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Chapter 26: Q8RQ (page 1463)
How is payback calculated with equal net cash inflows?
Answer
The payback period calculates by dividing by keeping the original investment amount in the numerator and the annual cash flow in the denominator.
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Why is it preferable to receive cash sooner rather than later?
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?
Refer to the Hunter Valley Snow Park Lodge expansion project in Short Exercise S26- 4. What is the project’s NPV (round to nearest dollar)? Is the investment attractive? Why or why not?
Hamilton Company is considering two capital investments. Both investments have an initial cost of \(7,000,000 and total net cash inflows of \)16,000,000 over 10 years. Hamilton requires a 20% rate of return on this type of investment. Expected net cash inflows are as follows:
Year | Plan Alpha | Plan Beta |
1 | \(1,600,000 | \)1,600,000 |
2 | \(1,600,000 | 2,200,000 |
3 | \)1,600,000 | 2,800,000 |
4 | \(1,600,000 | 2,200,000 |
5 | \)1,600,000 | 1,600,000 |
6 | \(1,600,000 | 1,500,000 |
7 | \)1,600,000 | 1,300,000 |
8 | \(1,600,000 | 1,100,000 |
9 | \)1,600,000 | 900,000 |
10 | \(1,600,000 | 800,000 |
Total | \)16,000,000 | \(16,000,000 |
Requirements
1. Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue?
2. Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not?
3. After further negotiating, the company can now invest with an initial cost of \)6,500,000. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?
Question: Defining capital investments and the capital budgeting process
Match each capital budgeting method with its definition.
Methods
1. Accounting rate of return
2. Internal rate of return
3. Net present value
4. Payback
Definitions
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