Beyond the numbers-Critical thinking
Business decision case A Lloyd's Company wishes to invest USD 750,000 in capital projects that have a minimum expected rate of return of 14 per cent. The company is evaluating five proposals. Acceptance of one proposal does not preclude acceptance of any of the other proposals. The company's criterion is to select proposals that meet its 14 per cent minimum required rate of return. The relevant information related to the five proposals is as follows:
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Investment
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Initial cash Outlay
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Expected after-tax net Cash inflow per year
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Expected life of Proposal (years)
|
|
A
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$ 150,000
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$ 45,000
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5
|
|
B
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300,000
|
60,000
|
8
|
|
C
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375,000
|
82,500
|
10
|
|
D
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450,000
|
78,000
|
12
|
|
E
|
150,000
|
31,500
|
10
|
a. Compute the net present value of each of the five proposals.
b. Which projects should be undertaken? Why? Rank them in order of desirability.
Business decision case B Slick Company is considering a capital project involving a USD 225,000 investment in machinery and a USD 45,000 investment in working capital. The machine has an expected useful life of 10 years and no salvage value. The annual cash inflows (before taxes) are estimated at USD 90,000 with annual cash outflows (before taxes) of USD 30,000. The company uses straight-line depreciation. Assume the federal income tax rate is 40 per cent.
The company's new accountant computed the net present value of the project using a minimum required rate of return of 16 per cent (the company's cost of capital). The accountant's computations follow:
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Cash inflows
|
$ 90,000
|
|
Cash outflows
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30,000
|
|
Net cash inflow
|
$ 60,000
|
|
Present value of net cash at 16%
|
X 4.833
|
|
Present value of net cash inflow
|
$283,980
|
|
Initial cash outlay
|
225,000
|
|
Net present value
|
$ 64,980
|
a. Are the accountant's computations correct? If not, compute the correct net present value.
b. Is this capital project acceptable to the company? Why or why not?
An accounting perspective – Writing experience C Refer to "An accounting perspective: Business insight". Write a brief paper explaining why managers in Japan might use lower measures of the cost of capital than US managers.
Ethics case – Writing experience D Rebecca Peters just learned that First Bank's investment review committee rejected her pet project, a new computerized method of storing data that would enable customers to have instant access to their bank records. Peters' software consulting firm specializes in working with financial institutions. This project for First Bank was her first as project manager.
Following up, Peters learned that First Bank's investment review committee liked the idea but were not convinced that the new software's financial benefits would justify the cost of the software. When she told a colleague about the rejection at First Bank, the colleague said, "Why not tell the committee this software will increase the bank's profits? After we installed the software in the bank in Indianapolis, Indiana, USA their profits increased substantially. We even have data from that bank that you could present."
Peters thought about the suggestion. She knew First Bank would be pleased with the software if they installed it, and she wanted to make the sale. She also knew that the situation in Indianapolis, Indiana, USA was different; profits there had increased primarily because of other software that had reduced the bank's operating costs.
What should Rebecca Peters do? Write her a letter telling what you would do.
Group assignment E For summer employment, a friend is considering investing in a coffee stand on a busy street near office buildings. Being unfamiliar with the concepts in this chapter, your friend does not know how to make the decision. In teams of four, help your friend get started by providing a framework and questions that your friend should answer. (For example, how much will the investment be? How much are the estimated cash flows from sales?) Prepare a memorandum from the group to your instructor; list your questions and suggestions for your friend. In the heading, include the date, to whom it is written, from whom, and the subject matter.
Group project F You have the option of choosing between two projects with equal total cash flows over five years but different annual cash flows. In groups of two or three students, determine which project should be selected for investment. Write a memorandum to your instructor addressing this issue. Be sure to provide examples to reinforce your answer. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Group project G A manager comments to her superior, "There is no need to perform a postaudit. The project was justified based on our initial projections and we were given the green light to proceed. It has been a year since we started the project, a postaudit would be a waste of time." In groups of two or three students, respond to this comment. Do you agree? Do you disagree? If this manager is right, why bother with a postaudit? Write a memorandum to your instructor addressing these questions. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.