Professional Documents
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Capital Budgeting - Part I
Capital Budgeting - Part I
CAPITAL BUDGETINGPART I
Colgate faces lower risk than J&J because it is expanding production of an existing, and successful,
product. The major risk is that the product will become less popular and sales will not materialize. The new plant
could also be too costly, but that seems unlikely as the technology to make consumer products is well-established.
J&J faces risks that the drug will not prove efficacious, that the Food and Drug Administration will not
approve it, or that another company will develop a better drug. One reason we use this example is to make the
point that R&D is just like any other investment, except that no depreciation is involved.
Either voyage is acceptable, but most students will probably select the shorter, safer one.
A lot can happen to a ship on a long voyagestorms, piracy, or collisions with icebergs or rocks. Considering
the hazards, who wouldn't feel a lot safer tying up his or her money for one year rather than five despite the
advantage of the longer voyage as determined under the normal techniques of analysis? Whether you would
choose to invest in the one-year or the five-year opportunity depends on your attitude about risk and return.
Because of its emphasis on the rapidity of return of investment, the payback method of evaluation gives higher
priority to the one-year voyage.
1. Investment will increase because net cash flows will increase and more projects will meet DCF criteria. Some
students might ask about the value of depreciation deductions, which will fall, but after-tax cash flows from
savings or higher sales will more than offset lower tax shields.
2. Investment will increase because cost of capital will decrease. More investments will meet companies’ capital
budgeting criteria.
3. Investments will increase because cash savings from depreciation will be immediate rather than spread out
over the life of an asset. You might wish to discuss ACRS and MACRS at this point, perhaps pointing out that
lives for tax purposes are significantly shorter than economic lives for most assets.
5. Investments will increase because as labor becomes costlier, companies will substitute capital, just as in item 3.
We tried to be very explicit about the effects in this question because we have used it as an exam question and
gotten disappointing results. Most students say that investments will decrease because the company will have less
cash to invest, which ignores external financing.
7-4 Capital Budgeting Effects of Events
1. An increase in labor rates makes labor-cost-saving projects more attractive, but makes increasing output less
attractive. Increasing output might still be attractive, but not as much as it would have been with lower labor
costs.
2. First, we have to assume that we will either reduce prices to meet the competition, or lose volume. If we
expect to hold prices and lose volume, cost-saving investments become less desirable because they affect fewer
7-1
units (assuming that the savings are in variable costs). Certainly, decisions to increase output will be much less
desirable because the volume will not be as high as originally forecast.
If we meet the price reductions, decisions to increase output will be less desirable because the
contribution margin from the additional sales will be lower than otherwise. Cost-reduction investments will
probably be unaffected.
3. Investments that reduce costs become more attractive, because cost reduction is critical in mature industries.
Investments that increase output become less attractive because the volume increases will be less than anticipated.
General Note to the Instructor: The purposes of this and the following question are (a) to encourage students to
think about both the quantitative and qualitative aspects of making decisions, and (b) to reduce students'
concentration on the mechanics of specific analytical techniques. The two questions should probably be
considered together, since one deals with rejecting a project that is economically acceptable while the other deals
with accepting a project deemed economically unacceptable.
We introduce capital rationing, sensitivity analysis, and mutually exclusive alternatives in Chapter 8. We
leave to courses in managerial finance the task of discussing the significance and calculation of cost of capital and
the use of risk-adjusted discount rates. Nevertheless, we have found that, if pushed, most groups of students will
come up with ideas encompassing most of the problematic aspects of capital budgeting decisions not covered in
the current chapter. The list of reasons we offer below is not all-inclusive but generalizes the points made by past
students.
1.
a. Top-level managers might object, in principle, to owning a tobacco farm. (Chapter 5 noted that convictions of
managers could affect their decisions.)
b. Estimates about the success of the farm might vary widely and include a significant probability of a large loss.
(At this point, students might express a lack of confidence in the estimates producing the positive NPV.) The
furor over tobacco in recent years lends an air of uncertainty as to the future of the industry.
c. The company might have many other projects with higher returns and not be able to fund all projects that are
acceptable. (Students are usually quick to raise the issue of limited funds, or capital rationing.)
d. The company might use other screens for its projects, such as a minimum IRR or a maximum payback period,
and this project might not meet those cutoffs. (Chapter 8 suggests that a company might establish such cutoffs.)
2. The general note at the beginning also applies here, but this introduces some additional ideas.
a. The project involves a product the company's top managers believe is needed
to round out its product line. (This reason relates to an overall issue and
could prevail even if analysis of the project gives full consideration to
complementary effects.)
b. The project could involve a change in the manufacturing process to meet mandated pollution or hazardous-
waste disposal guidelines. (This answer assumes that reasonable alternatives for meeting the guidelines produce
lower IRRs, and that management has consciously decided the company should not abandon the area of its
business affected by the mandated guidelines.)
c. The project could involve improving employee relations (e.g., a cafeteria, a recreation facility) or some other
issue on which the company might have already committed itself to making changes with the expectation of
selecting projects with the "lowest cost." (A project showing a 20% IRR is clearly better than one showing an 8%
return.)
d. The project might advance an important strategy. If the company's reputation for high-quality products
includes a role as an innovator, the project might be accepted to retain the company's competitive edge, despite
7-2
the company's inability to quantify the advantages of maintaining that role. If reducing cycle time, or improving
logistics, is critically important, the company might well accept a project that advances such a strategy, even
without favorable numbers.
e. Managers might believe that the combination of an attractive payback period, relatively low risk, and their
gross assessments of positive and
negative nonquantifiable factors offsets its lower IRR. (Most students are likely to come up with this technique-
related answer.)
Investment $60,000
Divided by cash flow $12,000
Present value factor annuity of 8 years 5.000
Factor for 12% 4.968
Investment $120,000
Divided by cash flow $150,000
Present value factor, 2 years .800
Factor for 12% .797
1. $34,050, the present value of $50,000 five years hence at 8% ($50,000 x .681).
3. He should take the $700,000 lump sum because the present value of the annuity is only $671,000 ($100,000 x
6.710). Of course, if he lives longer, he has a serious problem.
1. Just about $8,000 $12,880 x .621, the factor for 10% and 5 years
4. 4 years $100,000/$34,300 = 2.915. This factor is nearly equal to the factor for 14% and four years, 2.914.
1. $2,220
7-3
Annual cash return $ 7,000
Times present value factor for 4-year annuity at 10% 3.170
Present value of flows $22,190
Less required investment 18,800
Net present value $ 3,390
1. $39,550
Cash Flow
Cash savings $ 50,000
Present value factor, 5 years, 10% 3.791
Present value of future flows $189,550
Investment 150,000
Net present value $ 39,550
Note to the Instructor: We stated that Ms. Pawl wanted a 10% return from the business because an
entrepreneur such as she would probably not speak of cost of capital or cutoff rates. You might want to delve into
how a small business operator might make such judgments.
1. $16,804
2. About 14%. $150,000/$44,000 = 3.409 = the factor for five years. The closest factor is 3.433, for 14%. The
IRR is therefore a bit over 14%.
7-4
4. 18.7%, income of $14,000 ($20,000 - $6,000) divided by the $75,000 average investment.
1. $107,400
Tax Cash Flow
2. NPV increases $9,540, the present value of the after-tax cash from the $25,000 residual value to be received 4
years hence ($25,000 x 60% x .636), since the company can ignore salvage value for depreciation.
Note to the Instructor: This is a good time to remind the class that the sooner flows come in, the better. The
total tax savings from the asset are the same whether or not salvage value is included in the depreciation
calculations. But leaving salvage value out accelerates the savings, which are partly repaid when the gain is
realized and taxed.
1. $86,600
Cash Flow
Cash operating savings $200,000
Present value factor, 5 years, 14% 3.433
Present value of future flows $686,600
Investment 600,000
Net present value $ 86,600
2. Nearly 20%. The factor is 3.0 ($600,000/$200,000), which is closest to
2.991, the factor for 20%. Because the 3.0 is greater than the 20% factor,
the IRR is less than 20%.
7-14 Basic Capital Budgeting With Taxes (Extension of 7-13) (10 minutes)
1. Negative $23,260
Tax Cash Flow
Cash savings $200,000 $200,000
Depreciation ($600,000/5) 120,000
Increase in pretax income 80,000
Income tax at 40% $ 32,000 32,000
Net cash flow 168,000
Present value factor, 14%, five years 3.433
Present value of future flows, rounded $ 576,740
7-5
Investment 600,000
Net present value ($ 23,260)
2. The IRR is a bit over 12%. The factor is 3.571 ($600,000/$168,000), which
is closest to 3.605, the 12% factor.
(b) C, B, A
A B C
Average income $ 1,250 $10,000 $12,500
Divided by average investment
$70,000/2 $35,000 $35,000 $35,000
Equals book rate of return 3.6% 28.6% 35.7%
A B C
Present Present Present
Year Cash Flow Value Cash Flow Value* Cash Flow Value
1 $35,000 $30,170 $35,000 $30,170 $ 4,000 $ 3,448
2 35,000 26,005 10,000 7,430 8,000 5,944
3 0 0 45,000 28,845 10,000 6,410
4 5,000 2,760 20,000 11,040 98,000 54,096
Total $58,935 $77,485 $69,898
Investment 70,000 70,000 70,000
NPV ($11,065) $ 7,485 ($ 102)
7-6
Expected cash cost [$8,400 + (40,000 x $0.10)] 12,400 12,400
Annual savings $19,600 19,600
Depreciation ($20,000/5) 4,000
Pretax income 15,600
Tax at 30% $ 4,680 4,680
Net cash flow $14,920
Present value factor, 5 years, 16% 3.274
Present value of future flows $48,848
Less investment 20,000
Net present value $28,848
At least two nonquantitative factors might influence the decision. The owner might view employing high
school students as a contribution to the community and so be inclined not to purchase the new equipment.
However, with such a high NPV, it is unlikely that he would forego the purchase. He would tend to favor the
purchase even if it appeared marginally profitable, if he had experienced problems finding reliable students.
Note to the Instructor: This exercise has several purposes. First, it requires students to determine the cost
savings, information that is provided in most other assignments. Second, it forces consideration of qualitative
issues in a setting students are likely to understand.
a. $138,880
c. About 18%, the factor for 18% is 4.494 for students using tables.
General Note to the Instructor: The purpose of this exercise is to trace the flows so that the student can see
why the IRR is the interest rate that brings the NPV to zero.
1. ($9,240)
Tax Cash Flow
Cash savings (200,000 x $2) $400,000 $ 400,000
Depreciation ($1,000,000/4) 250,000
Increase in pretax income 150,000
Income tax at 40% $ 60,000 60,000
7-7
Net cash flow $ 340,000
Present value factor, 14%, 4 years 2.914
Present value of future flows 990,760
Investment 1,000,000
Net present value ($ 9,240)
2. About 13.5% from Lotus 1-2-3. The factor is 2.941 ($1,000,000/$340,000), which is close to the 2.914 factor
for 14%.
Cost $188,640
Divided by annual cash flow $ 45,000
Present value factor for 10 years 4.192
(e) $46,080
Annual cash flow $ 45,000
Times the present value factor for 14%, 10 years 5.216
Present value of future cash flows $234,720
Less cost 188,640
Net present value $ 46,080
2. (b) $337,050
(e) $86,700
3. (a) $62,073
Cost $300,000
Divided by the present value factor, 16%, 10 years 4.833
Equals annual cash flow $ 62,073
Cost $300,000
Plus net present value 81,440
Total present value of future cash flows $381,440
Divided by annual cash flow $ 62,073
Equals present value factor for 10 years 6.145
4. (a) $100,000
Cost $450,000
Plus net present value 115,000
Total present value $565,000
7-8
Divided by present value factor for 12%, 10 years 5.650
Equals annual cash flow $100,000
Cost $450,000
Divided by annual cash flow $100,000
Equals present value factor for 10 years 4.500
1. The hand-fed machine has the higher book rate of return on average investment.
Hand-Fed Semiautomatic
Revenue (200,000 x $10) $2,000,000 $2,000,000
Variable costs at $4, $2 800,000 400,000
Cash fixed costs 725,000 850,000
Depreciation ($800,000/4; $1,400,000/4) 200,000 350,000
Total costs 1,725,000 1,600,000
Pretax profit 275,000 400,000
Income tax at 40% 110,000 160,000
Net income $ 165,000 $ 240,000
Average investment
$800,000/2 $ 400,000
$1,400,000/2 $ 700,000
Book rate of return 41.25% 34.3%
Hand-Fed Semiautomatic
Net cash flows:
Net income $ 165,000 $ 240,000
Depreciation 200,000 350,000
Net cash flow $ 365,000 $ 590,000
Present value factor, 4 years, 14% 2.914 2.914
Present value $1,063,610 $1,719,260
Investment 800,000 1,400,000
Net present value $ 263,610 $ 319,260
7-9
Hand-Fed Semiautomatic
Investment $ 800,000 $1,400,000
Divided by annual cash flows (part 2) $ 365,000 $ 590,000
Equals present value factor for 4 years 2.192 2.373
Closest factors:
25% 2.362 2.362
24% 2.404
Note to the Instructor: The above answer assumes students will limit their search for an answer to the tables
available in the text. IRR on the hand-fed machine is between 29% and 30%.
1. $2,780 thousand
Tax Cash Flow
Contribution margin [(300 x ($90 - $65)] $ 7,500 $ 7,500
Fixed cash operating costs 4,200 4,200
Pretax cash flow 3,300 3,300
Depreciation ($8,000,000/4) 2,000
Increase in taxable income 1,300
Increased taxes (40%) $ 520 520
Increase in net cash flow $2,780
2. $443 thousand
3. 14.6% from Lotus 1-2-3. For students using tables, the factor is 2.878 ($8,000/$2,780), which falls between
the values for 14% and 16%.
$1,390 thousand
7-10
Total present value of future flows 5,890
Less investment 4,500
Net present value $1,390
Note to the Instructor: This assignment doesn't get into the details of benefits that JIT provides, but it can
serve as a basis for discussing JIT operations and how to measure some of their benefits. The $800 thousand
stated savings can come from any number of areas including lower material and labor costs, and lower costs for
such support activities as inspection, materials-handling, maintenance, and production scheduling. Some of these
costs are relatively easy to estimate and some are not. Among the costs of quality that should drop are the costs of
warranties, field engineering, and other elements that result from having less than superb quality.
Other qualitative factors that managers should consider include higher productivity as workers become more
involved and more satisfied, and higher sales because of increased quality. The importance of any such factor
depends on how well the company was doing before. In some cases the incremental benefit could be quite high,
in others relatively low.
2. The items covered in students' memos will differ, but the most likely recommendation is to install the
equipment despite its negative NPV. Memos should include some of the following items.
(a) The analysis understates the cost savings because it does not consider the potential for liability claims if
employees are injured (or worse). The analysis should include some estimate of the potential savings from not
increasing the potential losses in lawsuits brought by injured employees.
(b) The increased potential for injury to employees should be, in itself, a consideration in the decision. Moreover,
the cost to the company is relatively small. (The cost of the new system is $200,000, suggesting a much larger
value for the building and its contents, and this factory is only one of several owned by the company.)
(c) Another factor to consider in connection with the increased potential for injury to employees is the potential
for damage to the company's public image and reputation if the public became aware that the company refused to
install new equipment.
(d) The cost savings are likely to be understated by assuming that the premium differential this year applies to all
future years. If installation of a new system is delayed, premiums might increase even further, and, at some point,
coverage might not be available at virtually any price.
Note to the Instructor: In this slight revision of a problem used in previous editions, we tried to make obvious
the issue of risk of harm to employees by describing the insurance coverage and asking specifically about "other"
factors. It's likely that a few students still will not recognize that issue. Some who do see it will point out that
$8,051 is a small price to pay for a serious injury, let alone the life of even one employee. Such an assertion
presents the opportunity for class discussion of the many situations when efforts are made to place a value on a
human life (e.g., court cases and allocations of funds available for medical services).
7-11
Students should be encouraged to avoid making quick personal judgments about the relative size of some
known expenditure (or receipt). Such judgments are especially to be avoided when, as indicated in the
parenthetical material in item (b), facts are available to support at least a preliminary assessment of relative
magnitude. In this case, a preliminary assessment reduces the need to address the more general--and more
difficult--task of placing a specific value on human suffering. Absent analytical evidence that the cost is
"relatively small" for the entity in question, a student's assertion to that effect is a personal matter. For example,
had the negative NPV been, say, $200 million, individual judgments would surely have differed.
Professor Don Lucy shared with us a suggestion by one of his students that the company tell employees it is
spending $200,000 to make them safer.
1. Bob prefers the $2,000,000 for 10 years at his 10% discount rate.
30 years 10 years
Pretax flow $1,200,000 $2,000,000
Less tax at 30% 360,000 600,000
After-tax flow $ 840,000 $1,400,000
Present value factors 9.427 6.145
Present value $7,918,680 $8,603,000
Advantage to 10-year term = $684,320
2. The team prefers $1,200,000 for 30 years at its 14% discount rate.
30 years 10 years
Pretax flow $1,200,000 $2,000,000
Less tax at 40% 480,000 800,000
After-tax flow 720,000 1,200,000
Present value factors 7.003 5.216
Present value $5,042,160 $6,259,200
Advantage to 30-year term = $1,217,040
3. Bob wants a higher present value and the team wants a lower present value. It's not surprising that their
interests are opposed. The team's higher discount rate leads it to prefer lower flows over a longer period, and its
higher tax rate works in the same direction. Even if they used the same discount rate, their responses could differ
because of the tax differences.
Note to the Instructor: You might extend this assignment by asking whether the team might benefit by raising
the 30-year payment so that Bob would prefer it to the 10-year term. The 30-year payment that would make Bob
indifferent between the choices is $325,926.
The $5,477,898 present value is less than the $6,259,200 of the $2,000,000 for 10 years, so the team could pay
more than $1,303,702 over the 30 years and be better off. The maximum that the team could pay over 30 years is
$372,411.
7-12
Divided by 60% = maximum pretax payment $1,489,647
1. Negative $1,434
Tax Cash Flow
Savings in cash operating costs $30,000 $ 30,000
Less depreciation, $100,000/5 20,000
Increased taxable income 10,000
Income tax at 40% $ 4,000 4,000
Net cash flow $ 26,000
Present value factor, 5 years, 10% 3.791
Present value of future cash flows $ 98,566
Investment 100,000
Net present value ($ 1,434)
Year
1 2 3 4 5
* Net cash flow equals operating savings less tax expense (plus tax saving)
Note to the Instructor: Instructors who, like the authors, prefer that students not spend time on the
computational details associated with MACRS or other accelerated depreciation methods can assign this problem
to illustrate the principle of increased NPV.
1. $286,000
Tax Cash Flow
Increase in contribution margin (10,000 x $52) $520,000 $520,000
Increase in cash fixed costs 180,000 180,000
Increase in taxable income before depreciation 340,000 340,000
Increase in depreciation ($800,000/5) 160,000
Increase in taxable income 180,000
Increase in income taxes at 30% $ 54,000 54,000
Increase in after-tax cash flow $286,000
4. $181,838
7-13
Less investment 800,000
NPV $181,838
5. (a) BDR should not use the 11% interest rate to determine the present value. A return sufficient only to cover
the cost of a specific debt-funding source provides no return to the stockholders, and the company must earn a
satisfactory return for all its investors, both creditors and stockholders. Note also that the source of debt capital
for a specific project seldom will provide 100% of the funds needed for an investment, which means owners must
provide the rest and will expect a return on their investment. Moreover, both creditors and stockholders monitor a
company's solvency by watching such factors as the ratio of debt to equity, and the cost of obtaining capital from
either source is likely to rise as a company takes on more debt.
(b) BDR should not include the annual interest payments in computing annual cash flow. Discounting
provides for both return of capital and a return on capital at least equal to the discount rate. Including interest
in the cash flows would provide twice for the cost of funds.
Note to the Instructor: In covering requirement (a) we try to avoid extended discussion of the concept of
cost of capital. One idea that seems to make sense to introductory students is that money is a fungible good.
Applying this idea, a company obtaining funds from a variety of sources has a pool of money, no part of which is
identifiable by its source.
To avoid questions that might be raised later by students studying real estate, we usually point out, after
covering (a) and (b), that the analysis of single-project real estate investments for potential equity investors is a
special case of investment evaluation.
6. (a) If the applicable tax rate is constant, accelerating depreciation for tax purposes does not change the total
taxes paid. However, the higher tax deductions in earlier years would shift the cash outflows for taxes to later
years, so the present value of the cash outflows would be lower and the NPV of the project higher.
(b) The payback period would be shorter because the net cash inflows would be higher in earlier years of the
project's life.
Waddlum's major concern is how long he will live after retirement. Spending $80,000 per year, he will go
broke in the ninth year if he takes the lump-sum payment. Thus, if he lived longer than nine years, he would be
better off taking the $60,000 per year and living less comfortably than he prefers.
7-14
If he took the lump-sum payment, he would use $80,000 for expenses the first year, leaving $420,000 to be
invested at 10%. That investment allows nine withdrawals of $80,000, determined as follows.
Investment $420,000
Divided by annual withdrawals $ 80,000
Equals present value factor for annuity 5.25
The number of periods in the 10% column with the factor closest to 5.25 is eight (a factor of 5.335), which means
he could make nine withdrawals of $80,000 (including the first) plus one of about $65,000 in the last year. The
$80,000 used immediately, plus the eight future withdrawals covers nine years of retirement.
Note to the Instructor: This problem was made relatively simple by leaving out the many other options. For
example, pension plans provide for payments to survivors after the death of the retiree. Class discussion of this
exercise can emphasize how very difficult real-life decisions can be where an estate or other provision for
survivors is desired. Still, determining the number of years you can live as you wish from the lump-sum
investment seems to us a sensible first step in evaluating the options.
3. About 12.4% from Lotus 1-2-3. Students using tables will see that the rate is about 12%. The factor 3.57 lies
just below 3.605, the factor for 12%.
The memo should present a recommendation to buy the pumps and the NPV of the purchase alternative (shown
below). The memo could also include a brief comment on the implications of a change in the lease payments.
Lease pumps
Revenue $2,400
Operating expenses $550
Lease expense 850
Total expenses 1,400
Income before taxes $1,000
7-15
Buy versus lease
Tax Cash Flow
Annual lease savings $850 $ 850
Less depreciation ($1,500/3) 500
Increase in taxable income 350
Increase in income tax (40%) $140 140
Net cash flow $ 710
Present value factor, 3 years, 10% 2.487
Present value of future flows $1,766
Less investment 1,500
Net present value in favor of buying $ 266
Note to the Instructor: The chapter points out that financing and investing decisions should be separated. This
is an apparent exception, though we do not view a year-to-year lease as a financing arrangement. Note also that
the company has already decided to acquire the air pumps. Moreover, revenues exceed operating costs and lease
payments, so acquiring the pumps is profitable. Hence, the only question is how to acquire them. (Some students
will not see this point and will spend time trying to develop separate NPV analyses for the two alternatives.)
1. $976,404 ($6,000,000/6.145, the present value factor for a 10-year annuity at 10%)
2. The lump sum, because her discount rate is lower than the university's.
7-16
2. A 250,000 increase in volume is enough to justify the investment.
Note to the Instructor: You might wish to point out that requirement 2 can be solved by looking at differences.
The additional 50,000 pairs give:
7-17
Year Cash Flow After-Tax PV Factor Present Value
This assignment differs from others in that it does not have a single investment at time zero. Students should still
see that the NPV is the present value of all cash flows. For convenience, the chapter refers to future flows and
investment.
1. The center should be built; the net present value of the project is
$3,893,400.
7-18
1. The capital-intensive process gives the higher income.
Labor Capital
Intensive Intensive
Sales (100,000 x $50) $5,000,000 $5,000,000
Variable costs at $20, $10 2,000,000 1,000,000
Contribution margin 3,000,000 4,000,000
Fixed costs* 1,400,000 2,100,000
Taxable income 1,600,000 1,900,000
Income taxes (40%) 640,000 760,000
Net income $ 960,000 $1,140,000
4. The memo should report the NPVs of the two alternatives and express a
preference for the labor-intensive process because of its higher NPV. The
memo should also note the relatively small difference between the NPVs and
urge further consideration of qualitative factors that might tip the decision
one way or the other. The memo should emphasize that the preference was based on NPV rather than book rate of
return, and it could point out that book rates of return overstate the differences between the two alternatives.
7-19
Present value of salvage value ($300,000 x .552) 165,600
Total present value of investment 1,142,662
Investment 1,200,000
Net present value ($ 57,338)
7-39 Reevaluating an Investment (20 minutes)
An analysis using discounted cash flow techniques shows that the investment was unwise. Both NPV and IRR
suggest the same answer.
Note to the Instructor: It's important to point out that the wisdom of
the original investment decision has no bearing on whether the machinery
should be replaced now. Similar machinery purchased now might yield a return
greater than 16%. What can be said is that if the machinery available now
would cost $250,000, have a 10-year life with no salvage value, provide $69,000 in savings, and be depreciated
using the straight-line method, it is unwise to buy it, though just barely.
2. $1.04037
7-20
Divided by annual maximum purchases 1,000,000
Equals required savings per pound $ .24037
Plus price of copper from Boa .80000
Equals required market price $ 1.04037
Note to the Instructor: We use the term "relevant discount rate" because the loan is a relatively riskless
investment, or at least one that is less risky than those normally encountered by the firm. The discount rate should
probably be the cost of capital, but using a lower rate might be desirable depending on the credit worthiness of
Boa Company.
One could also argue that this type of investment is extremely risky taken as a whole because its success
depends on estimates of the prices of a raw material the price of which is known to fluctuate greatly. The problem
provides the opportunity to discuss how managers might predict future prices of copper and to lead into the topic
of sensitivity analysis in Chapter 9.
1. No, $50 is less than the present value of two $28 payments.
The assumption of 100% renewals for the second year is critical to seeing
the question as a comparison of the present values of two cash inflow options. Both the costs and the quantity
sold (number of subscription-years) are the same for the two subscription plans. Hence, the magazine has no
reason to offer the extended subscription at a rate that is not equivalent to what it would receive from a one-year
subscription plus renewal.
3. Yes, the NPV is $310.70 with the two-year subscription, $276.44 with the one year. The $50 rate increases
total volume enough to offset the expected
loss of subscriptions after the first year. The calculations below use a
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batch of 10, as suggested in the assignment.
4. About $46.57. This part requires restating the two-year analysis above
with the NPV of the one-year subscriptions as the required NPV.
Note to the Instructor: The situation in this assignment is familiar to students and to anyone else on mailing
lists. You might point out that advertising is a major source of revenue to magazines and that advertising rates
depend to a great extent on paid circulation. Therefore, the magazine could earn more, by way of higher ad rates,
if offering a bargain two-year rate keeps subscribers for a longer time. The company in this problem might be
able to offer a two-year rate even lower than the $46.57 computed in requirement 4 determined that the higher
advertising rates commanded by the higher circulation would offset the lower rate.
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Present value of future flows $22.60
Investment 6.50
Net present value $16.10
The memo should report that (1) accepting the order is wise even if the
company cannot increase capacity; (2) the NPV of undertaking the expansion is
a negative $10,742; and (3) the proposed limited expansion is probably unwise because it allows the company to
recover only the 10,000 units of regular sales lost by accepting the order.
* Capacity of 230,000 units - 40,000 for special order = 190,000 for sales
at regular prices.
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Net cash flow $ 882,000
Present value factor, 10 years, 14% 5.216
Present value of future flows $4,600,512
Present value of salvage** ($100,000 x .60 x .270) 16,200
Total present value 4,616,712
Investment 3,000,000
Net present value $1,616,712
**Residual value is taxable because the full cost was depreciated over the
project's useful life.
(a) The existing fixed manufacturing costs allocated to the new product are
sunk and irrelevant. Only the $200,000 incremental amount is relevant.
(c) The $900,000 already spent for research and development is a classic
example of a sunk cost and is irrelevant.
(d) Barker ignored the salvage value, though it should be included in the
calculation. The item is not large in this case, but it could be significant
in another.
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