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Capital Budgeting

Questions

1. Capital assets are the long-lived assets that are acquired by

a firm. Capital assets provide the essential production and

distributional capabilities required by all organizations.

2. Each criterion provides different information about projects.

By using multiple criteria, more dimensions of competing

projects can be compared as a basis for allocating scarce

capital to new investment.

3. Cash flows are the final objective of capital budgeting

investments just as cash flows are the final objective of any

investment. Accounting income ultimately becomes cash flow but

is reported based on accruals and other accounting assumptions

and conventions. These accounting practices and assumptions

detract from the purity of cash flows and are, therefore, not

used in capital budgeting.

4. Analysts separate the act of financing a business's many

integrated investments and the related financing cash flows

from the selection of capital projects and the cash flows

related to such selections because of the virtual

impossibility of convincingly assigning dollars obtained from

the many general financing sources to the particular projects

being selected during a given year.

5. Timelines provide clear visual models of the expected cash

inflows and outflows for each point in time for a project.

They provide an efficient and effective means to help organize

the information needed to perform capital budgeting analyses.

6. The payback method measures the time expected for the firm to

recover its investment. The method ignores the receipts

expected to occur after the investment is recovered and

ignores the time value of money.

113

114 Chapter 14

Capital Budgeting

7. The time value of money is important because having a sum of

money now allows a company to earn a return on it; if the same

amount were not received until some time in the future, a

return could not be earned on it between now and the time it

is received. All else being equal, managers prefer to have

cash receipts now rather than in the future and would prefer

to make cash disbursements in the future rather than now.

Future values can be converted into equivalent present values

by the process of discounting. The following methods use the

time value of money concept: net present value, internal rate

of return, and the profitability index. The accounting rate of

return and payback period do not use the time value of money

concept.

8. Return of capital means the investor is receiving the

principal that was originally invested. Return on capital

means the investor is receiving an amount earned on the

investment.

9. The NPV of a project is the present value of all cash inflows

less the present values of all outflows associated with a

project. If the NPV is zero, it is acceptable because, in

that case, the project will exactly earn the required cost of

capital rate of return. Also, when NPV equals zero, the

projects internal rate of return equals the cost of capital.

10. It is highly unlikely that the estimated NPV will exactly

equal the actual NPV achieved because of the number of

estimates necessary in the original computation. These

estimates include the project life, the discount rate chosen

and the timing and amounts of cash inflows and outflows. The

original investment may also include an estimate of the amount

of working capital that is needed at the beginning of the

project life.

11. The NPV method subtracts the initial investment from the

discounted net cash inflows to arrive at the net present

value. The PI divides the discounted cash inflows by the

initial investment to arrive at the profitability index. Thus,

each computation uses the same set of amounts in different

ways. The PI model attempts to measure the planned efficiency

of the use of the money (i.e., output/input) in that it

reflects the expected dollars of discounted cash inflows per

dollar of investment in the project.

12. The PI will exceed 1 only in instances where the net present

value exceeds 0. This is because the NPV is positive only if

the present value of cash inflows exceeds the present value of

cash outflows. Similarly, the present value of cash inflows

must exceed the present value of cash outflows if the

numerator of the PI formula is to exceed the denominator.

115 Chapter 14

Capital Budgeting

13. The IRR is the rate that would cause the NPV of a project to

equal zero. A project is considered potentially successful

(all other factors being acceptable) if the calculated IRR

exceeds the company's cost of capital.

14. On any prospective project, when the NPV exceeds zero, the

project's IRR will exceed the firm's discount rate that was

used to find the NPV. If the IRR equals the firm's discount

rate, the NPV will equal zero. If the IRR is less than the

firm's discount rate, the NPV will be negative. This

relationship holds true because, ultimately, under either

method the calculations for project selection are designed to

hinge on the project's cash flows in relation to the firm's

discount rate.

15. The amount of depreciation for a year is one factor that helps

determine the amount of cash outflow for income taxes.

Therefore, although depreciation is not a cash flow item

itself, it does affect the size of another item (income taxes)

that is a cash flow.

16. The tax shield is the amount of revenue on which the

depreciation prevents taxation. The tax benefit is the tax

that is saved because of the depreciation and is found by

multiplying the company's tax rate by the tax shield provided

by depreciation.

17. The four questions are:

1. Is the activity worthy of an investment?

2. Which assets can be used for the activity?

3. Of the assets available for each activity, which is the best

investment?

4. Of the best investments for all worthwhile activities, in

which ones should the company invest?

18. NPV: Ranks projects in descending order of magnitude.

PI: Ranks projects in descending order of magnitude if a

positive cash flow project.

IRR: Ranks projects in descending order of magnitude.

Payback: Ranks projects in ascending order of magnitude.

ARR: Ranks projects in descending order of magnitude.

19. Several techniques should be used because each technique

provides valuable and different information. Of preferred use

as the primary evaluator is the net present value in

conjunction with the present value index, because management's

goal should be to maximize, within budget and risk

constraints, the net present value of the firm.

116 Chapter 14

Capital Budgeting

20. Capital rationing exists because a firm often finds that it

has the opportunity to invest in more acceptable projects than

it has money available. Projects are first screened as to

desirability and then ranked as to impact on company

objectives.

21. Risk is defined as the likely variability of the future

returns of an asset. Aspects of a project for which risk is

involved are:

* Life of the asset

* Amount of cash flows

* Timing of cash flows

* Salvage value of the asset

* Tax rates

When risk is considered in capital budgeting analysis, the NPV

of a project is lowered.

22. Sensitivity analysis is used to determine the limits of value

for input variables (e.g., discount rate, cash flows, asset

life, etc.) beyond which the project's outcome will be

significantly affected. This process gives the decision maker

an indication of how much room there is for error in estimates

for input variables and which input variables need special

attention.

23. Postinvestment audits are performed for two reasons: to

obtain feedback on past projects and to make certain that the

champions of proposed projects submit realistic numbers

knowing their estimates will ultimately be compared to actual

numbers. These audits can provide information to correct

problems and to assess how well the capital investment

selection process is working. The larger the capital

expenditure, the more important it is to perform

postinvestment audits. Postinvestment audits are performed at

the completion of a project.

24. The time value of money refers to the concept that money has

time-based earnings power. Money can be loaned or invested to

earn an expected rate of return. Present value is always less

than future value because of the time value of money. A

future value must be discounted to determine its equivalent

(but smaller) present value. The discounting process strips

away the imputed rate of return in future values, thus

resulting in smaller present values.

25. An annuity is a cash flow that is repeated in successive

periods. Single cash flows occur only in one period.

117 Chapter 14

Capital Budgeting

26. ARR = Average annual profits Average investment

Unlike the rate used to discount cash flows or to compare

to the cost of capital rate, the ARR is not a discount rate to

apply to cash flows. It is measured from accrual-based

accounting information and is not intended to be associated

with cash flows.

Exercises

27. a. 3

b. 10

c. 2

d. 9

e. 5

f. 8

g. 6

h. 4

i. 1

j. 7

28. a. 9

b. 4

c. 7

d. 3

e. 6

f. 5

g. 10

h. 2

i. 8

j. 1

29. a. Payback = $750,000 $150,000 per year = 5.00 years

b. Year Amount Cumulative Amount

1 $ 75,000 $ 75,000

2 75,000 150,000

3 75,000 225,000

4 75,000 300,000

5 75,000 375,000

6 100,000 475,000

7 100,000 575,000

8 100,000 675,000

9 100,000 775,000

Payback = 8 + ($75,000 $100,000) years

= 8.75 years, or 8 years and 9 months

118 Chapter 14

Capital Budgeting

30. a. Year Amount Cumulative Amount

1 $ 5,000 $ 5,000

2 9,000 14,000

3 16,000 30,000

4 18,000 48,000

5 15,000 63,000

6 14,000 77,000

7 12,000 89,000

Payback = 4 years + ($12,000 $15,000)

= 4.8 years

b. Yes. Bachs should also use a discounted cash flow

technique for two reasons: (1) to take into account the

time value of money and (2) to consider those cash flows

that occur after the payback period.

31. Point in time Cash flows PV Factor Present Value

0 $(400,000) 1.0000 $(400,000)

1 70,000 0.8929 62,503

2 70,000 0.7972 55,804

3 85,000 0.7118 60,503

4 85,000 0.6355 54,018

5 85,000 0.5674 48,229

6 86,400 0.5066 43,770

7 86,400 0.4524 39,087

8 86,400 0.4039 34,897

9 62,000 0.3606 22,357

10 62,000 0.3220 19,964

NPV $ 41,132

Based on the NPV, this is an acceptable investment.

32. a. The contribution margin of each part is $28 ($50 - $22)

Contribution margin per year = $28 50,000 = $1,400,000

Point in time Cash flows PV factor Present Value

0 $ (500,000) 1.0000 $ (500,000)

1 - 8 (40,000) 5.7466 (229,864)

1 - 8 1,400,000 5.7466 8,045,240

NPV $7,315,376

b. Based on the NPV, this is a very acceptable investment.

119 Chapter 14

Capital Budgeting

c. Other considerations would include whether the company

has the necessary capacity to produce the additional

output, the possibility that the customer would decide to

purchase elsewhere or would no longer have need for the

parts after Machado Industrial has made its investment,

and whether the company has considered all of the costs

that would be affected by the decision to produce the new

partespecially labor and overhead.

33. PI = PV of cash inflows PC of cash outflows

= ($6,000 + $30,000) $30,000 = 1.20

34. a. PV of inflows $590,489 ($88,000 6.7101)

PV of investment $500,000

PI = $590,489 $500,000 = 1.18

b. The OTA should accept the project because its PI is

greater than 1.00.

c. To be acceptable, a project must generate a PI of at

least 1.

35. a. PV = discount factor annual cash inflow

$140,000 = discount factor $28,180

Discount factor = $140,000 $28,180 = 4.968

The IRR is 12%

b. Yes. The IRR on this proposal is greater than the firm's

hurdle rate of 10%.

c. $140,000 = 5.335 Cash flow

Cash flow = $26,242

36. a. Year Amount Cumulative Amount

1 $14,000 $ 14,000

2 14,000 28,000

3 11,000 39,000

4 11,000 50,000

Payback = 4 years + (52,000 - 50,000) $9,000

= 4.22 years

b. Point in time Cash flows PV Factor Present Value

0 $(52,000) 1.0000 $(52,000)

1 - 2 14,000 1.7356 24,298

3 - 4 11,000 1.4343 15,777

5 - 6 9,000 1.1854 10,669

6 7,500 0.5645 4,234

NPV $ 2,978

c. PI = ($52,000 + $2,978) $52,000 = 1.06

120 Chapter 14

Capital Budgeting

37. a. Investment Annual Savings = $2,300,000 $300,000 =

7.67 years.

b. Point in Time Cash Flows PV Factor Present Value

0 $(2,300,000) 1.0000 $(2,300,000)

1 - 11 300,000 6.4951 1,948,530

NPV $ (351,470)

c. PI = $1,948,530 $2,300,000 = 0.85

d. PV = discount factor annual cash inflow

$2,300,000 = discount factor $300,000

discount factor = $2,300,000 $300,000 = 7.6667

discount factor of 7.6667 corresponds to an IRR 7%

38. a. Straight-line method

Annual depreciation = $1,000,000 5 years

= $200,000 per year

Tax benefit = $200,000 0.35 = $70,000

PV = $70,000 3.7908 = $265,356

b.

Accelerated method

$1,000,000 0.40 0.35 .9091 = $127,274.00

$ 600,000 0.40 0.35 .8265 = 69,426.00

$ 360,000 0.40 0.35 .7513 = 37,865.52

$ 216,000 0.40 0.35 .6830 = 20,653.92

$ 129,600

*

0.35 .6209 = 28,164.02

Total $283,383.46

*

In the final year, the remaining undepreciated cost is

expensed.

c. The depreciation benefit computed in part (b). exceeds that

computed in part (a). solely because of the time value of

money. The depreciation method in part (b). allows for

faster recapture of the cost; therefore, there is less

discounting of the future cash flows.

121 Chapter 14

Capital Budgeting

39. a. SLD = $40,000,000 8 years = $5,000,000 per year

Before-tax CF $8,400,000

Less depreciation 5,000,000

Before-tax NI $3,400,000

Less tax (30%) 1,020,000

NI $2,380,000

Add depreciation 5,000,000

After-tax CF $7,380,000

Point in Time Cash Flows PV Factor Present Value

0 $(40,000,000) 1.0000 $(40,000,000)

1 - 8 7,380,000 5.7466 42,409,908

NPV $ 2,409,908

The project is acceptable.

b. Years 1 and 2 Years 3-8

Before-tax CF $ 8,400,000 $8,400,000

Less Depreciation 9,200,000 3,600,000

Before-tax NI $ (800,000) $4,800,000

Tax (tax benefit) (240,000) 1,440,000

After-tax NI $ (560,000) $3,360,000

Add Depreciation 9,200,000 3,600,000

After-tax CF $ 8,640,000 $6,960,000

Point in time Cash flows PV factor Present Value

0 $(40,000,000) 1.0000 $(40,000,000)

1 - 2 8,640,000 1.7833 15,407,712

3 - 8 6,960,000 3.9633 27,584,568

NPV $ 2,992,280

The project is acceptable.

122 Chapter 14

Capital Budgeting

c. Recomputation of part (a):

Before-tax CF $8,400,000

Less depreciation 5,000,000

NIBT $3,400,000

Less tax (50%) 1,700,000

NI $1,700,000

Add depreciation 5,000,000

After-tax CF $6,700,000

Point in Time Cash Flows PV Factor Present Value

0 $(40,000,000) 1.0000 $(40,000,000)

1 - 8 6,700,000 5.7466 38,502,220

NPV $ (1,497,780)

The project is not acceptable.

Recomputation of part (b):

Years 1 and 2 Years 3-8

Before-tax CF $ 8,400,000 $8,400,000

Less Depreciation 9,200,000 3,600,000

NIBT $ (800,000) $4,800,000

Less Tax(tax benefit) (400,000) 2,400,000

After-tax NI $ (400,000) $2,400,000

Add Depreciation 9,200,000 3,600,000

After-tax CF $ 8,800,000 $6,000,000

Point in Time Cash Flows PV Factor Present Value

0 $(40,000,000) 1.0000 $(40,000,000)

1 - 2 8,800,000 1.7833 15,693,040

3 - 8 6,000,000 3.9633 23,779,800

NPV $ (527,160)

The project is not acceptable.

40. a. Tax: $25,000 - $8,000 = $17,000

Financial accounting: $25,000 - $15,000 = $10,000

b. CFAT = Market value now minus taxes

= $17,000 - (($17,000 - $8,000) .40)

= $13,400

c. CFAT = $4,000 - (($4,000 - $8,000) .40) = $5,600

123 Chapter 14

Capital Budgeting

41. a. Find the rate that will cause the NPVs of the two

projects to be equal. By trial and error, the

indifference rate is just above 4%. At a 4% rate the NPV

of each project is computed as follows:

Project 1:

NPV = (8.1109 $85,000) - $400,000

NPV = $289,427

Project 2:

NPV = (8.1109 $110,000) - $600,000

NPV = $292,199

b. This rate is known as the Fisher rate.

c. Project 1:

NPV = (5.6502 $85,000) - $400,000

NPV = $80,267

Project 2:

NPV = (5.6502 $110,000) - $600,000

NPV = $21,522

Project 1 would be preferred due to its higher NPV,

42. a. cash flow annuity factor = $30,000

cash flow 3.6048 = $30,000

cash flow = $8,322

b. $30,000 $8,322 = 3.6 years

43. PV factor $180,000 = $400,000

PV factor = $400,000 $180,000 = 2.2222

This factor falls between 1.7591 (at 2 years) and 2.5313 (at 3

years) in the table using the 9% column. Thus, the cash flow

would have to persist for over 2 years but under 3 years.

44. a. cash flow discount factor = investment

cash flow 7.1607 = $1,200,000

cash flow = $167,581

b. cash flow discount factor = investment

$193,723 discount factor = $1,200,000

discount factor = 6.1944

This PV factor for 12 periods corresponds to 12%.

124 Chapter 14

Capital Budgeting

45. future value discount factor = present value

future value .5674 = $14,000

future value = $24,674

46. Cost = $9,000 + PV($1,200 annuity)

= $9,000 + ($1,200 30.1075)

= $45,129

47. a. PV = future value discount factor

= $50,000 .6302

= $31,510 should be invested to achieve the goal

b. PV = future value discount factor

= $200,000 .3083

= $61,660 would be equivalent today

c. PV = future value discount factor

= $60,000 .3522

= $21,132

d. timeline

time t0 t1 t2 t3 t4 t5

amount $210 $210 $210 $210 $210

Year 1 receipt: $210,000 .9246 = $194,166

Year 2 receipt: $210,000 .8548 = 179,508

Year 3 receipt: $210,000 .7903 = 165,963

Year 4 receipt: $210,000 .7307 = 153,447

Year 5 receipt: $210,000 .6756 = 141,876

Present value $834,960

Discount factors based on semi-annual rate of 4 percent.

e. Year 1 receipt: $ 30,000 .9259 = $ 27,777

Year 2 receipt: $ 50,000 .8573 = 42,865

Year 3 receipt: $ 60,000 .7938 = 47,628

Year 4 receipt: $100,000 .7350 = 73,500

Year 5 receipt: $100,000 .6806 = 68,060

Year 6 receipt: $100,000 .6302 = 63,020

Year 7 receipt: $100,000 .5835 = 58,350

Year 8 receipt: $100,000 .5403 = 54,030

Year 9 receipt: $ 70,000 .5003 = 35,021

Year 10 receipt: $ 45,000 .4632 = 20,844

Present value $491,095

f. No. Using any discount rate above 0, the present value

of the future annual cash flows is well below $1,000,000.

Only if the friend has substantial other assets would she

be a millionaire.

125 Chapter 14

Capital Budgeting

48. a. Change in net income = $250,000 - ($500,000 5)

= $150,000

ARR = $150,000 ($500,000 2) = 60%

Payback = $500,000 $250,000 per year = 2 years

b. Yes. The equipment investment meets all investment

criteria. The payback is less than 5 years and the

accounting rate of return exceeds 18%.

49. a. Annual cash receipts $16,000

Cash expenses (2,000)

Net cash flow before taxes $14,000

Depreciation 8,333

Income before tax $ 5,667

Taxes (1,983)

Net income $ 3,684

Depreciation 8,333

Annual after-tax cash flow $12,017

b. Payback = $50,000 $12,017 per year = 4.16 years

c. ARR = $3,684 ($50,000 2) = 14.74%

50. a. Before-tax cash flow $ 25,000

Depreciation

($60,000 5) (12,000)

Income before tax $ 13,000

Tax (28%) (3,640)

Net income $ 9,360

Depreciation 12,000

Annual after-tax cash flow $ 21,360

b. Point in time Cash flows PV factor Present Value

0 $(60,000) 1.0000 $(60,000)

1-5 $ 21,360 3.7908 80,971

NPV $ 20,971

c. From part a. accounting income = $9,360

d. ARR = $9,360 (($60,000 + $0) 2) = 31.2%

Payback = $60,000 $21,360 = 2.81 years

126 Chapter 14

Capital Budgeting

51. a. Payback = $750,000 $250,000 annually = 3 years

b. One of the other cost savings may come in the form of

improved quality. By adopting the higher technology,

fewer defects should occur. Additionally, the company

may be able to lower its costs because of its enhanced

flexibility to switch production from one job to another.

Additional costs may come in the form of maintenance and

repairs as well as training costs to upgrade skills of

workers to operate the new equipment.

52. Some of the factors that would weigh in favor of proceeding

with the investment as planned include these:

The cost savings will be received now instead of later.

Any learning curve effects will be enjoyed earlier.

Any quality effects on operations will be recognized sooner.

The reduced maintenance cost benefit will occur now rather

than later.

Demand for services may accelerate unexpectedly.

Delays in installing the equipment may result in price hikes

that could be avoided if the equipment is installed on

schedule.

The factors that might weigh in favor of delaying investment

include these:

Risk associated with the new investment may increase because

of the likelihood that demand will not pick up in the near

future.

Possible price reductions might be realized by delaying

acquisition of the equipment. Price reductions are more

likely on computerized equipment.

Possible layoffs of employees can be deferred.

More time is now available to evaluate alternative

technologies that may have emerged or will emerge soon.

The company should protect its cash flow in light of a

local, stagnating economy.

127 Chapter 14

Capital Budgeting

53. A companys R&D program is the major source of distant, future

cash flows. It is from the R&D effort that new products are

identified and developed. Without a successful R&D program,

the stream of future cash flows will dry up. Similarly, the

present products and services offered by a firm are

attributable to past R&D programs. Hence, the linkage is

established between R&D activity, and present and future cash

flows.

It is not surprising that much long-term planning should

be concentrated on the R&D activity. Managing the investment

in R&D activities is the main method available to managers to

balance current and present cash flows, as well as present and

future growth. R&D is expensed when incurred and this reduces

current earnings. This often tends to depress stock prices.

54. The capital budget interacts with the cash budget in that

acquisition of capital items represents a use of cash. The

capital budget also interacts with the statement of cash flows

investing activities section. Further, the capital budget

impacts depreciation expense on the budgeted income statement,

and assets on the budgeted balance sheet. Indirectly, the

capital budget interacts with other lines on the income

statement because the various projects included in the capital

budget will influence a variety of expenses including labor,

overhead, administration and marketing.

55. No response provided.

56. The market must be expecting an enormous increase in future

cash flows relative to current cash flows. If the total value

of the shares is viewed as the present value of the future

cash flows accruing to the equity holders, the only possible

explanation for the incredibly high value of the stock is that

investors expect future cash flows to be many times the level

of current cash flows.

57. If the value of a share of stock is viewed as the present

value of the future cash flows that will accrue to that share

of stock, then any change in the discount rate applied by

investors would affect the share price. If interest rates

move up and down, it is reasonable to expect stock prices to

move inversely to the change in interest rates because the

change in the prevailing interest rates represents a change in

the discount rate applied by investors.

128 Chapter 14

Capital Budgeting

58. The capital budget is a key control tool for a .com firm. Few

.com firms have turned a profit yet. They are very early in

the process of developing products and services to deliver

over the Internet and this process requires substantial

capital investment. Consequently, their investing activities,

managed by the capital budgeting process, are the focus of

much managerial time and talent. Only if these firms invest

in the right projects will the eventual success of the firm be

realized.

Problems

59. a. ($000s omitted)

t0 t1 t2 t3 t4 t5 t6 t7 t8

Investment -90.0

New CM 24.00 24.0 24.0 24.0 24.00 24.00 24.00 24.00

Oper. costs 0.0 -6.50 -7.2 -7.2 -7.2 -7.95 -9.45 -10.00 -11.25

Ann. savings -90.0 17.50 16.8 16.8 16.8 16.05 14.55 14.00 12.75

b. Year Cash Savings Cumulative Savings

1 $17,500 $17,500

2 16,800 34,300

3 16,800 51,100

4 16,800 67,900

5 16,050 83,950

Payback = 5 + (($90,000 - $83,950) $14,550) = 5.42 years

c. Time Cash Flow PV Factor for 10% Present Value

0 $(90,000) 1.0000 $(90,000)

1 17,500 .9091 15,909

2 16,800 .8265 13,885

3 16,800 .7513 12,622

4 16,800 .6830 11,474

5 16,050 .6209 9,965

6 14,550 .5645 8,213

7 14,000 .5132 7,185

8 12,750 .4665 5,948

NPV $(4,799)

60. a. Time: t0 t1 t2 t3 t4 t5 t6 t7

Amount: ($31,000) $6,800 $7,100 $7,300 $7,000 $7,000 $7,100 $7,200

b. Year Cash Flow Cumulative

Year 1 $6,800 $ 6,800

Year 2 7,100 13,900

Year 3 7,300 21,200

Year 4 7,000 28,200

Payback = 4 years + (($31,000-$28,200)$7,000) = 4.40 years

129 Chapter 14

Capital Budgeting

c.

Cash flow Discount Present

Description Time Amount Factor Value

Purchase the car t0 ($31,000) 1.0000 ($31,000)

Cost savings t1 6,800 .8929 6,072

Cost savings t2 7,100 .7972 5,660

Cost savings t3 7,300 .7118 5,196

Cost savings t4 7,000 .6355 4,448

Cost savings t5 7,000 .5674 3,972

Cost savings t6 7,100 .5066 3,597

Cost savings t7 7,200 .4524 3,257

NPV $ 1,202

61. a. Payback period = $64,000 ($25,000 - $4,500) = 3.12

years; the project does meet the payback criterion.

b. Discount factor = Investment annual cash flow

= $64,000 $20,500 = 3.1220

Discount factor of 3.1220 indicates IRR > 10.5%

which is an unacceptable IRR. The actual IRR is 10.71%.

62. a. Year Cash flow PV factor PV

0 $(2,500,000) 1.0000 $(2,500,000)

1-7 419,500 5.0330 2,111,344

7 200,000 .5470 109,400

NPV $ (279,256)

b. No, the NPV is negative; therefore this is an

unacceptable project.

c. PI = ($2,111,344 + $109,400) $2,500,000

= 0.89

d. The company should consider the quality of the work

performed by the machine versus the quality of the work

performed by the individuals; the reliability of the

manual process versus the reliability of the mechanical

process; and perhaps most importantly, the effect on

worker morale and the ethical considerations in

displacing 14 workers.

130 Chapter 14

Capital Budgeting

63. a. The incremental cost of the new machine: $290,000 - $6,000

= $284,000

Cash flow Discount Present

Description Time Amount Factor Value

Incremental cost t0 $(284,000) 1.0000 $(284,000)

Cost savings t1-t7 60,000 4.9676 298,056

NPV $ 14,056

PI = $298,056 $284,000 = 1.05

Yes, the machine should be purchased because the NPV > 0

and the PI > 1.

b. Payback = $284,000 60,000 per year = 4.73 years

c. Net investment annual annuity = discount factor of IRR

$284,000 60,000 = 4.7333

Discount factor of 4.7333 is between 13.0 and 13.5%

Using interpolation, the actual rate is 13.40%

64. a. Computation of net annual cash flow:

Increase in revenues $172,000

Increase in cash expenses (75,000)

Increase in pretax cash flow $ 97,000

Less Depreciation (39,000)

Income before tax $ 58,000

Income taxes (30 percent) (17,400)

Net income $ 40,600

Add Depreciation 39,000

After-tax cash flow $ 79,600

Cash Flow Discount Present

Description Time Amount Factor Value

Initial cost t0 $(780,000) 1.0000 $(780,000)

Annual cash flow t1-t20 79,600 7.9633 633,879

NPV $(146,121)

b. No, this is not an acceptable investment. The net

present value is not close to the cutoff value of $0.

131 Chapter 14

Capital Budgeting

c. Minimum annual cash flow discount factor =

$780,000

Minimum annual cash flow 7.9633 = $780,000

Minimum annual cash flow = $97,949

After-tax cash flow increase = Minimum cash flow -

Actual cash flow

After-tax cash flow increase = $97,949 - $79,600

After-tax cash flow increase = $18,349

Increase in revenues = After-tax cash flow increase (1-

tax rate)

Increase in revenues = $18,349 0.70

Increase in revenues = $26,213

65. a. Cash flow after tax (CFAT):

Year Pretax CF Depreciation Tax CFAT

1 $52,000 $32,000 $6,000 $46,000

2 59,000 51,200 2,340 56,660

3 59,000 30,400 8,580 50,420

4 51,000 24,000 8,100 42,900

5 43,000 22,400 6,180 36,820

Timeline:

t0 t1 t2 t3 t4 t5

$(160,000) $46,000 $56,660 $50,420 $42,900 $36,820

b. Year Net Cash Flow Cumulative Cash Flow

1 $46,000 $ 46,000

2 56,660 102,660

3 50,420 153,080

Payback = 3 years + (($160,000-153,080) $42,900)

= 3.16 years.

Net present value:

Time Amount Discount Factor Present Value

Year 0 $(160,000) 1.0000 $(160,000)

Year 1 $46,000 .9259 42,591

Year 2 56,660 .8573 48,575

Year 3 50,420 .7938 40,023

Year 4 42,900 .7350 31,532

Year 5 36,820 .6806 25,060

NPV $ 27,781

Profitability index = ($160,000 + $27,781) $160,000 =

1.17

IRR, is between 14.5% and 15%. Using a computer, the IRR

is found to be 14.68%.

132 Chapter 14

Capital Budgeting

66. a. Maple Commercial Plaza:

t0 t1-t10 t10

$(800,000) $210,000 $400,000

High Tower:

t0 t1-t10 t10

$(3,400,000) $830,000 $1,500,000

b. Maple Commercial Plaza:

Calculation of annual cash flow:

Pretax cost savings $210,000

Depreciation ($800,000 25) (32,000)

Pretax income $178,000

Taxes (40 percent) (71,200)

Aftertax income $106,800

Depreciation 32,000

Aftertax cash flow $138,800

t0 t1-t10 t10

$(800,000) $138,800 $432,000

*

*

Includes $32,000 from tax loss on sale

(0.40 ($400,000 - $480,000))

High Tower:

Calculation of annual cash flow:

Pretax cost savings $ 830,000

Depreciation ($3,400,000 25) (136,000)

Pretax income $ 694,000

Taxes (277,600)

Aftertax income $ 416,400

Depreciation 136,000

Aftertax cash flow $ 552,400

t0 t1-t10 t10

$(3,400,000) $552,400 $1,716,000

*

*

Includes $216,000 from tax loss on sale

(0.40 ($1,500,000 - $2,040,000))

133 Chapter 14

Capital Budgeting

c. After-tax NPV, Maple Commercial Plaza:

Amount Discount Factor Present Value

Year 0 $(800,000) 1.0000 $(800,000)

Year 1-10 138,800 5.8892 817,421

Year 10 432,000 .3522 152,150

NPV $ 169,571

After-tax NPV, Hightower:

Amount Discount Factor Present Value

Year 0 $(3,400,000) 1.0000 $(3,400,000)

Year 1-10 552,400 5.8892 3,253,194

Year 10 1,716,000 .3522 604,375

NPV $ 457,569

Based on the NPV criterion, Hightower is the preferred

investment

d. After-tax NPV, Hightower:

Amount Discount factor Present Value

Year 0 $(3,400,000) 1.0000 $(3,400,000)

Year 1-10 180,400 5.8892 1,062,412

Year 1-10 372,000

*

4.1925 1,559,610

Year 10 1,716,000 .3522 604,375

NPV $ (173,603)

*

Rental portion of cash flow = $620,000 (1 - tax rate)

= $620,000 0.60

= $372,000

Under this circumstance, Maple Commercial Plaza is the

preferred investment.

134 Chapter 14

Capital Budgeting

67. a. Project A

Year Cash Flow PV Factor PV

0 $(96,000) 1.0000 $(96,000)

1-6 25,600 4.1114 105,252

NPV $ 9,252

PI = $105,252 $96,000 = 1.10

IRR: Discount factor for 6 periods is $96,000 $25,600 =

3.7500, which yields a rate of just under 15.5%.

Project B

Year Cash Flow PV Factor PV

0 $(160,000) 1.0000 $(160,000)

1-10 30,400 5.6502 171,766

NPV $ 11,766

PI = $171,766 $160,000 = 1.07

IRR: Discount factor for 6 periods is $160,000 $30,400

= 5.2631, which yields a rate of about 13.75%.

b. Although the methods give conflicting results, the NPV of

B is greater than that of A and this is probably the best

indication for choice. Although the IRR for Project A is

higher, the reinvestment assumption of that method is

less attainable. Even though the PI of Project A is

slightly higher, its NPV is less and usually dollars are

the deciding criterion when rates are close.

c. Project A's IRR is 15.5% and Project B's is 13.75%. Above

13.75%, Project B will have a negative NPV. At 12%,

Project A's NPV is $9,252 and Project B's is $11,766. By

repeated trials, the Fisher rate (the rate at which the

NPVs are equal) is estimated to be between 12.50% and

13.0%. By programmable calculator, the rate is found to

be 12.64%.

135 Chapter 14

Capital Budgeting

68. a. Project name NPV PVI IRR

Film studios $3,578,846 1.18 13.03%

Cameras & equipment 1,067,920 1.33 18.62

Land investment 2,250,628 1.45 19.69

Motion picture #1 1,040,276 1.06 12.26

Motion picture #2 1,026,008 1.09 14.22

Motion picture #3 3,197,363 1.40 21.34

Corporate aircraft 518,916 1.22 18.15

b. Ranking according to:

NPV PVI IRR

1. Film Studios Land investment MP #3

2. MP #3 MP#3 Land Investment

3. Land Invest. Camera & Equip. Camera & Equip.

4. Cam. & Equip. Corp. Aircraft Corp. Aircraft

5. MP #1 Film Studio MP #2

6. MP #2 MP #2 Film Studios

7. Corp. aircraft MP #1 MP #1

c. Suggested purchases NPV

1. MP #3 @ $8,000,000 $3,197,363

2. Land invest. @ $5,000,000 2,250,628

3. Cam. & Equip. @ $3,200,000 1,067,920

4. Corp. Aircraft @ $2,400,000 518,916

Total NPV $7,034,827

69. a. Depreciation per year = $2,000,000 14 = $142,857

Before tax cash flows = [300 0.80 ($75 - $10) 50] -

$100,000

= $680,000 per year

Before-tax CF $680,000

Less Depreciation (142,857)

Income before tax $537,143

Less tax (35%) (188,000)

Net income $349,143

Add Depreciation 142,857

After-tax cash flow $492,000

PV of 14 yr. annuity of $492,000 @ 13% $3,100,830

Less cost (2,000,000)

NPV $1,100,830

b. It exceeds the highest rate provided in the table. By

computer it is 23.29%.

c. Cash flow discount factor = $2,000,000

Cash flow (6.3025) = $2,000,000

Cash flow = $317,334

136 Chapter 14

Capital Budgeting

d. 6 years

e. $217,425 after tax CF

[($217,425 - $142,857) 0.65] + $142,857 + $100,000 =

$357,577 before tax CF ($357,577 300) $65 = 19 rooms

(rounded up)

70. a. Year Revenue VC FC Net Cash Flow

1 - 4 $125,000 $ 75,000 $20,000 $ 30,000

5 - 8 175,000 105,000 20,000 50,000

9 - 10 100,000 60,000 20,000 20,000

Year Cash Flow PV Factor PV

0 $(145,000) 1.0000 $(145,000)

1 - 4 30,000 3.1699 95,097

5 - 8 50,000 2.1651 108,255

9 - 10 20,000 .8096 16,192

10 10,000 .3855 3,855

NPV $ 78,399

b. Year Revenue VC FC Net Cash Flow

1 - 4 $120,000 $ 78,000 $15,000 $27,000

5 - 8 200,000 130,000 17,500 52,500

9 - 10 103,000 66,950 25,000 11,050

Year Cash flow PV Factor PV

0 $(137,500) 1.0000 $(137,500)

1 - 4 27,000 3.1699 85,587

5 - 8 52,500 2.1651 113,668

9 - 10 11,050 .8096 8,946

10 23,500 .3855 9,059

NPV $ 79,760

c. The biggest factors are the increased level of variable

costs, the additional working capital, the lower

initial revenues, and the lower cost of production

equipment.

137 Chapter 14

Capital Budgeting

71. a. Year Net Income

1 $(107,500)

2 (40,000)

3 5,500

4 88,000

5 240,000

6 240,000

7 72,000

8 (42,000)

$456,000

Average annual income = $456,000 8 = $57,000

Average Investment = (Cost + Salvage) 2

= ($1,600,000 + $0) 2 = $800,000

ARR = $57,000 $800,000 = 7.125%

b. Cash Cash Net Cumulative

Year Receipts Expenses Inflows Cash Flows

1 $750,000 $ 657,500 $ 92,500 $ 92,500

2 800,000 640,000 160,000 252,500

3 930,000 724,500 205,500 458,000

4 1,280,000 992,000 288,000 746,000

5 1,600,000 1,160,000 440,000 1,186,000

6 1,600,000 1,160,000 440,000 1,626,000

Payback = 5 + (($1,600,000-$1,186,000) $440,000) years

= 5.94 years

c. Year Cash flow PV factor PV

0 $(1,600,000) 1.0000 $(1,600,000)

1 92,500 .8929 82,593

2 160,000 .7972 127,552

3 205,500 .7118 146,275

4 288,000 .6355 183,024

5 440,000 .5674 249,656

6 440,000 .5066 222,904

7 272,000 .4524 123,053

8 158,000 .4039 63,816

NPV $ (401,127)

138 Chapter 14

Capital Budgeting

72. a. Initial cost: t0 = $(730,000) + $170,000 = $(560,000)

Annual cash flow:

Additional revenue ($1.20 110,000) $132,000

Labor savings 30,000

Other operating savings ($192,000 - $80,000) 112,000

Total $274,000

NPV = $(560,000) + ($274,000 6.1446) = $1,123,620

b. Discount factor = $560,000 $274,000 = 2.0438

The IRR exceeds numbers reported in the present value

appendix. By computer, the IRR is found to be 47.96%.

c. $560,000 $274,000 = 2.04 years

d. ARR = ($274,000 - $31,000) (($560,000 + $0) 2)

= 86.79%

e. Incremental revenue ($132,000 10 years) $1,320,000

Labor cost savings ($30,000 10 years) 300,000

Savings in other costs ($112,000 10 years) 1,120,000

Less incremental cost (560,000)

Incremental profit $2,180,000

Because the incremental profit is greater than $0, the

firm should buy the new equipment.

139 Chapter 14

Capital Budgeting

Cases

73. Note: Students may have slightly different answers. The CMA

solution uses only two-digit present value factors.

a. Present Value Analysis (using 6%)

Initial

Outlay 2003 2004 2005 2006 2007 NPV

Internal

Financing

Outlay ($1,000,000)

Depr.

tax

shield $160,000 $ 96,000 $ 57,600 $ 43,200 $ 43,200

Net CF ($1,000,000) $160,000 $ 96,000 $ 57,600 $ 43,200 $ 43,200

PV factors 1.00 0.94 0.89 0.84 0.79 0.75

NPV ($1,000,000) $150,400 $ 85,440 $ 48,384 $ 34,128 $ 32,400 $(649,248)

Bank

Loan

Outlay ($100,000)

Loan

payment ($237,420)($237,420)($237,420)($237,420)($237,420)

Interest

tax shield 36,000 30,103 23,617 16,482 8,638

Depr.

tax shield $160,000 $ 96,000 $ 57,600 $ 43,200 $ 43,200

Net CF ($100,000) ($ 41,420)($111,317)($156,203)($177,738)($185,582)

PV factors 1.00 0.94 0.89 0.84 0.79 0.75

NPV ($100,000) ($ 38,935)($ 99,072)($131,211)($140,413)($139,187)$(648,818)

Lease

Outlay ($ 50,000)

Tax shield

on outlay $ 20,000

Payments

net of tax

($220,000

60%) ($132,000)($132,000)($132,000)($132,000)($132,000)

NCF ($ 50,000) ($112,000)($132,000)($132,000)($132,000)($132,000)

PV factors 1.00 0.94 0.89 0.84 0.79 0.75

NPV ($ 50,000) ($105,280)($117,480)($110,880)($104,280)($ 99,000)$(586,920)

NPV for internal financing = $(649,248)

NPV for bank loan = $(648,818)

NPV for lease = $(586,920)

140 Chapter 14

Capital Budgeting

Supporting calculations

Depreciation tax shield

Year Depreciation Rate Tax shield

1 $1,000,000 0.40 = $400,000 0.40 = $160,000

2 ($1,000,000-$400,000) 0.40 = 240,000 0.40 = 96,000

3 ($1,000,000-$640,000) 0.40 = 144,000 0.40 = 57,600

4 ($1,000,000-$784,000) 0.50 = 108,000 0.40 = 43,200

5 ($1,000,000-$784,000) 0.50 = 108,000 0.40 = 43,200

Interest tax shield

Year Interest Rate Tax shield

1 $90,000 0.40 $36,000

2 75,258 0.40 30,103

3 59,042 0.40 23,617

4 41,204 0.40 16,482

5 21,596 0.40 8,638

1. Metrohealth should employ the cost of debt of six

percent (which represents the after-tax effect of the

ten percent incremental borrowing rate) as a discount

rate in calculating the net present value for all three

financing alternatives.

Investment decisions (accept versus reject) and

financing decisions should be separated. Cost of

capital or hurdle rates apply to investment decisions

but not to financing decisions. This application is a

financing decision. Incremental cost of debt is the

basic rate used for discounting in financing decisions

because the assumption made is that the firm would have

no idle cash available for funding and would have to

borrow from an outside lending institution at the

incremental borrowing rate (10 percent in this case).

2. The financing alternative most advantageous to

Metrohealth is leasing. This alternative has the lowest

net present value ($586,920) when compared to the other

two alternatives.

141 Chapter 14

Capital Budgeting

b. Some qualitative factors Paul Monden should include for

management consideration before deciding on the financing

alternatives are:

The differential impact from one financing method versus

another for equipment acquisitions due to various health

care, third-party payor, reimbursement scenarios (the

federal government with DRG reimbursement or insurance

company reimbursement).

The technology of the equipment along with the risk of

technological obsolescence. If major technological

advances are expected, the preferred qualitative choice

would be leasing from a lessor who would absorb any loss

due to equipment obsolescence.

The maintenance agreement included in the operating

lease.

(CMA adapted)

74. a. Incremental annual after-tax cash flows:

Purchase Year 0

Purchase of new equipment $(300,000)

One time production expense

net of tax ($30,000 .6) (18,000)

Sale of old equipment

net of tax ($5,000 .6) 3,000

Total initial cash outflow $(315,000)

Annual Operations

Year 1 Year 2 Year 3 Year 4

Cash operating

savings $ 90,000 $150,000 $150,000 $150,000

Less tax effect(40%) (36,000) (60,000) (60,000) (60,000)

Cash savings

after-tax $ 54,000 $ 90,000 $ 90,000 $ 90,000

Depr. tax shield

(see sched. below) 48,000 36,000 24,000 12,000

After-tax operating

cash flows $102,000 $126,000 $114,000 $102,000

Depreciation Schedule

Depreciable base: $300,000

Life: four-year limit

Method: Sum-of-the-years'-digits

Year Rate Depreciation Depr. Shield

1 4/10 $120,000 $48,000

2 3/10 90,000 36,000

3 2/10 60,000 24,000

4 1/10 30,000 12,000

142 Chapter 14

Capital Budgeting

b. The company should accept the proposal since the NPV is

positive.

Year Cash Flow 12% PV Factor PV

0 $(315,000) 1.0000 $(315,000)

1 102,000 .8929 91,076

2 126,000 .7972 100,447

3 114,000 .7118 81,145

4 102,000 .6355 64,821

NPV $ 22,489

(CMA)

75. a. The benefits of a postcompletion audit program for capital

expenditure projects include these:

The comparison of actual results with projected results

to validate that a project is meeting expected

performance or to take corrective action or terminate a

project not achieving expected performance.

An evaluation of the accuracy of projections from

different departments.

The improvement of future capital project revenue and

cost estimates through analyzing variations between

expected and actual results from previous projects and

the motivational effect on personnel arising from the

knowledge that a postinvestment audit will be done.

b. Practical difficulties that would be encountered in

collecting and accumulating information include:

Isolating the incremental changes caused by one capital

project from all the other factors that change in a

dynamic manufacturing and/or marketing environment.

Identifying the impact of inflation on all costs in the

capital project justification.

Updating of the original proposal for approval of

changes that may have occurred after the initial

approval.

Having a sufficiently sophisticated information

accumulation system to measure actual costs incurred by

the capital project.

Allocating sufficient administrative time and expenses

for the postcompletion audit.

(CMA adapted)

143 Chapter 14

Capital Budgeting

Reality Check

76. a. It is no easier for a healthcare concern than any other

business to invest in capital assets when doing so is not

justified on financial grounds. The problem described in

the article would seem to describe a failure of the

information systems of healthcare providers to fairly

capture all relevant financial dimensions of long-term

strategic investments. It is unreasonable to think that

benefits such as improving quality of care or patient

satisfaction have no financial return.

b. As an accountant with a healthcare provider, you could

identify nonfinancial benefits such as those described

in part a. and, if appropriate, assign values to them.

The key contribution you would make is to provide a

rigorous investment analysis that includes not only those

costs and benefits usually captured by accounting

systems, but to add other benefits that may be missed

because the financial impact is indirect (e.g., increased

consumer satisfaction) rather than direct.

77. a. For labor-intensive operations, labor cost and quality

would be substantial considerations in locating new

investments. Having skilled labor available at a

competitive cost would determine the likelihood that the

new investment would be profitable.

b. In addition to labor cost and quality, firms would also

consider these factors:

Political risks of the alternative investment locations

Nearness to suppliers and markets

Tax rates of the alternative locations

Incentives offered by local governments

Location of competitors

78. a. When short-run economic conditions become difficult,

companies must be very careful when cutting costs to

protect profits. In particular, cutting spending on

training, research and development, and customer service

will surely have a deleterious effect on product and

service quality. Alternatively, cutting advertising

costs and other marketing costs may have much less effect

on product quality.

144 Chapter 14

Capital Budgeting

b. Any cost-cutting measures that affect employee and

managerial training or research and development will have

long-term implications. In cutting these activities, the

firm is essentially mining future profitability to

protect current profitability. The consequence will be

lower future profits, fewer product innovations, and

underdeveloped human resources.

79. a. Managers bear the burden of maximizing the wealth of

their investors. To the extent that holding assets (as

opposed to selling them) results in diminished wealth,

the managers are failing in their obligation to the

shareholders. Managers may have incentives to hold

nonperforming assets if their compensation and incentives

are related to the size of the firm. Even so, managers

have an ethical obligation to pursue the maximization of

investor wealth subject to ethical treatment of other

stakeholders. This obligation is no less binding merely

because it conflicts with the managers personal

incentives.

b. Spin-offs may result in the firing of workers or the

downgrading of their jobs. Managers have a

responsibility to see that workers who are involved in

spin-offs are treated ethically. Disaffected workers

should be given all the support services necessary to

find comparable alternative employment. If possible,

workers should be given opportunities to transfer to

other operations of the company. Otherwise, workers

should be provided with employment counseling and

training necessary to finding equivalent employment with

another firm.

80. a. A lease is often found appealing by consumers because it

results in a lower monthly payment in many instances than

the monthly payment that is required to purchase a car.

This allows the consumer either to enjoy a lower monthly

payment or, for the same monthly payment required to

amortize the cost of one vehicle, pay a similar monthly

amount for a more expensive car.

b. Yes. A consumer should be provided with all necessary

information to make a fair comparison between the lease

and purchase alternative.

c. As an accountant, you could provide a financial

comparison of the lease and purchase alternatives. Using

a discounted cash flow approach, you could compare the

present value of purchasing the vehicle to the present

value of leasing the vehicle.

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