Question

In: Accounting

V & T Faces, Inc., would like to open a retail store in Miami. The initial...

V & T Faces, Inc., would like to open a retail store in Miami. The initial investment to purchase the building is $420,000, and an additional $50,000 in working capital is required. Since this store will be operating for many years, the working capital will not be returned in the near future.

V & T Faces expects to remodel the store at the end of 3 years at a cost of $100,000. Annual net cash receipts from daily operations (cash receipts minus cash payments) are expected to be as follows:

Year 1 $80,000
Year 2 $115,000
Year 3 $118,000
Year 4 $140,000
Year 5 $155,000
Year 6 $167,000
Year 7 $175,000

The company’s required rate of return is 13 percent. Assume management decided to limit the analysis to 7 years.

  1. What is the weakness of using the payback period method to evaluate long-term investments?
  2. Assume the manager of the company wanted to live in Miami and intentionally inflated the projected annual cash receipts so that the proposal would be accepted. The proposal would otherwise have been rejected. Explain how the company’s use of a post audit would help to prevent this type of unethical behavior.

Solutions

Expert Solution

Ans:

NPV Table:

Present value is calculated using following formula: Inflow/Outflow*(1/13%)^n , Where n denotes number of year.

Year outflow    Present value of outflow @13% Inflow Present value of Inflow @13%
0 $470,000 $470,000
1 $80,000 $70,796
2 $115,000 $90,061
3 $100,000 $69,305 $118,000 $81,780
4 $140,000 $85,865
5 $155,000 $84,128
6 $167,000 $80,213
7 $255,000 $95,638
Total    $588,482

-Working capital to be received after 7 years.

NPV of the project = $588,482-$470,000-$69,305= $49,177.

So NPV of the project is positive, project can be accepted.

b.

Weakness of using payback method to eveluate long term investment is payback method doesn't provide base for a proper rate of return. Sometimes early receipts and lete receipts majorly change the interest rate and not affecting the payback period make differnces in decision making.

For example: Inflow of $500,000 , $300,000, $200,000 and $100,000 for 4 years compared with inflows of $100,000, $700,000, $150,000 and $150,000. Both have investment value of $800,000 gives same payback period of 2 years but rate of return in both cases would be majorly different.

c.

In case the manager inflate the projected cash flow so that proposal is accepted can be easily identified in post audit procedure. Management should periodically i.e. monthly or quarterly compare the projected cash flows with the actual cash flows and also reason for the same should also be identified. Any abnorml circumstances should not be taken into account while comparing these estimated cash flows to get correct picture of project income.


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