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Kent Tessman, manager of a Dairy Products Division, was pleased with his division’s performance over the past three years. Each year, divisional profits had increased, and he had earned a sizable bonus. (Bonuses are a linear function of the division’s reported income.) He had also received considerable attention from higher management. A vice president had told him in confidence that if his performance over the next three years matched his first three, he would be promoted to higher management. Determined to fulfill these expectations, Kent made sure that he personally reviewed every capital budget request. He wanted to be certain that any funds invested would provide good, solid returns. (The division’s cost of capital is 10 percent.) At the moment, he is reviewing two independent requests. Proposal A involves automating a manufacturing operation that is currently labor intensive. Proposal B centers on developing and marketing a new ice cream product. Proposal A requires an initial outlay of $250,000, and Proposal B requires $312,500. Both projects could be funded, given the status of the division’s capital budget. Both have an expected life of six years and have the following projected after-tax cash flows: After careful consideration of each investment, Kent approved funding of Proposal A and rejected Proposal B. Required: 1. Compute the NPV for each proposal. 2. Compute the payback period for each proposal. 3. According to your analysis, which proposal(s) should be accepted? Explain. 4. Explain why Kent accepted only Proposal A. Considering the possible reasons for rejection, would you judge his behavior to be ethical? Explain.

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Cornerstones of Cost Management (C...

4th Edition
Don R. Hansen + 1 other
Publisher: Cengage Learning
ISBN: 9781305970663

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BuyFindarrow_forward

Cornerstones of Cost Management (C...

4th Edition
Don R. Hansen + 1 other
Publisher: Cengage Learning
ISBN: 9781305970663
Chapter 19, Problem 27P
Textbook Problem
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Kent Tessman, manager of a Dairy Products Division, was pleased with his division’s performance over the past three years. Each year, divisional profits had increased, and he had earned a sizable bonus. (Bonuses are a linear function of the division’s reported income.) He had also received considerable attention from higher management. A vice president had told him in confidence that if his performance over the next three years matched his first three, he would be promoted to higher management.

Determined to fulfill these expectations, Kent made sure that he personally reviewed every capital budget request. He wanted to be certain that any funds invested would provide good, solid returns. (The division’s cost of capital is 10 percent.) At the moment, he is reviewing two independent requests. Proposal A involves automating a manufacturing operation that is currently labor intensive. Proposal B centers on developing and marketing a new ice cream product. Proposal A requires an initial outlay of $250,000, and Proposal B requires $312,500. Both projects could be funded, given the status of the division’s capital budget. Both have an expected life of six years and have the following projected after-tax cash flows:

Chapter 19, Problem 27P, Kent Tessman, manager of a Dairy Products Division, was pleased with his divisions performance over

After careful consideration of each investment, Kent approved funding of Proposal A and rejected Proposal B.

Required:

  1. 1. Compute the NPV for each proposal.
  2. 2. Compute the payback period for each proposal.
  3. 3. According to your analysis, which proposal(s) should be accepted? Explain.
  4. 4. Explain why Kent accepted only Proposal A. Considering the possible reasons for rejection, would you judge his behavior to be ethical? Explain.

1.

To determine

Calculate the net present value for each proposal.

Explanation of Solution

Net present value method (NVP): Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

Calculate the net present value for each investment using 18% discount rate as follows:

Proposal A:

Year

Cash inflow

(A)

Present value factor @10% (B)Present value (A×B)
1$ 150,0000.909$ 136,350
2$ 125,0000.826$ 103,250
3$ 75,0000.751$ 56,325
4$ 37,5000.683$ 25,613
5$ 25,0000.621$ 15,525
6$ 12,5000

2.

To determine

Calculate the payback period for each proposal.

3.

To determine

Identify the proposal which should be accepted for investment.

4.

To determine

Explain the reason why Company K has accepted proposal A rather than proposal B.

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Chapter 19 Solutions

Cornerstones of Cost Management (Cornerstones Series)
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