Chapter 14

# Chapter 14 - EILI'IZ A The Heritage Amusement Park would...

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Unformatted text preview: EILI'IZ A The Heritage Amusement Park would like to construct a new ride called the Sonic Boom, which the park management feels would be very popular. The ride would cost \$450,000 to construct, and it would have a 10% salvage value at the end of its 15-year useful life. The company estimates that the following annual costs and revenues w0uld be associated with the ride: Ticket revenues . . '. . . . . . i . . . -. \$250,000 . Less Operating expenses: . _ Maintenance. . . L- . . . . . \$40,000 .',_Salaries' -. . . . . . 90,000 . Depreciation . . . . . . . . . . . . ._ 27,000 '- lnSuran‘ce . .; . . . . . . . .1. . . 30,000 Total operating expenses . . . . . . . . I _ 187.000 :' N'etOperati'ngincome._. . _. _ \$ 63,000 Required: (Ignore income taxes.) 1. Assume that the Heritage Amusement Park will not construct a new ride-unless the ride provides a payback period of six years or less. Does the Sonic Boom ride satisfy this requirement? 2. Compute the simple rate of return promised by the new ride. If Heritage Amusement Park re— quires a simple rate of return of at least 12%, does the Sonic Boom ride meet this criterion? 1. Computation of the annual cash inﬂow associated with the new ride: Net operating income .............................. .. \$63,000 Add: Noncash deduction for depreciation 27,000 Net annual cash inﬂow ............................ .. M The payback computation would be: Investment required Payback period = a Net annual cash inﬂow : \$450,000 _ 5 6 \$90,000 per year _ y ars Yes, the new ride meets the requirement. The payback period is less than the maximum 6 years required by the Park. 2. The simple rate of return would be: Simple rate of return 2 Annual incremental net operating income Initial investment = \$63,000 \$450,000 Yes, the new ride satisfies the criterion. Its 14% return exceeds the Park’s requirement of a 12% return. = 140/0 Scalia's Cleaning Service is investigating the purchase of an ultrasound machine for cleaning window blinds. The machine would cost \$136,700, including invoice cost, freight, and training of employees to operate it. Scalia’s has estimated that the new machine would increase the company’s cash ﬂows, net of expenses, by \$25,000 per year. The machine would have a 14-year useful life with no expected Enron salvage value. Required: (Ignore income taxes.) 1. 2. 3. Compute the machine‘s internal rate of return to the nearest whole percent. Compute the machine’s net present value. Use a discount rate of 16% and the format shown in Exhibit 14—5. Why do you have a zero net present value? Suppose that the new machine would increase the company’s annual cash ﬂows, net of expenses, by only \$20,000 per year. Under these conditions, compute the internal rate of return to the nearest whole percent. Factor of the internal _ Required investment rate of return 5 Annual cash inﬂow \$136,700 \$25,000 = 5.468 Looking in Exhibit 14B—2 and scanning along the 14—period line, a factor of 5.468 represents an internal rate of return of 16%. Amountof 16% Present Value Item Year(s) Gas/7 Flows Factor of Cash Flows Initial investment ........ .. Now \$(136,700) 1.000 \$(136,700) Net annual cash inﬂows. 1-14 \$25,000 5.468 136 700 Net present value ........ .. i g The reason for the zero net present value is that 16% (the discount rate) represents the machine’s internal rate of return. The internal rate of return is the rate that causes the present value of a project’s cash in- ﬂows to just equal the present value of the investment required. Factor of the internal _ Required investment rate of return _ Annual cash inﬂow \$136,700 \$20,000 = 6.835 Looking in Exhibit 143—2 and scanning along the 14-period line, the 6.835 factor is closest to 6.982, the factor for the 11% rate of return. Thus, to the nearest whole percent, the internal rate of return is 11%. i: It! 157’: _ . Mountain View Hospital has purchased new lab equipment for \$134,650. The equrpment is expected to last for three years and to provide cash inﬂows as follows: Year 1 . . . . . . . . \$45,000 Year 2 . . . . . . . . \$60,000 Year 3.‘ . . . . . . . ? ' Required: Assuming that the equipment will yield exactly a 16% rate of return, what is the expected cash inﬂow for Year 3 ? Note: All present value factors have been taken from Exhibit 14B—1 in Appendix 148, using a 16% discount rate. Investment in the equipment ................ .. \$134,650 Less present value of Year 1 and Year 2 cash inflows: Year 1: \$45,000 x 0.862 ................. .. \$38,790 Year 2: \$60,000 x 0.743 . 44,580 83,370 Present value of Year 3 cash inﬂow ....... .. EJLAQQ Therefore, the expected cash inﬂow for Year 3 is: \$51,280 + 0.641 = \$80,000. PM we Doughboy Bakery would like to buy a new machine for putting icing and other toppings on pastries. These are now put on by hand. The machine that the bakery is considering costs \$90,000 new. It would last the bakery for eight years but would require a \$7,500 overhaul at the end of the ﬁfth year. After eight years, the machine could be sold for \$6,000. The bakery estimates that it will cost \$14,000 per year to operate the new machine. The present manual method of putting toppings on the pastries costs \$35,000 per year. In addition to reducing operating costs, the new machine will allow the bakery to increase its production of pastries by 5,000 packages per year. The bakery realizes a contribution margin of \$0.60 per package. The bakery requires a 16% return on all. investments in equipment. Required: (Ignore income taxes.) 1. What are the net annual cash inﬂows that will be provided by the new machine? 2. Compute the new machine’s net present value. Use the incremental cost approach, and round all dollar amounts to the nearest whole dollar. 1. The annual cash inﬂows would be: Reduction in annual operating costs: Operating costs, present hand method..... \$35,000 Operating costs, new machine ............... .. 14,000 Annual savings in operating costs .......... .. 21,000 Increased annual contribution margin: 5,000 packages x \$0.60 per package ..... .. 3 000 Total annual cash inflows ......................... .. \$_ 23,000 2. Present Amount Value of of Cash 16% Cash Item Year(s) Flows Factor Flows Cost of the machine Now \$(90,000) 1.000 \$(90,000) Overhaul required .... .. S \$(7,500) 0.476 (3,570) Annual cash inﬂows... 1—8 \$24,000 4.344 104,256 Salvage value ........... .. 8 \$6,000 0.305 1,830 Net present value ..... .. M 9/ ‘l r C cf 4 Rapid Parcel Service has been offered an eight~year contract to deliver mail and small parcels between army installations. To accept the contract, the company would have to purchase several new delivery trucks at a total cost of \$450,000. Other data relating to the contract follow: Net annual cashlreceipts: (before taxes) from thecontractg . . . . . . . . . \$108,000” Costof.overh'aulirigihe motors» , i i , in_the;trucks in'fiveyea'rs ..g’.r. :,\$45;0007 .salvagevalue’Qrtheirucksar .. » r termination oilhezcontrarct .\ i. r. r . . . . 'i\$20,000 If the contract were accepted. several old, fully depreciated trucks would be sold at a total price of \$30,000. These funds would be used to help purchase the new trucks. For tax purposes, the company computes depreciation deductions assuming zero salvage value and uses straight-line depreciation. The trucks would be depreciated over eight years. The company requires a 12% after-tax return on all equipment purchases. The tax rate is 30%. Required: Compute the net present value of this investment opportunity. Round all dollar amounts to the nearest whole dollar. Would you recommend that the contract be accepted? a) \$2) X (2) Present . ax er-7ax 120/ l/ Investmféﬁ/tﬁ: a113, Ct‘pumcpkgtat/ons Views) \$E4mount Eﬁ‘ect Cash Flows Fad; (bill/3:1; ................ .. ow 450,000 ﬁaltvage from sgle of the old trucks Now . \$30 000) 1 — 0 30 “gig? “432,83? e annua cas receipts .............. . . 1-8 \$108,000 1 030 I I I _ . A . .. , — . 75,600 4. gsglrﬁglaltiofn deductions* ................ .. 1-8 \$56,250 0.30 \$16,875 salv ufo motors ......................... .. 5 \$(45,000)1—0.30 \$(31,500) 0.567 (17’861) age rom the new trucks ........... .. 8 \$20,000 1 — 0 30‘ \$14 000 0 ', Net present value ........................... .. I I .404 \$4.33: * \$450,000 + 8 years = \$56,250 per year Since the project has a positive net present value, the contract should be accepted ...
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## Chapter 14 - EILI'IZ A The Heritage Amusement Park would...

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