life of the properties. Estimatedresidual value for Plan B is $1,200,000. Hill Company uses straight-line depreciationand requires an annual return of 10%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of thesetwo plans.
2. What are the strengths and weaknesses of these capital budgeting methods?
3. Which expansion plan should Hill Company choose? Why?
4. Estimate Plan A’s IRR. How does the IRR compare with the company’s requiredrate of return?
Outlining the capital budgeting process Review the following activities of the capital budgeting process: a. Budget capital investments. b. Project investments’ cash flows. c. Perform post-audits. d. Make investments. e. Use feedback to reassess investments already made. f. Identify potential capital investments. g. Screen/analyze investments using one or more of the methods discussed. Place the activities in sequential order as they occur in the capital budgeting process.
How is ARR calculated?
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?
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