8-1 Solutions to Chapter 8 Net Present Value and Other Investment ...

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Chapter 08 - Net Present Value and Other Investment CriteriaSolution to Minicase for Chapter 8None of the measures in the summary tables is appropriate for the analysis of this case,although the NPV calculations can be used as the starting point for an appropriate analysis.The payback period is not appropriate for the same reasons that it is always inappropriate foranalysis of a capital budgeting problem: Cash flows after the payback period are ignored;cash flows before the payback period are all assigned equal weight, regardless of timing; andthe cutoff period is arbitrary.The internal rate of return criterion can result in incorrect rankings among mutually exclusiveinvestment projects when there are differences in the size of the projects under considerationand/or when there are differences in the timing of the cash flows. In choosing between thetwo different stamping machines, both of these differences exist.The net present value calculations indicate that the Skilboro machines have a greater NPV($2.56 million) than do the Munster machines ($2.40 million). However, since the Munstermachines also have a shorter life, it is not clear whether the difference in NPV is simply amatter of longevity. To adjust for this difference, we can compute the equivalent annualannuity for each:Munster machines:C 10.151 0.15(1.15)7$2.40 millionC annuity factor (15%, 7 years) = $2.40 millionC 4.16042 = $2.40 million C = EAC = $0.57686 millionSkilboro machines:C 10.1510.15(1.15)10$2.56 millionC annuity factor (15%, 10 years) = $2.56 millionC 5.01877 = $2.56 million C = EAC = $0.51009 millionTherefore, the Munster machines are preferred.Another approach to making this comparison is to compute the equivalent annual annuitybased on the cost of the two machines. The cost of the Munster machine is $8 million, so theequivalent annual annuity is computed as follows:8-20
Chapter 08 - Net Present Value and Other Investment CriteriaMunster machines:C 10.151 0.15(1.15)7$8 millionC annuity factor (15%, 7 years) = $8 millionC 4.16042 = $8 million C = EAC = $1.92288 millionSkilboro machines:For the Skilboro machine, we can treat the reduction in operator and material cost as areduction in the present value of the cost of the machine: 1 1 PV $500,000 $2.5093810 million0.150.15(1.15) $12.5 million – $2.50938 million = $9.99062 millionC 10.1510.15(1.15)10$9.99062 millionC annuity factor (15%, 10 years) = $9.99062 millionC 5.01877 = $9.99062 million C = EAC = $1.99065 millionHere, the equivalent annual cost is less for the Munster machines.Note that the differences in the equivalent annual annuities for the two methods are equal.(Differences are due to rounding.)8-21
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8-1 Solutions to Chapter 8 Net Present Value and Other Investment ...

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