Review Session – 28/04/2017
Exercise #1:
Provide the missing data for the following divisions.
Division 1 Division 2
Asset base $ (a) $ (e)
Income $96,000 $480,000
Investment turnover (c) (f)
Return on sales ratio (b) 0.12
Return on investment 12% 15%
Sales $1,200,000 $ (d)
Various questions:
Question 1: The UST Company purchased a pied of equipment which is expected to have a useful life
of 7 years with no salve value and the end of the period. This equipment is expected to generate a cash
inflow of $32,000 each year of its useful life. If this investment has an internal rate of return of 14%,
then the initial cost of the equipment is:
A. $150,000
B. $137,216
C. $12,800
D. 343,360
Question 2: The following information is available on a new piece of equipment:
Cost of the equipment: $21,720
Salvage value: $0
Annual cash inflows: $5,000
Internal rate of return: 16%
Required rate of return: 10%
The life of the equipment is approximately:
A. 6 years
B. 4.3 years
C. 8 years
D. It is impossible to determine from the data given
Exercise #3:
Citco Company is considering investing up to $500,000 in a sustainability-enhancing project. Its
managers have narrowed their choices to three potential projects.
- Project A would redesign the production process to recycle raw materials waste back into the
production cycle, saving on direct materials costs and reducing the amount of waste sent to the
landfill.
- Project B would remodel an office building, utilizing solar panels and natural materials to create
a more energy-efficient and healthy work environment.
- Project C would build a new training center in an underserved community, providing jobs and
economic security for the local community.
The following table summarizes the costs and benefits of these three hypothetical projects:
Project A Project B Project C
Required investment $(450,000) $(300,000) $(400,000)
Annual cost savings $100,000 $60,000 $80,000
Project life 8 years 10 years 6 years
Salvage value $40,000 $75,000 $80,000
1/ Assuming that the cost of capital is 12%, compute the payback period, NPV, profitability index and
estimate a range for the internal rate of return.
2/ Based strictly on the economic analysis, in which project should they invest?
3/ What other factors should managers consider before reaching a final decision?
4/ Repeat requirements 1 & 2 using a cost of capital of 10%. Which of the capital budgeting indicators
changes and which remains the same? Why?
Exercise #4
Wescott Company has three divisions: A, B and C. The company has a hurdle rate of 8 percent.
Selected operating data for the three divisions are as follows:
Division A Division B Division C
Sales revenue $1,255,000 $920,000 $898,000
Cost of goods sold 776,000 675,000 652,000
Various operating expenses64,000 52,000 53,100
Interests and various taxes 48,000 41,000 41,500
Average invested assets 8,300,000 1,930,000 3,215,000
Wescott Company is considering an expansion project in the upcoming year that will cost $5 million
and return $450,000 per year. The project would be implemented by only one of the three divisions.
1/ Compute the ROI for each division
2/ Compute the residual income for each division
3/ Rank the divisions according to the ROI and residual income of each
4/ Compute the return on the proposed expansion project. Is this an acceptable project?
5/ Without any additional calculations, state whether the proposed project would increase of decrease
each division’s ROI.
6/ Compute the new ROI and residual income for each division if the project was implemented within
that division.
Exercise #1 – Solutions
(a) 96,000 / 0.12 = 800,000
(b) 96,000 / 1,200,000 = 0.08
(c) 1,200,000 / 800,000 = 1.5
(d) 480,000 / 0.12 = 4,000,000
(e) 480,000 / 0.15 = 3,200,000
(f) 4,000,000 / 3,200,000 = 1.25
Various questions:
Question 1: The UST Company purchased a pied of equipment which is expected to have a useful life
of 7 years with no salve value and the end of the period. This equipment is expected to generate a cash
inflow of $32,000 each year of its useful life. If this investment has an internal rate of return of 14%,
then the initial cost of the equipment is:
We know that with a 14% IRR the net present value of the cash outflows will be equal to that of the
cash inflows. So, we have:
32,000 * (1- 1/(1.14)^7))/0.14 = 137,216
Question 2: The following information is available on a new piece of equipment:
Cost of the equipment: $21,720
Salvage value: $0
Annual cash inflows: $5,000
Internal rate of return: 16%
Required rate of return: 10%
The life of the equipment is approximately:
We need to solve: 21,720 = 5,000 * (1-(1/(1.16)^n))/0.16
You can either solve it mathematically or replace the numbers suggested to you and find the one that match.
N=8
