Chapter 26, Problem 1BP

a.

To determine

Prepare a schedule showing the estimated increase in annual net income from the planned manufactured and sale of toys.

Explanation of Solution

Capital budgeting:

Capital budgeting is a process by which the management can plan and evaluate the investment proposal of plant assets.

Prepare a schedule showing the estimated increase in annual net income from the planned manufactured and sale of toys as follows:

Company M
Schedule of Estimated Net Income
Particulars	$	$
Estimated sales (1)		800,000
Less: Estimated incremental costs
Variable manufacturing costs (2)	300,000
Fixed manufacturing costs (except depreciation)	60,000
Depreciation expense (3)	130,000
Selling and general expenses	40,000	530,000
Income before income taxes		270,000
Less: Income taxes expense (4)		81,000
Estimated increase in annual net income		189,000

Table (1)

Therefore, the estimated increase in the annual net income is $189,000.

Working note:

Calculate the amount of estimated sales

$\begin{array}{c}\text{Estimated sales = Number of unit sold }\times \text{ Price per unit}\\ \text{=\$100,000 units }\times \text{\$8 per unit}\\ \text{=\$800,000}\end{array}$ (1)

Calculate the variable manufacturing cost

$\begin{array}{c}\text{Variable manufacturing costs = }\left(\begin{array}{l}\text{Number of unit sold }\times \\ \text{Variable manufacturing cost per unit}\end{array}\right)\\ =100,000\text{ units }\times \text{ \$3 per unit}\\ \text{=\$300,000}\end{array}$ (2)

Calculate the depreciation expense

$\begin{array}{c}\text{Depreciation expenes = }\frac{\text{Cost of equipment }-\text{Salvage value}}{\text{Useful life of the assets}}\\ =\frac{\$40,000-\$10,000}{3\text{ years}}\\ =\frac{\$390,000}{3}\\ =\$130,000\end{array}$ (3)

Calculate the income tax expense

$\begin{array}{c}\text{Income tax expense = Income before income tax }\times \text{Income tax rate}\\ \text{=\$370,000}\times \frac{30}{100}\\ =\$81,000\end{array}$ (4)

b.

To determine

Ascertain the annual net cash flows expected from the give project.

Explanation of Solution

Ascertain the annual net cash flows expected from the give project as follows:

Particulars	$	$
Cash receipts		800,000
Less: cash outlays
Variable manufacturing costs	300,000
Fixed costs (other than depreciation)	60,000
Selling and general expenses	40,000
Income taxes expense	81,000	481,000
Annual net cash flow from sale of new product		319,000

Table (2)

Therefore, the annual net cash flow from sale of new product is $319,000.

c.

To determine

Ascertain the (1) payback period, (2) return on average investment, and (3) net present value, and assume annual discount rate is 15 percent.

Explanation of Solution

Payback period: Payback period is the expected time period which is required to recover the cost of investment. It is one of the capital investment method used by the management to evaluate the proposal of long-term investment (fixed assets) of the business.

Return on investment (ROI): This financial ratio evaluates how efficiently the assets are used in earning income from operations. So, ROI is a tool used to measure and compare the performance of units or divisions of companies.

Present value: This is the amount of future value reduced or discounted at a rate of interest till particular current date.

Ascertain the (1) payback period, (2) return on average investment, and (3) net present value, and assume annual discount rate is 12 percent as follows:

(1) Payback period:

When the estimated annual net cash is equal, the cash payback period is calculated as below:

$\begin{array}{c}\text{Pay}\text{Back}\text{Period}\text{=}\frac{\text{Amount to be invested}}{\text{Estimated annual net cash }}\\ \text{=}\frac{\text{\$400,000}}{\text{\$319,000}}\\ \text{=}1.25\text{years}\end{array}$

Therefore, the payback period of the equipment is 1.25 years.

(2) Return on average investment:

$\begin{array}{c}\text{Return on average investment}\text{=}\frac{\text{Annual net income}}{\frac{\left(\text{Cost of investment + Salvage value}\right)}{2}}\\ \text{=}\frac{\text{\$189,000}}{\left[\frac{\$400,000+\$10,000}{2}\right]}\\ =\frac{\$189,000}{\$205,000}\times 100\\ \text{=}92.2\%\end{array}$

Therefore, the return on average investment is 92.2%.

(3) Net present value:

Particulars	$
Total present value of annual net cash flows (5)	766,238
Add: Present value of salvage, due in three years (6)	7,120
Total present value	773,358
Less: Amount to be invested	400,000
Net present value of the project	373,358

Table (3)

Therefore, the net present value of the project is $373,358.

Working note:

Calculate the present value of cash flow at the end of the 3rd year

Particulars	Amount ($)
Cash flow of the investment (a)	$319,000
PV at $1 annuity at discount rate of 12% for 3 years (b)	2.402
Present value of cash flow after 3 years $\left(\text{a}\times \text{b}\right)$	$766,238

Table (4)

(5)

Note: The Present value of an ordinary annuity of $1 for 3 years at 12% is 2.4023 refer present value table in Exhibit 4).

Calculate the present value of salvage value

Particulars	Amount ($)
Salvage value  (a)	$10,000
PV factor at an annual discount rate of 12% for 3rd year (b)	0.712
Present value of cash flow $\left(\text{a}\times \text{b}\right)$	$7,120

Table (5)

(6)

Note: The present value of $1 for 3rd year at 15% is 0.712 (refer present value table in Exhibit 3).