Question

Payback, NPV, Managerial Incentives, Ethical Behavior

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:

Year	Proposal A	Proposal B
1	$150,000	$(37,500)
2	125,000	(25,000)
3	75,000	(12,500)
4	37,500	212,500
5	25,000	275,000
6	12,500	337,500

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

The present value tables provided in Exhibit 19B.1 and Exhibit 19B.2 must be used to solve the following problems.

Required:

1. Compute the NPV for each proposal. Round intermediate calculations and your final answers to the nearest dollar.

	NPV
Proposal A	$
Proposal B	$

Can you show how you calculate NPV in Excel

Answer 1

Cash flows are discounted at the cost of capital, ie., 10%

NPV of Proposal A= $94,210

NPV of Proposal B=$129,760

Screen shot of Excel working is given below:

Present Value of cash flows from year 1 through year 6 can be calculated using NPV function of Excel as shown in the function arguments in the screen shot below.

fNPV($C$1,C5,C6, C7,C8, C9, C10) E14 A В C F Cost of capital 10% 1 2 Present value of CF (Cash Flow PV factor) PV factor Cash Flows (CF) 3 Year 4 Project A Project B Project A Project B 1 0.909091 $150,000 -$37,500 $136,364 -$34,091 -$20,661 5 2 0.826446 $125,000 -$25,000 $103,306 6 3 0.751315 $75,000 -$12,500 $56,349 $25,613 -$9,391 7 4 0.683013 $37,500 $212,500 $145,140 $170,753 $190,510 $442,260 $312,500 $129,760 $442,260 $129,760 5 0.620921 $25,000 $275,000 $15,523 9 6 0.564474 $12,500 $337,500 $7,056 10 $344,210 11 Total 12 Intial outlay 13 NPV (Total PV-Initial outlay) 14 Prest Value as per NPV Funcion of Excel 15 NPV (Total PV-Initial outlay) $250,000 $94,210 $344,210 $94,210 LL