CHAPTER 8 CAPITAL BUDGETING DECISIONS PART II 8-1 Kinds of Capital Budgeting

Merck can use the same techniques to some extent. Theoretically, it should evaluate all R&D projects as if they were ordinary capital expenditures. They are certainly capital expenditures in the sense that the company expects future returns from current expenditures. The problem is that estimates of returns for new projects are extremely speculative. As projects move toward fruition, estimates of returns become more solid and at some point DCF techniques make sense. But a company that thrives on new products, especially products with enormous R&D expenditures, must make the investments based on the best scientific judgment. The following continuum might be helpful in explaining the point. |__________________________________________________________________________| Basic Applied P&E for New research research Development product Replacements As you move from left to right, estimates of returns, and of required investments, become less speculative. With the routine decisions to replace existing plant assets, DCF techniques shine. However, to the left of the spectrum, other factors become more important. 8-2 Macroeconomic Events and Capital Budgeting

Note to the Instructor: The questions posed by this problem are designed to encourage students to think about the interrelationships in the economy and the factors that can affect the attitudes and plans of a given industry or firm. The depth of the discussion will be affected by the students' backgrounds in economics and the instructor's inclination to encourage students to exercise their reasoning powers. We've provided a minimum in response to each question. The instructor may want to explore the trickle-down effects of each factor. 1. Many industries will be affected by such a law. The law would reduce the investment spending of companies involved with gasoline-related products, including (but not limited to) companies making gasoline engines. Manufacturers of electrical charging units would be more inclined to invest. Further, the law is likely to affect the inclination of a given company to invest in different kinds of projects. For example, an oil company would shift its interest from one type of project to another, being more inclined to invest in a project related to alternative uses of oil. 2. The demand for cotton would increase and for other fibers would decrease. Companies involved in the processing of raw cotton would increase capital spending; those of companies using primarily cotton to produce other products would also increase. Companies using other fibers would reduce their spending. Companies producing cotton, including cotton farmers, will reduce their expected investments in production equipment. 3. Capital spending plans of domestic auto makers would probably increase. Prices of substitute products (foreign autos) are likely to rise unless

foreign manufacturers are willing to bear the increased cost. Domestic autos would become relatively lower-priced, which would increase demand. Of course. a tariff could prompt domestic makers to increase their prices and try to maintain unit volume at previous levels. Thus, we cannot be certain that domestic firms would increase capital spending to increase production, but it is a likely action. If domestic auto makers do increase their capital spending, their suppliers are likely to do so also. Increases in unit volume of domestic autos would spur increases in purchases of steel, glass, vinyl, and other components. 4. The expected effect of an increase in corporate income taxes is a reduced inclination to invest by all firms because of the reduction in future cash flows associated with any proposed project. (The subject of the incidence of corporate taxes can be raised if the students want to pursue this point.) 5. Capital spending plans for colleges and universities would be directly affected, with a general increase in inclination to invest. To a lesser extent, the plans of textbook publishers and other organizations that provide school supplies would be affected. 6. Capital spending would fall because the present value of depreciation tax shields would fall because the flows would come in later. 8-3 Capital BudgetingEffects of Events

1. A property tax increase reduces the acceptability of proposals requiring some investment in real property. A project considered acceptable before the tax increase might become unacceptable because of the increased future taxes. 2. Introduction of a tax credit reduces the cash investment required for any project qualifying for the credit. This should not affect projects already acceptable. It could, however, make some projects advisable that were unacceptable under the old tax environment. 3. It seems likely that the expected future cash flows from the project would be decreased because of either a lower price (to maintain the expected sales volume) or a lower volume to be expected at the same price. Hence, the present value of the future returns would decline, and a project heretofore acceptable might no longer be so. Note to the Instructor: A change in ranking of acceptable investments could result in each of the above cases. Projects not involving real estate investments could rise in rank; projects qualifying for the investment credit, projects involving new products, or projects involving new products other than that for which a substitute has been found could also rise in rank. 8-4 Choosing Depreciation Methods

The general answer is that a company should postpone taking tax deductions when doing so increases the amounts of the tax savings sufficiently to offset the delay in their receipt. An expected increase in the tax rate is the most obvious case. Other possibilities, not all of which all students will have reason to know, include (a) The company has operating losses and expects continuing losses (or only small operating profits) for several years. It might then be unable to take advantage of the higher deductions now.

(b) The company is unincorporated, and expected incomes of its owner(s) from other sources (and the likely marginal tax rates) will increase. The additional tax savings from straight-line depreciation could then exceed the penalty for delaying those deductions. Note to the Instructor: A factor common to some of the circumstances mentioned in requirement 2 is an understanding that straight-line depreciation for tax purposes uses ADR lives, which are almost always longer than the number of years for deductions using MACRS. Instructors with particular competence in taxation might wish to discuss the influence of the alternative minimum tax on a decision to forgo the benefits of accelerated depreciation. (We thank Professor Will Yancey for bringing the last point to our attention.) 8-5 Comparison of Methods (Extension of 7-15) Total Present Value $58,935 77,485 69,898 (5-10 minutes)

Project A B C

Investment $70,000 70,000 70,000

Profitability Index .842 1.107 .999

Rank 3 1 2

In this case, the rankings are the same as when the projects were analyzed using the net present value method. 8-6 1. Basic Investment Analysis Negative $2,150 Tax $60,000 24,000 $36,000 14,400 Cash Flows $ 60,000 14,400 $ 45,600 5.216 $237,850 240,000 ($ 2,150) (20 minutes)

Annual savings ($600,000 x .10) Depreciation ($240,000/10) Increase in taxable income Increase in taxes at 40% Net cash savings Present value factor, 10 years, 14% Present value of future flows Cost of project, investment Net present value 2. $60,687 Net present value, from requirement 1 Divided by present value factor, 10 years, 14% Required increase in after-tax annual flows Divided by (1 - 40% tax rate) Equals required increase in before-tax cash savings Plus expected savings Equals required savings

($ 2,150) 5.216 $ 412 60% $ 687 60,000 $60,687

A small increase in savings makes the investment worthwhile on a quantitative basis. If the company has other reasons for making the investment, it should go ahead even if the expected NPV is negative.

3.

Yes, the advantage is $17,679. Tax $ 60,000 $24,000 6,600 17,400 $ 42,600 17,040 Cash Flow $ 60,000

Savings with new machine Extra depreciation: New machine Old machine ($66,000/10) Increase in taxable income Increase in taxes at 40% After-tax cash flow increase Present value factor, 14%, 10 years Present value of future flows Cost of new machine: Cost of machine Less proceeds from sale of old machine

17,040 $ 42,960 5.216 $224,079

$240,000 12,000 $228,000 21,600 206,400 $ 17,679

Less tax saving, loss on sale of old machine [($66,000 - $12,000) x 40%] Net cost of new machine Difference, in favor of new machine 8-7 1. Basic Replacement Decision $84,800 (15-20 minutes)

Tax Cost of new lathe Resale price of existing lathe Book value Loss for tax purposes Tax saving at 40% Net required investment 2. $91,215 present value, for an NPV of $6,415 Tax $41,000 20,000 $21,000 8,400 $12,000 20,000 $ 8,000

Cash Flow $100,000 (12,000) ( 3,200) $ 84,800 Cash Flow $ 41,000 8,400 $ 32,600 2.798 $ 91,215 84,800 $ 6,415

Savings in cash costs ($63,000 - $22,000) Additional depreciation ($25,000 - $5,000) Increase in taxable income Increased income taxes at 40% Net cash flow Present value factor, 4 years, 16% Present value of future cash flows Cost of new investment (requirement 1) Net present value

The net present value is positive and reasonably high. should accept the investment on economic grounds.

The company

3. NPV increases by $1,656, to $8,071. Because salvage value is ignored for depreciation purposes, nothing changes until the last flow. Salvage value net of tax ($5,000 x 60%) Present value factor, single payment, 4 years, 16% Present value of recovery 8-8 1. Relationships $65,946 (25 minutes) $ 3,000 .552 $ 1,656

($250,000/3.791)

2. $76,577. The easiest approach is to recognize, as the chapter shows, that the $65,946 after-tax cash flow is the result of two things: the tax saving from depreciation and the operating cash flow after taxes.

After-tax cash flow Less cash flow from After-tax cash flow Divided by (1 - 40% Equals pre-tax cash 8-9

tax shield [40% x ($250,000/5)] from operations tax rate) flow from operations (20 minutes) Tax $300,000 140,000 160,000 75,000 $ 85,000 34,000

$65,946 20,000 45,946 60% $76,577

Working Capital Investment

$46,262 Contribution margin [60,000 x ($9 - $4)] Cash fixed costs Pretax cash flow Depreciation ($300,000/4) Increase in taxable income Increased income taxes at 40% Net cash flow Present value factor, 4 years, 12% Present value of operating flows Present value of return on working capital* Total present value Investment ($300,000 + $80,000 + $20,000) Net present value * ($80,000 + $20,000) x .636 8-10 Replacement DecisionWorking Capital (15-20 minutes) Cash Flow $300,000 140,000 160,000 34,000 126,000 3.037 $382,662 63,600 446,262 400,000 $ 46,262

$1,632, not a huge margin, so the company might not make the investment if its managers are uncertain about their estimates. Investment: Tax Purchase price Sale price of existing machine Tax basis Loss Tax benefit at 40% Net investment in machinery Working capital investment Recovery ($80,000 x .769) Total investment Annual savings: Cash savings ($180,000 - $60,000) Increased depreciation ($100,000 - $40,000) Increase in taxable income Increased tax at 40% Annual net cash flow Present value factor, 2 years, 14% Present value of flows Investment Net present value Tax $120,000 60,000 60,000 24,000 Cash Flow $120,000 24,000 96,000 1.647 158,112 156,480 $ 1,632 $50,000 80,000 30,000 (12,000) Cash Flow $200,000 (50,000) (12,000) $138,000 80,000 ( 61,520) $156,480

8-11

Basic MACRS

(10-15 minutes) 240,000 5.216 $1,251,840 423,600 1,675,440 1,500,000 $ 175,440 (10-15 minutes) $

After-tax cash flow ($400,000 x .60) Present value factor, 10 years, 14% Present value of operating flows MACRS shield ($1,500,000 x .40 x .706) Total present value Less investment Net present value 8-12 1. Mutually Exclusive Alternatives (Extension of 7-21)

1.330 for the hand-fed machine and 1.228 for the semiautomatic machine. Hand-Fed Total present value of future cash flows (from 7-22) Divided by investment Equals PI $1,063,610 $ 800,000 1.330 Semiautomatic $1,719,260 $1,400,000 1.228

2. The memo should include (a) reference to the results of analyzing the alternatives using discounted cash flow techniques, and (b) a recommendation that the choice depends on the projected returns for opportunities available for investing the $600,000 incremental outlay for the semiautomatic machine. Note to the Instructor: Class coverage of this assignment can be expanded by determining the return on the incremental outlay, and students' memos might include such an analysis. As shown below, the IRR on the $600,000 incremental outlay is over 18%, well above the 14% cost of capital. Incremental investment Divided by incremental cash flow Equals present value factor for 4 years Factor for 18% $600,000 $225,000 2.667 2.690

If expected returns from other available uses of the $600,000 approximate the cost of capital, investing in the hand-fed machine plus those other projects would produce the same total NPV available by acquiring the semiautomatic machine but with the additional risk accompanying reliance on more estimates. In an undergraduate introductory course, we try to avoid extended discussions of the concept of cost of capital and the conceptual issues differentiating the NPV and IRR approaches to evaluating investments. Some instructors might, however, choose to introduce reinvestment assumptions and other issues relating to these approaches. 8-13 Investing to Reduce Inventory, JIT (15-20 minutes) (in millions) Cash Flow $ 1.50 1.28 $ 0.22 3.605 $ 0.793 25.000 $24.207

About $24.2 million, so the investment is desirable. Additional cash operating costs Plus depreciation ($8.5/5) Decrease in taxable income Reduced income tax at 40% Net cash outflow Present value factor, 5 years, 12% Present value of future outflows Investment, net inflow, $8.5 - $43.7 + $10.2 Net present value Tax $1.50 1.70 $3.20 1.28

Note to the Instructor: You might wish to point out how the cash operating costs and depreciation tax shield nearly offset one another. This result is purely a function of the numbers we used, not a generalizable conclusion. 8-14 New Product DecisionSensitivity Analysis (20-25 minutes)

Note to the Instructor: You might want to ask the class whether Minnies might suffer losses in sales of its other doughnuts. We deem this likely because people probably dont increase their doughnut consumption every time a new product comes out. We deliberately did not mention this possibility in the text so that you could ignore it or deal with it as you choose. 1. $65,250 Tax $150,000 60,000 $ 90,000 35,000 $ 55,000 24,750 Cash Flow $150,000 60,000 90,000 24,750 $ 65,250

Additional contribution margin (50,000 x $3) New cash fixed costs Increase in income before depreciation New depreciation (210,000/6) Increase in taxable income Increase in taxes, at 45% Increase in annual after-tax cash flow 2. (a) $43,757

Increase in annual after-tax cash flow (from requirement 1) Present value factor, 14%, 6 years Total present value of future cash flows Less investment NPV (b) About 21.3%. Students using tables will find Investment Divided by annual cash flow Equals present value factor for 6 years Closest factors: For 20% 3.326 For 22% 3.167 (c) 3. 1.208 ($253,757/$210,000)

$ 65,250 3.889 $253,757 210,000 $ 43,757 $210,000 $ 65,250 3.218

$80,457 $ 43,757 3.889 $ 11,251 55% $ 20,457 60,000 $ 80,457

NPV (from 2a) Divided by present value factor, 14%, 6 years Allowable decrease in annual after-tax cash flows Divided by (1 - 45% tax rate) Equals allowable decrease in before-tax cash flows Cash fixed operating costs Allowable total cash fixed operating costs 4. More than 4 but less than 5 years. value factor (computed in 2b) factors for 16%: years years 3.218 2.798 3.274

Present Closest For 4 For 5

5. 43,181 units Estimated sales, in cases Allowable decrease in annual before-tax cash flows (from req 3) Divided by per-unit contribution margin Allowable decline in number of units sold Case sales to achieve 14% IRR 6. Variable cost could increase about $0.41, to $5.41.

50,000 $ 20,457 $3 6,819 43,181

Allowable decrease in annual before-tax cash flows (from req 3) Divided by expected volume in cases Allowable decrease in contribution margin per unit

$ 20,457 50,000 $ 0.41

Note to the Instructor: To remind students of the components of contribution margin, you might ask the class how much the expected selling price could fall and the project still return 14%. Of course, the answer is the same as for requirement 6, $0.41, because a lower selling price has the same effect on contribution margin as an increase in per-case variable cost. 8-15 Working Capital (15 minutes)

General Note to the Instructor: This exercise illustrates the principle that any delay in receiving cash flows involves the opportunity cost on the investment, whether or not there are capital expenditures. The exercise is simple enough that students should have little problem determining that there is a negative NPV. Some students might inquire as to the difference between this exercise and the principles in Chapter 5. Here we have a full year, just at the cut-off we mentioned in Chapter 5. More importantly, here the time value of money is significant. Present value of inflow (30,000 x $20 x .862) Investment NPV 8-16 Mutually Exclusive Investments (20 minutes) $517,200 540,000 ($ 22,800)

1. (a) $351,900 for the hand-fed machine, $408,840 for the semiautomatic machine. Hand-fed machine Revenue Cash operating costs Pretax cash flow Depreciation ($1,000,000/10) Increase in taxable income Increase in taxes at 40% Net cash flow Present value factor, 10 years, 10% Present value of future flows Less investment Net present value Tax $1,750,000 1,450,000 300,000 100,000 $ 200,000 80,000 Cash Flows $1,750,000 1,450,000 300,000 80,000 220,000 6.145 $1,351,900 1,000,000 $ 351,900 $

Semiautomatic machine Revenue Cash operating costs Pretax cash flow Depreciation ($2,000,000/10) Increase in taxable income Increase in taxes at 40% Net cash flow Present value factor, 10 years, 10% Present value of future flows Less investment Net present value (b) Tax $1,750,000 1,230,000 520,000 200,000 $ 320,000 128,000 Cash Flows $1,750,000 1,230,000 520,000 128,000 392,000 6.145 $2,408,840 2,000,000 $ 408,840 $

About 18% for the hand-fed, 14% for the semiautomatic

Hand-fed: $1,000,000/$220,000 = 4.545, which is close to the factor for 18% Semiautomatic: $2,000,000/$392,000 = 5.102, which is close to the factor for 14% (c) 1.352 for the hand-fed and 1.204 for the semiautomatic

Hand-fed: $1,351,900/$1,000,000 = 1.352 Semiautomatic: $2,408,840/$2,000,000 = 1.204 2. The semiautomatic machine is the better choice because its NPV is higher than that of the hand-fed machine. Note to the Instructor: One way to illustrate the acceptability of the incremental investment in the semiautomatic machine is to demonstrate, as below, the NPV (at cost of capital) for the incremental investment. Net cash flow, semiautomatic Net cash flow, hand-fed Incremental net cash flow from semiautomatic Present value factor, 10%, 10 years Present value of incremental flows Incremental investment ($2,000,000 - $1,000,000) Net present value of incremental investment $ 392,000 220,000 $ 172,000 6.145 $1,056,940 1,000,000 $ 56,940

The depth of the discussion depends on how deeply you wish to explore the concepts underlying the decision criteria, particularly their assumptions about reinvestment of cash flows. The only clue students have from the text is that the project with the higher NPV should be accepted unless doing so would force rejection of other projects returning more than cost of capital. 8-17 Sensitivity Analysis (Extension of 8-16) (20 minutes)

The sales volumes needed to provide a 10% return are $1,431,857 for the hand-fed machine and $1,565,188 for the semiautomatic model.

Hand-Fed Net present value, from previous assignment Divided by present value factor, 10 years, 10% Equals allowable decline in net cash flow Divided by (1 - the 40% tax rate) Equals allowable decline in pretax cash flow and contribution margin Divided by contribution margin percentages* Equals allowable decline in sales volume Expected sales Minus allowable decline, above Sales to yield 10% * 100% minus 70%, and minus 40%. $ $ $ $ 351,900 6.145 57,266 .60 95,443 30% 318,143

Semiautomatic $ $ $ $ 408,840 6.145 66,532 .60 110,887 60% 184,812

$1,750,000 318,143 $1,431,857

$1,750,000 184,812 $1,565,188

The decision to acquire the semiautomatic machine appears somewhat less desirable because break-even volume, based on NPV's, is higher for that machine. Thus, the semiautomatic machine is riskier than the hand-fed one. However, both break-even volumes are well below the $1,750,000 anticipated, so the difference is probably not large enough to change the decision. 8-18 1. Basic MACRS (15 minutes)

NPV is a negative $20,040. $463,968 115,992 579,960 600,000 ($

Present value of operating flows ($160,000 x 60% x 4.833) Present value of tax shield ($600,000/10 x 40% x 4.833) Total present value Less investment Net present value 20,040) 2. NPV becomes positive by $25,968.

Present value of operating flows, above Present value of tax shield ($600,000 x 40% x .675) Total present value Less investment Net present value

$463,968 162,000 625,968 600,000 $ 25,968

Using 7-year MACRS is worth $46,008 present value ($20,040 + $25,968, or $162,000 - $115,992. 8-19 1. Review of Chapters 7 and 8 $68,000 Contribution margin [60,000 x ($11 - $8)] Less cash fixed costs Increased income before depreciation Less depreciation ($210,000/6) Increase in taxable income Increased taxes at 40% Increase in annual after-tax cash flows Tax $180,000 90,000 90,000 35,000 $ 55,000 22,000 Cash Flow $180,000 90,000 90,000 22,000 $ 68,000 (25-40 minutes)

2.

$54,452 Increase in annual after-tax cash flows (requirement 1) Times present value factor, 6 years, 14% Equals total present value Less investment required Equals NPV $ 68,000 3.889 $264,452 210,000 $ 54,452

3.

$32,692 Total present value (computed in requirement 2) Add present value of return of investment in working capital ($40,000 x .456) Total present value of future receipts Less, investment required ($210,000 + $40,000) Net present value $264,452 18,240 282,692 250,000 $ 32,692

4. 5.

1.26

$264,452 from requirement 2/$210,000 $210,000/$68,000

3.1 years

6. Between 22% and 24%. The present value factor of 3.088 (requirement 5) is between the factors 3.167 and 3.020, for 22% and 24%, respectively. 7. 52,221 units Net present value, requirement 2 Divided by present value factor, 6 years, 14% Equals allowable decrease in annual after-tax cash flow of Divided by (1 - 40% tax rate) Equals allowable decrease in annual before-tax cash flow Divided by contribution margin per unit Allowable decrease in volume Required volume, 60,000 - 7,779 $54,452 3.889 $14,002 60% $23,337 $3 7,779 52,221

8. Between 4 and 5 years. The present value factor computed in requirement 5 (3.088) is between the factors at 16% for 4 and 5 years (2.798 and 3.274, respectively). 8-20 1. Relationships (c) $245,680 $ 40,000 6.142 $245,680 (25 minutes)

Annual cash flows Present value factor, 14%, 15 years Equals cost (f) $26,779

Cost Times profitability index Equals total present value of future flows Less cost Net present value (d) 12%

$245,680 1.109 $272,459 245,680 $ 26,779

Present value of future flows Divided by annual flows

$272,459 $ 40,000

Equals present value factor for 15 years, equals 12% factor 2. (b) $110,000 Investment Divided by present value factor for 8 years, 18% Equals annual cash flow (f) $29,370

6.811 $448,470 4.077 $110,000

Cash flow Times the present value factor for 8 years at 16% Equals total present value of future flows Less cost Net present value (g) $1.065

$110,000 4.344 $477,840 448,470 $ 29,370

Present value (from f) Divided by investment Profitability index 3. (a) 10 years

$477,840 $448,470 1.065

Present value of future flows (from part f) Divided by annual flows Equals present value factor for 12% cost of capital That factor is appropriate for 12% and (e)

$452,000 $ 80,000 5.65 10 years

Between 16% and 18%. Investment of $361,600 divided by annual flows of $80,000 produces a factor (4.52) for 10 years that falls between the factors for 16% and 18%. $90,400 1.25 $361,600 452,000 361,600 $ 90,400

(f)

Profitability index Times investment Equals total present value of future cash flows Less investment Net present value 8-21 1. Review of Chapters 7 and 8 Between 10% and 12%. Tax Annual cash flow: Cost savings Depreciation ($282,000/4) Increase in taxable income Increase in income taxes, at 30% Increase in annual after-tax cash flows Investment Present value factor, $282,000/$91,150 Closest factors: For 10% 3.170 For 12% 3.037 2. Negative $5,177. $100,000 70,500 29,500 8,850 Cash Flow (45-60 minutes)

$100,000 8,850 $ 91,150 282,000 3.094

Annual increase in after-tax cash flows (requirement 1) Present value factor, 12%, 4 years Total present value of increase in future cash flows Less investment Net present value 3. 4. .982 $102,436 $276,823 from requirement 2/$282,000

$ 91,150 3.037 $276,823 282,000 ($ 5,177)

Net present value, above 5,177) Divided by present-value factor for 12% for 4 years Equals required annual after-tax cash flows Divided by (1 - 30% tax rate) Equals required increase in pretax annual cash flow Plus expected savings Equals required savings to achieve 16% return 5. Negative $1,604 Years 1-3 Tax Cash Flow Annual cash flows: Savings $100,000 Depreciation ($282,000/3) 94,000 Taxable income $ 6,000 Taxes at 30% 1,800 Net cash flow Applicable present value factors: Annuity factor for 12% and 3 years Single-amount factor for 12%, 4 years Present value Total present value ($235,876 + $44,520) Less investment NPV $100,000 1,800 $ 98,200 2.402 $235,876

($ 3.037 1,705 70% $ 2,436 100,000 $102,436 $ Year 4 Tax/Cash $100,000 100,000 30,000 $ 70,000 .636 $ 44,520

$280,396 282,000 ($ 1,604)

Note to the Instructor: This requirement is one of several opportunities to address the impact of using accelerated depreciation for tax purposes without going into the specifics of MACRS. 6. NPV decreases $4,368 $12,000 7,632 $ 4,368

Decrease in NPV because of additional investment Increase in NPV for present value of return of working capital investment ($12,000 x .636) Net decrease

7.

$24,628 Cost savings Additional depreciation: Depreciation on new asset, as above Depreciation on existing asset ($25,000/4) Increase in taxable income Increase in taxes at 30% Increase in annual after-tax cash flow Present value factor, 12%, 4 years Present value of future flows Less investment: Purchase of new equipment Sale of old asset: Cash received $40,000 Less book value 25,000 Tax gain $15,000 Tax on gain at 30% Net cost of investment NPV Tax $100,000 $ 70,500 6,250 64,250 $35,750 10,725 Cash Flow $100,000

10,725 $ 89,275 3.037 $271,128

$282,000 (40,000) 4,500 246,500 $ 24,628

8-22

Asset Acquisition and MACRS

(15-20 minutes)

The NPV is $153,800. Present value of operating cash flows ($260,000 x 60% x 5.65) Present value of tax shield ($1,000,000 x 40% x .681) Total present value Less investment Net present value $ 881,400 272,400 1,153,800 1,000,000 $ 153,800

Note to the Instructor: You might wish to show how the investment would look if the company had to use straight-line depreciation over 10 years. Cash operating savings Less depreciation ($1,000,000/10) Increase in pretax profit Income tax on increase (40% x $160,000) Increase in net income Plus depreciation Net cash flow Times present value factor Present value of future flows $ 260,000 100,000 260,000 64,000 196,000 100,000 296,000 5.650 $1,107,400

The NPV drops to $107,400 under straight-line depreciation, a decline of $46,400. 8-23 Working Capital Investment (15-20 minutes)

The NPV is a positive $88,734 and the offer is desirable.

Sales ($300,000 x 12 months) Variable cost ($3,600,000 x .85) Contribution margin Cash fixed costs ($18,000 x 12) Incremental profit and cash flow Present value factor, 20%, 3 years Present value Investment: Inventories ($300,000 x .85 x 2) Receivables ($300,000 x 3) Total Less PV of recovery ($1,410,000 x .579) Net present value of offer

Cash Flow $3,600,000 3,060,000 540,000 216,000 $ 324,000 2.106 $ 682,344 $ 510,000 900,000 1,410,000 816,390 $

593,610 88,734

This problem involves no investment in fixed assets, only in working capital. It is a change of pace from the other assignments and some students will not see how to approach the solution. 8-24 Replacement Decision (15-20 minutes)

The NPV is a negative $20,644. Investment: Purchase price Tax benefit of loss on sale: Tax basis Selling price Loss Tax benefit at 40% Net investment $270,000 $60,000 35,000 $25,000 ( 10,000) (35,000) (10,000) $225,000 Tax Annual cash flows: Savings in operating costs ($130,000 - $20,000) Additional depreciation ($90,000 - $20,000) Increase in taxable income Income tax at 40% Net cash flow Present value factor, 3 years, 18% Present value of future flows Less investment, as above Net present value 8-25 Sensitivity Analysis and MACRS (Extension of 8-11) $110,000 70,000 $ 40,000 16,000 Cash Flow $110,000 16,000 $ 94,000 2.174 $204,356 225,000 ($20,644)

(10-20 minutes)

Annual savings of $343,942 in cash operating costs will make the investment yield just 14%. This is a decline of about 14% from the expected savings of $400,000 [($400,000 - $343,942)/$400,000]. Net present value from 8-11 Divided by present value factor Equals allowable decline in after-tax savings Divided by (1 - 40% tax rate) Equals allowable decline in pretax savings Pretax savings required, $400,000 - $56,058 $175,440 5.216 $ 33,635 60% $ 56,058 $343,942

8-26

Comparison of Alternatives

(25 minutes)

The memo should include, with supporting analyses, a recommendation to purchase Machine B. The most direct approach to analyzing the alternatives is to work with the advantage of Machine B over Machine A and determine if the additional cost of the former is justified. Savings in operating cost of B over A ($12,000 - $3,000) Tax on cost savings (40%) Net after-tax savings on operating cost alone Tax savings due to additional depreciation if B is purchased: Depreciation on B ($80,000/10) $8,000 Depreciation on A ($40,000/10) 4,000 Additional depreciation 4,000 Tax reduction because of extra depreciation (40%) Total after-tax savings from Machine B (over Machine A) Present value factor, 10 years, 10% Present value of after-tax savings from Machine B $ 9,000 3,600 5,400

1,600 $ 7,000 6.145 $43,015

Since the cost of this advantage is $40,000 ($80,000 cost of B vs. $40,000 cost of A), purchase of Machine B is wise. We can also approach the problem using totals. Machine A Tax Cash Flow $12,000 $12,000 4,000 $16,000 6,400 6,400 $ 5,600 6.145 $34,412 40,000 $74,412 Machine B Tax Cash Flow $ 3,000 $ 3,000 8,000 $11,000 4,400 4,400 ($ 1,400) 6.145 ($ 8,603) 80,000 $71,397

Operating costs Depreciation Tax deductible expenses Tax savings at 40% Net cash outflow (inflow) Present value factor Present value of flows Less investment Total present value

The difference, the advantage to B, is $3,015

($74,412 - $71,397).

Note to the Instructor: This assignment is particularly interesting when analyzed using the second of the above approaches because Machine A produces an annual cash outflow and present value of future flows, while Machine B produces an annual cash inflow and present value of future flows. Noting this difference, some students will conclude, without further consideration, that an increase in cash flow is always preferable to a decrease as long as some purchase must be made. (That is, students might arrive at the correct answer for the wrong reason.) It's important that students recognize that neither a smaller cash outflow nor the mere existence of a positive cash inflow is sufficient to choose between two alternatives. To illustrate, suppose that the annual before-tax costs of operating Machine B are $5,200 rather than the $3,000 in the original problem. Annual cash costs Depreciation Tax deductible expenses Tax savings at 40% Net cash inflow Tax $ 5,200 8,000 $13,200 5,280 Cash Flow $5,200 5,280 80

Annual cash flow (increase) Present value factor Present value of cash flow (increase) Present value of savings resulting from adopting Machine B ($34,412 + $492) Less cost of adopting Machine B NPV

Machine A $ 5,600 6.145 $34,412

Machine B ($ 80) 6.145 ($ 492) $34,904 40,000 $(5,096)

Despite the positive cash flows coming from Machine B, the investment is unwise. 8-27 1. Unit Costs (20-25 minutes) Tax Savings: Materials [200,000 x ($3.50 - $3.40)] Direct labor [200,000 x ($7.50 - $6.50)] Variable overhead [200,000 x ($2.50 - $2.15)] Total pretax cash savings Less depreciation Increased taxable income Increased tax at 40% Net cash flow Present value factor, 3 years, 18% Present value of flows Less investment Net present value 2. 12.9% from Lotus 1-2-3. closest to 2.322 for 14%. $ 20,000 200,000 70,000 290,000 200,000 $ 90,000 36,000 Cash Flow $ 20,000 200,000 70,000 290,000 36,000 $254,000 2.174 $552,196 600,000 ($ 47,804)

Negative $47,804

The factor is 2.36 ($600,000/$254,000), which is

Note to the Instructor: The above solution assumes it is profitable to proceed with the new shoes if there is no additional capital investment. This might not be the case. Such factors as negative effects on sales of existing shoes that are more profitable than the new model, or more profitable uses for the existing facilities, could sway the decision against the proposed shoe. 8-28 JIT, Inventory (15-20 minutes) Tax $240.0 180.0 $ 60.0 24.0 Cash Flow $ 240.0 24.0 216.0 5.650 $1,220.4

$260.4 thousand Savings in cash operating costs Less depreciation ($1,800/10) Increase in taxable income Income tax at 40% Net cash flow Present value factor, 10 years, 12% Present value of future inflows Investment: Investment in fixed assets Other after-tax investment ($2,900.0 x 60%) Less reduction in inventory ($2,700.0 - $120.0) Total investment Net present value

$1,800.0 1,740.0 (2,580.0) $ 960.0 260.4

Note to the Instructor: The solution follows the statement in the chapter that negative effects on inventory at some future date will not

materialize. Additionally, it's worth pointing out in connection with this assignment that some benefits of JIT manufacturing are not easily quantified, particularly those having to do with increased quality of product and additional manufacturing flexibility. Therefore, the investment might be desirable even if it had a negative NPV. 8-29 Pollution Control and Capital Budgeting (20 minutes)

The memo should conclude, subject to any expressed reservations about qualitative issues, that purchasing the CleanAir is the better alternative. The supporting analysis can be shown in one of two ways. One is to determine which device has the lower present value of future and current outflows. The other is to analyze the differences in cash flows. Starting with the first method, the analysis is as follows. Annual revenues Annual cash costs Net cash flow before taxes (outflow) Depreciation Net loss for tax purposes Tax savings at 40% of tax loss Decrease in net income Plus depreciation Net cash inflow (outflow)* Present value factor Present value of future flows (outflow) Investment Net present value CleanAir 0 180,000 ( 180,000) 100,000 280,000 112,000 ( 168,000) 100,000 ($ 68,000) 4.833 ($ 328,644) ( 1,000,000) ($1,328,644) $ Polcontrol 250,000 210,000 40,000 200,000 160,000 64,000 ( 96,000) 200,000 $ 104,000 4.833 $ 502,632 ( 2,000,000) ($1,497,368) $

* Combination of net cash flow before taxes and tax savings The difference between the present values of $168,724 ($1,497,368 $1,328,644) can be verified using the second method. Here, the question is whether it is worthwhile to invest an additional $1,000,000 for the Polcontrol, given its superiority in annual cash flows. Difference in flows favoring Polcontrol, $104,000 - (-$68,000) Present value factor, 10 years, 16% Present value of difference in cash flows Less additional investment Net present value of additional investment 168,724) 8-30 1. Replacement Decision and Sensitivity Analysis The investment is desirable; its NPV is $38,825. $25,000 3.433 $85,825 $65,000 18,000 47,000 $38,825 (25 minutes) 172,000 4.833 $ 831,276 1,000,000 ($ $

Annual cash savings ($45,000 - $20,000) Present value factor, annuity for 5 years at 14% Present value of future cash savings Cost of new equipment: Purchase price Less resale of existing equipment Net present value

2. Over 25%. The factor is 1.88 ($47,000/$25,000). For 5 years, the lowest factor in the table is 2.689, the factor for 25%. The actual rate is nearly 45%.

3.

About $13,691

$47,000/3.433

4. More than 2 years. The factor is 1.88 (requirement 2); the annuity factor in the 14% column for two years is 1.647. 8-31 1. Alternative Production Process $77,000 Data on Old Machine Cost of new machine, an outflow Cash from sale of old machine: Selling price, a cash inflow Less, book value of old machine Taxable gain on sale of old machine Tax on gain (at 40%), an outflow Net cash cost of new machine 2. -$2,016 Tax Savings ($64,000 - $40,000) $24,000 Less, additional depreciation: New machine ($100,000/5) $20,000 Old machine 4,000 16,000 Increase in taxable income $ 8,000 Increased tax at 40% 3,200 Increase in annual cash flow Times present value factor for 12%, 5 years Present value of future cash flows Net cost of new machine (requirement 1) Net present value of investment in alternative method 8-32 Sensitivity Analysis (25-30 minutes) Cash Flow $24,000 $25,000 20,000 $ 5,000 Cash for New Machine $100,000 (25,000) 2,000 $ 77,000 (10-15 minutes)

3,200 $20,800 3.605 $74,984 77,000 ($ 2,016)

1. 29,027 units Annual net contribution margin required: Investment Divided by present value factor, 4 years, 16% Equals net cash flow required Plus cash fixed costs Equals contribution margin needed Divided by per-unit contribution ($30 - $14) Equals annual unit volume required 2. 31,712 units

$600,000 2.798 $214,439 250,000 $464,439 $16 29,027

Investment Divided by the present value factor for 4 years at 10% Equals required annual after-tax cash flow Less cash savings from tax shield of depreciation ($600,000/4) x 40% Equals required after-tax cash flow of nondepreciation items Add after-tax effect of cash for fixed cost ($250,000 x 60%) Equals required after-tax effect of contribution margin Divided by (1 - 40% tax rate) Required contribution margin Divided by per-unit contribution margin Equals required annual volume

$600,000 2.798 $214,439 60,000 $154,439 150,000 $304,439 60% $507,398 $16 31,712

Note to the Instructor: The solution shown above follows the conceptual approach presented in the solution to 8-20. This approach differs little from the shortcut approach we present to deal with MACRS. Some students will use a longer method that first computes the NPV of the project and then uses the differential approach shown in the text. For such students, you might want to go over the steps required (shown below) when using that method. Tax Expected contribution margin (30,000 x $16), an inflow $480,000 Cash fixed costs, an outflow 250,000 Change in income from cash flows 230,000 Less depreciation ($600,000/4) 150,000 Increase in taxable income $ 80,000 Increase in taxes (at 40%), an outflow 32,000 Increase in annual after-tax cash flows Times present value factor, 4 years, 10% Equals present value of expected cash flows, rounded Less investment NPV 46,000) Divided by present value factor Equals required after-tax increase in expected annual cash flows Divided by (1 - 40% tax rate) Equals required increase in expected pretax annual cash flows Plus expected pretax annual cash flows (above) Equals required pretax annual cash flows Plus known cash fixed costs Equals required cash flow from contribution margin Divided by contribution margin per unit Equals required unit volume to achieve needed contribution margin 8-33 1. Determining Required Cost Savings About $3.89 $150,000 3.274 $ 45,816 32,000 $ 77,816 20,000 $3.891 (20 minutes) Cash Flow $480,000 250,000 230,000 32,000 $198,000 2.798 $554,000 600,000 ($ 2.798 $ 16,440 60% $ 27,400 230,000 257,400 250,000 $507,400 $16 31,712

Investment Divided by the present value factor for 16% and 5 years Equals required annual net cash flow Cash fixed operating costs Equals required total savings (cash inflow) Divided by annual unit volume Equals required per-unit saving 2. About $4.42.

The solution below uses the approach of CVP analysis. $45,816 30,000 15,816 .60 26,360 62,000 88,360 20,000 $4.418

Required after-tax cash flow (requirement 1) Less depreciation Equals required net income Divided by one minus the tax rate Equals required pretax income Plus fixed costs, $30,000 + $32,000 Equals required variable cost saving, in total Divided by expected annual volume Equals required unit variable cost saving

Note to the Instructor: Some students will have serious difficulties with this assignment because it does not follow the pattern of sensitivity analyses in the chapter, where one starts with an NPV and determines the change in the relevant factor. It is possible to solve by a kind of brute force approach, in which you assume a value for the reduction in variable

costs, then solve the sensitivity analysis. hypothetical $6.00 per unit saving.

Suppose we start with a Tax $120,000 32,000 88,000 30,000 $ 58,000 23,200 Cash Flow $120,000 32,000 88,000 23,200 64,800 3.274 212,155 150,000 $ 62,155 3.274 $18,984 60% $31,640 20,000 $ 1.582 $ 4.418

Savings in variable cost, $6 x 20,000 Cash operating costs (cash outflow) Pretax cash flow Depreciation ($150,000/5) Increase in taxable income Increase in taxes (at 40%) Increase in annual after-tax cash flow Times present value factor Equals present value of future after-tax cash flows Investment required Hypothetical NPV Divided by present value factor Equals allowable decline in net cash flow Divided by (1 - 40% tax rate) Equals allowable decline in pretax cash flow Divided by expected unit volume Equals allowable decline in variable cost savings Required saving = $6.00 - $1.582 3. About 22,090 units (rounded)

Required total annual savings (requirement 2) Divided by $4 estimated unit savings Equals annual unit volume required

$88,360 $4 22,090

Note to the Instructor: This problem is a good vehicle for pointing out to students that requirements 2 and 3 are items they were doing in Chapter 2, using CVP analysis. 8-34 1. Benefit-Cost Analysis (25 minutes) Kidney Disease $ 15,000 9.427 $141,405 100,000 $ 41,405 8.514 $212,850 150,000 $ 62,850 Heart Disease $ 25,000

Net present values of saved lives:

Annual incomes Present value factors, 10%: 30 years 20 years Present values of future incomes Less cost Net present value

2. If one considers only (perhaps as a first screen) the factors given, there is a narrow margin favoring the treatment of the heart disease. Assuming a convenient equal outlay for treatment, say $300,000, and computing a net present value per dollar spent, three persons could be saved from kidney disease or two from heart disease. Kidney Heart Disease Disease Present values of: 3 lives saved ($141,405 x 3) $424,215 2 lives saved ($212,850 x 2) $425,700 Less cost 300,000 300,000 Net present value $124,215 $125,700 Note to the Instructor: Students' answers to requirement 2 will depend

on their experiences and personal views. Scores of non-quantifiable factors are involved in a decision such as this, and there are other quantifiable issues as well. Personal views and experiences notwithstanding, the goal of improving students' analytical skills is served if class discussion includes coverage of the relatively simple analysis shown above as well as the matters covered in the analytical comments that follow. The NPV analysis is conceptually weak because it relates the cost to the community-treatment cost of the department, paid for by taxes, to the incomes of individuals treated, rather than to the benefits to the community. Individual incomes influence community benefits in some ways (e.g., receipts from local income taxes, contributions to charitable and cultural activities). But individual incomes are not a particularly good measure of benefits to the community and the issue here is use of community finances. For example, being younger, victims of kidney disease probably have more dependents than do the heart-disease victims whose children are more likely to be self-supporting. Thus, treating kidney disease might produce greater savings to the community (in social security, welfare, and other payments to dependents). Evaluation of community benefits must also consider that (a) more lives can be saved if kidney disease is treated, because of the lower cost to save one life; and that (b) treatment of kidney disease will add more years of life to community members because persons saved from that disease have ten more years of life than those saved from heart disease. (An important point to remember is that a decision such as the one in this problem does not consider the lives of any particular individuals.) As with any benefit/cost situation under conditions of resource scarcity, a decision must be made as to who is to benefit from the use of those resources. This socio-political problem can't be resolved with quantifiable factors alone. That this particular decision involves human lives does not negate the need for a decision about what the community is to do with its limited resources. The community can choose to increase the available resources, but it is still likely to set some limit short of taxing its members to a subsistence level. 8-35 When-to-Sell Decisions (20 minutes)

1. About 14%. The choice is between $700 now and $1,170 in four years. The present value factor is .598 ($700/$1,170), which is closest to .592 for four years and 14%. 2. About $1,100, which is $700/.636, the present value divided by the factor for four years and 12%. 3. Nine years gives the highest IRR. Price for Six-Year-Old Scotch $700 700 700 700 Expected Future Price $ 800 950 1,200 1,400 PV Factor .875 .737 .583 .500 Discount Rate for Closest Factor 14% (.877) 16% (.743) 20% (.579) 18% (.516)

Additional Holding Period 1 (sell at 7) 2 3 4

4. Ten years gives the highest present value and highest net present value because the investment is $700 under all choices.

Additional Holding Period 1 2 3 4

Expected Future Price $ 800 950 1,200 1,400

PV Factor at 12% .893 .797 .712 .636

Present Value $714 757 854 890

Note to the Instructor: Requirements 3 and 4 are contrived to give different decisions under the two criteria, IRR and NPV. As discussed in the chapter, in most cases the NPV criterion will give the better decision where mutually exclusive investments are under consideration. That conclusion is not always correct, because it depends on the assumed rate of return earned by the incoming cash flows. In this particular case, if the proceeds from sale after nine years could be reinvested at 20%, the IRR earned if the Scotch is held until it is nine years old, the company would have at the end of the fourth year $1,440 ($1,200 x 1.20), which is more than it would have if it held the Scotch until the end of year four. If the company could earn only the cost of capital of 9%, it would have $1,308 at the end of year four, which is less than it would have if it held the Scotch until it was ten years old ($1,400). 8-36 Increased Sales and Working Capital (25-30 minutes)

The decision is a tossup. The NPV is a negative $437, $160,000 $159,563, which is within rounding errors. Investment required: Outlay for the machine Increase in working capital Total current outlay Present value of cash flows: Annual returns of $26,450 for 10 years at 14% $26,450 (from below) x 5.216 Return of the investment in working capital, at the end of the 10th year ($80,000 x .270) Total present value Computation of Cash Flows for 10 Years Existing Conditions Revenues: 80,000 x $8 105,000 x $7 Variable costs: Labor: Currently ($2.25 x 80,000 units) Future (labor force constant) Other: 80,000 x $2.25 105,000 x $2.25 Total variable costs Contribution margin Increase in contribution margin Depreciation ($80,000/10) Increase in taxable income Tax on above increase (40%) Net increase in after-tax cash flow $640,000 $735,000 180,000 180,000 180,000 ________ 360,000 $280,000 $38,750 8,000 $30,750 12,300 $26,450 236,250 416,250 $318,750 $ 80,000 80,000 $160,000 $137,963 21,600 $159,563 Proposed Conditions

8-37 1.

Sensitivity Analysis (Extension of 7-33) 207,527 units, a drop of 42,473

(20 minutes)

Net present value, from 8-34 Divided by present value factor, 5 years, 14% Equals allowable decrease in net cash flow Divided by (1 - 40% tax rate) Equals allowable decrease in pretax cash flow and income Divided by contribution margin per unit ($4 - $1) Equals allowable decrease in unit volume Expected unit volume Less allowable decrease in unit volume Equals unit volume required to earn 14% IRR

$262,458 3.433 $ 76,452 60% $127,420 $3 42,473 250,000 42,473 207,527

2. Pitcairn's managers might be more inclined to make the investment after seeing that it would take a drop of 42,473 units in volume to bring the net present value to zero. The required volume is about 17% below the expected level of 250,000 units, which is a fairly large decrease. 8-38 1. Backing a Play (30 minutes)

The play appears to be a good investment, with a $325,851 NPV. Cash Flow $1,500,000 600,000 95,000 150,000 140,000 985,000 515,000 156,000 359,000 2.589 929,451

Tax Annual gross receipts $1,500,000 Cash expenses: Salaries 600,000 Rent [$20,000 + (5% x $1,500,000)] 95,000 Royalties (10% x $1,500,000) 150,000 Other cash expenses 140,000 Total cash expenses 985,000 Pretax cash flow 515,000 Depreciation ($500,000/4) 125,000 Taxable income $ 390,000 Tax at 40% Annual cash flow Present value factor, 20%, 4 years Total present value of future annual returns Present value of return of working capital investment $200,000 x 0.482 Total present value Less investment Net present value 2. $1,253,215

$ $

96,400 1,025,851 700,000 $ 325,851

Net present value, computed in requirement 1 Divided by present value factor for 4 years at 20% Equals allowable decline in net cash flow Divided by (1 - 40% tax rate) Equals allowable decline in pretax income and revenue Divided by contribution margin (100% less variable costs of 5% for rent and 10% for royalty) Equals allowable decline in gross receipts Expected revenue Less allowable decline Equals revenue needed for 20% IRR

$ $ $ $

325,851 2.589 125,860 60% 209,767 85% 246,785

$1,500,000 246,785 $1,253,215

The decline is 16.5% of revenue, so the decision is not extremely sensitive to the estimate of revenue. You might very well elect not to back the play for that reason, given that plays are probably riskier investments than most. 8-39 1. Replacement Decision $19,900 $37,300 $12,000 18,000 $ 6,000 (12,000) ( 2,400) ( 3,000) $19,900 (25 minutes)

Purchase price, outflow Tax saving from loss on sale of old machine: Sale of old machine, a cash inflow Book value of old machine Tax loss Tax saving at 40%, a cash inflow Saved cost of repairs, net of tax ($5,000 x 60%) Net cost

2. The new machine should be a wise investment because it involves a cash outlay of $19,900 with anticipated returns of $26,866 computed as below. Cash savings due to greater speed Change in depreciation: Depreciation on new asset ($37,300/10) Depreciation on old asset Additional depreciation from new asset Increase in taxable income Tax on increased income, at 40% Increase in net cash flow Present value factor, 10 years, 10% Total present value of savings 8-40 Valuing a Football Team 1. $ $3,730 1,800 $ 1,930 4,070 1,628 1,628 4,372 6.145 $ 26,866 Tax 6,000 $ Cash Flow 6,000

(25-35 minutes)

$17,591,288 calculated as follows. $ 2,880,000 5.216 $15,022,080

After-tax operating cash flow ($4,000,000 x .72) Present value factor, 10 years, 14% Present value of operating flows

Let M = the maximum investment. The amortization tax shield is [(M/10) x .28 x 5.216], which is subtracted from M along with the present value of the operating flows. Thus, M M .85395M M As proof, Operating Amortization ($17,591,288/10) Pretax profit Tax at 28% Net cash flow Present value factor Present value Tax $4,000,000 1,759,129 $2,240,871 Cash Flows $ 4,000,000 627,444 $ 3,372,556 5.216 $17,591,252 = = = = $15,022,080 $15,022,080 $15,022,080 $17,591,288 + [(M/10) + .14605M x .28 x 5.216]

The difference between the $17,591,252 and the $17,591,288 is from rounding. 2. $16,250,627. The tax shield here is a lump sum at the end of 10 years, so the shield = M x .28 x .270. (The .270 is the present value of a single payment in 10 years.) Thus, M M .9244M M As proof, = = = = $15,022,080 + (M x .28 x .27) $15,022,080 + .0756M $15,022,080 $16,250,627 $15,022,080 1,228,547 $16,250,627

Present value of operating flows, above Present value of write-off ($16,250,627 x .28 x .27) Equals investment 8-41 Investing in Quality, JIT, Declining Base (15-20 minutes)

About $1,221 thousand dollars. Saved contribution margin ($1,500.0 x 60%) Less additional cash fixed costs Pretax cash inflow Depreciation ($5,500.0/10) Decrease in taxable income Reduced income tax at 40%, a cash inflow Net cash inflow Present value factor, 10 years, 12% Present value of future flows Less investment ($5,500.0 - $4,800.0) Net present value $ Tax 900.0 700.0 200.0 550.0 $ 350.0 Cash Flow $ 900.0 700.0 200.0 140.0 340.0 5.650 $1,921.0 700.0 $1,221.0

Note to the Instructor: The solution follows the position in the chapter of assuming that there is no negative effect on inventory at some future date. This assignment also involves no additional cash inflows from sales but rather a halt in the decline of sales. Some students will not see this point and will wonder what the benefits are. If the point hasn't been made in connection with other assignments, it's worth pointing out here that some benefits of JIT operations are not easily quantified, particularly those having to do with increased quality of product and additional manufacturing flexibility. 8-42 Attracting Industry (20-25 minutes)

1. Looking only at the receipts and costs for the town, the investment will not return enough to meet the 9% required rate of return. Receipts: Rent Sales tax ($6,000,000 x 1%) Property taxes [($4,400,000/$1,000) x $80] Total receipts Additional costs Annual net cash inflow Present value factor, 9%, 20 years Present value of future cash inflows Less investment Net present value 150,000 60,000 352,000 562,000 105,000 $ 457,000 9.129 $4,171,953 4,300,000 ($ 128,047) $

2. The above analysis considers only the receipts and costs of the town itself. The state, as well as the town, would benefit from the new plant, because the state would save some of the money it now spends on unemployed people. Hence, it's possible the state might be willing to share some of the cost of this project. If the interest rate for the state is also 9%, it would be worth $27,387,000 ($2,000 x 1,500 reduced unemployment x 9.129, the present value factor) to the state if the 1,500 people were taken off the unemployment rolls. Of course, that figure assumes the level of unemployment would stay at about the same level for the next 20 years if the factory were not built. At least some of the unemployed are likely to become discouraged and move away. The town council and mayor might accept the project if they think it worthwhile to increase taxes somewhat to cover the required investment. They might consider it worthwhile to do so if they believe the town would benefit in noneconomic ways from having fewer unemployed persons. For example, they might consider the positive effects on the unemployed of being given jobs. 8-43 Dropping a Product 1. (30 minutes) Tax Present value of future cash flows: Contribution margin Avoidable fixed costs Cash flow before taxes Less depreciation Increase in taxable income Tax at 40% Net cash flow Present value factor, 14%, 5 years Present value of future cash flows Present value of disposal of equipment: Book value and loss for tax purposes Tax savings at 40%, and present value of inflow Net present value in favor of keeping Quickclean 2. Quickclean should be dropped. Tax $350,000 500,000 150,000 60,000 Cash Flow $350,000 60,000 $410,000 384,496 $ 25,504 $700,000 580,000 120,000 100,000 20,000 8,000 Cash Flow $700,000 580,000 120,000 8,000 $112,000 3.433 $384,496 200,000 $184,496

Quickclean should not be dropped.

$500,000

Selling price of machinery Book value Loss for tax purposes Tax saving at 40% rate Total present value of disposal Present value of future inflows, requirement 1 Net present value of dropping Quickclean 8-44 1. New ProductComplementary Effects (35 minutes)

The product should not be introduced. The NPV is a negative $155,160. Investment required: Machinery Inventories Receivables (10,000 units per month x 2 x $20) $2,000,000 500,000 400,000

Total investment Tax Present value of future cash flows: Contribution margin [120,000 x ($20 - $9)] Less: Additional fixed costs $300,000 Forgone rent of space 120,000 Cash flow before taxes Depreciation ($2,000,000/10) Taxable income Income tax at 40% Net operating cash flow, years 1-10 Present value factor, 10 years, 20% Present value of future operating cash flows Recovery of working capital investment (computed above) in year 10 Present value factor, single payment in 10 years at 20% Total present value of future cash flows Less investment required, above Net present value

$2,900,000 Cash Flows $1,320,000 420,000 900,000 280,000 620,000 4.192 $2,599,040

$1,320,000 420,000 900,000 200,000 700,000

900,000 .162 145,800 $2,744,840 2,900,000 ($ 155,160)

2. The complementary effects make the new product desirable. The positive present value of the future flows from increased sales of the existing product, less the additional investment in inventory and receivables, is $251,544, which is more than enough to offset the $155,160 deficiency in NPV considering the new product by itself as in requirement 1. Contribution margin [30,000 x ($10 - $6)] Less additional income tax at 40% Cash flow Present value factor, 10 years, 20% Present value of future operating flows Recovery of additional investment in working capital $60,000 Single payment factor, 10 years, 20% .162 Total present value of future inflows Less additional investment in receivables and inventory Net present value of increased sales 8-45 1. Closing a PlantExternalities (35 minutes) $ 120,000 48,000 72,000 4.192 301,824 9,720 311,544 60,000 251,544

A $268,800 difference in present values favors closing the plant.

Total Project Approach Close plant: Increased shipping costs Tax at 40% Net cash outflow Present value factor, 10 years, 14% Present value of increased shipping costs Severance pay, net of tax, $800,000 - $320,000 Subtotal Less selling price of plant Present value of future cash flows $ 900,000 360,000 540,000 5.216 2,816,640 480,000 3,296,640 400,000 $2,896,640

Keep plant open: Investment required Depreciation tax shield, $4,000,000/10 x 40% Present value factor, 10 years, 14% Present value of future cash inflows Present value of future cash outflows

$4,000,000 $ 160,000 5.216 834,560 $3,165,440 $ 268,800

Difference favoring closing plant, $3,165,440 - $2,896,640

The investment in equipment produces a net annual cash inflow from tax savings from the depreciation deduction. Some of the flows could be treated differently. For example, the severance pay and sale price of the plant could be treated as savings (avoided costs) under the alternative of keeping the plant open. Incremental Approach Tax Annual savings from keeping open: Shipping costs saved Less depreciation expense Difference in taxable income Difference in taxes at 40% Net annual savings Present value factor, 10 years, 14% Present value of future savings Net investment required: Equipment Foregone selling price Avoided severance pay, net of tax Net amount of investment Net present value favoring closing 2. $900,000 400,000 500,000 200,000 Cash Flows $ 900,000

200,000 700,000 5.216 $3,651,200 $

$4,000,000 400,000 (480,000) ($ 3,920,000 268,800)

Some of the factors also to be considered follow.

(a) Both the company's managers and city officials must consider the impact of the closing on the city of Vesalia. Nearly 400 people will be put out of work. How many of those people will find other employment is influenced by the availability of other employment locally. Some may leave the area; some of those who stay may require additional assistance from the city. Offering employees the opportunity to move to the new location might help those employees but could still have negative effects on the city. (b) The company's managers should assess the likelihood of reaching some type of compromise if the relevant information is shared with city officials and possibly with persons representing the company's employees. Managers could try to negotiate some assistance from the city, perhaps in the form of lower property taxes. Managers could also try to negotiate wage concessions from employees. (As an example, consider the wage concessions negotiated by troubled airlines in the early 1990s.) If the pollution standards were established locally, city officials might not have considered the costs to the city of the increase in unemployed citizens or the potential for reduced property-tax revenues. As interested parties, city officials might reconsider the standards when better informed of the company's situation. If the pollution standards were established at the national level, concessions on property taxes and/or wages might still be negotiated to offset the monetary advantage of closing the plant. (c) The company's managers might not have considered whether the Montclair

area has the additional workers needed to handle the increase in production at the Montclair plant. Note to the Instructor: Apart from the difficulties presented by the qualitative issues in it, this problem is difficult for many students because of the number of cash flow items involved. We've assumed the company considered all the discernible monetary aspects of the situation. As examples, we assumed that (1) the company's calculations include any changes in selling and administrative costs that would result from eliminating one of its locations; (2) no opportunities exist for reducing operating costs at the Vesalia plant other than the tax and wage concessions mentioned in requirement 2; (3) transferring production from the Vesalia to the Montclair plant would not affect any company plans for future use of the currently unused capacity at the Montclair plant; and (4) closing the Montclair plant and transferring its production to the Vesalia plant is financially unwise. An interesting aspect of this problem is that the analysis does not involve contribution margin. The inability to change selling price is a reasonable assumption in a competitive industry. The cost structures and relative sizes of the two plants are unknown. If the Montclair plant can handle the increased production, one must wonder about the implications of the assertion that cash production costs at the two plants are equal. 8-46 Modification of Equipment (35 minutes)

The memo should recommend that the new equipment be purchased and the old equipment sold. The computations submitted in support of the recommendation could be either of the two approaches shown below. Total-project approach The present value of the future outflows of buying new equipment is $96,080 less than that of modifying the existing equipment ($284,160 - $188,080). Tax Modify existing equipment: Annual cash OUTFLOW, excess of operating costs over new equipment* Depreciation [$100,000 + ($300,000/4)] Total tax deductible expense Tax saving at 40% Net after-tax cash flow (inflow) Present value factor, 16%, 4 years Present value of future cash savings Less investment required Present value of future cash inflows ($ 50,000) 175,000 225,000 90,000 Cash Flow ( 50,000) 90,000 ($ 40,000) 2.798 ($111,920) 300,000 $188,080

* This amount could also be shown as a reduction under the "buy new equipment" alternative. Tax Cash Flow Buy new equipment: Depreciation ($800,000/4) $200,000 Tax savings at 40% 80,000 ($ 80,000) Present value factor, 16%, 4 years 2.798 Present value of tax shield ($223,840)

Investment: Price of new equipment

$800,000

Less proceeds on sale of existing equipment $220,000 Book value of equipment 400,000 Loss for tax purposes $180,000 Tax saving at 40% Net investment Less present value of depreciation tax shield, above Present value of future cash outflows Incremental approach--buy rather than modify Operating savings, a cash inflow Increased depreciation ($200,000 - $175,000) Reduction in tax deductible expenses Lost tax savings at 40%, an outflow Net cash inflow favoring modification Times relevant present value factor Present value of future savings Net investment required: Net purchase price (above) $508,000 Modifications avoided 300,000 Net outlay Difference in favor of buying 8-47 Mutually Exclusive Investments (50 minutes) Tax $ 50,000 25,000 25,000 10,000

(220,000) ( 72,000) 508,000 223,840 $284,160 Cash Flow $ 50,000 10,000 $ 40,000 2.798 $111,920

208,000 $ 96,080

The company should buy the Rapidgo 350 and replace it in five years. Rapidgo 600 Present Values Original cost $ 90,000 Annual operating costs $15,000 Plus depreciation ($90,000/10) 9,000 Total expenses $24,000 Tax saving at 40% rate $ 9,600 Net cash outflows ($15,000 - $9,600) $ 5,400 Present value factor, 10 years, 16% 4.833 Present value of future annual cash flows 26,098 Total present value $116,098 Rapidgo 350 Present Values Original cost $ 50,000 Annual operating costs, first 5 years $12,000 Depreciation ($50,000/5) 10,000 Total expenses $22,000 Tax saving at 40% $ 8,800 Net cash outflows ($12,000 - $8,800) $ 3,200 Present value factor, 5 years, 16% 3.274 Present value of flows for first 5 years 10,477 Purchase price of replacement machine $60,000 Present value factor, 5 years, 16% .476 Present value of replacement cost 28,560 Annual operating costs, second 5 years $12,000 Depreciation ($60,000/5) 12,000 Total expense $24,000 Tax saving at 40% $ 9,600 Net cash outflows ($12,000 - $9,600) $ 2,400 Present value of flows* 3,742 Total present value $ 92,779 * $2,400 x 1.559, which is the sum of the present value factors for single payments 6, 7, 8, 9, and 10 years hence (.410 + .354 + .305 + .263 + .

227). Cash flow Times present value annuity factor, 5 years, 16% Equals present value of annuity at beginning of 6th year (5 years from now) Present value factor, single payment 5 years, 16% Present value of delayed annuity 8-48 1. Replacement Decision, MACRS Buy $1,600,000 640,000 $ 960,000 4.968 $4,769,280 (30 minutes) $2,400 3.274 $7,858 .476 $3,740

Purchase cost (80,000 x $20) Less tax saving at 40% Net cash outflow Present value factor, 12%, 8 years Present value of buying Make Variable costs (80,000 x $9.30*) Cash fixed costs Total cash costs Less tax savings at 40% Net cash flow Present value factor, 12%, 8 years Present value of operating flows Present value of MACRS ($2,500,000 x .40 x .738) Present value of salvage value ($100,000 x 60% x .404) Less investment Total present value of making * $9.30 = $4.50 + $3.00 + $1.80 2. About 63,831 units (80,000 - 16,169)

744,000 100,000 844,000 337,600 $ 506,400 4.968 $2,515,795 ( 738,000) ( 24,240) 2,500,000 $4,253,555

Advantage to making ($4,769,280 - $4,253,555) Divided by relevant present value factor Equals allowable decline in annual net cash flow Divided by (1 - 40% tax rate) Equals allowable decline in annual pretax cash flow Divided by difference in variable cost ($20.00 - $9.30) Equals allowable decline in unit volume 8-49 Evaluating an Investment Proposal (40 minutes)

$515,725 4.968 $103,809 60% $173,015 $ 10.70 16,170

The assistant is incorrect; the project should be accepted. assistant has made the following errors.

The

1. The research and development costs and administrative time have already been incurred and so are sunk costs. 2. Interest on debt specific to this particular project should not be a component of the cash flow analysis. 3. The tax saving from scrapping the existing equipment has been ignored.

4. The treatment of depreciation is incorrect. The analysis should use the difference between depreciation on the existing machinery and that on the new

machinery, not the depreciation on the new machinery. 5. The annual cash flow calculation is incorrect because the calculation included a deduction for depreciation, which is not a current cash flow. Depreciation should be added to the $75,000 to arrive at cash flow. The following analysis corrects the above errors. Investment required: Purchase price of machinery Tax savings on scrapping old machinery ($110,000 loss x 40%) Net investment required Annual cash flows: Labor Materials Variable overhead Less tax at 40% of savings Net saving before tax effect of depreciation Tax savings from increase in depreciation ($35,000 - $11,000*) x 40% Net increase in cash flow Present value factor, 10 years, 16% Present value of future cash flows Net investment required, from above Net present value $350,000 44,000 $306,000 Tax $ 75,000 80,000 40,000 $ 195,000 78,000 Cash Flows $ $ $ $ $ $ 75,000 80,000 40,000 195,000 78,000 117,000 9,600 126,600 4.833 611,858 306,000 305,858

* $110,000 book value divided by remaining life of 10 years 8-50 Expanding a Factory (60 minutes)

The smaller expansion, Plan A, should be accepted. The first step is to determine how to use the additional capacity. The products produce contribution margin per machine-hour as follows: 101-X, $9; 201-X, $6; 305-X, $8. Therefore, 101-X should be made first, until its sales potential is reached, then 305-X, and finally, 201-X. The NPV of Plan A is $497,400. The NPV of Plan B is $353,400, or $144,000 less than that of Plan A. Plan B can be analyzed in total or incrementally. Both approaches are shown below. Analysis of Plan A Computation of product quantities and contribution margin: Available machine-hours 200,000 Less production of 30,000 101-Xs (2 x 30,000) 60,000 Hours remaining 140,000 Divided by hours required for 305-X 5 Equals number of 305-Xs to be made 28,000 Contribution margin: 101-X (30,000 x $18) 540,000 305-X (28,000 x $40) 1,120,000 Total contribution margin $1,660,000

Tax

Cash Flows

Computation of NPV: Contribution margin Less additional fixed costs requiring cash Cash flow before taxes Less depreciation ($4,000,000/10) Increased taxable income Increase in income taxes (40%) Net cash flow Present value factor, 12%, 10 years Present value of future flows Investment required Net present value Analysis of Plan B Available machine-hours Less hours devoted To 101-X To 305-X Hours available in excess of Plan A Less hours used for additional production of 305-X (30,000 - 28,000) x 5 Hours remaining for production of 201-X Divided by hours required to produce 201-X Equals number of 201-Xs to be made Contribution margin: 101-X (30,000 x $18) 305-X (30,000 x $40) 201-X (17,500 x $24) Total contribution margin Annual cash flows: Contribution margin Less additional fixed costs requiring cash Cash flow before taxes Less depreciation ($5,500,000/10) Increased taxable income Increase in income tax, at 40% Net cash flow Present value factor, 12%, 10 years Present value of future flows Less investment required Net present value Incremental analysis

$1,660,000 600,000 1,060,000 400,000 660,000 264,000

$1,660,000 600,000 1,060,000 264,000 796,000 5.650 $4,497,400 4,000.000 $ 497,400 $

280,000 ( 60,000) (140,000) 80,000 ( 10,000) 70,000 4 17,500 540,000 1,200,000 420,000 $2,160,000 Tax $2,160,000 800,000 1,360,000 550,000 $ 810,000 324,000 Cash Flows $2,160,000 800,000 1,360,000 324,000 $1,036,000 5.650 $5,853,400 5,500,000 $ 353,400 Cash Flows $ 500,000 200,000 300,000 $

Tax Increased contribution margin $2,160,000 - $1,660,000 Increased fixed cash costs ($800,000 - $600,000) Increased pretax cash flow Increased depreciation ($550,000 - $400,000) Increased taxable income Increased income tax at 40% Increased net cash flow Present value factor, 12%, 10 years Present value of incremental cash flows Incremental investment Net present value of incremental investment $ 500,000 200,000 300,000 150,000 150,000 60,000

60,000 240,000 5.650 $1,356,000 1,500,000 ($ 144,000) $

The $144,000 is also the difference between the two net present values

($497,400 - $353,400). Note to the Instructor: As always, the validity of the analysis depends on the validity of the estimates. An additional factor some students might discuss is how pattern of demand might affect production scheduling and, hence, the decision on the magnitude of the expansion. For example, if demand is seasonal and inventory carrying costs high, the company might believe the benefits of volume flexibility with Plan B exceed the benefits of the stable production needed to meet demand with the smaller facility. Some students may pursue a point raised in the problem, the production manager's comment that the cost per machine hour and investment per machine hour figures were lower for Plan B than for Plan A. As shown below, the production manager is correct; but the point is irrelevant to the decision. Plan A Fixed cost per machine-hour ($600,000 + $400,000)/200,000 ($800,000 + $550,000)/280,000 Investment per machine-hour $4,000,000/200,000 $5,500,000/280,000 $ 5.00 $ 4.82 $20.00 $19.64 Plan B