Question

Most Company has an opportunity to invest in one of two new projects. Project Y requires a $345,000 investment for new machinery with a six-year life and no salvage value. Project Z requires a $345,000 investment for new machinery with a five-year life and no salvage value. The two projects yield the following predicted annual results. The company uses straight-line depreciation, and cash flows occur evenly throughout each year.

Project Y Project Z
Sales 360,000 288,000
Expenses
Direct materials 50,400 36,000
Direct labor 72,000 43,200
Overhead including depreciation 129,600 129,600
Selling and administrative expenses 26,000 26,000
Total expenses 278,000 234,800
Pretax income 82,000 53,200
Income taxes (38%) 31,160 20,216
Net income 50,840 32,984

Required:
a. Compute each project’s annual expected net cash flows.
b. Compute each project’s accounting rate of return.
c. Determine each project’s net present value using 6% as the discount rate. Assume that cash flows occur at each year-end.

Answer 1

Most Company

a. Annual expected net cash flows:

Project Y Project Z

Net cash flows before tax 139,500 122,200

Expected net cash flows:

Income taxes (38%) 31,160 20,216

Net cash flows after tax 108,340 101,984

b. Accounting rate of return:

= Annual Net Income/Average Investment

Project Y:

= $50,840/$278,000 * 100

= 18.29%

Project Z:

= $32,984/$234,800 * 100

= 14.05%

c. Net Present Value, using 6% discount rate:

Annuity PV Project Y Project Z

Annuity factor = 4.212

Annuity of operating outflows 929,746 698,350

Initial Investments 345,000 345,000

Total PV of investments $1,274,746 $1,043,350

Annuity of cash inflows $1,516,320 $1,213,056

Net present value $241,574 $169,706

Step-by-step explanation:

a) Data and Calculations:

1. Investments in Projects:

Project Y Project Z

Investments $345,000 $345,000

Project's life 6 years 5 years

Salvage value 0 0

Depreciation method = straight-line method

Annual Depreciation expenses $57,500 $69,000

2. Cash Inflows:

Sales 360,000 288,000

3. Cash Outflows:

Direct materials 50,400 36,000

Direct labor 72,000 43,200

Overhead 72,100 60,600

Selling & Admin. expenses 26,000 26,000

Total Operating Outflows 220,500 165,800

Net cash flows before tax 139,500 122,200

Expected net cash flows:

Income taxes (38%) 31,160 20,216

Net cash flows after tax 108,340 101,984

4. Accounting rate of returns calculations:

Project Y Project Z

Annual Net income $50,840 $32,984

Project's life 6 years 5 years

Initial Investments 345,000 345,000

Annual Cash Outflows 220,500 165,800

Total Cash Outflows 1,323,000 829,000

Total Investments 1,668,000 1,174,000

Average Investments $278,000 $234,800

Average investments = total investments/number of project's years.

5. Most Company's accounting rate of return measures the average annual net income as a percentage of the average investments, without considering the time value of money.

6. Most Company's NPV or net present value of a project calculates the difference between the present values of the inflows and the outflows of a project over its life.