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Chapter 26: Q11RQ (page 1463)
What are some criticisms of the payback method?
Answer
The payback method ignores the time value of money.
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John Johnson is the majority stockholder in Johnson鈥檚 Landscape Company, owning 52% of the company鈥檚 stock. John asked his accountant to prepare a capital investment analysis to purchase new mowers. John used the analysis to persuade a loan officer at the local bank to loan the company $100,000. Once the loan was secured, John used the cash to remodel his home, updating the kitchen and bathrooms, installing new flooring, and adding a pool.
Requirements
1. Are John鈥檚 actions fraudulent? Why or why not? Does John鈥檚 percentage of ownership affect your answer?
2. What steps could the bank take to prevent this type of activity?
You are planning for a very early retirement. You would like to retire at age 40 and have enough money saved to be able to withdraw \(215,000 per year for the next 40 years (based on family history, you think you will live to age 80). You plan to save by making 10 equal annual installments (from age 30 to age 40) into a fairly risky investment fund that you expect will earn 10% per year. You will leave the money in this fund until it is completely depleted when you are 80 years old.
Requirements
1. How much money must you accumulate by retirement to make your plan work? (Hint:Find the present value of the \)215,000 withdrawals.)
2. How does this amount compare to the total amount you will withdraw from the investment during retirement? How can these numbers be so different?
David is entering high school and is determined to save money for college. David feels he can save $6,000 each year for the next four years from his part-time job. If David is able to invest at 7%, how much will he have when he starts college?
Howard Company operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of \(8,500,000. Expected annual net cash inflows are \)1,600,000 for 10 years, with zero residual value at the end of 10 years. Under Plan B, Howard Company would open three larger shops at a cost of \(8,100,000. This plan is expected to generate net cash inflows of \)1,000,000 per year for 10 years, which is the estimated useful life of the properties. Estimated residual value for Plan B is $990,000. Howard Company uses straight-line depreciation and requires an annual return of 6%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of these two plans.
2. What are the strengths and weaknesses of these capital budgeting methods?
3. Which expansion plan should Howard Company choose? Why?
4. Estimate Plan A鈥檚 IRR. How does the IRR compare with the company鈥檚 required rate of return?
Using payback, ARR, and NPV with unequal cash flows
Hughes Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machine at a cost of \(2,600,000. If refurbished, Hughes expects the machine to last another eight years and then have no residual value. Option 2 is to replace the machine at a cost of \)3,800,000. A new machine would last 10 years and have no residual value. Hughes expects the following net cash inflows from the two options:
Year | Refurbish current machine | Purchase new machine |
1 | \(1,760,000 | \)2,970,000 |
2 | 440,000 | 490,000 |
3 | 360,000 | 410,000 |
4 | 280,000 | 330,000 |
5 | 200,000 | 250,000 |
6 | 200,000 | 250,000 |
7 | 200,000 | 250,000 |
8 | 200,000 | 250,000 |
9 | 250,000 | |
10 | 250,000 | |
Total | \(3,640,000 | \)5,700,000 |
Hughes uses straight-line depreciation and requires an annual return of 10%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of these two options.
2. Which option should Hughes choose? Why?
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