Questions -
Q1. Palo Alto Corporation is considering purchasing a new delivery truck. The truck has many advantages over the company's current truck (not the least of which is that it runs). The new truck would cost $55,950. Because of the increased capacity, reduced maintenance costs, and increased fuel economy, the new truck is expected to generate cost savings of $8,560. At the end of 8 years the company will sell the truck for an estimated $27,610. Traditionally the company has used a rule of thumb that a proposal should not be accepted unless it has a payback period that is less than 50% of the asset's estimated useful life. Larry Newton, a new manager, has suggested that the company should not rely solely on the payback approach, but should also employ the net present value method when evaluating new projects. The company's cost of capital is 8%.
(Refer the below table).
Compute the cash payback period and net present value of the proposed investment.
Q2. Doug's Custom Construction Company is considering three new projects, each requiring an equipment investment of $23,320. Each project will last for 3 years and produce the following net annual cash flows.
|
Year
|
AA
|
BB
|
CC
|
|
1
|
$7,420
|
$10,600
|
$13,780
|
|
2
|
9,540
|
10,600
|
12,720
|
|
3
|
12,720
|
10,600
|
11,660
|
|
Total
|
$29,680
|
$31,800
|
$38,160
|
The equipment's salvage value is zero, and Doug uses straight-line depreciation. Doug will not accept any project with a cash payback period over 2 years. Doug's required rate of return is 12%. (Refer the below table)
Compute each project's payback period.
Which is the most desirable project?
Which is the least desirable project?
Q3. Henkel Company is considering three long-term capital investment proposals. Each investment has a useful life of 5 years. Relevant data on each project are as follows.
|
Project Kilo
|
Project Lima
|
Project Oscar
|
|
Capital investment
|
$167,400
|
$178,200
|
$200,850
|
|
Annual net income:
|
|
|
|
|
Year 1
|
14,040
|
18,900
|
29,700
|
|
2
|
14,040
|
17,820
|
24,300
|
|
3
|
14,040
|
16,740
|
23,220
|
|
4
|
14,040
|
12,420
|
14,580
|
|
5
|
14,040
|
9,180
|
13,500
|
|
Total
|
$70,200
|
$75,060
|
$105,300
|
Depreciation is computed by the straight-line method with no salvage value. The company's cost of capital is 15%. (Assume that cash flows occur evenly throughout the year.) (Refer the below table)
Compute the cash payback period for each project.
Q4. Goltra Clinic is considering investing in new heart-monitoring equipment. It has two options: Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 4 years. Option B would require no rebuilding expenditure, but its maintenance costs would be higher. Since the Option B machine is of initial higher quality, it is expected to have a salvage value at the end of its useful life. The following estimates were made of the cash flows. The company's cost of capital is 6%.
|
Option A
|
Option B
|
|
Initial cost
|
$191,000
|
$263,000
|
|
Annual cash inflows
|
$72,000
|
$81,800
|
|
Annual cash outflows
|
$28,100
|
$26,700
|
|
Cost to rebuild (end of year 4)
|
$51,100
|
$0
|
|
Salvage value
|
$0
|
$7,900
|
|
Estimated useful life
|
7 years
|
7 years
|
Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for each option. (Hint: To solve for internal rate of return, experiment with alternative discount rates to arrive at a net present value of zero.)