171.Harry’s Seafood is considering the addition of a fish hatchery. Construction of the facility is estimated to cost $1,100,000 and will be depreciated over 10 years using the straight-line method. The hatchery is expected to have no estimated residual value. Harry’s Seafood has a required rate of return of 12%. Incremental net income related to each year of the investment is as follows:
Revenue $450,000
Expenses:
Material cost$ 60,000
Labor100,000
Depreciation110,000
Other 10,000 280,000
Income before taxes 170,000
Income tax expense at 40% 68,000
Net income $102,000
a.Determine the net present value of the investment. Should Harry’s Seafood invest in the hatchery?
b.Calculate the internal rate of return of the investment to the nearest ½ percent.
c.Calculate the payback period of the investment.
d.Calculate the accounting rate of return.
172.A project will require an initial investment of $580,000 and is expected to generate the following cash flows:
Year 1 $ 60,000
Year 2 250,000
Year 3 250,000
Year 4 200,000
Year 5 100,000
a.What is the project’s payback period?
b.If the required rate of return is 20% and taxes are ignored, what is the project’s net present value?
CHALLENGE EXERCISES
173. Tow’em Away is considering the purchase of a tow truck with a cost of $54,400 to be acquired on January 1, 2014. Tow’em estimates the truck can be sold for $10,400 at the end of its 5-year estimated life. Tow’em has a cost of capital of 6% and a required rate of return of 8%. This purchase would allow Tow’em to make 2,200 more tows per year. Annual cash basis net income relating to the tow truck is estimated at $20,200. Income taxes are 32%.
a. Calculate the depreciation tax shield for 2014.
b. What is the nature of the depreciation tax shield? Why is the depreciation tax shield a component of analyzing investment decisions?
c. Calculate Tow’em’s annual operating cash flows relating to the tow truck purchase.
174.For each capital budgeting project below, indicate whether management should Accept or Reject by placing an A or R, respectively, in the space provided next to each project. Select the best reason for the respective action from the list of reasons by printing a legible uppercase letter in the space provided.
Possible Reasons
A.The investment’s return is less than the cost of capital.
B.The investment earns a return rate equal to the company’s hurdle rate.
C.The cash outflows equal the cash inflows.
D.The investment’s internal rate of return is greater than the required rate of return.
E.The investment generates a return on profit less than the required rate of return.
G.The investment generates a cash return greater than the required rate of return.
H.The investment generates a cash return less than the required rate of return.
J. The hurdle rate is greater than the required rate of return.
K. The hurdle rate is less than the required rate of return.
M.The total cash paid out is less than the total cash received.
Capital budgeting projectsAccept (A) or Reject (R)?Reason
1.JT Corp. has a cost of capital at 6.2% and a required rate of return at 7.9%. The company evaluated an investment and determined the IRR was zero.
2.Save Company evaluated a potential investment and determined the NPV to be zero. Save Company’s required rate of return is 9.1% and its cost of capital is 6.4%.
3. An investment project has an internal rate of return of 10.8%. The initial outlay for the investment is $91,000. The hurdle rate is 10.2%.
4.An investment project has an NPV of ($5,200). The hurdle rate is 10%.
175.A proposed acquisition of a forklift on January 1, 2014 will cost $86,000, and have an estimated salvage value at the end of its estimated 5-year estimated life of $21,000.
20142015201620172018
Net income$ 7,300$ 8,700$ 8,000$ 5,100$ 1,400
Operating cash flows20,30021,70021,00018,10014,400
The company’s required rate of return is 7% and its cost of capital is 6%. The income tax rate is 32%.
a. Determine the payback period of the proposed acquisition.
b. Interpret the meaning of your answer in part A.
c. Suppose that the amounts for 2018 are a loss of $9,000 and cash flows of $4,000 instead of the amounts given. How will the payback period differ?
d. What are the criticisms against the payback period?
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