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Chapter 26: Q5RQ (page 1463)
List some common cash inflows from capital investments.
Investment, cash operating cost savings, and any future residual.
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What is the decision rule for IRR?
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?
Water City is considering purchasing a water park in Omaha, Nebraska, for \(1,920,000. The new facility will generate annual net cash inflows of \)472,000 for eight years. Engineers estimate that the facility will remain useful for eight years and have no residual value. The company uses straight-line depreciation, and its stockholders demand an annual return of 12% on investments of this nature.
Requirements
1. Compute the payback, the ARR, the NPV, the IRR, and the profitability index of this investment.
2. Recommend whether the company should invest in this project.
What is the decision rule for payback?
Refer to Short Exercise S26-4. Continue to assume that the expansion has no residual value. What is the project鈥檚 IRR? Is the investment attractive? Why or why not?
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