Financial & Managerial Accounting 16th Edition Chapter-26

Q1. A company invests $100,000 in plant assets with an estimated 20-year service life and no salvage value. These assets contribute $10,000 to an final net income when depreciation is computed on a straight-line basis. Compute the payback period and explain your computation.

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Q2. How much is that laser in the window?

The management of Metro Printers is considering a proposal to replace some existing equipment with a new highly efficient laser printer. The existing equipment has a current book value of $2,200,000 and a remaining life (if not replaced) of 10 years. The laser printer has a cost of $1,300,000 and an expected useful life of 10 years. The laser printer would increase the company’s annual cash flows by reducing operating costs and by increasing the company’s ability to generate revenue. Susan Mills, controller of Metro Printers, has prepared the following estimates of the laser printer’s effect on annual earnings and cash flows:

Estimated increase in annual cash flows (before taxes):

Incremental revenue………………………………………………………………….. $140,000

Cost savings (other than depreciation)………………………………………… 110,000 $250,000

Reduction in annual depreciation expense:

Depreciation on existing equipment……………………………………………$220,000

Depreciation on laser printer………………………………………………………. 130,000 90,000

Estimated increase in income before income taxes………………………………………………………..$340,000

Increase in annual income taxes (40%)……………………………………………………………………….. 136,000

Estimated increase in annual net income…………………………………………………………………… $204,000

Estimated increase in annual net cash flows

($250,000 – $136,000)……………………………………………………………………………………. $114,000

Don Adams, a director of Metro Printers, makes the following observation: “These estimates look fine, but won’t we take a huge loss in the current year on the sale of our existing equipment? Softer the invention of the laser printer, I doubt that our old equipment can be sold for much at all.” In response, Mills provides the following information about the expected loss on the sale of the existing equipment:

Book value of existing printing equipment……………………………………….. $2,200,000

Estimated current sales price, net of removal costs………………………………. 200,000

Estimated loss on sale, before income taxes…………………………………………. $2,000,000

Reduction in current year’s income taxes as a result of loss (40%)…………. 800,000

Loss on sale of existing equipment, net of tax savings……………………………… $1,200,000

Adams replies, “Good grief, our loss would be almost as great as the cost of the laser itself. Add this $1,200,000 loss to the $1,300,000 cost of the laser, and we’re into this new equipment for $2,500,000. I’d go along with a cost of $1,300,000, but $2,500,000 is out of question.”

Instructions

a. Use Exhibits 26-3 and 26-4 to help compute the net present value of the proposal to sell the existing equipment and buy the laser printer, discounted at an annual rate of 15 percent. In your computation, make the following assumptions regarding the timing of cash flows:

1. The purchase price of the laser printer will be paid in cash immediately.

2. The $200,000 sales price of the existing equipment will be received in cash immediately.

3. The income tax benefit from selling the equipment will be realized one year from today.

4. Metro uses straight-line depreciation in its income tax returns as well as its financial statements.

5. The annual net cash flows may be regarded as received at year-end for each of the next 10 years.

b. Is the cost to Metro Printers of acquiring the laser printer $2,500,000, as Adams suggests? Explain fully.

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Q3. The following are 10 technical accounting terms introduced or emphasized in this chapter:

Net Present Value Capital budgeting Incremental analysis

Discount Rate Payback period Present value

Sunk Cost Return on average investment Salvage value

Capital budget audit

Each of the following statements may (or may not) describe one of these terms. Answer “None” if the statement does not correctly describe any of the terms…..

a. The examination of differences among revenue, costs, and cash flows under alternative courses of actions….

b. A cost incurred in the past that cannot be changed as a result of future actions…..

c. The process of planning and evaluating proposals for investments in plant assets…..

d. The average annual net income from an investment expressed as a percentage of the average amount invested……

e. The length of time necessary to recover the entire cost of an investment from resulting annual net cash flows…..

f. The present value of an investments expected future cash flows…….

g. The amount of money today that is considered equivalent to the cash flows expected to take place in the future…..

h. The required rate of return used by an investor to discount future cash flows to their present value…..

i. Often an investments final cash flows to be considered in discounted cash flow analysis

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Q4. Toying With Nature wants to take advantage of children’s current fascination with dinosaurs by adding several scale-model dinosaurs to its existing product line. Annual sales of the dinosaurs are estimated at 80,000 units at a price of $6 per unit. Variable manufacturing costs are estimated at $2.50 per unit, incremental fixed manufacturing costs (excluding depreciation) at $45,000 annually, and additional selling and general expenses related to the dinosaurs at $55,000 annually.

To manufacture the dinosaurs, the company must invest $350,000 in design molds and special equipment. Since toy fads wane in popularity rather quickly, Toying With Nature anticipates the special equipment will have a three-year service life with only a $20,000 salvage value. Depreciation will be computed on a straight-line basis. All revenue and expenses other than depreciation will be received or paid in cash. The company’s combined federal and state income tax rate is 40 percent.

Instructions

a. Prepare a schedule showing the estimated increase in annual net income from the planned manufacture and sale of dinosaur toys. (Input all amounts as positive values. Round to the nearest whole dollar, where necessary. Omit the “$” sign in your response.)

b. Compute the annual net cash flows expected from this project. (Omit the “$” sign in your response.)

c. Compute for this project the i) payback period ii) return on average investment iii) net present value, discounted at an annual rate of 15 percent. Use Exhibit 26-3 and 26-4where necessary. (Round your “PV factors” to 3 decimal places, playback period to the nearest tenth of a year, the return on average investment to the nearest tenth of a percent, and the net present value to the nearest dollar. Omit the “$” & “%” signs in your response.)

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Q5. Monster Toys is considering a new toy monster called Garga. Annual sales of Garga are estimated at 100,000 units at a price of $8 per unit. Variable manufacturing costs are estimated at $3 per unit, incremental fixed manufacturing costs (excluding depreciation) at $60,000 annually, and additional selling and general expenses related to the monster at $40,000 annually.

To manufacture the monsters, the company must invest $400,000 in design molds and special equipment. Since toy fads wane in popularity rather quickly, Monster Toys anticipates the special equipment will have a three-year service life with only a $10,000 salvage value. Depreciation will be computed on a straight-line basis. All revenue and expenses other than depreciation will be received or paid in cash. The company’s combined federal and state income tax rate is 30%.

Instructions

a. Prepare a schedule showing the estimated increase in annual net income from the planned manufacture and sale of Garga.

b. Compute the annual net cash flows expected from this project.

c. Compute for this project the (1) payback period, (2) return on average investment, and (3) net present value, discounted at an annual rate of 12%. Round the payback period to the nearest tenth of a year and the return on average investment to the nearest tenth of a percent.

Solution-

Q6. Doug’s Conveyor Systems, Inc., is considering two investment proposals (1 and 2). Data for the two proposals are present here: 1 2 Cost of Investment $98,000 $98,500 Estimated Salvage value 12,000 6,500 Average estimated net income 13,000 10,500 calculate the return on average investment for both proposals.

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Q7. DQ – Identify some conditions where upper management might allows some divisions to have a lower required rate of return.

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Q8. Heartland Paper Company is considering the purchase of a new high-speed cutting machine. Two cutting machine manufacturers have approached Heartland with proposals: (1) Toledo Tools and (2) Akron Industries. Regardless of which vendor Heartland chooses, the following incremental cash flows are expected to be realized:….. Year = 1 … Incremental Cash Inflows = $26,000 … Incremental Cash Outflows = $20,000… Year = 2 … Incremental Cash Inflows = $27,000 … Incremental Cash Outflows = $21,000…. Year = 3 … Incremental Cash Inflows = $32,000 … Incremental Cash Outflows = $26,000…. Year = 4 … Incremental Cash Inflows = $35,000 … Incremental Cash Outflows = $29,000…. Year = 5 … Incremental Cash Inflows = $34,000 … Incremental Cash Outflows = $28,000…. Year = 6 … Incremental Cash Inflows = $33,000 … Incremental Cash Outflows = $27,000…. a. If the machine manufactured by Toledo Tools costs $27,000, what is its expected payback period?…. b. If the machine manufactured by Akron Industries has a payback period of 66 months, what is its cost?…. c. Which of the machines is most attractive based on its respective payback period? Should Heartland base its decision entirely on this criterion? Explain your answer.

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Q9. Micro technology is considering two alternative proposals for modernizing its production facilities. To provide a basis for selection, the cost accounting department has developed the following data regarding the expected annual operating results for the two proposals:

Proposal 1 Proposal 2

Required investment in equipment……………………………… $360,000 $350,000

Estimated service life of equipment……………………………. 8years 7 years

Estimated salvage value……………………………………………… $-0- $14,000

Estimated annual cost saving (net cash flow) 75,000 76,000

Depreciation on equipment (straight-line basis)………… 45,000 48,000

Estimated increase in annual net income…………………… 30,000 28,000

Instructions

a. for each proposal, compute the (1) payback period, (2) return on average investment, and (3) net present value, discounted at an annual rate of 12 percent. (Round the payback period tot eh nearest tenth of a year and the return on investment to the nearest tenth of a percent.) Use this exhibits 26-3 and 26-4 where necessary.

b. Based on your analysis in part a, state which proposal you would recommend and explain the reason for your choice.

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Q10. Macro Technology is considering two alternative proposals for modernizing its production facilities. To provide a basis for selection, the cost accounting department has developed the following data regarding the expected annual operating results for the two proposals:

Proposal 1 Proposal 2

Required investment in equipment $400,000 $380,000

Estimated service life of equipment 10 years 8 years

Estimated salvage value $ -0- $ 20,000

Estimated annual cost savings (net cash flow) 80,000 82,000

Depreciation on equipment (straight-line basis) 40,000 45,000

Estimated increase in annual net income 40,000 37,000

Instructions

a. For each proposal, compute the (1) payback period, (2) return on average investment, and (3) net present value, discounted at an annual rate of 15%. (Round the payback period to the nearest tenth of a year and the return on investment to the nearest tenth of a percent.)

b. Based on your analysis in part a, state which proposal you would recommend and explain the reasons for your choice.

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Q11. A particular investment proposal has a positive net present value of $20 when a discount rate of 8 percent is used. The same proposal has a negative present value of $2,000 when a discount rate of 10 percent is used. What conclusions can be drawn about the estimated return of this proposal?

Solution-

Q12. What are the pitfalls to avoid when investing in overseas activities? The following key issues have been identified as important:

a. Lower cost offshore does not always mean gains in efficiency.

b. Choose your model carefully, either run your own offshore operation or outsource

c. Get your current employees to be supportive, otherwise they can hinder the process

d. Be prepared to invest time and effort because quality control can be challenging

e. Treat your overseas partners as equals in your business dealings

Instructions-

1. Explain how the above list of key issues in offshore investments can have an impact on future cash flows associated with an offshore investment

2. Discuss the ethical implications of encouraging current employees to help a company shift jobs overseas.

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Q13. What is the major short coming of using the payback period as the only criterion in making capital budgeting decisions?

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Q14. Foz Co. is considering four investment proposals (A, B, C and D). The following table provides data concerning each of these investments:

A B C D

Investment cost $ 44,000 $ 45,000 $ 50,000 $

Estimated salvage value 8,000 5,000

4,000

Average estimated net income 6,000 ?? 5,400 4,500

Return on average investment ?? % 28 % 20 % 15

Compute the missing information pertaining to each investment proposal.

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Q15. Cartor Industries is evaluating two alternative investment opportunities. The controller of the company has prepared the following analysis of the two investment proposals:

Proposal A Proposal B

Required investment in equipment $ 220,000 $ 250,000

Estimated service life of equipment 5 years 6 years

Estimated salvage value $ 10,000 $ 0

Estimated annual net cash flow 60,000 60,000

Depreciation on equipment (straight-line basis) 42,000 40,000

Estimated annual net income 18,000 20,000

Instructions

a. For each proposed investment, compute the following. Assume discounted at an annual rate of 10 percent. Use Exhibits 26-3 and 26-4 where necessary. (Round your “PV factors” to 3 decimal places, payback period to the nearest tenth of a year and the return on average investment to the nearest tenth of a percent. Omit the “$” & “%” signs in your response.)

Proposal A Proposal B

(1) Payback period years years

(2) Return on average investment % %

(3) Net present value $ $

b. Based on your computations in part a, which proposal do you consider to be the better investment?

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Q16. Flagg Equipment Company is evaluating two alternative investment opportunities. The controller of the company has prepared the following analysis of the two investment proposals:

Proposal A Proposal B

Required investment in equipment $260,000 $280,000

Estimated service life of equipment 6 years 7 years

Estimated salvage value $ 20,000 $ -0-

Estimated annual net cash flow 82,000 65,000

Depreciation on equipment (straight-line basis) 40,000 40,000

Estimated annual net income 42,000 25,000

Instructions

a. For each proposal investment, compute the (1) payback period, (2) return on average investment, and (3) net present value, discounted at an annual rate of 15%. (Round the payback period to the nearest tenth of a year and the return on investment to the nearest tenth of a percent.)

b. Based on your analysis in part a, which proposal do you consider to be the better investment? Explain.

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Q16. Landry’s Tool Supply Corporation is considering purchasing a machine that costs $56,000 and will produce annual cash flows of $19,000 for six years. The machine will be repurchased at the end of six years for $2,000. What is the net present value of the proposed investment? Landry’s requires a 12 percent return on all capital investment.

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Q17. Using the tables in Exhibits 26-3 and 26-4, determine the present value of the following cash flows discounted at an annual rate of 15 percent.

a. $10,000 to be received 20 years from today.

b. $15,000 to be received annually for 10 years.

c. $10,000 to be received annually for five years, with an additional $12,000 salvage value expected at the end of the fifth year.

d. $30,000 to be received annually for the first three years, followed by $20,000received annually for the next two years (total of five years in which cash is received).

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Q18. Marengo is a popular restaurant located in Chilton resort. Management feels that enlarging

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Q19. Samba Is a popular restaurant located in Brazilton Resort. Management feels that enlarging the facility to incorporate a large outdoor seating area will enable Samba to continue to attract existing customers as well as handle large banquet parties that now must be turned away.

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Q20. A company is trying to decide whether to go ahead with an investment opportunity that costs $35,650. The expected incremental cash inflows are $78,000, while the expected incremental cash outflows are $67,500. What is the payback period?

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