Finance & Managerial Accounting
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1. We have three possible projects and we can invest in only one project. Suppose our weighted cost of capital is 7% and each project requires an investment of $10,000. Using payback, NPV and IRR decide which project we should select and explain why.
Project Year 1 Year 2 Year 3 Year 4
A $9,000 42,000 $1,000 $0
B 4,000 4,000 4,000 12,000
C 0 10,000 4,000 11,000
2. For many years Futura Company has purchased the starters that it installs in its standard line of farm tractors. Due to a reduction in output, the company has idle capacity that could be used to produce the starters. The chief engineer has recommended against the move, however, pointing out that the cost to produce the starters would be greater than the current $8.40 per unit purchase price.
Per Unit Total
Direct materials $3.10
Direct labor 2.70
Supervision 1.50 $60,000
Depreciation 1.00 40,000
Variable manufacturing overhead 0.60
Rent 0.30 12,000
Total production cost $9.20
A supervisor would have to be hired to oversee production of the starters. However, the company has sufficient idle tools and machinery that no new equipment would have to be purchased. The rent charge above is based on space utilized in the plant. The total rent on the plant is $80,000 per period. Depreciation is due to obsolescence rather than wear and tear. Prepare computations showing how much profits will increase or decrease as a result of making the starters.
3. Compare and contrast the direct and the indirect method of creating a statement of cash flows.
See attached file for full problem description.
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Solution Summary
The solution has problems relating to capital budgeting, make or buy and statement of cash flows
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1. We have three possible projects and we can invest in only one project. Suppose our weighted cost of capital is 7% and each project requires an investment of $10,000. Using payback, NPV and IRR decide which project we should select and explain why.
Project Year 1 Year 2 Year 3 Year 4
A $9,000 42,000 $1,000 $0
B 4,000 4,000 4,000 12,000
C 0 10,000 4,000 11,000
Payback period is the time taken to recover the initial investment. The initial investment is $10,000
Project A - We recover $9,000 in year 1, leaving $1,000 to be recovered in year 2. Time taken in year 2 to recover 1,000 is 1,000/42,000= 0.02 years. The payback period is 1.02 years.
Project B - We recover 8,000 in 2 years and the remaining 2,000 is recovered in year 3. Time taken in year 3 is 2,000/4,000=0.5 years. The payback period is 2.5 years
Project C - 10,000 is recovered in year 2 so the payback period is 2 years
Using Payback the project selected will be A
IRR - IRR is the rate that will make the present value of inflows equal to the initial investment. IRR can be found using trial and error method or using the IRR function in excel. Using excel (see the attached file), the IRR for the various projects comes to
IRR
Project A 155.8%
Project B 37.1%
Project C 37.0%
Using IRR the project selected is A
NPV - In NPV ...
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