P10–1 Payback period Jordan Enterprises is considering a capital expenditure that requires an initial investment of $42,000 and returns after-tax cash inflows of $7,000 per year for 10 years. The firm has a maximum acceptable payback period of 8 years.
- Determine the payback period for this project.
- Should the company accept the project? Why or why not?
P10–5 NPV Calculate the net present value (NPV) for the following 15-year projects. Comment on the acceptability of each. Assume that the firm has a cost of capital of 9%.
- Initial investment is $1,000,000; cash inflows are $150,000 per year.
- Initial investment is $2,500,000; cash inflows are $320,000 per year.
- Initial investment is $3,000,000; cash inflows are $365,000 per year.
P10–22 Payback, NPV, and IRR Rieger International is attempting to evaluate the feasibility of investing $95,000 in a piece of equipment that has a 5-year life. The firm has estimated the cash inflows associated with the proposal as shown in the following table.The firm has a 12% cost of capital.
Year (t) Cash inflows (CFt)
1 $20,000
2 25,000
3 30,000
4 35,000
5 40,000
- Calculate the payback period for the proposed investment.
- Calculate the net present value (NPV) for the proposed investment.
- Calculate the internal rate of return (IRR), rounded to the nearest whole percent,
for the proposed investment.
- Evaluate the acceptability of the proposed investment using NPV and IRR. What
recommendation would you make relative to implementation of the project? Why?
P11–3 Expansion versus replacement cash flows Edison Systems has estimated the cash
flows over the 5-year lives for two projects, A and B. These cash flows are summarized
in the table below.
Project A Project B
Initial investment $40,000 $12,000
Year Operating cash inflows
1 $10,000 $ 6,000
2 12,000 6,000
3 14,000 6,000
4 16,000 6,000
5 10,000 6,000
After-tax cash inflow expected from liquidation.
- If project A were actually a replacement for project B and the $12,000 initial investment
shown for project B were the after-tax cash inflow expected from liquidating
it, what would be the relevant cash flows for this replacement decision?
- How can an expansion decision such as project A be viewed as a special form of
a replacement decision? Explain.
P11–12 Initial investment: Basic calculation Cushing Corporation is considering the purchase
of a new grading machine to replace the existing one. The existing machine was purchased
3 years ago at an installed cost of $20,000; it was being depreciated under
MACRS using a 5-year recovery period. (See Table 4.2 on page 120 for the applicable
depreciation percentages.) The existing machine is expected to have a usable life of at
least 5 more years. The new machine costs $35,000 and requires $5,000 in installation
costs; it will be depreciated using a 5-year recovery period under MACRS. The existing machine can currently be sold for $25,000 without incurring any removal or cleanup costs. The firm is subject to a 40% tax rate. Calculate the initial investment associated with the proposed purchase of a new grading machine.
P12–2 Breakeven cash inflows The One Ring Company, a leading producer of fine cast silver
jewelry, is considering the purchase of new casting equipment that will allow it to expand
its product line. The up-front cost of the equipment is $750,000. The company
expects that the equipment will produce steady income throughout its 10-year life.
- If One Ring requires a 9% return on its investment, what minimum yearly cash
inflow will be necessary for the company to go forward with this project?
- How would the minimum yearly cash inflow change if the company required a
12% return on its investment?
INTEGRATION CASES: LASTING IMPRESSIONS ON COMPANY
Lasting Impressions (LI) Company is a medium-sized commercial printer of promotional
advertising brochures, booklets, and other direct-mail pieces. The
firm’s major clients are ad agencies based in New York and Chicago. The typical job
is characterized by high quality and production runs of more than 50,000 units. LI
has not been able to compete effectively with larger printers because of its existing
older, inefficient presses. The firm is currently having problems meeting run length
requirements as well as meeting quality standards in a cost-effective manner.
The general manager has proposed the purchase of one of two large, six-color
presses designed for long, high-quality runs. The purchase of a new press would enable
LI to reduce its cost of labor and therefore the price to the client, putting the
firm in a more competitive position. The key financial characteristics of the old press
and of the two proposed presses are summarized in what follows.
Old press Originally purchased 3 years ago at an installed cost of $400,000, it
is being depreciated under MACRS using a 5-year recovery period. The old
press has a remaining economic life of 5 years. It can be sold today to net
$420,000 before taxes; if it is retained, it can be sold to net $150,000 before
taxes at the end of 5 years.
Press A This highly automated press can be purchased for $830,000 and will
require $40,000 in installation costs. It will be depreciated under MACRS using
a 5-year recovery period. At the end of the 5 years, the machine could be sold to
net $400,000 before taxes. If this machine is acquired, it is anticipated that the
current account changes shown in the following table would result.
Integrative Case 5
Cash + $ 25,400
Accounts receivable + 120,000
Inventories – 20,000
Accounts payable + 35,000
Press B This press is not as sophisticated as press A. It costs $640,000 and
requires $20,000 in installation costs. It will be depreciated under MACRS using
a 5-year recovery period. At the end of 5 years, it can be sold to net
$330,000 before taxes. Acquisition of this press will have no effect on the firm’s
net working capital investment.
The firm estimates that its earnings before depreciation, interest, and taxes with
the old press and with press A or press B for each of the 5 years would be as shown
in the table at the top of the next page. The firm is subject to a 40% tax rate. The
firm’s cost of capital, r, applicable to the proposed replacement is 14%.
Earnings before Depreciation, Interest, and Taxes
for Lasting Impressions Company’s Presses
Year Old press Press A Press B
1 $120,000 $250,000 $210,000
2 120,000 270,000 210,000
3 120,000 300,000 210,000
4 120,000 330,000 210,000
5 120,000 370,000 210,000
TO DO
- For each of the two proposed replacement presses, determine:
(1) Initial investment.
(2) Operating cash inflows. (Note: Be sure to consider the depreciation in year 6.)
(3) Terminal cash flow. (Note: This is at the end of year 5.)
- Using the data developed in part a, find and depict on a time line the relevant
cash flow stream associated with each of the two proposed replacement presses,
assuming that each is terminated at the end of 5 years.
- Using the data developed in part b, apply each of the following decision techniques:
(1) Payback period. (Note: For year 5, use only the operating cash inflows—that
is, exclude terminal cash flow—when making this calculation.)
(2) Net present value (NPV).
(3) Internal rate of return (IRR).
- Draw net present value profiles for the two replacement presses on the same set
of axes, and discuss conflicting rankings of the two presses, if any, resulting from
use of NPV and IRR decision techniques.
- Recommend which, if either, of the presses the firm should acquire if the firm has
(1) unlimited funds or (2) capital rationing.
- The operating cash inflows associated with press A are characterized as very
risky in contrast to the low-risk operating cash inflows of press B. What impact
does that have on your recommendation?
