CHAPTER 8

#5 Describe the three steps required to evaluate investments using the net
present value method.
Most managers employ three strategies when appraising investments using the
net present value method. First, determine the quantity and timing of the cash flows
required over the investment's life. It is critical to calculate the expected cost of the
investments at this stage. The timing of cash flows is critical when making new
investment decisions. Second, determine a suitable interest rate for analyzing the
investment. The interest rate is estimated in this stage depending on the firm's cost of
capital. For long-term investments, the cost of capital is defined as the weighted
average of debt and equity. It should be noted that the larger the risk of the investment,
the higher the required rate of return. Third, compute and assess the investment's net
present value (NPV). As a general rule, accept the investment if the NPV is zero;
otherwise, reject the investment. Aside from that, if the NPV is greater than zero, the
investment's rate of return is more than the needed rate of return. The rate of return
from the investment is equal to the needed rate of return if the NPV is zero; otherwise,
the rate of return from the investment is less than the required rate of return.

#7 What is meant by the term internal rate of return? Explain the IRR decision
rule?
The internal rate of return (IRR) is the rate (r) that must be applied to a sequence
of cash flows in order to obtain a net present value (NPV) of zero. The IRR is the
adjusted rate of return on the investment in consideration. The IRR determination
guidelines specify that if the IRR is greater than or equal to the company's needed rate
of return (also known as the hurdle rate), the investment is approved; otherwise, the
investment is refused.
#12 What is the payback method, and why do managers use this method?

The payback method determines how long it will take to "pay back" or repay the
initial expenditure. The payback period, which is commonly represented in years, is the
time it takes for an investment to generate enough cash receipts to repay the financial
outflows. When considering whether to proceed with an investment, account and fund
managers assess the payback time. The payback period has the problem of ignoring
the time worth of money. Divide the investment amount by the yearly cash flow to
calculate the payback time.

#15 What does the term working capital refer to, and how does working capital
affect the evaluation of long-term investments?
Working capital is equal to current assets minus current liabilities. Working
capital is required for many long-term initiatives. Working capital is also required for
inventory and accounts receivable. Working capital for long-term investments should be
recorded as a cash outflow, often at the project's inception. Some long-term
investments have a set life expectancy after which operating cash is returned to the firm
for future investment. Working capital is included in the cash flow analysis as a cash
outflow at the start of the project and a cash inflow at the end when this occurs.

#16 Assume a company pays income taxes. How are revenue and expense cash
flows adjusted for income taxes when calculating the net present value?
When it comes to taxes in this circumstance, it is vital to always categorize which
cash flows are influenced by the tax rate and which are not. This is accomplished by
examining the income and cost inflows. When a business is obligated to pay income
taxes, all cash inflows and cash outflows effect net income and, as a result, the amount
of income taxes paid. The purpose is to compute the cash flow after taxes.
#17 Assume a company pays income taxes. How does depreciation expense
affect cash flows even though it is a noncash expense?
Despite the fact that depreciation is not a cash outflow, it decreases taxable
income and consequently taxes paid (remember that the entry to record depreciation for
financial accounting reasons has no effect on cash; deduct depreciation expense and
credit accumulated depreciation). This tax break is known as a depreciation tax shield.

#21 Net Present Value Calculations. Freefall, Inc.

A. In comparison, the Investment Y would have a higher net present value than the
Investment Z based on their amount of cash receipts.
B. As computed that the Investment Y has the higher net present value, Freefall Inc
should only invest in Investment Y. As the rule says that if the NPV > 0, the
investment should be accepted while if the NPV < 0 therefore the investment
is rejected. As we can see that Investment Y has NPV > 0 is better than the
Investment Z on which the NPV < 0.

INVESTMENT Y
Year 1 Year 2 Year 3 Year 4
Initial Cost -65,000 - - - -
Cash Receipts - 35,000 25,000 15,000 5,000
Total Cashflow -65,000 35,000 25,000 15,000 5,000
PV Factor (8%) 1 0.9259 0.8573 0.7938 0.735
Present Value -65,000 32,407 21,433 11,907 3,675 4,422

INVESTMENT Z
 Year 1 Year 2 Year 3 Year 4
Initial Cost -65,000 - - - -
Cash Receipts - 5,000 15,000 25,000 35,000
Total Cashflow -65,000 5,000 15,000 25,000 35,000
PV Factor (8%) 1 0.9259 0.8573 0.7938 0.735
Present Value -65,000 4,630 12,860 19,845 25,725 -1,940

Internal Rate of Return Calculation

Cash Flows Trial (10%)

Initial Cost of Investment -50,000 1 -50,000
Cash Savings 5,000 7.6061 38,031
Net Present Value -11,970

Cash Flows Trial (5%)

Initial Cost of Investment -50,000 1 -50,000
Cash Savings 5,000 10.3797 51,899
Net Present Value 1,899

Cash Flows Trial (7%)

Initial Cost of Investment -50,000 1 -50,000
Cash Savings 5,000 9.1079 45,540
Net Present Value -4,460

Cash Flows Trial (6%)

Initial Cost of Investment -50,000 1 -50,000
Cash Savings 5,000 9.7122 48,561
Net Present Value -1,439

APPROX. IRR = 6%
Interpolation (in between 5% - 6%):
1,899 + 1,439 = 3,338 1,899 / 3,338
 = 0.57 5% + 0.57 = 5.57
EXACT IRR = 5.57%

Using the exact IRR of 5.57%

Cash Flows Trial (5.57%)

Initial Cost of Investment -50,000 1 -50,000
Cash Savings 5,000 9.991 49,955
Net Present Value (5) rounding off difference

Payback Period Calculation. Textile Services, Inc.

Outflows Inflows Balance

Investment -80,000 - -80,000
Year 1 - 20,000 -60,000
Year 2 - 20,000 -40,000
Year 3 - 20,000 -20,000
Year 4 (payback period) - 20,000 0

Net Present Value Analysis with Multiple Investments

Cash Flows PVF (10%) PV

Initial Cost of Investment -20,000 1 -20,000
Additional Investment -10,000 0.9091 -9,091
Cash Savings 4,000 7.6061 30,424
NPV 1,333

Net Present Value Calculation with Taxes

Cash Flows PVF (10%) PV

Initial Cost of Investment -200,000 1 -200,000
Cash Savings 85,000 2.4437 207,715
NPV 7,715

#29 Net Present Value Analysis. Architect Services, Inc

Year 1 Year 2 Year 3 Year 4

Purchase Price -50,000 - - - -
Maintenance Cost - -14,000 -14,000 -14,000 -14,000
Cash Savings - 30,000 30,000 30,000 30,000
Salvage Value - - - - 10,000
Cash Flow -50,000 16,000 16,000 16,000 26,000
PVF 1 0.9009 0.8116 0.7312 0.6587 B. NPV
Present Value -50,000 14,414 12,986 11,699 17,126 6,225

B. Since the computed net present value amounted to positive 6.225, it is an indication
that the possible return of the proposal is above the required 11% rate of the company
based on the rule provided that if the IRR is ≥ the company’s required rate of return.
Therefore, the company should agree to purchase the blueprint machine. 

Internal Rate of Return Analysis. Architect Services, Inc.

Cash Flows Trial (11%) PV

Purchase Price -50,000 1 -50,000

Maintenance Cost -14,000 3.1024 -43,434

Cash Savings 30,000 3.1024 93,072
Salvage Value 10,000 0.6587 6,587
NPV 6,225

Cash Flows Trial (13%) PV

Purchase Price -50,000 1 -50,000

Maintenance Cost -14,000 2.9745 -41,643

Cash Savings 30,000 2.9745 89,235
Salvage Value 10,000 0.6133 6,133
NPV 3,725

Cash Flows Trial (15%) PV

Purchase Price -50,000 1 -50,000

Maintenance Cost -14,000 2.855 -39,970

Cash Savings 30,000 2.855 85,650
Salvage Value 10,000 0.5718 5,718
NPV 1,398

Cash Flows Trial (17%) PV

Purchase Price -50,000 1 -50,000

Maintenance Cost -14,000 2.7432 -38,405

Cash Savings 30,000 2.7432 82,296
Salvage Value 10,000 0.5718 5,337
NPV -772

Cash Flows Trial (16%) PV

Purchase Price -50,000 1 -50,000

Maintenance Cost -14,000 2.7982 -39,175

Cash Savings 30,000 2.7982 83,946
Salvage Value 10,000 0.5523 5,523
NPV 294

APPROX. IRR = 16%

Interpolation (in between 16% - 17%):
294 + 772 = 1,066 294 / 1,066
= 0.27 16% + 0.27 = 16.28
IRR = 16.28%

Trial
Cash Flows (16.28%)
Initial Cost of Investment -50,000 1 -50,000
Maintenance Cost -14,000 2.7826 -38,956
Cash Savings 30,000 2.7826 83,478
Salvage Value 10,000 0.547 5,470
Net Present Value (8) rounding off difference

Payback Period Calculation. Architect Services, Inc.

Outflows Inflows Balance

Investment -50,000 -50,000
Year 1 16,000 -34,000
Year 2 16,000 -18,000
Year 3 16,000 -2,000
Year 4 (payback period) 26,000

Net Present Value Analysis with Multiple Investments, Alternative Format.

Conway Construction Corporation

A.

Cash Flows Cash Flows PV

Purchase Price -260,000 -260,000 -260,000
Expenses -42,000 -42,000 -194,834
Receipts 135,000 135,000 626,252
Additional Cost – Eqp. -40,000 -40,000 -30,780
Salvage Value 20,000 20,000 7,012
NPV 147,650

B. The company should purchase the new fleets of trucks since, the positive net present
value amounted to 147,650 which is an indication that s the return of this proposal is
above the company’s required rate of return of 11%
 Net Present Value Analysis with Taxes. Timberline Company

Cash Flows PVF (12%) PV

Purchase Price -100,000 1 -100,000
Cash Revenue 30,000 3.6048 108,144
Cash Expenses -14,400 3.6048 -51,909
Depreciation Tax Savings 8,000 3.6048 28,838
NPV -14,927
A.

B. It shows that the computed net present value is negative amount of 14, 927,
therefore the proposal is rejected since the rate of return is lower than the required rate
of return. It results to not purchasing of the new machine.