accounting to managers questions

21.

Preference Decisions: NPV vs. IRR vs. Profit-ability Index LO1, 2, 3

Stephens Industries is contemplating four projects: Project P, Project Q, Project R, and Project S. The capital costs and estimated after-tax net cash flows of each project are shown in the table that follows. Stephens’s after-tax cost of capital is 12 percent. Excess funds cannot be reinvested at greater than 12 percent.

	Project P	Project Q	Project R	Project S
Initial cost	$200,000	$235,000	$190,000	$210,000
Annual cash flows:
Year 1	93,000	90,000	45,000	40,000
Year 2	93,000	85,000	55,000	50,000
Year 3	93,000	75,000	65,000	60,000
Year 4	0	55,000	70,000	65,000
Year 5	0	50,000	75,000	75,000
Net present value	$23,370	$29,827	$27,233	$(7,854)
Internal rate of return	18.7%	17.6%	17.2%	10.6%
Profitability index	1.12	1.13	1.14	0.95

Required

· A. Which of the four projects are acceptable options? Why?

· B. If only one project can be accepted, which one should the company choose?

23.

NPV vs. Payback Method: Impact of Varying Cash Flow Assumptions LO1, 2, 5

Winona Miller, president of CLJ Products, is considering the purchase of a computer-aided manufacturing system that requires an initial investment of $4,000,000 and is expected to provide cash benefits and savings for the next 10 years. CLJ Products’s cost of capital is currently 12 percent. The annual cash benefits/savings associated with the system are as follows:

Decrease in defective products	$100,000
Revenue increase due to improved quality	150,000
Decrease in operating costs	300,000

Required

· A. Calculate the payback period for the system. Assume that the company has a policy of accepting only projects with a payback of five years or less. Should the system be purchased?

· B. Calculate the NPV and the IRR (use Excel to calculate the IRR) for the project. Should the system be purchased? What if the system does not meet the payback criterion?

· C. The project manager reviewed the projected cash flows and pointed out that two items had been missed. First, the system would have a salvage value of $500,000 at the end of 10 years. Second, the increased quality of the company’s products produced with the new system would allow the company to increase its market share by 30 percent, leading to additional annual cash inflows of $180,000. Given this new information, recalculate the payback period, NPV, and IRR. Would your recommendation change? Why or why not?

28.

Decision Focus: Lease-or-Buy Decision by NPV Analysis LO1, 4

Bit and Byte is contemplating the acquisition of a computer system but is undecided whether it should be leased or purchased. Information regarding the system is as follows:

Equipment Purchase Information
Cash purchase price	$275,000
Annual maintenance	25,000
Salvage value at the end of three years	120,000
Equipment Leasing Information
Annual rental fee (includes maintenance)	$75,000 plus 10 percent of billings
Other Information
Estimated billings:
Year 1	$230,000
Year 2	250,000
Year 3	240,000
Income tax rate	40%
Depreciation method	Straight-line
Minimum desired after-tax rate of return	12%

Required

Prepare a net-present-value analysis that compares the purchase and leasing options. Which alternative is best for Bit and Byte?

30.

Decision Focus: Make-or-Buy Decision with NPV Analysis LO1, 4

Armstrong Company manufactures three models of paper shredders, including the waste container, which serves as the base. Whereas the shredder heads are different for all three models, the waste container is the same. The estimated numbers of waste containers that Armstrong will need during the next five years are as follows:

Year	Number of Containers
1	50,000
2	50,000
3	52,000
4	55,000
5	55,000

The equipment used to manufacture the waste container must be replaced because it is broken and cannot be repaired. The new equipment has a purchase price of $945,000 and is expected to have a salvage value of $12,000 at the end of its economic life in 5 years. The new equipment would be more efficient than the old equipment, resulting in a 25 percent reduction in direct materials.

The old equipment is fully depreciated and is not included in the fixed overhead. The old equipment can be sold for a salvage amount of $1,500. Armstrong has no alternative use for the manufacturing space at this time.

Rather than replace the equipment, one of Armstrong’s production managers has suggested that the waste containers be purchased. One supplier has quoted a price of $27 per container. This price is $8 less than the current manufacturing cost, which is composed of the following costs:

Direct materials	$10.00
Direct labor	8.00
Variable overhead	6.00	$24.00
Fixed overhead:
Supervision	$ 2.00
Facilities	5.00
General	4.00	11.00
Total manufacturing cost per unit		$35.00

Armstrong employs a plantwide fixed overhead rate in its operations. If the waste containers are purchased outside, the salary and benefits of one supervisor, included in the fixed overhead at $45,000, will be eliminated. There will be no other changes in the other cash and noncash items included in fixed overhead.

Armstrong is subject to a 40 percent income tax rate. Management assumes that all annual cash flows and tax payments occur at the end of the year and uses a 12 percent after-tax discount rate.

Required

· A. Define the problem that Armstrong faces.

· B. Calculate the net present value of the estimated after-tax cash flows for each option you identify.

· C. What is your recommendation? Support your recommendation by explaining the logic behind it.