Exercise 13-1 (10 minutes)

1.
Present
Value of
Cash 12% Cash
Item Year(s) Flow Factor Flows
Annual cost savings ... 1-8 $7,000 4.968 $ 34,776
Initial investment ...... Now $(40,000) 1.000 (40,000)
Net present value ...... $ (5,224)

2.
Total
Cash Cash
Item Flow Years Flows
Annual cost savings ... $7,000 8 $ 56,000
Initial investment ...... $(40,000) 1 (40,000)
Net cash flow ............ $ 16,000

Exercise 13-4 (10 minutes)

1. The project profitability index for each proposal would be:
Net Present Investment Project Profitability
Proposal Value Required Index
Number (a) (b) (a)  (b)
A $36,000 $90,000 0.40
B $(10,000) $100,000 -0.10
 C $35,000 $70,000 0.50
D $40,000 $120,000 0.33

2. The ranking would be:

Proposal Project Profitability
Number Index
C 0.50
A 0.40
D 0.33
B -0.10
Two points should be noted about the ranking. First, proposal B is not an acceptable proposal at all,
since it has a negative net present value. Second, proposal D has the highest net present value, but it
ranks lowest of the three acceptable proposals in terms of the project profitability index.

Exercise 13-5 (10 minutes)

1. The payback period is determined as follows:
Unrecovered
Year Investment Cash Inflow Investment
1 $15,000 $1,000 $14,000
2 $8,000 $2,000 $20,000
3 $2,500 $17,500
4 $4,000 $13,500
5 $5,000 $8,500
6 $6,000 $2,500
7 $5,000 $0
8 $4,000 $0
 9 $3,000 $0
10 $2,000 $0
The investment in the project is fully recovered in the 7th year. To be more exact, the payback
period is approximately 6.5 years.

2. Since the investment is recovered prior to the last year, the amount of the cash inflow in the last year
has no effect on the payback period.

Exercise 13-6 (10 minutes)

This is a cost reduction project, so the simple rate of return would be computed as follows:

Cost of the new machine .................... $120,000

Scrap value of old machine ................. 40,000
Initial investment................................ $ 80,000
Operating cost of old machine ............. $ 30,000
Operating cost of new machine ........... 12,000
Annual cost savings ............................ $ 18,000
Cost of new machine .......................... $120,000
Less salvage value .............................. 0
Depreciable cost of new machine ........ 120,000
Useful life of new machine .................. 10 years
Annual depreciation on new machine ... $ 12,000 per year
 Annual cost savings - Annual depreciation
Simple rate = on new equipment
of return Initial investment
$18,000 - $12,000
= = 7.5%
$80,000

Problem 13-7 (20 minutes)

Present
Amount of 20% Value of
Item Year(s) Cash Flows Factor Cash Flows
Cost of new equipment ............ Now R(275,000) 1.000 R(275,000)
Working capital required .......... Now R(100,000) 1.000 (100,000)
Net annual cash receipts .......... 1-4 R120,000 2.589 310,680
Cost to construct new roads ..... 3 R(40,000) 0.579 (23,160)
Salvage value of equipment ...... 4 R65,000 0.482 31,330
Working capital released .......... 4 R100,000 0.482 48,200
Net present value .................... R (7,950)

No, the project should not be accepted; it has a negative net present value at a 20% discount rate. This
means that the rate of return on the investment is less than the company’s required rate of return of
20%.

Exercise 13-11 (10 minutes)

Amount of 14% Present

Year(s) Cash Flows Factor Value of
 Cash Flows
Purchase of the stock ..... Now $(13,000) 1.000 $(13,000)
Annual cash dividends .... 1-3 $420 2.322 975
Sale of the stock ............ 3 $16,000 0.675 10,800
Net present value .......... $ (1,225)

No, Kathy did not earn a 14% return on the Malti Company stock. The negative net present value
indicates that the rate of return on the investment is less than the minimum required rate of return of
14%.

Exercise 13-12 (15 minutes)

1. Computation of the annual cash inflow associated with the new pinball machines:
Net operating income ............................................ $40,000
Add noncash deduction for depreciation .................. 35,000
Net annual cash inflow........................................... $75,000
The payback computation would be:
Investment required
Payback period =
Net annual cash inflow
$300,000
= = 4.0 years
$75,000 per year
Yes, the pinball machines would be purchased. The payback period is less than the maximum 5 years
required by the company.

2. The simple rate of return would be:

 Annual incremental - Annual incremental expenses,
Simple rate = revenues including depreciation
of return Initial investment
Annual incremental net income
=
Initial investment
$40,000
= = 13.3%
$300,000

Yes, the pinball machines would be purchased. The 13.3% return exceeds 12%.

Exercise 13-14 (20 minutes)

1. Annual cost of operating the present equipment ....... $85,000

Annual cost of the new dishwashing machine:
Cost for wages of operators .................................. $48,000
Cost for maintenance ........................................... 2,000 50,000
Net annual cost savings (cash inflow) ...................... $35,000

2. The net present value analysis would be as follows:

(1)×(2) Present
After-Tax Value of
(1) (2) Cash 14% Cash
Items and Computations Year(s) Amount Tax Effect Flows Factor Flows
Cost of the new dishwashing machine .. Now $(140,000) — $(140,000) 1.000 $(140,000)
Net annual cost savings (above) .......... 1-12 $35,000 1 – 0.30 $24,500 5.660 138,670
Depreciation deductions* .................... 1-7 $20,000 0.30 $6,000 4.288 25,728
Cost of the new water jets .................. 6 $(15,000) 1 – 0.30 $(10,500) 0.456 (4,788)
Salvage value of the new machine ....... 12 $9,000 1 – 0.30 $6,300 0.208 1,310
Net present value ............................... $ 20,920
*$140,000 ÷ 7 years = $20,000 per year
Yes, the new dishwashing machine should be purchased.

Exercise 13-15 (15 minutes)

1. The payback period would be:
Investment required
Payback period =
Net annual cash inflow
¥432,000
= = 4.8 years
¥90,000
No, the equipment would not be purchased, since the payback period (4.8 years) exceeds the
company’s maximum payback time (4.0 years).

2. The simple rate of return would be:

Annual cost savings - Annual depreciation
Simple rate of return =
Initial investment
¥90,000 - ¥36,000*
= = 12.5%
¥432,000
*¥432,000 ÷ 12 years = $36,000 per year.
No, the equipment would not be purchased, since its 12.5% rate of return is less than the company’s
14% required rate of return.
Problem 13-16 (30 minutes)
1. The income statement would be:
Sales revenue............................................ $300,000
Less variable expenses:
Cost of ingredients (20% × $300,000) ..... $60,000
Commissions (12.5% × $300,000) ........... 37,500 97,500
Contribution margin ................................... 202,500
Less operating expenses:
Salaries .................................................. $70,000
Rent ($3,500 × 12) ................................. 42,000
Depreciation* ......................................... 16,800
Insurance ............................................... 3,500
Utilities ................................................... 27,000 159,300
Net operating income ................................ $ 43,200
* $270,000 – $18,000 = $252,000
$252,000 ÷ 15 years = $16,800 per year.

2. The formula for the simple rate of return is:

Annual incremental net operating income
Simple rate of return =
Initial investment
$43,200
= = 16.0%
$270,000
Yes, the franchise would be acquired since it promises a rate of return in excess of 12%.
Problem 13-16 (continued)
3. The formula for the payback period is:
Investment required
Payback period =
Net annual cash inflow
$270,000
= = 4.5 years
$60,000*
*$43,200 Net operating income + $16,800 Depreciation =
$60,000 Net annual cash inflow
According to the payback computation, the franchise would not be acquired. The 4.5 years payback is
greater than the maximum 4 years allowed. Payback and simple rate of return can give conflicting
signals as in this example.

Problem 13-17 (60 minutes)

1. Factor of the internal Investment required

=
rate of return Net annual cash inflow
$330,000
= = 4.125
$80,000
From Table 14C-4, reading along the 9-period line, a factor of 4.125 is closest to 19%.

2. Factor of the internal Investment required

=
rate of return Net annual cash inflow

We know the investment is $330,000, and we can determine the factor for an internal rate of return
 of 14% by looking in Table 14C-4 along the 9-period line. This factor is 4.946. Using these figures in
the formula, we get:
$330,000
= 4.946
Net annual cash inflow
Therefore, the annual cash inflow would be: $330,000 ÷ 4.946 = $66,721.

3. a. 6-year useful life:

The factor for the internal rate of return would still be 4.125 [as computed in (1) above]. From
Table 14C-4, reading along the 6-period line, a factor of 4.125 falls closest to 12%.

b. 12-year useful life:

The factor of the internal rate of return would again be 4.125. From Table 14C-4, reading along
the 12-period line, a factor of 4.125 falls closest to 22%.
Problem 13-17 (continued)
The 12% return in part (a) is less than the 14% minimum return that Ms. Winder wants to earn on
the project. Of equal or even greater importance, the following diagram should be pointed out to Ms.
Winder:

As this illustration
shows, a decrease in years
3 years shorter 3 years longer has a much greater impact
6 9 12
on the rate of return than
Years Years Years an increase in years. This is
12% 19% 22% because of the time value
A decrease An increase of of money; added cash
of 7% 3% inflows far into the future
do little to enhance the rate
of return, but loss of cash
inflows in the near term
can do much to reduce it.
Therefore, Ms. Winder should be very concerned about any potential decrease in the life of the
equipment, while at the same time realizing that any increase in the life of the equipment will do little
to enhance her rate of return.

Problem 13-17 (continued)

4. a. The expected annual cash inflow would be:
$80,000 × 80% = $64,000.
 $330,000
= 5.156 (rounded)
$64,000
From Table 14C-4, reading along the 9-period line, a factor of 5.156 is closest to 13%.

b. The expected annual cash inflow would be:

$80,000 × 120% = $96,000.

$330,000
= 3.438 (rounded)
$96,000
From Table 14C-4, reading along the 9-period line, a factor of 3.438 is closest to 25%.

Unlike changes in time, increases and decreases in cash flows at a given point in time have basically
the same impact on the rate of return, as shown below:

20% decrease 20% increase

$64,000 $80,000 $96,000
Cash Inflow Cash Inflow Cash Inflow
13% 19% 25%

A decrease An increase
of 6% of 6%
Problem 13-17 (continued)
5. Since the cash flows are not even over the 8-year period (there is an extra $135,440 cash inflow from
sale of the equipment at the end of the eighth year), some other method has to be used to compute
the internal rate of return. Using trial-and-error or more sophisticated methods, it turns out that the
internal rate of return is 10%. This can be verified by computing the net present value of the project,
which is zero at the discount rate of 10%, as shown below:

Present
Amount of 10% Value of
Item Year(s) Cash Flows Factor Cash Flows
Investment in the equipment . Now $(330,000) 1.000 $(330,000)
Annual cash inflow ................ 1-8 $50,000 5.335 266,750
Sale of the equipment ........... 8 $135,440 0.467 63,250
Net present value ........................................................... $ 0