# Capital Budgeting decisions - NPV, Ranking, payback, return

Capital Budget Decisions

Chapter 12

1. Exercise 12-11 Net Present Value Analysis of Competing Projects, p.529.

Wriston Legacies, a retailer of fine estate jewelry, has $300,000 to invest. The company is trying to decide between two alternative uses of the funds. The alternatives are:

Project A Project B

Cost of equipment required..................................... $300,000 $0

Working capital investment required......................... $0 $300,000

Annual cash inflows.............................................. $80,000 $60,000

Salvage value of equipment in seven years................ $20,000 $0

Life of the project................................................. 7 years 7 years

The working capital needed for project B will be released for investment elsewhere at the end of seven years. Wriston Legacies uses a 20% discount rate.

Required:

Which investment alternative (if either) would you recommend that the company accept? Show all computations using the net present value method. Prepare separate computations for each project.

2. Problem 12-13A Ranking of Projects, p. 530.

Oxford Company has limited funds available for investment and must ration the funds among four competing projects. Selected information on the four projects follows:

Investment Net Present Life of the

Project Required Value Project (years)

A.......................................................... $140,000 $42,000 8

B.......................................................... $190,000 $49,400 14

C.......................................................... $175,000 $49,000 9

D.......................................................... $138,000 $31,740 3

The company wants your assistance in ranking the desirability of the projects.

Required:

1. Compute the project profitability index for each project.

2. In order of preference, rank the four projects in terms of:

a. Net present value

b. Project profitability index

3. Which ranking do you prefer? Why?

3. Problem 12-16A Simple Rate of Return and Payback Methods, p. 531.

Otthar's Amusement Center contains a number of electronic games as well as a miniature golf course and various rides located outside the building. Otthar Luvinson, the owner, would like to construct a water slide on one portion of his property. Otthar has gathered the following information about the slide:

a. Water slide equipment could be purchased and installed at a cost of $500,000. The slide would be usable for 10 years, after which it would have no salvage value.

b. Otthar would use straight-line depreciation on the slide equipment.

c. To make room for the water slide, several rides would be dismantled and sold. These rides are fully depreciated, but they could be sold for $40,000 to an amusement park in a nearby city.

d. Otthar has concluded that water slides would increase ticket sales by $320,000 per year.

e. On the basis of experience at the other water slides, Otthar estimates that annual incremental operating expenses for the slide would be: salaries, $115,000; insurance, $28,200; utilities, $12,000; and maintenance, $32,000.

Required:

1. Prepare an income statement showing the expected net operating income each year from the water slide.

2. Compute the simple rate of return expected from the water slide. On the basis of this computation, would the water slide be constructed if Otthar requires a simple rate of return of at least 15% on all investments?

3. Compute the payback period for the water slide. If Otthar accepts any project with a payback period of 5 years or less, would the water slide be constructed?

4. Problem 12-18A Net Present Value Analysis of Securities, p. 532.

Anita Vasquez received $160,000 from her mother's estate. She placed the funds in the hands of a broker, who purchased the following securities on Anita's behalf:

a. Common stock was purchased at a cost of $80,000. The stock paid no dividends, but was sold for $180,000 at the end of 4 years.

b. Preferred stock was purchased at its par value of $30,000. The stock paid 6% dividend (based on par value) each year for 4 years. At the end of 4 years, the stock sold for $24,000.

c. Bonds were purchased at a cost of $58,500. (Note: In discounting a cash flow that occurs semi-annually, the procedure is to halve the discount rate and double the number of periods. Use the same procedure in discounting the proceeds from the sale.)

The securities were sold at the end of four years so that Anita would have funds available to start a new business venture. The broker stated that the investments had earned more than 20% return, and he gave Anita the following computation to support his statement:

Common stock:

Gain on sale ($180,000 - $80,000)........................ $100,000

Preferred stock gain:

Dividends paid (6% X $30,000 X 4 years)............... 7,200

Loss on sale ($24,000 - $30,000)......................... (6,000)

Bonds:

Interest paid ($3,000 X 8 periods)......................... 24,000

Gain on sale ($58,500 - $50,000).......................... 8,500

Net gain on all investments................................... $133,700

$133,700/4 years

$160,000 = 20.9%

Required:

1. Using a 20% discount rate, compute the net present value of each of the three investments. On which investment(s) did Anita earn a 20% rate of return? (Round computations to the nearest whole dollar.)

2. Considering all three investments together, did Anita earn a 20% rate of return? Explain.

3. Anita wants to use the $262,500 proceeds ($180,000 + $24,000 + $58,500 = $262,500) from sale of the securities to open a fast-food franchise under a 10-year contract. What net annual cash inflow must the store generate for Anita to earn a 16% return over the 10-year period? Anita will not receive back her original investment at the end of the contract. (Round computations to the nearest whole dollar.)

5. Problem 12-19A Simple Rate of Return and Payback Analyses of Two Machines, pp. 532-533.

Blue Ridge Furniture is considering the purchase of two different items of equipment, as described below:

1. Machine A. A compacting machine has just come onto the market that would permit Blue Ridge Furniture to compress sawdust into various shelving products. At present the sawdust is disposed of as a waste product. The following information is available about the machine:

a. The machine would cost $780,000 and would have a 25% salvage value at the end of its 10-year useful life. The company uses straight-line depreciation and considers salvage value in computing depreciation deductions.

b. The shelving products manufactured from use of the machine would generate revenues of $350,000 per year. Variable manufacturing costs would be 20% of sales.

c. Fixed expenses associated with the new shelving products would be (per year): advertising, $42,000; salaries, $86,000; utilities, $9,000; and insurance, $13,000.

2. Machine B. A second machine has come onto the market that would allow Blue Ridge Furniture to automate a sanding process that is now done largely by hand. The following information is available:

a. The new sanding machine would cost $220,000 and would have no salvage value at the end of its 10-year useful life. The company would use straight-line depreciation on the new machine.

b. Several old pieces of sanding equipment that are fully depreciated would be disposed of at salvage value of $7,200.

c. The new sanding machine would provide substantial annual savings in cash operating costs. It would require an operator at an annual salary of $26,000 and $3,000 in annual maintenance costs. The current, hand-operated sanding procedure costs the company $85,000 per year in total.

Blue Ridge Furniture requires a simple rate of return of 16% on all equipment purchases. Also, the company will not purchase equipment unless the equipment has a payback period of 4 years or less.

Required:

1. For machine A:

a. Prepare a contribution format income statement showing the expected net operating income each year from the new shelving products.

b. Compute the simple rate of return.

c. Compute the payback period.

2. For machine B:

a. Compute the simple rate of return.

b. Compute the payback period

3. According to the company's criteria, which machine, if either, should the company purchase?

Building Your Skills

1. Analytical Thinking, pp. 534-535.

Wyndham Stores operates a regional chain of upscale department stores. The company is going to open another store soon in a prosperous and growing suburban area. In discussing how the company can acquire the desired building and other facilities needed to open the new store, Harry Wilson, the company's marketing vice president, stated, "I know most of our competitors are starting to lease facilities, rather than buy, but I just can't see the economics of it. Our developments people tell me that we can buy the building sit, put a building on it, and get all the store fixtures we need for $14 million. When you figure that we plan to keep a site for 20 years, that's a total cost of $18 million. But then when you realize that the building and property will be worth at least $5 million in 20 years, that's a net cost to us of only $13 million. Leasing costs a lot more than that.

"I'm not so sure," replied Erin Reilley, the company's executive vice president. "Guardian Insurance Company is willing to purchase the building site, construct a building and install fixtures to our specifications, and then lease the facility to us for 20 years for an annual lease payment of only $1 million."

"That's just my point," said Harry. "At $1 million a year, it would cost us $20 million over the 20 years instead of just $13 million. And what would we have left at the end? Nothing! The building would belong to the insurance company! I'll bet they would even want the first lease payment in advance."

"That's right," replied Erin. "We would have to make the first payment immediately and then one payment in the beginning of each of the following 19 years. However, you're overlooking a few things. For one thing, we would have to tie up a lot of our funds for 20 years under the purchase alternative. We would have to put $6 million down immediately if we buy the property, and then we would have to pay the other $8 million off over four years at $2 million a year."

"But that cost is nothing compared to $20 million for leasing," said Harry. "Also, if we lease, I understand we would have to put up a $400,000 security deposit that we wouldn't get back until the end. And besides that, we would still have to pay all the repair and maintenance costs just like we owned the property. No wonder those insurance companies are so rich if they can swing deals like this."

"Well, I'll admit that I don't have all the figures sorted out yet," replied Erin. "But I do have the operating cost breakdown for the building, which includes $90,000 annually for property taxes, $60,000 for insurance, and $50,000 for repairs and maintenance. If we lease, Guardian will handle its own insurance costs and will pay the property taxes, but we'll have to pay for the repairs and maintenance. I need to put all this together and see if leasing makes any sense with our 12% before-tax required rate of return. The president wants a presentation and recommendation in the executive committee meeting tomorrow."

Required:

1. Using the net present value approach, determine whether Wyndham Stores should lease or buy the new store.

2. How will you reply in the meeting if Harry Wilson brings up the issue of the building's future sales value?

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#### Solution Preview

See the attached file for complete solution. The text here may not be copied exactly as some of the symbols / tables may not print. Thanks

"Exercise 12-11 Net Present Value Analysis of Competing Projects

Wriston Legacies, a retailer of fine estate jewelry, has $300,000 to invest. The company is trying to decide between two alternative uses of the funds. The alternatives are:

"

Project A Project B

Cost of equipment required..................................... $300,000 $0

Working capital investment required......................... $0 $300,000

Annual cash inflows.............................................. $80,000 $60,000

Salvage value of equipment in seven years................ $20,000 $0

Life of the project................................................. 7 years 7 years

The working capital needed for project B will be released for investment elsewhere at the end of seven years. Wriston Legacies uses a 20% discount rate.

"Required:

Which investment alternative (if either) would you recommend that the company accept? Show all computations using the net present value method. Prepare separate computations for each project.

"

Cash Flows associated with Project A

Year Capital Investment Working Capital Salvage Value Revenues/Savings Net Cash Flows

0 $300,000 $0 ($300,000)

1 $80,000 $80,000

2 $80,000 $80,000

3 $80,000 $80,000

4 $80,000 $80,000

5 $80,000 $80,000

6 $80,000 $80,000

7 $20,000 $80,000 $100,000

Discount Rate 20%

NPV ($6,051.03)

Project A is rejected as the NPV is negative.

Cash Flows associated with Project B

Year Capital Investment Working Capital Salvage Value Revenues/Savings Net Cash Flows

0 $0 $300,000 ($300,000)

1 $60,000 $60,000

2 $60,000 $60,000

3 $60,000 $60,000

4 $60,000 $60,000

5 $60,000 $60,000

6 $60,000 $60,000

7 ($300,000) $0 $60,000 $360,000

Discount Rate 20%

NPV $0.00

Project B is just acceptable as the NPV is zero.

There is just one project which is acceptable at 20% required rate of return, which is project B.

Hence project B is recommended.

"Problem 12-13A Ranking of Projects, p. 530.

Oxford Company has limited funds available for investment and must ration the funds among four competing projects. Selected information on the four projects follows:

"

Investment Net Present Life of the

Project Required Value Project (years)

A.......................................................... $140,000 $42,000 8

B.......................................................... $190,000 $49,400 14

C.......................................................... $175,000 $49,000 9

D.......................................................... $138,000 $31,740 3

The company wants your assistance in ranking the desirability of the projects.

Required:

1. Compute the project profitability index for each project.

Profitability Index = NPV/Investment Required

Investment Net Present Life of the Profitability Rank based Rank based

Project Required Value Project (years) Index on NPV on PI

A.......................................................... $140,000 $42,000 8 0.30 1 3

B.......................................................... $190,000 $49,400 14 0.26 3 1

C.......................................................... $175,000 $49,000 9 0.28 2 2

D.......................................................... $138,000 $31,740 3 0.23 4 4

2. In order of preference, rank the four projects in terms of:

a. Net present value See the table above

b. Project profitability index See the table above

3. Which ranking do you prefer? Why?

Since the company has limited funds available for investment and must ration the funds among the four competing projects, the profitability index approach is better as NPV does not consider the amount of investment, whereas the profitability Index method considers the amount of investment and ranks the projects based on the amount of cash inflow generated for each dollar of investment.

Problem 12-16A Simple Rate of Return and Payback Methods

Otthar's Amusement Center contains a number of electronic games as well as a miniature golf course and various rides located outside the building. Otthar Luvinson, the owner, would like to construct a water slide on one portion of his property. Otthar has gathered the following information about the slide:

a. Water slide equipment could be purchased and installed at a cost of $500,000. The slide would be usable for 10 years, after which it would have no salvage value.

b. Otthar would use straight-line depreciation on the slide equipment.

c. To make room for the water slide, several rides would be dismantled and sold. These rides are fully ...

#### Solution Summary

This post answers following questions on Capital Budget Decisions - Wriston Legacies, Oxford, Otthar's, Blue Ridge, Wyndham . E12-11, P12-13A, P12-16A, P12-18A, P12-19A, and case on analytical thinking. This post can be used as a good practice for capital budgeting decisions questions for exam preparation.