MOS3370 Chapter 13 Practice Problems
Question 1
Ben Ryatt, a professor of languages at a university in western Canada, owns a small office building adjacent to the university campus. He acquired the property 12 years ago at a total cost of $560,000: $52,000 for the land and $508,000 for the building. He has just received an offer from a real estate company that wants to purchase the property. However, the property has been a good source of income over the years, so Ryatt is unsure whether he should keep it or sell it. His alternatives are as follows:
Keep the property. Ryatt’s accountant has kept careful records of the income realized from the property over the past 10 years. These records indicate the following annual revenues and expenses:
| Rental receipts | $ | 150,000 | ||||
| Less building expenses: | ||||||
| Utilities | $ | 28,600 | ||||
| Depreciation of building | 17,800 | |||||
| Property taxes and insurance | 19,500 | |||||
| Repairs and maintenance | 10,500 | |||||
| Custodial help and supplies | 43,500 | 119,900 | ||||
| Operating income | $ | 30,100 | ||||
Ryatt makes a $12,600 mortgage payment each year on the property. The mortgage will be paid off in 10 more years. He has been depreciating the building by the straight-line method, assuming a salvage value of $9,600 for the building, which he still thinks is an appropriate figure. He feels sure that the building can be rented for another 16 years. He also feels sure that 16 years from now the land will be worth 2.5 times what he paid for it.
Sell the property. A real estate company has offered to purchase the property by paying $150,000 immediately and $23,000 per year for the next 16 years. Control of the property would go to the real estate company immediately. To sell the property, Ryatt would need to pay the mortgage off, which could be done by making a lump-sum payment of $71,000. Ryatt requires a 14% rate of return. (Ignore income taxes.)
(Hint: Use Microsoft Excel to calculate the discount factor(s).)
Required:
a. Calculate the net present value of cash flows using total cost approach if he keeps the property. (Do not round intermediate calculations and round your final answer to the nearest dollar amount.)
b. Calculate the net present value of cash flows using total cost approach if he sells the property. (Do not round intermediate calculations and round your final answer to the nearest dollar amount.)
c. Would you recommend he keep or sell the property?
multiple choice
- Sell the property
- Keep the property
Question 2
The Riteway Ad Agency provides cars for its sales staff. In the past, the company has always purchased its cars from a dealer and then sold the cars after three years of use. The company’s present fleet of cars is three years old and will be sold very shortly. To provide a replacement fleet, the company is considering two alternatives:
Purchase alternative. If the new cars are purchased, then the costs incurred by the company will be as follows:
| Purchase cost of a new fleet: 10 cars at $17,000 each | $ | 170,000 |
| Annual cost of servicing, licences, and taxes for the fleet | $ | 3,000 |
| Repairs for the fleet: | ||
| First year | $ | 1,500 |
| Second year | $ | 4,000 |
| Third year | $ | 6,000 |
At the end of three years, the fleet could be sold for one-half of the original purchase price.
Lease alternative. The company can lease the cars under a three-year lease contract. The lease cost would be $55,000 per year (the first payment due at the end of Year 1). As part of this lease cost, the owner would provide all servicing and repairs, license the cars, and pay all the taxes. Riteway would be required to make a $10,000 security deposit at the beginning of the lease period, which would be refunded when the cars were returned to the owner at the end of the lease contract.
Riteway Ad Agency’s required rate of return is 18%.
Required:
1. What is the net present value of the cash flows associated with the purchase alternative?
2. What is the net present value of the cash flows associated with the lease alternative?
3. Which alternative should the company accept?
Question 3
Secure Homes is pondering an opportunity to produce and sell a new smart home monitoring system that can be managed remotely using a smartphone app. The company has gathered the following data on probable costs and market potential:
- New equipment would have to be acquired to produce the monitoring system. The equipment would cost $300,000 and be usable for 12 years. After 12 years, it would have a salvage value equal to 10% of the original cost.
- Production and sales of the monitoring system would require a working capital investment of $142,000 to finance accounts receivable, inventories, and day-to-day cash needs. This working capital would be released for use elsewhere by the company after 12 years.
- An extensive marketing study projects sales in units over the next 12 years as follows:
| Year(s) | Sales in Units | ||
| 1 | 4,380 | ||
| 2 | 7,150 | ||
| 3 | 10,390 | ||
| 4−12 | 12,030 | ||
- The monitoring systems would sell for $140 each; variable costs for production, administration, and sales would be $80 per unit.
- To gain entry into the market, the company would have to advertise heavily in the early years of sales. The advertising program follows:
| Year(s) | Amount of Advertising | ||
| 1–2 | $ | 219,000 | |
| 3 | 157,000 | ||
| 4−12 | 136,000 | ||
- Other fixed costs for salaries, insurance, maintenance, and straight-line depreciation on equipment would total $368,000 per year. (Depreciation is based on cost less salvage value.)
- The company’s required rate of return is 15%.
(Ignore income taxes.)
Required:
1. Compute the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from sale of the monitoring systems for each year over the next 12 years. (Enter any cash outflows with a minus sign. Round your intermediate and final answers to the nearest dollar amount.)
The net cash inflow from sales of the device for each year would be:
2-a. Using the data computed in requirement (1) above and other data provided in the problem, determine the net present value of the proposed investment. (Hint: Use Microsoft Excel to calculate the discount factor(s).) (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and PV factor. Round the final answers to the nearest whole dollar amount.)
2-b. Would you recommend that Secure Homes invest in the new product?
multiple choice
- Yes
- No
3. What is the project’s internal rate of return? (Hint: Use Microsoft Excel to calculate the discount factor(s).) (Round your answer to 1 decimal place.)
Question 4
Rosman Company has an opportunity to pursue a capital budgeting project with a five-year time horizon. After careful study, Rosman estimated the following costs and revenues for the project:
| Cost of new equipment | $ | 420,000 | ||
| Sale of old equipment no longer needed | $ | 80,000 | ||
| Annual cash inflows | $ | 135,000 | ||
| Working capital needed | $ | 65,000 | ||
| Equipment maintenance in each of Years 3 and 4 | $ | 20,000 | ||
The new piece of equipment mentioned above has a useful life of five years and zero salvage value. The old piece of equipment mentioned above would be sold at the beginning of the project and there would be no gain or loss realized on its sale. Rosman uses the straight-line depreciation method for financial reporting and the CCA rate for tax purposes is 20%. The company’s tax rate is 30% and its after-tax cost of capital is 12%. When the project concludes in five years the working capital will be released for investment elsewhere within the company.
Required:
1. Compute the net present value of this investment opportunity. (Round your PV factor to 4 decimal places and all the other calculations to nearest whole dollar.)
2. Would you recommend that the contract be accepted?
multiple choice
- Yes
- No
Question 5
Winthrop Company has an opportunity to manufacture and sell a new product for a five-year period. To pursue this opportunity, the company would need to purchase a piece of equipment for $130,000. The equipment would have a useful life of five years and a $10,000 salvage value. The CCA rate for the equipment is 30%. After careful study, Winthrop estimated the following annual costs and revenues for the new product:
| Sales revenues | $ | 250,000 |
| Variable expenses | $ | 130,000 |
| Fixed expenses | $ | 70,000 |
The company’s tax rate is 30% and its after-tax cost of capital is 10%.
Required:
1. Compute the net present value of the project. (Hint: Use Microsoft Excel to calculate the discount factor(s).) (Do not round intermediate calculations and PV factor. Round the final answers to the nearest whole dollar. Negative value should be indicated with minus sign.)
2. Would you recommend that the project be undertaken?
Solution – Chapter 13 Practice Problems
Question 1 Answer
a. Correct Answer – 251,529
Workings
The annual net cash inflow from rental of the property would be:
| Operating income | 30,100 |
| Add back depreciation | 17,800 |
| Annual net cash inflow | 47,900 |
The present value analysis would be as follows:
| Item | Year(s) | Amount of Cash Flows | |
| Keep the property: | |||
| Annual loan payment | 1-10 | (12,600) | (65,723) |
| Annual net cash inflow | 1-16 | 47,900 | 300,096 |
| Resale value of the property | 16 | 139,600 | 17,156 |
| Present value of cash flows | 251,529 |
*Land: $52,000 × 2.5 = $130,000; Building: $9,600; Total: $139,600.
**Calculated using NPV formula in Microsoft Excel and a 14% required return.
b) Correct Answer – 223,096
| Item | Year(s) | Amount of Cash Flows | |
| Sell the property: | |||
| Pay-off of mortgage | Now | (71,000) | (71,000) |
| Down payment received | Now | 150,000 | 150,000 |
| Annual payments received | 1-16 | 23,000 | 144,096 |
| Present value of cash flows | 223,096 |
**Calculated using NPV formula in Microsoft Excel and a 14% required return.
Please click on the Icon below to purchase the full answer at only $10
Instant Download on Payment
