UCF-ACG2071 Ch. 12 Capital Investment Decisions

UCF-ACG2071 Ch. 12 Capital Investment Decisions - Example#1...

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In Class Examples -   Chapter 12    Solutions Example #1  Requirement 1) Determine the payback period for each product. What is the major weakness of payback  analysis? Payback is the length of time it would take Floor Hugger to recover, in net cash inflows, the  $700,000 initial outlay.  The floor heaters have equal cash inflows each year, so: Payback Period = Amount Invested Expected Annual Net Cash Inflow As the annual net cash flows for floor heaters are annuities, we can calculate the payback period as follows: Payback Period for  Floor Heaters = $700,000 $140,000   =    5 years The payback period for humidifiers is more complicated because cash flows are not annuities, but are an uneven stream—meaning that the cash flows are different for each year.  To handle this problem, we must determine the point at which the cash flows equal the initial  outlay.  In this problem, the initial outlay is $700,000. We start with $700,000 Subtract year 1 cash flows    120,000 Leaving    580,000 Subtract year 2 cash flows   180,000 Leaving    400,000 Subtract year 3 cash flows   220,000 Leaving  $180,000 Because the cash flows in year 4 are $220,000, we only need $180,000 of this to zero the  above calculation.   Therefore, we will need $180,000 / $220,000 of a year to bring the above calculation to  zero. The payback period for humidifiers is 3 whole years and 0.818 years ($180,000 /  $220,000), or 3.818 years. The payback model favors the humidifiers because it recovers the investment more quickly.  The major weakness of payback analysis is that it only focuses on time, not on profit. The  payback period must be shorter than the useful life to provide any profit.   It also totally  1
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ignores TVM concepts.  It treats all the dollars the ame even though they were spread over  time. Requirement 2) Calculate the accounting rate of return. What is the major weakness of the accounting  rate of return? The accounting rate of return measures the average rate of return over the asset’s entire life.  It uses the following formula: Accounting Rate of Return = Average Annual Operating Income from Asset Initial Investment If operating income varies by year, compute the total operating income over the asset’s life.  Then divide the total by the number of years of life to find the average annual operating  income from the asset.  In the problem, the net cash flow is given for both floor heaters and humidifiers. To get  operating income, depreciation must be subtracted.  Floor heaters have a seven-year life, so depreciation per year equals: $700,000 7 = $100,000 Humidifiers have a five-year life, so depreciation per year equals:  $700,000 5 = $140,000
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