A SMORGASBORD OF CAPITAL BUDGETING PERFORMANCE MEASURES

Susanka Company’s president invited proposals from her management team for capital expenditures, and approved four proposals submitted by four different managers. She told the four managers that a bonus would be paid to the manager with the most successful capital project. The success of each project can be evaluated based on Net Present Value, Pre-Tax Accounting Rate of Return, Payback Method, or Internal Rate of Return. The following data are available.

Manager Initial Cost of the Asset

Useful Life Net Annual Increase to Cash Flows

from the Project

Mrs. White $280,000 2 years $170,050

Professor Plum

$300,000 1 years $330,000

Mr. Green $560,000 14 years $97,825

Ms. Scarlet $2,000,000 16 years $280,000

A SMORGASBORD OF CAPITAL BUDGETING PERFORMANCE MEASURES

All four of the capital expenditures have zero terminal value. Straight-line depreciation is used. The discount rate is 10%.

You are a financial analyst working for (look at your handout).

Which performance measure (or measures) will you recommend that your manager adopt in order to claim the bonus?

Manager Initial Cost of the Asset

Useful Life Net Annual Increase to Cash Flows

from the Project

Mrs. White $280,000 2 years $170,050

Professor Plum

$300,000 1 years $330,000

Mr. Green $560,000 14 years $97,825

Ms. Scarlet $2,000,000 16 years $280,000

Manager Initial Cost of the Asset

Net Annual Increase to Cash Flows

from the Project

Payback period

Mrs. White $280,000 $170,050 1.65 years

Professor Plum

$300,000 $330,000 0.91 years

Mr. Green $560,000 $97,825 5.72 years

Ms. Scarlet $2,000,000 $280,000 7.14 years

Payback Method= initial cost ÷ average net annual cash flow.

Manager Initial Cost of the Asset

Net Annual Increase to Cash Flows

from the Project

Payback period

Mrs. White $280,000 $170,050 1.65 years

Professor Plum

$300,000 $330,000 0.91 years

Mr. Green $560,000 $97,825 5.72 years

Ms. Scarlet $2,000,000 $280,000 7.14 years

Payback Method

Manager Initial Cost of the Asset

Net Annual Increase to Cash Flows

from the Project

Asset’s Useful Life

Mrs. White $280,000 $170,050 2 years

Professor Plum

$300,000 $330,000 1 year

Mr. Green $560,000 $97,825 14 years

Ms. Scarlet $2,000,000 $280,000 16 years

Net Present Value

Manager Calculation of NPV

Mrs. White ($170,050 x 1.7355) - $280,000 = $15, 122

Professor Plum

($330,000 x 0.9091) - $300,000 = $3

Mr. Green ($97,825 x 7.3667) - $560,000 = $160,647

Ms. Scarlet ($280,000 x 7.8237) - $2,000,000 = $190,636

Net Present Value

Manager Calculation of NPV

Mrs. White ($170,050 x 1.7355) - $280,000 = $15, 122

Professor Plum

($330,000 x 0.9091) - $250,000 = $3

Mr. Green ($97,825 x 7.3667) - $560,000 = $160,647

Ms. Scarlet

($280,000 x 7.8237) - $2,000,000 = $190,636

Net Present Value

Manager Initial Cost of the Asset

Net Annual Increase to Cash Flows

from the Project

Asset’s Useful Life

Mrs. White $280,000 $170,050 2 years

Professor Plum

$300,000 $330,000 1 year

Mr. Green $560,000 $97,825 14 years

Ms. Scarlet $2,000,000 $280,000 16 years

Internal Rate of Return

Manager Calculation of IRR

Mrs. White $280,000 ÷ $170,050 = 1.647 1.647 in Row 2 → 14%

Professor Plum

$300,000 ÷ $330,000 = 0.9090.909 in Row 1 → 10%

Mr. Green $560,000 ÷ $97,825 = 5.72455.7245 in Row 14 → 15%

Ms. Scarlet

$2,000,000 ÷ $280,000 = 7.1437.143 in Row 16 → between 11% & 12%

Internal Rate of Return

Manager Calculation of IRR

Mrs. White $280,000 ÷ $170,050 = 1.647 1.647 in Row 2 → 14%

Professor Plum

$300,000 ÷ $330,000 = 0.9090.909 in Row 1 → 10%

Mr. Green $560,000 ÷ $97,825 = 5.72455.7245 in Row 14 → 15%

Ms. Scarlet

$2,000,000 ÷ $280,000 = 7.1437.143 in Row 16 → between 11% & 12%

Internal Rate of Return

Manager Initial Cost of the Asset

Net Annual Increase to Cash Flows

from the Project

Asset’s Useful Life

Mrs. White $280,000 $170,050 2 years

Professor Plum

$300,000 $330,000 1 year

Mr. Green $560,000 $97,825 14 years

Ms. Scarlet $2,000,000 $280,000 16 years

Accounting Rate of Return

Manager Calculation of Annual Depreciation Expense

Mrs. White Annual Depreciation Expense = $280,000 ÷ 2 = $140,000

Professor Plum

Annual Depreciation Expense = $300,000

Mr. Green Annual Depreciation Expense = $560,000 ÷ 14 = $40,000

Ms. Scarlet

Annual Depreciation Expense = $2,000,000 ÷ 16 = $125,000

Accounting Rate of Return

Manager Calculation of Average Book Value

Mrs. White Average Book Value = $280,000 ÷ 2 = $140,000

Professor Plum

Average Book Value = $300,000 ÷ 2 = $150,000

Mr. Green Average Book Value = $560,000 ÷ 2 = $280,000

Ms. Scarlet

Average Book Value = $2,000,000 ÷ 2 = $1,000,000

Accounting Rate of Return

Manager Calculation of Accounting Rate of Return

Mrs. White ($170,050 - $140,000) ÷ $140,000= 21.5%

Professor Plum

($330,000 - $300,000) ÷ $150,000= 20.00%

Mr. Green ($97,825 - $40,000) ÷ $280,000= 20.65%

Ms. Scarlet

($280,000 - $125,000) ÷ $1,000,000= 15.5%

Accounting Rate of Return

Manager Calculation of Accounting Rate of Return

Mrs. White

($170,050 - $140,000) ÷ $140,000 = 21.5%

Professor Plum

($330,000 - $300,000) ÷ $150,000= 20.00%

Mr. Green ($97,825 - $40,000) ÷ $280,000= 20.65%

Ms. Scarlet

($280,000 - $125,000) ÷ $1,000,000= 15.5%

Accounting Rate of Return

Manager Payback NPV IRR ARR

Mrs. White

Professor Plum

Mr. Green

Ms. Scarlet

Summary