Managerial Accounting
ACT 5733 – Advanced Managerial Accounting
Fall 2012
HW #3
Question #1
Consider the following potential investment, which has the same risk as the firm’s other projects:
Time Cash Flow
0 -$95,000
1 $20,000
2 $24,000
3 $24,000
4 $24,000
5 $24,000
6 $32,000
a) What are the investment’s payback period, IRR, and NPV, assuming the firm’s WACC is 10%.
b) If the firm requires a payback period of less than 5 years, should this project be accepted?
Answer:
Yes it should accept the project because the payback period for the project meets the less than five years requirement with 4.13 years.
c) Based on the IRR and NPV rules, should this project be accepted? Be sure to justify your choice.
Answer: Yes the project should be accepted based on the IRR of 13% the company will get back on its investment and also the positive NPV of $10, 406 of the future cash flow of the project. However, the IRR is not compared against any other project so the firm cannot rely on this rule as it should the NPV.
d) Which of the decision rules (payback, NPV, or IRR) do you think is the best rule for a firm to use when evaluating projects? Be sure to justify your choice.
Answer: Of the three decision rules, the NPV is the best rule for a firm to use when evaluating projects for the following reasons:
a) It takes the time value of money into consideration
b) It takes cost of capital (WACC) into consideration also
c) It includes all cash flows in the decision
d) It has the ability to incorporate multiple discount rates
Question #2
A firm believes it can generate an additional $250,000 per year in revenues for the next 5 years if it replaces existing equipment that is no longer usable with new equipment that costs $240,000. The firm expects to be able to sell the new equipment when it is finished using it (after 5 years) for $10,000. The existing equipment has a book value of $20,000 and a market value of $12,000. Variable costs are expected to total
Fall 2012
HW #3
Question #1
Consider the following potential investment, which has the same risk as the firm’s other projects:
Time Cash Flow
0 -$95,000
1 $20,000
2 $24,000
3 $24,000
4 $24,000
5 $24,000
6 $32,000
a) What are the investment’s payback period, IRR, and NPV, assuming the firm’s WACC is 10%.
b) If the firm requires a payback period of less than 5 years, should this project be accepted?
Answer:
Yes it should accept the project because the payback period for the project meets the less than five years requirement with 4.13 years.
c) Based on the IRR and NPV rules, should this project be accepted? Be sure to justify your choice.
Answer: Yes the project should be accepted based on the IRR of 13% the company will get back on its investment and also the positive NPV of $10, 406 of the future cash flow of the project. However, the IRR is not compared against any other project so the firm cannot rely on this rule as it should the NPV.
d) Which of the decision rules (payback, NPV, or IRR) do you think is the best rule for a firm to use when evaluating projects? Be sure to justify your choice.
Answer: Of the three decision rules, the NPV is the best rule for a firm to use when evaluating projects for the following reasons:
a) It takes the time value of money into consideration
b) It takes cost of capital (WACC) into consideration also
c) It includes all cash flows in the decision
d) It has the ability to incorporate multiple discount rates
Question #2
A firm believes it can generate an additional $250,000 per year in revenues for the next 5 years if it replaces existing equipment that is no longer usable with new equipment that costs $240,000. The firm expects to be able to sell the new equipment when it is finished using it (after 5 years) for $10,000. The existing equipment has a book value of $20,000 and a market value of $12,000. Variable costs are expected to total