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Managerial Accounting: The Corners...

7th Edition
Maryanne M. Mowen + 2 others
ISBN: 9781337115773
BuyFindarrow_forward

Managerial Accounting: The Corners...

7th Edition
Maryanne M. Mowen + 2 others
ISBN: 9781337115773
Textbook Problem
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Basic Internal Rate of Return Analysis

Julianna Cardenas, owner of Baker Company, was approached by a local dealer of air-conditioning units. The dealer proposed replacing Baker’s old cooling system with a modern, more efficient system. The cost of the new system was quoted at $339,000, but it would save $60,000 per year in energy costs. The estimated life of the new system is 10 years, with no salvage value expected. Excited over the possibility of saving $60,000 per year and having a more reliable unit, Julianna requested an analysis of the project’s economic viability. All capital projects are required to earn at least the firm’s cost of capital, which is 8%. There are no income taxes.

Required:

  1. 1. Calculate the project’s IRR. Should the company acquire the new cooling system?
  2. 2. Suppose that energy savings are less than claimed. Calculate the minimum annual cash savings that must be realized for the project to earn a rate equal to the firm’s cost of capital.
  3. 3. Suppose that the life of the new system is overestimated by 2 years. Repeat Requirements 1 and 2 under this assumption.
  4. 4. CONCEPTUAL CONNECTION Explain the implications of the answers from Requirements 1, 2, and 3.

1.

To determine

Find out the IRR of the project. Also suggest that the new cooling system should be acquired or not.

Explanation

Internal Rate of Return:

An interest rate at which the present value of an investment’s cash inflows is equal to the present value cost of the investment is known as internal rate of return. The value of NPV is 0 in case of an internal rate of return.

Use the following formula to calculate discount factor of the project:

Discountfactor=InvestmentAnnualcash<

2.

To determine

Find out the minimum annual cash that will earn the rate equal to the cost of capital of the firm.

3.

To determine

Find out the IRR and minimum annual cash savings to earn a rate equal to the firm’s cost of capital if the estimated life of the new system is 8 years.

4.

To determine

Describe the implication of the answers from the above requirements.

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