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PROBLEM 1

1. Initial cost of investment in a longer runway:


Land acquisition ...........................................................................
Runway construction ...................................................................
Extension of perimeter fence .......................................................
Runway lights ..............................................................................
New snow plow ............................................................................
Salvage value of old snow plow ..................................................
Initial cost of investment ..............................................................

$ (70,000)
(200,000)
(29,840)
(39,600)
(100,000)
10,000
$(429,440)

Annual net incremental benefit from runway:


Runway maintenance ...................................................................
Incremental revenue from landing fees ........................................
Incremental operating costs for new snow plow ..........................
Additional tax revenue .................................................................
Annual incremental benefit ..........................................................

$ (28,000)
40,000
(12,000)
64,000
$ 64,000

Internal rate of return:


Annuity discount factor associated
with the internal rate of return

=
=

initial cost of investment


annual incremental benefit
$429,440
6.710
$64,000

Find 6.710 in the 10-year row of Table IV of Appendix A. It falls in the 8 percent
column, so the internal rate of return on the runway project is 8 percent.
Conclusion: From a purely economic perspective, the longer runway should not be
approved, since its internal rate of return (8 percent) is lower than the hurdle rate (12
percent). Qualitative considerations, such as convenience for the countys residents,
should also be considered.

2. Net present-value analysis:


Runway maintenance ...................................................................
Incremental revenue from landing fees ........................................
Incremental operating costs for new snow plow ..........................
Additional tax revenue .................................................................
Annual incremental benefit ..........................................................
Annuity discount factor (Table IV: r = .12, n = 10) ....................
Present value of annual benefits ..................................................
Less: Initial costs:
Land acquisition ...............................................................
Runway construction .......................................................
Extension of perimeter fence ...........................................
Runway lights ..................................................................
New snow plow ................................................................
Salvage value of old snow plow ......................................
Net present value ..........................................................................

$ (28,000)
40,000
(12,000)
64,000
$ 64,000
5.650
$361,600
(70,000)
(200,000)
(29,840)
(39,600)
(100,000)
10,000
$ (67,840)

From a purely economic perspective, the board should not approve the runway, since its
net present value is negative. Qualitative considerations, such as the convenience of the
countys residents, should also be taken into consideration by the board.
Data that are likely to be most uncertain include the following:

Annual cost of maintaining new runway

Annual incremental revenue from landing fees

Annual additional tax revenue

Each of these data covers a lengthy time horizon. Moreover, they depend on
unpredictable factors, such as the level of economic activity in the county, the
inflation rate, and the rate of deterioration of the runway (which depends on the
weather).
The least uncertain data would likely include the following:

Cost of acquiring land

Cost of runway lights

Cost of new snow plow

Salvage value of old snow plow

Almost as certain would be the following:

Cost of runway construction

Cost of extending perimeter fence

These data all refer to the present or near future. Acquisition costs can be determined
by direct inquiry, and construction costs can be determined by obtaining estimates or
bids from contractors.

3.
Annuity discount factor associated
with the internal rate of return

initial cost of investment


annual incremental benefit

For the internal rate of return to be 12 percent, the annuity discount factor must be 5.650 (Table
IV in Appendix A: r = .12, n = 10). Therefore:
5.650

initial cost of investment


annual incremental benefit

5.650

$429,440*
annual incremental benefit

Annual incremental benefit

$429,440
= $76,007 (rounded)
5.650

*Initial cost = $70,000 + $200,000 + $29,840 + $39,600 + $100,000 $10,000


We calculate the required increase in annual tax revenue as follows:
Required incremental benefit ...............................................................
Add: Annual costs to cover:
Promotional campaign .............................................................
Runway maintenance ...............................................................
Incremental operating costs of new snow plow .......................
Total annual costs ....................................................................
Subtotal ................................................................................................
Deduct: Incremental revenue from landing fees ..................................
Required increase in tax revenue .........................................................

$ 76,007
$20,000
28,000
12,000
60,000
$136,007
(40,000)
$ 96,007

Conclusion: In order for the longer runway to be economically justifiable, the $20,000 annual
promotional campaign must result in an increase in tax revenue of $96,007 per year.
Note: Some students got $32,007 (96,007-64,000), which is also acceptable. It depends on the
understanding of the word incremental in the problem, i.e., total incremental tax revenue or the
amount incremental to the original estimate.

PROBLEM 2
1.

Interior fire-control stations:


Staff compensation (annual) ....................................................
Other operating costs (annual) .................................................
Total annual cash flow .............................................................
Annuity discount factor (r = .10, n = 10) .................................
Net present value of costs ........................................................

$ (1,600,000)
(800,000)
$ (2,400,000)

6.145
$(14,748,000)

Perimeter fire-control stations:


Staff compensation (annual) ....................................................
Other operating costs (annual) .................................................
Total annual cash flow .............................................................
Annuity discount factor (Table IV*: r = .10, n = 10)
Present value of annual cash flows ..........................................
Construction costs (time 0) ......................................................
Acquisition of equipment (time 0) ...........................................
Salvage value of half of the old equipment (time 0) ................
Demolition of old stations ........................................................
Net present value of costs ........................................................
Difference in NPV of costs
(favors perimeter fire-control stations) ......................................
2.

$ (1,200,000)
(440,000)
$ (1,640,000)

6.145
$(10,077,800)
(800,000)
(2,000,000)
480,000
(80,000)
$(12,477,800)
$ (2,270,200)

Incremental-cost approach: Interior fire-control stations


Year

Cash flow

10% factor

PV

Incremental staff
compensation

1-10

(400,000)

6.145

(2,458,000)

Other operating costs

1-10

(360,000)

6.145

(2,212,200)

Construction costs

now

800,000

1.000

800,000

Acquisition of equipment

now

2,000,000

1.000

2,000,000

Salvage value of old


equipment

now

(480,000)

1.000

(480,000)

Demolition of old stations

now

80,000

1.000

80,000

NPV
3.

(2,270,200)
Qualitative factors to be considered: effectiveness of fighting the fires, public safety,
aesthetic considerations, etc. For example, public safety might be greater with eight firecontrol stations dispersed throughout the state forest.

PROBLEM 3
1. Computation of the annual net cost savings:
Savings in labor costs (25,000 hours $16 per hour) .............................
Savings in inventory carrying costs.........................................................
Total .........................................................................................................
Less increased power and maintenance cost
($2,500 per month 12 months) .........................................................
Annual net cost savings ...........................................................................
2.
Cost of the robot ........................
Installation and software............
Cash released from inventory ....
Annual net cost savings .............
Salvage value .............................
Net present value .......................

Year(s)
Now
Now
1
1-10
10

$400,000
210,000
610,000
30,000
$580,000

Amount of Cash
20%
Present Value of
Flows
Factor
Cash Flows
$(1,800,000)
1.000
$(1,800,000)
$(900,000)
1.000
(900,000)
$400,000
0.833
333,200
$580,000
4.192
2,431,360
$70,000
0.162
11,340
$ 75,900

Yes, the robot should be purchased. It has a positive net present value at a 20% discount rate.
3.

Recomputation of the annual net cost savings:


Savings in labor costs (22,500 hours $16 per hour) ..........................
Savings in inventory carrying costs......................................................
Total ......................................................................................................
Less increased power and maintenance cost
($2,500 per month 12 months) ......................................................
Annual net cost savings ........................................................................
Recomputation of the net present value of the project:
Year(s)
Cost of the robot .......................... Now
Installation and software.............. Now
Cash released from
inventory ..................................
1
Annual net cost savings ............... 1-10
Salvage value ...............................
10
Net present value .........................

$360,000
210,000
570,000
30,000
$540,000

Amount of Cash
20%
Present Value of
Flows
Factor
Cash Flows
$(1,800,000)
1.000
$(1,800,000)
$(975,000)
1.000
(975,000)
$400,000
$540,000
$70,000

0.833
4.192
0.162

333,200
2,263,680
11,340
$ (166,780)

It appears that the company did not make a wise investment because the rate of return that
will be earned by the new equipment is less than 20%.

4. a. Several intangible benefits are usually associated with investments in automated


equipment. These intangible benefits include:
Greater variety of products.
Higher quality.
Reduction in human errors.
The value of these benefits can equal or exceed any savings that may come from reduced
labor cost. However, these benefits are hard to quantify.
b. Negative net present value to be offset

Present value factor, 10 years at 20%

$166,780
= $39,785
4.192

Thus, the intangible benefits in (a) would have to generate a cash inflow of $39,785 per
year in order for the robot to yield a 20% rate of return.

PROBLEM 4
1. Rachel Arnetts revision of her first proposal can be considered a violation of the IMAs
Statement of Ethical Professional Practice. She discarded her reasonable projections and
estimates after she was questioned by William Earle. She used figures that had a remote
chance of occurring. By doing this, she violated the requirements to Communicate
information fairly and objectively and disclose all relevant information that could
reasonably be expected to influence an intended users understanding of the reports, analyses,
or recommendations. By altering her analysis, she also violated the Integrity standard. She
engaged in an activity that would prejudice her ability to carry out her duties ethically. In
addition, she violated the Competence standardProvide decision support information and
recommendations that are accurate, clear, concise, and timely.
2. The internal controls Fore Corporation could implement to prevent unethical behavior
include:

designating a non-accounting/finance manager to coordinate capital expenditure


requests and/or segregating duties during the preparation and approval of capital
expenditure requests.

requiring the internal audit staff to review all capital expenditure proposals or
contracting external auditors to review the proposal if the corporation lacks manpower.

etc.