Chapter 26, Problem 9AP

a.

To determine

Ascertain the payback period for the given proposals.

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.

Ascertain the payback period for the given proposals as follows:

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

Computer chip equipment:

$\begin{array}{c}\text{Payback}\text{Period}\text{=}\frac{\text{Amount to be invested}}{\text{Estimated annual net cash }}\\ \text{=}\frac{\text{\$300,000}}{\text{\$100,000 (2)}}\\ \text{=}3\text{years}\end{array}$

Therefore, the payback period for the computer chip equipment is 3 years.

Working note:

Calculate the depreciation expense incurred during the current year

$\begin{array}{c}\text{Depreciation expenes = }\frac{\text{Cost of equipment }-\text{Salvage value}}{\text{Useful life of the assets}}\\ =\frac{\$300,000-\$0}{\text{6 years}}\\ =\frac{\$300,000}{6}\\ =\$50,000\end{array}$ (1)

Calculate the incremental annual cash flow of investment

Particulars	$
Incremental annual revenue of investment	300,000
Less: Incremental annual expenses of investment	250,000
Incremental annual income of investment	50,000
Add: Depreciation expense (1)	50,000
Incremental annual cash flow of investment	100,000

Table (1)

(2)

Software bank installation:

$\begin{array}{c}\text{Payback}\text{Period}\text{=}\frac{\text{Amount to be invested}}{\text{Estimated annual net cash }}\\ \text{=}\frac{\text{\$240,000}}{\text{\$70,000 (4)}}\\ \text{=}3.4\text{years}\end{array}$

Therefore, the payback period for the Software bank installation is 3.4 years.

Working note:

Calculate the depreciation expense incurred during the current year

$\begin{array}{c}\text{Depreciation expenes = }\frac{\text{Cost of equipment }-\text{Salvage value}}{\text{Useful life of the assets}}\\ =\frac{\$240,000-\$0}{\text{6 years}}\\ =\frac{\$240,000}{6}\\ =\$40,000\end{array}$ (3)

Calculate the incremental annual cash flow of investment

Particulars	$
Incremental annual revenue of investment	160,000
Less: Incremental annual expenses of investment	130,000
Incremental annual income of investment	30,000
Add: Depreciation expense (3)	40,000
Incremental annual cash flow of investment	70,000

Table (2)

(4)

b.

To determine

Ascertain the return on average investment for the given proposals.

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.

Ascertain the return on average investment for the given proposals as follows:

Computer chip equipment:

$\begin{array}{c}\text{Return on average investment}\text{=}\frac{\text{Annual net income}}{\frac{\left(\text{Cost of investment + Salvage value}\right)}{2}}\\ \text{=}\frac{\text{\$50,000}}{\left[\frac{\$300,000+\$0}{2}\right]}\\ =\frac{\$50,000}{\$150,000}\times 100\\ \text{=}33.33\%\end{array}$

Therefore, the return on average investment for computer chip equipment is 33.33%.

Software bank installation:

$\begin{array}{c}\text{Return on average investment}\text{=}\frac{\text{Annual net income}}{\frac{\left(\text{Cost of investment + Salvage value}\right)}{2}}\\ \text{=}\frac{\text{\$30,000}}{\left[\frac{\$240,000+\$0}{2}\right]}\\ =\frac{\$60,000}{\$120,000}\times 100\\ \text{=}25\%\end{array}$

Therefore, the return on average investment for software bank installation is 25%.

c.

To determine

Ascertain the net present value for the given proposals, and assume annual discount rate is 15%.

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.

Ascertain the net present value for the given proposals, and assume annual discount rate is 15% as follows:

Computer chip equipment:

Particulars	$
Total present value of annual net cash flows (5)	378,400
Less: Amount to be invested	300,000
Net present value of the project	78,400

Table (3)

Therefore, the net present value for the computer ship equipment is $78,400.

Working note:

Calculate the present value of cash flow at the end of the 6th year

Particulars	Amount ($)
Cash flow of the investment (a)	$100,000
PV at $1 annuity at discount rate of 15% for 6 years (b)	3.784
Present value of cash flow after 6 years $\left(\text{a}\times \text{b}\right)$	$378,400

Table (4)

(5)

Note: The Present value of an ordinary annuity of $1 for 6 years at 15% is 3.784 (refer present value table in Exhibit 4).

Software bank installation:

Particulars	$
Total present value of annual net cash flows (6)	264,880
Less: Amount to be invested	240,000
Net present value of the project	24,880

Table (5)

Therefore, the net present value for the computer ship equipment is $24,880.

Working note:

Calculate the present value of cash flow at the end of the 6th year

Particulars	Amount ($)
Cash flow of the investment (a)	$70,000
PV at $1 annuity at discount rate of 15% for 6 years (b)	3.784
Present value of cash flow after 8 years $\left(\text{a}\times \text{b}\right)$	264,880

Table (6)

(6)

Note: The Present value of an ordinary annuity of $1 for 6 years at 15% is 3.784 (refer present value table in Exhibit 4).

d.

To determine

Identify the non-financial factors that the Company S should consider in the decision making.

Explanation of Solution

Identify the non-financial factors that the company S should consider in the decision making as follows:

• Determine the customer preference and demand of the product
• Industry trend regarding software distribution
• Evaluate the medium which provides the most protection against piracy and theft
• Evaluate the risk regarding software bank installation
• Adopting or changes in the federal and state government legislations
• Legal considerations related to the formation and operation of the business
• Types of alternative investment opportunities

e.

To determine

Explain the reason that the Company S’s employees would most likely underestimates the benefits of investing in software bank.

Explanation of Solution

Explain the reason that the Company S’s employees would most likely underestimates the benefits of investing in software bank as follows:

If company S invests in the software bank, this will not use the employees to load the following programs,

• Process orders
• Employee efficiency
• Packaging and shipping
• Quality of the product, and
• Other non-financial factors

These types (above) of disadvantages would underestimate the employees to invest in the software bank.

f.

To determine

Evaluate the proposal and recommend which proposal is best for the investment.

Explanation of Solution

Evaluate the proposal and recommend which proposal is best for the investment as follows:

Computer chip equipment is best for the investment purpose, because payback period of computer chip equipment (3 years) is less than the software bank installation (3.4 years), return on investment of computer chip equipment (33.33%) is higher than the software bank installation (25%), and net present value of computer chip equipment ($78,400). is higher than the software bank installation ($24,880). Therefore, computer chip equipment is preferable for the investment purpose.