Explain why projects with internal rates of return have positive net present values.

  1. Identify and explain four characteristics of good investments. Explain how each helps the firm reach its goal of maximizing long-run profits.
  2. Describe the advantages and disadvantages of the payback and average rate of return methods for evaluating capital budgeting decisions.
  3. Explain why projects with internal rates of return have positive net present values.
  4. What is the difference between the benefit/cost ratio method and the net present value method when assessing a capital budget opportunity?
  5. Complete the table below. Assuming that the initial investment is $1500, which investment is most desirable? What is the disadvantage of this investment analysis?

Year Investment A Investment B
1 $1000 $200
2 $800 $400
3 $600 $600
4 $400 $800
5 $200 $1000
6 — $1200
Total Benefits
Payback in years

  1. Complete the table below. Assuming that the initial investment is $1500, which investment is most desirable?

Investment A 1 2 3 4 5 6 Average
After-tax Benefits $1000 $800 $600 $400 $200 — $600
Value of investment Jan 1 $1500 $1200 $900 $600 $300 —
Value of investment Dec 31 $1200 $900 $600 $300 0 —
Average
Average rate of return =

Investment B 1 2 3 4 5 6 Average
After-tax Benefits $200 $400 $600 $800 $100 $1200 $700
Value of investment Jan 1 $1500 $1250 $1000 $750 $500 $250
Value of investment Dec 31 $1250 $1000 $750 $500 $250 $0
Average
Average rate of return =

  1. Using Table 1 in your book, determine the value of $300 placed in a savings account earning 5% interest per year for 10 years.
  2. Using Table 2 in your book, determine how much money you would need to invest today at 5% interest in order to have $100,000 in 10 years.
  3. Using Table 3 in your book, determine how much money you would need to invest today to receive $1000 payments each year for the next ten years if the interest rate is 5%.
  4. Complete the Net Present Value Table below for the two investments. Determine which investment would be preferred.

Year Yearly After-Tax Benefit Present Value Factor (Use 8%) After Tax Present value of Benefits
1 $1000 .9259
2 $800 .8573
3 $600 .7938
4 $400 .7350
5 $200 .6806
6 — — —
Total
Less Initial Outlay — — $1,500.00
Net Present Value — —
Benefit/Cost Ratio — —

Year Yearly After-Tax Benefit Present Value Factor (Use 8%) After Tax Present value of Benefits
1 $200 .9259
2 $400 .8573
3 $600 .7938
4 $800 .7350
5 $1000 .6806
6 $1200 .6302
Total
Less Initial Outlay — — $1,500.00
Net Present Value — —
Benefit/Cost Ratio — —

What consideration should be given to the internal rate of return in deciding which projects to accept?

Chapter 16 Questions

  1. Explain why depreciation is a noncash expense.
  2. Define risk and uncertainty. Explain how a manager can best deal with each.
  3. Give three advantages of owning assets rather than leasing them. Give three advantages of leasing for an agribusiness.
  4. Explain why depreciation expenses, unlike other tax-deductible expenses, generate just a tax shield and how this affect the cash flow in a capital budgeting decision.
  5. Explain the difference between an operating lease, a financial lease, and a lease/purchase agreement.

Should you lease, borrow, or buy? You have the opportunity to buy new equipment for $25,000. The purchase can be financed by either (a) paying cash, (b) putting $4,750 down and financing the rest with a five year loan at 12%, or (c) taking a financial lease for five years with annual payments of $6,000. If you decide to lease, the first lease payment is due on delivery. You are in the 20% tax bracket and typically you earn 10% after taxes on your investments. The dealer offers you a purchase option at the end of the lease to buy the equipment for $5,000.

NPV Analysis – Cash Purchase Option

Year Item Amount Annuity or PV Factor Tax Effect After-Tax Present Value
0 Buy equipment $25,000 1 -$25,000
1-5 Depreciation Tax Shield $8,000
Discounted at 10% NPV =

NPV Analysis – Purchase/Borrow Option

Year Item Amount Annuity or PV Factor Tax Effect After-Tax Present Value
0 Down Payment $4,750 1
1-5 Loan Payments —
1-5 Depreciation Tax Shield $ 8,000
Discounted at 10% NPV =

NPV Analysis – Financial Lease Option

Year Item Amount Annuity or PV Factor Tax Effect After-Tax Present Value
0 Lease Payment $6,000 1 (1-.20)
1-4 Annual Lease Payment (1-.20)
5 Buy equipment $5,000 –
Discounted at 10% NPV =

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