a smorgasbord of capital budgeting performance measures susanka company’s president invited...
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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.
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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
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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?
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Manager Payback NPV IRR ARR
Mrs. White
Professor Plum
Mr. Green
Ms. Scarlet
Summary