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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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Review of Basic Capital Budgeting Procedures

Dr. Whitley Avard, a plastic surgeon, had just returned from a conference in which she learned of a new surgical procedure for removing wrinkles around eyes, reducing the time to perform the normal procedure by 50%. Given her patient-load pressures. Dr. Avard is excited to try out the new technique. By decreasing the time spent on eye treatments or procedures, she can increase her total revenues by performing more services within a work period. In order to implement the new procedure, special equipment costing $74,000 is needed. The equipment has an expected life of 4 years, with a salvage value of $6,000. Dr. Avard estimates that her cash revenues will increase by the following amounts:

Chapter 12, Problem 45P, Review of Basic Capital Budgeting Procedures Dr. Whitley Avard, a plastic surgeon, had just returned

She also expects additional cash expenses amounting to $3,000 per year. The cost of capital is 12%. Assume that there are no income taxes.

Required:

  1. 1. Compute the payback period for the new equipment.
  2. 2. Compute the ARR. Round the percentage to two decimal places.
  3. 3. CONCEPTUAL CONNECTION Compute the NPV and IRR for the project. Use 14% as your first guess for IRR. Should Dr. Avard purchase the new equipment? Should she be concerned about payback or the ARR in making this decision?
  4. 4. CONCEPTUAL CONNECTION Before finalizing her decision. Dr. Avard decided to call two plastic surgeons who have been using the new procedure for the past 6 months. The conversations revealed a somewhat less glowing report than she received at the conference. The new procedure reduced the time required by about 25% rather than the advertised 50%. Dr. Avard estimated that the net operating cash flows of the procedure would be cut by one-third because of the extra time and cost involved (salvage value would be unaffected). Using this information, recompute the NPV of the project. What would you now recommend?

1.

To determine

Find out the payback period for the new equipment.

Explanation

Payback Period:

The time taken by an investment to recover its original value is known as payback period. It is calculated by dividing the original amount of investment by annual cash flow from the investment.

Calculate payback period:

Year

Unrecovered investment($)

(Beginning of year)

Annual cash

Flow($)

Time needed for payback

(Years)

174,00016,8001.0
257,20024,0001.0
333,20029,4001...

2.

To determine

Find out accounting rate of return (ARR).

3.

To determine

Find out the NPV and IRR for the project. Also recommend that the project should be purchased or not and if there is concern about payback period or ARR.

3.

To determine

Recalculate the NPV of the project by cutting one-third of the net operating cash flows. Also, state the recommendations to select or reject the project.

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