CHAPTER 12PROBLEMS: SET B

P12-1B The Borders and Noble partnership is considering three long-term capital investment proposals. Each investment has a useful life of five years. Relevant data on each
project are as follows.
Project Mary

Project Winnie

Project Sarah

Capital investment
Annual net income:
Year 1
2
3
4
5

$140,000

$175,000

$190,000

$10,000
10,000
10,000
10,000
10,000

$12,500
12,000
11,000
8,000
6,000

$19,000
16,000
14,000
9,000
8,000

Total

$50,000

$49,500

$66,000

Compute annual rate of

return, cash payback, and net
present value.

(LO 2, 3, 8), AN

Depreciation is computed by the straight-line method with no salvage value. The companys cost of capital is 12%. (Assume cash flows occur evenly throughout the year.)
Instructions
(a) Compute the cash payback period for each project. (Round to two decimals.)
(b) Compute the net present value for each project. (Round to nearest dollar.)
(c) Compute the annual rate of return for each project. (Round to two decimals.)
(Hint: Use average annual net income in your computation.)
(d) Rank the projects on each of the foregoing bases. Which project do you recommend?
P12-2B Ben Paul is an accounting major at a western university located approximately
60 miles from a major city. Many of the students attending the university are from the
metropolitan area and visit their homes regularly on the weekends. Ben, an entrepreneur
at heart, realizes that few good commuting alternatives are available for students doing
weekend travel. He believes that a weekend commuting service could be organized and
run profitably from several suburban and downtown shopping mall locations. Ben has
gathered the following investment information.

(b) M $(3,018); S $(3,075)

Compute annual rate of

return, cash payback, and net
present value.

(LO 2, 3, 8), AN

1. Five used vans would cost a total of $90,000 to purchase and would have a three-year
useful life with negligible salvage value. Ben plans to use straight-line depreciation.
2. Ten drivers would have to be employed at a total payroll expense of $43,000.
3. Other annual out-of-pocket expenses associated with running the commuter service
would include Gasoline $26,000, Maintenance $4,000, Repairs $5,300, Insurance
$4,500, and Advertising $2,200.
4. Ben desires to earn a return of 15% on his investment.
5. Ben expects each van to make 10 round trips weekly and carry an average of six students each trip. The service is expected to operate 32 weeks each year, and each student
will be charged $15 for a round-trip ticket.
Instructions
(a) Determine the annual (1) net income and (2) net annual cash flows for the commuter
service.
(b) Compute (1) the cash payback period and (2) the annual rate of return. (Round to two
decimals.)
(c) Compute the net present value of the commuter service. (Round to the nearest dollar.)
(d)
What should Ben conclude from these computations?

(a) (1) $29,000

(b) (1) 1.53 years

P-1

P-2

Problems: Set B

Compute net present value,

profitability index, and
internal rate of return.

(LO 3, 5, 7), AN

P12-3B Platteville Eye Clinic is considering investing in new optical-scanning equipment. It has two options: Option A would have an initial lower cost but would require
a significant expenditure for rebuilding after three years. Option B would require no
rebuilding expenditure, but its maintenance costs would be higher. Since the Option B
machine is of initial higher quality, it is expected to have a salvage value at the end of its
useful life. The following estimates were made of the cash flows. The companys cost of
capital is 11%.
Initial cost
Annual cash inflows
Annual cash outflows
Cost to rebuild (end of year 3)
Salvage value
Estimated useful life

(a) (1) NPV A $(3,376)

(3) IRR B 12%

Compute net present value

considering intangible benefits.

(LO 3, 4), E

Option A

Option B

$100,000
$56,000
$24,000
$53,000
$0
6 years

$160,000
$60,000
$24,000
$0
$24,000
6 years

Instructions
(a) Compute the (1) net present value, (2) profitability index, and (3) internal rate of
return for each option. (Hint: To solve for internal rate of return, experiment with
alternative discount rates to arrive at a net present value of zero.)
(b) Which option should be accepted?
P12-4B Isaacs Auto Repair is considering the purchase of a new tow truck. The garage
doesnt currently have a tow truck, and the $65,000 price tag for a new truck would represent a major expenditure for the garage. Isaac Mayer, owner of the garage, has compiled
the following estimates in trying to determine whether to purchase the truck.
Initial cost
Estimated useful life
Net annual cash inflows from towing
Overhaul costs (end of year 4)
Salvage value

$65,000
8 years
$9,600
$7,000
$16,000

Isaacs good friend, Brad Jolie, stopped by. He is trying to convince Isaac that the tow truck
will have other benefits that Isaac hasnt even considered. First, he says, cars that need
towing need to be fixed. Thus, when Isaac tows them to his facility his repair revenues will
increase. Second, he notes that the tow truck could have a plow mounted on it, thus saving
Isaac the cost of plowing his parking lot. (Brad will give him a used plow blade for free if
Isaac will plow Brads driveway.) Third, he notes that the truck will generate goodwill; that
is, people who are rescued by Isaac and his tow truck will feel grateful and might be more
inclined to use his service station in the future or buy gas there. Fourth, the tow truck will
have Isaacs Auto Repair on its doors, hood, and back tailgatea form of free advertising
wherever the tow truck goes.
Brad estimates that, at a minimum, these benefits would be worth the following.
Additional annual net cash flows from repair work
Annual savings from plowing
Additional annual net cash flows from customer goodwill
Additional annual net cash flows resulting from free advertising

$2,600
600
1,200
500

The companys cost of capital is 10%.

(a) NPV $(11,102)
(b) NPV $15,039

Instructions
(a) Calculate the net present value, ignoring the additional benefits described by Brad.
Should the tow truck be purchased?
(b) Calculate the net present value, incorporating the additional benefits suggested by
Brad. Should the tow truck be purchased?
(c) Suppose Brad has been overly optimistic in his assessment of the value of the additional benefits. At a minimum, how much would the additional benefits have to be
worth in order for the project to be accepted?

Problems: Set B
P12-5B Lewis Corp. is thinking about opening a basketball camp in Texas. In order to
start the camp, the company would need to purchase land and build eight basketball
courts and a dormitory-type sleeping and dining facility to house 110 basketball players.
Each year, the camp would be run for eight sessions of one week each. The company
would hire college basketball players as coaches. The camp attendees would be male and
female basketball players ages 12 to 18. Property values in Texas have enjoyed a steady
increase in value. It is expected that after using the facility for 20 years, Lewis can sell the
property for more than it was originally purchased for. The amounts shown on the next
page have been estimated.
Cost of land
Cost to build dorm and dining facility
Annual cash inflows assuming 110 players and eight weeks
Annual cash outflows
Estimated useful life
Salvage value
Discount rate

Compute net present value

and internal rate of return
with sensitivity analysis.

(LO 3, 7), E

$200,000
$350,000
$700,000
$570,000
20 years
$700,000
12%

Instructions
(a) Calculate the net present value of the project.
(b) To gauge the sensitivity of the project to these estimates, assume that if only 90 campers
attend each week, annual cash inflows will be $570,000 and annual cash outflows will
be $508,000. What is the net present value using these alternative estimates? Discuss
your findings.
(c) Assuming the original facts, what is the net present value if the project is actually
riskier than first assumed, and a 15% discount rate is more appropriate?
(d) Assume that during the first five years the annual net cash inflows each year were only
$65,000. At the end of the fifth year, the company is running low on cash, so management decides to sell the property for $668,000. What was the actual internal rate of
return on the project? Explain how this return was possible given that the camp did
not appear to be successful.

P-3

(a) NPV $493,596

(d) IRR 15%