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Chapter 25, Problem 25.6APR

1.

To determine

Cash payback method:

Cash 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 long-term investment (fixed assets) of the business.

Average rate of return method:

Average rate of return is the amount of income which is earned over the life of the investment. It is used to measure the average income as a percent of the average investment of the business, and it is also known as the accounting rate of return.

The average rate of return is computed as follows:

Average rate of return =Estimated average annual incomeAverage investment

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.

Present value index:

Present value index is a technique, which is used to rank the proposals of the business.  It is used by the management when the business has more investment proposals, and limited fund. 

The present value index is computed as follows:

Present value index =Total present value of net cash flowAmount to be invested

The cash payback period for the given proposals.

1.

Expert Solution
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Explanation of Solution

The cash payback period for the given proposals is as follows:

Proposal A:

Initial investment=$680,000

         
 Cash payback period of Proposal A
         
 Year    Net cash flows    Cumulative net cash flows
                1       200,000           200,000
                2       200,000           400,000
                3       200,000           600,000
6 months (1)         80,000           680,000

Table (1)

Hence, the cash payback period of proposal A is 3 years and 6 months.

Working note:

1. Calculate the no. of months in the cash payback period:

No. of months = (Balance amount of intital investmentTotal cash flow for particular year)×No. of months in a year=$80,000$160,000×12 months= 6 months (1)

Proposal B:

Initial investment=$320,000

Cash payback period of Proposal B
         
 Year    Net cash flows    Cumulative net cash flows
                1            90,000           90,000
                2            90,000         180,000
 3            70,000         250,000
                4            70,000         320,000

Table (2)

Hence, the cash payback period of proposal B is 4 years.

Proposal C:

Initial investment=$108,000

Cash payback period of Proposal C
         
 Year    Net cash flows    Cumulative net cash flows
                  1       55,000            55,000
                  2       53,000          108,000

Table (3)

Hence, the cash payback period of proposal C is 2 years.

Proposal D:

Initial investment=$400,000

Cash payback period of Proposal D
         
 Year    Net cash flows    Cumulative net cash flows
                1     180,000          180,000
                2     180,000          360,000
3 months (2)       40,000          400,000
         

Table (4)

Hence, the cash payback period of proposal D is 2 years and 3 months.

Working note:

2. Calculate the no. of months in the cash payback period:

No. of months = (Balance amount of intital investmentTotal cash flow for particular year)×No. of months in a year=$40,000$160,000×12 months= 3 months (2)

2.

To determine

The average rate of return for the give proposals.

2.

Expert Solution
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Explanation of Solution

The average rate of return for the given proposals is as follows:

Proposal A:

Average rate of investment = (Income from operationsUseful life of years)(Cost of investment2)=($240,0005 years)($680,0002)=$48,000$340,000=0.141In percentage 0.141×100 = 14.1%

Hence, the average rate of return for Proposal A is 14.1%.

Proposal B:

Average rate of investment = (Income from operationsUseful life of years)(Cost of investment2)=($20,0005 years)($320,0002)=$4,000$160,000=0.025In percentage 0.025×100 = 2.5%

Hence, the average rate of return for Proposal B is 2.5%.

Proposal C:

Average rate of investment = (Income from operationsUseful life of years)(Cost of investment2)=($142,0005 years)($108,0002)=$28,400$54,000=0.526In percentage 0.526×100 = 52.6%

Hence, the average rate of return for Proposal C is 52.6%.

Proposal D:

Average rate of investment = (Income from operationsUseful life of years)(Cost of investment2)=($300,0005 years)($400,0002)=$60,000$200,000=0.300In percentage 0.300×100 = 30.0%

Hence, the average rate of return for Proposal D is 30.0%.

3.

To determine

To indicate: The proposals which should be accepted for further analysis, and which should be rejected.

3.

Expert Solution
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Explanation of Solution

The proposals which should be accepted for further analysis, and which should be rejected is as follows:

Bundle: Financial & Managerial Accounting, 13th + Working Papers, Volume 1, Chapters 1-15 For Warren/reeve/duchac’s Corporate Financial Accounting, ... 13th + Cengagenow™v2, 2 Terms Access Code, Chapter 25, Problem 25.6APR , additional homework tip  1

Figure (1)

Proposals A and B are rejected, because proposal A and B fails to meet the required maximum cash back period of 3 years, and they has less rate of return than the other proposals. Hence, Proposals C and D are preferable.

4.

To determine

The net present value of preferred proposals.

4.

Expert Solution
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Explanation of Solution

Calculate the net present value of the proposals which has 12% rate of return as follows:

Proposal C:

Bundle: Financial & Managerial Accounting, 13th + Working Papers, Volume 1, Chapters 1-15 For Warren/reeve/duchac’s Corporate Financial Accounting, ... 13th + Cengagenow™v2, 2 Terms Access Code, Chapter 25, Problem 25.6APR , additional homework tip  2

Figure (2)

Hence, the net present value of proposal C is $62,067.

Proposal D:

Bundle: Financial & Managerial Accounting, 13th + Working Papers, Volume 1, Chapters 1-15 For Warren/reeve/duchac’s Corporate Financial Accounting, ... 13th + Cengagenow™v2, 2 Terms Access Code, Chapter 25, Problem 25.6APR , additional homework tip  3

Figure (3)

Hence, the net present value of proposal D is $94,920.

5.

To determine

To determine:  The present value index for each proposal.

5.

Expert Solution
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Explanation of Solution

The present value index for each proposal is as follows:

Proposal C:

Calculate the present value index for proposal C:

Present value index for proposal C = Total presest value of cash flowAmount to be invested=$170,067$108,000=1.575

Hence, the present value index for proposal C is 1.575.

Proposal D:

Calculate the present value index for proposal D:

Present value index for proposal D= Total presest value of cash flowAmount to be invested=$494,920$400,000=1.237

Hence, the present value index for proposal D is 1.237.

6.

To determine

To rank: The proposal from most attractive to least attractive, based on the present value of net cash flows.

6.

Expert Solution
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Explanation of Solution

Proposals are arranged by rank is as follows:

Proposals  Net present value  Rank
 Proposal D  $      94,920 1
 Proposal C  $      62,067 2

Table (5)

7.

To determine

To rank: The proposal from most attractive to least attractive, based on the present value of index.

7.

Expert Solution
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Explanation of Solution

Proposals are arranged by rank is as follows:

Proposals  Present value index  Rank
 Proposal C 1.57 1
 Proposal D 1.24 2

Table (6)

8.

To determine

To analysis: The proposal which is favor to investment, and comment on the relative attractiveness of the proposals based on the rank.

8.

Expert Solution
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Explanation of Solution

On the basis of net present value:

The net present value of Proposal C is $62,067, and Proposal D is $94,920. In this case, the net present value of proposal D is more than the net present value of proposal C. Hence, investment in Proposal D is preferable.

On the basis of present value index:

The present value index of Proposal C is 1.57, and the present value index of Proposal D is 1.24. In this case, Proposal C has the favorable present value index, because the present value index of Proposal C (1.57) is more than Proposal D (1.24).  Thus, the investment in Proposal C is preferable (favorable).

Every business tries to get maximum profit with minimum investment. Hence, the cost of investment in Proposal C is less than the proposal D. Thus, investment in Proposal C is preferable.

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Chapter 25 Solutions

Bundle: Financial & Managerial Accounting, 13th + Working Papers, Volume 1, Chapters 1-15 For Warren/reeve/duchac’s Corporate Financial Accounting, ... 13th + Cengagenow™v2, 2 Terms Access Code

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