Chapter 26, Problem 8AP

a.

To determine

Compute the payback period of each proposal.

Explanation of Solution

Capital budgeting:

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

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.

Compute the payback period for Snow –making equipment.

$\begin{array}{c}\text{Payback}\text{Period}\text{=}\frac{\text{Amount to be invested}}{\text{Estimated annual net cash }}\\ \text{=}\frac{\text{\$125,000}}{\text{\$31,250 (2)}}\\ \text{=}4\text{years}\end{array}$

Therefore, the payback period for Snow –making equipment is 4 years.

Compute the payback period for Chairlift equipment.

$\begin{array}{c}\text{Payback}\text{Period}\text{=}\frac{\text{Amount to be invested}}{\text{Estimated annual net cash }}\\ \text{=}\frac{\text{\$180,000}}{\text{\$40,000 (4)}}\\ \text{=}4.5\text{years}\end{array}$

Therefore, the payback period for chairlift equipment is 4.5 years.

Working Notes:

Calculate the depreciation expense incurred during the current year for Snow-making equipment:

$\begin{array}{c}\text{Depreciation expenes = }\frac{\text{Cost of equipment }-\text{Salvage value}}{\text{Useful life of the assets}}\\ =\frac{\$125,000-\$0}{\text{20years}}\\ =\frac{\$125,000}{20}\\ =\$6,250\end{array}$ (1)

Calculate the incremental annual cash flow of investment for Snow-making equipment:

Particulars	$
Incremental annual revenue of investment	40,000
Less: Incremental annual expenses of investment	15,000
Incremental annual income of investment	25,000
Add: Depreciation expense (1)	6,250
Incremental annual cash flow of investment	31,250

Table (1)

(2)

Calculate the depreciation expense incurred during the current year for chairlift equipment:

$\begin{array}{c}\text{Depreciation expenes = }\frac{\text{Cost of equipment }-\text{Salvage value}}{\text{Useful life of the assets}}\\ =\frac{\$180,000-\$0}{\text{36 years}}\\ =\frac{\$180,000}{36}\\ =\$5,000\end{array}$ (3)

Calculate the incremental annual cash flow of investment for chairlift equipment:

Particulars	$
Incremental annual revenue of investment	54,000
Less: Incremental annual expenses of investment	19,000
Incremental annual income of investment	35,000
Add: Depreciation expense (3)	5,000
Incremental annual cash flow of investment	40,000

Table (2)

(4)

b.

To determine

Compute the return on average investment of each proposal.

Explanation of Solution

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 a units or divisions or a companies.

Compute the return on average investment for Snow-making equipment:

$\begin{array}{c}\text{Return on average investment}\text{=}\frac{\text{Annual Estimated net income}}{\frac{\left(\text{Original cost +Salvage value}\right)}{2}}\\ \text{=}\frac{\text{\$25,000}}{\left[\frac{\$125,000+\$0}{2}\right]}\\ =\frac{\$25,000}{\$62,500}\times 100\\ \text{=}40\%\end{array}$

Therefore, the return on average investment for Snow- making equipment is 40%.

Compute the return on average investment for chairlift equipment:

$\begin{array}{c}\text{Return on average investment}\text{=}\frac{\text{Annual Estimated net income}}{\frac{\left(\text{Original cost +Salvage value}\right)}{2}}\\ \text{=}\frac{\text{\$35,000}}{\left[\frac{\$180,000+\$0}{2}\right]}\\ =\frac{\$35,000}{\$90,000}\times 100\\ \text{=38}\text{.89}\%\end{array}$

Therefore, the return on average investment for chairlift equipment is 38.89%.

c.

To determine

Compute the net present value of each proposal using the tables of present value factor and present value of annuity factor.

Explanation of Solution

Net present value method:

Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

Calculate the net present value for Snow-making equipment, and assume annual discount rate is 20% as follows:

Particulars	Amount  in $
Net present value:
The discounted present value of the incremental annual cash flow of the investment  discounted at 20% for 20 years is ($31,250 × 4.870)	152,188
Less: Cost of investment	125,000
Net present value	27,188

Table (3)

Therefore, the net present value for Snow-making equipment is $27,188.

Calculate the net present value for chairlift equipment, and assume annual discount rate is 20% as follows:

Particulars	Amount  in $
Net present value:
The discounted present value of the incremental annual cash flow of the investment  discounted at 20% for 36 years is ($40,000 × 4.993)	199,720
Less: Cost of investment	180,000
Net present value	19,720

Table (4)

Therefore, the net present value for chairlift equipment is $19,720.

d.

To determine

Discuss the nonfinancial factors should be considered.

Explanation of Solution

• The management of Mountain J should analyze the best investment opportunity available to its customers. It must also try to determine whether usage of long lift line is better than the short lift line at the time of adequate snow coverage.
• Management should undergo a marketing study about customers’ expectations. Moreover, the management should also consider the resort’s existing chairlifts and their weather pattern and also should identify the best alternative investment opportunities.

e.

To determine

Recommend the best proposal suitable for the capital investment for the Mountain J.

Explanation of Solution

• The management should opt for making investment in snow-making equipment.  Investing in snow-making equipment helps the management in having shortest payback period, a greater return on average investment and helps to have a higher to present value. 
• Skiers mostly try to tolerate to usage of long lift lines when there is good snow condition, than the short lift lines with poor snow conditions. The management can concentrate on future investment of high speed chairlift, after installing the snow-making investment equipment.