Solution manual managerial accounting and finance for hospitality operations CHAPTER 09

If the cash outlay today is P10,000 and the present value of the total cash returns were P9,500, one should not make the investment because this means that the investment will not yield

CAPITAL BUDGETING DECISIONS

I Questions

1 A hotel may consider buying an item of equipment with a rapid payback rather than one with a high average rate of return if

a) Management is risk-averse; that is, it does not want to assume risk of its money being tied up in an investment for a relatively long period of time

b) Management believes that the equipment can be subjected to rapid obsolescence

c) The company has obtained a loan to finance the equipment and it wants

to repay the principal right away to avoid financing costs

2 The money is worth more now than that same amount of money a year from now

3 If the cash outlay today is P10,000 and the present value of the total cash returns were P9,500, one should not make the investment because this means that the investment will not yield the desired return on investment For the project to be acceptable, the present value of the returns should at least be equal to the present value of the investment

4 Net Present Value is the excess of the present value of cash inflows generated by

the project over the amount of the initial investment This is computed as follows:

Present value of cash inflows computed based

Discounted Rate of Return, also known as internal rate of return (IRR) and

time-adjusted rate of return, is the rate which equates the present value of the future cash inflows with the cost of the investment which produces them It is also the equivalent maximum rate of interest that could be paid each year for the capital employed over the life of an investment without loss on the project

If an independent project is being evaluated, then the NPV and IRR criteria always lead to the same accept/reject decision

For mutually exclusive projects (choosing among acceptable alternative) especially those that differ in scale (project size) and/or timing, a conflicts of ranking may arise That is, the IRR method may favor one alternative over another while the NPV method may indicate otherwise If conflicts arise, the NPV method should be used The NPV method assumes the cash flows will be reinvested at the firm’s cost of capital while the IRR method assumes reinvestment at the project’s IRR Because reinvestment at the cost of capital is generally a better (closer to reality) assumption, the NPV is superior to the IRR

5 Comparison between the cash flows from operations before and after the landscaping is done may be made The purpose of the investment is to make the resort more attractive to patrons and guests Hence, when more resources are generated after the investment is made, it is an indication that the decision has been beneficial to the company

Negative NPV would generally indicate that the investment proposal is not acceptable because the desired rate of return is not attainable It does not mean however that the project will be unprofitable Therefore if the prospective investor is willing to accept a lower rate of return, then the project may become acceptable

II Practical Exercises and Problems

A EXERCISES

EXERCISE 1

Requirement (a)

Payback period:

Requirement (b)

Yes Machine B It is the more preferable investment because the recovery period of capital is shorter

P25,800

P5,940 = 4.34 yrs. P24,200P7,800 = 3.10 yrs.

EXERCISE 2

Repayment schedule:

B PROBLEMS

PROBLEM 1

Relevant Data Period Amount PVf at 13% Present Value

Cash flows from

Salvage value of furniture

The prospective investor should not make the investment because it would not yield the desired rate of return of 13% The negative net present value as shown in the computation indicates that the internal rate of return is lower than 13%

Through Trial Computations, the IRR can be determined as follows:

)

1.000 (205,000) (205,000

)

1.000 (205,000

)

5,599 (5,767)

To get the Internal Rate of Return closest to the exact rate, interpolation may be applied as follows:

Proof: Using 6.98% as the discount rate, the net present value will be as follows:

* Rounding off difference

PROBLEM 2

Requirement (a)

Payback Period:

Alternative 1

CF

IRR = 6% + 5,599 – 0 5,599 – (5,767) x 2%

= 6% + 11,3665,599 x 2%

= 6% + 0.98%

Payback Period

= 4.42 years

Alternative 2

CF

Payback Period

= 3.76 years

Requirement (b)

Net Present Value – 10% discount rate

End of Alternative 1 Alternative 2

Relevant Data Year Amount PVf PV Amount PVf PV

Investment 0 P(35,000) 1.000 P(35,000) P(35,000) 1.000 P(35,000)

5 12,000 0.621 7,452 4,000 0.621 2,484

No Both alternatives would not yield the desired rate of return of 10%

35,000 – 30,000 12,000

35,000 – 30,900 5,400