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Chapter 26: Q10RQ (page 1463)
What is the decision rule for payback?
Answer
The general rule is that investments with shorter payback periods are observed as more appropriate and preferable.
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Henderson Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machineat a cost of \(1,200,000. If refurbished, Henderson expects the machine to last anothereight years and then have no residual value. Option 2 is to replace the machine at acost of \)4,600,000. A new machine would last 10 years and have no residual value.Henderson expects the following net cash inflows from the two options:
YearRefurbish CurrentPurchase New
MachineMachine
1 \( 350,000 \) 3,780,000
2 340,000 510,000
3 270,000 440,000
4 200,000 370,000
5 130,000 300,000
6 130,000 300,000
7 130,000 300,000
8 130,000 300,000
9 300,000
10 300,000
Total \( 1,680,000 \) 6,900,000
Henderson uses straight-line depreciation and requires an annual return of 10%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of these twooptions.
2. Which option should Henderson choose? Why?
Splash Nation is considering purchasing a water park in Atlanta, Georgia, for \(1,910,000. The new facility will generate annual net cash inflows of \)483,000 foreight years. Engineers estimate that the facility will remain useful for eight years andhave no residual value. The company uses straight-line depreciation, and its stockholdersdemand an annual return of 10% on investments of this nature.
Requirements
1. Compute the payback, the ARR, the NPV, the IRR, and the profitability index ofthis investment.
2. Recommend whether the company should invest in this project.
Using NPV to make capital investment decisions Holmes Industries is deciding whether to automate one phase of its production process. The manufacturing equipment has a six-year life and will cost \(910,000.
Year 1 \) 262,000 Year 2 254,000 Year 3 222,000 Year 4 215,000 Year 5 200,000 Year 6 175,000 |
Requirements
Holmes could refurbish the equipment at the end of six years for \(104,000. The refurbished equipment could be used one more year, providing \)77,000 of net cash inflows in year 7. Additionally, the refurbished equipment would have a $55,000 residual value at the end of year 7. Should Holmes invest in the equipment and refurbish it after six years? (Hint: In addition to your answer to Requirement 1, discount the additional cash outflow and inflows back to the present value.)
Darren Dillard, majority stockholder and president of Dillard, Inc., is working with his top managers on future plans for the company. As the company’s managerial accountant, you’ve been asked to analyze the following situations and make recommendations to the management team.
Requirements
1. Division A of Dillard, Inc. has \(5,250,000 in assets. Its yearly fixed costs are \)557,000, and the variable costs of its product line are \(1.90 per unit. The division’s volume is currently 500,000 units. Competitors offer a similar product, at the same quality, to retailers for \)4.25 each. Dillard’s management team wants to earn a 12% return on investment on the division’s assets.
a. What is Division A’s target full product cost?
b. Given the division’s current costs, will Division A be able to achieve its target profit?
c. Assume Division A has identified ways to cut its variable costs to \(1.75 per unit. What is its new target fixed cost? Will this decrease in variable costs allow the division to achieve its target profit?
d. Division A is considering an aggressive advertising campaign strategy to differentiate its product from its competitors. The division does not expect volume to be affected, but it hopes to gain more control over pricing. If Division A has to spend \)120,000 next year to advertise and its variable costs continue to be \(1.75 per unit, what will its cost-plus price be? Do you think Division A will be able to sell its product at the cost-plus price? Why or why not?
2. The division manager of Division B received the following operating income data for the past year:
| DIVISION B OF DILLARD, INC. Income Statement For the Year Ended December 31, 2018 | |||
| Product Line | Total | ||
| T205 | B179 | ||
Net sales revenue | \)310,000 | \(360,000 | \)670,000 |
Cost of goods sold: | |||
Variable | 31,000 | 44,000 | 75,000 |
Fixed | 275,000 | 67,000 | 342,000 |
The total cost of goods sold | 306,000 | 111,000 | 417,000 |
Gross profit | 4,000 | 249,000 | 253,000 |
Selling and administrative expenses: | |||
Variable | 68,000 | 80,000 | 148,000 |
Fixed | 47,000 | 27,000 | 74,000 |
Total selling and administrative expenses | 115,000 | 107,000 | 222,000 |
Operating income (loss) | \((111,000) | \)142,000 | \(31,000 |
The manager of the division is surprised that the T205 product line is not profitable. The division accountant estimates that dropping the T205 product line will decrease fixed cost of goods sold by \)75,000 and decrease fixed selling and administrative expenses by \(10,000.
a. Prepare a differential analysis to show whether Division B should drop the T205 product line.
b. What is your recommendation to the manager of Division B?
3. Division C also produces two product lines. Because the division can sell all of the product it can produce, Dillard is expanding the plant and needs to decide which product line to emphasize. To make this decision, the division accountant assembled the following data:
| Per unit | ||
K707 | G582 | |
Sales price | \)84 | \(50 |
Variable cost | 24 | 21 |
Contribution margin | \)60 | \(29 |
Contribution margin ratio | 71.4% | 58.0% |
After expansion, the factory will have a production capacity of 4,700 machine hours per month. The plant can manufacture either 40 units of K707s or 62 units of G582s per machine hour.
a. Identify the constraining factor for Division C.
b. Prepare an analysis to show which product line to emphasize.
4. Division D is considering two possible expansion plans. Plan A would expand a current product line at a cost of \)8,600,000. Expected annual net cash inflows are \(1,525,000, with zero residual value at the end of 10 years. Under Plan B, Division D would begin producing a new product at a cost of \)8,000,000. This plan is expected to generate net cash inflows of \(1,100,000 per year for 10 years, the estimated useful life of the product line. Estimated residual value for Plan B is \)980,000. Division D uses straight-line depreciation and requires an annual return of 10%.
a. Compute the payback, the ARR, the NPV, and the profitability index for both plans.
b. Compute the estimated IRR of Plan A.
c. Use Excel to verify the NPV calculations in Requirement 4(a) and the actual IRR for the two plans. How does the IRR of each plan compare with the company’s required rate of return?
d. Division D must rank the plans and make a recommendation to Dillard’s top management team for the best plan. Which expansion plan should Division D choose? Why?
Using payback, ARR, and NPV with unequal cash flows
Hughes Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machine at a cost of \(2,600,000. If refurbished, Hughes expects the machine to last another eight years and then have no residual value. Option 2 is to replace the machine at a cost of \)3,800,000. A new machine would last 10 years and have no residual value. Hughes expects the following net cash inflows from the two options:
Year | Refurbish current machine | Purchase new machine |
1 | \(1,760,000 | \)2,970,000 |
2 | 440,000 | 490,000 |
3 | 360,000 | 410,000 |
4 | 280,000 | 330,000 |
5 | 200,000 | 250,000 |
6 | 200,000 | 250,000 |
7 | 200,000 | 250,000 |
8 | 200,000 | 250,000 |
9 | 250,000 | |
10 | 250,000 | |
Total | \(3,640,000 | \)5,700,000 |
Hughes uses straight-line depreciation and requires an annual return of 10%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of these two options.
2. Which option should Hughes choose? Why?
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