12-18 Test Bank for Managerial Accounting, Third Edition

93. Cleaners, Inc. is considering purchasing equipment costing $30,000 with a 6-year useful
life. The equipment will provide cost savings of $7,300 and will be depreciated straight-
line over its useful life with no salvage value. Cleaners, Inc. requires a 10% rate of return.
What is the approximate profitability index associated with this equipment?

Present Value of an Annuity of 1

Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784

a. 1.23
b. 1.03
c. 1.06
d. .73

Answers to Multiple Choice Questions

Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans.
26. a 36. c 46. a 56. c 66. c 76. b 86. b
27. d 37. d 47. c 57. d 67. b 77. c 87. c
28. b 38. c 48. b 58. d 68. d 78. c 88. c
29. a 39. a 49. d 59. d 69. d 79. d 89. b
30. d 40. b 50. d 60. c 70. c 80. a 90. c
31. c 41. d 51. c 61. b 71. b 81. d 91. d
32. b 42. c 52. c 62. b 72. b 82. b 92. b
33. b 43. b 53. b 63. d 73. d 83. c 93. c
34. c 44. a 54. b 64. d 74. d 84. b
35. b 45. c 55. d 65. c 75. b 85. b

BRIEF EXERCISES
Ex. 94

Diamond Co. is considering investing in new equipment that will cost $900,000 with a 10-year
useful life. The new equipment is expected to produce annual net income of $30,000 over its
useful life. Depreciation expense, using the straight-line rate, is $90,000 per year.

Instructions
Compute the payback period.

Solution 94 (5 min.)

$900,000 ÷ ($30,000 + $90,000) = 7.5 years

Ex. 95

Madeline Company is proposing to spend $140,000 to purchase a machine that will provide
annual cash flows of $25,000. The appropriate present value factor for 10 periods is 5.65.

Instructions
 Planning for Capital Investments 12-19

Compute the proposed investment’s net present value, and indicate whether the investment
should be made by Madeline Company.

Solution 95 (5 min.)

Present Value
Cash inflows – $25,000 X 5.65 $ 141,250
Cash outflow – investment $140,000 X 1.00 (140,000)
Net present value $ 1,250

The investment should be made because the net present value is positive.

Ex. 96

LakeFront Co. is considering investing in a new dock that will cost $280,000. The company
expects to use the dock for 5 years, after which it will be sold for $150,000 at that time.
LakeFront anticipates cash flows of $50,000 resulting from the new dock and the company’s
borrowing rate is 8%, while its cost of capital is 10%.

Instructions
Calculate the net present value of the dock and indicate whether LakeFront should make the
investment.

Solution 96 (5 min.)

Cash 10% Discount Present

Flows X Factor = Value
Present value of annual cash flows $50,000 X 3.79079 = $189,540
Present value of salvage value 150,000 X .62092 = 93,138
282,678
Capital investment (280,000)
Net present value $ 2,678

Since the net present value is positive, LakeFront should accept the project.

Ex. 97

Mobil Co. has hired a consultant to propose a way to increase the company’s revenues. The
consultant has evaluated two mutually exclusive projects with the following information provided
for each project:

Project Turtle Project Snake

Capital investment $790,000 $440,000
Annual cash flows 140,000 80,000
Estimated useful life 10 years 10 years

Mobil Co. uses a discount rate of 9% to evaluate both projects.

12-20 Test Bank for Managerial Accounting, Third Edition

Instructions
(a) Calculate the net present value of both projects.
(b) Calculate the profitability index for each project.
(c) Which project should Mobil accept?

Solution 97 (10-15 min.)

Project Turtle
Cash 9% Discount Present
Flows X Factor = Value
Present value of annual cash flows $140,000 X 6.41766 = $898,472
Present value of salvage value 0 X .42241 = 0
898,472
Capital investment (790,000)
Net present value $ 108,472

Profitability index = $898,472/$790,000 = 1.14

Project Snake
Cash 9% Discount Present
Flows X Factor = Value
Present value of annual cash flows $80,000 X 6.41766 = $513,413
Present value of salvage value 0 X .42241 = 0
513,413
Capital investment (440,000)
Net present value $ 73,413

Profitability index = $513,413/$440,000 = 1.17

Project Snake has a lower net present value than Project Turtle, but because of its lower capital
investment, it has a higher profitability index. Based on its profitability index, Project Snake should
be accepted.

Ex. 98

An investment costing $90,000 is being contemplated by Mint Co. The investment will have a life
of 8 years with no salvage value and will produce annual cash flows of $16,870.

Instructions
What is the approximate internal rate of return associated with this investment?
 Planning for Capital Investments 12-21

Solution 98 (5 min.)

When net annual cash inflows are expected to be equal, the internal rate of return can be
approximated by dividing the capital investment by the net annual cash inflows to determine the
discount factor, and then locating this discount factor on the present value of an annuity table.

$90,000/$16,870 = 5.33

By tracing across on the 8-year row we see that the discount factor for 10% is 5.33493. Thus, the
internal rate of return on this project is approximately 10%.

Ex. 99

Salt Co. is considering investing in a new facility to extract and produce salt. The facility will
increase revenues by $240,000, but will also increase annual expenses by $160,000. The facility
will cost $980,000 to build, but will have a $20,000 salvage value at the end of its 20-year useful
life.

Instructions
Calculate the annual rate of return on this facility.

Solution 99 (5 min.)

The annual rate of return is calculated by dividing expected annual income by the average
investment. The company’s expected annual income is:

$240,000 – $160,000 = $80,000

Its average investment is:

$980,000 + $20,000
= $500,000
2

Therefore, its annual rate of return is:

$80,000/$500,000 = 16%

EXERCISES
Ex. 100
Corn Doggy, Inc. produces and sells corn dogs. The corn dogs are made by hand. Austin Beagle,
production manager, is considering purchasing a machine that will make the corn dogs. Austin
has shopped for machines and found that the machine he wants will cost $262,000. In addition,
12-22 Test Bank for Managerial Accounting, Third Edition

Austin estimates that the new machine will increase the company’s annual net cash inflows by
$42,400. The machine will have a 12-year useful life and no salvage value.

Instructions
(a) Calculate the cash payback period.
(b) Calculate the machine’s internal rate of return.
(c) Calculate the machine’s net present value using a discount rate of 10%.
(d) Assuming Corn Doggy Inc.’s cost of capital is 10%, is the investment acceptable? Why or
why not?

Solution 100 (13–18 min.)

(a) Cash payback period: $262,000 ÷ $42,400 = 6.1793 years
(b) Internal rate of return: Scanning the 12-year line, a factor of 6.1793 represents an internal
rate of return of approximately 12%.
(c) Net present value using a discount rate of 10%:
Time Period Cash Flow PV Factor Present Value
-0- ($262,000) 1.0000 ($262,000)
1-12 42,400 6.8137 288,900
Net Present Value $ 26,900
(d) Yes, the investment is acceptable. Indications are that the investment will earn a greater
return than 10%. The internal rate of return is estimated to be 12%, and the net present
value is positive.

Ex. 101
Top Growth Farms, a farming cooperative, is considering purchasing an tractor for $475,000. The
machine has a 10-year life and an estimated salvage value of $27,500. Delivery costs and set-up
charges will be $12,100 and $400, respectively. Top Growth uses straight-line depreciation.

Top Growth estimates that the tractor will be used five times a week with the average charge to
the individual farmers of $400. Gas is $25 for each use of the tractor. The present value of an
annuity of 1 for 10 years at 9% is 6.418.

Instructions
For the new tractor, compute the:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.

Solution 101 (16–22 min.)

(a) Cost of the tractor: $475,000 + $12,100 + $400 = $487,500

Annual Cash Flow:

Number of uses: 52 × 5 = 260
Contribution margin per use: $400 – $25 = $375
Total annual cash flow: 260 × $375 = $97,500
 Planning for Capital Investments 12-23

$487,500
Cash payback: ———— = 5 years
$97,500

(b) Present value of cash flow ($97,500 × 6.418) = $625,755

Capital investment 487,500
Net present value $ 138,255

(c) $487,500 + $27,500

Average Investment: ————————— = $257,500
2

$487,500 – $27,500
Annual Depreciation: ————————— = $46,000
10 years

Annual Net Income: $97,500 – $46,000 = $51,500

$51,500
Average Annual Rate of Return: ———— = 20%
$257,500
12-24 Test Bank for Managerial Accounting, Third Edition

Ex. 102
Mimi Company is considering a capital investment of $240,000 in new equipment. The equipment
is expected to have a 5-year useful life with no salvage value. Depreciation is computed by the
straight-line method. During the life of the investment, annual net income and cash inflows are
expected to be $30,000 and $78,000, respectively. Mimi's minimum required rate of return is
10%. The present value of 1 for 5 periods at 10% is .621 and the present value of an annuity of 1
for 5 periods at 10% is 3.791.

Instructions
Compute each of the following:
(a) cash payback period.
(b) net present value.
(c) annual rate of return.

Solution 102 (10–15 min.)

(a) Cash payback period = $240,000 ÷ $78,000 = 3.08 years

(b) Present value of cash inflows ($78,000 × 3.791) = $295,698

Capital investment 240,000
Net present value $ 55,698

(c) Annual rate of return = $30,000 ÷ [($240,000 + $0) ÷ 2] = 25%

Ex. 103
Savanna Company is considering two capital investment proposals. Relevant data on each
project are as follows:
Project Red Project Blue
Capital investment $400,000 $560,000
Annual net income 30,000 50,000
Estimated useful life 8 years 8 years

Depreciation is computed by the straight-line method with no salvage value. Savanna requires
an 8% rate of return on all new investments. The present value of 1 for 8 periods at 8% is .540
and the present value of an annuity of 1 for 8 periods is 5.747.

Instructions
(a) Compute the cash payback period for each project.
(b) Compute the net present value for each project.
(c) Compute the annual rate of return for each project.
(d) Which project should Savanna select?
 Planning for Capital Investments 12-25

Solution 103 (14–18 min.)

(a) Project Red Project Blue
Annual net income $30,000 $50,000
Annual depreciation 50,000* 70,000**
Annual cash inflow $80,000 $120,000
*($400,000 ÷ 8) **($560,000 ÷ 8)

$400,000 $560,000
Cash payback period: ———— = 5.0 years ———— = 4.7 years
$80,000 $120,000

(b) Project Red Project Blue

Present value of cash inflows: $459,760* $689,640**
Capital investment 400,000 560,000
Net present value $ 59,760 $ 129,640
*($80,000 x 5.747) **(120,000 x 5.747)

(c) Annual rate of return: Project Red Project Blue

$30,000 $50,000
————————— = 15% ————————— = 17.9%
($400,000 + $0) ÷ 2 ($560,000 + $0) ÷ 2

(d) Savanna should select Project Blue because it has a larger positive net present value and a
higher annual rate of return. In addition, Project Blue has a slightly shorter cash payback
period.

Ex. 104
Tom Bat became a baseball enthusiast at a very early age. All of his baseball experience has
provided him valuable knowledge of the sport, and he is thinking about going into the batting cage
business. He estimates the construction of a state-of-the-art facility and the purchase of
necessary equipment will cost $630,000. Both the facility and the equipment will be depreciated
over 12 years using the straight-line method and are expected to have zero salvage values. His
required rate of return is 13% (present value factor of 5.9176). Estimated annual net income and
cash flows are as follows:
Revenue $329,000
Less:
Utility cost 40,000
Supplies 8,000
Labor 126,000
Depreciation 52,500
Other 38,500 265,000
Net income $64,000

Instructions
For this investment, calculate:
(a) The net present value.
(b) The internal rate of return.
(c) The cash payback period.
12-26 Test Bank for Managerial Accounting, Third Edition

Solution 104 (12–16 min.)

(a) Net present value of the investment:
Item Present Value Cash Flow Factor Present Value
Initial Investment ($630,000) 1.0000 ($630,000)
Revenue $329,000
Expense (212,500)* 116,500 5.9176 689,400
Net Present Value $ 59,400
*$40,000 + $8,000 + $126,000 + $38,500

(b) Internal rate of return of the investment:

$630,000 ÷ $116,500 = 5.4077
Scanning the 12-year line, a factor of 5.4077 represents an IRR of approximately 15%.

(c) Cash payback period of the investment:

$630,000 ÷ $116,500 = 5.41 years.

Ex. 105
Vista Company is considering two new projects, each requiring an equipment investment of
$90,000. Each project will last for three years and produce the following cash inflows:

Year Cool Hot

1 $38,000 $42,000
2 42,000 42,000
3 48,000 42,000
$128,000 $126,000

The equipment will have no salvage value at the end of its three-year life. Vista Company uses
straight-line depreciation, and requires a minimum rate of return of 12%.

Present value data are as follows:

Present Value of 1 Present Value of an Annuity of 1

Period 12% Period 12%
1 .893 1 .893
2 .797 2 1.690
3 .712 3 2.402

Instructions
(a) Compute the net present value of each project.
(b) Compute the profitability index of each project.
(c) Which project should be selected? Why?
 Planning for Capital Investments 12-27

Solution 105 (12–16 min.)

(a) Project Cool
Year Annual Cash Inflows Present Value of 1 Present Value
1 $38,000 .893 $33,935
2 42,000 .797 33,474
3 48,000 .712 34,176
$128,000 $101,584

Present value of cash inflows $101,584

Capital investment 90,000
Net present value $ 11,584

Project Hot
Present value of cash inflows ($42,000 × 2.402) $100,884
Capital investment 90,000
Net present value $ 10,884

(b) Cool Hot

Profitability index: $101,584 ÷ $90,000 = 1.13 ($100,884 ÷ $90,000) = 1.12

(c) Both projects are acceptable because both show a positive net present value. Project Cool
is the preferred project because its net present value is greater than project Hot's net present
value and it has a slightly higher profitability index.

Ex. 106
Santana Company is considering investing in a project that will cost $73,000 and have no salvage
value at the end of its 5-year life. It is estimated that the project will generate annual cash inflows
of $20,000 each year. The company requires a 10% rate of return and uses the following
compound interest table:

Present Value of an Annuity of 1

Period 6% 8% 9% 10% 11% 12% 15%
5 4.212 3.993 3.890 3.791 3.696 3.605 3.352

Instructions
(a) Compute (1) the net present value and (2) the profitability index of the project.
(b) Compute the internal rate of return on this project.
(c) Should Santana invest in this project?

Solution 106 (10–18 min.)

(a) (1) Present value of cash inflows ($20,000 × 3.791) $75,820
Capital investment 73,000
Net present value $ 2,820

(2) Profitability index: $75,820 ÷ $73,000 = 1.04

12-28 Test Bank for Managerial Accounting, Third Edition

Solution 106 (cont.)

(b) Capital Investment
—————————— = Internal Rate of Return Factor
Net Annual Cash Inflow

$73,000
———— = 3.65
$20,000

Since the calculated internal rate of return factor of 3.65 is very near the factor 3.605 for five
periods and 12% interest, this project has an approximate interest yield of 12%.

(c) Santana should invest in this project because it has a positive net present value, a
profitability index above 1, and its internal rate of return of 12% is greater than the company's
10% required rate of return.

Ex. 107
Johnson Company is considering purchasing one of two new machines. The following estimates
are available for each machine:
Machine 1 Machine 2
Initial cost $152,000 $170,000
Annual cash inflows 50,000 60,000
Annual cash outflows 15,000 20,000
Estimated useful life 6 years 6 years

The company's minimum required rate of return is 9%.

Present Value of an Annuity of 1

Period 8% 9% 10% 11% 12% 15%
6 4.623 4.486 4.355 4.231 4.111 3.784

Instructions
(a) Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for
each machine.
(b) Which machine should be purchased?

Solution 107 (12–16 min.)

(a) Machine 1 Machine 2
(1) Present value of net cash flows $157,010* $179,440**
Capital investment 152,000 170,000
Net present value $ 5,010 $ 9,440
*($35,000 × 4.486) **($40,000 × 4.486)

Machine 1 Machine 2
$157,010 $179,440
(2) Profitability index ———— = 1.03 ———— = 1.06
$152,000 $170,000
 Planning for Capital Investments 12-29

Solution 107 (cont.)

(3) Machine 1 Machine 2
Internal rate of return factor $152,000 $170,000
———— = 4.34 ———— = 4.25
$35,000 $40,000

Internal rate of return 10% (4.355 factor) 11% (4.231 factor)

(b) Both machines are acceptable because both show a positive net present value, have a
profitability index above 1, and have an internal rate of return greater than the company's
minimum required rate of return. Machine 2 is preferred because its net present value,
profitability index, and internal rate of return are all greater than Machine 1's amounts.

Ex. 108
Yappy Company is considering a capital investment of $320,000 in additional equipment. The
new equipment is expected to have a useful life of 8 years with no salvage value. Depreciation is
computed by the straight-line method. During the life of the investment, annual net income and
cash inflows are expected to be $22,000 and $62,000, respectively. Yappy requires a 9% return
on all new investments.
Present Value of an Annuity of 1
Period 8% 9% 10% 11% 12% 15%
8 5.747 5.535 5.335 5.146 4.968 4.487

Instructions
(a) Compute each of the following:
1. Cash payback period.
2. Net present value.
3. Profitability index.
4 Internal rate of return.
5. Annual rate of return.
(b) Indicate whether the investment should be accepted or rejected.

Solution 108 (15–20 min.)

(a) 1. Cash payback period: $320,000 ÷ $62,000 = 5.16 years
2. Present value of cash inflows ($62,000 × 5.535) $343,170
Capital investment 320,000
Net present value $ 23,170
3. Profitability index: $343,170 ÷ $320,000 = 1.07
4. Internal rate of return factor: $320,000 ÷ $62,000 = 5.16
Internal rate of return = 11% (5.146 factor)
5. Annual rate of return: $22,000 ÷ [($320,000 + $0) ÷ 2] = 13.75%

(b) Yappy should accept the investment, since its net present value is positive and its internal
rate of return of 11% is greater than the company's required rate of return of 9%. In addition,
its cash payback period of 5.16 years is significantly shorter than the equipment's useful life
of 8 years.
12-30 Test Bank for Managerial Accounting, Third Edition

Ex. 109
Platoon Company is performing a post-audit of a project that was estimated to cost $300,000,
have a useful life of 6 years with a zero salvage value, and result in net cash inflows of $70,000
per year. After the investment has been in operation for a year, revised figures indicate that it
actually cost $340,000, will have a 9-year useful life, and will produce net cash inflows of
$58,000. The present value of an annuity of 1 for 6 years at 10% is 4.355 and for 9 years is
5.759.

Instructions
Determine whether the project should have been accepted based on (a) the original estimates
and then on (b) the actual amounts.

Solution 109 (8–12 min.)

(a) Present value of the estimated net cash inflows ($70,000 × 4.355) $304,850
Estimated capital investment 300,000
Net present value $ 4,850

Yes, Platoon Company should have invested in the project based on the original estimates,
since the net present value is positive.

(b) Present value of the actual net cash inflows ($58,000 x 5.759) $334,022
Actual capital investment 340,000
Net present value ($ 5,978)

Platoon should not have invested in the project based on the actual amounts, since the net
present value is negative. The decrease of $10,828 in net present value was caused due to
a decrease of $12,000 per year in net cash inflows and a $40,000 increase in the cost of the
capital investment. This more than offsets the 3-year increase in useful life.

Ex. 110
Sophie’s Pet Shop is considering the purchase of a new delivery van. Sophie Smith, owner of the
shop, has compiled the following estimates in trying to determine whether the delivery van should
be purchased:

Cost of the van $25,000

Annual net cash flows 4,300
Salvage value 3,000
Estimated useful life 8 years
Cost of capital 10%
Present value of an annuity of 1 5.335
Present value of 1 .467

Sophie's assistant manager is trying to convince Sophie that the van has other benefits that she
hasn't considered in the initial estimates. These additional benefits, including the free advertising
the store's name painted on the van's doors will provide, are expected to increase net cash flows
by $500 each year.
 Planning for Capital Investments 12-31

Ex. 110 (cont.)

Instructions
(a) Calculate the net present value of the van, based on the initial estimates. Should the van be
purchased?
(b) Calculate the net present value, incorporating the additional benefits suggested by the
assistant manager. Should the van be purchased?
(c) Determine how much the additional benefits would have to be worth in order for the van to
be purchased.

Solution 110 (15–19 min.)

(a) Present value of annual cash flows ($4,300 × 5.335) $22,941
Present value of salvage value ($3,000 × .467) 1,401
$24,342
Capital investment 25,000
Net present value ($ 658)
Based on the negative net present value of $658, the van should not be purchased.

(b) Present value of annual cash flows [($4,300 + $500) × 5.335] $25,608
Present value of salvage value ($3,000 × .467) 1,401
$27,009
Capital investment 25,000
Net present value $ 2,009
Incorporating the additional benefits of $500/year into the calculation produces a positive net
present value of $2,009. Therefore, the van should be purchased.

(c) The additional benefits would need to have a total present value of at least $658 in order for
the van to be purchased.

Ex. 111
Schilling Corp. is thinking about opening a baseball camp in Florida. In order to start the camp,
the company would need to purchase land, build five baseball fields, and a dormitory-type
sleeping and dining facility to house 100 players. Each year the camp would be run for 10
sessions of 1 week each. The company would hire college baseball players as coaches. The
camp attendees would be baseball players age 12-18. Property values in Florida have enjoyed a
steady increase in value. It is expected that after using the facility for 20 years, Schilling can sell
the property for more than it was originally purchased for. The following amounts have been
estimated:
Cost of land $ 600,000
Cost to build dorm and dining facility 2,100,000
Annual cash inflows assuming 100 players and 10 weeks 2,520,000
Annual cash outflows 2,250,000
Estimated useful life 20 years
Salvage value 3,900,000
Discount rate 10%
Present value of an annuity of 1 8.514
Present value of 1 .149
12-32 Test Bank for Managerial Accounting, Third Edition

Ex. 111 (cont.)

Instructions
(a) Calculate the net present value of the project.
(b) To gauge the sensitivity of the project to these estimates, assume that if only 80 campers
attend each week, revenues will be $2,085,000 and expenses will be $1,875,000. What is
the net present value using these alternative estimates? Discuss your findings.
(c) Assuming the original facts, what is the net present value if the project is actually riskier than
first assumed, and a 12% discount rate is more appropriate? The present value of 1 at 12%
is .104 and the present value of an annuity of 1 is 7.469.

Solution 111 (15–20 min.)

(a) Present value of net cash flows ($270,000 × 8.514) $2,298,780
Present value of salvage value ($3,900,000 × .149) 581,100
$2,879,880
Capital investment ($600,000 + $2,100,000) 2,700,000
Net present value $ 179,880

(b) Present value of net cash flows ($2,100,000 × 8.514) $1,787,940

Present value of salvage value 581,100
$2,369,040
Capital investment 2,700,000
Net present value ($330,960)

If the number of campers attending each week is only 80 instead of 100, the net present
value decreases by $510,840 (from a positive $179,880 to a negative $330,360). This
indicates that the camp should not be invested in unless the number attending is closer to
100.

(c) Present value of net cash flows ($270,000 × 7.469) $2,016,630

Present value of salvage value ($3,900,000 × .104) 405,600
$2,422,230
Capital investment 2,700,000
Net present value ($ 277,770)