Chapter 26

Capital Investment Decisions

Demonstration Problems

© 2016 Pearson Education, Ltd. 26-1

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-2

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

12345678

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-3

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

1 $220,000

$220,000

2345678

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-4

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

1 $220,000

$220,000

2160,000 380,000

345678

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-5

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

1 $220,000

$220,000

2160,000 380,000

3150,000 530,000

45678

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-6

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

1 $220,000

$220,000

2160,000 380,000

3150,000 530,000

4150,000 680,000

5678

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-7

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

1 $220,000

$220,000

2160,000 380,000

3150,000 530,000

4150,000 680,000

5150,000 830,000

678

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-8

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

1 $220,000

$220,000

2160,000 380,000

3150,000 530,000

4150,000 680,000

5150,000 830,000

6150,000 980,000

78

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-9

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

1 $220,000

$220,000

2160,000 380,000

3150,000 530,000

4150,000 680,000

5150,000 830,000

6150,000 980,000

7150,000 1,130,000

8

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-10

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

1 $220,000

$220,000

2160,000 380,000

3150,000 530,000

4150,000 680,000

5150,000 830,000

6150,000 980,000

7150,000 1,130,000

8150,000 1,280,000

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-11

Net Cash Outflows Net Cash InflowsYear Amount Invested Annual Accumulated

0 $780,000

1 $220,000

$220,000

2160,000 380,000

3150,000 530,000

4150,000 680,000

5150,000 830,000

6150,000 980,000

7150,000 1,130,000

8150,000 1,280,000

Demonstration of E26-19

Lang, Inc., is adding a new product line that will require an investment of $780,000. Managers estimate that this investment will have an 8-year life and generate net cash inflows of $220,000 the first year, $160,000 the second year, and $150,000 each year thereafter for six years. Compute the payback period. Round to one decimal place.

© 2016 Pearson Education, Ltd. 26-12

Payback = 4 years + Amount needed to complete recovery in year 5Net cash inflow in year 5

Demonstration of E26-19

© 2016 Pearson Education, Ltd. 26-13

Payback = 4 years + Amount needed to complete recovery in year 5Net cash inflow in year 5

= 4 years + Amount invested – Accumulated net cash

inflows at the end of year 4Net cash inflow in year 5

Demonstration of E26-19

© 2016 Pearson Education, Ltd. 26-14

Payback = 4 years + Amount needed to complete recovery in year 5Net cash inflow in year 5

= 4 years + Amount invested – Accumulated net cash

inflows at the end of year 4Net cash inflow in year 5

= 4 years +$780,000 – $680,000

$150,000

Demonstration of E26-19

© 2016 Pearson Education, Ltd. 26-15

Payback = 4 years + Amount needed to complete recovery in year 5Net cash inflow in year 5

= 4 years + Amount invested – Accumulated net cash

inflows at the end of year 4Net cash inflow in year 5

= 4 years +$780,000 – $680,000

$150,000

= 4 years +$100,000$150,000

Demonstration of E26-19

© 2016 Pearson Education, Ltd. 26-16

Payback = 4 years + Amount needed to complete recovery in year 5Net cash inflow in year 5

= 4 years + Amount invested – Accumulated net cash

inflows at the end of year 4Net cash inflow in year 5

= 4 years +$780,000 – $680,000

$150,000

= 4 years +$100,000$150,000

= 4 years + 0.7 years

Demonstration of E26-19

© 2016 Pearson Education, Ltd. 26-17

Payback = 4 years + Amount needed to complete recovery in year 5Net cash inflow in year 5

= 4 years + Amount invested – Accumulated net cash

inflows at the end of year 4Net cash inflow in year 5

= 4 years +$780,000 – $680,000

$150,000

= 4 years +$100,000$150,000

= 4 years + 0.7 years

= 4.7 years

Demonstration of E26-19

© 2016 Pearson Education, Ltd. 26-18

Demonstration of E26-24

Use the NPV method to determine whether Jade Products should invest in the following projects:

• Project A: Costs $380,000 and offers six annual net cash inflows of $98,000. Jade Products requires an annual return of 12% on investments of this nature.

• Project B: Costs $320,000 and offers seven annual net cash inflows of $60,000. Jade Products demands an annual return of 9% on investments of this nature.

Requirements

1. What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

2. What is the maximum acceptable price to pay for each project?

3. What is the profitability index of each project? Round to two decimal places.

© 2016 Pearson Education, Ltd. 26-19

NetCashInflow

Annuity PV FactorPresentValueYears (i = 12%, n = 6) (i = 9%, n = 7)

Project A:

Requirement 1: What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-20

NetCashInflow

Annuity PV FactorPresentValueYears (i = 12%, n = 6) (i = 9%, n = 7)

Project A:1 – 6 Present value of annuity $

98,000

× 4.111a $402,878

Requirement 1: What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

a Appendix B, Table B-2, Present Value of Annuity of $1

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-21

NetCashInflow

Annuity PV FactorPresentValueYears (i = 12%, n = 6) (i = 9%, n = 7)

Project A:1 – 6 Present value of annuity $

98,000

× 4.111a $402,878

0 Initial investment(380,000)

Requirement 1: What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

a Appendix B, Table B-2, Present Value of Annuity of $1

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-22

NetCashInflow

Annuity PV FactorPresentValueYears (i = 12%, n = 6) (i = 9%, n = 7)

Project A:1 – 6 Present value of annuity $

98,000

× 4.111a $402,878

0 Initial investment(380,000)

Net present value of the project $22,878

Requirement 1: What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

a Appendix B, Table B-2, Present Value of Annuity of $1

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-23

NetCashInflow

Annuity PV FactorPresentValueYears (i = 12%, n = 6) (i = 9%, n = 7)

Project A:1 – 6 Present value of annuity $

98,000

× 4.111a $402,878

0 Initial investment(380,000)

Net present value of the project $22,878

Project B:

Requirement 1: What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

a Appendix B, Table B-2, Present Value of Annuity of $1

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-24

NetCashInflow

Annuity PV FactorPresentValueYears (i = 12%, n = 6) (i = 9%, n = 7)

Project A:1 – 6 Present value of annuity $

98,000

× 4.111a $402,878

0 Initial investment(380,000)

Net present value of the project $22,878

Project B:1 – 7 Present value of annuity $

60,000

× 5.033a $301,980

Requirement 1: What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

a Appendix B, Table B-2, Present Value of Annuity of $1

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-25

NetCashInflow

Annuity PV FactorPresentValueYears (i = 12%, n = 6) (i = 9%, n = 7)

Project A:1 – 6 Present value of annuity $

98,000

× 4.111a $402,878

0 Initial investment(380,000)

Net present value of the project $22,878

Project B:1 – 7 Present value of annuity $

60,000

× 5.033a $301,980

0 Initial investment(320,000)

Requirement 1: What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

a Appendix B, Table B-2, Present Value of Annuity of $1

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-26

NetCashInflow

Annuity PV FactorPresentValueYears (i = 12%, n = 6) (i = 9%, n = 7)

Project A:1 – 6 Present value of annuity $

98,000

× 4.111a $402,878

0 Initial investment(380,000)

Net present value of the project $22,878

Project B:1 – 7 Present value of annuity $

60,000

× 5.033a $301,980

0 Initial investment(320,000)

Net present value of the project $(18,020)

Requirement 1: What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

a Appendix B, Table B-2, Present Value of Annuity of $1

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-27

NetCashInflow

Annuity PV FactorPresentValueYears (i = 12%, n = 6) (i = 9%, n = 7)

Project A:1 – 6 Present value of annuity $

98,000

× 4.111a $402,878

0 Initial investment(380,000)

Net present value of the project $22,878

Project B:1 – 7 Present value of annuity $

60,000

× 5.033a $301,980

0 Initial investment(320,000)

Net present value of the project $(18,020)

Requirement 1: What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

a Appendix B, Table B-2, Present Value of Annuity of $1

The net present value of Project A is $22,878 and the net present value of Project B is $(18,020).

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-28

Requirement 2: What is the maximum acceptable price to pay for each project?

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-29

Requirement 2: What is the maximum acceptable price to pay for each project?

The maximum acceptable price to pay is $402,878 for Project A and $301,980 for project B. (The total present value of net cash inflows from each project, calculated in Requirement 1.)

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-30

Requirement 3: What is the profitability index of each project? Round to two decimal places.

Present value of net cash inflowsInitial investment =

Profitability Index

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-31

Requirement 3: What is the profitability index of each project? Round to two decimal places.

Present value of net cash inflowsInitial investment =

Profitability Index

Project A$ 402,878a

$ 380,000 = 1.06 (rounded)

a Calculated in Requirement 1.

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-32

Requirement 3: What is the profitability index of each project? Round to two decimal places.

Present value of net cash inflowsInitial investment =

Profitability Index

Project A$ 402,878a

$ 380,000 = 1.06 (rounded)

Project B$ 301,980a

$ 320,000 = 0.94 (rounded)

a Calculated in Requirement 1.

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-33

Requirement 3: What is the profitability index of each project? Round to two decimal places.

Present value of net cash inflowsInitial investment =

Profitability Index

Project A$ 402,878a

$ 380,000 = 1.06 (rounded)

Project B$ 301,980a

$ 320,000 = 0.94 (rounded)

The profitability index of Project A is 1.06 (rounded) and the profitability index of Project B is 0.94 (rounded).

a Calculated in Requirement 1.

Demonstration of E26-24

© 2016 Pearson Education, Ltd. 26-34