CHAPTER 12—PROBLEMS: SET B P12-1B The Borders and Noble partnership is considering three long-term capital investment proposals Each investment has a useful life of five years Relevant data on each project are as follows Project Mary Project Winnie Project Sarah Capital investment Annual net income: Year $140,000 $175,000 $190,000 $10,000 10,000 10,000 10,000 10,000 $12,500 12,000 11,000 8,000 6,000 $19,000 16,000 14,000 9,000 8,000 Total $50,000 $49,500 $66,000 Compute annual rate of return, cash payback, and net present value (LO 2, 3, 8), AN Depreciation is computed by the straight-line method with no salvage value The company’s cost of capital is 12% (Assume cash flows occur evenly throughout the year.) Instructions (a) Compute the cash payback period for each project (Round to two decimals.) (b) Compute the net present value for each project (Round to nearest dollar.) (c) Compute the annual rate of return for each project (Round to two decimals.) (Hint: Use average annual net income in your computation.) (d) Rank the projects on each of the foregoing bases Which project you recommend? P12-2B Ben Paul is an accounting major at a western university located approximately 60 miles from a major city Many of the students attending the university are from the metropolitan area and visit their homes regularly on the weekends Ben, an entrepreneur at heart, realizes that few good commuting alternatives are available for students doing weekend travel He believes that a weekend commuting service could be organized and run profitably from several suburban and downtown shopping mall locations Ben has gathered the following investment information (b) M $(3,018); S $(3,075) Compute annual rate of return, cash payback, and net present value (LO 2, 3, 8), AN Five used vans would cost a total of $90,000 to purchase and would have a three-year useful life with negligible salvage value Ben plans to use straight-line depreciation Ten drivers would have to be employed at a total payroll expense of $43,000 Other annual out-of-pocket expenses associated with running the commuter service would include Gasoline $26,000, Maintenance $4,000, Repairs $5,300, Insurance $4,500, and Advertising $2,200 Ben desires to earn a return of 15% on his investment Ben expects each van to make 10 round trips weekly and carry an average of six students each trip The service is expected to operate 32 weeks each year, and each student will be charged $15 for a round-trip ticket Instructions (a) Determine the annual (1) net income and (2) net annual cash flows for the commuter service (b) Compute (1) the cash payback period and (2) the annual rate of return (Round to two decimals.) (c) Compute the net present value of the commuter service (Round to the nearest dollar.) (d) What should Ben conclude from these computations? (a) (1) $29,000 (b) (1) 1.53 years P-1 P-2 Problems: Set B Compute net present value, profitability index, and internal rate of return (LO 3, 5, 7), AN P12-3B Platteville Eye Clinic is considering investing in new optical-scanning equipment It has two options: Option A would have an initial lower cost but would require a significant expenditure for rebuilding after three 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 11% Initial cost Annual cash inflows Annual cash outflows Cost to rebuild (end of year 3) Salvage value Estimated useful life (a) (1) NPV A $(3,376) (3) IRR B 12% Compute net present value considering intangible benefits (LO 3, 4), E Option A Option B $100,000 $56,000 $24,000 $53,000 $0 years $160,000 $60,000 $24,000 $0 $24,000 years Instructions (a) 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.) (b) Which option should be accepted? P12-4B Isaac’s Auto Repair is considering the purchase of a new tow truck The garage doesn’t currently have a tow truck, and the $65,000 price tag for a new truck would represent a major expenditure for the garage Isaac Mayer, owner of the garage, has compiled the following estimates in trying to determine whether to purchase the truck Initial cost Estimated useful life Net annual cash inflows from towing Overhaul costs (end of year 4) Salvage value $65,000 years $9,600 $7,000 $16,000 Isaac’s good friend, Brad Jolie, stopped by He is trying to convince Isaac that the tow truck will have other benefits that Isaac hasn’t even considered First, he says, cars that need towing need to be fixed Thus, when Isaac tows them to his facility his repair revenues will increase Second, he notes that the tow truck could have a plow mounted on it, thus saving Isaac the cost of plowing his parking lot (Brad will give him a used plow blade for free if Isaac will plow Brad’s driveway.) Third, he notes that the truck will generate goodwill; that is, people who are rescued by Isaac and his tow truck will feel grateful and might be more inclined to use his service station in the future or buy gas there Fourth, the tow truck will have “Isaac’s Auto Repair” on its doors, hood, and back tailgate—a form of free advertising wherever the tow truck goes Brad estimates that, at a minimum, these benefits would be worth the following Additional annual net cash flows from repair work Annual savings from plowing Additional annual net cash flows from customer “goodwill” Additional annual net cash flows resulting from free advertising $2,600 600 1,200 500 The company’s cost of capital is 10% (a) NPV $(11,102) (b) NPV $15,039 Instructions (a) Calculate the net present value, ignoring the additional benefits described by Brad Should the tow truck be purchased? (b) Calculate the net present value, incorporating the additional benefits suggested by Brad Should the tow truck be purchased? (c) Suppose Brad has been overly optimistic in his assessment of the value of the additional benefits At a minimum, how much would the additional benefits have to be worth in order for the project to be accepted? Problems: Set B P12-5B Lewis Corp is thinking about opening a basketball camp in Texas In order to start the camp, the company would need to purchase land and build eight basketball courts and a dormitory-type sleeping and dining facility to house 110 basketball players Each year, the camp would be run for eight sessions of one week each The company would hire college basketball players as coaches The camp attendees would be male and female basketball players ages 12 to 18 Property values in Texas have enjoyed a steady increase in value It is expected that after using the facility for 20 years, Lewis can sell the property for more than it was originally purchased for The amounts shown on the next page have been estimated Cost of land Cost to build dorm and dining facility Annual cash inflows assuming 110 players and eight weeks Annual cash outflows Estimated useful life Salvage value Discount rate Compute net present value and internal rate of return with sensitivity analysis (LO 3, 7), E $200,000 $350,000 $700,000 $570,000 20 years $700,000 12% Instructions (a) Calculate the net present value of the project (b) To gauge the sensitivity of the project to these estimates, assume that if only 90 campers attend each week, annual cash inflows will be $570,000 and annual cash outflows will be $508,000 What is the net present value using these alternative estimates? Discuss your findings (c) Assuming the original facts, what is the net present value if the project is actually riskier than first assumed, and a 15% discount rate is more appropriate? (d) Assume that during the first five years the annual net cash inflows each year were only $65,000 At the end of the fifth year, the company is running low on cash, so management decides to sell the property for $668,000 What was the actual internal rate of return on the project? Explain how this return was possible given that the camp did not appear to be successful P-3 (a) NPV $493,596 (d) IRR 15%