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Chapter 26: Q1FC (page 1480)

John Johnson is the majority stockholder in Johnson’s Landscape Company, owning 52% of the company’s stock. John asked his accountant to prepare a capital investment analysis to purchase new mowers. John used the analysis to persuade a loan officer at the local bank to loan the company $100,000. Once the loan was secured, John used the cash to remodel his home, updating the kitchen and bathrooms, installing new flooring, and adding a pool.

Requirements

1. Are John’s actions fraudulent? Why or why not? Does John’s percentage of ownership affect your answer?

2. What steps could the bank take to prevent this type of activity?

Short Answer

Expert verified
  1. Theactions followed by John are fraudulentand will affect the company's other stakeholders.
  2. Inspection after disbursement and disbursement through check in the name of the machine vendor.

Step by step solution

01

Definition of Fraudulent Activities

The intentional action is taken to take undue advantages by using false facts, and illegal means are known as fraudulent activities.

02

Actions of John

The action of John is fraudulent because he is taking a loan in the company’s name and using it for other purposes. Even if he has a more significant stake in the company, he must not use the company's fund for personal use.

The loan will become the liability of the company,not John. If John sells his stake in the company, then the overall burden of the loan will fall on the company, and the other stakeholders will get affected.

03

Step that a bank must take to prevent the fraudulent activities

The bank must not provide cash;instead, the bank must issue the check in the name of the company from whom the mower will be purchased. It will restrict the use of loans towards a specific activity only.

The bank can also visit the company after loan disbursement to check whether the company has used the funds in the specified activity or not.

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Most popular questions from this chapter

Howard Company operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of \(8,500,000. Expected annual net cash inflows are \)1,600,000 for 10 years, with zero residual value at the end of 10 years. Under Plan B, Howard Company would open three larger shops at a cost of \(8,100,000. This plan is expected to generate net cash inflows of \)1,000,000 per year for 10 years, which is the estimated useful life of the properties. Estimated residual value for Plan B is $990,000. Howard Company uses straight-line depreciation and requires an annual return of 6%.

Requirements

1. Compute the payback, the ARR, the NPV, and the profitability index of these two plans.

2. What are the strengths and weaknesses of these capital budgeting methods?

3. Which expansion plan should Howard Company choose? Why?

4. Estimate Plan A’s IRR. How does the IRR compare with the company’s required rate of return?

Hill Company operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of\(8,700,000. Expected annual net cash inflows are \)1,550,000 for 10 years, with zeroresidual value at the end of 10 years. Under Plan B, Hill Company would open threelarger shops at a cost of \(8,340,000. This plan is expected to generate net cash inflowsof \)990,000 per year for 10 years, the estimated useful life of the properties. Estimatedresidual value for Plan B is $1,200,000. Hill Company uses straight-line depreciationand requires an annual return of 10%.

Requirements

1. Compute the payback, the ARR, the NPV, and the profitability index of thesetwo plans.

2. What are the strengths and weaknesses of these capital budgeting methods?

3. Which expansion plan should Hill Company choose? Why?

4. Estimate Plan A’s IRR. How does the IRR compare with the company’s requiredrate of return?

Use the Present Value of \(1 table (Appendix A, Table A-1) to determine the present value of \)1 received one year from now. Assume a 8% interest rate. Use the same table to find the present value of \(1 received two years from now. Continue this process for a total of five years. Round to three decimal places.

Requirements

1. What is the total present value of the cash flows received over the five-year period?

2. Could you characterize this stream of cash flows as an annuity? Why or why not?

3. Use the Present Value of Ordinary Annuity of \)1 table (Appendix A, Table A-2) to determine the present value of the same stream of cash flows. Compare your results to your answer to Requirement 1.

4. Explain your findings.

How is payback calculated with equal net cash inflows?

P26-40 Using payback, ARR, NPV, and IRR to make capital investment decisions

This problem continues the Piedmont Computer Company situation from Chapter 25. Piedmont Computer Company is considering purchasing two different types of servers. Server A will generate net cash inflows of \(25,000 per year and have a zero residual value. Server A’s estimated useful life is three years, and it costs \)45,000. Server B will generate net cash inflows of \(25,000 in year 1, \)15,000 in year 2, and \(5,000 in year 3. Server B has a \)5,000 residual value and an estimated useful life of three years. Server B also costs $45,000. Piedmont Computer Company’s required rate of return is 14%.

Requirements

1. Calculate payback, accounting rate of return, net present value, and internal rate of return for both server investments. Use Microsoft Excel to calculate NPV and IRR.

2. Assuming capital rationing applies, which server should Piedmont Computer Company invest in?
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