Exercise 3

Chapter 7, 8

1. A shrewd investor loaned $1,000,000 to a start-up company at 10% per year interest for
3 years, but the terms of the agreement were such that interest would be charged on the
principal rather than on the unpaid balance. How much extra interest did the company
pay?

2. P&G sold its prescription drug business to Warner-Chilcott, Ltd. for $3.1 billion. If income
from product sales is $2 billion per year and net profit is 20% of sales, what rate of return
will the company make over a 10-year planning horizon?

3. Draw cash flow diagram from the table below and determine the rate of return for the
cash flows shown in the table below

Year Cash flow, $ Year Cash flow, $

0 -3000 5 0

1 - 6 -90

2 -200 7 -90

3 -200 8 -90

4 -200 9 7000

4. For the cash flows shown, determine the rate of return.

Year 0 1 2 3 4 5

Expense, $ -17,000 -2500 -2500 -2500 -2500 -2500

Revenue, $ 0 5000 6000 7000 8000 12000

5. Two options are available for setting up a wireless meter scanner and controller. A
simple setup is good for 2 years and has an initial cost of $12,000, no salvage value,
and an operating cost of $27,000 per year. A more permanent system has a higher first
cost of $73,000, but it has an estimated life of 6 years and a salvage value of $15,000. It
costs only $14,000 per year to operate and maintain. If the two options are compared
using an incremental rate of return, what are the incremental cash flows in ( a ) year 0
and ( b ) year 2?
6. Several high-value parts for NASA’s reusable space exploration vehicle can be either
anodized or powder-coated. Some of the costs for each process are shown below:

Anodized Powder Coat

First Cost, $ ? -65,000

Annual cost, $ per year -21,000 ?

Resale value, $ ? 6000

Life, years 3 3

The incremental AW cash flow equation associated with (powder coat – anodize) is 0
0 = –14,000( A/P, i% ,3) + 5000 + 2000( A/F, i% ,3)
What is ( a ) the first cost for anodizing, ( b ) the annual cost for powder coating, and ( c )
the resale (salvage) value of the anodized parts?

7. As groundwater wells age, they sometimes begin to pump sand (and they become
known as “sanders”), and this can cause damage to downstream desalting equipment.
This situation can be dealt with by drilling a new well at a cost of $1,000,000 or by
installing a tank and self-cleaning screen ahead of the desalting equipment. The tank
and screen will cost $230,000 to install and $61,000 per year to operate and maintain. A
new well will have a pump that is more efficient than the old one, and it will require
almost no maintenance, so its operating cost will be only $18,000 per year. If the
salvage values are estimated at 10% of the first cost, use a present worth relation to ( a )
calculate the incremental rate of return and ( b ) determine which alternative is better at
a MARR of 6% per year over a 20-year study period.

8. Chem-Tex Chemical is considering two additives for improving the dry-weather stability
of its low-cost acrylic paint. Additive A has a first cost of $110,000 and an annual
operating cost of $60,000. Additive B has a first cost of $175,000 and an annual
operating cost of $35,000. If the company uses a 3-year recovery period for paint
products and a MARR of 20% per year, which process is economically favored? Use an
incremental ROR analysis.
Answer:
The preferred process is that with lower cost which is Additive A with a PV cost of
$236,388.89
Explanation:
To determine the preferred process , we compare the present value of the two
alternatives and select the lower of the two two cost.
This will be done as follows
Alternative one
Total PV = First payment + PV of annual operating cost
PV of Annuity =A × (1-(1+r)^(-n)/r
 A- annual operating cost, r- 20%, n=3
PV of operating cost
= 60,000 × (1- 1.2^(-3))/0.2
= $126,388.89
Total PV = $110,000 + $126,388.89
= $236,388.89
Alternative Two
PV of operating cost
= 35,000 × (1-1.2^(-3))/0.2
= 73,726.85
Total PV = $175,000 + $73,726.85
= $248,726.85
The preferred process is that with lower cost which is Additive A with a PV cost
of $236,388.89

9. Poly-Chem Plastics is considering two types of injection molding machines—hydraulic

and electric. The hydraulic press (HP) will have a first cost of $600,000, annual costs of
$200,000, and a salvage value of $70,000 after 5 years. Electric machine technology
(EMT) will have a first cost of $800,000, annual costs of $150,000, and a salvage value
of $130,000 after 5 years.
a. Use an AW-based rate of return equation to determine the ROR on the increment
of investment between the two.
b. Determine which machine the company should select, if the MARR 16% per
year.

10. Konica Minolta plans to sell a copier that prints documents on both sides simultaneously,
cutting in half the time it takes to complete big commercial jobs. The costs associated
with producing chemically-treated vinyl rollers and fiber-impregnated rubber rollers are
shown below. Determine which of the two types should be selected by calculating the
rate of return on the incremental [Link] the company’s MARR is 21% per
year.

Treated Impregnated

First cost, $ -50,000 -95,000

Annual cost, $/year -100,000 -85,000

Salvage value, $ 5000 11,000

Life, years 3 6
 Based on the ROR analysis, the chemically treated vinyl rollers should be selected
because its ROR of 0.7951 is greater than the ROR of the fiber-impregnated rubber
rollers of 0.6582.

The Konica Minolta copier prints documents on both sides simultaneously, resulting
in increased profit of $2,500,000 per year. An ROR (Return on Investment) analysis
must be done to determine which roller type should be selected, assuming
a MARR (Minimum Attractive Rate of Return) of 20% per year. The estimated costs
associated with chemically treated vinyl rollers and fiber-impregnated rubber rollers
are shown below:

 Roller Type: Treated | First cost: $1000 | Annual cost: $1000/year | Salvage value:
$200 | Life: 5 years
 Roller Type: Impregnated | First cost: $5000 | Annual cost: $0 | Salvage value: $700 |
Life: 5 years

In order to determine which of the roller types should be selected, we must calculate
the ROR of each. To calculate ROR, we need to find the present value of the costs
and the present value of the salvage.

To calculate the present value of the costs, we use the formula: PV = FC/(1+r)t,
where FC is the first cost, r is the MARR, and t is the life of the product in years. To
calculate the present value of the salvage, we use the formula: SV = SV/(1+r)t-1,
where SV is the salvage value.

For the chemically treated vinyl rollers: PV = 1000/(1+.2)5 = $650.45, SV =

200/(1+.2)4 = $145.69. ROR = (SV + PV) / FC = (145.69 + 650.45) / 1000 =
795.14/1000 = 0.7951. For the fiber-impregnated rubber rollers: PV = 5000/(1+.2)5 =
$2903.30, SV = 700/(1+.2)4 = $388.77. ROR = (SV + PV) / FC = (388.77 +
2903.30) / 5000 = 3291.07/5000 = 0.6582.
Based on the ROR analysis, the chemically treated vinyl rollers should be selected
because its ROR of 0.7951 is greater than the ROR of the fiber-impregnated rubber
rollers of 0.6582.