AQ3 - WCNet



Solution: Acct 2220 Zeigler - AQ #3 - Chp 10 (15 Pts)

Note: For Examination #2, Handout #1 (Table factors) will be provided, but the “Key Formulas” will not.

Note: Only a basic $2 calculator may be used for Exam #2. No Phones, TI, or equivalent calculators allowed.

____ 1. All of the following are capital investment decisions except:

A. acquiring $100,000 of common stock.

B. buying a $5,000,000 manufacturing plant.

C. purchasing equipment for $80,000.

D. paying $600,000 to renovate a restaurant.

____ 2. The rate of return that equates the present value of cash inflows with cash outflows (i.e. where NPV is zero) is: 

A. The minimum rate of return.

B. The internal rate of return. (pg 304/308: use Key Formula #2 for equal cash flows; Excel for unequal)

C. The desired rate of return.

D. The maximum rate of return.

3. (2 pts) Burgess & Blausey, Inc. is evaluating a capital investment project. They calculated the net present value (NPV) using their minimum required rate of return of 12%. Using this rate, the net present value is slightly negative. Zeigler, an enthusiatic intern, proclaimed “this finding indicates a loss and, accordingly, the project should not be funded under any circumstances”. Do you agree with the intern? Clearly state your position on this matter to top management.  

If the net present value is negative, the project should not go forward on a quantitative basis as the expected rate of return for the project is less than the minimum required rate of return. If slightly negative, the project may still earn say… 11%, but does not meet the minimum required rate of return in this case. Per class discussion, this does not indicate a “loss” and the firm may still choose to go forward with the project (possibly on some qualitative basis) even though the minimum desired rate of return is not met.

  

Use the following to complete questions 4 & 5 only:

Magnacca, Inc. is considering two unique projects, A and B. The following estimates are available:

 [pic] 

4. What is the net present value (NPV) for Project A? Would this be an acceptable investment on a quantitative basis? 

Net present value = $84,360[pic]$77,000 = $7,360. Because net present value is positive, the project is acceptable.

5. Which one of the two projects should be recommended based solely upon the use of the “Present Value Index”?

Project A: $84,360 / $77,000 = 1.096

Project B: $55,100 / $49,000 = 1.125 (Higher PV Index supports the choice of Project B on a quantitative basis)

____ 6. Burkhardt, Inc. is considering a capital investment project. Which statement BEST describes the relevance of depreciation when calculating cash flows for any Time Value of Money (TVM) analysis?

a. Depreciation is relevant only when addressing a “pre-tax” TVM analysis.

b. Depreciation is relevant only when addressing a “post-tax” TVM analysis.

c. Depreciation is always relevant with any TVM analysis.

d. Depreciation is never relevant with any TVM analysis.

Use the following to complete questions 7-14 (* NOTE: Show all work and circle all answers *):

McKinnon, Allen, McKenzie & Southard, Inc. is considering the purchase of equipment that would cost $45,000, have no salvage value, and offer annual cost savings of $10,500 over an 8-year useful life. In anticipation of the upcoming simulation competition, mgmt predicts high profits and will therefore require a 20% minimum rate of return for its shareholders. Where applicable, the company uses straight-line depreciation.

7. Determine the pre-tax net present value (NPV). Should the company make this investment on a quantitative basis? Show all work and explain.

Using Key Formula #1, and Table 2 (Annuity here), NPV @ 20% = 10,500 * 3.837160 = $40,290 - $45,000 invest today = ($4,710) = Reject on a quantitative basis.

8. Is/Was the preparation of an income statement required to determine your pre-tax answer above? YES NO

Clearly explain.

No, this is a pre-tax analysis. Preparation of an income stmt is only required to compute income taxes. This would be required to determine the after-tax cash flows to be expected for the project.

9. Using a “Key Formula” and the factor tables, what would be the approximate Internal Rate of Return on this project (expressed as a whole percentage)? Key Formula #2: Approximately 16+% ($45,000 / $10,500 = 4.285714 Factor)

NOTE: The exact IRR (practice yourself using our Web-based Excel IRR Calculator) would be 16.418%

10. Using a “Key Formula” and the factor tables, what would be the minimum annual cost savings that the equipment must offer for the investment to be acceptable given the 18% pre-tax required rate of return as determined by mgmt?

Key Formula #3: Investment / Factor (i.e. 20% factor here) = 45,000 / 3.837160 = $11,727 minimum benefit / yr

Compare this higher (minimum) amount to the $10,500 annual benefit in the original facts. NOTE: You can prove this by repeating the IRR analysis used in question #9 (using the minimum amount determined in this question) and/or plugging into the IRR Excel Calculator (see class website).

11. IF a salvage value were expected at the end of the useful life of the machine, with all original facts remaining

the same, the NPV (and therefore, the expected rate of return) would be:

a. Higher

b. Lower

This is specifically due to: an additional one-time cash inflow at end of the equipment’s useful life.

12. IF income taxes were involved, with all original facts remaining the same, the NPV and expected rate of return

of this project would be:

a. Higher

b. Lower

This is specifically due to: income tax cash outflows. The pre-tax benefit per period would be subject to taxation. An income stmt (Handout #4) is prepared solely to determine the effects of depreciation deductions on taxable income, and the payment of tax. The difference between pre-tax and post-tax cash flows is the income tax paid.

13. Based on the original facts, what would be the “Payback” period? Ignore taxes and circle (and label) your answer.

- Same as Key Formula #2, but with different meaning as no TVM considerations are present or considered (pg 316).

- Investment / Periodic (annual) Cash benefit (net inflow) = $45,000 / 10,500 = 4.29 years to recoup the investment.

14. Based on the original facts, what would be the “Unadjusted Rate of Return” (based upon average investment). Ignore taxes and circle your answer.

NOTE: Again, NO TVM principles are used here. This is an accrual-basis determination (see pg 317)

Average Incremental increase in annual net income / (Net Cost of original investment / 2)

= $10,500 - $5,625 depr = (annual increase of $4,875 in profit on the Income Stmt) / ($45,000/2)

= $4,875 / $22.500 = ~22% See page 314 for more discussion.

Again, for Examination #2, only Handout #1 (Table factors) will be provided.

Further, only a $2 basic calculator is allowed (no TI, phone or equivalent calculator may be used).

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